Gohar

Multinational Financial Management:
An Overview
CHAPTER 1
Chapter Objectives
 Identify the management goal and organizational

structure of the Multinational Corporation (MNC).
 Describe the key theories that justify international
business.
 Explain the common methods used to conduct
international business.
 Provide a model for valuing the MNC.
2
Multinational Corporation (MNC)
▪ A multinational corporation is defined as one that has

operating subsidiaries, branches or affiliates located in foreign
countries.
▪ The ownership of some MNCs is so dispersed
internationally that they are known as transnational
corporations.
▪ The transnationals are usually managed from a global
perspective rather than from the perspective of any single
country.
Managers of MNCs are expected to make decisions that will

maximize the stock price and thereby serve the shareholders’
interests.
3
The Environment of MNCs
4
Managing the MNC
How Business Disciplines Are Used to Manage the

MNC
▪ Common finance decisions include:
▪ Whether to discontinue operations in a particular country
▪ Whether to pursue new business in a particular country
▪ Whether to expand business in a particular country
▪ How to finance expansion in a particular country
▪ Finance decisions are influenced by other business functions:
▪ Marketing
▪ Management
▪ Accounting and information systems
5
Managing the MNC
Agency Problems
▪ The conflict of goals between managers and shareholders
▪ Agency costs
▪ The costs of ensuring that managers maximize shareholder wealth
are normally higher for MNCs than for purely domestic firms for
several reasons:
▪ Monitoring managers of distant subsidiaries in foreign countries is
more difficult.
▪ Foreign subsidiary managers raised in different cultures may not
follow uniform goals.
▪ Sheer size of larger MNCs can create large agency problems.
▪ Some subsidiary managers tend to downplay the short-term effects of
decisions and can pursue other goals.
6
Managing the MNC
Agency Problems (cont.)

▪ Parent control of agency problems
▪ Parent should clearly communicate the goals for each subsidiary
to ensure managers focus on maximizing the value of the MNC
and not of their respective subsidiaries.
▪ Corporate control of agency problems
▪ Entire management of the MNC must be focused on maximizing
shareholder wealth.
▪ Regulatory changes (e.g., Sarbanes-Oxley Act enacted in
2002)
▪ Ensures a more transparent process for managers to report on
the productivity and financial condition of their firm.
7
SOX Methods to Improve Reporting
Agency Problems (cont.)

▪ How SOX Improved Corporate Governance of MNCs
▪ Establishing a centralized database of information
▪ Ensuring that all data are reported consistently among
subsidiaries
▪ Implementing a system that automatically checks for unusual
discrepancies relative to norms
▪ Speeding the process by which all departments and subsidiaries
have access to all the data they need
▪ Making executives more accountable for financial statements
8
Management Structure of an MNC
Management Structure of MNCs

▪ Centralized
▪ Allows managers of the parent to control foreign subsidiaries
and therefore reduce the power of subsidiary managers
▪ Decentralized
▪ Gives more control to subsidiary managers who are closer to
the subsidiary’s operation and environment
▪ How the Internet Facilitates Management Control
▪ Makes it easier for the parent to monitor the actions and
performance of its foreign subsidiaries
9
Exhibit 1.1a Management Styles of MNCs
10
Exhibit 1.1b Management Styles of MNCs
11
Why Firms Pursue International Business
Theory of Comparative Advantage: specialization

increases production efficiency.
Imperfect Markets Theory: factors of production are
somewhat immobile providing incentive to seek out foreign
opportunities.
Product Cycle Theory: as a firm matures, it recognizes
opportunities outside its domestic market.
12
Exhibit 1.2 International Product Life Cycles
13
How Firms Engage in International Business
▪ International trade
▪ Licensing
▪ Franchising
▪ Joint Ventures
▪ Acquisitions of existing operations
▪ Establishment of new foreign subsidiaries
14
Foreign Presence and Foreign Investment
15
International Trade
▪ Relatively conservative approach that can be used by firms to:
▪ penetrate markets (by exporting)
▪ obtain supplies at a low cost (by importing)
▪ Minimal risk – no capital at risk

▪ How the Internet Facilitates International Trade
▪ The internet facilitates international trade by allowing firms to
advertise their products and accept orders on their websites.
16
Licensing
▪ Obligates a firm to provide its technology (copyrights, patents,
trademarks, or trade names) in exchange for fees or some
other specified benefits.
▪ Allows firms to use their technology in foreign markets
without a major investment and without transportation costs
that result from exporting.
▪ Major disadvantage – difficult to ensure quality control in
foreign production process.
17
Franchising
▪ Obligates firm to provide a specialized sales or service
strategy, support assistance, and possibly an initial investment
in the franchise in exchange for periodic fees.
▪ Allows penetration into foreign markets without a major
investment in foreign countries.
Joint Ventures
▪ A venture that is jointly owned and operated by two or more
firms. A firm may enter the foreign market by engaging in a
joint venture with firms that reside in those markets.
▪ Allows two firms to apply their respective comparative
advantages in a given project.
18
Acquisitions of Existing Operations

▪ Acquisitions of firms in foreign countries allows firms to have
full control over their foreign businesses and to quickly obtain
a large portion of foreign market share.
▪ Subject to the risk of large losses because of larger investment
required.
▪ Liquidation may be difficult if the foreign subsidiary performs
poorly.
19
Establishing New Foreign Subsidiaries

▪ Firms can penetrate markets by establishing new operations in
foreign countries.
▪ Requires a large investment.
▪ Establishing new subsidiaries as opposed to foreign
acquisitions allows operations to be tailored exactly to the
firm’s needs.
▪ May require smaller investment than buying existing firm.
20
Summary of Methods
▪ Any method of increasing international business that requires
a direct investment in foreign operations is referred to as
direct foreign investment (DFI).
▪ International trade and licensing usually not included in this
category.
▪ Foreign acquisitions and establishment of new foreign
subsidiaries represent the largest portion of DFI.
21
Exhibit 1.3 Cash Flow Diagrams for MNCs
22
Valuation Model for an MNC:
Domestic Model
n
 E CF$,t 
V   t 
t 1  1  k  
Where
▪ V represents the present value of expected cash flows
▪ E(CF$,t) represents expected cash flows to be received at the
end of period t,
▪ n represents the number of periods into the future in which
cash flows are received,
▪ k represents the required rate of return by investors (WACC).
23
Multinational Model

E CF$,t    E CF j ,t  E S j ,t  
m
j 1
Where
▪ CFj,t represents the amount of cash flow denominated in a
particular foreign currency j at the end of period t,
▪ Sj,t represents the exchange rate at which the foreign currency
(measured in dollars per unit of the foreign currency) can be
converted to dollars at the end of period t.
24
Multinational Model (cont.)
 E CF  E S 
m
n j ,t j ,t
V 
j 1
t 1 1  k  2
Discount the estimated total dollar cash flow for each period
at the weighted average cost of capital (k).
25
Uncertainty Surrounding an MNC’s Cash Flows

▪ Exposure to international economic conditions – If
economic conditions in a foreign country weaken, purchase of
products decline and MNC’s sales in that country may be
lower than expected.
▪ Exposure to international political risk – A foreign
government may increase taxes or impose barriers on the
MNC’s subsidiary.
▪ Exposure to exchange rate risk – If foreign currencies
related to the MNC’s subsidiary weaken against the U.S. dollar,
the MNC will receive a lower amount of dollar cash flows than
was expected.
26
Exhibit 1.4 How an MNC’s Valuation is Exposed
to Uncertainty (Risk)
27
Exhibit 1.5 Potential Effects of International
Economic Conditions
28
How Uncertainty Affects the MNC’s cost of Capital

▪ A higher level of uncertainty increases the return on
investment required by investors and the MNC’s valuation
decreases.
29
Exhibit 1.6 Organization of Chapters
30
Chapter Questions
1. What is the appropriate definition of an MNC?

2. What are typical reasons why MNCs expand
internationally?
3. Why unfavorable economic or political conditions
affect the MNCs’ cash flows, cost of capital, and
valuation?
4. What are the risks faced by MNCs that expand
internationally?
5. Should an MNC reduce its ethical standards to
compete internationally?
31
International Flow of Funds
CHAPTER 2
Chapter Objectives
 Explain the key components of the balance of payments.

 Explain the growth in international trade activity over
time.
 Explain how international trade flows are influenced by
economic factors and other factors.
 Explain how international capital flows are influenced by
country characteristics.
 Introduce the agencies that facilitate the international
flow of funds.
2
Balance of Payments
The balance of payments is a summary of transactions

between domestic and foreign residents for a specific
country over a specified period of time.
3
Balance of Payments
Components of the Balance-of-Payments

Statement:
▪ Current Account: summary of flow of funds due to
purchases of goods or services or the provision of income
on financial assets.
▪ Capital Account: summary of flow of funds resulting from
the sale of assets between one specified country and all
other countries over a specified period of time.
▪ Financial Account: refers to special types of investment,
including DFI and portfolio investment.
4
Balance of Payments
Current Account
▪ Payments for merchandise and services
▪ Merchandise exports and imports represent tangible products
that are transported between countries. Service exports and
imports represent tourism and other services. The difference
between total exports and imports is referred to as the balance
of trade.
▪ Factor income payments
▪ Represents income (interest and dividend payments) received by
investors on foreign investments in financial assets (securities).
▪ Transfer payments
▪ Represent aid, grants, and gifts from one country to another.
5
Exhibit 2.1 Examples of Current Account
Transactions
6
Exhibit 2.2 Summary of Current Account in the
Year 2011 (billions of $)
7
Balance of Payments
Capital Account
▪ Originally included the financial account
▪ Includes the value of financial assets transferred across
country borders by people who move to a different country
▪ Includes patents and trademarks
▪ Relatively minor (in terms of dollar amounts) to financial
account
8
Balance of Payments
Financial Account
▪ Direct foreign investment
Investments in fixed assets in foreign countries.
▪ Portfolio investment
Transactions involving long term financial assets (such as stocks and
bonds) between countries that do not affect the transfer of
control.
▪ Other capital investment
Transactions involving short-term financial assets (such as money
market securities) between countries.
▪ Errors and omissions and reserves
Measurement errors can occur when attempting to measure the
value of funds transferred into or out of a country.
9
Growth in International Trade
Events That Increased Trade Volume

▪ Removal of the Berlin Wall: Led to reductions in trade barriers
in Eastern Europe.
▪ Single European Act of 1987: Improved access to supplies from

firms in other European countries.
▪ North American Free Trade Agreement (NAFTA): Allowed

U.S. firms to penetrate product and labor markets that previously
had not been accessible.
▪ General Agreement on Tariffs and Trade (GATT): Called for

the reduction or elimination of trade restrictions on specified
imported goods over a 10-year period across 117 countries.
10
Events That Increased Trade Volume (cont.)

▪ Inception of the Euro: Reduced costs and risks associated with
converting one currency to another.
▪ Expansion of the European Union: reduced restrictions on
trade with Western Europe.
▪ Other Trade Agreements: The United States and the European

Union have established trade agreements with many other
countries.
11
Impact of Outsourcing on Trade

▪ Definition of Outsourcing: The process of subcontracting
to a third party in another country to provide supplies or
services that were previously produced internally.
▪ Impact of outsourcing:
▪ Increased international trade activity because MNCs now
purchase products or services from another country.
▪ Lower cost of operations and job creation in countries with low
wages.
▪ Criticism of outsourcing:
▪ Outsourcing may reduce jobs in the home country.
12
Impact of Outsourcing on Trade (cont.)

▪ Managerial decisions about outsourcing
▪ Shareholders may suggest that the managers are not maximizing
the MNC’s value as a result of their commitment to creating jobs
at home.
▪ If the same products can be produced in foreign markets at a
fraction of the cost, shareholders may pressure the managers to
establish a foreign subsidiary or to outsource.
▪ Managers should consider the potential savings that could occur
as a result of outsourcing.
▪ Managers must also consider the possible adverse effects of
outsourcing (bad publicity or bad morale among remaining local
workers).
13
Growth in International Trade (U.S. example)
Trade Volume Among Countries

▪ The annual international trade volume of the United States is
between 10 and 20 percent of its annual GDP.
▪ Trade volume between the United States and Other
Countries:
▪ About 20 percent of all U.S. exports are to Canada, while 13
percent are to Mexico.
▪ Canada, China, Mexico, and Japan are the key exporters to the
United States. Together, they account for more than half of the
value of all U.S. imports.
14
Exhibit 2.3 Distributions of U.S. Exports by
Country (2010, billions of $)
15
Exhibit 2.4 2008 Distribution of U.S. Exports
and Imports by Country (2008)
16
Trend in U.S. Balance of Trade

▪ The U.S. balance of trade deficit increased substantially from
1997 until 2008.
▪ In the 2008–2009 period, U.S. economic conditions weakened
and the U.S. demand for foreign products and services
decreased.
▪ In recent years, the U.S. annual balance of trade deficit with
China has exceeded $200 billion.
▪ Any country’s balance of trade can change substantially over
time.
17
Exhibit 2.5 U.S. Balance of Trade Over Time
(Quarterly)
18
Factors Affecting International Trade Flows
Cost of Labor: Firms in countries where labor costs are

low commonly have an advantage when competing globally,
especially in labor-intensive industries.
Inflation: Current account decreases if inflation increases
relative to trade partners.
National Income: Current account decreases if national
income increases relative to other countries.
Credit Conditions: Credit conditions tend to tighten
when economic conditions weaken, causing banks to be less
willing to extend financing to MNCs.
19
Government Policies:
▪ Restrictions on imports
▪ Subsidies for exporters
▪ Restrictions on piracy
▪ Environmental restrictions
▪ Labor and business laws
▪ Tax breaks
▪ Country trade requirements
▪ Government ownership or subsidies
▪ Country security laws
▪ Policies to punish country governments
20
Impact of Government Policies (cont.)

▪ Restrictions on Imports: Taxes (tariffs) on imported goods
increase prices and limit consumption. Quotas limit the
volume of imports.
▪ Subsidies for Exporters: Government subsidies help firms
produce at a lower cost than their global competitors.
▪ Restrictions on Piracy: A government can affect
international trade flows by its lack of restrictions on piracy.
▪ Environmental Restrictions: Environmental restrictions
impose higher costs on local firms, placing them at a global
disadvantage compared to firms in other countries that are
not subject to the same restrictions.
21

▪ Labor Laws: countries with more restrictive laws will incur
higher expenses for labor, other factors being equal.
▪ Business Laws: Firms in countries with more restrictive
bribery laws may not be able to compete globally in some
situations.
▪ Tax Breaks: Though not necessarily a subsidy, but still a form
of government financial support that might benefit many firms
that export products.
▪ Country Trade Requirements: Requiring various forms or
licenses (bureaucracy) before MNCs can export to the
country is a strong trade barrier.
22

▪ Government Ownership or Subsidies: Some
governments maintain ownership in firms that are major
exporters.
▪ Country Security Laws: Governments may impose certain
restrictions when national security is a concern, which can
affect trade.
▪ Policies to Punish Country Governments: Many expect
countries to restrict imports from countries that …
▪ Fail to enforce environmental laws and child labor laws
▪ Initiate war against another country
▪ Are unwilling to participate in a war
23

▪ Summary of Government Policies:
▪ Every government implements some policies
▪ No formula ensure a completely fair contest for market share
24
Exchange Rates: current account decreases if currency

appreciates relative to other currencies.
▪ How exchange rates may correct a balance of trade deficit:
When a home currency is exchanged for a foreign currency to buy
foreign goods, then the home currency faces downward pressure,
leading to increased foreign demand for the country’s products.
▪ Why exchange rates may not correct a balance of trade deficit:
Exchange rates will not automatically correct any international
trade balances when other forces are at work.
25
Exchange Rates (cont.)

▪ Limitations of a Weak Home Currency Solution
▪ Competition: foreign companies may lower their prices to remain
competitive.
▪ Impact of other currencies: a country that has balance of trade
deficit with many countries is not likely to solve all deficits
simultaneously.
▪ Prearranged international trade transactions: international
transactions cannot be adjusted immediately. The lag is estimated
to be 18 months or longer, leading to a J-curve effect.
▪ Intracompany trade: Many firms purchase products that are
produced by their subsidiaries. These transactions are not
necessarily affected by currency fluctuations.
26
Exhibit 2.6 J-Curve Effect
27
Exchange Rates (cont.)

▪ Exchange Rates and International Friction
▪ All governments cannot weaken their home currencies
simultaneously.
▪ Actions by one government to weaken its currency causes
another country’s currency to strengthen.
▪ Government attempts to influence exchange rates can lead to
international disputes.
28
International Capital Flows
Factors Affecting Direct Foreign Investment

▪ Changes in Restrictions
▪ New opportunities have arisen from the removal of government
barriers.
▪ Privatization
▪ DFI is stimulated by new business opportunities associated with
privatization.
▪ Managers of privately owned businesses are motivated to ensure
profitability, further stimulating DFI.
29
Factors Affecting Direct Foreign Investment (Cont.)

▪ Potential Economic Growth
▪ Countries with greater potential for economic growth are
more likely to attract DFI.
▪ Tax Rates
▪ Countries that impose relatively low tax rates on corporate
earnings are more likely to attract DFI.
▪ Exchange Rates
▪ Firms typically prefer to pursue DFI in countries where the
local currency is expected to strengthen against their own.
30
Factors Affecting International Portfolio Investment

▪ Tax Rates on Interest or Dividends
▪ Investors normally prefer to invest in a country where taxes are
relatively low.
▪ Interest Rates
▪ Money tends to flow to countries with high interest rates, as long
as the local currencies are not expected to weaken.
▪ Exchange Rates
▪ Investors are attracted to a currency that is expected to
strengthen.
31
Impact of International Capital Flows

▪ The United States relies heavily on foreign investment in:
▪ U.S. manufacturing plants, offices, and other buildings.
▪ Debt securities issued by U.S. firms.
▪ U.S. Treasury debt securities
▪ Foreign investors are especially attracted to the U.S. financial
markets when the interest rate in their home country is
substantially lower than that in the United States.
▪ U.S. reliance on foreign funds: In general, access to
international funding has allowed more growth in the U.S.
economy over time but has also made the U.S. more reliant on
foreign investors.
32
Exhibit 2.7 Impact of the International Flow of Funds
on U.S. Interest Rates and Business Investment
33
Agencies that Facilitate International Flows
International Monetary Fund

▪ Major Objectives of the IMF:
▪ promote cooperation among countries on international
monetary issues,
▪ promote stability in exchange rates,
▪ provide temporary funds to member countries attempting to
correct imbalances of international payments,
▪ promote free mobility of capital funds across countries,
▪ promote free trade.
▪ Its compensatory financing facility (CFF) attempts to
reduce the impact of export instability on countries.
▪ Financing is measured in special drawing rights (SDRs).
34
World Bank (International Bank for Reconstruction and

Development)
▪ Major Objective of the IBRD:
▪ Make loans to countries to enhance economic development.
▪ Structural Adjustment Loans (SALs) are intended to

enhance a country’s long-term economic growth.
▪ Funds are distributed through cofinancing agreements:
▪ Official aid agencies
▪ Export credit agencies
▪ Commercial banks
35
World Trade Organization

▪ Major Objective of the WTO:
▪ Provide a forum for multilateral trade negotiations and to settle
trade disputes related to the GATT.
▪ Member countries are given voting rights that are used to

make judgments about trade disputes and other issues.
36
International Financial Corporation

▪ Major Objective of the IFC:
▪ Promote private enterprise within countries.
▪ Provides loans to corporations and purchases stock.
▪ It traditionally has obtained financing from the World Bank but
can also borrow in the international financial markets.
International Development Association
▪ Major Objective of the IDA:
▪ Extends loans at low interest rates to poor nations that cannot
qualify for loans from the World Bank.
37
Bank for International Settlements

▪ Major Objective of the BIS:
▪ Facilitate cooperation among countries with regard to
international transactions.
▪ Provides assistance to countries experiencing financial crises.
▪ Sometimes referred to as the “central banks’ central
bank” or the “lender of last resort.”
38
Organization for Economic Cooperation and Development (OECD)
Organization for Economic Cooperation and

Development (OECD)
▪ Major Objective of the OECD:
▪ Facilitate governance in governments and corporations of
countries with market economics.
▪ It has 30 member countries and has relationships with
numerous countries.
▪ Promotes international country relationships that lead to
globalization.
39
Regional Development Agencies

▪ Inter-American Development Bank: focusing on the needs of
Latin America
▪ Asian Development Bank: established to enhance social and
economic development in Asia
▪ African Development Bank: focusing on development in African
countries
▪ European Bank for Reconstruction and Development: created
in 1990 to help Eastern European countries adjust from
communism to capitalism.
40
Chapter Questions
1. Should trade restrictions be used to influence

human rights issues?
2. Would the U.S. balance of trade deficit be larger or
smaller if the dollar depreciates against all
currencies, versus depreciating against some
currencies but appreciated against others?
3. Why international trade volume has increased over
time?
4. How the existence of the euro may affect U.S.
international trade?
41
International Financial Markets
CHAPTER 3
Chapter Objectives
Describe the background and corporate use of the

following International Financial Markets:
} Foreign exchange market
} International money market

} International credit market
} International bond market

} International stock markets
2
Foreign Exchange Market
} Provides the physical and institutional structure through

which one currency of one country is exchanged for
that of another country.
} Exchange rate specifies the rate at which one currency
can be exchanged for another.
3
History of Foreign Exchange

§ Gold Standard (1876 – 1913)
§ Each currency was convertible into gold at a specified rate. When
World War I began in 1914, the gold standard was suspended.
§ Agreements on Fixed Exchange Rates
§ Bretton Woods Agreement 1944 – 1971
§ Smithsonian Agreement 1971 – 1973
§ Floating Exchange Rate System
§ Widely traded currencies were allowed to fluctuate in
accordance with market forces.
4
Foreign Exchange Transactions

§ The over-the-counter market is the telecommunications
network where companies normally exchange one currency
for another.
§ Foreign exchange dealers serve as intermediaries in the
foreign exchange market.
§ Spot Market: A foreign exchange transaction for immediate
exchange occurs in the spot market. The exchange rate in the
spot market is known as the spot rate.
§ Spot Market Structure: Trading between banks occurs in the
interbank market.
5
Foreign Exchange Transactions (cont.)

§ Use of the U.S. dollar in spot markets: The U.S. Dollar is
the commonly accepted medium of exchange in the spot
market.
§ Spot market time zones - Foreign exchange trading is
conducted only during normal business hours in a given
location. Thus, at any given time on a weekday, somewhere
around the world a bank is open and ready to accommodate
foreign exchange requests.
§ Spot market liquidity: More buyers and sellers means more
liquidity.
6
Foreign Exchange Transactions (cont.)

§ Attributes of Banks That Provide Foreign Exchange
§ Competitiveness of quote
§ Special relationship with the bank
§ Speed of execution
§ Advice about current market conditions
§ Forecasting advice
7
Foreign Exchange Quotations

§ At any given point in time, a bank’s bid (buy) quote for a
foreign currency will be less than its ask (sell) quote.
§ Bid/Ask spread of banks: The bid/ask spread covers the
bank’s cost of conducting foreign exchange transactions.
§ Comparison of Bid/Ask spread among currencies
(bid/ask spread in percentage terms)
Ask rate - Bid rate

Bid / ask spread =
Ask rate
8
Exhibit 3.1 Computation of the Bid/Ask Spread
9
Foreign Exchange Quotations (cont.)

§ Factors That Affect the Spread
§ Order costs: Costs of processing orders, including clearing costs
and the costs of recording transactions.
§ Inventory costs: Costs of maintaining an inventory of a
particular currency.
§ Competition: The more intense the competition, the smaller the
spread quoted by intermediaries.
§ Volume: Currencies that have a large trading volume are more
liquid because there are numerous buyers and sellers at any given
time.
§ Currency risk: Economic or political conditions that cause the
demand for and supply of the currency to change abruptly.
10
Interpreting Foreign Exchange Quotations

§ Direct versus Indirect Quotations at One Point in
Time
§ Direct Quotation represents the value of a foreign currency in
home currency units (e.g., number of dollars per currency).
§ Example: $1.031 per Euro
§ Indirect quotation represents the number of units of a foreign

currency per unit of home currency in (e.g., euros per dollar).
§ Example: €0.97 per Dollar
§ Indirect quotation = 1 / Direct quotation
11
Exhibit 3.2 Direct and Indirect Exchange Rate
Quotations
12
Interpreting Foreign Exchange Quotations (cont.)

§ Direct versus Indirect Exchange Rates Over Time
§ When the euro is appreciating against the dollar (based on
an upward movement of the direct exchange rate of the euro),
the indirect exchange rate of the euro is declining.
§ When the euro is depreciating (based on a downward

movement of the direct exchange rate) against the dollar, the
indirect exchange rate is rising.
13
Exhibit 3.3 Relationship Over Time between the
Euro’s Direct and Indirect Exchange Rates
14

§ Source of Exchange Rate Quotations
§ Updated currency quotations are provided for several major
currencies on Yahoo’s website (finance.yahoo.com/currency).
§ Exchange rate quotations are also provided by many other

online sources, including oanda.com.
15

§ Cross Exchange Rates
Cross exchange rate is the amount of one foreign currency per
§
unit of another foreign currency
§ Example
Value of peso = $0.07
Value of Canadian dollar = $0.70
Value of peso in C$ = Value of peso in $
Value of C$ in $
= $0.07 = C$ 0.10
$0.70
§ Source of Cross Exchange Rate Quotations: Cross
exchange rates are provided for several major currencies on Yahoo’s
website (finance.yahoo.com/currency-investing).
16

§ Currency Derivatives: A contract with a price that is
partially derived from the value of the underlying currency that
it represents.
§ Forward Contracts: agreements between a foreign exchange
dealer and an MNC that specifies the currencies to be
exchanged, the exchange rate, and the date at which the
transaction will occur.
§ The forward rate is the exchange rate specified in the
forward contract.
§ The forward market is an over-the-counter market where
forward contracts are traded.
17

§ Currency Futures Contracts: similar to forward contracts
but sold on an exchange.
§ Specifies a standard volume of a particular currency to be
exchanged on a specific settlement date.
§ The futures rate is the exchange rate at which one can

purchase or sell a specified currency on the specified
settlement date.
§ The future spot rate is the spot rate that will exist at a future
point in time and is uncertain as of today.
18
Currency Derivatives

§ Currency Options Contracts
§ Currency Call Option: provides the right to buy currency at a
specified strike price within a specified period of time.
§ Currency Put Option: provides the right to sell currency at

specified strike price within a specified period of time.
19
International Money Market
Corporations or governments often need short-term

funds denominated in a currency different from their home
currency.
The international money market has grown because firms:
§ May need to borrow funds to pay for imports
denominated in a foreign currency.
§ May choose to borrow in a currency in which the interest
rate is lower.
§ May choose to borrow in a currency that is expected to
depreciate against their home currency.
20
Origins and Development
§ European Money Market: Dollar deposits in banks in

Europe and other continents are called Eurodollars or
Eurocurrency. Origins of the European money market can be
traced to the Eurocurrency market that developed during the
1960s and 1970s.
§ Asian Money Market: Centered in Hong Kong and

Singapore. Originated as a market involving mostly dollar-
denominated deposits, and was originally known as the Asian
dollar market.
21
Money Market Interest Rates Among Currencies
§ The money market interest rates in any particular country

depend on the demand for short-term funds by borrowers,
relative to the supply of available short-term funds that are
provided by savers.
§ Money market rates vary due to differences in the interaction

of the total supply of short-term funds available (bank
deposits) in a specific country versus the total demand for
short-term funds by borrowers in that country.
22
Exhibit 3.4 Comparison of 2011 International
Money Market Interest Rates
23

(cont.)
§ Global Integration of Money Market Interest Rates
§ Money market interest rates among countries tend to be highly
correlated over time.
§ When economic conditions weaken, the corporate need for
liquidity declines, and corporations reduce the amount of short-
term funds they wish to borrow.
§ When economic conditions strengthen, there is an increase
in corporate expansion, and corporations need additional liquidity
to support their expansion.
24
Risk of International Money Market Securities

(cont.)
§ Risk of International Money Market Securities
§ International Money Market Securities are debt securities
issued by MNCs and government agencies with a short-term
maturity (1 year or less).
§ Normally, these securities are perceived to be very safe from the
risk of default.
§ Even if the international money market securities are not exposed
to credit risk, they are exposed to exchange rate risk when
the currency denominating the securities differs from the home
currency of the investors.
25
International Credit Market
MNCs sometimes obtain medium-term funds through term

loans from local financial institutions or through the
issuance of notes (medium-term debt obligations) in their
local markets.
Loans of 1 year or longer extended by banks to MNCs or
government agencies in Europe are commonly called
Eurocredits or Eurocredit loans.
To avoid interest rate risk, banks commonly use floating
rate loans with rates tied to the London Interbank Offer
Rate (LIBOR).
26
Syndicated Loans in the Credit Market
§ Sometimes a single bank is unwilling or unable to lend the

amount needed by an MNC or government agency.
§ A syndicate of banks can be formed to underwrite the loans,

and the lead bank is responsible for negotiating the terms with
the borrower.
27
Regulations in the Credit Market

§ Single European Act
§ Capital can flow freely throughout Europe.
§ Banks can offer a wide variety of lending, leasing, and securities
activities in the EU.
§ Regulations regarding competition, mergers, and taxes are similar
throughout the EU.
§ A bank established in any one of the EU countries has the right to
expand into any or all of the other EU countries.
§ Basel Accord - Banks must maintain capital equal to at least

4 percent of their assets. For this purpose, banks’ assets are
weighted by risk.
28
Regulations in the Credit Market (Cont.)

§ Basel II Accord - Attempts to account for differences in
collateral among banks. In addition, this accord encourages
banks to improve their techniques for controlling operational
risk, which could reduce failures in the banking system. Also
plans to require banks to provide more information to existing
and prospective shareholders about their exposure to
different types of risk.
§ Basel III Accord - Called for new methods of estimating

risk-weighted assets that would increase the level of risk-
weighted assets, thus requiring banks to maintain higher levels
of capital.
29
Impact of the Credit Crisis on the Credit Market
§ The credit crisis of 2008 triggered by defaults in subprime

loans led to a halt in housing development, which reduced
income, spending, and jobs.
§ Financial institutions became cautious with their funds and

were less willing to lend funds to MNCs.
30
International Bond Market
Foreign bonds are issued by borrower foreign to the

country where the bond is placed.
Eurobonds are bonds sold in countries other than the
country whose currency is used to denominate the bonds.
§ Features of Eurobonds
§ Bearer bonds
§ Annual coupon payments
§ Convertible or callable
§ Denominations of Eurobonds
§ Commonly denominated in a number of currencies
31
Eurobonds (cont.)
§ Underwriting Process
§ Multinational syndicate; simultaneously placed in many countries.
§ Secondary Market
§ Market makers are in many cases the same underwriters who sell
the primary issues.
§ Impact of the Euro on the Eurobond Market
§ Before the euro’s adoption, many MNCs issued bonds denominated
in their local currency.
§ With many bonds issued in euro denominations, the market is much
larger and more liquid.
32
Development of Other Bond Markets

§ Bond markets have developed in Asia and South America.
§ Bond market yields among countries tend to be highly
correlated over time.
§ When economic conditions weaken, aggregate demand for
funds declines with the decline in corporate expansion.
§ When economic conditions strengthen, aggregate demand
for funds increases with the increase in corporate expansion.
33
Risk of International Bonds

§ Interest Rate Risk - potential for the value of bonds to
decline in response to rising long-term interest rates.
§ Exchange Rate Risk - represents the potential for the value
of bonds to decline (from the investor’s perspective) because
the currency denominating the bond depreciates against the
home currency.
§ Liquidity Risk - represents the potential for the value of
bonds to decline because there is no consistently active
market for the bonds.
§ Credit Risk - represents the potential for default.
34
International Stock Markets
Issuance of Stock in Foreign Markets – the existence of

various markets for new issues provides corporations in
need of equity with a choice.
§ Impact of the Euro - resulted in more stock offerings in
Europe by U.S. and European-based MNCs.
Issuance of Foreign Stock in the U.S.
§ Yankee stock offerings - Non-U.S. corporations that need
large amounts of funds sometimes issue stock in the United
States.
§ American Depository Receipts (ADR) - Certificates
representing bundles of stock. ADR shares can be traded
just like shares of a stock.
35
Non-U.S. Firms Listing on U.S. Exchanges
§ Non-U.S. firms have their shares listed on the New York Stock
Exchange or the Nasdaq market so that the shares can easily
be traded in the secondary market.
§ Effect of Sarbanes-Oxley Act on Foreign Stock Listings - Many

non-U.S. firms decided to place new issues of their stock in the
United Kingdom instead of the United States so that they
could avoid complying with the law.
36
Investing in Foreign Stock Markets

§ Many investors purchase stocks outside of the home country.
§ Favorable economic conditions in a foreign county
§ Foreign currency is expected to strengthen over time
§ Portfolio diversification
§ Recently, firms outside the U.S. have been issuing stock more
frequently, which has led to the growth of non-U.S. stock
markets.
37
Exhibit 3.5 Comparison of Stock Exchanges
(2013)
38
How Market Characteristics Vary among Countries

§ Stock market participation and trading activity are higher in
countries where managers are encouraged to make decisions
that serve shareholder interests and where there is greater
transparency.
§ Factors that influence trading activity:
§ Shareholder Rights (vary by country)
§ Legal protection of shareholders
§ Government enforcement of securities laws
§ Accounting laws
39
Exhibit 3.6 Impact of Governance on Stock
Market Participation and Trading Activity
40
Integration of Stock Markets

§ Stock market conditions reflect the host country’s conditions.
If the country is integrated, the stock market will be as well.
Integration of International Stock Markets and

Credit Markets
§ The key link is the risk premium, which affects the rate of
return required by financial institutions who provide credit or
invest in securities.
41
How Financial Markets Serve MNCs (Exhibit 3.7)
Corporate functions that require use of foreign exchange

markets:
§ Foreign trade with business clients.
§ Direct foreign investment, or the acquisition of foreign real
assets.
§ Short-term investment or financing in foreign securities.
§ Longer-term financing in the international bond or stock
markets.
42
Exhibit 3.7 Foreign Cash Flow Chart of a
Multinational Corporation (MNC)
43
Chapter Questions
1. Why firms may issue stock in foreign markets?

2. Why would a bank want to participate in a
syndicated Eurocredit loan?
3. What is LIBOR, and how is it used in the Eurocredit
market?
4. Assume Poland’s currency (the zloty) is worth $.17
and the Japanese yen is worth $.008. What is the
cross rate of the zloty with respect to yen?
44
Exchange Rate Determination
CHAPTER 4
Chapter Objectives
} Explain how exchange rate movements are

measured.
} Explain how the equilibrium exchange rate is
determined.
} Examine factors that determine the equilibrium
exchange rate.
} Explain the movement in cross exchange rates.
} Explain how financial institutions attempt to
capitalize on anticipated exchange rate movements.
2
Measuring Exchange Rate Movements
1. Depreciation is a decline in a currency’s value.

2. Appreciation is an increase in a currency’s value.
3. Comparing foreign currency spot rates (direct quotation)
over two points in time, S and St-1
S - St -1
Percent D in foreign currency value =
St -1
4. A positive percent change indicates that the currency has

appreciated. A negative percent change indicates that it has
depreciated.
3
Exhibit 4.1 How Exchange Rate Movements and
Volatility Are Measured
4
Exchange Rate Equilibrium
The exchange rate represents the price of a currency or

the rate at which one currency can be exchanged for
another.
Demand for a currency increases when the value of the
currency decreases, leading to a downward sloping demand
schedule.
Supply of a currency increases when the value of the
currency increases, leading to an upward sloping supply
schedule.
Equilibrium equates the quantity of currency demanded
with the supply of currency for sale.
5
Exhibit 4.4 Equilibrium Exchange Rate
Determination
6
Exchange Rate Equilibrium
Change in the Equilibrium Exchange Rate

§ Increase in demand schedule: Banks will increase the
exchange rate to the level at which the amount demanded is
equal to the amount supplied in the foreign exchange market.
§ Decrease in demand schedule: Banks will reduce the
§ Increase in supply schedule: Banks will reduce the
§ Decrease in supply schedule: Banks will increase the
7
Factors That Influence Exchange Rates
} The equilibrium exchange rate will change over time as supply

and demand schedules change.
e = f (DINF , DINT , DINC , DGC , DEXP)
where
e = percentage change in the spot rate
DINF = change in the differential between U.S. inflation
and the foreign country' s inflation
DINT = change in the differential between the U.S. interest rate
and the foreign country' s interest rate
DINC = change in the differential between the U.S. income level
and the foreign country' s income level
DGC = change in government controls
DEXP = change in expectations of future exchange rates
8
Relative Inflation Rates: Increase in U.S. inflation leads

to increase in U.S. demand for foreign goods, an increase in
U.S. demand for foreign currency, and an increase in the
exchange rate for the foreign currency.
Relative Interest Rates: Increase in U.S. rates leads to
increase in demand for U.S. deposits and a decrease in
demand for foreign deposits, leading to a increase in
demand for dollars and an increased exchange rate for the
dollar.
§ Real Interest Rates (Fisher Effect):
Real interest rate @ Nominal interest rate - Inflation rate
9
Exhibit 4.5 Impact of Rising U.S. Inflation on the
Equilibrium Value of the British Pound
10
Exhibit 4.6 Impact of Rising U.S. Interest Rates
on the Equilibrium Value of the British Pound
11
Relative Income Levels: Increase in U.S. income leads to

increased U.S. demand for foreign goods and increased
demand for foreign currency relative to the dollar and an
increase in the exchange rate for the foreign currency.
Government Controls via:

§ Imposing foreign exchange barriers
§ Imposing foreign trade barriers
§ Intervening in foreign exchange markets
§ Affecting macro variables such as inflation, interest rates, and
income levels.
12
Exhibit 4.7 Impact of Rising U.S. Income Levels
on Equilibrium Value of the British Pound
13
Expectations:
§ Impact of favorable expectations: If investors expect
interest rates in one country to rise, they may invest in that
country leading to a rise in the demand for foreign currency
and an increase in the exchange rate for foreign currency.
§ Impact of unfavorable expectations: Speculators can
place downward pressure on a currency when they expect it
to depreciate.
§ Impact of signals on currency speculation. Speculators
may overreact to signals, causing currency to be temporarily
overvalued or undervalued.
14
Interaction of Factors: some factors place upward

pressure on the value of a foreign currency while other
factors place downward pressure.
Influence of Factors across Multiple Currency
Markets: it is common for European currencies to move in
the same direction against the dollar.
Influence of Liquidity on Exchange Rate Adjustment:
If a currency’s spot market is liquid, then its exchange rate
will not be highly sensitive to a single large purchase or sale.
15
Exhibit 4.8 Summary of How Factors Affect
Exchange Rates
16
Movements in Cross Exchange Rates
} If currencies A and B move in same direction, there is

no change in the cross exchange rate.
} When currency A appreciates against the dollar by a
greater (smaller) degree than currency B, then currency
A appreciates (depreciates) against B.
} When currency A appreciates (depreciates) against the
dollar, while currency B is unchanged against the dollar,
currency A appreciates (depreciates) against currency B
by the same degree as it appreciates (depreciates)
against the dollar.
17
Exhibit 4.9 Example of How Forces Affect the
Cross Exchange Rate
18
Capitalizing on Expected Exchange Rate
Movements
Institutional speculation based on expected
appreciation – When financial institutions believe that a
currency is valued lower than it should be in the foreign
exchange market, they may invest in that currency before it
appreciates.
Institutional speculation based on expected
depreciation – If financial institutions believe that a currency
is valued higher than it should be in the foreign exchange
market, they may borrow funds in that currency and convert it
to their local currency now before the currency’s value
declines to its proper level.
Speculation by individuals – Individuals can speculate in
foreign currencies.
19
Capitalizing on Expected Exchange Rate
Movements
The “Carry Trade” – Where investors attempt to
capitalize on the differential in interest rates between two
countries.
§ Involves borrowing a currency with a low interest rate and
investing the funds in a currency with a high interest rate.
§ Impact of appreciation in the investment currency:
Increased trade volume can have a major influence on
exchange rate movements over a short period.
§ Risk of the Carry Trade: Exchange rates may move
opposite to what the investors expected, causing a loss.
20
Chapter Questions
1. Why do most crises in countries (such as the Asian

crisis) cause the local currency to weaken abruptly?
Is it because of trade or capital flows?
2. How can persistently weak currencies be stabilized?
3. Assume U.S. interest rates fall relative to British
interest rates. Other things being equal, how should
this affect the:
} U.S. demand for British pounds,
} Supply of pounds for sale, and
} Equilibrium value of the pound?
21
Government Influence on
Exchange Rates
CHAPTER 6
Chapter Objectives
} Describe the exchange rate systems used by various

governments.
} Describe the development and implications of a
single European currency.
} Explain how governments can use intervention to
influence exchange rates.
} Explain how government intervention in the foreign
exchange market can affect economic conditions.
2
Exchange Rate Systems
Exchange rate systems can be classified according to the

degree of government control and normally fall into one of
the following categories:
§ Fixed
§ Freely floating
§ Managed float
§ Pegged
3
Fixed Exchange Rate System

§ Exchange rates are either held constant or allowed to
fluctuate only within very narrow boundaries.
§ Central bank can reset a fixed exchange rate by devaluing or
reducing the value of the currency against other currencies.
§ Central bank can also revalue or increase the value of its
currency against other currencies.
4
Fixed Exchange Rate System (cont.)

§ Bretton Woods Agreement, 1944 – 1971: Each
currency was valued in terms of gold.
§ Smithsonian Agreement ,1971 – 1973: Called for a
devaluation of the U.S. dollar by about 8 percent against
other currencies.
§ Advantages of fixed exchange rates
§ Insulate firms from risk of currency appreciation or depreciation.
§ Allow firms to engage in direct foreign investment without concern
about exchange rate movements.
§ Disadvantages of fixed exchange rates
§ Risk that government will alter value of currency.
§ The country and its MNCs may be more vulnerable to economic
conditions in other countries.
5
Freely Floating Exchange Rate System

§ Exchange rates are determined by market forces without
government intervention.
§ Advantages of a freely floating system:
§ Country is more insulated from inflation of other countries.
§ Country is more insulated from unemployment of other countries.
§ Does not require central bank to maintain exchange rates within
specified boundaries.
§ Disadvantages of a freely floating exchange rate
system:
§ Can adversely affect a country that has high unemployment.
§ Can adversely affect a country with high inflation.
6
Managed Float Exchange Rate System

§ Governments sometimes intervene to prevent their currencies
from moving too far in a certain direction.
§ Countries with floating exchange rates: Currencies of
most large developed countries are allowed to float, although
they may be periodically managed by their respective central
banks.
§ Criticisms of the managed float system: Critics suggest
that managed float allows a government to manipulate
exchange rates to benefit its own country at the expense of
others.
7
Exhibit 6.1 Countries with Floating Exchange
Rates and Their Currencies
8
Pegged Exchange Rate System

§ Home currency value is pegged to one foreign currency or to
an index of currencies.
§ Limitations of pegged exchange rate
§ May attract foreign investment because exchange rate is
expected to remain stable.
§ Weak economic or political conditions can cause firms and
investors to question whether the peg will be broken.
9
Pegged Exchange Rate System (cont.)

Examples:
§ Europe’s Snake Arrangement, 1972 – 1979
§ European Monetary System (EMS), 1979 – 1992
§ Mexico’s Pegged System, 1994
§ China’s Pegged Exchange Rate, 1996 – 2005
§ Venezuela’s Pegged Exchange Rate, 2010
10
Pegged Exchange Rate System (cont.)

§ Currency Boards Used to Peg Currency Values
§ A system for pegging the value of the local currency to some
other specified currency. The board must maintain currency
reserves for all the currency that it has printed.
§ Interest Rates of Pegged Currencies
§ Interest rate will move in tandem with the interest rate of the
currency to which its own currency is tied.
§ Exchange Rate Risk of a Pegged Currency
§ A currency that is pegged to another currency will move in
tandem with it against all other currencies. Currencies are
commonly pegged to the U.S. dollar or to the euro.
11
Exhibit 6.2 Countries with Pegged Exchange Rates
and the Currencies to Which They Are Pegged
12
Dollarization
§ Replacement of a foreign currency with U.S. dollars.
§ This process is a step beyond a currency board because it
forces the local currency to be replaced by the U.S. dollar.
Although dollarization and a currency board both attempt to
peg the local currency’s value, the currency board does not
replace the local currency with dollars.
§ One attraction of dollarization is that sound monetary and
exchange-rate policies no longer depend on the intelligence
and discipline of domestic policymakers.
13
A Single European Currency
Monetary Policy in the Eurozone

§ European Central Bank - based in Frankfurt and is responsible for
setting monetary policy for all participating European countries.
§ Objective is to control inflation in the participating countries and to
stabilize (within reasonable boundaries) the value of the euro with
respect to other major currencies.
Impact on Firms in the Eurozone - Prices of products are
now more comparable among European countries.
Impact on Financial Flows in the Eurozone - Bond
investors who reside in the eurozone can now invest in
bonds issued by governments and corporations in these
countries without concern about exchange rate risk, as long
as the bonds are denominated in euros.
14
Exposure of Countries within the Eurozone

§ A single European monetary policy prevents any individual
European country from solving local economic problems
with its own unique monetary policy.
§ Any given monetary policy used in the eurozone during a
particular period may enhance conditions in some countries
and adversely affect others.
Impact of Crises within the Eurozone - may affect the
economic conditions of the other participating countries
because they all rely on the same currency and same
monetary policy.
15
Impact of Crises within the Eurozone (cont.)

§ Lessons from Eurozone crisis
§ Financial problems of one bank can easily spread to other banks.
§ Banks in Eurozone frequently engage in loan participations. If
companies have trouble repaying loans, all banks may be affected.
§ News about adverse conditions in one area of Eurozone can
trigger concerns in other member countries.
§ Eurozone country governments must rely on fiscal policy when
they experience serious financial problems.
§ Banks lend heavily to governments. Their performance is
dependent on whether that government can repay its debts.
16
Impact of Crises within the Eurozone (cont.)

§ ECB Role in Resolving Economic Crises
§ In recent years the bank’s role has expanded to include providing
credit for eurozone countries that are experiencing a financial
crisis.
§ The ECB imposes restrictions intended to help resolve the
country’s budget deficit problems over time.
17
Impact on a Country that Abandons the Euro

§ Would allow a country to set its own exchange rate to
encourage purchasers of exports.
§ Would possibly be expelled from the European Union, which
would almost certainly reduce its trade with other European
Union countries.
Impact of Abandoning the Euro on Eurozone
Conditions
§ Investors may fear other countries would eventually abandon
the euro and might reduce investments in the eurozone.
§ Critics agree that the threat of abandonment creates more
problems than actual abandonment.
18
Government Intervention
Reasons for Government Intervention

§ Smoothing exchange rate movements
§ If a central bank is concerned that its economy will be affected by
abrupt movements in its home currency’s value, it may attempt to
smooth the currency movements over time.
§ Establishing implicit exchange rate boundaries
§ Some central banks attempt to maintain their home currency
rates within some unofficial, or implicit, boundaries.
§ Responding to temporary disturbances
§ A central bank may intervene to insulate a currency’s value from a
temporary disturbance.
19
Direct Intervention
§ To force the dollar to depreciate, the Fed can intervene
directly by exchanging dollars that it holds as reserves for
other foreign currencies in the foreign exchange market.
§ By “flooding the market with dollars” in this manner, the Fed
puts downward pressure on the dollar.
§ If the Fed desires to strengthen the dollar, it can exchange
foreign currencies for dollars in the foreign exchange market,
thereby putting upward pressure on the dollar.
20
Exhibit 6.3 Effects of Direct Central Bank
Intervention in the Foreign Exchange Market
21
Direct Intervention (cont.)

§ Reliance on reserves
§ The potential effectiveness of a central bank’s direct intervention
is influenced by the amount of reserves it can use.
§ Frequency of Intervention
§ Number of direct interventions has declined from 97 different
days in 1989 to no more than 20 days in a year.
§ Coordinated Intervention
§ Intervention more likely to be effective when it is coordinated by
several central banks.
22
Direct Intervention (cont.)

§ Nonsterilized versus sterilized intervention
§ When the Fed intervenes in the foreign exchange market without
adjusting for the change in the money supply, it is engaging in a
nonsterilized intervention.
§ In a sterilized intervention, the Fed intervenes in the foreign
exchange market and simultaneously engages in offsetting
transactions in the Treasury securities markets.
§ Speculating on direct intervention
§ Some traders in the foreign exchange market attempt to
determine when Federal Reserve intervention is occurring and
the extent of the intervention in order to capitalize on the
anticipated results of the intervention effort.
23
Exhibit 6.4 Forms of Central Bank Intervention
in the Foreign Exchange Market
24
} Indirect Intervention – the Fed can affect the dollar’s

value indirectly by influencing the factors that determine it.
e = f (DINF , DINT , DINC , DGC , DEXP)
where
e = percentage change in the spot rate
DINF = change in the differential between U.S. inflation
and the foreign country' s inflation
DINT = change in the differential between the U.S. interest rate
and the foreign country' s interest rate
DINC = change in the differential between the U.S. income level
and the foreign country' s income level
DGC = change in government controls
DEXP = change in expectations of future exchange rates
25
Indirect Intervention
Indirect Intervention (cont.)

} Government Control of Interest Rates by increasing or
reducing interest rates.
} Government Use of Foreign Exchange Controls such
as restrictions on the exchange of the currency.
} Intervention Warnings intended to warn speculators. The
announcements could discourage additional speculation and
might even encourage some speculators to unwind
(liquidate) their existing positions in the currency.
26
Intervention as a Policy Tool
A weak home currency can stimulate foreign demand

for products.
A strong home currency can encourage consumers
and corporations of that country to buy goods from
other countries.
27
Exhibit 6.5 How Central Bank Intervention Can
Stimulate the U.S. Economy
28
Exhibit 6.6 How Central Bank Intervention Can
Reduce Inflation
29
Chapter Questions
1. Should China be forced to alter the value of its

currency?
2. What is the impact of a weak home currency on
the home economy, other things being equal? What
is the impact of a strong home currency on the
home economy, other things being equal?
3. If most countries in Europe experience a recession,
how might the European Central Bank use direct
intervention to stimulate economic growth?
30
International Arbitrage And
Interest Rate Parity
CHAPTER 7
Chapter Objectives
} Explain the conditions that will result in various

forms of international arbitrage and the
realignments that will occur in response.
} Explain the concept of interest rate parity.
} Explain the variation in forward rate premiums
across maturities and over time.
2
International Arbitrage
1. Arbitrage is defined as capitalizing on a discrepancy in

quoted prices by making a riskless profit.
2. Arbitrage will cause prices to realign.
3. Three forms of arbitrage (international in scope):
§ Locational arbitrage
§ Triangular arbitrage
§ Covered interest arbitrage
3
Locational Arbitrage
§ The process of buying a currency at a location where it is
priced cheap and immediately selling it at another location
where it is priced higher.
§ Gains from locational arbitrage are based on the amount
of money used and the size of the discrepancy.
§ Realignment due to locational arbitrage drives prices to
adjust in different locations so as to eliminate discrepancies.
4
Exhibit 7.1 Currency Quotes for Locational
Arbitrage Example
5
Exhibit 7.2 Locational Arbitrage
6
Triangular Arbitrage
§ Gains from triangular arbitrage: Currency transactions
are conducted in the spot market to capitalize on the
discrepancy in the cross exchange rate between two
countries.
§ Accounting for the Bid/Ask Spread: Transaction costs
(bid/ask spread) can reduce or even eliminate the gains from
triangular arbitrage.
§ Realignment due to triangular arbitrage forces exchange
rates back into equilibrium.
7
Exhibit 7.3 Example of Triangular Arbitrage
8
Exhibit 7.4 Currency Quotes for a Triangular
Arbitrage Example with Transaction Costs
9
Exhibit 7.5 Example of Triangular Arbitrage
Accounting for Bid/Ask Spreads
10
Exhibit 7.6 Impact of Triangular Arbitrage
11
Covered Interest Arbitrage

§ Steps involved in covered interest arbitrage
§ Defined as the process of capitalizing on the interest rate
differential between two countries while covering your exchange
rate risk with a forward contract.
§ Consists of two parts:
§ Interest arbitrage: the process of capitalizing on the difference
between interest rates between two countries.
§ Covered: hedging the position against interest rate risk.
§ Realignment due to covered interest arbitrage causes
market realignment.
§ Timing of realignment may require several transactions
before realignment is completed.
12
Exhibit 7.7 Example of Covered Interest Arbitrage
13
Covered Interest Arbitrage (cont.)

§ Realignment is focused on the forward rate
§ The forward rate is likely to experience most if not all of the
adjustment needed to achieve realignment.
§ Accounting for spreads
§ Investor must account for the effects of the spread between the
bid and ask quotes and of the spread between deposit and loan
rates.
§ Covered interest arbitrage by Non-U.S. investors
§ The concept of covered interest arbitrage applies to any two
countries for which there is a spot rate and a forward rate
between their currencies as well as risk-free interest rates quoted
for both currencies.
14
Comparison of Arbitrage Effects

§ The threat of locational arbitrage ensures that quoted
exchange rates are similar across banks in different locations.
§ The threat of triangular arbitrage ensures that cross exchange
rates are properly set.
§ The threat of covered interest arbitrage ensures that forward
exchange rates are properly set. Any discrepancy will trigger
arbitrage, which should eliminate the discrepancy.
§ Thus, arbitrage tends to ensure a more orderly foreign
exchange market.
15
Comparison of Arbitrage Effects (cont.)

§ How arbitrage reduces transaction costs
§ Locational arbitrage limits the differences in a spot exchange rate
quotation across locations, while covered interest arbitrage
ensures that the forward rate is properly priced. Thus, an MNC’s
managers should be able to avoid excessive transaction costs.
16
Exhibit 7.8 Comparing Arbitrage Strategies
17
1. In equilibrium, the forward rate differs from the spot

rate by a sufficient amount to offset the interest rate
differential between two currencies.
2. Derivation of Interest Rate Parity:
1 + ih
p= -1
1+ i f
where
p = forward premium
ih = home interest rate
i f = foreign interest rate
18
Determining the Forward Premium

§ Effect of the interest rate differential: The relationship
between the forward premium (or discount) and the interest
rate differential according to IRP is simplified in an
approximated form: F -S
p= @ ih - i f
S
where
p = forward premium (or discount)
F = forward rate in dollars
S = spot rate in dollars
ih = home interest rate
i f = foreign interest rate
19
Graphic Analysis of Interest Rate Parity

§ Points representing a discount: points A and B
§ Points representing a premium: points C and D
§ Points representing IRP: points A, B, C, D
§ Points below the IRP line: points X and Y
§ Investors can engage in covered interest arbitrage and earn a
higher return by investing in foreign currency after considering
foreign interest rate and forward premium or discount.
§ Points above the IRP line: point Z
§ U.S. investors would achieve a lower return on a foreign
investment than on a domestic one.
§ Foreign investors investing in the U.S. can profit from covered
interest arbitrage.
20
Exhibit 7.9 Illustration of Interest Rate Parity
21
How to Test Whether Interest Rate Parity Holds

§ The location of the points provides an indication of
whether covered interest arbitrage is worthwhile.
§ For points to the right of the IRP line, investors in the
home country should consider using covered interest
arbitrage, since a return higher than the home interest
rate (ih) is achievable.
§ Of course, as investors and firms take advantage of such
opportunities, the point will tend to move toward the IRP
line.
§ Covered interest arbitrage should continue until the
interest rate parity relationship holds.
22
Interpretation of Interest Rate Parity

§ Interest rate parity does not imply that investors from
different countries will earn the same returns.
Does Interest Rate Parity Hold?
§ Compare the forward rate (or discount) with interest rate
quotations occurring at the same time. Due to limitations in
access to data, it is difficult to obtain quotations that reflect
the same point in time.
23
Considerations When Assessing Interest Rate Parity

§ Transaction costs
§ The actual point reflecting the interest rate differential and
forward rate premium must be farther from the IRP line to make
covered interest arbitrage worthwhile.
§ Political risk
§ A crisis in the foreign country could cause its government to
restrict any exchange of the local currency for other currencies.
§ Differential tax laws
§ Covered interest arbitrage might be feasible when considering
before-tax returns but not necessarily when considering after-tax
returns.
24
Exhibit 7.10 Potential for Covered Interest
Arbitrage When Considering Transaction Costs
25
Variation in Forward Premiums
Forward Premiums across Maturities

§ The annualized interest rate differential between two countries can
vary among debt maturities, and so will the annualized forward
premiums.
Changes in Forward Premiums over Time
§ Exhibit 7.12 illustrates the relationship between interest rate
differentials and the forward premium over time, when interest rate
parity holds. The forward premium must adjust to existing interest
rate conditions if interest rate parity holds.
§ Explaining changes in the forward rate
§ The forward rate is indirectly affected by all the factors that can
affect the spot rate over time, including inflation differentials and
interest rate differentials. The change in the forward rate can
also be due to a change in the premium.
26
Exhibit 7.11 Quoted Interest Rates for Various
Times to Maturity
27
Exhibit 7.12
Relationship over
Time between the
Interest Rate
Differential and
the Forward
Premium
28
Chapter Questions
1. Does arbitrage destabilize foreign exchange

markets?
2. Why do you think currencies of countries with high
inflation rates tend to have forward discounts?
3. If the relationship that is specified by interest rate
parity does not exist at any period but does exist on
average, then covered interest arbitrage should not
be considered by investors. Do you agree or
disagree with this statement?
29
Relationships among Inflation,
Interest Rates and Exchange Rates
CHAPTER 8
Chapter Objectives
} Explain the purchasing power parity (PPP) theory

and its implications for exchange rate changes.
} Explain the International Fisher effect (IFE) theory

and its implications for exchange rate changes.
} Compare the PPP theory, the IFE theory, and the

theory of interest rate parity (IRP), which was
introduced in the previous chapter.
2
Purchasing Power Parity (PPP)
Interpretations of Purchasing Power Parity

§ Absolute Form of PPP – without international barriers,
consumers shift their demand to wherever prices are lower.
Prices of the same basket of products in two different
countries should be equal when measured in common
currency.
§ Relative Form of PPP – due to market imperfections,
prices of the same basket of products in different countries
will not necessarily be the same when measured in a
common currency. However, the rate of change in prices
should be similar when measured in common currency.
3
Rational Behind Relative PPP Theory

§ Exchange rate adjustment is necessary for the relative
purchasing power to be the same whether buying products
locally or from another country.
§ If the purchasing power is not equal, consumers will shift
purchases to wherever products are cheaper until the
purchasing power is equal.
4
Derivation of Purchasing Power Parity

Relationship between relative inflation rates (I) and the exchange
rate change (e).
1+ Ih
ef = -1
1+ I f
5
Using PPP to Estimate Exchange Rate Effects

§ The relative form of PPP can be used to estimate how an
exchange rate will change in response to differential inflation
rates between countries.
§ International trade is the mechanism by which the inflation
differential affects the exchange rate according to this theory
§ Using a simplified PPP relationship:
e f @ Ih - I f
§ The percentage change in the exchange rate should be
approximately equal to the difference in inflation rates between
the two countries.
6
Exhibit 8.1 Summary of Purchasing Power Parity
7
Graphic Analysis of Purchasing Power Parity

§ Using PPP theory, we should be able to assess the potential
impact of inflation on exchange rates. Given an inflation
differential between the home and the foreign country of X
percent, the foreign currency should adjust by X percent due
to that inflation differential.
§ PPP Line - The diagonal line connecting all these points
together.
8
Exhibit 8.2 Illustration of Purchasing Power
Parity
9
Graphic Analysis of Purchasing Power Parity (cont.)

§ Purchasing Power Disparity
§ Any points off of the PPP line represent purchasing power
disparity. If the exchange rate does not move as PPP theory
suggests, there is a disparity in the purchasing power of the
two countries.
§ Point C in Exhibit 8.3 represents a situation where home
inflation (Ih) exceeds foreign inflation (If ) by 4 percent.Yet, the
foreign currency appreciated by only 1 percent in response to
this inflation differential. Consequently, purchasing power
disparity exists.
10
Exhibit 8.3 Identifying Disparity in Purchasing
Power
11
Testing the Purchasing Power Parity Theory

§ Simple test of PPP
§ Choose two countries (such as the United States and a foreign
country) and compare the differential in their inflation rates to
the percentage change in the foreign currency’s value during
several time periods.
§ Statistical Test of PPP
§ Apply regression analysis to historical exchange rates and inflation
differentials.
§ Results of Statistical Tests of PPP
§ Deviations from PPP are not as pronounced for longer time
periods, but they still exist. Thus, reliance on PPP to derive a
forecast of the exchange rate is subject to significant error, even
when applied to long-term forecasts.
12
Exhibit 8.4 Comparison of Annual Inflation Differentials
and Exchange Rate Movements for Four Major Countries
13
Testing the Purchasing Power Parity Theory (cont.)

§ Limitation of PPP Tests
§ Results vary with the base period used. The base period chosen
should reflect an equilibrium position since subsequent periods
are evaluated in comparison to it. If a base period is used when
the foreign currency was relatively weak for reasons other than
high inflation, most subsequent periods could show higher
appreciation of that currency than what would be predicted by
PPP.
14
Why Purchasing Power Parity Does Not Hold

§ Confounding Effects
§ A change in a country’s spot rate is driven by more than the inflation
differential between two countries (ΔINF):
15
Why Purchasing Power Parity Does Not Hold

§ No Substitutes for Traded Goods
§ If substitute goods are not available domestically, consumers may
not stop buying imported goods.
16
International Fisher Effect (IFE)
Fisher effect
§ Suggests that the nominal interest rate contains two
components:
§ Expected inflation rate
§ Real interest rate
§ The real rate of interest represents the return on the
investment to savers after accounting for expected inflation.
17
Using the IFE to Predict Exchange Rate Movements

§ Apply the Fisher Effect to Derive Expected Inflation per
Country
§ The first step is to derive the expected inflation rates of the two
countries based on the Fisher effect. The Fisher effect suggests
that nominal interest rates of two countries differ because of the
difference in expected inflation between the two countries.
§ Rely on PPP to Estimate the Exchange Rate Movement
§ The second step of the international Fisher effect is to apply the
theory of PPP to determine how the exchange rate would change
in response to those expected inflation rates of the two
countries.
18
Implications of the International Fisher Effect

§ The international Fisher effect (IFE) theory suggests that
currencies with high interest rates will have high expected
inflation (due to the Fisher effect) and the relatively high
inflation will cause the currencies to depreciate (due to the
PPP effect).
§ Implications of the IFE for Foreign Investors
§ The implications for foreign investors who attempt to capitalize
on relatively high U.S. interest rates – the foreign investors will be
adversely affected by the effects of a relatively high U.S. inflation
rate if they try to capitalize on the high U.S. interest rates.
§ Implications of the IFE for two non-U.S. currencies – the IFE
theory can be applied to any exchange rate, even exchange rates
that involve two non-U.S. currencies.
19
Exhibit 8.5 The International Fisher Effect from
Various Investor Perspectives
20
Derivation of the International Fisher Effect

§ Relationship between the interest rate (i) differential between
two countries and the expected change in exchange rate (e):
1 + ih
ef = -1
1+ i f
§ Simplified relationship
e f @ ih - i f
21
Derivation of the International Fisher Effect (cont.)

§ Numerical example based on derivation of the IFE
§ Assume that the interest rate on a one-year insured home country
bank deposit is 11 percent, and the interest rate on a 1-year insured
foreign bank deposit is 12 percent. For the actual returns of these
two investments to be similar from the perspective of investors in
the home country, the foreign currency would have to change over
the investment horizon by the following percentage:
1 + ih
ef = -1
1+ i f
1 + .11
ef = -1
1 + .12
e f = -.0089, or - .89%
22
Exhibit 8.6 Summary of International Fisher
Effect
23
Graphic Analysis of the International Fisher Effect

§ Point E in Exhibit 8.7 reflects a situation where the foreign
interest rate exceeds the home interest rate by three
percentage points. The foreign currency has depreciated by 3
percent to offset its interest rate advantage.
§ Point F represents a situation where home interest rate is 2
percent above the foreign interest rate. IFE theory suggests
that the foreign currency should appreciate by 2 percent to
offset the interest rate disadvantage.
§ Point F also illustrates the IFE from a foreign investor’s
perspective. The home interest rate will appear attractive to
the foreign investor. However, IFE theory suggests that the
home currency will depreciate by 2 percent.
24
Exhibit 8.7 Illustration of IFE Line (When Exchange Rate
Changes Perfectly Offset Interest Rate Differentials)
25
Graphic Analysis of the International Fisher Effect

(cont.)
§ Points on the IFE Line
§ All the points along the IFE line reflect exchange rate adjustments
to offset the differential in interest rates. This means investors will
end up achieving the same yield (adjusted for exchange rate
fluctuations) whether they invest at home or in a foreign country.
§ Points below the IFE Line
§ Points below the IFE line generally reflect the higher returns from
investing in foreign deposits.
§ Points above the IFE Line
§ Points above the IFE line generally reflect returns from foreign
deposits that are lower than the returns possible domestically.
26
Tests of the International Fisher Effect
What Can be Tested

§ If the actual points (one for each period) of interest rates and
exchange rate changes were plotted over time on a graph, we
could determine whether:
§ the points are systematically below the IFE line (suggesting
higher returns from foreign investing),
§ above the line (suggesting lower returns from foreign investing),
§ evenly scattered on both sides (suggesting a balance of higher
returns from foreign investing in some periods and lower
foreign returns in other periods).
§ Statistical Test of the IFE
§ Apply regression analysis to historical exchange rates and the
nominal interest rate differential.
27
Exhibit 8.8 Illustration of IFE Concept (Exchange Rate
Changes Offsetting Interest Rate Differentials on Average)
28
Limitations of the IFE

§ The IFE theory relies on the Fisher effect and PPP
§ Limitation of the Fisher Effect
§ The difference between the nominal interest rate and actual
inflation rate is not consistent. Thus, while the Fisher effect can
effectively use nominal interest rates to estimate the market’s
expected inflation over a particular period, the market may be
wrong.
§ Limitation of PPP
§ Other country characteristics besides inflation (income levels,
government controls) can affect exchange rate movements. Even
if the expected inflation derived from the Fisher effect properly
reflects the actual inflation rate over the period, relying solely on
inflation to forecast the future exchange rate is subject to error.
29
IFE Theory versus Reality

§ The IFE theory contradicts how a country with a high
interest rate can attract more capital flows and therefore
cause the local currency’s value to strengthen (Ch. 4).
§ IFE theory also contradicts how central banks may purposely
try to raise interest rates in order to attract funds and
strengthen the value of their local currencies (Ch. 6).
§ Whether the IFE holds in reality is dependent on the
countries involved and the period assessed.
§ The IFE theory may be especially meaningful in cases when
the MNCs and large investors consider investing in countries
where the prevailing interest rates are very high.
30
Comparison of the IRP, PPP, and IFE
Although all three theories relate to the determination of

exchange rates, they have different implications.
§ IRP focuses on why the forward rate differs from the spot
rate and on the degree of difference that should exist. It
relates to a specific point in time.
§ PPP and IFE focus on how a currency’s spot rate will change
over time.
§ Whereas PPP suggests that the spot rate will change in
accordance with inflation differentials, IFE suggests that it will
change in accordance with interest rate differentials.
§ PPP is related to IFE because expected inflation differentials
influence the nominal interest rate differentials between two
countries.
31
Exhibit 8.9 Comparison of the IRP, PPP, and IFE
Theories
32
Chapter Questions
1. If investors in the U.S. and Canada require the same

real interest rate, and the nominal interest rate is
2% higher in Canada, what does this imply about
expectations of U.S. inflation and Canadian inflation?
What do these inflationary expectations suggest
about future exchange rates?
2. Assume that several European countries that use
the euro experience higher inflation than the U.S.,
while two other European countries experience
lower inflation than the U.S. According to PPP, how
will the euro’s value against the dollar be affected?
33
Forecasting Exchange Rates
CHAPTER 9
Chapter Objectives
} Explain how firms can benefit from forecasting

exchange rates.
} Describe the common techniques used for

forecasting.
} Explain how forecasting performance can be

evaluated.
} Explain how interval forecasts can be applied.
2
Why Firms Forecast Exchange Rates
Hedging decisions
§ Whether a firm hedges may be determined by its forecasts
of foreign currency values.
Short-term investment decisions
§ Corporations sometimes have a substantial amount of
excess cash available for a short time period. Large deposits
can be established in several currencies.
Capital budgeting decisions
§ When an MNC’s parent assesses whether to invest funds in
a foreign project, the firm takes into account that the
project may periodically require the exchange of currencies.
3
Why Firms Forecast Exchange Rates
Earnings assessment
§ The parent’s decision about whether a foreign subsidiary
should reinvest earnings in a foreign country or remit
earnings back to the parent may be influenced by exchange
rate forecasts.
Long-term financing decisions
§ MNCs that issue bonds to secure long-term funds may
consider denominating the bonds in foreign currencies.
4
Exhibit 9.1 Corporate Motives for Forecasting
Exchange Rates
5
Forecasting Techniques
1. Technical Forecasting
2. Fundamental Forecasting
3. Market-Based Forecasting
4. Mixed Forecasting
6
Technical Forecasting
§ Involves the use of historical exchange rate data to predict
future values.
§ Limitations of technical forecasting:
§ Focuses on the near future.
§ Rarely provides point estimates or range of possible future values.
§ Technical forecasting model that worked well in one period may
not work well in another.
7
Fundamental Forecasting
§ Based on fundamental relationships between economic
variables and exchange rates.
§ Use of sensitivity analysis for fundamental forecasting
§ Considers more than one possible outcome for the factors
exhibiting uncertainty.
§ Use of PPP for fundamental forecasting
§ While the inflation differential by itself is not sufficient to
accurately forecast exchange rate movements, it should be
included in any fundamental forecasting model.
§ Limitations of fundamental forecasting include:
§ Unknown timing of the impact of some factors
§ Forecasts of some factors may be difficult to obtain
§ Some factors are not easily quantified
§ Regression coefficients may not remain constant
8
Market-Based Forecasting
§ Using the spot rate: Today’s spot rate may be used as a forecast
of the spot rate that will exist on a future date.
§ Using the forward rate to forecast the future spot rate.
E (e) = p
( S )- 1
E (e) = F
where
E(e) = expected percentage change in the exchange rate
p = percentage by which the forward rate (F)
exceeds the spot rate (S)
§ Rationale for using the forward rate – should serve as a
reasonable forecast for the future spot rate because otherwise
speculators would trade forward contracts (or futures contracts)
to capitalize on the difference between the forward rate and the
expected future spot rate.
9
Market-Based Forecasting (Cont.)

§ Long-Term Forecasting with Forward Rates
§ Long-term exchange rate forecasts can be derived from long-term
forward rates. Like any method of forecasting exchange rates, the
forward rate is typically more accurate when forecasting
exchange rates for short-term horizons than for long-term
horizons.
§ Implications of the IFE for Forecasts
§ Since the forward rate captures the interest rate differential (and
therefore the expected inflation rate differential) between two
countries, it should provide more accurate forecasts for
currencies in high-inflation countries than the spot rate.
10
Mixed Forecasting
§ Use of a combination of forecasting techniques.
§ Mixed forecast is then a weighted average of the various
forecasts developed.
Guidelines for Implementing a Forecast
§ Apply forecasts consistently within the MNC
§ Measure impact of alternative forecasts
§ Consider other sources of forecasts
11
Exhibit 9.2 Forecasts of the Mexican Peso Drawn
from Each Forecasting Technique
12
Forecast Error
Measurement of forecast error
Forecast errors among time horizons

The potential forecast error for a particular currency depends on
the forecast horizon.
Forecast error over time periods
The forecast error for a given currency changes over time.
Forecast errors among currencies
The ability to forecast currency values may vary with the currency
of concern.
13
Exhibit 9.3 How the Forecast Error Is Influenced
by Volatility
14
Forecast Error
Forecast bias
§ When a forecast error is measured as the forecasted value
minus the realized value, negative errors indicate
underestimating, while positive errors indicate overestimating.
§ Statistical test of forecast bias: A conventional method of
testing for a forecast bias is to apply the following regression
model to historical data.
where
S t = spot rate at time t
S t = a 0 + a1 Ft -1 + µ t
Ft -1 = forward rate at time t - 1
µ t = error term
a 0 = intercept
a1 = regression coefficient
15
Forecast Error
Forecast bias (cont.)

§ Graphic Evaluation of Forecast Bias
§ Forecast bias can be examined with the use of a graph that
compares forecasted values with the realized values for various
time periods.
§ Shifts in Forecast Bias over Time
§ Because the forecast bias can change over time, refining a forecast
to adjust for a forecast bias detected in the past is not a perfect
solution.
16
Exhibit 9.4 Evaluation of Forecast Performance
17
Exhibit 9.5 Graphic Evaluation of Forecast
Performance
18
Forecast Error
Comparison of Forecasting Methods

§ An MNC can compare forecasting methods by plotting the
points that each method generates on a graph similar to
Exhibit 9.5.
§ The performance of the two methods can be evaluated by
comparing distances of points from the 45-degree line.
§ In some cases, neither forecasting method may stand out as
superior when compared graphically.
19
Exhibit 9.6 Comparison of Forecast Techniques
20
Forecast Error
Forecasting under Market Efficiency

§ Weak-form efficiency: historical and current exchange rate
information is already reflected in today’s exchange rate and is
not useful for forecasting.
§ Semi-strong-form efficiency: all relevant public information is
already reflected in today’s exchange rate.
§ Strong-form efficiency: all relevant public and private
information is already reflected in today’s exchange rate.
21
Using Interval Forecasts
Methods of Forecasting Exchange Rate Volatility

§ Using recent levels of volatility
§ The volatility of historical exchange rate movements over a
recent period can be used to forecast the future.
§ Using historical patterns of volatilities
§ If there is a pattern to the changes in exchange rate volatility
over time, a series of time periods may be used to forecast
volatility in the next period.
§ Using implied standard deviation
§ Derive the exchange rate’s implied standard deviation (ISD)
from the currency option pricing model.
22
Chapter Questions
1. Lexington Co. is a U.S.-based MNC with subsidiaries

in most major countries. Each subsidiary is
responsible for forecasting the future exchange rate
of its local currency relative to the U.S. dollar.
Comment on this policy.
2. Cooper, Inc., a U.S.-based MNC, periodically obtains
euros to purchase German products. It assesses U.S.
and German trade patterns and inflation rates to
develop a fundamental forecast for the euro. How
could Cooper possibly improve its method of
fundamental forecasting as applied to the euro?
23
Measuring Exposure to Exchange
Rate Fluctuations
CHAPTER 10
Chapter Objectives
} Discuss the relevance of an MNC’s exposure to

exchange rate risk.
} Explain how transaction exposure can be measured.
} Explain how economic exposure can be measured.
} Explain how translation exposure can be measured.
2
Relevance of Exchange Rate Risk
§ Exchange rate risk can be broadly defined as the risk that

a company’s performance will be affected by exchange
rate movements.
§ Exchange rates are extremely volatile.
§ The value of an MNC’s future payables or receivables in a

foreign currency can change substantially in response to
exchange rate movements.
3
Exhibit 10.1 Amount of Dollars Needed to Obtain
Imports (transaction value = 1 million euros)
4
The Investor Hedge Argument: exchange rate risk is

irrelevant because investors can hedge exchange rate risk
on their own.
Currency Diversification Argument: if an MNC is well
diversified across numerous currencies, its value will not be
affected by exchange rate movements because of offsetting
effects.
Stakeholder Diversification Argument: if stakeholders
are well diversified, they will be somewhat insulated against
losses due to MNC’s exchange rate risk.
5
Response from MNCs
§ Many MNCs attempt to stabilize their earnings with hedging

strategies because they believe exchange rate risk is relevant.
Because we manufacture and sell products in a number of countries

throughout the world, we are exposed to the impact on revenues and
expenses of movements in currency exchange rates.
—Proctor & Gamble Co.
Increased volatility in foreign exchange rates … may have an adverse

impact on our business results and financial condition.
—PepsiCo
6
Response from MNCs (cont.)

§ Forms of Exchange Rate Exposure
§ Transaction exposure
§ Economic exposure (or operating exposure)
§ Translation exposure
7
Transaction Exposure
Transaction exposure is the sensitivity of the firm’s

contractual transactions in foreign currencies to exchange
rate movements.
In order to assess transaction exposure, an MNC must:

§ Estimate net cash flows in each currency
§ Measure potential impact of the currency exposure
s p = Wx2s x2 + Wy2s y2 + 2WxWys xs y CORRxy

W = proportion of portfolio value in currency x or y
σ = standard deviation of percentage changes in currency x or y
CORR = correlation coefficient of percentage changes in currencies x and y
8
Exhibit 10.2 Consolidated Net Cash Flow
Assessment of Miami Co.
9
Exhibit 10.3 Estimating the Range of Net Inflows
or Outflows for Miami Co.
10
Exposure of an MNC’s Portfolio
Exposure of an MNC’s Portfolio

§ Measurement of currency volatility
§ The standard deviation statistic measures the degree of
movement for each currency. In any given period, some currencies
clearly fluctuate much more than others.
§ Currency volatility over time
§ The volatility of a currency may not remain consistent from one
time period to another. An MNC can identify currencies whose
values are most likely to be stable or highly volatile in the future.
§ Measurement of currency correlations
§ The correlation coefficients indicate the degree to which two
currencies move in relation to each other.
11
Exposure of an MNC’s Portfolio (cont.)

§ Applying currency correlations to net cash flows
§ If a MNC has positive net cash flows in various currencies that
are highly correlated, it may be exposed to exchange rate risk.
However, many MNCs have some negative net cash flow positions
in some currencies to complement their positive net cash flows in
other currencies.
§ Currency correlations over time
§ Because currency correlations change over time, an MNC cannot
use previous correlations to predict future correlations with
perfect accuracy.
12
Exhibit 10.4 Standard Deviation of Exchange Rate
Movements Based on Quarterly Exchange Rates, 2007–2012
13
Exhibit 10.5 Shift In Currency Volatility During
The Financial Crisis
14
Exhibit 10.6 Correlations among Movements in
Quarterly Exchange Rates
15
Exhibit 10.7 Impact of Cash Flow and Correlation
Conditions on an MNC’s Exposure
16
Transaction Exposure Based on Value at Risk (VaR)

§ Measures the potential maximum 1-day loss on the value of
positions of an MNC that is exposed to exchange rate
movements.
§ Factors that affect the maximum 1-day loss:
§ Expected percentage change in the currency for the next day
§ Confidence level used
§ Standard deviation of the daily percentage changes in the currency
over a previous period
17

(cont.)
§ Applying VaR to Longer Time Horizons
§ The standard deviation should be estimated over the time
horizon in which the maximum loss is to be measured.
§ Applying VaR to Transaction Exposure of a Portfolio
§ Since MNCs are commonly exposed to more than one currency,
they may apply the VaR method to a portfolio of currencies. When
considering multiple currencies, software packages can be used to
perform the computations.
18

(cont.)
§ Estimating VaR with an Electronic Spreadsheet
§ Obtain the series of exchange rates for all relevant dates for each
currency of concern and list each currency in its own column.
§ Compute the percentage changes per period (from one date to
the next) for each exchange rate in a column.
§ Estimate the standard deviation of the column of percentage
changes for each exchange rate.
§ In a separate column, compute the periodic percentage change in
the portfolio value by applying weights to the individual currency
returns.
§ Use a “compute” statement to determine the standard deviation
of the column of percentage changes in the portfolio value.
19
Exhibit 10.8 Spreadsheet Analysis Used to Apply
Value-at-Risk
20

(cont.)
§ Limitations of VaR
§ If the distribution of exchange rate movements is not normal, the

estimate of the maximum expected loss is subject to error.
§ The VaR method assumes that the volatility (standard deviation)

of exchange rate movements is stable over time. If past exchange
rate movements are less volatile than future movements, the
estimated maximum expected loss derived from the VaR method
will be underestimated.
21
Economic Exposure
Economic exposure is the sensitivity of the firm’s cash

flows to exchange rate movements (sometimes referred to
as operating exposure).
Exposure to local currency appreciation
§ Appreciation in the firm’s local currency causes a reduction in
both cash inflows and outflows. The impact on a firm’s net cash
flows will depend on whether the inflow transactions are affected
more or less than the outflow transactions.
Exposure to local currency depreciation
§ Depreciation of the firm’s local currency causes an increase in
both cash inflows and outflows.
Economic Exposure of Domestic Firms
§ Even purely domestic firms are affected by economic exposure.
22
Exhibit 10.9 Examples That Subject a Firm to
Economic Exposure
23
Exhibit 10.10 Economic Exposure to Exchange
Rate Fluctuations
24
Economic Exposure
Measuring Economic Exposure

§ Using sensitivity analysis
§ Consider how sales and expense categories are affected by
various exchange rate scenarios.
§ Use of regression analysis
PCFt = a0 + a1et + µt
where
PCFt = percentage change in inflation - adjusted
cash flows measured in home currency
et = percentage change in direct exchange rate
µt = random error term
a0 = intercept
a1 = slope coefficient
25
Exhibit 10.11 Estimated Sales and Expenses for Madison’s
U.S. and Canadian Business Segments (in millions)
26
Exhibit 10.12 Impact of Possible Exchange Rates on
Cash Flows of Madison Co. (millions of currency units)
27
Translation Exposure
Translation exposure is the exposure of the MNC’s

consolidated financial statements to exchange rate
fluctuations.
Determinants of translation exposure:
§ Proportion of business by foreign subsidiaries: The greater
the percentage of an MNC’s business conducted by its foreign
subsidiaries, the larger the percentage of a given financial
statement item that is susceptible to translation exposure.
§ Locations of foreign subsidiaries: Location can also influence
the degree of translation exposure because the financial
statement items of each subsidiary are typically measured by the
respective subsidiary’s home currency.
28
Determinants of translation exposure (cont.)

§ Accounting Methods: An MNC’s translation exposure is
strongly affected by the accounting procedures used to
translate when consolidating financial statement data.
§ Many important consolidated accounting rules for U.S.-based
MNCs are based on FASB 52:
§ The functional currency of an entity is the currency of the
economic environment in which the entity operates.
§ The current exchange rate as of the reporting date is used to
translate the assets and liabilities of a foreign entity from its
functional currency into the reporting currency.
29
Determinants of translation exposure (cont.)

§ Accounting Methods (cont.)
§ The weighted average exchange rate over the relevant period is
used to translate revenue, expenses, and gains and losses of a
foreign entity from its functional currency into the reporting
currency.
§ Translated income gains or losses due to changes in foreign
currency values are not recognized in current net income but are
reported as a second component of stockholder’s equity; an
exception to this rule is a foreign entity located in a country with
high inflation.
§ Realized income gains or losses due to foreign currency
transactions are recorded in current net income, although there
are some exceptions.
30
Exposure of an MNC’s Stock Price to Translation

Effects
§ Because an MNC’s translation exposure affects its
consolidated earnings, it can affect the MNC’s valuation.
§ Signals that complement translation effects: exchange
rate conditions that cause a translation effect can also signal
changes in expected cash flows in future years. Such changes
could also influence the stock price.
§ Exposure of managerial compensation to translation
effects: Since an MNC’s stock may be subject to translation
effects and since managerial compensation is often tied to the
MNC’s stock price, it follows that managerial compensation is
affected by translation effects.
31
Exhibit 10.13 How Translation Exposure Can
Affect the MNC’s Stock Price
32
Chapter Questions
1. Kopetsky Co. has net receivables in several

currencies that are highly correlated with each
other. What does this imply about the firm’s overall
degree of transaction exposure?
2. Why are the cash flows of a purely domestic firm
exposed to exchange rate fluctuations?
3. Boulder, Inc., exports chairs to Europe (invoiced in
U.S. dollars) and competes against local European
companies. If purchasing power parity exists, why
would Boulder not benefit from a stronger euro?
33
Managing Transaction Exposure
CHAPTER 11
Chapter Objectives
} Compare the techniques commonly used to hedge

payables.
} Compare the techniques commonly used to hedge
receivables.
} Describe limitations of hedging.
} Suggest other methods of reducing exchange rate
risk when hedging techniques are not available.
2
Policies for Hedging Transaction Exposure
Hedging Most of the Exposure

§ Hedging most of the transaction exposure allows MNCs to
more accurately forecast future cash flows (in their home
currency) so that they can make better decisions regarding
the amount of financing they will need.
Selective Hedging
§ MNC must identify its degree of transaction exposure.
§ MNC must consider the various techniques to hedge the
exposure so that it can decide which hedging technique is
optimal and whether to hedge its transaction exposure.
3
Hedging Exposure to Payables
An MNC may decide to hedge part or all of its known

payables transactions using:
§ Forward or futures hedge
§ Money market hedge
§ Currency option hedge
4
Forward or Futures Hedge on Payables

§ Allows an MNC to lock in a specific exchange rate at which it
can purchase a specific currency and, thus, hedge payables. A
forward contract is negotiated between the firm and a financial
institution. The contract will specify the:
§ currency that the firm will pay
§ currency that the firm will receive
§ amount of currency to be received by the firm
§ rate at which the MNC will exchange currencies (called the
“forward” rate)
§ future date at which the exchange of currencies will occur
5
Money Market Hedge on Payables

§ Involves taking a money market position to cover a future
payables position.
§ If a firm prefers to hedge payables without using its cash
balances, then it must
§ Borrow funds in the home currency, and
§ Invest in the foreign currency
§ Money market hedge versus forward hedge
§ Since the results of both hedges are known beforehand, the
firm can implement the one that is more feasible.
6
Call Option Hedge on Payables

§ A currency call option provides the right to buy a specified
amount of a particular currency at a specified strike price (or
exercise price) within a given period of time.
§ The currency call option does not obligate its owner to buy
the currency at that price. The MNC has the flexibility to let
the option expire and obtain the currency at the existing spot
rate when payables are due.
7
Call Option Hedge on Payables (cont.)

§ Cost of call options based on contingency graph
§ Advantage: provides an effective hedge
§ Disadvantage: premium must be paid
§ Cost of call options based on currency forecasts
§ MNC can incorporate forecasts of the spot rate to more
accurately estimate the cost of hedging with call options.
§ Consideration of Alternative Call Options
§ Several different types of call options may be available, with
different exercise prices and premiums for a given currency and
expiration date.
§ Whatever call option is perceived to be most desirable for
hedging a particular payables position would be analyzed, so that
it could then be compared to the other hedging techniques.
8
Exhibit 11.1 Contingency Graph for Hedging
Payables With Call Options
9
Exhibit 11.2 Use of Currency Call Options to Hedge
Euro Payables (exercise price = $1.20, premium = $.03)
10
Comparison of Techniques to Hedge Payables

§ The cost of the forward hedge or money market hedge can be
determined with certainty.
§ The currency call option hedge has different outcomes
depending on the future spot rate at the time payables are
due.
11
Exhibit 11.3 Comparison of Hedging Alternatives
for Coleman Co.
12
Comparison of Techniques to Hedge Payables

§ Optimal Technique for Hedging Payables
§ Select optimal hedging technique by:
§ Considering whether futures or forwards are preferred.
§ Considering desirability of money market hedge versus
futures/forwards based on cost.
§ Assessing the feasibility of a currency call option based on
estimated cash outflows.
§ Choose optimal hedge versus no hedge for payables
§ Even when an MNC knows what its future payables will be, it
may decide not to hedge in some cases.
Evaluate the hedge decision by estimating the real cost of
hedging versus the cost if not hedged.
13
Exhibit 11.4 Graphic Comparison of Techniques
to Hedge Payables
14
Hedging Exposure to Receivables
Forward or futures hedge on receivables allows the

MNC to lock in the exchange rate at which it can sell a
specific currency.
Money market hedge on receivables involves
borrowing the currency that will be received and using the
receivables to pay off the loan.
15
Put option hedge on receivables provides the right to

sell a specified amount of a particular currency at a
specified strike price by a specified expiration date.
§ Cost of Put Options Based on Contingency Graph
§ Advantage: provides an effective hedge
§ Disadvantage: premium must be paid
§ Cost of Put Options Based on Currency Forecasts
§ MNC can use currency forecasts to more accurately estimate the
dollar cash inflows to be received when hedging with put options.
§ Consideration of Alternative Put Options
§ Several different types of put options may be available that feature
different exercise prices and premiums for a given currency and
expiration date.
16
Exhibit 11.5 Contingency Graph for Hedging
Receivables with Put Options
17
Exhibit 11.6 Use of Currency Put Options for Hedging Swiss
Franc Receivables (exercise price = $.72; premium = $.02)
18
Comparison of Techniques for Hedging Receivables

§ Optimal Technique for Hedging Receivables:
§ Consider whether futures or forwards are preferred.
§ Consider desirability of money market hedge versus
futures/forwards based on cost.
§ Assess the feasibility of a currency put option based on estimated
cash outflows.
§ Optimal hedge versus no hedge on receivables
§ An MNC may know what its future receivables will be, yet still
decide not to hedge. In that case, the MNC needs to determine
the probability distribution of its revenue from receivables when
not hedging.
19
Exhibit 11.7 Comparison of Hedging Alternatives
for Viner Co.
20
Exhibit 11.8 Graph Comparison of Techniques to
Hedge Receivables
21
Exhibit 11.9 Review of Techniques for Hedging
22
Limitations of Hedging
Limitation of Hedging an Uncertain Payment

§ Some international transactions involve an uncertain amount
of foreign currency, leading to overhedging.
Limitation of Repeated Short-Term Hedging
§ The continual short-term hedging of repeated transactions
may have limited effectiveness.
§ Long-term Hedging as a Solution
§ Some banks offer forward contracts for up to 5 years or 10 years
on some commonly traded currencies.
§ Another alternative to repeated short-term hedging is a parallel
loan (or “back-to-back” loan): exchange of currencies between
two parties with a promise to re-exchange currencies at a
specified exchange rate on a future date.
23
Exhibit 11.10 Repeated Hedging of Foreign Payables
When the Foreign Currency Is Appreciating
24
Exhibit 11.11 Long-Term Hedging of Payables When
the Foreign Currency Is Appreciating
25
Alternative Hedging Techniques
Leading and Lagging: adjusting the timing of a payment

or disbursement to reflect expectations about future
currency movements.
Cross-Hedging: hedging by using a currency that serves as
a proxy for the currency in which the MNC is exposed.
Currency Diversification: reduce exposure by
diversifying business among numerous countries.
26
Chapter Questions
1. Should an MNC risk overhedging?

2. If hedging is expected to be more costly than not
hedging, why would a firm even consider hedging?
3. You are an exporter of goods to the United
Kingdom, and you believe that today’s forward rate
of the British pound substantially underestimates the
future spot rate. Company policy requires you to
hedge your British pound receivables in some way.
Would a forward hedge or a put option hedge be
more appropriate?
27
Managing Economic Exposure and
CHAPTER 12
Chapter Objectives
} Explain how an MNC’s economic exposure can be

hedged.
} Explain how an MNC’s translation exposure can be
hedged.
2
Managing Economic Exposure
Economic exposure represents the impact of exchange

rate fluctuations on a firm’s future cash flows.
Assessing economic exposure
§ An MNC must measure its exposure to each currency in
terms of its cash inflows and cash outflows.
Restructuring to reduce economic exposure, e.g.
§ Increase sensitivity of revenues to exchange rate movements.
§ Decrease sensitivity of expenses to exchange rate
movements.
§ Expediting the analysis with computer spreadsheets
§ By revising the input to reflect various possible restructurings,
the analyst can determine how each operational structure
would affect the firm’s economic exposure.
3
Exhibit 12.1 How Managing Exposure Can
Increase an MNC’s Value
4
Exhibit 12.2 Original Impact of Possible Exchange
Rates on Cash Flows of Madison Co. (in Millions)
5
Exhibit 12.3 Impact of Possible Exchange Rate Movements
on Earnings under Two Alternative Operational Structures
(in Millions)
6
Exhibit 12.4 Economic Exposure Based on the
Original and Proposed Operating Structures
7
Managing Economic Exposure
Issues Involved in the Restructuring Decision

§ Should the firm attempt to increase or reduce sales in new or
existing foreign markets?
§ Should the firm increase or reduce its dependency on foreign
suppliers?
§ Should the firm establish or eliminate production facilities in
foreign markets?
§ Should the firm increase or reduce its level of debt
denominated in foreign currencies?
8
Exhibit 12.5 Restructuring Operations to Balance the
Impact of Currency Movements on Cash Inflows and
Outflows
9
A Case on Hedging Economic Exposure
Savor Co.’s Dilemma

U.S. firm with exposure to the Euro
§ Assessment of economic exposure – assess the relationship
between the euro’s movements and each unit’s cash flows over
the last nine quarters.
§ Assessment of each unit’s exposure using regression analysis
§ Identifying the source of each unit’s exposure
10
Exhibit 12.6 Assessment of Savor Co.’s Cash
Flows and the Euro’s Movements
11
Possible strategies to hedge economic exposure:

§ Pricing policy
§ Hedging with forward contracts
§ Purchasing foreign supplies

§ Financing with foreign funds
§ Revising operations of other units
12
Savor’s Hedging Strategy: instruct other units to do

their financing in euros as well.
Limitations of Savor’s Optimal Hedging Strategy:
the impact of the euro’s movements on Savor’s cash
outflows needed to repay the loans is known with certainty,
but the impact on cash inflows (revenue) is uncertain and
can change over time.
13
Hedging Exposure to Fixed Assets
Hedging the sale of fixed assets by:

§ Selling the currency forward in long-term forward contract.
§ Creating a liability in that currency that matches the
expected value of the assets in the future (when they may
be sold).
Limitations of hedging the sale of fixed assets:
§ MNC may not know the date when it will sell the assets.
§ MNC may not know the price in the local currency at which
it will sell them.
14
Managing Translation Exposure
Translation exposure occurs when each subsidiary’s

financial data is translated to an MNC’s home currency for
consolidated financial statements.
Hedging with Forward Contracts
§ Translation exposure can be hedged with forward or futures
contracts.
§ Sell the currency forward that the foreign subsidiary receives as
earnings.
§ If the foreign currency depreciates against the home currency, the
adverse impact on the consolidated income statement can be
offset by the gain on the forward sale in that currency.
15
Managing Translation Exposure
Limitations of hedging translation exposure:

§ Inaccurate earnings forecasts - earnings in a future period
are uncertain.
§ Inadequate forward contracts for some currencies –
forward contracts are not available for all currencies.
§ Accounting distortions – the forward rate gain or loss
reflects the difference between the forward rate and the
future spot rate, whereas the translation gain or loss is caused
by the change in the average exchange rate over the period in
which the earnings are generated.
§ Increased transaction exposure – the MNC may be
increasing its transaction exposure with a forward contract.
16
Chapter Questions
1. Can an MNC reduce the impact of translation

exposure by communicating?
2. Can an MNC forgo economies of scale when it
restructures its operations to reduce its economic
exposure?
3. Would a more established MNC or a less
established MNC be better able to effectively hedge
its given level of translation exposure?
17

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Multinational Financial Management:

 Identify the management goal and organizational

▪ A multinational corporation is defined as one that has

Managers of MNCs are expected to make decisions that will

How Business Disciplines Are Used to Manage the

Agency Problems (cont.)

Agency Problems (cont.)

Management Structure of MNCs

Theory of Comparative Advantage: specialization

▪ Minimal risk – no capital at risk

Acquisitions of Existing Operations

Establishing New Foreign Subsidiaries

Multinational Model (cont.)

Uncertainty Surrounding an MNC’s Cash Flows

How Uncertainty Affects the MNC’s cost of Capital

1. What is the appropriate definition of an MNC?

 Explain the key components of the balance of payments.

The balance of payments is a summary of transactions

Components of the Balance-of-Payments

Events That Increased Trade Volume

▪ Single European Act of 1987: Improved access to supplies from

▪ North American Free Trade Agreement (NAFTA): Allowed

▪ General Agreement on Tariffs and Trade (GATT): Called for

Events That Increased Trade Volume (cont.)

▪ Other Trade Agreements: The United States and the European

Impact of Outsourcing on Trade

Impact of Outsourcing on Trade (cont.)

Trade Volume Among Countries

Trend in U.S. Balance of Trade

Cost of Labor: Firms in countries where labor costs are

Impact of Government Policies (cont.)

Impact of Government Policies (cont.)

Impact of Government Policies (cont.)

Impact of Government Policies (cont.)

Exchange Rates: current account decreases if currency

Exchange Rates (cont.)

Exchange Rates (cont.)

Factors Affecting Direct Foreign Investment

Factors Affecting Direct Foreign Investment (Cont.)

Factors Affecting International Portfolio Investment

Impact of International Capital Flows

International Monetary Fund

World Bank (International Bank for Reconstruction and

▪ Structural Adjustment Loans (SALs) are intended to

World Trade Organization

▪ Member countries are given voting rights that are used to

International Financial Corporation

Bank for International Settlements

Organization for Economic Cooperation and

Regional Development Agencies

1. Should trade restrictions be used to influence

Describe the background and corporate use of the

} International money market

} International bond market

} Provides the physical and institutional structure through

History of Foreign Exchange

Foreign Exchange Transactions

Foreign Exchange Transactions (cont.)

Foreign Exchange Transactions (cont.)