INTERNATIONAL FINANCE
Professor Ivar Bredesen
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
What is special about
international finance?
•
•
•
•
Foreign exchange rate risk
Political risk
Market imperfections
Expanded opportunity set
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Course contents
• The course is divided into three parts:
– The International Financial Environment
– Exchange Rate Behaviour
– Exchange Rate Risk Management
• Workload – 7.5 ECTS
– Examination (80 %) and assignments (20 %)
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Required reading
Madura and Fox, 2nd ed.
• Good, intermediate level
text in international
finance
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
We will cover the following
chapters:
– 1: Multinational Financial Management
– 2: International Flow of Funds
– 3: International Financial Markets
– 4: Exchange rate determination
– 5: Currency Derivatives
– 7: International arbitrage and interest rate
parity
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
We will cover the following
chapters:
– 8: Inflation, interest rates and exchange rates
– 9: Forecasting exchange rates
– 10: Measuring exposure to exchange rate
fluctuations
– 11: Managing transaction exposure
– 12: Managing economic exposure and translation
exposure
• Note that we will cover some chapters in more
depth than the textbook. It is therefore important
to read the lecture notes also.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Financial Risk Management
• The field of financial risk management normally
contain the following:
– Interest rate risk
– Commodity price risk
– Equity risk
– Currency risk
• This course will deal with currency risk
• We need to know some finance to assess the
instruments used to hedge currency risk and some
economics to understand exchange rate behaviour
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Foreign Exchange Risk
– This is risk that foreign currency profits may
evaporate in dollar terms due to unanticipated
unfavorable exchange rate movements.
– Suppose $1 = ¥100 and you buy 10 shares of Toyota
at ¥10,000 per share. One year later the investment
is worth ten percent more in yen: ¥110,000.
– But, if the yen has depreciated to $1 = ¥120, your
investment has actually lost money in dollar terms.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
1-8
Europe’s Sovereign-Debt Crisis of 2010
• In December of 2009 the new Greek government revealed
that its budget deficit for the year would be 12.7% of GDP,
not the 3.7% forecast.
• Investors sold off Greek government bonds and the ratings
agencies downgraded them to “junk.”
• While Greece represents only 2.5% of euro-zone GDP, the
crisis became a Europe-wide debt crisis.
• The challenge remains that fiscal indiscipline of one eurozone country can escalate to a Europe-wide crisis.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
1-9
The Greek Drama
• Greece paid no premium above the German rate until late fall
2009.
• The Greek interest rate rose until the bailout package on May 9.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
1-10
Foreign Exchange Markets
• The FOREX market provides the physical and
institutional structure through which
– The money of one country is exchanged for that of
another country
– The rate of exchange between currencies is
determined
– Foreign exchange transactions are physically
completed
• The FOREX market is extremely competitive
and highly efficient
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Transactions in the Interbank
Market
• Transactions within this market can be
executed on a spot, forward, or swap
basis
– A spot transaction requires almost immediate
delivery of foreign exchange
– A forward transaction requires delivery of
foreign exchange at some future date
– A swap transaction is the simultaneous
exchange of one foreign currency for another
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Outright Forward Transactions
• This transaction requires delivery at a future value
date of a specified amount of one currency for
another
• The exchange rate is agreed upon at the time of the
transaction, but payment and delivery are delayed
• Forward rates are contracts quoted for value dates
of one, two, three, six, nine and twelve months
– Terminology typically used is buying or selling
forward
– A contract to deliver dollars for euros in six months is
both buying euros forward for dollars and selling
dollars forward for euros
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Swap Transactions
• A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount
of foreign exchange for two different value dates
• Both purchase and sale are conducted with the
same counterpart
• A common type of swap is a spot against forward
– The dealer buys a currency in the spot market and
simultaneously sells the same amount back to the
same bank in the forward market
– Since this transaction occurs at the same time and
with the same counterpart, the dealer incurs no
exchange rate exposure
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Size of the FOREX Market
http://www.bis.org/publ/rpfxf10t.pdf
• The Bank for International Settlements (BIS)
estimates that daily global net turnover in traditional
FOREX market activity to be US$4.0 trillion in April
2010, up from 3.2 trillion in 2007
– Spot transactions at $1,490 billion/day, up 48 %
– Outright forward transactions at $475 billion/day
– Swap transactions at $1,765 billion/day
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Global Foreign Exchange Market Turnover, April
2010 (daily averages, billions of U.S. dollars)
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Turnover by instrument
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Turnover by currency
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Top trading centers
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Norway April 2010 (million USD)
total, USD, Euro, Yen, GBP, Swiss Francs
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Foreign Exchange Rates &
Quotations
• Direct and Indirect Quotes
– A direct quote is a home currency price of a
unit of a foreign currency
• NOK 5/$ is a direct quote in Norway
– An indirect quote measures how much foreign
currency you can buy for one unit of your own
• NOK 0.2/$ is an indirect quote in the Norway,
• NOK 0.2/$ is a direct quote in the US and an
indirect quote in Norway
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Foreign Exchange Rates &
Quotations
• Interbank quotes are given as a bid and ask
– The bid is the price at which a dealer will buy
another currency and the ask or offer is the
price at which a dealer will sell another currency
– This is the bid/ask spread.
bid/ask % spread = ask rate – bid rate
ask rate
– Example: ¥118.27 - ¥118.37/$ is the bid/ask for Japanese
yen
– Bid/Ask spread = (118.37 – 118.27)/118.37 = 0.0845 %
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Foreign Exchange Rates &
Quotations
• Forward Quotations can be expressed in several
ways
– We will generally use the actual forward exchange
rate – called an outright quote
– Forward quotes are also quoted in terms of points i.e.
how much they differ from the spot rate. A point is the
last digit of a quotation, with convention dictating the
number of digits to the right of the decimal
– The difference between spot rates and forward rates
can also be expressed as a % per-annum deviation
from the spot rate (premium or discount)
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Foreign Exchange Rates &
Quotations
• Expressing Forward Quotations on a Points
Basis
– The yen is quoted only to two decimal points
– A forward quotation is not a foreign exchange rate,
rather the difference between the spot and forward
rates
Bid
Ask
– Example:
Outright spot:
¥118.27
Plus points (3 months)
Outright forward:
¥116.84
¥118.37
-1.43
-1.40
¥116.97
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Foreign Exchange Rates &
Quotations
• Forward Quotations in Percentage Terms
– For direct quotes (i.e. quote expressed in home
currency terms), the formula is
Forward - Spot 360
f 
x
x 100
Spot
days
H
If > 0, the foreign currency is said to be trading with
a premium, if < 0 the foreign currency is trading with
a discount
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Euro spot and forward Jan 14 – 2013
http://markets.ft.com/RESEARCH/markets/DataArchiveFetchReport?Category=CU&Type=ESP&Date=01/14/2013
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Foreign Exchange Rates &
Quotations
• Cross Rates
– Many currencies pairs are inactively traded, so their
exchange rate is determined through their relationship
to a widely traded third currency
– Example: A Mexican importer needs Japanese yen to
pay for purchases in Tokyo. Both the Mexican peso
(MXP) and Japanese yen (¥) are quoted in US dollars
• Assume the following quotes:
Japanese yen ¥110.73/$
Mexican peso MXP 11.4456/$
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Foreign Exchange Rates &
Quotations
• Cross Rates
– The Mexican importer can buy one US dollar
for 11.4456 Mexican pesos and with that
dollar buy ¥110.73; the cross rate would be
– 110.73/11.4456 = ¥9.6745/MXP
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Currency Futures and Options
Market
• A currency futures contract specifies a
standard volume of a particular currency to be
exchanged on a specific settlement date. Unlike
forward contracts however, futures contracts are
sold on exchanges.
• Currency options contracts give the right to
buy or sell a specific currency at a specific price
within a specific period of time. They are sold on
exchanges too.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA