International Finance

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Assignment 1.docx

1. Elaborate on the benefits of a proactive approach to globalization and global competition. (1.3)

2. What are the various ways in which domestic firms enter international markets? What are the benefits and risks of each strategy of foreign market entry?(1.8)

3. In 2002 , one dollar bought ¥125. In 2006, it bought about ¥115. (2.2)

a. What was the dollar value of the yen in 2002? What was the yen's dollar value in 2006?

b. By what percent has the yen risen in value between 2002 and 2006?

c. By what percent has the dollar fallen in value between 2002 and 2006?

4. On "1'1ne 14, 2001, Domingo Cavallo, Argentina's trea' ·J secretary announced a new exchange rate policy designed to stimulate Argentina's slumping economy Under the new policy, exporters and importers would be able to convert between dollars and pesos at an exchange rate that was an average of the dollar and the euro exchange rates, that is, P1 = $0.50 + €0.50. At that time, the euro was trading at $0.85. (2.6)

a. How many pesos would an exporter receive for one dollar under the new system?

b. How many dollars would an importer receive for one peso under the new system?

5. The experiences of fixed exchange-rate systems and target-zone arrangements have not been entirely satisfactory. (3.5)

a. ·what lessons can economists draw from the breakdown of the Bretton Woods system?

b. What lessons can economists draw from the exchange rate experiences of the EMS?

6. Gold has been called "the ultimate burglar alarm." Explain what this expression means. (3.3)

7. Two countries, the United States and England, produce only one good, wheat. Suppose the price of wheat is $3.25 in the United States and is £1.35 in England. (4.2)

a. According to the law of one price, what should the $:£spot exchange rate be?

b. Suppose the price of wheat over the next year is expected to rise to $3.50 in the United States and to £1.60 in England. What should the 1-year $:£ forward rate be?

c. If the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from England, what is the maximum possible change in the spot exchange rate that could occur?

8. Suppose that 3-month interest rates (annualized) in japan and the United States are 7% and 9% respectively the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1. (4.13)

a. Where would you invest?

b. Where would you borrow?

c. What arbitrage opportunity do these present?

d. Assuming no transaction costs, what would be your arbitrage profit per dollar or dollar-equivalent borrowed?

9. During the year, japan had a current-account surplus of $98 billion and a financial-account deficit, aside from the change in its foreign-exchange reserves, of $67 billion. (5.3)

a. Assuming the preceding data are measured with precision, what can you conclude about the change in Japan's foreign exchange reserves during the year?

b. What is the gap between japan's national expenditure and its national income?

c. What is the gap between japan's savings and its domestic investment?

d. What was Japan's net foreign investment for the year?

e. Suppose the government's budget ran a $22 billion during the year. What can you conclude about japan's private savings-investment balance for the year?

10. Suppose Dow Chemical receives quotes of $0.00824245 for the yen and $0.03023-27 for the Taiwan dollar (NT$). (6.6)

a. How many U.S. dollars will Dow Chemical receive from the sale of ¥50 million?

b. What is the U.S. dollar cost to Dow Chemical of buying ¥1 billion?

c. How many NT$ will Dow Chemical receive for U.S.$500,000?

d. How many yen will Dow Chemical receive for NT$200 million?

e. What is the yen cost to Dow Chemical of buying NT$80 million?

11. As a foreign exchange trader at Sumitomo Bank, you have a customer who would like spot and 30-day forward yen quotes on Australian dollars. Current market rates are as follows: (6.8)

Spot 30-day

¥121.37-85/U.S.$1 15-13

A$1.1878-98/U.S.$1 20-26

a. What bid and ask yen cross rates would you quote on spot Australian dollars?

b. What outright yen cross rates would you quote on 30-day forward Australian dollars?

c. What is the forward premium or discount on buying 30-day Australian dollars against yen delivery?

12. On january 10, Volkswagen (VW) agrees to import auto parts worth $7 million from the United States. The parts will be delivered on March 4 and are payable immediately in dollars. VW decides to hedge its dollar position by entering into CME futures contracts. The spot rate is $1.3447/€, and the March futures price is $1.3502/€. (7.5)

a. Calculate the number of futures contracts that VW must buy to offset its dollar exchange risk on the parts contract.

b. On March 4, the spot rate turns out to be $1.3452/€, while the March futures price is $1.3468/€. Calculate VW's net euro gain or loss on its futures position. Compare this figure with VV1ts gain or loss on its unhedged position.

13. A trader executes a "bear spread" on the japanese yen consisting of a long PHLX 103 March put and a short PHLX 101 March put. (7.7)

a. If the price of the 103 put is 2.81(l00th of ¢1¥), while the price of the 101 put is 1.6 (lOOth of¢!¥), what is the net cost of the bear spread?

b. What is the maximum amount the trader can make on the bear spread in the event the yen depreciates against the dollar? c. Redo your answers to Parts (a) and (b) assuming the trader executes a "bull spread" consisting of a long PHLX 97 March call priced at 1.96 (100th of ¢!¥) and a short PHLX 103 March call priced at 3.91 (100th of ¢1¥). What is the trader's maximum profit? Maximum loss?

14. Suppose that IBM would like to borrow fixed-rate yen, whereas Korea Development Bank (KDB) would like to borrow floating-rate dollars. IBM can borrow fixed-rate yen at 4.5% or floating-rate dollars at UBOR + 0.25%. KDB can borrow fixed-rate yen at 4.9% or floating-rate dollars at LlBOR + 0.8%. (8.3)

a. What is the range of possible cost savings that IBM can realize through an interest rate/currency swap with KDB?

b. Assuming a notional principal equivalent to $125 million and a current exchange rate of ¥105/$, what do these possible cost savings translate into in yen terms?

c. Redo Parts (a) and (b) assuming that the parties use Bank of America, which charges a fee of 8 basis points to arrange the swap.

15. In May 1988, Walt Disney Productions sold to Japanese investors a 20-year stream of projected yen royalties from Tokyo Disneyland. The present value of that stream of royalties, discounted at 6% (the return required by the Japanese investors), was ¥93 billion. Disney took the yen proceeds from the sale, converted them to dollars, and invested the dollars in bonds yielding 10%. According to Disney's chief financial officer, Gary Wilson, "ln effect, we got money at a 6% discount rate, reinvested it at I 0%, and hedged our royalty stream against yen fluctuations-all in one transaction." (8.2)

a. At the time of the sale, the exchange rate was ¥124 = $1. What dollar amount did Disney realize from the sale of its yen proceeds?

b. Demonstrate the equivalence between Walt Disney's transaction and a currency swap.

c. Comment on Gary Wilson's statement. Did Disney achieve the equivalent of a free lunch through its transaction?

ch01[1].ppt

Multinational Financial Management
Alan Shapiro
7th Edition
J.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

CHAPTER 1

Introduction: Multinational Enterprise and Multinational Financial Management

CHAPTER OVERVIEW:

I. The Rise of the Multinational Corporation

II. The Internationalization of Business and Finance

III. Multinational Financial Management: Theory and Practice

PART 1 THE RISE OF THE MULTINATIONAL CORPORATION

I. The MNC: Definition

a company with production and distribution facilities in more than one country.

THE RISE OF THE MULTINATIONAL CORPORATION

A. Forces Changing Global Markets

Massive deregulation

Collapse of communism

Privatizations of state-owned industries

Revolution in information technology

Wave of M&A

Emergence of free market policies

Rise of Big Emerging Markets (BEMs)

THE RISE OF THE MULTINATIONAL CORPORATION

B. Prime Transmitter of Competitive Forces in the Global Economy:

The MNC emphases group performance such as

Global coordinated allocation of resources

Market – entry strategy

Ownership of foreign operations

Production, marketing and financial activities

THE RISE OF THE MULTINATIONAL CORPORATION

C. EVOLUTION OF THE MNC

Reasons to Go Global:

1. More raw materials

2. New markets

3. Minimize costs of production

THE RISE OF THE MULTINATIONAL CORPORATION

RAW MATERIAL SEEKERS

exploit markets in other countries

historically first to appear

modern-day counterparts

British Petroleum

Exxon

THE RISE OF THE MULTINATIONAL CORPORATION

MARKET SEEKERS

produce and sell in foreign markets

heavy foreign direct investors

representative firms:

IBM

MacDonald’s

Nestle

Levi Strauss

THE RISE OF THE MULTINATIONAL CORPORATION

COST MINIMIZERS

seek lower-cost production abroad

motive: to remain cost competitive

Texas Instruments

Intel

Seagate Technology

THE RISE OF THE MULTINATIONAL CORPORATION

D. THE MNC: A BEHAVIORAL VIEW

1. State of mind:

committed to producing,

undertaking investment and marketing, and financing globally.

THE RISE OF THE MULTINATIONAL CORPORATION

E. THE GLOBAL MANAGER

1. Understands political and

economic differences;

2. Searches for most cost-

effective suppliers;

3. Evaluates changes on value of the firm.

Part II The Internationalization of Business and Finance

I. Globalization

A. Political and Labor Union Concerns

The Internationalization of Business and Finance

B. Consequences of Global Competition

Acceleration of the global economy

PART III. MULTINATIONAL FINANCIAL MANAGEMENT: THEORY AND PRACTICE

I. THE MULTINATIONAL FINANCIAL SYSTEM

A. Main Objective of MNC:

Maximize shareholder wealth

B. Other Objectives Reflect Ability to Link:

via affiliate transfer mechanisms

THEORY AND PRACTICE

C. Mode of Transfer:

Reflects freedom to select a variety of financial channels.

D. Timing Flexibility:

Most MNC have some flexibility in timing of fund flows.

THEORY AND PRACTICE

E. Value

The ability to avoid national taxes has led to controversy.

THEORY AND PRACTICE

II. FUNCTIONS OF FINANCIAL

MANAGEMENT

A. Two Basic Functions:

1. Financing

2. Investing

THEORY AND PRACTICE

B. Additional Factors Facing the MNC Executive

1. Political risk

2. Economic risk

THEORY AND PRACTICE

III. THEORETICAL FOUNDATIONS

A. Useful Concepts from Financial Economics:

1. Arbitrage

2. Market Efficiency

3. Capital Asset Pricing

THEORY AND PRACTICE

B. Importance of Total Risk

1. Adverse Impact

lower sales and higher costs

2. Justifies hedging activities of MNC

3. Diversification reduces risk

THEORY AND PRACTICE

IV. THE GLOBAL FINANCIAL MARKET PLACE

A. Inter-linkage by Computers

B. Market Acts as A Global

Referendum Process:

Currencies may rise or fall

ch02[1].ppt

Multinational Financial Management
Alan Shapiro
7th Edition
J.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

CHAPTER 2

THE DETERMINATION OF EXCHANGE RATES

CHAPTER 2 OVERVIEW:

I. EQUILIBRIUM EXCHANGE RATES

II. ROLE OF CENTRAL BANKS

III. EXPECTATIONS AND THE ASSET MARKET MODEL

Part I.
Equilibrium Exchange Rates

I. SETTING THE EQUILIBRIUM

A. Exchange Rates

market-clearing prices that equilibrate the quantities supplied and demanded of foreign currency.

Equilibrium Exchange Rates

B. How Americans Purchase German Goods

1. Foreign Currency Demand

-derived from the demand for foreign country’s goods, services, and financial assets.

e.g. The demand for German goods by Americans

Equilibrium Exchange Rates

2. Foreign Currency Supply:

a. derived from the foreign country’s demand for local goods.

b. They must convert their currency to purchase.

e.g. German demand for US goods means Germans convert Euros to US$ in order to buy.

Equilibrium Exchange Rates

3. Equilibrium Exchange Rate:

occurs when the quantity supplied equals the quantity demanded of a foreign currency at a specific local

price.

Equilibrium Exchange Rates

C. How Exchange Rates Change

1. Increased demand

as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa.

Equilibrium Exchange Rates

2. Home Currency Depreciation

a. Foreign currency becomes more valuable than the home currency.

b. The foreign currency’s value has appreciated against the home currency.

Equilibrium Exchange Rates

3. Calculating a Depreciation:

Currency Depreciation

where e0 = old currency value

e1 = new currency value

Note: Resulting sign is always negative

Equilibrium Exchange Rates

Currency Appreciation

Equilibrium Exchange Rates

EXAMPLE: euro appreciation

If the dollar value of the euro goes from $0.64 (e0) to $0.68 (e1), then the euro

has appreciated by

= (.68 - .64)/ .64

= 6.25%

Equilibrium Exchange Rates

EXAMPLE: US$ Depreciation

We use the first formula,

(e0 - e1)/ e1

substituting

(.64 - .68)/ .68 = - 5.88%

which is the value of the US$ depreciation.

Equilibrium Exchange Rates

D. FACTORS AFFECTING EXCHANGE RATES:

1. Inflation rates

2. Interest rates

3. GNP growth rates

I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION

A. Role of Exchange Rates:

LINKS BETWEEN THE DOMESTIC AND THE WORLD ECONOMY

PART II. THE ROLE OF CENTRAL

BANKS

B. THE IMPACT OF EXCHANGE RATE CHANGES

1. Currency Appreciation:

-domestic prices increase relative to foreign prices.

- Exports: less price competitive

- Imports: more attractive

THE ROLE OF CENTRAL BANKS

2. Currency Depreciation

- domestic prices fall relative to foreign prices.

- Exports: more price competitive.

- Imports: less attractive

THE ROLE OF CENTRAL BANKS

C. Foreign Exchange Market Intervention

1. Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate.

THE ROLE OF CENTRAL BANKS

2. Goal of Intervention:

- to alter the demand for one currency by changing the supply of another.

THE ROLE OF CENTRAL BANKS

D. The Effects of Foreign Exchange Intervention

1. Effects of Intervention:

- either ineffective or irresponsible

2. Lasting Effect:

- If permanent, change results

Part III. EXPECTATIONS

WHAT AFFECTS A CURRENCY’S VALUE?

A. Current events

B. Current supply

C. Demand flows

D. Expectation of future exchange rate

EXPECTATIONS

II. Role of Expectations :

A. Currency = financial asset

B. Exchange rate = simple relation of two financial assets

EXPECTATIONS

III. Demand for Money and Currency Values: Asset Market Model

A. Exchange rates reflect the supply of and demand for foreign-currency denominated assets.

EXPECTATIONS

B. Soundness of a Nation’s Economic Policies

- a nation’s currency tends to strengthen with sound economic policies.

EXPECTATIONS

IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR

- exchange rates also influenced by

expectations of central bank behavior.

EXPECTATIONS

A. Central Bank Reputations

B. Central Bank Independence

C. Currency Boards

ch03[1].ppt

Multinational Financial Management
Alan Shapiro
7th Edition
J.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

CHAPTER 3

THE INTERNATIONAL MONETARY SYSTEM

CHAPTER OVERVIEW

I. ALTERNATIVE EXCHANGE RATE SYSTEMS

II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYTEM

III. THE EUROPEAN MONETARY SYSTEM AND MONETARY UNION

IV. EMERGING MARKET CURRENCY CRISES

PART I. ALTERNATIVE
EXCHANGE RATE SYSTEMS

I. FIVE MARKET MECHANISMS

A. Freely Floating (“Clean Float”)

1. Market forces of supply and demand determine rates.

ALTERNATIVE EXCHANGE RATE SYSTEMS

2. Forces influenced by

a. price levels

b. interest rates

c. economic growth

3. Rates fluctuate randomly over time.

ALTERNATIVE EXCHANGE RATE SYSTEMS

B. Managed Float (“Dirty Float”)

1. Market forces set rates unless excess volatility occurs.

2. Then, central bank determines rate.

ALTERNATIVE EXCHANGE RATE SYSTEMS

C. Target-Zone Arrangement

1. Rate Determination

a. Market forces constrained to upper and lower range of rates.

b. Members to the arrangement

adjust their national economic policies to maintain target.

ALTERNATIVE EXCHANGE RATE SYSTEMS

D. Fixed Rate System

1. Rate determination

a. Government maintains target rates.

b. If rates threatened, central banks buy/sell currency.

c. Monetary policies coordinated.

ALTERNATIVE EXCHANGE RATE SYSTEMS

E. Current System

1. A hybrid system

a. Major currencies: use freely- floating method

b. Other currencies move in and out of various fixed-rate systems.

PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

I. THE USE OF GOLD

A. Desirable properties

B. In short run: High production costs limit changes.

C. In long run: Commodity money insures stability.

A BRIEF HISTORY

II. The Classical Gold Standard

(1821-1914)

A. Major global currencies on gold standard.

1. Nations fix the exchange rate in terms of a specific amount of gold.

A BRIEF HISTORY

2. Maintenance involved the

buying and selling of gold at that price.

3. Disturbances in Price Levels:

Would be offset by the price- specie*-flow mechanism.

* specie = gold coins

A BRIEF HISTORY

a. Price-specie-flow mechanism

adjustments were automatic:

1.) When a balance of payments surplus led to a gold inflow;

2.) Gold inflow led to higher prices which reduced surplus;

3.) Gold outflow led to lower prices and increased surplus.

A BRIEF HISTORY

III. The Gold Exchange Standard (1925-1931)

A. Only U.S. and Britain allowed to hold gold reserves.

B. Others could hold both gold, dollars or pound reserves.

A BRIEF HISTORY

C. Currencies devalued in 1931

- led to trade wars.

D. Bretton Woods Conference

- called in order to avoid

future protectionist and

destructive economic policies

A BRIEF HISTORY

V. The Bretton Woods System (1946-1971)

1. U.S.$ was key currency;

valued at $1 - 1/35 oz. of gold.

2. All currencies linked to that price in a fixed rate system.

A BRIEF HISTORY

3. Exchange rates allowed to fluctuate by 1% above or below initially set rates.

B. Collapse, 1971

1. Causes:

a. U.S. high inflation rate

b. U.S.$ depreciated sharply.

A BRIEF HISTORY

V. Post-Bretton Woods System (1971-Present)

A. Smithsonian Agreement, 1971:

US$ devalued to 1/38 oz. of gold.

By 1973: World on a freely floating exchange rate system.

A BRIEF HISTORY

B. OPEC and the Oil Crisis (1973-774)

1. OPEC raised oil prices four fold;

2. Exchange rate turmoil resulted;

3. Caused OPEC nations to earn large surplus B-O-P.

A BRIEF HISTORY

4. Surpluses recycled to debtor nations which set up debt crisis of 1980’s.

C. Dollar Crisis (1977-78)

1. U.S. B-O-P difficulties

2. Result of inconsistent monetary policy in U.S.

A BRIEF HISTORY

3. Dollar value falls as confidence shrinks.

D. The Rising Dollar (1980-85)

1. U.S. inflation subsides as the Fed raises interest rates

2. Rising rates attracts global capital to U.S.

A BRIEF HISTORY

3. Result: Dollar value rises.

E. The Sinking Dollar:(1985-87)

1. Dollar revaluated slowly downward;

2. Plaza Agreement (1985)

G-5 agree to depress US$

further.

A BRIEF HISTORY

3. Louvre Agreement (1987)

G-7 agree to support the falling US$.

F. Recent History (1988-Present)

1. 1988 US$ stabilized

2. Post-1991 Confidence resulted in stronger dollar

3. 1993-1995 Dollar value falls

PART III.
THE EUROPEAN MONETARY SYSTEM

I. INTRODUCTION

A. The European Monetary System (EMS)

1. A target-zone method (1979)

2. Close macroeconomic policy coordination required.

THE EUROPEAN MONETARY SYSTEM

B. EMS Objective:

to provide exchange rate stability to all members by holding exchange rates within specified limits.

THE EUROPEAN MONETARY SYSTEM

C. European Currency Unit (ECU)

a “cocktail” of European currencies with specified weights as the unit of account.

THE EUROPEAN MONETARY SYSTEM

1. Exchange rate mechanism (ERM)

- each member determines mutually agreed upon central cross rate for its currency.

THE EUROPEAN MONETARY SYSTEM

2. Member Pledge:

to keep within 15% margin above or below the central rate.

THE EUROPEAN MONETARY SYSTEM

D. EMS ups and downs

1. Foreign exchange interventions:

failed due to lack of support by coordinated monetary policies.

THE EUROPEAN MONETARY SYSTEM

2. Currency Crisis of Sept. 1992

a. System broke down

b. Britain and Italy forced towithdraw from EMS.

THE EUROPEAN MONETARY SYSTEM

G. Failure of the EMS:

members allowed political priorities to dominate exchange rate policies.

THE EUROPEAN MONETARY SYSTEM

H. Maastricht Treaty

1. Called for Monetary Union by 1999 (moved to 2002)

2. Established a single currency:

the euro

THE EUROPEAN MONETARY SYSTEM

3. Calls for creation of a single

central EU bank

4. Adopts tough fiscal standards

THE EUROPEAN MONETARY SYSTEM

I. Costs / Benefits of A Single Currency

A. Benefits

1. Reduces cost of doing business

2. Reduces exchange rate risk

THE EUROPEAN MONETARY SYSTEM

B. Costs

1. Lack of national monetary flexibility.

PART IV. EMERGING MARKET CURRENCY CRISES

Transmission Mechanisms

A. Trade links

contagion spreads through trade

B. Financial System

-more important transmission mechanism

-investors sell off to make up for losses

EMERGING MARKET CURRENCY CRISES

Origins of Emerging Market Crises

A. Moral hazard

B. Fundamental Policy Conflict

EMERGING MARKET CURRENCY CRISES

Policy Proposals for Dealing with Emerging Market Crises

A. Currency Controls

B. Freely Floating Currency

C. Permanently Fixed Exchange Rate

ch04[1].ppt

Multinational Financial Management
Alan Shapiro
7th Edition
J.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

CHAPTER 4

PARITY CONDITIONS AND
CURRENCY FORECASTING

CHAPTER OVERVIEW

I. ARBITRAGE AND THE LAW OF

ONE PRICE

II. PURCHASING POWER PARITY

III. THE FISHER EFFECT

IV. THE INTERNATIONAL FISHER EFFECT

V. INTEREST RATE PARITY THEORY

VI. THE RELATIONSHIP BETWEEN THE FORWARD AND FUTURE SPOT RATE

VII. CURRENCY FORECASTING

PART I. ARBITRAGE AND THE LAW OF ONE PRICE

I. THE LAW OF ONE PRICE

A. Law states:

Identical goods sell for the same price worldwide.

ARBITRAGE AND THE LAW OF ONE PRICE

B. Theoretical basis:

If the price after exchange-rate

adjustment were not equal, arbitrage in the goods worldwide ensures eventually it will.

ARBITRAGE AND THE LAW OF ONE PRICE

C. Five Parity Conditions Result From These Arbitrage Activities

1. Purchasing Power Parity (PPP)

2. The Fisher Effect (FE)

3. The International Fisher Effect

(IFE)

4. Interest Rate Parity (IRP)

5. Unbiased Forward Rate (UFR)

ARBITRAGE AND THE LAW OF ONE PRICE

D. Five Parity Conditions Linked by

1. The adjustment of various

rates and prices to inflation.

ARBITRAGE AND THE LAW OF ONE PRICE

2. The notion that money should have no effect on real variables (since they have been adjusted for price changes).

ARBITRAGE AND THE LAW OF ONE PRICE

E. Inflation and home currency depreciation:

1. jointly determined by the growth of domestic money supply;

2. Relative to the growth of

domestic money demand.

ARBITRAGE AND THE LAW OF ONE PRICE

F. THE LAW OF ONE PRICE

- enforced by international

arbitrage.

PART II. PURCHASING POWER PARITY

I. THE THEORY OF PURCHASING

POWER PARITY:

states that spot exchange rates between currencies will change to the differential in inflation rates between countries.

PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING

POWER PARITY

A. Price levels adjusted for

exchange rates should be

equal between countries

PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING

POWER PARITY

B. One unit of currency has same purchasing power globally.

PURCHASING POWER PARITY

III. RELATIVE PURCHASING POWER PARITY

A. states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.

PURCHASING POWER PARITY

1. In mathematical terms:

where et = future spot rate

e0 = spot rate

ih = home inflation

if = foreign inflation

t = the time period

PURCHASING POWER PARITY

2. If purchasing power parity is

expected to hold, then the best

prediction for the one-period

spot rate should be

PURCHASING POWER PARITY

3. A more simplified but less precise relationship is

that is, the percentage change should be approximately equal to the inflation rate differential.

PURCHASING POWER PARITY

4. PPP says

the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation.

PURCHASING POWER PARITY

B. Real Exchange Rates:

the quoted or nominal rate adjusted for a country’s inflation rate is

PURCHASING POWER PARITY

C. Real exchange rates

1. If exchange rates adjust to inflation differential, PPP states that real exchange rates stay the same.

PURCHASING POWER PARITY

C. Real exchange rates

2. Competitive positions:

domestic and foreign firms

are unaffected.

PART III.
THE FISHER EFFECT (FE)

I. THE FISHER EFFECT

states that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations.

R = a + i

THE FISHER EFFECT

B. Real Rates of Interest

1. Should tend toward equality

everywhere through arbitrage.

2. With no government interference nominal rates vary by inflation differential or

rh - rf = ih - if

THE FISHER EFFECT

C. According to the Fisher Effect,

countries with higher inflation rates have higher interest rates.

THE FISHER EFFECT

D. Due to capital market integration globally, interest rate differentials are eroding.

PART IV. THE INTERNATIONAL
FISHER EFFECT (IFE)

I. IFE STATES:

A. the spot rate adjusts to the interest rate differential between two countries.

THE INTERNATIONAL FISHER EFFECT

IFE = PPP + FE

THE INTERNATIONAL FISHER EFFECT

B. Fisher postulated

1. The nominal interest rate differential should reflect the inflation rate differential.

THE INTERNATIONAL FISHER EFFECT

B. Fisher postulated

2. Expected rates of return are equal in the absence of government intervention.

THE INTERNATIONAL FISHER EFFECT

C. Simplified IFE equation:

(if rf is relatively small)

THE INTERNATIONAL FISHER EFFECT

D. Implications of IFE

1. Currency with the lower interest rate expected to appreciate relative to one

with a higher rate.

THE INTERNATIONAL FISHER EFFECT

D. Implications of IFE

2. Financial market arbitrage:

insures interest rate differential is an unbiased predictor of change in future spot rate.

PART VI. INTEREST RATE PARITY THEORY

I. INTRODUCTION

A. The Theory states:

the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.

INTEREST RATE PARITY THEORY

2. The forward premium or

discount equals the interest

rate differential.

(F - S)/S = (rh - rf)

where rh = the home rate

rf = the foreign rate

INTEREST RATE PARITY THEORY

3. In equilibrium, returns on

currencies will be the same

i. e. No profit will be realized

and interest parity exists

which can be written

(1 + rh) = F

(1 + rf) S

INTEREST RATE PARITY THEORY

B. Covered Interest Arbitrage

1. Conditions required:

interest rate differential does

not equal the forward premium or discount.

2. Funds will move to a country

with a more attractive rate.

INTEREST RATE PARITY THEORY

3. Market pressures develop:

a. As one currency is more demanded spot and sold forward.

b. Inflow of fund depresses interest rates.

c. Parity eventually reached.

INTEREST RATE PARITY THEORY

C. Summary:

Interest Rate Parity states:

1. Higher interest rates on a

currency offset by forward discounts.

2. Lower interest rates are offset by forward premiums.

PART VI. THE RELATIONSHIP BETWEEN THE
FORWARD AND THE FUTURE SPOT RATE

I. THE UNBIASED FORWARD RATE

A. States that if the forward rate is unbiased, then it should reflect the expected future spot rate.

B. Stated as

ft = et

PART VI. CURRENCYFORECASTING

I. FORECASTING MODELS

A. Created to forecast exchange rates in addition to parity conditions.

B. Two types of forecast:

1. Market-based

2. Model-based

CURRENCY FORECASTING

MARKET-BASED FORECASTS:

derived from market indicators.

A. The current forward rate contains implicit information about exchange rate changes for one year.

B. Interest rate differentials may be used to predict exchange rates beyond one year.

CURRENCY FORECASTING

MODEL-BASED FORECASTS:

include fundamental and technical analysis.

A. Fundamental relies on key macroeconomic variables and policies which most like affect exchange rates.

B. Technical relies on use of

1. Historical volume and price data

2. Charting and trend analysis

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ch06[1].ppt

Multinational Financial Management
Alan Shapiro
7th Edition
J.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

COUNTRY RISK ANALYSIS

CHAPTER 6

PART I. THE MEASUREMENT OF POLITICAL RISK

I. MEASURING POLITICAL RISK

A. Country-specific perspective

THE MEASUREMENT OF POLITICAL RISK

B. Political Stability

1. Measured by:

a. Frequency of government changes

b. Level of violence

c. Number of armed insurrections

d. Conflict with other states

THE MEASUREMENT OF POLITICAL RISK

C. Economic Factors

1. Indicators of political unrest

a. Rampant inflation

b. Balance of payment deficits

c. Slowed growth of per capita GDP

THE MEASUREMENT OF POLITICAL RISK

D. Subjective Factors

1. Profit Opportunity Recommendation

2. Political Risk and Uncertain Property Rights

THE MEASUREMENT OF POLITICAL RISK

3. Capital Flight

a. Definition:

the export of savings by a

nation’s citizens because of

safety-of-capital fears.

b. Measurement: use the

balance-of- payment account

THE MEASUREMENT OF POLITICAL RISK

c. Causes of capital flight

1.) Inappropriate economic policies

2.) Expectation of devaluation

3.) High political risk

PART II. ECONOMIC AND POLITICAL FACTORS

II. Economic and Political Factors Primary focus: How well is the country doing economically?

A. Fiscal Irresponsibility

-high government deficits

B. Monetary Instability

C. Controlled Exchange Rate System

-currency usually overvalued

D. Wasteful Government Spending

-inability to service foreign debt

ECONOMIC AND POLITICAL FACTORS

D. Resource Base

-lack of strong work ethic

E. Country Risk and Adjustment to External Shocks

1. What are the impacts of external shocks:

-how well a nation responds varies

ECONOMIC AND POLITICAL FACTORS

2. Key Indicators of Country Risk

a. Relative size of government debt

b. Money expansion

c. Existence of government- imposed barriers to market forces

ECONOMIC AND POLITICAL FACTORS

2. Key Indicators of Country Risk (con’t)

d. Level of tax rates

e. Amount of government-owned firms

f. Political and fiscal responsibility

g. Amount and extent of corruption

ECONOMIC AND POLITICAL FACTORS

Key indicators of economic health

a. Structural incentives

b. Legal structure

c. Clear incentives to save

d. Open economy

e. Stable macroeconomic policies

PART III. COUNTRY RISK ANALYSIS IN INTERNATIONAL BANKING

Country Risk and the Terms of Trade

What ultimately determines a nation’s ability to repay foreign loans?

- the speed of adjustment

COUNTRY RISK ANALYSIS IN INTERNATIONAL BANKING

The Government’s Cost/Benefit Calculus

- debt to wealth ratio

- cost of default

- fluctuations in the terms of trade

COUNTRY RISK ANALYSIS IN INTERNATIONAL BANKING

Lessons from the International Debt Crisis of 1982

Economic reforms that work:

Strong head of state

Viable economic plan

Competent economic team

Support “at the top”

Sell the program to all levels of society

ch07[1].ppt

Multinational Financial Management
Alan Shapiro
7th Edition
J.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

CHAPTER 7

THE FOREIGN EXCHANGE MARKET

CHAPTER OVERVIEW

I. INTRODUCTION

II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

III. THE SPOT MARKET

IV. THE FORWARD MARKET

PART I. INTRODUCTION

I. INTRODUCTION

A. The Currency Market:

where money denominated in one currency is bought and sold with money denominated in another currency.

INTRODUCTION

B. International Trade and Capital Transactions:

facilitated with the ability

to transfer purchasing power

between countries

INTRODUCTION

C. Location

1. OTC-type: no specific location

2. Most trades by phone,

telex, or SWIFT

SWIFT: Society for Worldwide Interbank Financial Telecommunications

PART II.
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET

A. Participants at 2 Levels

1. Wholesale Level (95%)

- major banks

2. Retail Level

- business customers