UNSW Sydney
FINS5516
International Corporate Finance
T1,2023
Lecture 1
Mohamad Mourad – Lecturer in Charge
(m.mourad@unsw.edu.au)
Lecture 1 –
Schedule
•
Course Logistics.
•
Expectations of Students.
•
Course Aims and Overview.
•
MNCs.
•
Exchange Rate Determination.
•
International Monetary Systems.
•
Week 1 BONUS Exercise.
Note: These notes are property of the author (Mohamad Mourad).
They are for the exclusive use of students enrolled in FINS5516 International
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516
International Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in
Corporate Finance for Term 1,2023. Reproduction, distribution
and
re-use
of The
these
notes
outside
scope
any way, shape
or form
is strictly prohibited.
author and UNSW
bear no responsibility
for anythe
loss, injury
or claims madeof
by anythe
party, course, in any way, shape or
entity or individual, however defined, if these notes are used in valuations or providing investment advice for private or commercial
purposes.
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury
or claims made by any party, entity or individual, however
defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Course Logistics
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Course Logistics
-
Course Website: Moodle.
-
Lectures and consultation sessions: Online via Zoom.
-
Emailing LIC: Use only your official UNSW e-mail account. Include your student ID
and course code. Emails to me should only be for personal/private matters.
-
General Administration Questions: See FINS5516 Course Outline. If the course
outline does not answer your question, ONLY then post on the admin Moodle forum.
-
Course content questions: must be posted on the relevant discussion forum on
Moodle.
-
Textbook: Multinational Financial Management, Shapiro, 11th Edition (Wiley). The
10th edition is also useful.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Course Assessments
Assessment Task
Weighting
Due Date
Weekly Homework
10%
Weekly.
Mid-Session Quiz
35%
Saturday of Week 6.
Data Exercise Assignment
15%
End of Week 9.
Final Exam (Comprehensive)
40%
Exam Period.
Total
100%
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Weekly Homework Submission (10%)
- Students will be required to submit solutions to selected homework questions.
- The due date (which is a hard deadline) is included within each homework
problem set document.
- Students are encouraged to work on these questions in groups BUT you must
submit your own work otherwise this will be considered academic
misconduct.
- These homework questions serve as preparation for the mid-term quiz and
final exams.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Mid-Session Quiz (35%)
- Week 6
Date: Saturday 25 March 2023
Time: 12:00 – 14:10 (Sydney, Australia time)
Examinable Content: Weeks 1 – 5.
Format: Multiple Choice and Calculation Questions (35 questions)
Place: Online (Moodle)
- Note: No other times are available. It is expected that students free their schedules.
- Note: Work commitments, regular weekend activities (sports, shopping etc) are NOT a
valid reason for not being able to sit these quizzes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Data Exercise Assignment (15%)
- Basic exercise will be forecasting changes in exchange rates.
o Emphasis on practically testing Purchasing Power Parity Theory (PPP).
o Emphasis on applying statistical techniques (regression) to conduct empirical analysis.
- All students should have a FactSet account (from previous courses).
o You need it to complete the assignment.
o If you’re an exchange student/new student etc, you will be provided with an account by the School of
Banking and Finance.
- Release of Data Exercise Assignment: Following the last FINS5516 Lecture in Week
4.
- Due Date: End of Week 9 (Sunday 16 April 2023 – 23:59 Sydney, Australia time)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Final Exam (40%)
- Comprehensive, but with some emphasis on Week 6 – 10 topics.
- University Exam Period.
- 40 Multiple Choice Questions and Calculation Questions.
- Two Hours.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Expectations of Students
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Expectations of Students
- Read the course outline. It contains the key details of the course.
- Read ALL course announcements.
- Maintain email etiquette and discussion forum etiquette.
o Course Code in Email
o Student ID
- Keep in mind that the discussion forum, in-class exercises, lectures
are designed to be platforms for students to obtain feedback on their
understanding of concepts.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Course Aims and Overview
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Course Overview
FINS5511
FINS5516
Politics
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Prevalence of Political Factors: Case Study 1
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Prevalence of Political Factors: Case Study 2
What has been the impact on MNCs?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Prevalence of Political Factors: Case Study 3
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Prevalence of Political Factors: Case Study 4
- BREXIT
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Prevalence of Political Factors: Case Study 5
Source: https://www.rt.com/business/461147-russia-china-nuclear-reactors/
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Course Orientation
- We take the perspective of the financial manager of a multinational
corporation (MNC).
- By definition, the MNC has investments and operations in more than
one country.
- We consider MNC’s exposure to the key risks:
o Foreign Exchange Risk,
o Financial Risk and
o Political Risk.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Course Overview
Assessment Task
Week
The Multinational Corporation and International Financial
Markets
1-3
Foreign Exchange Risk Management
4-6
Cross-Border Financing and Investment
7-10
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Multinational Corporations (MNCs)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
MNCs: Key Stats
-
As at Sep 2020: 80,000+ MNCs globally.
-
Typical setup: 1 headquarter in country of
incorporation. Between 1 and 100+ foreign
branches and subsidiaries.
-
US MNCs account for 19% of employment
levels, 25% of wages, 41% of economic growth,
48% of exports, and 74% of R&D spending –
despite only representing 1% of US firms!
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
MNCs and the Theory of Comparative Advantage
-
MNC’s existence is based on the international mobility of factors of production and
carrying over skills and resources to other countries.
-
Countries are becoming increasingly homogenous in terms of production factors.
-
Firms’ abilities to transfer skills and resources are crucial for competitiveness.
-
Differences in firms’ abilities to use globally available resources and skills is more
important for international competitiveness than macroeconomic differences between
countries.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Theory of Comparative Advantage
-
-
-
Output from production is maximised
when each nation specializes in the
good in which it has the lowest
opportunity cost. Each nation will then
export a proportion of the goods in
line
with
its
consumption
requirements.
Which nation has a comparative
advantage in cotton?
Which nation has a comparative
advantage in wine?
Portugal
UK
Cotton
(Tonne/day)
Wine
(Litre/day)
Cotton
(Tonne/day)
Wine
(Litre/day)
42
0
30
0
35
7
25
2
28
14
20
4
21
21
15
6
14
28
10
8
7
35
5
10
0
42
0
12
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Theory of Comparative Advantage
-
Plot of total output under different production plans:
Source: Author.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Alternative Explanations for the Rise of the MNC
-
Knowledge seeking: Enter foreign markets to gain information that can be used
elsewhere (e.g. production processes).
-
Following domestic clients: Guaranteeing a continuing product flow across countries
(e.g. banks, consulting firms set up foreign operations, to follow their MNC clients).
-
Exploiting financial market imperfections: Reduce taxes, circumvent currency
controls, benefit from international diversification.
-
Firms become multinational by degree:
o Exporting
o Licensing
o Sales subsidiary
o Distribution system
o Overseas production
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Exchange Rate Determination
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
MNCs and Exchange Rates
- Conceptually, we compare MNCs with purely domestic firms.
- MNCs can reduce their operating risk through international diversification
o Countries’ economic cycles vary over time and are not perfectly correlated.
o However, exchange rate fluctuations are still a considerable source of risk.
- Managing exchange rate risk involves:
o Forecasting exchange rates and changes in foreign exchange rates
o Hedging exchange rate risk
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Understanding the Exchange Rate Conceptually
Apples: $3.50/kg
Laptop: $1,200/unit
Milk: $2.70/litre
Wooden Slab: $20/metre
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Understanding the Exchange Rate Conceptually
USD0.75/AUD
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Thus, what is the exchange rate?
-
The FINS5516 textbook quotation of exchange rates is as follows:
AUD1.5103/USD
-
Quotations of the exchange rate on FX markets is:
USD/AUD = 1.5103.
-
This means it takes AUD1.5103 to buy 1 USD.
For the FINS5516 course, we will use the textbook convention.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Exchange Rate Changes Illustrated
-
Suppose American consumers preferences change dramatically and they demand
more Japanese manufactured cars compared with US manufactured cars.
-
Thus, demand for foreign goods (Japan) in the home country (US) increases.
-
US consumers will have to convert their USD holdings into Yen in order to import the
cars. Why? Contextually, Japanese car manufacturers have no use for USD and will
thus accept Yen since they are based in Japan.
-
Demand for Yen increases while simultaneously supply of USD will increase. The
price of the foreign currency (JPY) increases in terms of the local currency (USD).1
Yen costs more USD, i.e. USD/JPY increases.
-
Local currency value (USD) decreases, and the foreign currency value (JPY)
increases
USD/JPY exchange rate increases → Yen appreciation.
JPY/USD exchange rate decreases → USD depreciation.
-
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
A Note About Exchange Rate Changes
-
Take any two currencies and express one in terms of the other.
-
For example, if we have the AUD and USD, then
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝑈𝐷/𝑈𝑆𝐷 ≠ % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑈𝑆𝐷/𝐴𝑈𝐷
Proof:
1
-
If 𝑒1 = 𝐴𝑈𝐷/𝑈𝑆𝐷, then 𝑒 = 𝑈𝑆𝐷/𝐴𝑈𝐷.
-
The percentage change in 𝐴𝑈𝐷/𝑈𝑆𝐷 is:
𝑒1
𝑒0
− 1 100
The percentage change in 𝑈𝑆𝐷/𝐴𝑈𝐷 is:
1
𝑒1
1
𝑒0
− 1 100 =
-
1
𝑒0
𝑒1
− 1 100
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Exchange Rate Changes: Example 1
-
Suppose the current exchange rate between the Australian dollar (AUD) and the US
dollar is USD0.75/AUD. If the AUD’s value decreased by 15% against the USD, what
is the percentage change in the USD against the AUD?
-
The new USD/AUD exchange rate is:
= 1 − 0.15 𝑈𝑆𝐷0.75/𝐴𝑈𝐷
-
= 𝑈𝑆𝐷0.6375/𝐴𝑈𝐷
Taking the reciprocal of the new exchange rate, to express USD in terms of AUD:
= 1𝐴𝑈𝐷/0.6375𝑈𝑆𝐷
-
= 𝐴𝑈𝐷1.5686/𝑈𝑆𝐷
The percentage change in the USD against the AUD is:
𝐴𝑈𝐷1.5686/𝑈𝑆𝐷
− 1 100 = 17.647%
𝐴𝑈𝐷1.3333/𝑈𝑆𝐷
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Exchange Rate Changes: Example 2
-
Suppose the current exchange rate between the British Pound (£) and the US dollar
is USD1.35/£. If the pound’s value increased by 8% against the USD, what is the
percentage change in the USD against the pound?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS5516 International
Corporate Finance for Term 1,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Fundamental Factors Affecting a Nation’s Currency Value Relative
to Another Currency’s Value
Relative
Rates of
Inflation
Relative
Rates of
Interest
Terms of
Trade
Degree
of
Political
Stability
Factors Affecting
the Exchange Rate
Public
Debt
Relative
Economic
Growth
Rates
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Relative Inflation Rates and the Exchange Rate
-
Consider two countries: Australia and the US.
-
Suppose that the rate of inflation in Australia increases, while that in the US remains
unchanged such that the relative rate of inflation increases. What is the likely impact
on the AUD/USD exchange rate? Illustrate using the demand and supply model.
-
Firstly, what is the process of economic events?
o Demand for AUS products decreases, demand for US products increases.
o The supply of USD (and demand for AUD) decreases.
o Demand for USD increases.
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Relative Inflation Rates and the Exchange Rate
-
Let’s reconsider the same example on the previous slide, but this time have numbers.
Suppose the initial exchange rate is USD0.75/AUD. The RBA has recently increased
the domestic money supply by 5% through printing money. Economists expect that
the annual rate of inflation in the US is likely to remain at 2% over the next 12 months.
What is the expected USD/AUD exchange rate at the end of the year?
-
Firstly, what theoretical framework should we use to identify the expected rate of
inflation in Australia? The Quantity Theory of Money.
𝑀 𝑠 𝑉 = 𝑃𝑌
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Relative Inflation Rates and the Exchange Rate
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Relative Inflation Rates and the Exchange Rate
-
Now, we can use relative purchasing power parity (RPPP) to forecast the USD/AUD
exchange rate:
𝑅𝑃𝑃𝑃 → 𝐸 𝑠𝑈𝑆𝐷/𝐴𝑈𝐷
𝑒
1 + 𝜋𝑈𝑆𝐷
=
𝑠𝑈𝑆𝐷/𝐴𝑈𝐷
𝑒
1 + 𝜋𝐴𝑈𝐷
𝑅𝑃𝑃𝑃 → 𝐸 𝑆𝑈𝑆𝐷/𝐴𝑈𝐷 =
1 + 0.02
𝑈𝑆𝐷0.75/𝐴𝑈𝐷
1 + 0.05
𝑅𝑃𝑃𝑃 → 𝐸 𝑠𝑈𝑆𝐷/𝐴𝑈𝐷 = 𝑈𝑆𝐷0.7286/𝐴𝑈𝐷
-
What is the forecast depreciation of the AUD against the USD?
𝑈𝑆𝐷0.7286𝐴𝑈𝐷
=
− 1 100
𝑈𝑆𝐷0.75𝐴𝑈𝐷
What is this number?
(the expected inflation
rate differential)
5% - 2%= 3%.
= −2.857%
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Relative Interest Rates and the Exchange Rate
-
Suppose we expect the annual real interest rate in Australia to be lower than that in
the US. What do we expect to happen to the exchange rate by the end of the year?
-
Firstly, let us specify the economic process that will ensue.
-
Increase in demand for USD-denominated securities relative to AUD-denominated
securities.
-
Demand for USD increases while the demand for AUD decreases.
-
The USD/AUD rate depreciates.
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Relative GDP Growth Rates & the Exchange Rate
-
Suppose the economic growth rate (real GDP) in Australia is expected to be higher
than that of the US.
-
Strong AUD GDP growth → demand for AUD assets and investment capital increases.
-
Demand for AUD increases, demand for USD decreases.
-
AUD/USD depreciates.
-
But there is an offsetting action. Can you identify what it is?
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Political Risk and the Exchange Rate
-
Consider political and economic risk and the AUD/USD exchange rate.
-
Suppose political risk (or perceptions of) in Australia increases relative to the US.
-
Demand for risky AUS assets decreases.
-
Demand for AUD decreases, demand for USD increases.
-
USD/AUD depreciates.
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Why does a currency have value?
-
Recall that the nominal exchange rate = relative price of two currencies.
-
It reflects investors’ expectations about future currency supply and demand.
-
Liquidity
o Depends on volume of transactions and demand for assets (i.e. interest rates,
expected economic growth, and political and economic stability).
-
Store of value
o Depends on the expected inflation rate(s).
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Central Bank Reputations and Expectations
-
Central banks use monetary policy to achieve price level stability, set interest rates, or
maintain a certain currency value.
-
Fiat money, so value of money and exchange rates are driven by investors’
expectations of central bank behaviour.
-
Expectations partly determined and hence dependent on central bank reputations.
-
Monetary policy objectives:
-
Independence:
o Reputable central banks maintain price level stability at all costs, for example.
-
Central banks that are not independent from the government are often forced to monetize
government deficits. This means that have to purchase the government’s bonds to cover
the deficit.
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Central Bank Reputations and Expectations
Note: Inflation and economic growth rates calculated for the period 1951–1988. Source: Adapted from J. Bradford Delong and Lawrence H.
Summers. ‘‘Macroeconomic Policy and Long-Run Growth, ’’Economic Review, Federal Reserve Bank of Kansas City, Fourth Quarter
1992,pp.14-16.
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Types of Interventions by Central Banks
-
Unsterilized intervention
o For example, if the RBA wants to let USD/AUD to depreciate it can buy USD in exchange
for AUD (i.e. sell AUD for USD). However, Australia’s money supply increases. Implications?
-
Sterilized intervention
o Open-market operations to keep money supply constant.
o Usually by buying or selling treasury securities. For example,
the RBA can reduce the
supply of AUD by selling AUD-denominated securities to investors.
o However, sustained interventions can lead to investors changing their expectations about a
nation’s monetary policy. In turn, this could lead to further induced changes to the exchange
rate.
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International Monetary Systems
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Three Key Objectives
- The government of each country would like to obtain the following three
policy objectives:
Stable
Exchange
Rate
Independent
Monetary
Policy
Capital
Market
Integration
- But according to Mundell (1963) and Fleming (1962), only two of the three
can be achieved simultaneously.
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The Impossible Trinity
Where would you
place the following?
A
- China
- Australia
Stable
Exchange Rate
Independent
Monetary Policy
- Bretton Woods
- Argentina
- Gold Standard
- Euro
B
Capital Market Integration
C
- Intra Eurozone
- Hong Kong
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The Impossible Trinity – Proof
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Exchange Rate Systems
Target-Zone
Arrangement
Floating Currency
- Free (clean) float:
supply and demand
(market forces).
- Dirty float: market
forces with some
central bank
intervention.
- Managed Floating
Currencies: more
central bank
intervention than a
dirty float.
Fixed/Pegged
Currency
- Target exchange rate
set by government,
with central bank
intervention if deviates
- Requires coordinated
monetary policies +
commitment to target
rate.
Market forces within a
margin around agreedupon fixed exchange
rate.
Crawling Peg
Currency depreciation
against a reference
currency on a regular,
controlled basis. It is
used to ease transition
from a fixed to
fluctuating exchange
rate.
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International Monetary System 1: Gold Standard
(1821 – 1931)
Gold Standard
- Limited short-run changes in gold value. Why?
(high production costs)
-
UK paid £4.247/ounce, US paid $20.67/ounce.
-
We can infer the exchange rate between the pound and the USD.
Gold Exchange Standard (1925 – 1931):
- UK and US held gold, other countries held gold, GBP, or USD .
-
Broke down following WWI and Great Depression:
o Mining and storing gold is costly and does not pay interest.
o Countries had incentives to leave gold standard after WWII (e.g. Germany).
o Large gold and capital flows led to unrealistic exchange rates.
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Monetary System 2: Bretton Woods
(1946 – 1971)
-
Post-WWII: avoid protectionist exchange rate policies.
-
Fixed exchange rates with respect to USD.
o USD pegged at $35/ounce gold
o e.g. DM set at 1/140 ounce = $0.25/DM
-
Maintained by buying or selling USD in open market.
-
Required coordinated monetary policy cross countries. 19 out of the 21 countries
devalued/revaluated/floated their currencies by mid-1971
-
in 1971: USD convertibility terminated and USD devalued due to oil price shocks
causing a run on gold.
-
The International Monetary Fund (IMF) and the World Bank were created from the
Bretton Woods System.
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International Monetary System 3: Floating Exchange
Rate Regime (1971 – present)
-
Market forces determine the rate of exchange of currencies.
-
Also, exchange rate changes should account for international inflation rate differentials
in order to maintain real exchange rate stability.
-
However, in practice we see a high degree of real exchange rate volatility.
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International Monetary System 4: European
Monetary System (EMS)
European Monetary System was operational between 1979 – 1993. Key characteristics
of the EMS:
-
Target-zone arrangement. It holds exchange rates within pre-specified limits of a
mutually agreed-on central exchange rate.
-
Exchange rate stability. However, it required the coordination of general economic
policy and monetary policy.
-
Difficult to maintain with the central banks of member states. Why?
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Monetary System 5: European
Monetary Union (EMU)
The European Monetary Union was founded in 1999. Key characteristics of the EMU:
-
European Central Bank (ECB) was the only central bank with power to issue currency
(Euro).
-
EMU member nations were required to meet inflation, currency stability, and deficit
spending standards.
-
All monetary autonomy of EMU members surrendered to ECB – Governments can
issue Euro-denominated bonds, but are unable to print money to service debts.
-
ECB provides price level stability, member states are responsible for budgetary and
borrowing needs.
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Monetary Unions
Advantages
Disadvantages
Lower cross-border currency
conversion costs.
Monetary Policy dependence.
Higher degree of transparency for
prices.
Higher lag times for adjustments to
macroeconomic changes.
Lower exchange rate risk.
Increased trading volumes.
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Reference List
1. Mundell, Robert A. (1963). "Capital mobility and stabilization policy under fixed and flexible exchange
rates". Canadian Journal of Economics and Political Science. 29 (4): 475–485.
2. Fleming, J. Marcus (1962). "Domestic financial policies under fixed and floating exchange rates". IMF Staff
Papers. 9: 369–379.
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Week 1 BONUS Exercise
Refer back to the slide where Australia’s money supply increased
by 5% and the expected rate of inflation in the US is 2%.
Assuming that the circumstances are replicated perfectly each
period, forecast the USD/AUD exchange rate at the end of year 3.
What is the cumulative change in the AUD’s value?
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