International financial management

Prof. S.Jayapandian

IFM is the application of the principles of financial management to cross border businessesCross border businesses are>trade>set up—marketing, servicing and

production

Corporates dealing in cross boarder businesses are “multi-national companies”MNCs

MNC

Multinational company is one which has operating subsidiaries, branches or affiliates located in foreign countriesIt should have at least 5-6 subsidiarieswith strategic interaction to be recognised as

MNC.

Purposes of multinational dealings

>Exploring Market >Seeking Raw material

>Minimizing Cost

Mode of operation

Direct sale to consumersConsignment LicensingFranchising Opening BranchesEstablishing SubsidiariesEntering into Joint ventures

Why cross border business?

Adam Smith(1776)“If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the product of our own industry employed in such a way in which we have some advantage”

Countries due to their specific ecological, ethnical and climatic conditions are advantageously placed for the production of certain goods. It would be to the advantage of all concerned if each concentrates on its advantage and exchange with other countries goods which they could produce advantageouslyeg. Assuming same currency for US and Canada and both the countries can produce both wheat and oranges, but at different costs

Wheat OrangesUS –requirements (kgs ) 10m 15 mCost of production-kg($) 0.2 0.05Total cost $ 2,000,000 750,000Total = $2,750,000CANADA- requirements (kgs) 8M 10MCost of production-kg($) 0.25 0.03Total cost $ 2,000,000 300,000Total = $2,300,000Cost for both countries = $ 5.05mIt could be seen that US has an edge over Canada in the production of wheat, where as Canada has advantage inthe production of orangesSuppose US concentrates on wheat and Canadaon oranges and they exchange, then

US wheat cost for 18mkgs =$3.60 mCanada oranges cost for 25mkgs =$0.75 mTotal for both =$ 4.35m(5.05m)Total cost saving =$ -0.70mUS exchanges wheat @ $.21 =$1.68mCanada exchanges orange$.03 = $.45mCost for US= -3.6+1.68 -.45 =$2.37 (2.75m) Cost Savings =$ - 0.38mCost for Canada =-0.75-1.68 +0.45 =1.98m(2.3m)Cost Savings =$ - 0.32mMutually advantageous .Multinational trade would take place.

Process of internationalisation-FDI

Domestic production > export >licensing or establishing sales subsidiaries > providing service service > establishing distribution system > establishing production abroad >ceasing local production

Theories of internationalising market imperfections theory—product differentiation transaction cost theory –domestic R&D, high cost eclectic theory –firm specific and location specific

advantages and internalising product life cycle theory –1.R&D, 2.product

introduction in home market 3. growth stage –EXPORT 4.Setting production-maturity5.Importing from advantageous locations/closing domestic production

Exchanges between countries result in either surplus or deficit to countriesHow to pay for or receive the deficit or surplus?Not by the deficit countries’ currency.Search for internationally acceptable means of paymentChoice fell on precious metals—gold and SilverEmergence of international monetary systems

International Monetary System

Set of policies, institutions, practices, regulations and mechanisms that determines the rate at which one currency is exchanged for other.

Evolution of the International Monetary System

• Bimetallism: Before 1875• Classical Gold Standard: 1875-1914• Interwar Period: 1915-1944• Bretton Woods System: 1945-1972• The Flexible Exchange Rate Regime:

1973-Present

Bimetallism: Before 1875

A “double standard” where both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. Some countries were on the gold standard, some on the silver standard, some on both.

Classical Gold Standard: 1875-1914

During this period in most major countries:– Gold alone was used for coinage– There was two-way convertibility between

gold and national currencies at a stable ratio.– Gold could be freely exported or imported.

The exchange rate between two country’s currencies determined by their relative gold contents.

Dollar was pegged at U.S.$30 = 1 ounce of gold British pound pegged at £6 = 1 ounce of gold.The exchange rate between $ and £ wasdetermined by the relative gold contents:$=30ounce = £ =6ounce. i.e.. 30 :6 = $5 = £1

EXAMPLE

Countries on gold standardCountries From 1.UK2.GERMANY3.SCANDINAVIAN COUNTRIES4.FRANCE,BELGIUM,SWIZ,ITALY,GREECE5.HOLLAND6.URUGUAY7.US8.AUSTRIA9.CHILE10.JAPAN11.RUSSIA12.DOMINICAN REPUBLIC13.PANAMA14.MEXICO

1816-1914,1926-19311871-1913,1924-193118731874187518761879-19711892189518971898190119041905

Advantages

>Highly stable exchange rates >Provided environment conducive to

international trade and investment>Misalignment of exchange rates and

international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

Price-Specie-Flow MechanismSuppose Great Britain exported more to France than France imported from Great Britain.This cannot persist under a gold standard.

– Net exports of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain.

– This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain.

- The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France. - reverse flow of gold; equilibrium restored

Shortcomings of gold standard:

– The supply of newly minted gold is so limited that the growth of world trade and investment was hampered on account of insufficient monetary reserves.

– It is delicate system-a fair weather craft of doubtful sea worthiness on stormy.

– Gold standard was sinned against than sinning

Inter-war Period: 1915-1944Exchange rates fluctuated as countries widely

used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market.

Attempts were made to restore gold standard, but participants lacked the political will to “follow the rules of the game”.

Result :international trade and investment was profoundly affected.

Bretton Woods System: 1945-1972

>meeting of 44 nations at Bretton Woods, New Hampshire in 1944>to design a post-war international monetary system.>goal was stability in exchange rate without gold

standard.>result - creation of IMF and IBRD (World Bank).

Bretton Woods System: 1945-1972

>Under the Bretton Woods system, U.S. dollar pegged to gold at $35 per ounce and other currencies pegged to the U.S. dollar.

>Each country responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves($ or gold) where necessary.

>Bretton Woods system was a dollar-based gold exchange standard.

Bretton Woods System: 1945-1972

German markBritish

poundFrench franc

U.S. dollar

Gold

Pegged at $35/oz.

Par Value

Par ValuePar

Value

Collapse of fixed exchange system

>Pressure to devalue dollar led to collapse >President Johnson financed Vietnam war by printing

money, resulting in high inflation and high spending on imports

>August 8, 1971, Nixon announced dollar no longer convertible into gold.– Countries agreed to revalue their currencies against the

dollar– March 19, 1972, Japan and most of Europe floated their

currencies– In 1973. Bretton Woods failed as key currency (dollar) was

under speculative attack

The Flexible Exchange Rate Regime: 1973-Present.

• Flexible exchange rates were declared acceptable to the IMF members.– Central banks were allowed to intervene in the

exchange rate markets to iron out unwarranted volatilities.

• Gold was abandoned as an international reserve asset.

• Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

Current Exchange Rate Arrangements

• Free Float – largest number of countries, about 48, allow market forces to

determine their currency’s value.• Managed Float /selective intervention

– About 25 countries combine government intervention with market forces to set exchange rates.

• Pegged to another currency – Such as the U.S. dollar or euro.-Dubai, Singapore

• No national currency– Some countries do not bother printing their own, they just

use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

European Monetary System• Eleven European countries maintain exchange

rates among their currencies within narrow bands, and jointly float against outside currencies ( Target–Zone–Arrangement)

• Objectives:– To establish a zone of monetary stability in Europe.– To coordinate exchange rate policies vis-à-vis non-

European currencies.– To pave the way for the European Monetary Union.Euro was introduced as the currency

Balance of PaymentsThe Balance of Payments is the statistical

record of a country’s international transactions over a certain period of time presented in the form of double entry book-keeping.

Components of BOP• Current Account (CA) and • Capital/Financial Account (KA)• Official Reserves Account

.

Balance of PaymentsThe BP includes three accounts:

(1) current account—a record of all merchandise exports, imports, and services plus unilateral transfers of funds;

(2) the capital account—a record of direct investment, portfolio investment, and short-term capital movements to and from countries;

(3) the official reserves account—a record of exports and imports of gold, increases or decreases in foreign exchange, and increases or decreases in liabilities to foreign central banks;

The Current Account• Includes all imports and exports of

goods and services.• Includes unilateral transfers of foreign

aid.• If the debits exceed the credits, then a

country is running a trade deficit.• If the credits exceed the debits, then a

country is running a trade surplus.

The Capital Account• The capital account measures the

difference between the country’s sales of assets to foreigners and the country’s purchases of foreign assets.

• The capital account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

The Official Reserves Account

Official reserves assets including gold, foreign currencies, SDRs , reserve positions in the IMF.It is the means of settling international indebtedness

The Balance of Payments Identity

BCA + BKA + BRA = 0whereBCA = balance on current accountBKA = balance on capital accountBRA = balance on the reserves account

Are trade deficits a problem?

• A trade deficit is not necessarily a bad thing (e.g. when growing domestic industries attract foreign investments)

• However, if a country persistently runs a trade deficit this is something to worry about (e.g. vulnerability to loss of foreign investors’ confidence)

• Current account deficit reflects a shortage of saving over investment; current account surplus reflects an excess of saving over investment.

• Any current account deficit must be matched by an equal capital account surplus, and vice versa.

Data on India’s merchandise trade and commodity-wise details furnished by the Directorate General of Commercial Intelligence and Statistics (DGCI&S)

It is also available in RBI reports

Table 1: India’s Merchandise Trade:

April-December

(US $ million)

Items 2005-06 R 2006-07 P

Exports 73,382 89,543

(29.9) (22.0)

Imports 105,101 131,178

(37.8) (24.8)

Oil Imports 31,477 43,825

(46.9) (39.2)

Non-Oil Imports 73,624 87,353

(34.3) (18.6)

Trade Balance -31,719 -41,635

P: Provisional; R: Revised.Figures in parentheses show percentage change over the previous year.Source: DGCI&S.

What is forex?Foreign Exchange means the rate at which a country’s currency is exchanged for another country’s currencyEg.Rs.40.37 = $1Exchange market is the arrangement for determining and buying and selling of different currencies Players in exchange markets are>Banks>Central bank>Exchange brokers and>Users

Typesof transactionsDealingSpeculatingArbitrage Terms: Bid (buy) and Ask/ offer (sell)

How quotedIn Rupees£ = Rs.82.00 / 83 .53$ = Rs.40.400/ 41.44€ = Rs.55.4005/56.49SF=33.5437/ 34.61First is buy rate; second sell rateTwo way quote =market makersQuotes are among bankersSpread is their marginSpread= Difference/Buy rate*100Exercise=work out margin on the above quotations

Spread%

£ = Rs.82.00 /83 .53 =1.87%$ = Rs.40.400/ 41.44 =2.57%€ = Rs.55.4005/56.49 =1.97%SF=33.5437/ 34.61 =3.18%

Ways of quoting American quote :how many units of homecurrency is exchangeable for one unit of foreign currency---direct quoteIn India, Rs.40.56/ 40.95 = 1 $ =AQEuropean quote: how many units of foreign currency is exchangeable for one unit of home currency---indirect quoteIF 1 Re quoted at $0.0246 / 0.0216 = EQNote :in indirect quote, sell rate would be less

than buy rate- why?

Exercises

1. in London =Rs.83 per £2. In Swiss =SF1.25 per$3. In Dubai = DH 3.75 per $4.In Singapore =S $ 3.15 per £5. In France = $1.76 per FFCould you identify which of the quotes are

AQ and EQ?

Types of rates

1. Spot rates2. Forward rates3. Cross ratesSpot rate is the rate prevailing on a particular point of time.Delivery of spot deal is 2 days

WHAT IS CROSS RATE?

Usually countries quote the exchange rates of other countries in relation to their currencies. The exchange rate among the countries’ currencies, worked out from the quotations, is the cross rate

.Rupee Pound Sterling 89.54. –89.74Rupee Dollar 43.90 – 44.25A wants to find out how many units of $ a £could buy, or buy rateof $ for a £.He could sell a £ for Rs.89.54, with the proceed buy $@ Rs.44.25 = $2.0235- buy rateIf he wants to know the sell rate of $ for a £,he could sell $ @ Rs.43.90 and with the proceeds buy £ @Rs.89.74 . He needs =$ 2.0442 to get a £--sell rateThe cross rate = 2.0235 / 2.0442Cross rate could also be worked out mechanically by crossing the rates

Rupee Pound Sterling : . 89.54. –89.74

Rupee Dollar : 43.90 – 44.25.

Note: currency to be exchanged is denominatorCross rate of $ to £= 89.54 / 44.25 89.74 / 43.90 =2.0235 / 2.0442 .

Cross rates -examples

Rupee Pound Sterling : 89.54 – 89.74Rupee Dollar : 43.90 – 44.25Rate (value) of $ to a ₤ =$2.0235 -2.0442Rupee Dollar : 43.90 – 44.25Rupee Pound Sterling : 89.54 – 89.74Rate (value) of ₤ to a $ = ₤ 0.489 - 0.494

Work out cross rate of SF to € and € to SF

INR SF Rs.31.40/34.55INR € Rs.52.60 / 56.85

SF to € = 1.52 / 1.81€ to SF = 0.55 / 0.66

UTILITY OF CROSS RATECross rates between two centers would reveal opportunities for arbitrage. Arbitrageurs would first work out the cross rate between two centers for a currency and buy in cheap center and sell in dear center and in the process brings about equilibrium rates. Eg.Quotation for € and $ in India€ and Re =Rs.55.85$ and Re = 40.40In London, £ is quoted at $ 2.02 and € 1.50Cross rate of € in India per $ = 40.40 / 55.85 = 0.72337 and in London =1.50 / 2.02 = 0.7426Arbitrageur finds € per $ is cheap in London compared to India.

He would buy for a $, € 0.7426 in London, sell the€ in India @ 0.72337 and realise s $ 1.02658(.7426 / .72337) and makes a gain of $0.02658 per $ transaction.Gain would induce demand for € in London (supply of $ ) and in India supply of € (demand for$ ). € would strengthen against $ in London and weaken in India till equilibrium reached. Alternatively, arbitrageurs could also work out crossRate of $ per € in India at $1.3824(55.85 / 40.40) and in London at $1.347(2.02/1.50).$ cheap in India. Buy $ for € in India(1.3824) and sell in London @1.347,realise.€1.02628 Gain € 0.02628 per€ transaction.

Find out whether there is opportunity for arbitrage when

Exchange Rate in India: Japanese ¥(1000) = Rs.310 and Swedish Kroner =Rs.5.50In New York: $7.67 per ¥(1000) and $ 0.136 per SK

Cross rate in IndiaS. Kroner 56.36 = ¥(1000) Cross rate in New YorkS. Kroner 56.40 = ¥(1000)S. Kroner per ¥(1000 is cheap in NYBuy SK at 56.40 in NY for ¥(1000), sell in India @ 56.36 and realise 1.0007 ¥(1000) . Profit per ¥(1000) = 0. 0007 ¥(1000)in NY,Demand for SK would strengthen SKand supply of ¥(1000) would weaken ¥(1000).In India, supply of SK would weaken its rate and demand for ¥(1000) would strengthen it ,till Equilibrium reached

FORWARD RATE

Forward contract is “an agreement to buy or sell a certain quantity of a country’s currency, at a predetermined rate in terms of home currency, on a specified date.

Purpose OF FORWARD RATE

> Traders to hedge> Speculators to benefit by risk takingArbitrageurs to make money without taking

risk by matching differences in different markets.

Bankers to square their position

Bankers square their position

1.By reducing the quote, when in excess buy position

Eg. From 40.90 – 41.25 per dollar, to say 40.75-41.10

2. When in excess sell, by increasing the quoteEg. From 40.90 – 41.25 per dollar, to say 41.05-

41.40How it works?

Forward Rate Quotes 1.Outright F Rate = exact rate eg. 3 months forward rate

for $=Rs.40.90 – 41.25 2.Swap rate = quoting either at premium or at discount.Eg: Rupee $ spot = 40.653 months forward Outright rate = 40.45Formula for calculating swap: Swap rate= Forward Rate– Spot rate x 12 X 100 Spot rate contracted months= 40.45 – 40.65 x 12 x 100 = - 1.97%

40.65 3Swap rate =- 1.97

Exercises: Work out swap rates in the following

Currency Spot rate Rs

3 months F. rate Rs

Sterling £Euro €Swiss francUAE DH

78.7052.6031.4010.50

80.2053.8530.5511.05

SOLUTION

• Sterling £ == 7.62%• Euro € == 9.51%• Swiss franc== -10.83%• UAE DH ==20.95%

Exercises: Work out outright quotes for 3 monthsin from swaps

Currency Spot rate Forward swap%

Sterling £Euro €Swiss francUAE DH

78.7052.6031.4010.50

6%-8%-10%12%

outright forward rates

Sterling £ =78.70* 1.015 = 79.88Euro € = 52.60* .98 = 51.55 Swiss franc = 31.40 *.975 = 30.615UAE DH = 10.50 * 1.03 = 10.815

Factors destabilising exchange rates

Differential rates of interest between countries

and differential inflation rates between countries

Or both

Forward rate would be equal to spot rate if the rate of interest and rate of inflationbetween countries remain the same. First consider rate of interest (and assuming inflation rate to be same). $ spot rate Rs.40.35. Rates of interest in India and US are same at 6%.A trader requires 3 months forward dollar to pay for imports. He could enter FC or buy and holdif Forward rate differed from Spot rate.

How he does it?

He could borrow Rs.40.35 at 6 %in India for3 months ,buy $ at spot rate (40.35),and invest in US at 6% for 3 months.At the end of 3 months, he would realise $1.015 and the cost in India =Rs.40.95525$1.015 = Rs.40.95525$1 = 40.35Spot rate and forward rates remain same

Spot rate and forward rate differ due to different rates of interest between countries

In the same example, if the rate of interest in India is 8% and in US 6%, then the difference in the rates would get reflected in the forward exchange rate. 3 months forward rate would be the difference in interest rates * spot rate or1.02 / 1.015 *40.35= Rs.40.55The formula for forward rate is thereforeFR = (1+rh) / (1+rf) *SRExercise: confirm the forward rate through the buy and

hold route

Borrow a $ in US at 6%, convert into rupee = Rs.40.35 Invest in India for 3 months= Rs.41.157US borrowing at the end of 3 months =$1.015$1.015 = 41.157$ 1 = Rs.40.55

EXERCISESWork out, with interest rates of 6% in India, threemonths forward rate for 1. £ with 7% in UK. Spot rate for £ is Rs.84.202.$ with interest rate of 5%. Spot rate is Rs.40.353.DH with interest rate of 8%.Spot rate is

Rs.11.40

3 months Forward rates

£= (1.015 / 1.0175)* 84.20= 83.99$ = (1.015 / 1.0125)*40.35= 40.45DH= (1.015 / 1.02) * 11.40= 11.34

FR and the SR on the date of expiration of forward contract, tend to be same. UBFR is equilibrium rate .If FR is different from UBFR, there will be mismatch in the rate of a currency between two quotes. This mismatch offers opportunity for arbitrage profits.This opportunity is covered interest arbitrage Arbitrageurs would step in and bring backEquilibrium rate .How this happens?

Example Spot $ =Rs.40.35-3 months forward Rs.40.25Interest rates-- India 8% US 6%Arbitrageur would work out UBFR ,which in this case is Rs.40.55Official FR at 40.25 is biased. In Forward $ is quoted weak against Rupee. Arbitrageurs would buy $ in forward marker at Rs.40.25 and cash it on expiration date at Rs.40.55,which would be the spot rate on strike date. Or he would take the investment route

Arbitrageur could borrow $1m @6% for 3 monthsin US, convert at spot rate into Rs.40.35m in India, invest in India for 3 months and cover the proceeds (Rs.41.157m) in forward market into$1.0225341m at the official FR.At the end of 3 months, his loan amount would accumulate to $1.015m.His net gain $0.0075341 m in 3 months for an investment of $1m.Lesson: when the rate of interest in a country is higher than that of another, it would attract moreforeign investment and it would become strong inthe spot, but weak in forward .

Consequences :Initial REACTIONS• Rupee will become strong in spot- more supply of

spot $ and more demand for spot rupee• $ will become strong in forward market-more

demand for forward $ and more supply of forward rupeeConsequential Effects 1.Demand for $ would increase in US and rate of interest in US would rise.2.Supply of money would depress interest rate in India .Till equilibrium rate (of Rs.40.55 ) is reached.Arbitrage is thus the price discovery mechanism

Ascertain covered interest arbitrage opportunity in the following

India-Rs US -$ UK - £ UAE- DH

Spot rate 3 months forward Rate of interest 6%

40.35 84.20 11.4040.25 85.45 10.207% 5% 8%

1.In $ no opportunity2. In £, UBFR =84.41as against FR of 85.45—arbitrageurs would sell F £ till rate reached UBFRIn DH, UBFR = 11.344as against FR of Rs.10.20–arbitrageurs would buy F $ by paying Rs10.20 and encash it at Rs.11.344 on expiration date. Or take the investment route. Transactions would continue till UBFR reached

Exercise

Spot rate of exchange in India is Rs 44 to a dollar and a three months forward rate is Rs.43. Interest Rate in India changes from 6% to 7% as against the rate of interest in US, which remained at 6% .How does an arbitrageur act and restores equilibrium

1 m. Dollar borrowed in US would be $1.015 in 3 months. $1m ; converted at spot rate into Rs.44m; invested @7%= Rs. 44.77 m in 3 months, covered in forward @43 = $1.04116m =profit of $0.02616m.Profit spurs investment into India. Spot rupee demand increases and spot rate moves up. Demand for $ in US Would increase US interest rate. Inflow of funds would reduce interest rate in India. Forward $ would become stronger till equilibrium reached. Covered interest rate arbitrage would remove bias.

Determinants of exchange rate

In the Short run, supply and demand In the Long run, purchasing power parity as

impacted by >Change in rates of interest<Change in rates of inflation< Both.

Demand >Trade- payment for imports>Payment for services availed of>Transfers of foreigners living in a host country>Tourists visiting other countries, business trips,

education abroad>Payment of interest and repayment of

borrowings>Investment abroad>Payment of dividend and repatriation of capital>Donations , gifts and lines of credit

Supply>Export receipts>Receipts for services rendered abroad>Remittances by non-residents abroad>Tourists from other country>TransfersReceipt of interest and loan already made abroadForeigners investing in the host countryReceipt of dividend and principal from abroadGifts and donations received from abroad

In the long run, exchange rate is determined by their relative purchasing power in their countries caused by <Change in rates of interest--<Change in rates of inflation—< Change in bothChange in interest and or inflation would affect the country’s currency’s purchasing powerWhich would in turn affect its exchange rate..

PPPWhat a currency could buy in terms of goods and services in home country vs. how many units of the other country’s currency required to buy thesame quantity of goods or service in that country.Eg. Wheat in US 5 kgs for a $ , in India Rs.8 per Kg. How many rupees are required to command the quantity purchased by a dollar will determine $ exchange rate PPP = 1$ =8 kgs in US; in India, 5 kgs would cost Rs.40 (8*5 ).There fore 1 $ = Rs. 40

Work out rate of exchanges between India and the countries based on PPP

COUNTRY PRICE OF WHEAT/kg

SrilankaPakistan Singapore UKIndia

SNR 15PNR 11.50S$ 0.31£0.10Rs.8

Direct quote

1.Sri lankan Rupee = 0.53 INR2. Pakistan Rupee = 0.70 INR3. Singapore $ = 25.81 INR4. £ = 80 INR

PPP Measured in terms of WPI and rate of Inflation is on annual basis.

• The Wholesale Price Index (WPI) was first published in India in 1902

• Current basis is 1993-94 ---100• A total of 435 commodities. Data on price level

is tracked and weighted• weightage• primary article 22.02 %• fuel,power 14.23 %• manufactured products 63.75 %

WPI at beginning of 2007=198 POINTSCurrent Inflation Rate

2.69% (30th June 2007 )==WPI =203.33pointsSuppose INR on 1.1.2007 was 42.12 per dollar• Rate of inflation in India during the year 2.69%--

US 5.65%Formula = SR * (1+ hi / fi )• The Current $ Rate would be = 42.12 * ( 1.0269

/ 1.0565) = Rs.40.94

Alternatively ,If during the year, US inflation is 5.65% and Indian inflation is 7.2,

the exchange rate would have beenbe 42.12*(1.072/1.0565) = Rs.42.74The exchange rate for the next year would be based on the rate at the end of this year

Current year 2007 $= Rs. 40.35

Suppose next year inflation in India 3% and in US 2.5%, the rate of exchange for next year (2008)would be40.35 *(1.03/1.025) = Rs.40.55On the other hand, if expected inflation in India next year 3% and US 4%, the rate of $ would be • 40.35(1.03 / 1.04) =Rs.39.96

Formula for PPP

Forward Rate of exchange =(1+hi) / (1 + fi ) = et/eo or

=

FR =(1+hi) / (1 + fi ) *SRWhere hi is inflation at home, fi is inflation in the foreign

country, et is exchange rate at t time and eo is spot rate

Eg. Spot rate RS. 40.30 per dollar, inflation India 5% US 6 %, rate of exchange would move to 1.05 / 1.06* 40.30 =39.92

Work out FR for 2008 for each currency when

Country Exchange Rate 2007Rs

Inflation 2008

IndiaUK--£USA-$Singapore-S$Dubai – DHJapan--¥(1000)

-82.5640.3525.269.95310

2.95%3.45%4.75%3.75%7.50%1.25%

• UK--£ = Rs. 82.16• USA-$ = Rs. 39.66• Singapore-S$ = Rs. 25.07• Dubai – DH = Rs. 9.53• Japan--¥(1000)= Rs.315.20

The UBFR as calculated should be the spot rate on the expiry of the period.Forward rates quoted should be = to the PPPIf not, opportunity for arbitrage is openArbitrageurs on the look out for mismatch would spring into action till the mismatch is removed and PARITY restored

PPP brings about equilibrium in exchange rates

Supposing $ is quoted at Rs.40.50.Wheat price in US1$ =5 kgs; in India a kg. of wheat is Rs.8.50. It means

that what a $ could buy in terms of wheat in US(5 kgs) , India needs Rs.42.50. This might spur traders to buy @5 kgs. of wheat for a $ in America, export to India, sell for Rs.42.50, exchange for $1.049 at the prevailing rate of Rs. 40.5, make profit of $ 0.049 per $. Imports of wheat in to India would increase and demand for $ for payment . $ would become stronger (rupee weak). Increased buy of wheat in US would increase its price, ( increased supply would reduce price in India) till the rate reaches equilibrium.

RepeatThe equilibrium is called unbiased forward rate (UBFR) If there is difference it would lead to arbitrage

and ultimately equilibrium reached

Forecasting forward exchange rate

Requirements for successful forecasting>exclusive use of superior model>access to prior information>ability to predict govt. intervention

Techniques of forecasting

>market based>model based

Techniques Market based

Based on Forward rate –coincides with the spot rate of exchange on its strike date (UBR)

Spot £=Rs.82.65, interest in India 8%, in UK 9% and this rates are expected to continue,

work out 1. forward rate for £ in 4 years in India and 2. forward rate for Re. in UK

India = £ spot rate Rs.82.654 years £ FR = Rs.83,65 * (1.08/ 1.09 )4

=Rs.78.927642In UK Re spot = £ 0.01209924 years Re FR = £0.0120992* (1.09 / 1.08) = £ 0.0126698

Suppose rates of interest are expected to change to

2008 India 8% UK 9%2009 India 9% UK 9%2010 India 10% UK 9%

WHAT WOULD BE FORWARD RATE QUOTE FOR FOR £ ?

£ would quote at

FR 2008 Rs. 82.65 * 1.08 / 1.09 = Rs81.89FR 2009 Rs.81.89 * (1.09/ 1.09 )= Rs.81.89FR 2010 Rs. 81.89 * (1.10 / 1.09)=Rs.82.64

MODEL BASED

>Fundamental analysisRelative inflation and interest rates, GDP

growth, changes in money supply>Technical analysis—based on price and

volume movements.Charts and graphs to note similar trends

Forecasting in controlled economy

Depends upon governmental intentionBut there would be black market for rateBlack market rate would reflect equilibriumrate

Real interest rate vs nominal interest rate

Contracts are made on nominal rates.Real (DESIRED) return (r) is nominal rate (a)adjusted

to rate of Inflation(i)—Fishers effectr = real rate +premium for inflationr = (1+a)(1+i) -1,Where “r” is the return (expected nominal rate), “a” is real interest rate , “i” is inflation rateEg. Real interest rate 5%, expected inflation 6%, Expected nominal rate would be =(1.05)(1.06)-1=11.3%

Exercise –work out inflation adjusted expected rate in each country for each

investorInvestor Real rate Inflation rate-in

countriesABCD

6%7%5%9%

1. 3.5%2. 4.25%3. 1.25%4. 7%

Investor Country 1

%Country 2

%Country 3

%Country 4

%

ABCD

9.7110.758.6812.82

10.5111.559.4613.63

7.338.346.3110.36

13.4214.4912.3516.63