International Financial Management
Professor XXXXX
Course Name / Number
Fixed Versus Floating Exchange
Rates
Floating
exchange rate
system
• Currencies float freely in this system, and
exchange rates (prices) are set by supply
and demand.
• $US, Japanese Yen, British Pound, Swiss
Franc float freely.
Fixed
exchange rate
system
• Currency value is fixed (pegged) in terms
of another currency.
• If demand for currency increases
(decreases), Government must sell (buy)
currency to maintain fixed rate.
Managed
floating rate
system
2
• Currency is loosely pegged to other
currency.
Exchange Rate Quotes
$US equivalent
Currency per
$US
3
dollars
1

peso
peso/dolla r
• The dollar cost of one unit of foreign
currency
• One Argentine peso equals $0.3451 on
August 15, 2003 and $0.3457 on August
14, 2003.
• The peso thus depreciated against the
dollar.
• The value of each currency relative to one
U.S. dollar. Reciprocal of US$ Equivalent.
• One dollar was worth 2.9250 Argentine
pesos on April 3, 2002 and 2.7850
Argentine pesos on April 4, 2002.
• The dollar appreciated against the peso.
1
$0.3451/Ps 
Ps 2.8977/$
Spot and Forward Exchange
Rates
Spot exchange
rate
• The exchange rate that applies to
currency trades that occur immediately
• On August 15, 2003, spot exchange rate
for British pound was $1.5955/£.
Forward
exchange rate
• The fixed price that applies for contracts
with delivery in the future
• On August 15, 2003, the agreement to
trade dollars for pounds one month later
was a specified forward price of
$1.5924/£.
The pound trades at a forward discount relative to the dollar.
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F  S $1.5924/£ - $1.5955/£

 0.19%
S
$1.5955/£
Annualized forward discount  - 2.33%
Triangular Arbitrage
Cross exchange
rate
• The exchange rate between two
currencies other than $US
• Divide the dollar exchange rate for one
currency by the dollar exchange rate for
another currency: on August 15, 2003
$0.3451/Ps
 £ 0.2163/Ps
$1.5955/£
Assume you are quoted
the following exchange
rates
• SF1.50/$; €1.00/$; SF1.25/€
• Arbitrage opportunity
1. Exchange $1,000,000 into SF1,500,000 (at SF1.50/$).
2. Trade SF1,500,000 for €1,200,000 (at €0.80/SF).
3. Convert €1,200,000 into $1,200,000 (at $1.0000/€).
5
Could make a riskless, instant profit of $200,000.
Winners and Losers From ER
Changes
Suppose the euro appreciates against the Canadian
Dollar.
This benefits European consumers or producers buying
Canadian goods.
It hurts Canadian consumers or producers buying European
goods.
Winners and losers reversed when a currency depreciates.
6
Forward-Spot Parity
If a forward market exists, the forward rate should be
approximately equal to expected future spot rate.
• An example…
• Assume: Spot = $1.5/£
1M forward = $1.55/£
• Assumption of risk neutrality for all firms
All U.K. (risk neutral) firms who intend to buy U.S. dollars in
the future will either:
1. Enter the forward contract today if E(S) < $1.55/£.
2. Wait and buy dollars at the spot rate if E(S) > $1.55/£.
7
U.S. firms who will need to pay in pounds in the future will do the
opposite.
Forward-Spot Parity
Equilibrium: the forecast of the spot price is equal to the
current forward rate (forward – spot parity).
E(S) = F
U.S. and U.K. firms are indifferent in this case whether they
transact in the spot or forward market.
Forward-spot parity does not hold. Forward rate is not a
reliable predictor of the direction of the spot rate.
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– Many studies show that on average, the spot rate moves in
opposite direction than that predicted by the forward rate.
– All studies of exchange rates find a great deal of randomness in
spot rate movements.
The Law of One Price
Identical goods trading in different markets should sell at the
same price.
• An example…
• Assume $/£ exchange rate currently $2.00/£, and gold is selling
for $400.00/oz in New York City.
What is the most and least that gold can sell for in London (in £) without
offering arbitrage opportunity?
• Gold should sell for $400.00 ÷ $2.00/£ = £200.00 in London.
• If gold costs more than £200.00; buy in NYC, sell in London.
• If gold costs less than £200.00; buy in London, sell in NYC.
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Purchasing Power Parity (PPP)
Differences in expected inflation between two countries are
associated with expected changes in currency values.
E ( S for / dom ) [1  E (i for )]

for / dom
[1  E (idom )]
S
Key empirical predictions of PPP:
Low-inflation nations  appreciating currency
High-inflation nations  depreciating currency
Law holds for tradable goods over time, but deviations occur
in the short run. Reasons:
– The process of trading goods across countries cannot happen
instantaneously.
– Legal restrictions or physical impediments apply to transporting
goods.
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Interest Rate Parity (IRP)
Interest rate parity says that the risk-free returns around the
world should be equal.
An investor can either buy a domestic risk-free asset or a
foreign risk-free asset using forward contract to cover
currency exposure.
The currency of the country with lower risk-free rate should
trade at a forward premium.
IRP:
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F for / dom 1  R for 

for / dom
1  Rdom 
S
Covered Interest Arbitrage
• An example…
• Current spot rate = C$ 2.00/£
• Forward rate = C$ 2.05/ £
• Annualized interest rate on a six-month Canadian government
bond is 6%.
• Rate on similar UK instrument is 2%.
C$2.05/£ 1.03

C$2 / £
1.01
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This means Canadian interest rate is “too low” or UK interest rate is “too
high.” Arbitrage opportunity!
Covered Interest Arbitrage
Borrow C$1,000,000 at 6% per year, convert to 500,000
pounds.
This will grow to 505,000 pounds in six months, at which
time you convert back at the forward rate to C$1,035,250.
Next, repay the Canadian loan which takes C$1,030,000.
Arbitrage profit is C$5,250.
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Real Interest Rate Parity: The
Fisher Effect
Fisher effect: the nominal interest rate R is made up of two
components:
– Real required return, assumed to be same in both countries.
– Inflation premium equals the expected rate of inflation, i.
If real required return is the same across countries,
then the following equation is true.
[1  E (i for )]
1  R for

1  Rdom [1  E (idom )]
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Real Interest Rate Parity: The
Fisher Effect
• Assume that expected inflation in the United States equals 3% and
expected inflation in Italy is 8%.
• One-year risk free rate in the U.S is 3.2%.
What should the one year interest rate be to maintain real interest rate
parity?

1  0.08

1  0.032 1  0.03
1  R Italy
R Italy  8.20%
Deviations from real interest rate parity occur because of
limits to arbitrage.
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– Scarcity of risk-free investments that offer fixed real, rather than
nominal, returns
Transaction Risk
Exchange rate risk arises when the value of a company’s
cash flows can be affected by a change in exchange rates.
• An example…
• Assume Boeing Company has sold an airplane to a Japanese buyer:
1. Boeing must receive $1,200,000 to cover costs and profits.
2. Since payment usually in buyer’s currency, priced in Yen.
3. Current exchange rate is ¥105.00/$.
4. Price of airplane therefore ¥126,000,000.
• If delivery and payment occur immediately, there is no foreign
exchange risk: Just exchange ¥126,000,000 for $1,200,000 on spot
market.
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If price is set today, but delivery is in 6 months, Boeing is exposed to
significant foreign exchange risk unless it hedges that risk.
Transaction Risk
If exchange rate in 6 months is ¥110.00/$:
• The dollar appreciates; yen depreciates.
• Boeing will still receive the same ¥126,000,000 but these will only be
worth $1,145,454.5.
1. Boeing will suffer an exchange rate loss of $54,545.5.
2. Japanese customer is unaffected, since yen price is fixed.
If exchange rate in 6 months is ¥100/$ instead:
• Boeing will receive $1,260,000 for its ¥126 million payment.
1. Boeing will enjoy an exchange rate gain of $60,000.
2. Japanese customer again unaffected.
Question: who would gain/lose if price set in dollars?
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Translation and Economic Risk
Translation
(accounting)
exposure
Economic
exposure
18
• Cost and revenue of the subsidiary (in
foreign currency) are translated in the
domestic currency to be included in the
financial statements of the MNC.
• How does the foreign exchange rate affect
firm’s value?
• Exchange rate changes might influence
firm’s cash flows.
• Rise in the value of the dollar against the
yen makes Japanese cars less expensive
to U.S. customers and U.S. cars more
expensive for Japanese customers.
• Hedge by using currency derivatives and
by matching costs and revenues in a given
currency.
Political Risk
Actions taken by a government which have an impact on the
value of foreign companies operating in that country:
Tax increases or barriers to repatriation of profits
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Macro political
risk
• Impacts all foreign firms in the country
• Near collapse of Indonesia currency in
1997-1998
Micro political
risk
• Government actions that affect only a
subset of companies operating in a foreign
country
• 1970s nationalization of the assets of
international oil companies by a large
number of oil-exporting countries
EMU and the Rise of Regional
Trading Blocks
European Monetary Union established Euro as currency for
twelve countries in Western Europe.
In 1991, Brazil, Argentina, Paraguay, and Uruguay formed
the Mercosur Group.
– Removed tariffs and other barriers to intraregional trade
– Common tariffs on external trade from 1994
General Agreement on Tariffs and Trade (GATT):
international treaty that regulates trade
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– In 1994 revised GATT established the World Trade Organization (WTO).
The Growth of World Trade
World trade increased at a compound interest rate of around
8% from 1973-2000.
Merchandise trade has tripled since 1986 to $6.5 trillion;
services add another $2-3 trillion.
Developing country exports account for almost 40% of the
world’s total.
Foreign Direct
Investment
(FDI)
21
• The transfer by a multinational firm of
financial, managerial, and technical assets
from home country to a host country
• FDI inflows grew from $180 billion in 1991
to $1.2 trillion in 2000.
• U.S. attracts over 20% of total FDI
inflows.
Capital Budgeting
MNCs have to answer the following questions in their capital
budgeting process.
• In what currency should the firm express a foreign project's cash flows?
• How is the cost of capital computed for MNCs?
• An example…
• Assume U.S. firm performs analysis for project with cash flows in
euros:
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Initial Cost
Year 1
Year 2
Year 3
- €5,000,000
€1,900,000
€2,200,000
€2,300,000
Two alternatives
to compute
project’s NPV
• Discount euro-denominated cash flows
using euro-based cost of capital and then
convert back to dollars.
• Calculate NPV in dollar terms.
First Approach to Compute NPV
Assume risk-free in Europe is 5% and the spot rate is $0.98/€.
The company estimates that cost of capital for this project is
10% (5% risk premium).
NPV  5,000,000 
1,900,000 2,200,000 2,300,000


 273,478.59
2
3
1.1
1.1
1.1
Convert into dollar-based NPV
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NPV  $268,009
• The firm can hedge its currency exposure in the future with
forward contracts.
– Accept or reject the project based on NPV of project; currency
exposure should not affect the decision.
Second Approach to Compute NPV
Calculate NPV in dollar terms; risk free rate in U.S. is 4%.
– Assume that the firms will hedge the project's cash flows using
forward contracts.
• Using interest parity, can compute one, two, and three year forward
exchange rates:
$ / euro
F
S $ / euro
$ / euro
F
S $ / euro
1  RUS 

1  Reuro 
1  RUS 2

1  Reuro 2
F $ / euro 1  RUS 

$ / euro
S
1  Reuro 2
2
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euro
F1$ /year
1.04
1.05
euro
F1$ /year
 $0.97 / euro

1.0816
1.1025
euro
F2$/year
 $0.9615 / euro

1.1249
1.1576
0.98
euro
F2$/year
0.98
euro
F3$/year
0.98

euro
F3$/year
 $0.9523 / euro
Second Approach to Compute NPV
Cash flow of the project converted in dollars: same results
as the first approach
Currency Initial Investment
Year 1
€
-5,000,000 X .98
1,900,000 X .97
$
4,900,000
1,843,000
Year 2
Year 3
2,200,000 X .9615 2,300,000 X .9523
2,115,300
2,190,290
Need to discount the cash flow at risk-adjusted U.S. interest
rate:
(1  RUS )  (1  0.10)
NPV  4,900,000 
25
NPV  267,277.25
(1  0.04)
(1  0.05)
RUS  8.95%
1,843,000 2,115,300 2,190,290


 273,478.59
2
3
1.0895
1.0895
1.0895
Cost of Capital
• Compute beta of the investment to assess the risk and use CAPM
to compute discount rate for the project’s cash flows.
– A Japanese auto manufacturer that plans to build a plant in
U.S. computes two betas.
• If firm’s shareholders cannot diversify internationally:
– Compute project’s beta by measuring the covariance of similar
European investments with the U.S. market.
– Japanese firm computes beta of 1.2 for the project. Risk-free
interest rate is 0.8%; market risk premium on Nikkei is 8%.
– Rproject=0.8%+1.2(8%)=10.4%.
• If firm’s shareholders have portfolios internationally diversified:
– Compute project’s beta by computing the covariance of return
of similar investments with returns on a worldwide stock
index.
– Project beta is computed 1.4. The world market risk premium
is 5%: Rproject=0.8%+1.4(5%)=7.8%.
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International Financial Management
Multinational corporations dominate international
trade and investment today.
Companies trading in the international markets are
exposed to exchange rate risk.
Total volume of foreign direct investment surged
during the 1990s.
MNCs can use a variety of techniques to hedge or
even profit from exchange rate fluctuations.