Copyright ©2000 Ian H. Giddy
International Financial Management 1
Ian Giddy
Copyright ©2000 Ian H. Giddy
International Financial Management 2
INTERNATIONAL
FINANCIAL
MANAGEMENT
 www.stern.nyu.edu
 www.stern.nyu.edu/~igiddy/ifmx.htm
 www.giddy.org
International
Financial Management
Prof. Ian Giddy
Stern School of Business,
New York University
International Financial Management
Management of international assets
 Management of international liabilities
 Management of cross-border financial
risks
 Cross-border funds transfers

These depend on the environmental
features of international finance-notably, the global financial markets
Copyright ©2000 Ian H. Giddy
International Financial Management 8
Corporate Finance
CORPORATE FINANCE
DECISONS
INVESTMENT
FINANCING
PORTFOLIO
RISK MGT
MEASUREMENT
CAPITAL
DEBT
M&A
Copyright ©2000 Ian H. Giddy
EQUITY
TOOLS
International Financial Management 9
What is Special about Corporate Finance
in the International Environment?

Financial markets are partially linked, partially
separated by national jurisdications

Exchange rate fluctuations affect revenues,
costs and valuation of firms

The competitive international financial
markets offer special tools, opportunities and
risks
Copyright ©2000 Ian H. Giddy
International Financial Management 10
What are the Global Financial Markets?

The Foreign Exchange Market

The Derivatives
Domestic and International Money Markets
Domestic and International Capital Markets
Beyond the Money and Bond Markets:
International Equity and Commodity Markets
Using the Global Capital Markets: Investors’
and Issuers’ Perspectives




Copyright ©2000 Ian H. Giddy
International Financial Management 11
The Eurocurrency Market
“A Eurodollar is a dollar deposited in a bank
within a jurisdication outside the United
States”
 Separation of currency, institution and
jurisdiction
 Why do people want Eurocurrency deposits
and loans?
 Why is LIBOR the world’s key benchmark
rate?
Copyright ©2000 Ian H. Giddy
International Financial Management 14
The Eurocurrency Market
“A Eurodollar is a dollar deposited in a bank
within a jurisdication outside the United
States”
 Separation of currency, institution and
jurisdiction
 Why do people want Eurocurrency deposits
and loans?
 Why is LIBOR the world’s key benchmark
rate?
Copyright ©2000 Ian H. Giddy
International Financial Management 15
Where the Eurocurrency Market Fits In
US Domestic
Market
EUR0CURRENCY MARKET
Eurodollar
Market
Euro-Deutsche Mark
Market
Euro-Yen
Market
Copyright ©2000 Ian H. Giddy
German
Domestic
Market
Japanese
Domestic
Market
International Financial Management 16
Where the Eurocurrency Market Fits In
US Domestic
Market
EUR0CURRENCY MARKET
Eurodollar
Market
Euro-Commercial
Paper Market
Copyright ©2000 Ian H. Giddy
German
Domestic
Market
Euro-Deutsche Mark
Market
Foreign
Exchange
Market
Euro-Yen
Market
Euro-Floating Rate
Note Market
Japanese
Domestic
Market
Straight
Eurobond Market
International Financial Management 17
Interest Rate Linkages in the
International Money Market
Two stories to tell:
 Domestic vs. Euro
 Eurocurrency A vs. Eurocurrency B
Domestic Market A
Treasury
Bill
Treasury
Bond
Copyright ©2000 Ian H. Giddy
Bank
Deposit
Corporate
Bond
The Euromarkets
Euro
Deposit
Market
Euro
Bond
Market
Euro
Deposit
Market
Euro
Bond
Market
Domestic Market B
Bank
Deposit
Corporate
Bond
Treasury
Bill
Treasury
Bond
International Financial Management 18
Domestic versus Euro
The Eurodollar Premium
Market price of risk
versus
Cost of regulation

Eurodollar vs. U.S. Interest Rate
Effective cost of domestic deposit
=
(interest rate + FDIC fees)
(1 - reserve requirement)

Capital controls and divided credit markets
Copyright ©2000 Ian H. Giddy
International Financial Management 19
Covered Interest Arbitrage
Money
market 1
Money
market 2
Spot
Forward
Copyright ©2000 Ian H. Giddy
International Financial Management 25
Diagram of a Dealing Room
Foreign exchange and Eurocurrency dealing
are interrelated activities and so are done on
the same trading floor.
The Dealing Room
CUSFORThe
DealingSPOT
Room WARD
TOMER
Foreign
Exchange
Dealing
Money
FUNDING
Copyright ©2000 Ian H. Giddy
EUROCURRENCY
Market
Dealing
International Financial Management 26
Diagram of a Dealing Room
Foreign exchange and Eurocurrency dealing
are interrelated activities and so are done on
the same trading floor.
The Dealing Room
CUSTOMER
SPOT
FORWARD
Foreign
Exchange
Dealing
Money
FUNDING
Copyright ©2000 Ian H. Giddy
EUROCURRENCY
Market
Dealing
International Financial Management 27
Linkages Between Eurocurrency Rates
Interest rate
differential
Forward
premium
Copyright ©2000 Ian H. Giddy
Expected
% change in
exchange rate
International Financial Management 29
Linkages Between Eurocurrency Rates
Interest rate
differential
Covered interest
rate parity
Forward
premium
Copyright ©2000 Ian H. Giddy
Expected
% change in
exchange rate
International Financial Management 30
Linkages Between Eurocurrency Rates
Interest rate
differential
Covered interest
rate parity
Forward
premium
Copyright ©2000 Ian H. Giddy
Uncovered interest
rate parity
Expected
% change in
exchange rate
International Financial Management 31
Linkages Between Eurocurrency Rates
Interest rate
differential
Covered interest
rate parity
Uncovered interest
rate parity
Expected
% change in
exchange rate
Forward
premium
Unbiased
forward rate
Copyright ©2000 Ian H. Giddy
International Financial Management 32
Interest-Rate Parity
$1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt
where St is the spot exchange rate (dollars per British
Pound) and Fnt is the forward rate.
to a close approximation,
(/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100
Interest-rate differential = forward
premium or
discount
Copyright ©2000 Ian H. Giddy
International Financial Management 33
Example: Anglo’s Funding

Anglo-American, the natural resources
conglomerate, is seeking 3-month US$
funding.
Anglo
can fund in the US CP market at
5.5%
Or in the Eurosterling market at 6.7%
The BP is:
spot $1.5484, 3-mo forward $1.5454
Which is cheaper?
Copyright ©2000 Ian H. Giddy
International Financial Management 34
Anglo’s Answer
It’s cheaper for Anglo-American to borrow
in the US CP market. Reason:
US:
simply borrow for 3 months
 Cost:
$1(1+5.5%/4) = 1.01375
UK:
borrow British pounds, change into
dollars at spot rate, cover by buying
sterling at 3-mo forward rate to repay the
pounds
 Cost:
Copyright ©2000 Ian H. Giddy
($1/1.5484)(1+6.7%/4)1.5454 = 1.01478
International Financial Management 35
Unbiased Forward Rate Theory
EXCHANGE
RATE
Spot
Forward
Actual
Today
Copyright ©2000 Ian H. Giddy
TIME
In three
months
International Financial Management 36
Unbiased Forward Rate Theory
EXCHANGE
RATE
Probability
distribution
of actual
exchange rate
Spot
Forward
Actual
Today
Copyright ©2000 Ian H. Giddy
TIME
In three
months
International Financial Management 37
Unbiased Forward Rate
Forward premium or discount
= Expected annual rate of change
of the exchange rate
That is,
P$/DM
Copyright ©2000 Ian H. Giddy
=
E(R$/DM )
International Financial Management 38
International Fisher Effect
EXCHANGE RATE
Probability
distribution
of actual
exchange rate
Spot
INTEREST
RATE
DIFFERENTIAL
Forward
Actual
TIME
Today
Copyright ©2000 Ian H. Giddy
In three
months
International Financial Management 39
International Fisher Effect
/E$ = /EDM + E(R$/DM )
That is,
Interest-rate differential
equals
Expected annual rate of change of
exchange rate
Copyright ©2000 Ian H. Giddy
International Financial Management 40
Cost of Hedging
Type of Hedge
Cost of Hedging
Forward
Forward premium
Money Market Hedge Interest rate
(Borrow to match
differential
assets)
Do nothing
Expected rate of
change of
exchange rate
Copyright ©2000 Ian H. Giddy
International Financial Management 41
Corporate Hedging Decisions:
Frutas Amazonas
Exporting bananas to Spain, get paid in
Spanish pesetas. Funding is in U.S.
dollars.
Copyright ©2000 Ian H. Giddy
International Financial Management 42
Corporate Hedging Decisions:
Frutas Amazonas
Continue funding in U.S. dollars. The
peseta might get stronger in the next
three months, from $1=128 pesetas to
$1=126 pesetas. This could be the
cheapest
 Switch funding to pesetas, despite the
slightly higher cost
 Borrow in dollars, but hedge the
exchange risk in the forward market.

Copyright ©2000 Ian H. Giddy
International Financial Management 43
Frutas Amazonas
Eurodollar 3-month
loan rate
Europeseta 3month loan rate
Spot exchange
rate today
Forward exchange
rate today
Forward discount,
% per annum
Copyright ©2000 Ian H. Giddy
5 9/16%
7 15/16%
Pta128.210 per
USD
Pta129.005 per
USD
-2.5
International Financial Management 44
Frutas Amazonas
Type of Hedge
Cost of Hedging
Forward
2.5%
Money Market Hedge 2.375%
(Borrow to match
assets)
Do nothing
2/128 x 4
= 6.25% gain
(or 2.5% loss?)
Copyright ©2000 Ian H. Giddy
International Financial Management 45
Law of One Price
p=Sp*
The Price of Tin
In New York
273c per lb.
= US$6.02
per kilograma
On the Kuala
Lumpur
Market
15.37 ringgit
per kilogram
=US5.70
per kilogramb
a1 avoirdupois pound = 0.45359 kilograms
bUS$1 = 2.6965 Malaysian ringgit on the date of calculation
c 1 tonne = 1000 kilogram.
All data taken from the Commodities section
of the London Financial Times.
Copyright ©2000 Ian H. Giddy
On the
London Metal
Metal
Exchange
US$5830 per
tonne
= US5.83
per kilogramc
International Financial Management 46
Purchasing Power Parity:
Theory and Evidence
S t=1-St
St
=
I-I*
1+I*
EXCHANGERATE
CHANGE

MEXICO 1994
RELATIVE
INFLATION

Copyright ©2000 Ian H. Giddy
JAPAN 1995
International Financial Management 47
REAL EXCHANGE RATE
Deviations from
Purchasing Power Parity
140
130
JAPAN
120
110
100
90
UNITED STATES
80
70
1996Q1
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
60
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies,
adjusted for change in relative wholesale price of domestic manufactures. A fall in the index
indicates improved international competitiveness.
Copyright ©2000 Ian H. Giddy
International Financial Management 48
REAL EXCHANGE RATE
Deviations from
Purchasing Power Parity
140
JAPAN
130
GERMANY
120
110
FRANCE
100
ITALY
90
UK
UNITED STATES
80
70
1996Q1
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
60
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies,
adjusted for change in relative wholesale price of domestic manufactures. A fall in the index
indicates improved international competitiveness.
Copyright ©2000 Ian H. Giddy
International Financial Management 49
Inflation & Interest Rates
US Expected Inflation Rate 2%
Canadian Expected Inflation Rate 7%
US Interest Rate 5%
Canadian Interest Rate 10%
Copyright ©2000 Ian H. Giddy
International Financial Management 50
Inflation & Interest Rates
US Expected Inflation Rate 2%
Canadian Expected Inflation Rate 7%
US Interest Rate 5%
Canadian Interest Rate 10%
Expected Rate of Change
of the Exchange Rate
Copyright ©2000 Ian H. Giddy
International Financial Management 51
Inflation & Interest Rates
Borrow at US Interest Rate 5%
Invest at Canadian Interest Rate 10%
Copyright ©2000 Ian H. Giddy
International Financial Management 52
Inflation & Interest Rates
Borrow at US Interest Rate 5%
Invest at Canadian Interest Rate 10%
Buy Canadian Dollars Forward
(at discount of 5%)
Copyright ©2000 Ian H. Giddy
International Financial Management 53
Inflation & Interest Rates
Borrow at US Interest Rate 5%
Invest at Canadian Interest Rate 10%
Buy Canadian Dollars Forward
(at discount of 5%)
Buy Canadian Dollar Futures
(at discount of 5%)
Copyright ©2000 Ian H. Giddy
International Financial Management 54
The Linkages Again
Relative
excess
money
supply
1
2
4
Relative
interest
rates
5
Copyright ©2000 Ian H. Giddy
Relative
inflation
rates
Forward
exchange
premium
or discount
3
Exchange
rate
change
6
International Financial Management 55
A Framework
Country A
Country B
DOMESTIC
ECONOMIC
POLICIES
DOMESTIC
ECONOMIC
POLICIES
INFLATION
RATE
INFLATION
RATE
EXCHANGE
RATE
INTEREST
RATE
INTEREST
RATE
FORWARD
RATE
Copyright ©2000 Ian H. Giddy
International Financial Management 56
Conclusion:
Corporate Exchange Rate Risk

Exchange Rate Risk is the risk arising from
fluctuating exchange rates between two
currencies
Copyright ©2000 Ian H. Giddy
International Financial Management 57
Conclusion:
Corporate Exchange Rate Risk

Exchange Rate Risk is the risk arising from
fluctuating exchange rates between two
currencies; but it’s tied to prices and to
business risk.
Relative
monetary
and fiscal
policies
Copyright ©2000 Ian H. Giddy
Relative
inflation
Exchange
rate
change
International Financial Management 58
Turkey, 1995
Turkish Lira:
Down 33.5%
Copyright ©2000 Ian H. Giddy
International Financial Management 59
Turkey, 1995
Turkish prices:
up 83.8%!
Turkish Lira:
Down 33.5%
Copyright ©2000 Ian H. Giddy
International Financial Management 60
Copyright ©2000 Ian H. Giddy
International Financial Management 62
www.giddy.org
Copyright ©2000 Ian H. Giddy
International Financial Management 63
Copyright ©2000 Ian H. Giddy
International Financial Management 64