International Finance

Unit Highlights:
 International Finance and Its Features.
 Short term Investment Decisions.
 Foreign Investment.
 International Borrowing Decision.
 The Interest Rate Pariy Theorem.
 International Aspects of Long-Term
Financing.
 Organization of International Banking.
 Bangladesh Open University

Lesson-1 : International Finance

Lesson Objectives
After studying this lesson, you will be able to:
 define International Finance;
 explain the subject matter of international finance;
 describe different types of risks in international transactions;
 define forward premium and discount on a currency and
 understand the concepts of 'currency future' and 'currency options'.

In a tautological way, one can say that international finance deals with finance in
an international setting. Think of the camera that you have purchased yesterday
International
from the nearby departmental store. You never cared to know where it was
transactions
manufactured. Later you discovers that it was made in Japan. If you think
involving
carefully you will easily convince yourself that from the manufacture to the final
purchase and
sale various persons and institutions had been involved in international
sale of goods,
investments and movements of money along a tortuous payment network.
services and
A study of the issues and problems surrounding receipts and payments that arise financial assets
in connections with the buying and selling of goods, services, and financial assets give rise to
between countries with distinct national currencies and economic policies is the receipts and
subject of international finance. Events far away from a country's frontiers such as payments.
the fall of a government through election, or a revolution, or a rise in the price of International
an important fuel are apt to send their ripple effects across the national and finance studies
international financial centres. Money and capital markets are so closely the issues and
interrelated and integrated now-a-days that it is impossible to study one ignoring problems
others. related to these
receipts and
A business manager can hardly function effectively in an international setting
payments.
without being properly informed about developments in the field of international
money and capital markets. He must know how his firm will be affected by
international events so that he can take steps to insulate his enterprise from their
harmful efforts or to take advantages of them. Among these events are changes in
exchange rates, inflation rates and national incomes, not to mention the important
changes in international political environment. These variables are inextricably
linked and often change in unpredictable ways. To keep abreast of them, to
analyze and to understand them pose constant challenges to the financial
management of any internationally oriented firm.
Foreign exchange is the key variable in international finance. In unit 6, we have
discussed in general terms how the rate of exchange is determined under the fixed
as well as flexible exchange rate regimes and what changes in the foreign
exchange mean to various participants in the foreign exchange market. We have
also briefly dealt with how persons and institutions facing a foreign exchange risk
might try to avoid it through various devices. And in Unit -9 we have examined the
reasons why considerations of portfolio management and adjustment induce firms
and institutions to engage in short- and long- term borrowing and lending
operations.

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In this unit, we look more closely at how the international financial markets
operate, what kinds of problems the participants face and how they deal with
them. This we propose to do in two stages. First, we discuss the problems of when
and why individuals and firms prefer to invest their funds abroad or borrow from
foreign countries. Here the problems are those of short-term money market
financing. Finally, we take up the problem related to long-term financing decisions
involving international capital markets. The issues here are qualitatively different
from those of short-term money market financing mainly for two reasons : (a)
investors borrowers in long- term securities market cannot deal with the problems
of exchange rate fluctuations by the simple expedient of forward cover, and (b) the
regulations imposed by the foreign governments on equity positions taken by non-
residents may be more stringent than in the case of short-term capital flows.

Types of Risk
Any individual or institution making a transaction involving a foreign currency
inevitably faces a potential foreign exchange risk. The values of foreign currency
denominated assets and liabilities must be translated into the domestic currency for
Since purposes of computing domestic taxes and drawing up financial statements. For
international example, suppose that a US resident has a certain sterling balance at a UK bank
involve foreign which is to be converted into US dollars for accounting purposes. Since the
currencies, the exchange rate fluctuates, the dollar value of the sterling balance will fluctuate too.
transactors In general, any uncertainty about the exchange rate at the time of translation will
inevitably face lead to uncertain dollar values of existing assets and liabilities in US account
potential foreign books. This uncertainty gives rise to what is known as translation risk. Related to
exchange risks. this is the so-called transaction risk which arises when transactions occur
involving foreign currency assets and liabilities ( e.g. when assets are actually
sold or liabilities repaid).
Translation and transactions risks are limited to amounts that appear in the book
of accounts. But there is another kind of risk to which all those whose foreign
incomes have not yet been received or dues have not been paid are always exposed
(e.g. exporters and importers). For example, a US exporter may not have any
foreign currency denominated assets or liabilities (and have no translation or
transaction risk), and yet his sales to U.K. may get a boost if there is a fall in the
value of the pound sterling (against dollar), because a depreciation of the pound
sterling will make US goods relatively cheaper in U.K. markets (in terms of
pounds). On the other hand, a British importer's profitability may be adversely
affected by a depreciation of the pound. This kind of risk which is independent of
any foreign currency demoninated assets and liabilities is known as 'economic risk'
and is said to result from economic exposure (such as exporting and importing).
In the Foreign exchange risks are only a part of the additional risk that a firm faces in an
international international environment. A more deadly risk is associated with expropriation,
environment, a confiscation or destruction of property during a war or revolution and so on. As
firm faces with foreign exchange risk, there are devices by which potential political risks can
political risks be averted or reduced. For instance, the firm can buy an insurance policy against
(e.g. these odds; it can borrow from the markets in which investments are to occur (to
expropriation) discourage expropriation); it can engage in a joint-venture, or it can hold back
too. expertise.

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Forward Premium and Discount

We have mentioned in Unit-6 that the foreign exchange risk can be avoided by
engaging in forward exchange transactions. It may be recalled that a forward
exchange rate is the rate that is contracted today for the delivery of a currency at a
specified future date at a price agreed upon today. On the other hand, the spot rate
is the price of a unit of foreign currency at a particular point in time. Needless to
say, the future rate will usually differ from the spot rate.
In forward transactions, a currency may be at a premium or at a discount. Let Fn
($/£) be the n-year forward exchange rate of dollars to pounds. More generally, Fn
(i/j) is the n-year forward rate of currency i to currency j. If F ($/£) = 1.89, it
1/ 4 Forward
means that the price of a pound agreed upon today but to be delivered three exchange
months later (one quarter) is $ 1.89. We can define premium (discount) as follows. transactions can
help avoid
Fn($/£)–S($/£) foreign
Premium/ Discount = n S($/£) exchange risks.
where S($/£) is the spot price of a pound in terms of dollar. We have divided the
difference between the forward and spot rates by n (in addition to S) so as to have
the premium / discount expressed on an annual basis (the way the interest rates are
quoted). Let us suppose that F2 ($/£) = 2.25 and S($/£) = 1.89; then
2.25–1.89
Premium/Discount = 2 x 1.89 = 0.095238095

This is a premium on the pound because the pound costs approximately 9.5% (per
annum) higher in the forward exchange market than on the spot market. Evidently,
to say that the pound is at a premium is equivalent to saying that the dollar is at a
discount.
Forward contracts are not always outright agreements, but often take the from of
swaps. Outright agreements generally take place between bank and non-bank
customers for a straight forward purchase or sale of a foreign currency. Swaps, on
the other hand, may take place between banks or between a bank and a large
corporation. Swaps involve two transactions and have two contracts.
A foreign exchange swap is an agreement to both buy and sell foreign exchange at
pre- determined (and agreed upon) exchange rates, but buying and selling are
separated in time. In many swaps, one transaction is a spot transaction, while the Forward
second is a forward transaction. Such swaps are called 'spot-forward' swaps, contracts often
where the trader buys (sells) on the spot market. As a result, the original exchange take the form of
is reversed. When the reversal takes place on adjacent days, the transaction is swaps in which
called a roll-over. buying and
selling are
Swaps are valuable to anyone intending to invest or borrow abroad. An investor in
separated in
a foreign treasury bill can sell forward the maturity value of the bill at the same
time.
time he purchases the foreign currency on the spot market. Similarly a borrower
can buy forward the foreign currency needed for repayment in future and at the
same time can convert the borrowed funds on the spot market. While swaps are
popular with international investors and borrowers, they are not very attractive to
exporters and importers because they face long delays in receiving. or making
payments. They generally tend to prefer outright forward purchase (importers) or
forward sale (exporters).

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Currency Futures
These are also forward transactions in currencies, but have two distinguishing
features. First, the contracts are relatively homogeneous which lends them the
characteristics of commodity futures. The homogeneity requirement means that
there are relatively few value dates. Contracts are traded in whole units such as £
25,000 or DM 60,000. Secondly, currency futures are traded in specialized formal
future exchanges (like the International Money Market (IMM) of the Chicago
Mercantile Exchange) which are physical locations like stock exchanges.
Forward exchange contracts are agreements between banks and their customers
Unlike the (usually other banks) which are made in informal markets. On the other hand,
futures, forward currency futures involve agreements between future dealers and their customers.
contracts are Forward contracts can be tailor-made to meet the requirement of two counter
neither very parties, in terms of both the size of transactions and the dates of future delivery.
liquid, nor very But forward contracts are neither very liquid nor very marketable. On the other
marketable. hand, the futures being standardized contracts can be easily exchanged between
counter parties. Not surprisingly because of their greater flexibility, the forward
contracts are favoured by most exporters and importers, and by large borrowers
and lenders.
The currency market for forwards is much larger than that for futures. But despite
the large differences in size, one can significantly impact on the other. This
interdependence is due to the fact that when prices in the two markets differ, the
arbitrager can make profit by taking offsetting positions in these markets. For
example, suppose that the 3-month forward buying price of the pound is $
1.8960/£, while the selling price on the same day on the Chicago IMM is $
1.8980. Then the arbitrager could buy forward from a banks and sell forward on
the IMM, making a profit of $ 0.0020 per pound. But note that this arbitrage
involves some risk, because the futures market requires 'maintenance', as daily
contract prices vary. This partly explains why the forward and future prices may
vary. But at the same time, the difference cannot be too large. Arbitrage can
ensure that the sale price of the forward currency does not exceed the bid price of
currency futures, and vice versa.

Currency Options
Forward exchange contracts or currency futures must be exercised; they are not
options. It is true that a currency future can be sold back to the futures exchange
Forward and that a forward contract can be offset by a reverse agreement with a bank.
exchange However, it remains true that all (outstanding) forward contracts and currency
contracts or futures must be honoured (settled) by both parties on the delivery date. There is no
currency futures question of allowing a party to renege on the ground that the events have not
must be turned out to be in its favour.
exercised, and The options are different. An option gives the holder the right but not the
so they are not obligation to buy or sell an underlying security at a fixed price (the exercise price
options. or the strike price) on or before a specified date (the maturity date or the expiry
date). A call option gives the right to buy a security, while the put option gives the
right to sell a security. For example, an American call option on the stock of an
American corporation may give the holder of the option the right to buy a certain
number of its shares at a given price per share (say $ 100) before a particular
date. If the market price of the share falls below the stipulated price (say, falls to $

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80) on the expiry date, the holder will not exercise his option (but if the price is $
120, he can exercise his option). In return for the insurance (against the possible
unfavourable outcomes) provided by the option, a price (i.e. the option premium)
has to be paid. Note that a European option can be exercised only on the expiry
date, whereas the American option can be exercised at any time before expiry date.
A currency option allows the holder to buy or sell a currency at a stated '' strike''
price, if it is preferable to the spot rate. The exporters and importers can use
currency options to reduce their downside risk. An importer, for example, will buy
a call option (option to buy) of the currency that he needs at a stipulated exchange
rate which will remain valid until the date of expiry. If the spot rate goes up before Most options
the expiry date, he can exercise his option. This means that he knows exactly the are not
maximum amount that he will have to pay in local currency for his imports. But he exercised.
may get away paying less than the maximum amount , if the spot rate falls below
the stipulated rate, because in that case it is in his interest not to exercise the
option. Similarly, an exporter can buy a put option (a option to sell) that gives him
the right to sell a given amount of a foreign currency at a fixed rate before a
stipulated date. This allows him to figure out the minimum amount in local
currency that he will receive for his exports. He may, however, get more than that
if the spot rate goes up in the mean time. Note that as with currency forwards, no
payment is made until the option is exercised (and most options are not exercised).

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Questions for Review

MCQ (tick the right answer)
1. International finance deals with finance
a. in inter city transactions
b. intra city transactions
c. in an international setting
d. none of the above.
2. Translation risks and transaction risks are:
a. absolutely different
b. related
c. same
d. none of the above
3. Foreign exchange contracts are agreement between:
a. banks and their customers
b. two customers
c. furture dealers and their
d. none of the above
4. A call option gives the right to
a. buy a security
b. sell a security
c. both buy and sell a security
d. do none of the above
5. A put option gives the right to
a. buy a security
b. sell a security
c. both buy and sell a security
d. do none of the above
6. A forward contract
a. can never be offset
b. can be offset by presenting it to the central bank
c. can be offset by a reverse agreement with a bank
d. need not be honourd.
7. If it is preferable to the spot rate, a currency option allows the holder
a. to buy a currency at a stated 'strike' price
b. to sell a currency at a stated 'strike' price
c. both (a) & (b)
d. none of the above.

Short Questions
1. "Foreign exchange is the key variable in international finance." Explain.
2. What are translation and transaction risks? Are they different from foreign
exchange risks? Elaborate.
3. In forward transactions a currency may be at a premium or at a discount.
Explain what is meant by this statement. Use numerical examples to illustrate
your point.
4. What is a foreign exchange swap? How is it different from a outright forward
contract?

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5. What are forward exchange contracts and currency futures? Is there any
difference between the two? Explain.
6. Explain how the market for forwards and the market for futures can impact on
each other.
7. Can you explain why most options are not exercised?

Essay-type Questions
1. What is international finance? Discuss.
2. Describe the different types of risks in international trade.
3. Define the following concepts:
Forward premium; currency futures; and currency options.

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Lesson-2 : Short term and Long-term Investment and

Borrowing decisions
Lesson Objectives
After studying this lesson, you will be able to:
 understand the criteria for short-term investment decisions;
 understand when a domestic investor will invest abroad;
 explain interest rate parity theorem and the Fisher open condition;
 see why long-term borrowing and investment decision rules are different; and
 understand the role of inflation in causing exchange rate variations.

Short Term Investment Decisions : Domestic vs Foreign Market

We are now in a position to develop the criteria for short term borrowing and
investment decisions involving securities trading in the money markets (securities
with origin term to maturity of less than a year). We take up the investment
Investment decision first.
abroad faces
translation and Suppose that a US investor has to decide whether to invest his funds abroad, when
transaction he has the option of investing in US money market instruments which mature in
risks, while three months. While the former involves translation and transactions risks
investment in (referred to earlier), the latter is free of such complications. Suppose also that the
domestic money annualized interest rate on US money market instruments is ra (in percentage
market terms). Then for every dollar invested in US, the investor will receive, when the
instruments is  ra
instrument matures, a sum of dollars equal to 1+ 4 
free of these  
risks.
ra
Where 4 gives the interest received on $ 1.00 invested for a quarters (3 months).
For example, if the rate of interest is 12% (=0.12), then $ 1.00 will bring $ 0.03 as
interest for there months.
If the investor wants to invest in the UK money market, the first step is to convert
his dollars into pound sterling. For each dollar converted at the spot rate, S($ / £),
the investor will receive 1/S pounds, if there is no transaction cost involved (from
now on we will use S for S($ / £) for the sake of brevity) Now suppose that the
annualized U.K. interest rate on 3-month treasury bills is rb. Then for every dollar
Investing invested in U.K. the investor will receive after 3 months a sum of pounds equal to
abroad involves
exchange risk, 1  rb
£S 1+ 4  ………………………………………………....(10.1)
but it can be   
avoided by For example, if S=$1.90 and rb=18% = 0.18, then for each dollar invested in U.K.
buying forward
will bring the investor
contracts.
 1 0.18 
£1.901+ 4  = £ 0.55
  
While it is certain that the investor will receive £ 0.55 at the end of 3 months, he is
not certain how much £ 0.55 will be worth in terms of dollars, because the exact
amount will depend on the prevailing exchange rate (i.e. the spot rate at the date of

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maturity). But as we have seen, the investor can easily get rid of this uncertainty
by buying a forward contract. It will offer him a complete hedge and will
unambiguously tell him how many dollars he will finally receive.
Denote the 3 month forward exchange rate by F1/4 ($/£), or simply F1/4. Then by
multiplying (10.1) by this rate, we get the number of dollars received for each
pound sold forward. The return in U.K. from a dollar invested there is then given
by
F1
4 rb
S 1 + 4  ………………………………………………….. (10.2)
For example if F1/ =1.9160, then £0.55 will be equivalent to $1.9160 x
4
0.55=$1.0538. Therefore, the annualized interests on $1 invested in U.K. will be
1.0538-1.0000
4
 1.0000 
= 0.2152 or 21.52%
It must be noted carefully that the dollar amount represented by (10.2) is a certain
amount, because the purchase of spot pounds, the U.K. treasury bill and the
forward sale of the U.K. pounds all take place at the same time, leaving no doubt
about the number of dollars to be received on $ 1.00 invested in U.K. after 3
months.
Now we are ready to develop the decision rule, on the assumption that the investor
wants the highest possible yield on the funds invested. He should invest in the
domestic (US) money market if
F1
1 +  > 4 1 + rb
r a
 4 S  4
When the reverse inequality holds, it is more profitable for him to invest in the
U.K. money market. And when
F1
1 + a = 4 1 + rb …………………………………………. (10.3)
r
 4 S  4
the investor would be indifferent between investing at home or abroad. In order to
rb
present these criteria from a different angle, we subtract (1+ 4 )from both side of
(10.3) and after necessary manipulations, we get
F1/4-S  rb
ra = rb + 4  S  1 + 4 
  
F1/4-S F1/4-S rb
or, ra = rb + 4  S + S . 4  ..……………………………….. (10.4)
 

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Now the second term within the parenthesis on the right hand side of (10.4) will
frequently be very small (being the product of two small fractions), and so we will
ignore it to highlight the more important factors. Then (10.4) reduces to
F1/4 S
If the domestic ra = rb + 4 S  ...……………………………………..... (10.5)
interest rate  
exceeds the Using (10.5) we can reformulate the criteria for investment decision. The US
foreign interest investor will find it more profitable to invest in US if the domestic interest rate
rate plus the exceeds the foreign interest rate plus the annualized forward premium / discount
annualized on the foreign currency. In the opposite case, he would be better off investing in
forward U.K. He will be indifferent between domestic and foreign investment , if the
premium/ equality (10.5) holds. Or, to put the same point differently, we can say that to
discount on the decide where to invest an investor will compare the domestic interest rate with the
foreign sum of foreign interest rate and the cost of spot-forward swap of pounds for
currency, the dollars, where the swap is put on annualized terms.
domestic
investors will Foreign Investment : Selecting the Right Country
profit more by
investing in the In the exercise above, the US investor had to compare US returns with returns
home country. from investment in a single foreign country(U.K.). As a matter of fact, he will
If the contrary have to shop around and compare yields from many countries in order to come to
holds they will an optimal decision. The bottom line of Table 10.1 summarizes the results of such
prefer foreign an exercise. It shows the annualized yields from investments in several financial
investment. centres of different countries. These yields have been obtained by using the
formula:
F1/4 -S 1+rj
Yield in centre j = rj + 4 S   4 
  
Table 10.1 : Exchange and Interest Rates in Major Money Markets: Yields
on Treasury Bills
New York London Frankfirst* Paris Tokyo≠
Ya rb S($/£) F1/4 ($/£) rg S($/DM) F1/4 ($/DM) rf S($/Fr) F1/4 ($/Fr) rj S($/¥) F1/4 ($/¥)

12.50 14.82 1.8930 1.8960 5.73 0.4535 0.4591 16.75 0.1809 0.1795 5.63 0.004372 0.004472
Convert Yields**
12.50% 14.48% 10.74% 13.52% 14.91%

* German treasury bills are for 180 days

≠ Japanese treasury bills are for 60 days
Lower interest
rates in some F14 ($/j) - S($/j)
financial centers ** Covered yield are computed as rj +  S($/j)  (1+ rj4)
may be
compensated by
Source : The Wall Street Journal, New York, and the Harris Bank,
higher forward
Weekly Review, Oct. 9,1981.
premiums there.
where j stands for the j-th financial center. In this example, the country with
highest yield is U.K, which incidentally does not offer the highest interest rate.
Also note that the yield differentials are smaller than the interest rate differentials.

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This is explained by the fact that lower interest rates in some financial centers
have been compensated by higher forward premiums there.
Now we can calculate the size of extra gains to the U.S. investor with a fund of $
8, 000, 000 to invest when he decides to invest abroad rather than at home. The
total (risk-free) returns from U.K. investment is
.1548
$ 8,000,000 (1+ 4 ) = $ 8,309,600

while the total (again risk-free by assumption) returns from domestic investment is
.1250
$ 8,000,000 (1+ 4 ) = $ 8,250,600
Thus, the US investor would have deprived himself of $59,600 (=$ 8,309,600 - $
8,250,600) if he had invested in US rather than abroad (U.K.)

International Borrowing Decisions

A borrower
A borrower would like to borrow from a source where the cost of borrowing per would like to
unit is the lowest, other things equal. From our discussion above, it is now borrow from the
relatively easy to develop the criterion for borrowing at home or abroad. For each cheapest source,
dollar borrowed at home by a US borrower, the total payment (principal plus even if it is a
interest ) after a period of 3 months is foreign source.
ra In this respect,
$ (1+ 4 ) --------------------------------------------------------------------(10.6) a simple
comparison of
If the borrower had access to UK markets, for each dollar borrower in UK, he will
domestic and
pay (interest plus principal)
foreign interest
 1  rb rates will not
£  S 1+ 4  ----------------------------------------------------------------(10.7) help.
  
The amount of dollars that will be required to pay for each dollar borrowed in
U.K. is uncertain because of the fact that S($/£) is subject to fluctuations. But, as
we have seen, this uncertainty can be totally eliminated, if the borrower buys
forward the amount of pounds given in (10.7). If F1/4 the 3-month forward rate,
then the borrower will pay for each dollar borrowed abroad
F1 
 4  rb
$ S 1 + 4  ------------------------------------------------------------------10.8)
  
Therefore, the borrower will borrow abroad if
F1
1 + a > 4 1 + rb ------------------------------------------------------- (10.9)
r
 4 S  4
He will borrow domestically, if the inequality (10.9) is reversed, and will be
indifferent between domestic and foreign borrowing if (10.6) equals (10.8). Not
surprisingly, the decision rules for borrowing are just the reverse of the investment
decision rules.

Borrowing and Investing for Arbitrage Profit

A large corporation or a bank can easily borrow large sums in its home money
market and or in foreign money markets. As before, let us suppose that it can

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borrow for 3 months in the home country (US) at the annualized rate of interest of
 ra
ra. Then for each dollar borrowed, it has to pay $ 1+ 4  as principal plus
 
interest. For each dollar it transfers to UK money market, it gets 1/S($/£) pounds
which, when invested at the annualized interest rate of rb, will amount to
1  rb
S 1+ 4  pounds at maturity. These can be sold forward at the rate F1/4 ($/£)
for sum of
F1
4 rb
S 1 + 4 
Interest
arbitrage dollars. Forward cover ensures that there is no foreign exchange risk in this
activities are investment. But more important is the fact that the firm need not have any fund of
usually confined its own; it is borrowing in order to lend in an effort to make profits. It will succeed
to large scale if the inequality
commercial
F1
banks.
1+ra < 4 1+rb
 4 S  4 
holds. If the left hand side is smaller than the right hand side, the bank or the
corporation will gain by borrowing at home and lending abroad. But if the reverse
inequality holds, it will still be making profit by borrowing in U.K. and lending in
US. This act of borrowing for the purpose lending is known as 'interest arbitrage'.
If as a result of the arbitrage,
F1
 ra  4 r 
1+  = 1+ b 
 4 S  4 
then there will be no scope for making profit from further arbitrage. Moreover, in
that case, borrowers and investor will be indifferent, other things equal, between
which markets to choose for borrowing or investing. Note in this connection that
interest arbitrage activities are usually limited to large scale commercial banks.
This is because they can borrow and invest funds with narrow spreads and do not
have to incur any significant transaction costs for buying and selling.

The Interest-Rate Parity Theorem

We have already established [in (10.3)] that a US investor intending to invest for a
3-month period will be indifferent between the US and the U.K. money markets if
The interest F1
parity theorem r 4  rb 
 a
may sound 1+ 4  = S 1+ 4 
   
depressing, but
what it says is or, in general terms, if
not surprising. 1+nrj Fn(j/i)
1+nri = S(j/i) ------------------------------------------------------------ (10.10)

And we have just shown that when this equality (10.10) holds, interest arbitrage is
no longer profitable.

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The interest parity theorem (IPT) says that (10.10) will indeed hold, and,
therefore, there will be no advantage to be derived from borrowing or investing in
any particular money market or from interest arbitrage.
This may sound depressing after we have invested so much effort in developing the
decision criteria for investing and borrowing at home and abroad. But note that the
IPT does not tell us anything contrary to what we have learnt. We learnt that if
and only if the relevant inequalities hold, it will be profitable to borrow or invest in In practice, the
one money market or the other. What the interest parity theorem asserts is that IRP theorem
when this process works itself out and equilibrium is reached, the covered yields in does not hold
all money markets will be the same. And then the investor or the borrower will not strictly because
have to worry about which market to choose, until the equality is disturbed for one of various
reason or another. In practice, the interest parity theorem does not strictly hold, transaction
and there are several reasons why this should be true. First, in the actual financial costs.
markets, brokerage cost have to be incurred for buying and selling of foreign
exchange and/or securities. These are known as 'transaction costs'. The presence
of these costs allows some covered interest advantage to exist, but the advantage
should not be larger than the cost of doing arbitrage. The transaction costs are
usually small, but can become significant when covered interest yields are
annualized. Secondly, there are political risks in foreign investments. Funds
invested in a foreign country may be frozen, confiscated, or rendered inconvertible.
In some countries, the political risk in the home country may be perceived to be
higher than in foreign country. Then some foreign investments can take place even
at a covered interest disadvantage. But generally, we would expect a premium
from a foreign investment. Thirdly, taxes can and do vary among countries which
cause interest rates to move away from parity levels. But the effect of tax
differentials is small. Finally, covered foreign investments are less liquid because
additional exchange transaction costs have to be incurred for liquidating foreign
securities.

The Speculator
One frequently found actor in the forward exchange market is the speculator.
Unlike other participants-borrowers, lenders, exporters, importers- he is there to
court risk in an effort to make a profit, if possible. Two traditional ways of
speculation in the foreign exchange market are 'spot speculation' and 'forward
speculation'.
Spot
Spot speculation is based on uncovered interest arbitrage. Let us assume that the
speculation and
speculator is speculating in pounds. If he wants to have £1 in a year's time, he
1 forward
must buy today 1+r pounds, where rb is the U.K. interest rate. In dollar terms, speculation are
b
S two well-known
this will amount to , which can be thought of as the current dollar cost of forms of
1+rb
speculation in
having a pound a year from now. The speculator, not having funds of his own,
the foreign
decides to borrow this amount from the US market. If the US rate of interest is
S exchange
ra(per annum), then borrowing 1+r dollars means that he will pay at the end of market.
b
S(1+r )
a
the year a sum of dollars equal to .
(1+rb)

This is the dollar cost of acquiring £1 for 1 year ahead.

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*
Let s1 ($/£) be the spot exchange rate 1 year ahead that the speculator thinks will
prevail. Then he will like to borrow in the US to acquire pound one year ahead if
* S(1+ra)
S1 > (1+r ) . If his expectations are realized, he will convert the pound into
b
dollars at the spot rate at the end of the year and pay his creditor in US. He will
S(1+ra)
find that he has made a profit. But if the actual spot rate (S1) is less than 1+r ) ,
( b
the speculator will lose money (dollar). For example, suppose that the U.K.
interest rate is rb=10% and the US interest rate, ra=15% then to get £1 for 1 year
1
ahead, the speculator must purchase today £0.91 = 1+0.10 which is equivalent
 
to $1.82 at the spot rate S=$ 2/£. If he borrows $1.82 in US, he must pay at the
end of the year $2.093(=1.82 (1+.15). At the end of the year he sells £1 at the spot
rate then prevailing (S1). For instance, if S1=$3.00/£, then the speculator's profit
per £ of speculation is $0.907 (=3.000-2.093). If, on the other hand, the spot rate
(S1) happens to be less than $2.093/£, then the speculator will lose money.
In our illustration the speculator borrowed dollars to buy pounds. This is known
as going `long' in pounds (and short in dollars). In the opposite form of spot
speculation (going short in pounds, and long in dollars), the speculator will borrow
in U.K. to speculate in dollars. It can be shown that if the speculator thinks
S(1+ra)
S1*($/£)< (1+r ) ,
b

then the short-pound spot speculation will be profitable. If his expectations are
actually realized, he will make a profit. But if the spot value of the pound turns
out to be greater, then
S(1+ra)
(1+rb) the short speculation will be unprofitable.

Forward Speculation
Speculation in the forward exchange rate involves comparison of the forward
exchange rate and the speculator's expected future spot rate. As before, let us say
The speculators that Sn*($/£) is the spot exchange rate that the speculator expects n years ahead.
need not be Then ignoring any risk premia, we can say that a forward speculator will like to
looked upon as sell pounds for delivery n years forward, if Fn($/£) > Sn*($/£), and that in the
villains. They opposite case, he will buy pounds. We will illustrate the latter. Suppose that
can contribute
to stabilization F1=1.8800 and that the speculator's expected spot rate 1 year ahead S1* =1.8850.
of the foreign Then the speculator will buy pounds forward. Expected profit per pound will be
exchange $.0050, or, for £1,000,000 the profit is $5,000.
market. Note that speculators need not be looked upon as villains. In the course of going
long and short, the speculator can contribute a great deal towards stabilizing the
foreign exchange markets, and thereby perform a useful function.

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Variations in the Exchange Rate: The Role of Inflation

Inflation lowers the domestic purchasing power of the home currency. It also
The rate of
lowers the amount of foreign currency that a unit of domestic currency can buy,
inflation and the
because the higher the rate of inflation at home, the less will a unit of foreign
rate of
currency buy in the home market. It is, therefore, reasonable to assume that the
exchange are
rate of inflation and the rate of exchange will be related, at least in the long run. It
related, at least,
is quite possible, however, that day-to-day variations in the exchange rates are
in the long run.
determined by a variety of other events.

The Purchasing Power Parity (PPP) Condition

In different locations of a domestic market, the price of a commodity should
ultimately be equal, if we abstract if from transportation and related costs. If this
were not true, there will be people who will buy from the market where the price is The absolute
low and sell where it is high. This is what is called commodity arbitrage. As a version of the
result of this arbitrage activity, prices will be equalized across markets, and then purchasing
there will be no further scope for profitable arbitrage. It has been claimed that power parity
what commodity arbitrage can do to the price of a commodity in domestic market, cannot strictly
it can do the same to the price of a good traded internationally, if we ignore hold for varions
transportation costs, tariffs and other kinds of taxes. The absolute version of this reasons
idea known as the absolute purchasing power parity theory asserts that including
restriction on
Pa= S($/£). Pb --------------------------------------------- (10.11) free commodity
where Pa and Pb are prices in US and U.K. respectively of a standard basket of arbitrage.
wholesale goods, and S($/£) is the spot exchange rate. For example, it S = 2 and
Pb = £10, then Pa must be $20. It is easy to see that static or absolute version of
the purchasing power parity (PPP) theory cannot strictly hold, because of
differential shipping costs, differential tariffs on different suppliers and other
restrictions on free commodity arbitrage. This deficiency has led to the
formulation of a relative of "dynamic " version or the PPP theory.

Relative Form of PPP

Let S($/£) be the percentage change in the spot exchange rate over a year, and Pa
and Pb the annual inflation rates respectively in US and U.K. Using these The relative
notations, we can write the absolute version of PPP for two successive years: form of PPP
Pa= S($/£). Pb --------------------------------------------------------------- (10.12) says that the
change in the
and Pa(1+Pa)=S[1+S] Pb (1+Pb) exchange rate is
approximately
Dividing (10.13) by (10.12), we get equal to the
( 1+Pa) = (1+S) (1+Pb) difference
between the
or, Pa- Pb = S(1+Pb)------- -- ---------------------------------------- ---- (10.14) domestic and
Equation (10.14) gives the 'relative' or 'dynamic' form of the PPP. If we assume foreign interest
that the foreign rate of inflation is relatively small (i.e. Pb is small), then, ignoring rates.
Pb, we can write
Pa- Pb = S ($ / £) ------ -- ----- - (10.15)

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which says that the change in the exchange rate is approximately equal to the
difference between the inflation rates. We should not expect PPP to hold precisely
within a short period of time. For example, under the fixed exchange rate system,
the PPP may be upset by regulated exchange rate of the central bank, which may
not allow devaluation in the face of rapid inflation. Even when the exchange rate is
flexible, departures from PPP are possible. In this scenario, the exchange rate will
be affected not only by the inflation rates, but also by factors such as interest rate
differentials, relative growth rates of national income and important political
developments. But in the long run, other factors become less important and PPP
takes hold. Therefore, PPP is said to be true, if at all, only in the long run.

Combining PPP and Interest Parity : The Fisher-open Condition

We can obtain another important relation in international finance by combining the
purchasing power parity condition with a condition similar to the interest parity
condition. The resulting relation is called the Fisher-open condition. The interest
parity condition that is conventionally used to derive the Fisher - open condition is
of the following form:
ra = rb + S*($/£) ----- -- ----- ---- - ----- ---- - --- - ----- ---- - ----- (10.16)
where S* is the expected annual rate of change in the number of dollars per pound.
When a pound appreciation is expected, we have S* >o, and when a pound
depreciation is expected, we have S* < O . What the 'modified' interest parity
condition (10.16) says is simply this: the expected yields (or costs of borrowing) in
two countries are equal if the domestic interest rate at home equals the interest rate
abroad plus the annual rate of appreciation (or, minus the annual rate of
depreciation) of the foreign currency.
Assuming that the relative form of PPP will also hold in the ex ante (expected)
sense, we can write (10.15) as
* *
Pa - Pb = S* --------- --------- ---- - ----- ---- - -- - ----- ---- - ----- (10.17)

which says that one should expect the exchange rate to change by an amount
which is equal to the difference between the two expected rates of inflation (Note
that an asterisk means the expected value of the variable concerned).
Now comparing (10.17) with the interest parity condition in (10.16) we notice a
The Fisher-open clear similarity.
condition * *
asserts that the Pa - Pb = S* ---- -- ----- ---- ---- - ----- ---- ---- - ----- ---- - ----- (10.17)
expected real
rate of interest ra - rb = S* ----- -- ----- ---- - ----- ----- -------- - ----- ---- - ----- (10.16)
at home and We can now write
abroad tends to
get equalized. * *
ra - rb = Pa - Pb ---- -- ----- ---- -- -------- - ---------- ---- - -- (10.18)

* *
or, ra - pa = ra - pb ----- -- ----- ------- - ----- ---- - --- -- -- (10.19)

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But the nominal market rate of interest minus the expected rate of inflation is the
expected 'real' rate of interest. So what (10.19) says is that the expected real rate
of interest in US and in UK. will get equalized. The relation (10.19) is known as
the Fisher -open condition.
We write below the ex ante variants of
"interest parity" : ra - rb = S*($/£)
* *
PPP : Pa - Pb = S*($/£)

* *
Fisher -open : r a - pa = r a - pb

We can immediately discover, that we can derive any one from the other two.
Finally, note that, even through none of them holds precisely, the PPP, interest
parity and the Fisher-open condition represent ways in which economies of
different countries are linked.

International Aspects of Long Term Financing

Forward
Many unique issues arise for a firm (or an individual) which wishes to engage in
exchange
long-term borrowing or investment in an international setting. For one thing, the
markets do not
foreign exchange risk cannot usually be avoided by recourse to forward exchange
exist for long
market, simply because such markets do not exist for long-term loans and
term loans and
investments. For another the political control of foreign investment is often stricter
investments. So
in the long-term, not to speak of the risk of outright loss of assets through seizure
for these, the
or confiscation. In the long-term setting, other methods must be available for
foreign
coping with the inevitable foreign exchange and political risk of foreign
exchange risk
transactions. We first discuss the issue of debt financing and then move on to
cannot be
equity financing.
avoided by
forward
Ordinary Bond Finance : Modified Criteria transactions.
We have seen that a firm in US would prefer to borrow abroad if
ra > rb + S* ($/£) ---- -- ----- --- ---- --- (10.20)

i.e. , if the rate of interest in US is higher than the sum of interest rate in UK and Over a long
the borrower's expected rate of increase in the spot price of pound over the year. period, the final
If, on the other hand, exchange rate
ra < rb + S*($/£) may deviate a
great deal from
the borrower will prefer to sell bonds in the domestic market. As an example, the initial
suppose that ra =12%, rb =16% and S*=-7%. In such a situation, exchange rate.
ra > rb + S*($/£) (because .12>.16 -.07) This makes
long-term
and therefore the borrower should sell bonds in U.K. investment
decisions more
Note that in (10.20) we have used the expected (by the management) rate of
complicated
change in the exchange rate because, as state before, forward cover is not
than the short-
available for the life of bonds, which could be 10 years or more. In this long
term ones.

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period the actual rates of exchange may deviate considerably from those applied to
come to a borrowing (lending) decision.
And when this happens, a large loss or a large gain may result. History is full of
examples in which currencies have shown wild gyrations. One reason for this is
that small yearly changes in the exchange rates (in a given direction) can add up to
a mighty total in the course of a decade or so.
What all this means is that before deciding to borrow (or invest) abroad, the
foreign country must offer some non-trivial advantage to compensate for the risk
of foreign ventures. For example, the management may think that for borrowing
abroad to be worth the risk, the foreign cost (the right hand side of (10.20) should
be lower by more than a certain percentage (say, 4%). Then we have to revise the
inequality (10.20) as follows:
ra > rb + S* ($ / £) +.07 ----------------------------------------------- (10.21)

If (10.21) is satisfied, then the expected borrowing cost will be sufficiently lower
in U.K. to justify borrowing in that market.
As before, suppose that
ra = 12%
rb = 16%
The risk
premium to be S* = -7%
applied is
Now the criterion for foreign borrowing as given in (10.21) will not be satisfied,
largely a matter
since
of judgment and
cannot be ra < rb +S* + .04 (because .12<.13)
objectively
derived. We see that after the addition of 7% risk premium, the decision with respect to the
source of borrowing has to be reversed. The risk premium to be applied is, of
course, a matter of judgment of the management. During times of greater
uncertainty and potential volatility of the exchange markets, a higher premium will
usually be applied to compensate for the greater risks involved.
It should be noticed that what is needed for a 'correct' decision is to compare the
interest rate differential with the actual, not the expected, annual change in the
exchange rate. Since the actual rate of change can only be known ex-post, the
management tries to make up for this lack of knowledge at the time of decision
making by applying a risk premium. The larger the risk premium, the more often
Eurobonds are is the decision likely to be correct in retrospect. But at the same time large
not regarded as premium will imply missing of many opportunities.
foreign bonds
because the
currency of Income in Foreign Currency
their A firm may sometimes earn a steady and relatively predictable long-term income
denomination is in a foreign country. For such a firm there is less risk in borrowing abroad than at
not the same as home. That is especially so if the firm is such that it has sizeable foreign
the currency of operations. Why? Because the foreign currency receivables could act as a basis for
the country in a negative premium on foreign borrowing.
which bonds are
sold.

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Foreign Bonds & Eurobonds

One way of reducing borrowing costs is to issue foreign bonds. A Japanese firm
might sell dollar denominated bonds in New York. Or, a Korean company may sell
bonds in Germany which are denominated in German marks. Both Japanese and
Korean bonds are foreign bonds. A borrower may choose to sell foreign bonds
because it thinks that in this way it can take advantage of the lower cost of
borrowing and also raise large funds, because foreign bonds are often popular
with foreign buyers (partly because they do not have to bear the exchange risk
which is borne by the issuing company)
A bond that is sold in country which do not use the currency of denomination of
the bond is a Eurobond. Suppose a British or a German firm sell dollar
denominated bonds outsides USA (say, France). These are Eurobonds. Why are
these not foreign bonds? These are not foreign bonds, because the currency of their
denomination is not the same as that of the country in which the bonds are sold.
Some Eurobonds are multi-currency bonds where the lender can pick up the
currency of his choice.
Finally, it may be noted that some bond financing (borrowing) abroad may be
dictated by the desire to insure investments abroad. If a firm's assets are seized,
the firm may refuse to repay local debts and thereby reduce its losses.

Equity Financing
A firm may buy stocks in different countries in order to form a portfolio with
lower risk. Why ? The degree of dependence among yields will generally vary. A firm can form
Risk can be reduced by holding only a portion of the wealth in any of the assets a portfolio with
whose yields are relatively independent. This device may not give the maximum lower risk by
overall rate of return, because some wealth will be invested in assets, with lower buying stocks
expected yields. But if the investor has some degree of risk-aversion, the lower risk of different
will compensate him for lower return. countries.
Now yields on securities of a given country may show some independence, but
they are also affected in the same general way by overall domestic activity (say, a
fall in national income). As a result, the gain from diversification using domestic
securities is rather limited. Across different countries, greater degrees of
independence of yields on securities are to be expected, as confirmed by a number
of studies. Therefore, there are more gains to be had from international
diversification than from domestic diversification. The systematic (undiversifiable)
risk in the internationally diversified portfolio is less than in a domestically
diversified one. This, in turn, means that international diversification reduces the
cost of equity capital to the firm.

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Questions for Review

Multiple Choice Questions (tick the correct answer)
1. To select the right country to invest in, the investor has to shop around and
compare……… from many countries.
a. yields
b. offers
c. assistance
d. imports.
2. A borrower would like to borrow from a source where the ……… per unit is
the ……….
a. profit; highest
b. cost of borrowing; lowest
c. cost of borrowing; highest
d. return from borrowing; highest.
3. Transaction cost is one kind of
a. brokerage cost
b. transport cost
c. production cost
d. none of the above.
4. A speculator in the forward exchange market
a. always earns profit
b. always incurs loss
c. never incurs loss
d. none of the above.
5. Inflation ……… the amount of foreign currency that a domestic currency
can……
a. enhance; buy
b. lowers; buy
c. justifies; afford
d. none of the above.

Short Questions
1. "Investment in the domestic money market is free of transaction and
translation risk." Do you agree? If not, would you say that foreign investment
too involves no risk of any kind?
2. When is the domestic investor likely to profit more by investing at home than
abroad? When will be come to the opposite conclusion? Explain.
3. If you find that in some large financial center interest rates are low but
forward premiums are high, what would you conclude from this?
4. A simple comparison of domestic and foreign interest rates will not sulfite if
not interest is to decide whether to lead to or borrow from foreign countries.
Do you find this agreement convening? Why?
5. Can you explain why interest arbitrage activities are usually confined to large
scale commercial banks?
6. "If the interest rate parity theorem holds, then one should not absolve any one
to engage in interest arbitrage activities." Do you agree? Why?
7. Distinguish between spot and forward speculations in foreign exchange.

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8. What does the relative version of the PPP say? Would you expect PPD to
hold preciously within a short period? Why?
9. What is Fisher-Open condition? What does it asset? Does it tell you that
economics of different countries are liked? How?
10. For long term borrowing and leading, the exchange risk cannot be avoided by
forward exchange operations. Why?
11. What are foreign bounds and foreign bonds? Are they really different?
12. "Equity financing is an important way of reducing risks of long term
leading." In what sense? Explain.

Essay-type Questions
1. Explain how the decisions to invest in home or foreign market are made by an
investor?
2. How does an investor select the right country to invest his money in?
3. State how international borrowing decisions are made.
4. Explain the role of inflation in changing the exchange rate.
5. Discuss the international aspects of long term financing.

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Lesson-3 : Organization of International Banking

Lesson Objectives
After studying this lesson, you will be able to understand
 the logic of correspondent banking;
 the functions of foreign branches of banks in international finance; and
 the role of consortium banks arranging large loans.

Banks occupy an important place in national as well as in international finance. To

facilitate international transactions banks in different countries have to maintain
close ties with one another, and these ties are both formal and informal. Let's
discuss these matters briefly.

Correspondent Banking
Correspondent Banks in different countries sometimes maintain correspondent accounts with one
accounts another, thereby setting up an informal linkage. Many banks in US maintain
facilitate correspondent relationship with banks in countries in which they do not have
international branches. Maintaining correspondent accounts facilitate international payment and
payments. On collections for customers. For example, if a US corporation wants to pay its
the other hand, Korean suppliers, it may ask its US bank to initiate the necessary procedures.
foreign Accordingly, the US bank would ask its corespondent bank in Korea where it
branches can holds account. The Korean bank will credit the supplier's account, while the
perform American bank will debit the account of the American corporation. Then the two
clearing banks will settle among themselves. Correspondent banking permits banks to help
operations more their customers in international transactions without having to maintain any
quickly then personal or overseas office.
correspondent
banking.
Bank Agencies
An agency is like a full-fledged bank, except that it does not handle deposits. It
arranges loans, clear drafts and cheques and channel funds into financial markets.
It may sometimes arrange loans for customers, but they deal primarily on behalf of
the home office.

Foreign Branches
Foreign branches are like local banks, but their director and owners are residents
elsewhere. With the help of foreign branches, customers in different countries can
enjoy the advantage of very quick cheque clearance, because the debit and credit
operations are internal matters which can be initiated by a simple telephone call.
This obviates the need for time-consuming clearing operations via correspondent
banks. In some small countries, the foreign branches sometimes provide those
services which only large banks can provide, but cannot be provided by relatively
small local banks. Many governments restrict by law the opening of foreign
branches in their countries, mainly to protect local banks from aggressive foreign
competition.

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Foreign Subsidiaries and Affiliates

Foreign
A foreign branch is part of the parent organization incorporated in a foreign affiliates,
country. A foreign subsidiary, on the other hand, is locally incorporated, but though locally
owned partly or wholly, by a foreign parent. Foreign subsidiaries perform almost incorporated,
all functions that a local bank performs. Foreign affiliates are, like foreign are joint
subsidiaries, locally incorporated, but they are joint ventures. No individual ventures.
foreigner has control over it, though a group of such owners many have such
control.

Consortium Banks
These are joint ventures of large commercial banks from numerous countries.
They are primarily concerned with investment, arranging loans and underwriting
stocks and bonds. They do not take deposits and deal with large corporation or
perhaps governments. They also participate in takeovers and mergers.

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Questions for Review

Multiple Choice Questions (tick the correct answer)
1. Correspondent banking is an ––––– between the banks of different countries:
a. formal linkage
b. informal linkage
c. agreement (formal)
d. none of the above.
2. Foreign branches are like ––––
a. local banks
b. an affiliated agency
c. an exchange market
d. none of the above.
3. Foreign affiliates are:
a. joint ventures
b. not like foreign subsidiaries
c. controlled by an individual foreigner
d. none of the above.
4. Consortium banks-------
a. are not concerned with investment
b. do not take deposits
c. do not arrange loans
d. none of the above.

Essay-type Questions
1. Discuss functions of the following in international finance:
a. correspondent banking
b. bank agencies
c. foreign branches
d. consortium banks.

Answer key for MCQ's

Lesson-1: 1.c, 2.b, 3.a, 4.a, 5.b, 6.c, 7.c
Lesson-2:L 1.a, 2.b, 3.a, 4.d, 5.b
Lesson-3: 1.a, 2.a, 3.a, 4.b

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