international financial management by [email protected]

8/7/2019 international financial management by [email protected]

1/29

INTERNATIONAL FINANCIAL

MANAGEMENT


2/29

THE FOREIGN EXCHANGE

MARKET

The foreign exchange market is themarket where the currency of onecountry is exchanged for the currency of

another country. Most currencytransactions are channelled through theworld-wide interbank market. Interbankmarket is the wholesale market in which

major banks trade with each other.

2


3/29

Foreign Exchange Rates

A foreign exchange rate is the price of one currency quoted interms of another currency.

When the rate is quoted per unit of the domestic currency, it isreferred to as direct quote. Thus, the US$ and INR exchange ratewould be written as US$ 0.02538/INR.

When the rate is quoted as units of domestic currency per unit ofthe foreign currency, it is referred to as indirect quote.

A cross rate is an exchange rate between the currencies of twocountries that are not quoted against each other, but are quotedagainst one common currency.

Suppose that German DM is selling for $ 0.62 and the buying ratefor the French franc (FF) is $ 0.17, what is the DM/FF cross-rate? Itis:

3

$ 0.62 3.65

$ 0.17

US FF FF

DM US DM

v !


4/29

Foreign Exchange Rates

The spot exchange rate is the rate at which a currency can be boughtor sold for immediate delivery which is within two business days afterthe day of the trade.

Bid-ask spread is the difference between the bid and ask rates of a

currency. The forward exchange rate is the rate that is currently paid for the

delivery of a currency at some future date.

The forward rate may be at a premium or at a discount.

For a direct quote, the annualised forward discount or premium canbe calculated as follows:

4

Spot rate Forward rate 360Forward premium (discount)

Spot rate Days

! v


5/29

INTERNATIONAL PARITY

RELATIONSHIPS

There are the following four international

parity relationships:

Interest rate parity (IRP)

Purchasing power parity (PPP)

Forward rates and future spot rates

parity International Fisher effect (IFE).

5


6/29

Interest Rate Parity

It states that the exchange rate of two countries will be affectedby their interest rate differential. In other words, the currency ofa high-interest-rate-country will be at a forward discount relativeto the currency of a low-interest-rate-country, and vice versa.This implies that the exchange rate (forward and spot)

differential will be equal to the interest rate differential betweenthe two countries. That is:

Interest differential = Exchange rate (forward and spot)differential

6

/

/

(1 )

(1 )

F F D

D F D

r f

r s

!


7/29

Purchasing Power Parity

In absolute terms, purchasing power parity states that the exchange ratebetween the currencies of two countries equals the ratio between the prices ofgoods in these countries. Further, the exchange rate must change to adjust tothe change in the prices of goods in the two countries. In relative terms,purchasing power states that the exchange rate between the currencies of thetwo countries will adjust to reflect changes in the inflation rates of the twocountries. In formal terms, it implies that the expected inflation differentialequals to the current spot rate and the expected spot rate differential. Thus:

Inflationratedifferential= Currentspotrateandexpectedspotratedifferential

7

/

/

(1 ) ( )

(1 )

F F D

D F D

i E s

i s

!


8/29

Expectation TheoryofForward

Rates

The expectation theory of forward exchange rates states that the

forward rate provides the best and unbiased forecast of the expected

future spot rate. In formal terms, it means that the forward rate and the

current rate differential must be equal to the expected spot rate andthe current spot rate differential. Thus:

Forwardandcurrentspotratedifferential= Expectedandcurrentspotrate

differential

8

/ /

/ /

( )F D F D

F D F D

f E s

s s!


9/29

International Fisher Effect

In formal terms, the international Fisher

effect states that the nominal interest rate

differential must equal to the expectedinflation rate differential in two countries.

Thus:

Nominalinterestratedifferential= Expected

inflationratedifferential

9

(1 ) (1 )

(1 ) (1 )

F F

D D

r E i

r E i

!


10/29

Foreign Exchange Risk

Foreign exchange risk is the risk that the domestic currencyvalue of cash flows, denominated in foreign currency, maychange because of the variation in the foreign exchangerate. There would not be any foreign exchange risk if theexchange rates were fixed.

We can distinguish between three types of foreignexchange exposure:

Transactionexposure

Economicexposure

Translationexposure

10


11/29

TypesofExchange-Rate

Risk

Exposure

Translation ExposureTranslation Exposure -- Relates to the change in

accounting income and balance sheet statements caused

by changes in exchange rates. Transactions ExposureTransactions Exposure -- Relates to settling a particular

transaction at one exchange rate when the obligation was

originally recorded at another.

Economic ExposureEconomic Exposure ---- Involves changes in expected futurecash flows, and hence economic value, caused by a change

in exchange rates.


12/29


13/29

forwardcontractforwardcontract

A forwardforward contractcontract is a contract for the delivery ofa commodity, foreign currency, or financialinstrument at a price specified now, with delivery

and settlement at a specified future date Cost of forward contract is the difference

between the forward rate and the expected spot

rate (not the current spot rate) at the time cashflows are paid or received.

13


14/29

Foreign Currency Option

The foreign currency option is the right (not

an obligation) to buy or sell a currency at an

agreed exchange rate (exercise price) on or

before an agreed maturity period.

The right to buy is called a call option and

right to sell a put option.

A foreign currency option holder will exercise

his right only if it is advantageous to do so.

14


15/29

MONEY MARKET OPERATIONS

Another hedging technique is the money marketoperations. Suppose, Air India can borrow FF 1,000million now, convert them into rupees at the current

exchange rate and invest in the money market in Indiafor six months. If interest rate parity holds, thedifference in the forward rate and the spot rate is thereflection of the differences in the interest rates intwo countries. Thus, Air India will be able to hedgeagainst the change in the exchange rate.

15


16/29

Structuring International

Trad

eT

ransactions In international trade, sellers often have difficulty

obtaining thorough and accurate credit information

on potential buyers. Channels for legal settlement in cases of default are

more complicated and costly to pursue.

Key documents are

(1) an order to pay (international trade draft),

(2) a bill of lading, and

(3) a letter of credit.


17/29

International

Trad

eD

raft The internationaltradedraft(billofexchange)internationaltradedraft(billofexchange)is a

written statement by the exporter ordering the

importer to pay a specific amount of money at aspecified time.

SightdraftSightdraftis payable on presentation to the party

(drawee) to whom the draft is addressed.

TimedraftTimedraftis payable at a specified future date after

sight to the party (drawee) to whom the draft is

addressed.


18/29

Time Draft Features An unconditional order in writing signed by the

drawer, the exporter.

It specifies an exact amount of money that the

drawee, the importer, must pay.

It specifies the future date when this amount

must be paid.

Upon presentation to the drawee, it is acceptedaccepted.


19/29

T

imeD

raftF

eatures The acceptance can be by either the draweedrawee or a

bankbank.

If the drawee accepts the draft, it is

acknowledged in writing on the back of the draft

the obligation to pay the amount so many

specified days hence.

It is then known as a tradedrafttradedraft(bankersbankers

acceptanceacceptance if a bank accepts the draft).


20/29

BillofLading

It serves as a receipt from the transportation companyto the exporter, showing that specified goods havebeen received.

It serves as a contract between the transportation

company and the exporter to ship goods and deliverthem to a specific party at a specific destination.

It serves as a document of title.

Bill of LadingBill of Lading -- A shipping document indicating

the details of the shipment and delivery of goods

and their ownership.


21/29

LetterofCredit

A letter of credit is issued by a bank on behalf of the importer.

The bank agrees to honor a draft drawn on the importer,provided the bill of lading and other details are in order.

The bank is essentially substituting its credit for that of theimporter.

Letter of Credit - A promise from a third party (usually a

bank) for payment in the event that certain conditions

are met. It is frequently used to guarantee payment ofan obligation.


22/29

Countertrade

Used effectively when exchange restrictions exist or other

difficulties prevent payment in hard currencies. Quality, standardization of goods, and resale of goods that

are delivered are risks that arise with countertrade.

CountertradeCountertrade -- Generic term for barter and other

forms of trade that involve the international sale of

goods or services that are paid for -- in whole or in part-- by the transfer of goods or services from a foreign

country.


23/29

Forfaiting

The forfaiter assumes the credit risk and collects the amount

owed from the importer. Most useful when the importer is in a less-developed

country or in an Eastern European nation.

ForfaitingForfaiting -- The selling without recourse of medium-

to long-term export receivables to a financial

institution, the forfaiter. A third party, usually a bankor governmental unit, guarantees the financing.


24/29


25/29

POLITICAL RISK OF FOREIGN

INVESTMENTS

There are two ways in which a firm can handle thepolitical risks in the investment evaluation.

The firm may increase the cost of capital (discount rate)to allow for the political risks

or

Adjust the investments cash flows to account forpolitical risk.

25


26/29

FINANCING INTERNATIONAL

OPERATIONS

Eurocurrency Loans

Eurobondsand ForeignBonds

Depository Receipts

26


27/29

Costand RiskofInternational

Financing

A firm may be capable of raising funds below

market rate due to government subsidies, tax

asymmetries government regulations.

Borrowing in local currency to finance a

foreign investment can expose a company to

foreign exchange risks.

27


28/29

THE INTERNATIONAL MONETARY SYSTEM

world monetary and financial organization thatfacilitates transfer of funds between parties, conversionof national currencies in to one another and

international credit creation.There are some aspect of international monetarysystem.

1- exchange rate regimes

2- the adjustment process how does the systemfacilitate the process of coping with paymentsimbalances between trading nation


29/29

Bibliography

VAN HORNE ,FINANCIAL MANAGEMENT

POLICY, Pearson education, twelfth edition,

2004

PANDEY, I.M. , FINANCIAL MANAGEMENT

tenth edition

VIJ, MADHU, International Financial

Management, Excel Books, third Edition,

2010

international financial management by [email protected]

Documents