I. Overview of The Foreign Exchange Market
1. Definition
- The foreign exchange (FX) market is the place where currencies are traded and its primary
function is to facilitate international trade and investment.
- The FX market has no physical location where traders get together to exchange currencies. It is an
electronically linked networks of banks, foreign exchange brokers and dealers whose function is to
bring together buyers and sellers of foreign exchange.
- The purpose of the FX market is to permit transfers of purchasing power denominated in one
currency to another - to permit trading of one currency for another currency.
- The FX market is the largest financial market in the world. The average foreign exchange daily
trading volume is $1.5 trillion, or $375 trillion a year in 1998. London is the largest currency
trading market in the world with daily turnover in 1998 estimated at $637 billion. The United States
is second, at about $351 billion in 1998. In contrast, average daily trading volume on the New York
Stock Exchange is only about $7 billion.
2. Types of Transactions
- Three general types of transactions take place in the FX market: spot, forward and swap.
- Spot transactions involve an agreement on price today with settlement day usually two business
days later. Spot transactions account for about 40% of the market.
- Forward transactions involve an agreement on price today for settlement at some date in the future.
Frequently traded forward maturities are for one or two weeks, or one through twelve months.
Forward contracts account for 9% of foreign exchange transactions.
- A swap is the sale (purchase) of a foreign currency with a simultaneous agreement to repurchase
(resell) it at some date in the future. Swap transactions represent 51% of foreign exchange
transactions.
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3. Foreign Exchange Rates and Quotations
A foreign exchange rate is the price of one currency expressed in terms of another currency.
a. Direct and Indirect Quotes
Foreign exchange quotations are either direct or indirect.
Direct quote - the home currency price of one unit of foreign currency. e.g., $0.8914/euro
Indirect quote - the foreign currency price of one unit of home currency. e.g., euro 1.1218/$
c. Bid and Offer Quotations
- Foreign exchange quotations are expressed as a bid and an offer (ask).
Bid price - the price at which a dealer is willing to buy a currency.
Offer price - the price at which a dealer is willing to sell a currency.
e.g., euro 1.1218 -1.1220 per $
d. Cross Rates
Exchange rates of almost all currencies are quoted against the U.S. dollars. For example, both the
British pound and euros will be traded with prices quoted against the U.S. dollar. If a commercial
customer asked for a euro price in terms of the British pound, this cross rate will be determined
from the two dollar rates.
Example: A bank is currently quoting the following exchange rates with respect to the dollar:
Euro 1.1218/$; $1.4374/L
What euro per British pound cross rate would the bank quote, it asked?
e. Measuring a Change in Spot Exchange Rates
Suppose the yen value of the dollar dropped from Y106/$ to Y102/$. What is the percent
decrease in the yen value of the dollar? What is the percent increase in the dollar value of the
yen?
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II. Foreign Exchange Parity Conditions and Forecasting
1. Parity Conditions
In the competitive and efficient foreign exchange market, the following economic
relationships, called parity conditions, among foreign exchange rates, inflation and interest rates.
A. Purchasing Power Parity
B. Fisher Effect
C International Fisher Effect
D. Interest Rate Parity
E. Forward Rate as an Unbiased Predictor of Future Spot Rates
A. Purchasing Power Parity (PPP)
(a) The Absolute Version
Exchange-adjusted price levels should be identical worldwide. In other words, a unit of home
currency should have the same purchasing power around world.
S0 
PIf
PIh
The absolute PPP ignores the effects on free trade of transportation costs, tariffs, quotas and other
restrictions.
(b) The Relative Version
The Exchange rate change during a period should equal the inflation differential for that same
period. Or currencies with high rates of inflation should devalue relative to currencies with lower
rates of inflation.
S1  S 0
 fh
S0
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B. The Fisher Effect (FE)
Nominal interest rates in each country are equal to the real rate of return plus the expected
inflation rate.
i =  + E(
C. The International Fisher Effect (IFE)
The expected future spot exchange rate should change in an equal amount but in the opposite
direction to the difference in interest rates between two countries.
S1  S 0
 i f  ih
S0
In short, the IFE says that currencies with low interest rates are expected to appreciate relative to
currencies with high interest rates.
D. Interest Rate Parity
The difference in the national interest rates for securities of similar risk and maturity should
be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency.
Algebraically,
F1 1  i f

S 0 1  ih
or, in approximation,
F1  S 0
 i f  ih
S0
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- According to the interest rate parity theorem, if interest rates are higher (lower) in the domestic
country than in the foreign country, then the foreign country's currency will be selling at a premium
(discount) in the forward market.
- In short, interest rate parity says that high interest rates on a currency are offset by forward
discounts and that low interest rates are offset by forward premiums.
- Consider a trader with access to the interbank market in foreign exchange and eurocurrency.
Strategy A
- At time 0, deposit one unit of domestic currency
- At time 1, withdraw 1 + ih units of domestic currency.
Strategy B
- At time 0, purchase S0 units of foreign currency; deposit them at the interest rate of 1 + if; sell
forward S0(1 + if) units of foreign currency at forward rate F1.
- At time 1, deposit matures and pays S0(1 + if) units of foreign currency; deliver this amount of
foreign currency in fulfillment of forward contract receiving S0(1 + if)/ F1 units of domestic
currency.
With no arbitrage opportunities, we must have equality between the rate of return on domestic
assets and covered foreign assets:
1 + ih = S0(1 + if)/ F1
or
F
S0

1 if
1  ih
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Example 1: Let the spot rate S0 = euro 1.4/$ and the one-year forward rate F1 = euro1.3/$. Let the
rates on eurodollar deposits and euro deposits be, respectively, ih = 4% and if = 3.714%. Compare
the return on domestic lending with the return on covered foreign lending.
Example 2: Suppose an interbank trader noticed the following market prices:
S0 = L0.7/$, F1 = L0.8/$; ih = 10% and if = 6%.
Is there an arbitrage opportunity?
E. Forward Rate as an Unbiased Predictor of the Future Spot Rate
If the foreign exchange market is efficient, the expected value of the future spot rate at time 2
equals the present forward rate for time 2 delivery, available at time 1 (now).
E(S1) = F1
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3. Exchange Rate Forecasting
A. Fundamental Versus Technical Analysis
- Fundamental analysis is to construct forecasts on the basis of financial and economic theories.
- Technical analysis is to derive forecasts from the trend of the data series itself.
(a) Fundamental Analysis
Fundamental analysis is split into two schools of thought: the balance of payments approach and
the asset market approach.
- The balance of payments approach emphasizes analysis of a country's balance of payments as an
indicator of pressure on a managed exchange rate.
- The asset market approach postulates that the relative attractiveness of a currency for investment
purpose is the main force driving exchange rates.
(b) Technical Analysis
Technical analysis is to attempt to forecast future foreign exchange rates through the analysis of
past price and volume data. One advantage of the technical analysis is to be able to assess the
market psychology.
B. Forecasting Exchange Rates in the Short Run
The two primary alternatives for forecasting exchange rates in the short run are time series
techniques which emphasize trend and the use of the forward rate itself as a prediction.
C. Forecasting Exchange Rates in the Long Run
Forecasting methods for the long run include computerized time series analysis and the
econometric analysis using fundamental analysis.
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III. Foreign Exchange Risk Management
(1) There are three main types of foreign exchange exposure: Operating, Transaction, and
Accounting.
(2) Exposure refers to the degree to which a company is affected by foreign exchange changes.
(3) Operating exposure, or economic exposure, measures a change in the present value of firm that
results from changes in future operating cash flows caused by an unexpected change in exchange
rates.
(4) Transaction exposure measures changes in the value of outstanding financial obligations due to
an unexpected change in exchange rates.
(5) Accounting exposure, or translation exposure, measures potential accounting-derived changes in
owners' equity that result from the need to translate foreign currency financial statements to into a
single reporting home currency. 
1. Operating Exposure
(1) The Nominal vs. Real Exchange Rates
- The real exchange rate is defined as the nominal exchange rate adjusted for changes in the relative
purchasing power of each currency since some base period, i.e.,
S t'  St
(1 h )t
(1 f )t
- A change in the nominal exchange rate accompanied by an equal change in the price level would
have no effect on the relative prices of domestic and foreign goods. In contrast, a change in the real
exchange rate will cause relative price changes - changes in the ratio of domestic goods' prices to
prices of foreign goods.
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(2) Inflation and the Nominal Exchange Risk
- Without relative price changes, a multinational company has no operating exposure. A
multinational firm's foreign cash flows vary with the foreign rate of inflation. But the exchange rate
also depends on the difference between the foreign and the domestic rates of inflation. Therefore,
the movement of the exchange rate exactly cancels the change in the foreign price
level, leaving real dollar cash flows unaffected.
(3) Real Exchange Rate Changes and Exchange Risk
- The economic impact of a currency change on a firm depends on whether the exchange rate is
fully offset by the difference in inflation rates or whether the real exchange rate and, hence, relative
prices change. It is these relative price changes that ultimately determine a firm's long-run operating
exposure.
- Example
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(4) Economic Effects of Exchange Rate Changes on MNCs
Example: Sunbeam Inc. considers selling its product to Mexico. Two alternative ways of selling the
product overseas is to export or to construct production facilities in Mexico and sell the product
locally. Sunbeam Inc. plans to set the export price at $180 per product if it decides to export and the
local sales price at 630 pesos if it chooses to manufacture and sell in Mexico. The unit production
cost is $70 if the product is manufactured in the U.S. and 245 pesos if it is manufactured in Mexico.
The current exchange rate is Peso 3.5/$. At this current exchange rate, Sunbeam forecasts the
export volume of 1,200 units. Sunbeam also forecasts that if the peso value revalues to peso 3.0/$,
the export volume will increase to 1,500 units, and if the peso devalues to peso 4.0/$, the export
volume will decrease to 900 units. If Sunbeam chooses the second alternative of constructing
production facilities in Mexico, the local sales volume will remain to be 1,200 units. Calculate the
profit margin (= sales revenue - production cost) for the three cases (i.e., at the current exchange
rate, the case of revaluation and the case of devaluation) under each of the two alternatives (i.e.,
export and foreign direct investment), respectively. You must fill all the entries in dollar terms.
(1) Export
At current
exchange rate
After revaluation
After devaluation
After revaluation
After devaluation
Sales Rev.
Production
cost
Profit
Margin
(2) Foreign direct investment
At current
exchange rate
Sales Rev.
Production
cost
Profit
Margin
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- Observation
(a) Domestic facilities that supply foreign markets entail much greater exchange risk than do foreign
facilities supply local markets. e.g., Nissan Motors
(b) A firm producing solely for the domestic market and using only domestic sources of inputs can
be strongly affected by currency changes, even though its accounting exposure is zero. e.g.,
American automobile companies.
(5) Managing Operating Exposure
a. Match any change in the inflow on assets due to a currency change with a corresponding change
in the outflow on the liabilities used to fund those assets.
b. Reduce the price elasticity of demand
The less price elastistic the demand, the more price flexibility a company will have to respond to
exchange rate changes. Price elasticity, in turn, depends on the degree of competition and the
location of key competitors
c. Enhance the ability to shift production and sourcing of inputs among countries
The greater a company's flexibility to substitute between home-country and foreign-country inputs
or production, the less exchange risk the company will face. Other things being equal, firms with
worldwide production system can cope with currency changes by increasing production in a nation
whose currency has undergone a real devaluation and decreasing production in a nation whose
currency has revalued in real terms.
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2. Transaction Exposure
(1) Causes
Transaction exposure measures gains or losses that arise from the settlement of financial
obligations whose terms are stated in a foreign currency. Transaction exposure arises from
a. purchasing or selling on credit goods or services whose prices are stated in foreign currencies,
b. borrowing or lending funds when repayment is to be made in a foreign currency.
(2) Examples
a. Suppose that a U.S. firm sells merchandise on open account to a French buyer for FF1,000,000,
payment to be made in 60 days. The current exchange rate is FF5.7/$, and the U.S. seller expects to
exchange FF1,000,000 for $175,439 when payment is received.
b. Britain's Beecham Group borrowed SF100 million in 1971 at a time
when that amount of
Swiss francs was worth L10.13 million. When the loan came due five years later the cost of
repayment of principal was L22.73 million-more than double the amount borrowed.
(3) Managing Transaction Exposure
Transaction exposure can be managed by hedges in the forward, money, futures, options markets,
as well as swap agreements.
Example: Dow Chemical, imports a chemical processor from VEBA Group, a German firm, in
March for euro1,000,000. Payment is due three months later, in June. The following quotes are
available.
Spot exchange rate: euro 0.70/$
Three-month forward rate: euro0.80/$
Germany borrowing interest rate: 6% per annum
Germany investment interest rate: 5% per annum
U.S. borrowing interest rate: 8% per annum
U.S. investment interest rate: 6.8% per annum
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Dow Chemical's International Finance Division forecasts that the spot rate in three months will be
euro0.78/$.
Four alternatives are available to Dow Chemical:
. Remain unhedged
. Hedge in the forward market
. Hedge in the money market
. Hedge in the options market
. Hedge in the swap market
a. Unhedged Position
b. Forward Market Hedge
c. Money Market Hedge
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3. Foreign Currency Futures
A. Definition
A futures contract obligates you to sell or purchase a specific amount of a commodity at a specific
time in the future.
B. Purpose of Futures Markets
to meet the needs of the following three groups of futures market users.
- Those who wish to transfer unwanted risk to some other party.
- Those who wish to speculate
- Those who wish to discover information about futures spot prices of commodities.
C. Futures vs. Forward Markets
Futures Markets
Forward Markets
(a) Futures contracts are always traded
on an organized exchange
Loosely organized.
Do not have physical location devoted
to trading
(b) Futures contracts are highly
standardized and well specified
commitments for a carefully
described goods to be delivered
at a certain time and in a certain
manner
Not standardized
(c) The buyer and seller hold formal
contracts with the clearing
house of the futures exchange.
Thus, either party can liquidate
its futures obligation to buy (or
sell) by "offsetting" it with a sale
(or purchase) of the same contract prior
to the scheduled delivery date. In the
futures market, almost all contracts are
"offset" prior to delivery.
The buyer and seller hold formal
contracts with each other.
Contracts are ordinarily satisfied by actual
delivery of specified items on the specific
date.
(d) Initial margin requirement and daily resettlement features.
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D. FX Futures Contracts
(a) The two most important places where FX futures contracts can be traded are at the International
Money Market (IMM) of the Chicago Mercantile Exchange and at the London International
Financial Futures Exchange (LIFFE).
(b) The most active currency futures contracts are Canadian dollar, Deutsche mark, French franc,
Japanese yen, British pound, and Swiss franc.
(c) Delivery takes place on the third Wednesday of the spot month or if that is not a business day,
the next business day. Trading in a contract ends two business days prior to the delivery day.
4. Foreign Currency Options
A. Definition
An option is a contract giving its owner the right to buy or sell an underlying asset at a fixed price
on or before a given date. There are two types of options: call and put options. A call option gives
the owner the right to buy an asset and a put option the right to sell an asset.
B. Some jargons
(a) Exercising the option: The act of buying or selling the underlying asset via the option contract.
(b) Striking price or exercise price: The fixed price in the option contract at which the holder can
buy or sell the underlying asset.
(c) Expiration date: The maturity date of the option.
(d) American and European options: An American option may be exercised any time up to the
expiration date. A European option differs from an American option in that it can be exercised only
on the expiration date. Nearly all options now traded in the U.S. are of the American type.
C. The foreign currency options market
The market for foreign currency options consists of an interbank market centered in London and
New York, and exchange-based markets in Philadelphia (the PHLX), Chicago (the CME and
CBOE), and London (LIFFE and LSE).
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D. Hedging with foreign currency options
(a) Foreign currency put options on spot can be used as insurance to establish a floor price on the
domestic currency value of foreign exchange. This floor price is approximately
Floor price = Exercise price of put - Put premium
(b) Foreign currency call options can be used as insurance to establish a ceiling price on the
domestic currency cost of foreign exchange. The ceiling price is approximately
Ceiling price = Exercise price of call + Call premium
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IV. The Swap Markets
1. Definition
A swap is an exchange of financial obligations between two parties, called counterparties, each of
whom has incurred a financial obligation in a currency or in a type of interest payment that was not
really desired, but was the cheapest alternative.
2. Types
Interest-rate swaps and currency swaps.
(1) Interest-rate swaps
The most common type of interest-rate swap is a fixed-for-floating rate swap. In this type of
swap, the first counterparty agrees to make fixed-rate interest payments to the second counterparty
in exchange for floating-rate interest payments to the first counterparty by the second counterparty.
(2) Currency swaps
In the basic currency swap, the two counterparties agree to an immediate exchange of one
currency for another at some exchange rate; this exchange rate is usually the current spot rate.
These currencies are later swapped back at the same exchange rate. In the interim, the
counterparties exchange interest payments.
3. The Basic Structure
(1) Currency Swaps
The currency swaps involves three distinct sets of cash flows: (a) the initial exchange of
principals; (b) the interest payments of each counterparty to the other between the exchange of
principals; and (c) the final exchange of principals.
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Example: Metrobank's Bucharest office recently arranged a swap deal in which the bank
intermediated between the Wooden Stake Corporation, a northwestern U.S. lumber firm that wanted
six-year fixed rate sterling funds, and the Bank of Transylvania, which wanted floating-rate dollar
funds. Wooden Stake obtained a floating-rate loan linked to LIBOR while Bank of Transylvania
issued a fixed rate Bulldog bond; each effectively paid the other's interest with Metrobank coming
in between.
i. Show, by means of diagram, the initial, annual and final cash flows arising from this swap.
ii. Show what flows (if any) might have occurred if Wooden Stake have wanted dollar funds
instead.
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(2) Interest-Rate Swaps
Suppose Company A and Company B, both of whom are domiciled in the U.S. have matchable
borrowing needs. Company A needs to raise $1 million of five-year money and would like a
floating rate. Company A can borrow at a fixed annual rate of 12 percent or at a floating rate of
LIBOR plus 2.5 percent. At the same time, Company B needs to raise $1 million of five-year
money but wants a fixed rate. Company B can borrow at a fixed rate of 14 percent or a floating rate
of LIBOR plus 3.5 percent.
Comparison of Borrowing Costs with and without a Swap
Without a Swap
Company
Fixed Rate
Floating Rate
A
12.0%
LIBOR + 2.5%
B
14.0%
LIBOR + 3.5%
With a Swap
A
Pays fixed to third party
Pays floating to B
Receives fixed from B
+ 12%
+ LIBOR + 3.5%
- 13.5%
_______________
LIBOR + 2.0%
Net Cost to A
Net Savings to A = 50 basis points
B
Pays floating to third party
Pays fixed to A
Receives floating from A
Net Cost to B
+ LIBOR +3.5%
+ 13.5%
- (LIBOR + 3.5%)
________________
13.5%
Net Savings to B = 50 basis points
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V. Multinational Capital Budgeting
1. Basics of Capital Budgeting
(1) Relevant cash flows = the incremental after-tax cash flows
ATCF = (R - C - D)(1 - ) + D
(2) Relevant discount rate = the weighted average cost of capital
WACC = (
D
E
) k D (1 -  ) + (
)k E
D+ E
D+ E
kE = rf + E(rM - rf)
(3) Example
A local department store considers replacing the current elevator with a new escalator. The
new escalator costs $0.6 million and has a 3 year life. Sales revenue, operating costs and
depreciation charges with the current elevator and the new escalator would be as follows:
Elevator
year
1
2
3
sales revenue
$1 mil
$1 mil
$1 mil
operating costs
$0.7 mil
$0.7 mil
$0.7 mil
annual depreciation
$0.1 mil
$0.1 mil
$0.1 mil
Escalator
year
1
2
3
sales revenue
$1.3 mil
$1.3 mil
$1.3 mil
operating costs
$0.7 mil
$0.7 mil
$0.7 mil
annual depreciation
$0.2 mil
$0.2 mil
$0.2 mil
The elevator is selling at $0.2 mil. The corporate tax rate is 34% and the appropriate discount rate is
10%.
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2. Issues in Foreign Investment Analysis
(1) The choice of currency. foreign or home
Cash flows in home (foreign) currency should be discounted back at the home (foreign)
currency discount rate.
(2) The discount rate
The home-currency WACC can be converted to a foreign-currency WACC by using the
interest rate parity condition.
1 + S =
1 if
1  ih
=
1  WACC f
1  WACC h
(3) Corporate taxes
The U.S. uses a "tax credit" system: Foreign taxes of virtually all types paid abroad may be
claimed as a credit against taxes paid on foreign-source income in the home country. Foreign tax
credit limitations generally result in the higher of the two marginal corporate tax rates being paid.
Thus, the higher corporate tax rate should be used in computing after-tax cash flows for a crossborder project.
(4) Earned versus remitted cash flows
Cash flows that are earned on an investment in a foreign country may or may not be
converted into home currency and remitted directly back to the foreign parent. These possibilities
raise the question of whether one should use earned or remitted cash flows in valuing cross-border
investments. In most situations, earned cash flows should be used whether or not they are remitted
directly to the parent.
(5) Terminal value
The terminal value of a project often represents a significant proportion of its total present
value and must always be included. The appropriate method of computing a project’s terminal
value depends largely on how and when a project is likely to end, and on the length of the
forecasting time horizon. Going concerns with an indefinite life are often best handled by assuming
that the last period’s free cash flow will be received as a perpetuity or as a long-lived annuity,
possibly growing at some reasonable constant rate in either case.
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The simple net book value of the investment at the forecasting horizon is also commonly
used as an estimate of terminal value. Book value is often used for finite-lived projects under the
assumption that all assets can be liquidated and liabilities discharged at their respective book values.
If reliable estimates of liquidating values can be determined, however, these will generally be
superior to simple book values.
(5) Inflation Risk
Inflation risk is most problematic when attempting to value investments in hyperinflationary
environments. Hyperinflation is generally characterized by highly volatile rates of inflation from
one period to the next, as well as very high rates. Because it is difficult to ascertain long-term
expected inflation in hyperinflation economies, it can be extremely difficult to determine an
appropriate discount rate.
Under these circumstances, the best course of action is to execute the analysis in real, not
nominal, terms. That is, expected cash flows should be discounted using a real rather than inflated
monetary values, and they should be forecasted using real rather than inflated monetary values, and
they should be discounted using a real rather than nominal cost of capital. Although such an
analysis can, in principle, be executed in any currency, it is often most expedient to do so in a stable
currency, such as dollars, for which reliable real rates of return can be estimated.
(6) Adjusting for special risks
Multinational projects are subject to special risks such as foreign exchange risk,
expropriation risk and the risk of currency inconvertibility.
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