International Financial Management
Professor Thomson
Fin 3013
International Finance
• Broadens the application of finance
• If you have excess cash available, you
could look at all of the US banks to make
your deposit and choose the highest rate
• A broader perspective would be to look at
banks around the world
• Similarly, you would like to sell your
product into the market that will pay the
most, or you may wish to expand sales by
selling in more places
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International Finance
What are the risks from transacting on a
global scale?
– One risk is that the transactions will not be
made in $US so if currencies fluctuate you
have added a degree of risk
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Fixed versus Floating Exchange
Rates
Floating
exchange rate
system
Fixed
exchange rate
system
Managed
floating rate
system
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• 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.
• 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.
• Currency is loosely pegged to other
currency, but value is mostly
determined by supply/demand.
Exchange Rate Quotes
$US equivalent
Currency per
$US
5
dollars
1

peso
peso/dollar
• The dollar cost of one unit of foreign
currency
• One Argentine peso equals $0.3525
on April 20, 2004 and $0.3506 on
April 21, 2004.
• The peso thus depreciated against
the dollar.
• The value of each currency relative
to one U.S. dollar. Reciprocal of US$
equivalent
• One dollar was worth 2.8369
Argentine pesos on April 20, 2004
and 2.8523 Argentine pesos on April
21, 2004.
• The dollar appreciated vs. the peso.
1
$0.3506/Ps 
Ps 2.8523/$
See www.xe.com for current
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Winners and Losers from Exchange
Rate 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.
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Law of one price
• States that the same good must have the
same price in all markets, or else there will
be an arbitrage opportunity.
• If that new plasma TV costs less at Best
Buy than Circuit City everyone will buy at
Best Buy, so Circuit City will have to match
the price
• The limits to arbitrage are the transaction
costs of implementing the required trades
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Where to buy those sunglasses
• XE.com displays the following exchange
rate for $1 US.
• 0.7844 Euros
0.5443 British Pounds
• Julbo Colorados can be purchase for 44
Euros or 35 Pounds. Which country has
the best deal?
• Euro deal is 1/.7844 * 44= $56.09
• British deal is 1/.5443 * 30 = $55.12
• Buy those shades in Britian
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Definition: Arbitrage
• The purchase of securities on one market
for immediate resale on another market in
order to profit from a price discrepancy.
• [Middle English, arbitration, from Old
French, from arbitrer, to judge, from Latin
arbitr r , to give judgment. See
arbitrate.]
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Arbitrage Opportunity
• You could buy Julbo’s in Britain, and sell
them in Europe and make $.97. You sell
them for $56.09 (Euro selling price
converted in dollars) after buying them for
$55.12 (British pound selling price
converted into dollars)
• The transactions cost of doing so,
however, may limit your profit opportunity
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Absence of Arbitrage
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• Because Arbitrage is easy to do, financial
markets rely on the concept of “Absence of
Arbitrage”
• In other words, any arbitrage opportunity will
disappear quickly as someone will see it and
take advantage of it
• Computers monitor markets around the world
for arbitrage opportunities and make trades to
take advantage of them.
• Apparent arbitrage opportunities are limited due
to transactions costs
Purchasing Power Parity
• If everything is cheaper in one country
than others, everyone will try to buy from
the cheap country and sell to the
expensive countries. This will create a
high demand for the currency people need
to purchase (to buy the goods), which will
push up the exchange rate, and thus
remove the arbitrage opportunity
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Purchasing Power Parity
• The Economist's Big Mac index is based on
the theory of purchasing-power parity,
under which exchange rates should adjust
to equalise the cost of a basket of goods
and services, wherever it is bought around
the world. Our basket is the Big Mac. The
cheapest burger in our chart is in China,
where it costs $1.30, compared with an
average American price of $3.15. This
implies that the yuan is 59% undervalued.
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The Big Mac Index (example of
purchasing power parity)
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Currency Equilibrium
Given our previously quoted exchange rates, to exclude
arbitrage, what must the Pounds to Euro exchange rate?
($1=0.5443 Pounds)
($1=0.7844 Euro so, 1 Euro =1/0.7844 = 1.2749$
By dimensional analysis we see:
Pounds Dollars Pounds


Dollars Euros
Euros
• Applying to our data
0.5433 1.2749

 0.6939
1
1
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Triangular Currency Arbitrage
Cross exchange
rate
• The ratio of the exchange rate of
each currency, expressed in terms of
a third currency.
• Divide the dollar exchange rate for
one currency by the dollar exchange
rate for another currency: 4/21/04:
$1.7733/£
 C$ 2.4117/£
$0.7353/C$
Assume you are
• C$2.5000/£
quoted the following
• Arbitrage opportunity
exchange rate:
1. Exchange $1,000,000 into £563,920 (at £0.5639/$).
2. Trade £ 563,920 for C$1,409,800 (at C$2.5000/ £).
3. Convert C$1,409,800 into $1,036,626(at
$0.7353/C$).
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Allows a riskless, instant profit of $36,626
Spot and Forward Markets
• Spot market – the market for the
immediate exchange of goods
• Forward market – the market to exchange
in the future, at a price set today
• Futures market – the standardization of
forward market contracts
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Spot and Forward Exchange
Rates
Spot exchange
rate
Forward
exchange rate
• The exchange rate that applies to
currency trades that occur
immediately.
• On April 21, 2004, spot exchange
rate for British pound: $1.7733/£.
• The fixed price that applies for
contracts with delivery in the future.
• On April 21, 2004, the agreement to
trade dollars for pounds one month
later was a specified forward price of
$1.7686/£.
The pound trades at a forward discount relative to
the dollar.
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F  S $1.7686/£ - $1.7733/£

 0.545%
S
$1.7733/£
Annualized forward discount  - 6.54%
Why are forward rates important?
• If Dell has a contract to sell computers in
England in 3 months, but has to buy the parts
today to fulfill the contract, it can protect its
profits by transacting in the currency futures
market and thus remove the risk of the
exchange rate changing.
• This is a risk reducing action which is referred to
as “hedging” its currency risk
• If you believe you can predict the direction of
exchange rate movements, you could
“speculate” by trading in futures markets
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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 sells an airplane to
a Japanese buyer:
1. Boeing must receive $1,000,000 to cover costs and profits.
2. Since payment usually in buyer’s currency, priced in Yen.
3. Current exchange rate is ¥100.00/$.
4. Price of airplane therefore ¥100,000,000.
• If delivery and payment occur immediately, there is no
foreign exchange risk: just exchange ¥100,000,000 for
$1,000,000 on spot market.
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If price is set today, but delivery is in 6 months,
Boeing is exposed to significant foreign exchange risk
unless it hedges that risk.
Transaction Risk
If exchange rate in 6 months is ¥110.00/$:
• The dollar appreciates; yen depreciates.
• Boeing will still receive the same ¥100,000,000 but these will
only be worth $909,091.
1. Boeing will suffer an exchange rate loss of $90,909.
2. Japanese customer is unaffected, since yen price is fixed.
If exchange rate in 6 months is ¥90/$ instead:
• Boeing will receive $1,111,111 for its ¥100 million payment.
1. Boeing will enjoy an exchange rate gain of $111,111.
2. Japanese customer again unaffected.
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Who would gain/lose if price were set in dollars?
Interest Rate Parity
• Just as prices of goods across the world will tend
to equilibrate, so will financial instruments
• Investors will choose countries with the highest
rates, subject to the effect of changing currency
values
• If inflation is high in one country compared to
another, purchasing power parity will force the
exchange rates to change to enforce the law of
one price
• The combination of inflation rate and exchange
rate will allow investors to estimate the real rate
it can earn in any country.
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Translation and Economic Risk
Translation
(accounting)
exposure
Economic
exposure
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• 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 vs. 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.
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, other barriers to intra-regional trade
• Common tariffs on external trade from 1994
General Agreement on Tariffs and Trade (GATT):
international treaty that regulates trade
• In 1994, revised GATT established World Trade Organization (WTO)
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Political Risk
• A further risk of international investments
is that of political risk
• Current examples are the freezing of oil
assets in some countries as the
government takes over the assets
• WSJ earlier this semester reported that
the Government of Sudan is not honoring
its oil contracts with British Petroleum
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Purchasing Power Parity (PPP)
Differences in expected inflation between two
countries are associated with expected changes in
currency values.
Key empirical predictions of PPP:
for / dom
[1  E (i for )]
E (S
)

for / dom
[1  E (idom )]
S
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:
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• The process of trading goods across countries cannot happen
instantaneously.
• Legal restrictions or physical impediments apply to
transporting goods.
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 contracts
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$ 1.5855/$
• 6-month forward rate = C$ 1.5937/$
• Annualized interest rate on a six-month Canadian
government bond is 6%.
• Rate on similar U.S. instrument is 2%.
 0.06 
1 

C$1.5937/$ 
2 

C$1.5855 / $  0.02 
1 

2 

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This means Canadian interest rate is “too high”/ U.S.
interest rate is “too low” . Arbitrage opportunity!
Covered Interest Arbitrage
Borrow $1,000,000 at 2% per year, convert to
C$1,585,500
This will grow to C$1,633,065 in six months, at
which time you convert back at the forward rate to
$1,024,700.
Next, repay the U.S. loan, which takes C$1,010,000.
Arbitrage profit is $14,700.
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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
zero and expected inflation in Italy is 12%.
• One-year risk free rate in the U.S. is 3%.
What should the one year interest rate be to
maintain real interest rate parity?
1  R Italy 1  0.12

1  0.0
1  0.03
R Italy  15.36%
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
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
- €2,000,000
€900,000
€850,000
€800,000
Two alternatives
to compute
project’s NPV:
• Discount euro-denominated cash
flows using euro-based cost of
capital,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 $0.95/€
The company estimates that cost of capital for this
project is 10% (5% risk premium).
NPV  2,000,000 
900,000 850,000 800,000


 121,713
2
3
1.10
1.10
1.10
Convert into dollarbased NPV
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NPV  $116,000
• 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; U.S. risk free rate is
3%
• 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:
F $ / euro 1  RUS 

$ / euro
1  Reuro 
S
F $ / euro 1  RUS 

$ / euro
S
1  Reuro 2
2
F $ / euro 1  RUS 

$ / euro
S
1  Reuro 3
3
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euro
F1$ /year
0.95

1.03
1.05
euro
F2$/year
1.032

0.95 1.052
euro
F3$/year
1.033

0.95 1.053
euro
F1$ /year
 $0.9319 / euro
euro
F2$/year
 $0.9142 / euro
euro
F3$/year
 $0.8967 / 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
Year 2
Year 3
€
-2,000,000 X .95
900,000 X .9319
8500,000 X .9142
800,000 X .8967
$
-1,900,000
839,000
777,000
717,000
Need to discount the cash flow at risk-adjusted U.S.
interest rate:
(1  0.03)
(1  RUS )  (1  0.10)
(1  0.05)
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RUS  7.9%
839,000 777,000 717,000
NPV  1,900,000 


 $116,000
1
2
3
1.079
1.079
1.079
Cost of Capital
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• Compute beta of investment to assess 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 1.1 for the project.
Risk-free interest rate is 2%; market risk premium on
Nikkei is 8%.
• Rproject= 2%+1.1(8%)=10.8%
• If firm’s shareholders have portfolios internationally
diversified:
• Compute project’s beta by computing covariance of
return of similar investments with returns on worldwide
stock index.
• Project beta is computed 1.3. The world market risk
premium is 5%: Rproject=2%+1.3(5%)= 8.5%.
Forward-Spot Parity
If a forward market exists, the forward rate should
be approximately equal to expected future spot rate.
• An example…
• Assume: Spot = $1.4/£
1M forward = $1.50/£
Risk-neutral U.K. firms who intend to buy U.S. dollars
in the future will either:
1. Enter the forward contract today if E(S) < $1.50/£.
2. Wait and buy dollars at spot rate if E(S) > $1.50/£.
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U.S. firms who will need to buy pounds in the future
will do the opposite.
Forward-Spot Parity
Equilibrium: the forecast of the spot price is equal to
the current forward rate (forward – spot parity).
E(S) = F
U.S. and U.K. firms are indifferent in this case
whether they transact in the spot or forward market.
Forward-spot parity does not hold. Forward rate
does not reliably predict the direction of the spot
rate.
• Studies of exchange rates find a great deal of
randomness in spot rate movements.
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International Financial Management
Multinational corporations dominate international
trade and investment today.
Companies trading in the international markets are
exposed to exchange rate risk.
Total volume of foreign direct investment surged
during the 1990s.
MNCs can use a variety of techniques to hedge or
even profit from exchange rate fluctuations.
Political Risk
Actions taken by a government which have an impact
on the value of foreign companies operating in that
country:
Tax increases or barriers to repatriation of profits
Macro political
risk
Micro political
risk
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• Impacts all foreign firms in the
country
• Near collapse of Indonesia currency
in 1997-1998
• Government actions that affect only
a subset of companies operating in a
foreign country
• 1970s nationalization international
oil company assets by large number
of oil-exporting countries
The Law of One Price
Identical goods trading in different markets should
sell at the same price.
• An example…
• Assume €/$ exchange rate currently €0.95/$, and a pair
of Maui Jim sunglasses is selling for €180 in Italy.
What if a pair of the same sunglasses sells for $200
in the United States?
• Sunglasses should sell for €180 ÷ €0.95/$ = $189.47 in
U.S.
• Buy sunglasses in Italy for €180 and sell them for $200
in U.S.
• Convert back to euros, receive €190 ($200 x €0.95/$)
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