Module Code: FMT503

Module Title: International Financial Management

Topic 1 – Introduction to International Financial Management

(IFM)
Session Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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 Topic Objectives
Introduction to IFM

At the end of this topic, students will be able to:

• Discuss the importance of studying international financial
management
• Distinguish international finance from domestic finance
• Explain the goals of international financial management
• Describe the structure of the international financial system
• Discuss the construct of exchange rate regimes

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 What’s Special about
“International” Finance?

• F 3
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 What’s Special about
“International” Finance?

• F 4
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 What’s Special about
“International” Finance?
An Example of Foreign Exchange Risk

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 What’s Special about
“International” Finance?

• M 6
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 What’s Special about
“International” Finance?

• E 7
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 Goals for International Financial Management

• The focus of the course is to equip the reader with the

“intellectual toolbox” of an effective global manager—but
what goal should this effective global manager be working
toward?
• Maximization of shareholder wealth?
or
• Other Goals?

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 Maximize Shareholder Wealth

• Long accepted as a goal in the Anglo-Saxon countries, but

complications arise.
 Who are and where are the shareholders?
 In what currency should we maximize their wealth?

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 Other Goals

• In other countries shareholders are viewed as merely one

among many “stakeholders” of the firm including:
 Employees
 Suppliers
 Customers
• In Japan, managers have typically sought to maximize the
value of the keiretsu—a family of firms to which the
individual firms belongs.

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 Other Goals

• No matter what the other goals, they cannot be achieved in the long
term if the maximization of shareholder wealth is not given due
consideration.

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 Globalization of the World Economy: Recent Trends
• Emergence of globalized financial markets.
• Emergence of the Euro as a global currency (beginning of 1999).
• Trade liberalization (GATT and WTO) and economic integration
(EU,SAFTA)
• Privatization, PPP
• Multinational corporations (GE, Vodaphone, Toyota, Siemens, TATA)

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 Modern day history of the Euro

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 What is money?
Barter economy
 Search frictions
 Indivisibilities
 Transferability
Commodity money
 Beaver pelts
 Dried corn
 Metals
Fiat money
 Faith in government (China introduced in 11th Century)

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 Emergence of Globalized
Financial Markets
• Deregulation of Financial Markets coupled with
• Advances in Technology have greatly reduced information
and transactions costs, which has led to:
• Financial Innovations, such as
 Currency futures and options
 Multi-currency bonds
 Cross-border stock listings
 International mutual funds

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 Economic Integration

• O 16
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 Liberalization of
Protectionist Legislation

• T 17
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 Privatization

• T 18
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 Multinational Corporations

• A 19
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 Top MNCs
1 Samsung South Korea
2 Royal Dutch Shell Netherlands/ UK
3 Exxon Mobil Corporation United States
4 Volkswagen Group Germany
5 Toyota Japan
6 Apple United States
7 BP UK
8 Berkshire Hathaway United States
9 General Electric United States
10 Daimler Germany

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 Investment opportunities
%
MNC’s investment
opportunity set Domestic firm’s marginal
cost of capital

Domestic firm’s investment MNC

opportunity set

Domestic firm Capital budget 21

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 Financing opportunities
%
Domestic firm’s marginal
cost of capital

MNC’s marginal
Domestic firm’s investment
cost of capital
opportunity set

Domestic firm Capital budget

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 The value of multinationality
Return
25%

20% MNC’s investment

opportunity set Do mestic firm’s
cost of capital
15%

10%

MNC’s cost Do mestic firm’s investment

5% of capital opportunity set

0%
0 100 200 300 400 500
Do mestic firm Multinati onal corporation (MNC)

Capital budget ($ millions) 23

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 International Monetary System
Bimetallism: Before 1875
 Free coinage was maintained for both gold and silver
 Gresham’s Law: Only the abundant metal was used as money,
driving more scarce metals out of circulation
Classic gold standard: 1875-1914
 Great Britain introduced full-fledged gold standard in 1821,
France (effectively) in the 1850s, Germany in 1875, the US in
1879, Russia and Japan in 1897
 Gold alone is assured of unrestricted coinage
 There is a two-way convertibility between gold and national
currencies at a stable ratio
 Gold may be freely exported and imported
 Cross-border flow of gold will help correct misalignment of
exchange rates and will also regulate balance of payments
 The gold standard provided a 40 year period of unprecedented
stability of exchange rates which served to promote international
trade

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 Classical Gold Standard:
1875-1914
• Misalignment of exchange rates and international imbalances of
payment were automatically corrected by the price-specie-flow
mechanism
 UK exported more to France than the former imported from
them
 Net exports from UK to France will be accompanied by a net
flow of gold from France to UK
 Domestic money stock will rise in UK
 Fall in price level in France and rise in UK
 Slowdown export from UK and encourage exports from France
 Initial net export will disappear
 David Hume- price-specie-flow mechanism
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 International Monetary System
Interwar period: 1915-1944
 World War I ended the classical gold standard in 1914
 Trade in gold broke down
 After the war, many countries suffered hyper inflation
 Countries started to “cheat”
Sterilization of gold, by matching inflows and outflows of gold with reductions and
increases in domestic money and credit
 Predatory devaluations (recovery through exports!)
 The US, Great Britain, Switzerland, France and the Scandinavian countries
restored the gold standard in the 1920s.
 After the great depression, and ensuing banking crises, most countries
abandoned the gold standard.
Bretton Woods system: 1945-1972
U.S. dollar was pegged to gold at $35.00/oz.
Other major currencies established par values against the dollar. Deviations of
±1% were allowed, and devaluations could be negotiated.

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 The Monetary System
Jamaica Agreement (1976)
 Central banks were allowed to intervene in the foreign exchange
markets to iron out unwarranted volatilities
 Gold was officially abandoned as an international reserve asset,
half of the IMF’s gold holdings were returned to the members
and the other half were sold, with proceeds used to help poor
nations
 Non-oil exporting countries and less-developed countries were
given greater access to IMF funds
Plaza Accord (1985)
 G-5 countries (France, Japan, Germany, the U.K., and the U.S.)
agreed that it would be desirable for the U.S. dollar to depreciate
Louvre Accord (1987)
 G-7 countries (Canada and Italy were added) would cooperate to
achieve greater exchange rate stability
 G-7 countries agreed to more closely consult and coordinate
their macroeconomic policies

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 Current Exchange Rate Arrangements

35 major currencies, such as the U.S. dollar, the Japanese yen, the
Euro, and the British pound are determined largely by market forces
82 countries, including the China, India, Russia, and Singapore, adopt
some forms of “Managed Floating” system
10 countries do not have their own national currencies - Dollarized!
13 countries have Currency Board arrangements, maintain national
currencies but they are permanently fixed to USD or Euro
The remaining countries have some mixture of fixed and floating
exchange-rate regimes

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 The Euro
Product of the desire to create a more integrated European
economy.
Eleven European countries adopted the Euro on January 1,
1999:
 Austria, Belgium, Finland, France, Germany, Ireland, Italy,
Luxembourg, Netherlands, Portugal, and Spain.
The following countries opted out initially:
 Denmark, Greece, Sweden, and the U.K.
Euro notes and coins were introduced in 2002
Greece adopted the Euro in 2001
Slovenia adopted the Euro in 2007

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 Will the UK (Sweden) join the Euro?
The Mini-Case can be found in E&R, p. 57.
 Please read E&R pp. 35-46 in preparation for the discussion next
time
Think about:
 Potential benefits and costs of adopting the euro
 Economic and political constraints facing the country
 The potential impact of British adoption of the euro on the
international financial system, including the role of the U.S.
dollar
 The implications for the value of the euro of expanding the EU to
include, e.g., Eastern European countries

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 The Foreign Exchange Market
The FX market encompasses:
 Conversion of purchasing power from one currency to another;
bank deposits of foreign currency; credit denominated in foreign
currency; foreign trade financing; trading in foreign currency
options & futures, and currency swaps
No central market place
 World-wide linkage of bank currency traders, non-bank dealers
(IBanks, insurance companies, etc.), and FX brokers—like an
international over-the-counter (OTC) market
Largest financial market in the world
 Daily trading is estimated to be US$5.3 trillion
 Trading occurs 24 hours a day
 London is the largest FX trading center

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 Global Foreign Exchange Market Turnover

Source: BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2013.
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 Source: BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in April 2020. 34
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 The Foreign Exchange Market
The FX market is a two-tiered market:
 Interbank Market (Wholesale)
Accounts for about 83% of FX trading volume—mostly speculative or
arbitrage transactions
About 100-200 international banks worldwide stand ready to make a market
in foreign exchange
FX brokers match buy and sell orders but do not carry inventory
averaged $5.3 trillion per day in April 2013
 Client Market (Retail)
Accounts for about 17% of FX trading volume
Market participants include international banks, their customers,
non-bank dealers, FX brokers, and central banks

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 The Foreign Exchange Market

1
Source: Lilley, Mark Euro money FX survey 2020 results revealed
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 The Foreign Exchange Market

Source: "World’s Most Traded Currencies By Turnover in

2019". BIS report, September 2019

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 Central Banking
The U.S. monetary authorities WEDNESDAY, NOVEMBER 8, 2000
U.S. INTERVENES IN THIRD QUARTER TO BUY 1.5
occasionally intervene in the foreign BILLION EUROS NEW YORK FED REPORTS
exchange (FX) market to counter
disorderly market conditions NEW YORK – The U.S. monetary authorities
intervened in the foreign exchange markets on
The Treasury, in consultation with the one occasion during the third quarter, on
Federal Reserve System, has September 22nd, buying a total of 1.5 billion
responsibility for setting U.S euros, the Federal Reserve Bank of New York
exchange rate policy, while the said today in its quarterly report to the U.S.
Congress.
Federal Reserve Bank New York is The dollar appreciated 8.2 percent against the
responsible for executing FX euro and appreciated 2 percent against the
intervention Japanese yen during the three month period
U.S. FX intervention has become less that ended September 30, 2000
The intervention was carried out by the foreign
frequent in recent years exchange trading desk at the New York Fed,
operating in coordination with the European
Central Bank (ECB) and the monetary
authorities of Japan, Canada, and the United
Kingdom. The amount was split evenly
between the Federal Reserve System and the
U.S. Treasury Department’s Exchange
Stabilization Fund (ESF)
[Link]
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 The Foreign Exchange Market

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 The Spot Market
The spot market involves the immediate purchase or sale of foreign
exchange
 Cash settlement occurs 1-2 days after the transaction
Currencies are quoted against the US dollar
Interbank FX traders buy currency for their inventory at the bid price
Interbank FX traders sell currency for their inventory at the ask price
Bid price is less than the ask price
Bid-ask spread is a transaction cost

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 The Spot Market – Direct Quotes
US dollar price of 1 unit of foreign currency—$ are in the numerator
(foreign currency is priced in terms of dollars)
 $/€ = 1.5000 (1€ costs $1.5000)
 $/£ = 2.0000 (1£ costs $2.0000)
Currency changes
 Suppose that today, $/€ = 1.5000 and in 1 month, $/€ = 1.5050
 The $ has depreciated in value
 Alternatively, the € has appreciated in value
 Suppose that today, $/£ = 2.0000 and in 1 month, $/£ = 1.9950
 The $ has appreciated in value
 Alternatively, the £ has depreciated in value

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 The Spot Market – Indirect Quotes
Foreign currency price of $1—$ are in the denominator (US dollar is priced in terms
of foreign currency)
€/$ = 0.6667 ($1costs €0.6667)
£/$ = 0.5000 ($1 costs £0.5000)
Currency changes
Suppose that today, €/$ = 0.6667 and in 1 month, €/$ = 0.6600
The $ has depreciated in value
Alternatively, the € has appreciated in value
Suppose that today, £/$ = 0.5000 and in 1 week, £/$ = 0.5050.
The $ has appreciated in value
Alternatively, the £ has depreciated in value

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 The Spot Market - Conventions
Denote the spot rate as S
For most currencies, use 4 decimal places in calculations
 With exceptions: i.e. S(¥/$)=109.0750, but S($/¥)=0.009168
If we are talking about the US, always quote spot rates as the dollar
price of the foreign currency
 i.e. as direct quotes, S($/€), S($/C$), S($/£), etc
Increase in the exchange rate  the US dollar is depreciating
 Costs more to buy 1 unit of foreign currency
Decrease in the exchange rate  the US dollar is appreciating
 Costs less to buy 1 unit of foreign currency

According to the 2013 Triennial Survey, the volumes are

EURUSD: 24.1%
USDJPY: 18.3%
GBPUSD (also called cable): 8.8% 44
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 The Spot Market
Currency
Wednesday, January 8, 1997
US dollar price:
U.S. $ equiv. per U.S. $
EXCHANGE RATES Country
Japan (Yen)
W ed.
.008639
Tues.
.008681
W ed.
115.75
Tues.
115.20
The New York foreign exchange selling rates below apply to 30-Day Forward .008676 .008718 115.26 114.71
trading among banks in amounts of $1 million and more, as quoted
at 4 p.m. Eastern time by Dow Jones Telerate Inc. and other sources.
Retail transactions provide fewer units of foreign currency per
90-Day Forward
180-Day Forward
Jordan (Dinar)
.008750
.008865
1.4075
.008791
.008907
1.4075
114.28
112.80
.7105
113.76
112.28
.7105
S($/£)=1.6880
£1 costs $1.6880
dollar. Kuwait (Dinar) 3.3367 3.3389 .2997 .2995
Currency Lebanon (Pound) .0006445 .0006445 1551.50 1551.50
U.S. $ equiv. per U.S. $ Malaysia (Ringgit) .4018 .4002 2.4885 2.4990
Country W ed. Tues. W ed. Tues. Malta (Lira) 2.7624 2.7701 .3620 .3610
Argentina (Peso) 1.0012 1.0012 .9988 .9988 Mexico (Peso) .... .... .... ....
Australia (Dollar) .7805 .7902 1.2812 1.2655 Floating r ate .1278 .1277 7.8220 7.8330
Austria (Schilling) .09043 .09101 11.058 10.988 Netherland (Guilder) .5655 .5699 1.7685 1.7547
Bahrain (Dinar) 2.6525 2.6525 .3770 .3770 New Zealand (Dollar) .7072 .7106 1.4140 1.4073
Belgium (Franc) .03080 .03105 32.470 32.205 Norway (Krone) .1540 .1548 6.4926 6.4599
Brazil (Real) .9607 .9615 1.0409 1.0401 Pakistan (Rupee) .02529 .02529 39.540 39.540
Peru (new Sol) .3814 .3840 2.6218 2.6039

UK pound price:
Britain (Pound) 1.6880 1.6946 .5924 .5901
30-Day Forward 1.6869 1.6935 .5928 .5905 Philippines (Peso) .03800 .03802 26.318 26.300
90-Day Forward 1.6843 1.6910 .5937 .5914 Poland (Zloty) .3460 .3475 2.8900 2.8780
180-Day Forward 1.6802 1.6867 .5952 .5929 Portugal (Escudo) .006307 .006369 158.55 157.02

S(£/$)=0.5924
Canada (Dollar) .7399 .7370 1.3516 1.3568 Russia (Ruble) (a) .0001787 .0001788 5595.00 5594.00
30-Day Forward .7414 .7386 1.3488 1.3539 Saudi Arabia (Riyal) .2666 .2667 3.7503 3.7502
90-Day Forward .7442 .7413 1.3437 1.3489 Singapore (Dollar) .7116 .7124 1.4053 1.4037
180-Day Forward .7479 .7450 1.3370 1.3422 Slovak Rep. (Koruna) .03259 .03259 30.688 30.688
Chile (Peso)
China (Renm inbi)
Colombia (Peso)
.002352
.1201
.002356
.1201
425.25
8.3272
.0009985 .0009985 1001.50 1001.50
424.40
8.3276
South Africa (Rand)
South Korea (W on)
Spain (Peseta)
.2141
.001184
.007546
.2142
.001184
.007603
4.6705
844.75
132.52
4.6690
844.65
131.53
$1 costs £0.5924
Czech. Rep (Krouna) .... .... .... .... Sweden (Krona) .1431 .1435 6.9865 6.9697
Com mercial rate .03662 .03677 27.307 27.194 Switzerland (Franc) .7334 .7387 1.3635 1.3537
Denmark (Krone) .1663 .1677 6.0118 5.9633 30-Day Forward .7357 .7411 1.3593 1.3494
Ecuador (Sucre) .... .... .... .... 90-Day Forward .7401 .7454 1.3511 1.3416
Floating rate .0002766 .0002787 3615.00 3587.50 180-Day Forward .7470 .7523 1.3386 1.3293
Finland (Markka) .2121 .2135 4.7150 4.6841 Taiwan (Dollar) .03638 .03637 27.489 27.493

And note that

France (Franc) .1879 .1893 5.3220 5.2838 Thailand (Baht) .03902 .03906 25.625 25.605
30-Day Forward .1882 .1896 5.3126 5.2741 Turkey (Lira) .00000911 .00000915 109755.00 109235.00
90-Day Forward .1889 .1903 5.2935 5.2558 United Arab (Dirham ) .2723 .2723 3.6720 3.6720
180-Day Forward .1901 .1914 5.2617 5.2243 Uruguay (New Peso) .... .... .... ....
Germany (M ark) .6352 .6394 1.5744 1.5639 Financial .1145 .1145 8.7300 8.7300

1
30-Day Forward .6364 .6407 1.5714 1.5607 Venezuela (Bolivar) .002098 .002096 476.70 477.12
90-Day Forward .6389 .6432 1.5652 1.5547 ---

S ($ / £) 
180-Day Forward .6430 .6472 1.5552 1.5450 SDR 1.4315 1.4326 .6986 .6980
Greece (Drachm a) .004049 .004068 246.98 245.80 ECU 1.2308 1.2404 .......... ...........

S (£/$)
Hong Kong (Dollar) .1292 .1292 7.7390 7.7390
Hungary (Forint) .006139 .006164 162.89 162.23 Special Drawing Rights (SDR) are based on exchange rates for
India (Rupee) .02787 .02786 35.875 35.890 the U.S., German, British, French, and Japanese currencies. Source:
Indonesia (Rupiah) .0004233 .0004233 2362.15 2362.63 International M onetary Fund.
Ireland (Punt) 1.6664 1.6714 .6001 .5983 European Currency Unit (ECU) is based on a basket of comm unity
Israel (Shekel) .3079 .3085 3.2474 3.2412 currencies.
Italy (Lira) .0006483 .0006510 1542.50 1536.00 a-fixing, Moscow Interbank Currency Exchange.

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 Class Exercise: The Spot Market
• The current exchange, S($/€)=1.5000. In 1 month, it is
S(€/$)=0.6689
 Has the US dollar appreciated or depreciated?
 By what % has the exchange rate changed?

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 The Spot Market – A Recap
Direct Quotes
 Price of 1 unit of foreign currency in domestic currency terms. Written with domestic currency in the
numerator and foreign currency in the denominator.
 For example,
 S($/INR) = $.015 (INR 1 costs $.015), from US perspective
 S(INR/$) = Rs. 66 ($1 costs INR 68), from India perspective
Indirect Quotes
Price of 1 unit of domestic currency in foreign currency terms. Written with domestic currency in the
denominator and foreign currency in the numerator.
 For example,
 S(INR/$) = Rs. 66 ($1 costs INR 66), from US perspective
 S($/INR) = $.015 (INR 1 costs $.015), from India perspective
In general, S(j/k) refers to the price of 1 unit of currency k (denominator) in
terms of currency j (numerator)
It should be intuitive that the Indian and American terms quotes are reciprocals of one
another

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 Summary
• International Financial Management has its special features which
distinguishes it from Domestic financial management
• These special features include Financial Risk, Political Risk and
Expanded Opportunity set
• No matter what the other goals, they cannot be achieved in the long
term if the maximization of shareholder wealth is not given due
consideration
• There has been a sea change in the attitudes of many of the world’s
governments who have abandoned mercantilist views and embraced
free trade as the surest route to prosperity for their citizenry
• Many MNCs obtain raw materials from one nation, financial capital from
another, produce goods with labor and capital equipment in a third
country and sell their output in various other national markets.

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 Summary
• International Monetary standards have included the following:
Bimetallism: Before 1875, Classic gold standard: 1875-1914, Interwar
period: 1915-1944, Bretton Woods system: 1945-1972, Jamaica
Agreement (1976), Plaza Accord (1985), Louvre Accord (1987)
• The Foreign exchange market comprises Interbank Market (Wholesale
Transactions) and Client Market (Retail Transactions)
• The spot market involves the immediate purchase or sale of
foreign exchange and quotes could be either direct quotes or
indirect quotes.
• Use 4 or more decimals to quote currencies in order to maintain
accuracy in calculations and conversions across currencies

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 Topic 2 – International Banking and Money Market

Topic Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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 Topic Objectives
International Banking and Money Market

At the end of this topic, students will be able to:

• Discuss the role of International Banking Services
• Discuss relevant problems in International Finance Management
• Discuss the functioning of Forward Rate Agreements
• Analyse the cause and effect of International Financial Crises

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 International Banking Services

• I 52
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 The World’s 10 Largest Banks

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 Reasons for International Banking

• L 54
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 Reasons for International Banking

• L 55
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 Reasons for International Banking

• L 56
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 Reasons for International Banking

• L 57
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 Reasons for International Banking

• L 58
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 Reasons for International Banking

• L 59
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 Reasons for International Banking

• L 60
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 Reasons for International Banking

• K 61
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 Reasons for International Banking

• H 62
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 Reasons for International Banking

• P 63
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 Types of International
Banking Offices

• C
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 Correspondent Bank
• A correspondent banking relationship exists when two banks
maintain deposits with each other.
• Correspondent banking allows a bank’s MNC client to conduct
business worldwide through his local bank or its correspondents

Example: A customer of Wells Fargo Bank in Minneapolis (USA) might wish to

pay a German firm €1,000,000 for machinery the customer has purchased.
Wells Fargo has a correspondent banking relationship with Deutsche Bank in
Frankfurt and the banks agree that, at an exchange rate of $1.30 to one euro,
this is equivalent to US$1,300,000 and Wells Fargo's balance or credit with
Deutsche Bank is at least US$1,300,000 / €1,000,000. Wells Fargo takes the
$1,300,000 out of the customer's bank account, and instructs Deutsche Bank
to take the same US$1,300,000 as €1,000,000 out of Wells Fargo's
correspondent account at Deutsche Bank and pay the euros to the German
firm's account
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 Representative Offices

• A representative office is a small service facility

staffed by parent bank personnel that is designed to
assist MNC clients of the parent bank in dealings with
the bank’s correspondents
• Representative offices also assist with information
about local business customs, and credit evaluation of
the MNC’s local customers

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 Foreign Branches

• A foreign branch bank operates like a local bank, but is legally part
of the parent.
 Subject to both the banking regulations of home country and
foreign country.
 Can provide a much fuller range of services than a
representative office.
• Branch Banks are the most popular way for U.S. banks to expand
overseas.

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 Subsidiary and Affiliate Banks

• A 68
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 Edge Act Banks

• E 69
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 Offshore Banking Centers

• A 70
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 Offshore Banking Centers
• The IMF recognizes
 the Bahamas
 Bahrain
 the Cayman Islands
 Hong Kong
 the Netherlands Antilles
 Panama
 Singapore
• As major offshore banking centers

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 “Shell” Branches
• Shell branches need to be nothing more than a post office box.
• The actual business is done by the parent bank at the parent bank
• The purpose was to allow U.S. banks to compete internationally
without the expense of setting up operations “for real”

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 International Banking Facilities
• An international banking facility is a separate set of accounts that
are segregated on the parents books
• An international banking facility is not a unique physical or legal
identity
• Any U.S. bank can have one
• International banking facilities have captured a lot of the Eurodollar
business that was previously handled offshore

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 Capital Adequacy Standards
• Bank capital adequacy refers to the amount of equity capital and
other securities a bank holds as reserves
• Three Pillars of Capital Adequacy
 Minimum capital requirements
 Supervisory review process
 Effective use of market discipline

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 Capital Adequacy Standards

• While traditional bank capital standards may be enough to protect

depositors from traditional credit risk, they may not be sufficient
protection from derivative risk
• For example, Barings Bank, which collapsed in 1995 from derivative
losses, looked good on paper relative to the capital adequacy
standards of the day

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 New Capital Adequacy Standards

• T 76
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 International Money Market

• E 77
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 Eurocurrency Market
• Most Eurocurrency transactions are interbank transactions in the
amount of $1,000,000 and up
• Common reference rates include
 LIBOR the London Interbank Offered Rate
 PIBOR the Paris Interbank Offered Rate
 SIBOR the Singapore Interbank Offered Rate
• A new reference rate for the new euro currency
 EURIBOR the rate at which interbank time deposits of € are
offered by one prime bank to another

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 Eurocredits

• E 79
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 Forward Rate Agreements

• A 80
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 Forward Rate Agreements: Uses

• F 81
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 Forward Rate Agreements: Example

• A three against nine FRA is on a six-month interest rate for a six-

month period beginning three months from now.

0 1 2 3 4 5 6 7 8 9

Agreement period FRA period (6

months)
(3 months)

Cash Settlement

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 Settling a FRA

• At the end of the agreement period, the loser pays the winner an
amount equal to the difference between the settlement rate and
the agreement rate, sized according to the length of the agreement
period and the notational amount.

days
Notational Amount × (SR – AR) × 360
days
1 + SR × 360

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 Settling a FRA
• A €5,000,000, 4%, 3 against 9 FRA entered into January 1,
2006 has the following terms:

1 2 4 5 6 7 8

On 3/1/06 if the actual 184 days

rate is 4% there is no 184
payment. €5,000,000 × (0.04 – AR) ×
360
If on 1/3/06 the AR > 4%
the seller pays the buyer. 184
1 + 0.04 ×
360
If on 1/3/06 the AR < 4% the buyer pays the seller.

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 Euro notes

• E 85
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 Euro-Medium-Term Notes

• T 86
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 Eurocommercial Paper

• U 87
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 International Debt Crisis

• S 88
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 International Debt Crisis

• L 89
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 Debt-for-Equity Swaps

• As part of debt rescheduling agreements among the bank

lending syndicates and the debtor nations, creditor banks
would sell their loans for U.S. dollars at discounts from face
value to MNCs desiring to make equity investment in
subsidiaries or local firms in the Less developed countries
(LDCs)
• An LDC central bank would buy the bank debt from a MNC at
a smaller discount than the MNC paid, but in local currency
• The MNC would use the local currency to make pre-
approved new investment in the LDC that was economically
or socially beneficial to the LDC

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 Debt-for-Equity Swap Illustration

International
Bank
Sell $100m
$60m LDC debt at
$80m in
LDC firm or Equity Investor 60% of face
local
MNC currency or MNC
subsidiary $80m in local Redeem LDC
currency debt at 80% of
LDC Central face in local
Bank currency
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 Japanese Banking Crisis

• T 92
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 Japanese Banking Crisis

• The collapse of the Japanese stock market set in motion a

downward spiral for the entire Japanese economy and in
particular Japanese banks
• This put in jeopardy massive amounts of bank loans to
corporations
• It is unlikely that the Japanese banking crisis will be rectified
anytime soon
 The Japanese financial system does not have a legal
infrastructure that allows for restructuring of bad bank loans
 Japanese bank managers have little incentive to change
because of the keiretsu structure

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 The Asian Crisis

• T 94
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 The Asian Crisis

• A 95
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 Credit Crunch of 2007–2008

• T 96
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 Credit Crunch of 2007–2008

• Many banks and mortgage lenders lowered their credit standards

to attract customers who could afford to make mortgage payments
at current low interest rates, or at even-lower “teaser” rates that
were temporarily set at a low level during the early years of an
adjustable-rate mortgage, but would reset to a higher rate later on
• Many of these home buyers would not have qualified for mortgage
financing under more stringent credit standards, nor would they
have been able to afford mortgage payments at more conventional
rates of interest
• These so-called subprime mortgages were typically not held by the
originating bank making the loan, but instead were resold for
packaging into mortgage-backed securities (MBS)
 Between 2001 and 2006, the value of subprime mortgages
increased from $190 billion to $600 billion

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 Summary
• International Banks do everything domestic banks do and arrange
trade financing, arrange foreign exchange, offer hedging services
for foreign currency receivables and payables through forward and
option contracts, offer investment banking services (where
allowed)
• Rationale for international banking includes knowledge Advantage,
Home Nation Information Services, Prestige, Regulatory Advantage,
Wholesale Defensive Strategy, Retail Defensive Strategy,
Transactions Costs, circumvention of government currency controls
• Shell branches need to be nothing more than a post office box. The
actual business is done by the parent bank at the parent bank. The
purpose was to allow U.S. banks to compete internationally without
the expense of setting up operations “for real”
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University
University
ofof
Applied
Applied
Sciences
Sciences
 Summary
• A Forward rate agreement (FRA) is an interbank contract that
involves two parties, a buyer and a seller where the buyer agrees to
pay the seller the increased interest cost on a notational amount if
interest rates fall below an agreed rate and the seller agrees to pay
the buyer the increased interest cost if interest rates increase above
the agreed rate
• As part of debt rescheduling agreements among the bank lending
syndicates and the debtor nations, creditor banks would sell their
loans for U.S. dollars at discounts from face value to MNCs desiring
to make equity investment in subsidiaries or local firms in the LDCs
• Some important crises discussed include the Japanese Banking
crisis, Asian currency crisis and the financial crisis of 2007-2008

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University
University
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Applied
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Sciences
 Topic 3 – Structure of Foreign Exchange Market

Session Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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 Topic Objectives
The Structure of Foreign exchange markets

At the end of this Topic , students will be able to:

 Discuss the structure of Balance of Payments
 Identify the roles of the International Monetary Fund (IMF)
 Explain the concept of the “Impossible Trinity”

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 Balance of Payments

Balance of Payment systematically records the economic

transactions between the residents and the residents of the
rest of the world during a given period of time usually a year

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 Need for Balance of Payment

For Government: The BOP provides valuable information for the

conduct of economic and fiscal policy

For Firms and Individuals: It provides clues about expectations for

such matters as the volume of trade and capital flows ,the movement
of exchange rate and the profitable course of economic policy

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 Balance of Payments Accounting

The Balance of Payments is the statistical record of a

country’s international transactions over a certain period
of time presented in the form of double-entry
bookkeeping

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 Balance of Payments Accounts

The balance of payments accounts are those that record all

transactions between the residents of a country and residents of all
foreign nations
They are composed of the following:
 The Current Account
 The Capital Account
 Financial Account
 The Official Reserves Account
 Statistical Discrepancy

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 The Current Account

Includes all imports and exports of goods and services

Includes unilateral transfers of foreign aid
If the debits exceed the credits, then a country is running a trade
deficit
If the credits exceed the debits, then a country is running a trade
surplus

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 India Current Account Deficit as Percent of GDP
Source: World Bank Data

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 The Financial Account

The capital account measures the difference between India sales of

assets to foreigners and Indian purchases of foreign assets
In 2012, India. had Rs 3,190 billion in financial account
The capital account is composed of Foreign Direct Investment (FDI),
portfolio investments and other investments

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 India BOP data

Source: RBI Website

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 BOP Accounts

Current Account (1.A+1.B+1.C)

1.A Goods and Services (1.A.a+1.A.b)
1.A.a Goods (1.A.a.1 to 1.A.a.3)
1.A.b Services (1.A.b.1 to 1.A.b.13)

1.B Primary Income (1.B.1to1.B.3)

1.B.1 Compensation of employees
1.B.2 Investment income
1.B.3 Other primary income

1.C Secondary Income (1.C.1+1.C.2)

1.C.1 Financial corporations, nonfinancial corporations, households, and NPISH*s
1.C.2 General Governments

* Non profit institutions serving households

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 BOP Accounts
2 Capital Account (2.1+2.2)
2.1 Gross acquisitions (DR.)/disposals (CR.) of non-produced nonfinancial assets
2.2 Capital transfers

3 Financial Account (3.1 to 3.5)

3.1 Direct Investment (3.1A+3.1B)
3.1.A Direct Investment in India
3.1.B Direct Investment by India

3.2 Portfolio Investment

3.2A Portfolio Invesment in India
3.2.B Portfolio Investment by India
3.3 Financial derivatives (other than reserves) and employee stock options
3.4 Other investment
3.5 Reserve assets

4 Net errors and omissions

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 The Official Reserves Account

Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF

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 Errors and Omissions – Statistical Discrepancy

There’s likely going to be some omissions and mis-recorded

transactions - so there is a use of a “plug” figure to get things to
balance

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 The Balance of Payments Identity

BCA + BKA + BRA = 0

where
BCA = balance on current account
BKA = balance on Financial and Capital account
BRA = balance on the reserves account
Under a pure flexible exchange rate regime,
BCA + BKA = 0

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 The Importance of BOP Statistics

• May have immediate impact on the exchange rate

owing to supply-demand changes in currency
• Example: A country facing CA deficit can increase
interest rates to attract foreign capital . Or it can tighten
Money supply so that domestic currency may not leave
local shores. Or it can force exporters to bring capital
back home

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 U.S. Balance of Payments Data

  Credits Debits
During the same year, the U.S.
Current Account     attracted net investment of
1 Exports $1,167.61   $264.58 billion—clearly the
2 Imports   ($1,295.53)
rest of the world found the U.S.
to be a good place to invest
3 Unilateral Transfers $6.13 ($45.01)
Balance on Current Account
(Assume no transactions in
  ($166.80)
Financial Account    
Capital Account).
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Financial Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)

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 U.S. Balance of Payments Data

  Credits Debits Under a pure flexible

Current Account     exchange rate regime,
1 Exports $1,167.61   these numbers would
2 Imports   ($1,295.53) balance each other
3 Unilateral Transfers $6.13 ($45.01) out.
  Balance on Current Account ($166.80)
Financial Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Financial Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)

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 U.S. Balance of Payments Data

  Credits Debits In the real world,

Current Account     there is a statistical
1 Exports $1,167.61   discrepancy.
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Financial Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Financial Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)

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 U.S. Balance of Payments Data

  Credits Debits
Current Account     Including that, the
1 Exports $1,167.61   balance of payments
2 Imports   ($1,295.53) identity should hold:
3 Unilateral Transfers $6.13 ($45.01) BCA + BKA = - BRA
  Balance on Current Account ($166.80)
Financial Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2)
  Balance on Financal Account $264.58  
7 Statistical Discrepancies   ($96.76)
  Overall Balance $1.02  
Official Reserve Account ($1.02)

($166.80) + $264.58 + ($96.76) = $1.02= –($1.02)

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 Balance of Payments and the Exchange Rate

  Credits Debits
Current Account    
1 Exports $1,167.61   P S
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Financial Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2) D
  Balance on Financial Account $264.58  
7 Statistical Discrepancies   ($96.76)
Overall Balance Q
  $1.02  
Official Reserve Account ($1.02) Exchange rate $

As U.S. citizens export, others demand dollars at the FOREX market.

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 Balance of Payments and the Exchange Rate

  Credits Debits
Current Account    
1 Exports $1,167.61   P S
S1
2 Imports   ($1,295.53)
3 Unilateral Transfers $6.13 ($45.01)
  Balance on Current Account ($166.80)
Financial Account    
4 Direct Investment $107.93 ($119.44)
5 Portfolio Investment $387.62 ($79.28)
6 Other Investments $194.95 ($227.2) D
  Balance on Financial Account $264.58  
7 Statistical Discrepancies   ($96.76)
Overall Balance Q
  $1.02  
Official Reserve Account ($1.02) Exchange rate $

As the U.S. government sells dollars, the supply of dollars increases.

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 Balance of Payments Trends

• Since 1982 the U.S. has experienced continuous deficits on

the current account and continuous surpluses on the capital
account
• During the same period, Japan has experienced the
opposite

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 Balance of Payments Trends

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 Balance of Payments Trends

• India traditionally has had current account deficits

• Capital and financial account surplus helps in balancing
• Reserves help to a certain extent
• What matters is the nature and causes of the disequilibrium

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 Balance of Payments Trends

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 The Impossible Trinity

Free Capital Flow

Fixed Exchange Rate Sovereign monetary policy

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 The Role of the IMF
 IMF maintained exchange rate
 Discipline
• National governments had to manage inflation through their
money supply
 Flexibility
• Provides loans to help members states with temporary balance-of-
payment deficit;
 Allows time to bring down inflation
 Relieves pressures to devalue
• Excessive drawing from IMF funds came with IMF supervision of
monetary and fiscal policies
 Allowed to 10% devaluations and more with IMF approval
 188 member countries as on date

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 Purposes of IMF
Articles of Agreement of the IMF
i. Promote international monetary cooperation
ii. Expansion and balanced growth of international trade
iii. Promote exchange rate stability

iv. Help establish multilateral system of payments and eliminate foreign

exchange restrictions

v. Make resources of the Fund available to members

vi. Shorten the duration and lessen the degree of disequilibrium in

international balances of payments

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 Where IMF gets money

• Most comes from the quota subscriptions

 The money each member contributes when joining
the IMF

• General Arrangements to Borrow (1962)

 Line of credit set up with several governments and
banks throughout the world

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 Special Drawing Right (SDRs)

• SDR is an invented currency

 Its value is based on the worth of the world’s major
currencies US Dollar, Pound Sterling, Japanese Yen,
Euro
• Countries add SDRs to their holdings of foreign
currencies
 Keep available for need of payments that must be
made in foreign exchange

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 Organization of IMF
• Board of Governors
 Each member country appoints one Governor and
Alternate Governor
 Meets with IMF Board yearly
• Executive Board
 24 Executive Directors which are representatives for the
members, holds policy meetings thrice a week
• Managing Director
 Chairman of the Executive Board, usually a European,
heads the IMF staff

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 Power among the IMF members

• Size of the quotas determine voting power

• IMF decides on the quota for each member
 Richer countries have larger quota
• US having largest economy provides 17% of the total
quota (about $122 billion)
 US has largest voting power (17% or 26,5000)
 India has 2.4% of the quota

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 How much money a member can borrow from the IMF

• 25% of the country’s quota may be used

• If this is not sufficient, then members can borrow up to 3

times the amount of its quota
 Present plans for reform to Executive Directors

• If these plans are sufficient for the Executive Directors, the

IMF grants the member a loan

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 When is a country in need ?

• A country that had not taken in enough foreign currency

to pay the other countries for what they have bought
 Spends more money than it takes in
• IMF will lend foreign exchange to that member
 Hoping to stabilize its currency which will strengthen its trade

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 Summary
• Balance of Payment systematically records the economic
transactions between the residents and the residents of the
rest of the world during a given period of time usually a year
• Current Account includes all imports and exports of goods
and services, unilateral transfers of foreign aid
• The capital account measures the difference between India
sales of assets to foreigners and Indian purchases of foreign
assets
• Balance of payment identity states that BCA + BKA + BRA = 0
• Not possible to simultaneously achieve Free Capital Flow,
Sovereign monetary policy Fixed Exchange Rate

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 Topic 5 – Exchange Rate Determination

Session Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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 Topic Objectives
Exchange Rate Determination

At the end of this topic, students will be able to:

 Explain Structural Models of Exchange Rate Determination
 Describe the Fischer effect and its influence on exchange rates
 Discuss Interest Rate Parity (IRP) and Purchasing Power Parity
(PPP)

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 Structural Models of Exchange Rate Determination

SUPPLY AND DEMAND MODEL (FLOW MODEL)

 Demand originates in home country citizens wanting to
purchase foreign goods and services
 Residents of home country wishing to acquire assets,
both real and financial, denominated in the foreign
currency and wishing to service foreign currency liabilities
incurred earlier
 Central banks intervening in the foreign exchange market
to buy the foreign currency because the home currency is
over valued
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 Mundell Fleming Model (Flow model)

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 Structural Models of Exchange Rate Determination

CURRENT ACCOUNT MONETARY MODEL (ASSET MARKET MODEL)

S = k + (ma – mb) - φ (ya – yb ) + λ(ia – ib )

 If ma rises then A’s citizens want to get rid of excess money stock and buy foreign
assets and hence A’s currency depreciates and foreign currency appreciates. This in
turn raises foreign goods prices and thus increases prices at home to restore PPP
 An increase in ia depreciates the A currency. In the monetary model the nominal
interest rate (given ib ) can only rise when the expected depreciation of A rises
 General empirical testing of the model has yielded dismal results
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 Structural Models of Exchange Rate Determination

CAPITAL ACCOUNT MONETARY MODEL (ASSET MARKET MODEL)

^ ^ ^ ^
S = (ma – mb) -θφ (ya – yb ) -αλ(ia – ib )+β(πae - πbe )

 If ma rises then A’s citizens want to get rid of excess money stock and buy foreign
assets and hence A’s currency depreciates and foreign currency appreciates. This in
turn raises foreign goods prices and thus increases prices at home to restore PPP
 The counter-intuitive effect of the interest rate effect in the current account model
has been removed and the negative effect of interest rate now appears
 These are long run conditions as opposed to current account model which
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 Expectations, EMH and the Role of News
 Recall EMH from Portfolio Management
 Current exchange rate reflects all past information
 New information will cause immediate jumps to the exchange rate
 The exchange rate fluctuation can be broken down into two
components Expected change and Unexpected change
 Expected change consists of a discounted sum of expected changes in
the fundamentals
 Unexpected change is due to the changes in expectations about the
future value of the fundamentals
 Regress to get St+1= A1 + A2Ft,t+1+ ut and test the hypothesis for A1 and to
be zero and A2 to be 1 if forward rate is unbiased

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 Expectations, EMH and the Role of News

The departure of Forward rate from future spot rate

happens because of several reasons:
 Expectation is a theory and has been proven wrong on many occasions
 Time taken by market to absorb news
 Speculations by traders
 Market intervention by Central Banks (increases volatility)

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 Structural Models of Exchange Rate Determination

PORTFOLIO BALANCE MODEL (ASSET MARKET MODEL)

 Earlier two models assumed money was the only asset
 However, Domestic and foreign bonds may also be traded by the investor
 Problem starts to look like an asset diversification one
 Basic rule that an asset’s supply changes influence the return on that asset
 If UK Central Bank issues fresh bonds, then interest rate in UK should rise. In the short
run the pound should weaken against the dollar (Current account monetary model)
 Once the pound weakens investors would move bonds from UK to US
 This portfolio rebalancing will cause interest rates to rise in UK and fall in US
 In the long run, investors will be attracted to higher interest rates in UK and lower
interest rate in US and portfolio allocation will be restored (Capital Account model)
 Empirical verification of this model has not been satisfactory

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 Exchange Rate Determinants

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 Short-Run Determinants

 Generally dependent on bandwagon effects, over-reaction to news,

speculation, technical analysis
 Trend following Behaviour is the tendency for the market to follow
a trend. Increase in exchange rate is likely to be followed by
another increase
 Investor Sentiment is based on the consensus of the market. A
bullish market on the dollar is likely to strengthen it against other
currencies
 Order Flow : There is evidence of positive correlation between
exchange rate movements and order flows in the inter-dealer
market and with movements in customer – order flow

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 Long-Run Determinants

 Purchasing Power Parity or PPP [Price Ratio] and Relative PPP

[Difference in Inflation rates ]
 Structural Changes
 Investment Spending : increased investment will help strengthen the
currency
 Fiscal Stimulus : Government Spending can help strengthen a country’s
currency
 Private Savings: Japan’s savings rate has helped the country’s currency
strengthen
 Terms of Trade
 The price of a good that trades in international markets will have an impact
of the associated country’s currency e.g. oil prices can impact the Venezuelan
Bolivar
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 Medium Run Determinants (MRD)

• International Parity Conditions

• Current Account Trends
• Capital Flows
• Monetary Policy
• Fiscal Policy
• Economic Growth
• Central Bank Interventions

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 MRD - International Parity Conditions
Interest Rate Parity (IRP)

Market forces cause the forward rate to differ from the

spot rate by an amount that is sufficient to offset the
interest rate differential between the two currencies
Then, covered interest arbitrage is no longer feasible, and
the equilibrium state achieved is referred to as Interest
Rate Parity (IRP)

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 MRD - International Parity Conditions

Interpretation of IRP

• When IRP exists, it does not mean that both local and foreign
investors will earn the same returns
• What it means is that investors cannot use covered interest
arbitrage to achieve higher returns than those achievable in their
respective home countries

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 MRD - International Parity Conditions

An illustration:
• Assume that you are in UK and need dollars in three months.
Realistically, you can do one of the following
 Buy a 90 day dollar forward today, Keep the money in GBP
deposit and convert after 90 days
 Buy dollars today, invest in a dollar fixed deposit maturing in
90 days

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 MRD - International Parity Conditions
Covered Interest Parity Theorem
• In Theory there should be no difference between two currencies
or else we could benefit from Covered Interest Arbitrage
 S is the GBP/USD spot rate
 Fn is the GBP/USD forward rate for n-year
 iGBP is the Annualized interest rate on sterling deposits of
maturity for n years
 iUSD is the Annualized interest rate on Eurodollar deposits of
maturity for n years

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 MRD - International Parity Conditions
Covered Interest Parity Theorem
Two clear choices
i. Invest in GBP for n years which will give (1+n iGBP ) in n years
ii. Convert at S now, get S USD now, invest in Eurodollar, get (1+n
iUSD ) in n years, and convert back into GBP after n years at the Fn
rate
There should be no difference between the two therefore

(1+n iGBP ) = (S) x (1+n iUSD ) x (1/Fn)

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 MRD- International Parity Conditions
Covered Interest Parity Theorem

If we assume that
(1+n iGBP ) > (S) x (1+n iUSD ) x (1/Fn)
The following would result
Assume for a moment
If LHS exceeds RHS i. Upward pressure on iUSD
i. Investors would borrow ii. Depreciation of dollar so S
dollars would increase
ii. Convert to GBP iii. Downward pressure on iGBP
iii. Invest in GBP iv. Rising demand for USD
iv. Enter into Fn contract forward implies Fn will fall
v. Till… RHS = LHS
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 MRD- International Parity Conditions
Covered Interest Parity Theorem

Therefore in the absence of restriction on capital

flows and transaction costs

(1+n iA )/(1+n iB ) = Fn /S

Using approximation, when niB is small enough

(n iA - n iB ) = (Fn - S)/S
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 MRD - International Parity Conditions
An example on Covered Interest Parity
Assume
S USD/Pound = 1.5000
F6 month USD/Pound = 1.4625
i USD = 1.50% and i Pound = 4.00 %

Parity condition requires

(1 + i Pound)/(1 + i USD ) = F USD/Pound /S USD/Pound
Þ F USD/Pound = S USD/Pound x (1 + i USD )/ (1 + iPound )
Þ F USD/Pound = 1.5000 x (1.0075/1.02) = 1.4816
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 MRD- International Parity Conditions
An example on Covered Interest Parity
Since the F6 month USD/Pound = 1.4625 < 1.4816
We should borrow in Pounds, convert now to USD, invest in
i USD enter into Forward contract, pay interest in i Pound and
convert back to USD

i) Borrow 1 million Pound, convert to USD

ii) Invest 1.5 million USD and get 1.0075 x 1.5 million = 1.51125 USD
iii) Convert it back to USD at the attractive rate of 1.4625 at the end of 6 months to get 1.033
million Pound
iv) Pay principal and interest back to British Bank of 1.02 million Pound
v) Pocket the difference of .0133 million Pounds!

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 MRD- International Parity Conditions
An example on Covered Interest Arbitrage
Eurodollar rate = 8.00 % per annum
Start End
$1,000,000 x 1.04 $1,040,000 Arbitrage
$1,044,638 Potential
Dollar money market

S =¥ 106.00/$ 180 days F180 = ¥ 103.50/$

Yen money market

.
¥ 106,000,000 . x 1.02 ¥ 108,120,000

Euroyen rate = 4.00 % per annum

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 Uncovered Interest Parity

(1+n iA )/(1+n iB )= [Sen (B/A ) /S(B/A )]

(n iA- niB )= [Sen (B/A ) - S(B/A )]/S(B/A )

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 MRD - International Parity Conditions
An example on Uncovered Interest Arbitrage
Investors borrow yen at 0.40% per annum
Start End
¥ 10,000,000 x 1.004 ¥ 10,040,000 Repay
¥ 10,500,000 Earn
Japanese yen money market ¥ 460,000 Profit

S =¥ 120.00/$ 360 days S360 = ¥ 120.00/$

US dollar money market

$ 83,333,333 x 1.05 $ 87,500,000

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 MRD : PPP Intro

S = PH/PF

[1 + (∆S/S)] = (1+πF)/(1+ πH)

Using Approximation,
(∆S/S) = (πF- πH)/(1+πH) = πF - πH

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 MRD - International Parity Conditions
Purchasing Power Parity and Exchange Rate Determination

When one country’s inflation rate rises relative to that of

another country, decreased exports and increased imports
depress the country’s currency
The theory of purchasing power parity (PPP) attempts to
quantify this inflation - exchange rate relationship

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 MRD - International Parity Conditions
Interpretations of PPP
• The absolute form of PPP, or the “law of one price,” suggests that
similar products in different countries should be equally priced
when measured in the same currency
• The relative form of PPP accounts for market imperfections like
transportation costs, tariffs, and quotas. It states that the rate of
price changes should be similar

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 MRD – PPP and Real Exchange Rate

Rt(B/A) = St(B/A)x PtB/PtA

Year India (A) USA (B)

CPI Rs/$ CPI
1997 100 36 100
2007 180 45 130

Rt(USD/INR) = 36 x 180/130 = 50
Thus the Rupee has shown real appreciation
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 MRD - International Parity Conditions
International Fisher Effect (IFE)
1. According to the Fisher effect, nominal risk-free interest rates contain a real rate
of return and an anticipated inflation (i = r + πe )
2. According to PPP, exchange rate movements are caused by inflation rate
differentials (∆S/S = πae - πbe )
3. Remember UIP states that (∆S/S = iae - ibe )

From 1, 2 and 3 above the Fischer Open Relation can be determined that ra = rb

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 Problem 1
Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for six
months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in
Canada. Currently, the spot exchange rate is C$1.60 per US dollar and the six-month forward
exchange rate is C$ 1.56 per US dollar. The treasurer of IBM does not wish to bear any
exchange risk. Where should he/she invest to maximize the return?

Solution: The market conditions are summarized as follows:

I$ = 4%; iC$ = 3%; S = 1.60 C$/USD; F = 1.56 C$/ USD
If $1,000,000 is invested in the U.S., the maturity value in six months will be
$1,040,000 = $1,000,000 (1 + .04).
Alternatively, $1,000,000 can be converted into C$ and invested at the Canada interest
rate, with the Canada maturity value sold forward. In this case the dollar maturity
value will be
$1,056,410 = ($1,000,000 x 1.60)(1 + .03)(1/1.56)
Clearly, it is better to invest $1,000,000 in Canada with exchange risk hedging.
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 Problem 2
While you were visiting London, you purchased a Jaguar for £35,000, payable in three months. You have enough
cash at your bank in New York City, which pays 0.35% interest per month, compounding monthly, to pay for the
car. Currently, the spot exchange rate is $1.45/£ and the three-month forward exchange rate is $1.40/£. In
London, the money market interest rate is 2.0% for a three-month investment. There are two alternative ways of
paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the
maturity value becomes equal to £35,000.
Evaluate each payment method. Which method would you prefer? Why?
Option a:
When you buy £35,000 forward, you will need $49,000 in
three months to fulfill the forward contract. The present value
 Solution: The problem situation is of $49,000 is computed as follows:
summarized as follows: $49,000/(1.0035)3 = $48,489.
A/P = £35,000 payable in three months Thus, the cost of Jaguar as of today is $48,489.
iNY = 0.35%/month, compounding monthly Option b:
iLD = 2.0% for three months The present value of £35,000 is £34,314 = £35,000/(1.02). To
buy £34,314 today, it will cost $49,755 = 34,314x1.45. Thus the
S = $1.45/£; F = $1.40/£. cost of Jaguar as of today is $49,755.
You should definitely choose to use “option a”, and save
$1,266, which is the difference between $49,755 and $48489.

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 Summary
 Central banks intervene in the foreign exchange market to buy the
foreign currency because the home currency is over valued
 In the monetary model the nominal interest rate ia (given ib ) can only
rise when the expected depreciation of A rises
 The counter-intuitive effect of the interest rate effect in the current
account model has been removed and the negative effect of interest
rate appears in the capital account model
 Departure from Expectation can occur because of
 Time taken by market to absorb news
 Speculations by traders
 Market intervention by Central Banks (increases volatility)

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 Summary

• Investor Sentiment is based on the consensus of the market. A

bullish market on the dollar is likely to strengthen it against other
currencies. This is a major short run determinant of exchange rates
• Long run determinants of exchange rates can include parity of
interest rates, difference in inflation levels of two countries and
structural elements such as policy
• Medium run determinants include International Parity Conditions,
Current Account Trends, Capital Flows, Monetary Policy, Fiscal
Policy, Economic Growth, Central Bank Interventions
• The absolute form of PPP, or the “law of one price,” suggests that
similar products in different countries should be equally priced
when measured in the same currency

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 Summary

• The relative form of PPP accounts for market imperfections like

transportation costs, tariffs, and quotas. It states that the rate of
price changes should be similar
• The Fischer open relation states that the percent change in spot
rate is equal to the difference in inflation between the two
countries
• Central Bank Intervene for reasons that Forex markets may not use
all information available, Forex markets may be dominated by trend
following traders, Excessive speculation is happening in the market

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 Topic 6 – Exchange Rate Forecast

Topic Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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 Topic Objectives
Exchange Rate Forecasting
At the end of this topic, students will be able to:
 Explain the method of Exchange Rate Forecasting
 Describe Moving average of exchange rates
 Discuss Transfer Pricing and Netting

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 Leading Indicators of Currency Crisis

 Excessive real appreciation of the emerging-market currency

 Weak domestic economic growth
 Rising unemployment
 A deteriorating current-account balance
 Excessive domestic credit expansion
 Banking-system difficulties

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 Leading Indicators of Currency Crisis

 Unsustainably large government budget deficits

 Overly expansionary monetary policies
 A high ratio of M2 money supply to reserves
 Foreign exchange reserve losses
 Falling asset prices
 A huge buildup in short-term liabilities by either the private or public
sector

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 Forecasting Exchange Rates
Fundamental Approach
 GNP, Consumption, Trade Balance, Inflation Rates, Interest Rates,
Unemployment, productivity indices, etc
 The fundamental forecasts are generally based on structural or
equilibrium models
 It is considered an Art as well as Science
 Analysts often use forecasts to issue a buy or sell rating
 Market makers use these forecasts to balance currency holdings

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 Forecasting Exchange Rates

Fundamental Approach

Start with expected value of Spot Rate

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 Forecasting Exchange Rates

Summary of Forecasting Steps using fundamentals

1. Selection of Model (PPP, IRP)

2. Collection of St Xt
3. Estimation of model, if needed (Demonstration using regression)
4. Generation of forecasts based on estimated model
5. Evaluation and refinement of model

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 Forecasting Exchange Rates
Fundamental Approach using PPP

Assume you have the following information

Spot rate is 1.9754 $/₤

Where

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 Forecasting Exchange Rates
Fundamental Approach using PPP

The fundamental value of the $ seems to be 1.9813. Since this is less than 1.9914
if we believe our model then a sell signal should be issued on the GBP

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 Forecasting Exchange Rates
Technical Approach
 It is generally based on price information
 It relies on past trends and not on fundamental analysis
 Looks for a repetition of past price trends
 It is an art, not a science
 Moving Average, Filters, Momentum indicators are the popular
techniques used in Technical Analysis

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 Forecasting Exchange Rates

Technical Approach
 Moving Average
 Main objective is to smooth the erratic daily swings of asset prices
 A Moving Average is simply an arithmetic average of previous Q data points. The
simple moving average is SMA and is given by

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 Forecasting Exchange Rates

Technical Approach

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 Forecasting Exchange Rates
Technical Approach: MVA

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 Forecasting Exchange Rates
Technical Approach: Filter Technique

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 Forecasting Exchange Rates

Fundamental Approach – Evidence from Forecasting

Services in USA
Study by Levich, 1979, New York University
Forecasting Services are more wrong than right!

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 Forecasting Exchange Rates
Technical Approach: Momentum Indicators

 Determine the strength of an asset by examining change in

velocity in the movement of asset prices
 If an asset climbs at an increasing speed, a buy signal is generated
 This method should be used with discretion because it depends
heavily on the time period chosen, filters used and method used
to calculate momentum

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 Forecasting Exchange Rates
Technical Approach: Evidence
 Proponents of EMH deride technical analysts
 EMH says that if one spotted an undervalued currency, they
would buy and that would raise its price thereby suppressing its
return
 Bilson from Illinois Institute of Technology collected data from
1975 to 1991 on the major currencies (German mark, GBP and
Japanese yen) and found that technical analysis and filters were
useful in predicting exchange rates
 Richard Sweeney (1986) says in Journal of Finance that Technical
analysis using simple filter rules has the ability to generate excess
returns during 1973 - 1980

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 Cash Management Techniques

• The following are the two major techniques which are used by
global firms in managing their cash positions:
 Netting Systems
• Bilateral and Multilateral
 Netting the cash positions of the various affiliates.
Transferring the net amounts (not the gross amounts)
 Transfer Pricing
 Establishing prices among affiliates for the intra-global firm
selling of produces and services
 Means of moving (repositioning) cash within the global firm

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 Netting Systems
• Begins with an analysis of the global firm’s internal cash flows (i.e.,
among affiliates and the parent)
 What are the amount of the payments that each entity expects
to pay and expects to receive
• Netting the above amounts is a way of reducing the amount of cash
flow (and its associated cost) within the organization
 Netting is an efficient and cost-effective mechanism for settling
interaffiliate foreign exchange transactions
• However, not all countries allow MNCs to net payments
 If this is the case, larger foreign exchange transactions flow
through the local (host country) banking system

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 Exposure Netting: an Example

Consider a U.S. MNC with three subsidiaries and the following foreign
exchange transactions:

$20
$30

$40

$35 $10
$10 $30 $40
$25
$60
$20
$30

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 Bilateral Netting: an Example
Initial: Funds to be moved = $350
With Bilateral Netting: Funds to be moved = $90
This is a reduction of $260 in foreign exchange transactions
HOW TO SIMPLIFY EVEN MORE?

$10

$20 $15
$25 $10

$10

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 Multilateral Netting: an Example

With this.
Multilateral netting: Total funds moved = $55

$15

$40

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 Government Policies and Netting

• Not all governments permit global firms to net their account:

 Who does without request:
• United States, U.K, Canada, Germany, Switzerland, Hong Kong
 Who does upon request and approval:
• Italy, the Netherlands, Belgium
 Who doesn’t:
• Spain. Austria, the Philippines
• Why: Want transactions to flow through local banking system
(generate fees for local banks)

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 Benefits of Netting

• Studies have shown the following:

 Decrease in the expenses associated with moving funds
internationally
 Decrease in the number of foreign exchange transactions (also
reduces costs)
 Reduction in intra-company float (wire transfers can take up to 5
days)
 Savings in administrative time

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 Transfer Pricing

• Refers to the prices being assigned to goods and/or services

transferred among the affiliates (including the parent) within a
global organization
 The transfer price will reposition funds (cash) within the
organization
 High transfer price transfers to selling entity!

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 Reasons for Transfer Pricing

• Reposition funds
 Out of high risk areas
• Concerns about exchange rate changes, host government policy changes
affecting funds transfers, political risk…
 Move funds (profits) into low tax rate countries
• Minimize the consolidated tax liability of the global firm

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 Government Involvement in Transfer Pricing

• Most governments monitor the use of transfer pricing by

firms within their political boundaries
 Concerned with companies attempting to escape their
“appropriate” tax liabilities
• Most governments insist that the transfer price be:
 An “arm’s-length” price, or what the selling affiliate would
charge an unrelated customer

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 Transfer Pricing in the Indian Context

• Finance Act of 2001 introduced the law of transfer pricing in India

 The law applies to an international transaction involving any
organization transferring goods or services to an affiliate
enterprise (TRP should be within 5% of ALP)
• Methods of determining ALP [Arm’s length Price]

 Comparable Uncontrolled Price Method

 Third Party Price
 Cost Plus Method

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 Transfer Pricing Methods

 Comparable uncontrolled price.

• Between affiliate and unrelated parties
 Third party price
• Similar goods/services sold in the market place
 Cost-plus price
• Appropriate profit added to the cost of production

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 Transfer Pricing: Profit Split Method

The profit split method is used to evaluate controlled

transactions to determine if the allocation of profits and losses
between the related parties were conducted at arm's length
based on the relative value of their contributions to the profit or
loss

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 Summary

• Leading indicators include Excessive real appreciation of the

emerging-market currency, Weak domestic economic growth,
rising unemployment
• Exchange rates can be forecast using fundamental technique or
using a technical approach. Either method can create its own set of
errors
• Fundamental indicators include PPP and IRP theories and use the
spot rate as the independent variable
• Technical indicators are generally based on price information, rely
on past trends and not on fundamental analysis, and look for a
repetition of past price trends
• In general, forecasting services have shown poor performance in
prediction of the exchange rate
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 Summary
• Two techniques discussed for cash management in an international
context include Netting of currencies and Transfer pricing
• Netting amounts is a way of reducing the amount of cash flow (and
its associated cost) within the organization
 Netting is an efficient and cost-effective mechanism for settling
inter-affiliate foreign exchange transactions
• Transfer pricing refers to the prices being assigned to goods and/or
services transferred among the affiliates (including the parent)
within a global organization

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 Topic 7 – Foreign Exchange Exposure

Session Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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 Topic Objectives
Foreign Exchange Exposure

At the end of this topic, students will be able to:

• Explain meaning of Currency Risk exposure
• Discuss types of Currency Risk Exposure

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 Financial Risks

• International Business Risks: Risks arising out of

fluctuations in exchange rates, interest rates and
commodity prices are pervasive that is they affect
most of the firms
• However they affect different firms in different
ways and are therefore firm specific
• Foreign exchange risk and exposure have been
central issues of international financial
management for many years

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 Foreign exchange risk and exposure

• Foreign exchange risk is related to the variability of

domestic-currency values of assets and liabilities due
to unanticipated changes in exchange rates

• Foreign exchange exposure is the amount that is at

risk

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 Types of Exposure

1. Economic (Operating) Exposure: Exchange rate

risk as applied to the firm’s competitive position

2. Transaction Exposure: Exchange rate risk as

applied to the firm’s home currency cash flows

3. Translation Exposure: Exchange rate risk as

applied to the firm’s consolidated financial statements

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 Economic (Operating) Exposure

• Changes in exchange rates can affect not only firms

that are directly engaged in international trade but
also purely domestic firms
• Exchange rate risk as applied to the firm’s
competitive position
• Any anticipated changes in the exchange rates would
have been already discounted and reflected in the
firm’s value
• Economic (operating) exposure can be defined as
the extent to which the value of the firm would be
affected by unanticipated changes in exchange rates

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 Measuring Economic (Operating) Exposure

• Economic (Operating) exposure is the sensitivity of the

future home currency value of the firm’s assets and
liabilities and the firm’s operating cash flow to random
changes in exchange rates
• There exist statistical measurements of sensitivity
 Sensitivity of the future home currency values of the firm’s
assets and liabilities to random changes in exchange rates
 Sensitivity of the firm’s operating cash flows to random
changes in exchange rates

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 Managing Economic (Operating) Exposure

Reducing Economic Exposure through Restructuring:

relocating manufacturing, modifying sourcing,
streamlining distribution
Issues Involved in the Restructuring Decision: exiting
a country not easy, especially if regulations exist for
flight of capital, Labour laws may prevent layoffs etc

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 Determinants of Economic(Operating) Exposure

The firm’s operating exposure is determined by:

The market structure of inputs and products
How competitive or how monopolistic the markets facing
the firm are and
 The firm’s ability to adjust its markets, product mix, and
sourcing in response to exchange rate changes

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 Recognizing Operating Exposure
 Volvo produces most of its cars in Sweden, but buys most of its inputs
from Germany
 The U.S. is an important export market for Volvo
 Volvo management believed that a depreciating Swedish krona versus
the $ and an appreciating Swedish krona versus the DM would be
beneficial to Volvo
 But researchers found that statistically:
 A depreciating krona relative to the Deutschemark improved
Volvo’s cash flow!

 These results reflect the fact that Volvo’s major competitors are the
German firms BMW, Mercedes and Audi

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 Conduits for Operating Exposure
 Impact of Exposure can be DIRECT or INDIRECT

Home currency (HC) strengthens HC weakens

Direct Exposure
Sales abroad Unfavourable Favourable
Source abroad Favourable Unfavourable
Profits abroad Unfavourable Favourable

Indirect Exposure
Local Competitor sources abroad and you source locally
Unfavourable Favourable

Supplier sources abroad

Favourable Unfavourable
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 How to Estimate Operating Exposure?
 Audits/Scenario Analysis: Qualitative examination of the
separate elements of a firm’s operating cash flow and
anticipating its sensitivity to real exchange rate changes

 Statistical Approach: Regress changes in firm value on

changes in exchange rates to obtain a quantitative
assessment of sensitivity
 Presumption is that changes in the value of a firm’s public
securities measures the effect of exchange rate changes. (measure
of aggregate exposure)

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 Managing Operating Exposure

 Pass Through – can the company pass the price increase on to

the customer?
 This depends on the product and the level of competition in
the market
 For low-quality goods, price competition is usually intense, so
no one company can change prices
 For high-quality goods, there may be room to increase prices
and not effect demand

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 Managing Operating Exposure
 Use of Marketing Strategies
 Market Selection
 Pricing Strategy/Product Strategy
 Promotional Strategy

 Use of Production Management

 Input mix
 Plant Location & Shifting production among plants
 Raising Productivity (i.e. lowering costs)

 Financial Hedging techniques may also be used

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 Operating Exposure Example
 Matsushita exports TVs to the US. Suppose the yen is expected to
move from ¥130/$ to ¥110/$ over the next few years. What can
Matsushita do about its currency risk?
 As yen appreciates, Matsushita becomes less competitive. Can it
increase prices in the US? Probably not as TV market is competitive
 It can keep US$ prices constant to retain market share but this will hurt
profits. Can it cut costs and become more efficient?
 Matsushita could move production to US or low-cost US$ zone
 Move to high-end TVs or other products with less price competition
 Hedge using currency derivatives
 Stop selling in US markets

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 Managing Economic (Operating) Exposure

• Selecting Low Cost Production Sites

• Flexible Sourcing Policy
• Diversification of the Market
• R&D and Product Differentiation
• Financial Hedging

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 Translation Methods

• Current/Noncurrent Method
• Monetary/Nonmonetary Method
• Temporal Method
• Current Rate Method

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 Current/Noncurrent Method
• The underlying principal is that Assets and Liabilities should be
translated based on their Maturity
 Current Assets translated at the spot rate
 Non-Current Assets translated at the historical rate in effect when the
item was first recorded on the books
 Translation Gains/Losses are passed through income statement as
foreign exchange gain (loss) thus impacting Retained Earnings
• This method of foreign currency translation was generally accepted in the
United States from the 1930s until 1975, at which time FASB 8 became
effective

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 Current/Noncurrent Method
Balance Sheet Local Current/
• Current assets Currency Noncurrent
translated at the spot AUD
rate Cash 2,100 £1,050.00
e.g. AUD 2= £1 Inventory 1,500 £750.00
• Noncurrent assets Net fixed assets 3,000 £1,000.00
translated at the Total Assets 6,600 £2,800.00
historical rate in effect Current liabilities 1,200 £600.00
when the item was Long-Term debt 1,800 £600.00
first recorded on the Common stock 2,700 £900.00
books Retained earnings 900 £700.00
e.g. AUD 3= £ 1 CTA -------- --------
Total Liabilities and 6,600 £2,800.00
Equity
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 Monetary/Nonmonetary Method

• The underlying principle is that monetary accounts have a

similarity because their value represents a sum of money
whose value changes as the exchange rate changes
• All monetary balance sheet accounts (cash, marketable
securities, accounts receivable, etc.) of a foreign subsidiary
are translated at the current exchange rate
• All other (nonmonetary) balance sheet accounts (owners’
equity, land) are translated at the historical exchange rate
in effect when the account was first recorded

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 Monetary/Nonmonetary Method
• All monetary balance Balance Sheet Local Monetary/
sheet accounts are Currency Nonmonetary
translated at the AUD
current exchange Cash 2,100 £1,050.00
rate. e.g. AUD 2= £ 1 Inventory 1,500 £500.00
• All other balance Net fixed assets 3,000 £1,000.00
sheet accounts are Total Assets 6,600 £2,550.00
translated at the Current liabilities 1,200 £600.00
historical exchange Long-Term debt 1,800 £600.00
rate in effect when Common stock 2,700 £900.00
the account was first Retained earnings 900 £450.00
recorded. [Link] 3= CTA -------- --------
£1 Total Liabilities and 6,600 £2,550.00
Equity

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 Temporal Method

• The underlying principal is that assets and liabilities

should be translated based on how they are carried on
the firm’s books
• Balance sheet account are translated at the current spot
exchange rate if they are carried on the books at their
current value
• Items that are carried on the books at historical costs are
translated at the historical exchange rates in effect at the
time the firm placed the item on the books

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 Temporal Method
Balance Sheet Local Temporal
• Items carried on the
Currency
books at their
AUD
current value are
translated at the Cash 2,100 $1,050.00
spot exchange rate Inventory 1,500 $900.00
e.g. AUD 2= £ 1 Net fixed assets 3,000 $1,000.00
• Items that are Total Assets 6,600 $2,950.00
carried on the books Current liabilities 1,200 $600.00
at historical costs are Long-Term debt 1,800 $900.00
translated at the Common stock 2,700 $900.00
historical exchange Retained earnings 900 $550.00
rates CTA -------- --------
e.g. AUD 3= £ 1 Total Liabilities and 6,600 $2,950.00
Equity

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 Income statement Accounting

Current/Non- Monetary/Non Temporal Current Rate

Current -Monetary

Sales Average Average Average Average

COGS Average Historic Average Average

Depreciation Historic Historic Historic Average

Foreign Non Zero Non Zero Non Zero Zero

Exchange Gain
or Loss
Retained Adjusted Adjusted Adjusted Not Adjusted
Earnings

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 Balance Sheet Accounting
Current/Non- Monetary/Non- Temporal Current Rate
Current Monetary
Cash Current Current Current Current
Inventory Current Historic Current/Historic Current
Receivable Current Current Current/Historic Current
Net Fixed Assets Historic Historic Current/Historic Current
Current Liabilities Current Current Current Current
Long Term Debt Historic Current Current/Historic Current
Retained earnings Calculated & Calculated & Calculated & Calculated &
Adjusted Adjusted Adjusted Not Adjusted
Stock Holder’s Historic Historic Historic Historic
Equity
Cumulative Zero Zero Zero Plug
Translation
Adjustment (CTA)

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 Current Rate Method

• All balance sheet items (except for stockholder’s equity)

are translated at the current exchange rate
• Very simple method in application
• A “plug” equity account named cumulative translation
adjustment is used to make the balance sheet balance

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 Current Rate Method
• All balance sheet Balance Sheet Local Current
items (except for Currency Rate
stockholder’s equity) DM
are translated at the Cash 2,100.00 $1,050
current exchange Inventory 1,500.00 $750
rate Net fixed assets 3,000.00 $1,500
• A “plug” equity Total Assets 6,600.00 $3,300
account named Current liabilities 1,200.00 $600
cumulative Long-Term debt 1,800.00 $900
translation Common stock 2,700.00 $900
adjustment is used to Retained earnings 900.00 $360
make the balance CTA -------- $540
sheet balance Total Liabilities 6,600.00 $3,300
and Equity

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 FASB Statement 8

• Essentially the temporal method, with some subtleties

 Such as translating inventory at historical rates, which is a
problem
• Requires taking foreign exchange gains and losses through
the income statement
• This leads to variability in reported earnings
• Which leads to irritated corporate executives

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 FASB Statement 52

• The Mechanics of the FASB 52 Translation Process

 Function Currency
 Reporting Currency
• Highly Inflationary Economies

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 Management of Translation Exposure

Translation Exposure vs. Transaction Exposure

Hedging Translation Exposure
 Balance Sheet Hedge
 Derivatives Hedge
Translation Exposure vs. Operating Exposure

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 Transaction Exposure

• Transaction exposure exists when the future cash transactions of

a firm are affected by exchange rate fluctuations.
• When transaction exposure exists, the firm faces three major
tasks:
 Identify its degree of transaction exposure
 Decide whether to hedge its exposure
and
 Choose among the available hedging techniques if it decides
on hedging

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 Identifying Net Transaction Exposure

Centralized Approach - A centralized group consolidates

subsidiary reports to identify, for the MNC as a whole, the
expected net positions in each foreign currency for the
upcoming period(s)
Note that sometimes, a firm may be able to reduce its
transaction exposure by pricing some of its exports in the
same currency as that needed to pay for its imports (if
customer accepts)

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 Recognizing Transaction Exposure
 Aspen Skiing Company owns and operates ski resorts in
Colorado
• Uses only American labour and materials
• Nonetheless, hurt by a strong dollar that made
American skiers opt for the French Alps or the
Canadian Rockies, and foreign skiers stay at home
 So, even a domestic firm with zero transaction exposure to
exchange rates can be vulnerable to exchange rate risk

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 Techniques to Eliminate Transaction Exposure

• H 236
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 Techniques to Eliminate Transaction Exposure

• A 237
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 Techniques to Eliminate Transaction Exposure

• A 238
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 Techniques to Eliminate Transaction Exposure

• A 239
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 Techniques to Eliminate Transaction Exposure

R 240
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 Techniques to Eliminate Transaction Exposure

• If the real cost of hedging is negative, then hedging is more

favorable than not hedging and if real cost of hedging is positive
then not hedging is better
• To compute the expected value of the real cost of hedging, first
develop a probability distribution for the future spot rate, and
then use it to develop a probability distribution for the real cost
of hedging

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 Techniques to Eliminate Transaction Exposure

• If the forward rate is an accurate predictor of the future spot rate,

the real cost of hedging will be zero
• If the forward rate is an unbiased predictor of the future spot
rate, the real cost of hedging will be zero on average

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 Techniques to Eliminate Transaction Exposure

• A 243
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 Techniques to Eliminate Transaction Exposure using
Money Market
A US firm needs to pay NZ$1,000,000 in 30 days.

Borrows at 8.40%
for 30 days
1. Borrows 3. Pays $651,293
$646,766

Effective
Exchange at exchange rate
$0.6500/NZ$ $0.6513/NZ$

Lends at 6.00% for 30 days

2. Holds NZ$995,025 3. Receives NZ$1,000,000

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 Techniques to Eliminate Transaction Exposure using
Money Market
A US firm expects to receive S $400,000 in 90 days.

Borrows at 8.00%
for 90 days
1. Borrows 3. Pays S$400,000
S$392,157

Effective
Exchange at exchange rate
$0.5500/S$ $0.5489/S$

Lends at 7.20% for 90 days

2. Holds $215,686 3. Receives $219,568

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 Techniques to Eliminate Transaction Exposure

• Note that taking just one money market position may be

sufficient.
 A firm that has excess cash need not borrow in the home
currency when hedging payables
 Similarly, a firm that is in need of cash need not invest in the
home currency money market when hedging receivables

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 Techniques to Eliminate Transaction Exposure

• If interest rate parity (IRP) holds, and transaction costs do not

exist, a money market hedge will yield the same result as a
forward hedge
• This is so because the forward premium on a forward rate reflects
the interest rate differential between the two currencies

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 Summary

• Foreign exchange risk is related to the variability of domestic-

currency values of assets and liabilities due to unanticipated
changes in exchange rates
• Economic (operating) exposure can be defined as the extent to
which the value of the firm would be affected by unanticipated
changes in exchange rates
• Economic exposure can be direct (based on our receivables or
payables) or indirect, based on competitor and supplier strategies
• Economic exposure can be measured using audits and regression
analysis
• Freedom to increase price to pass on economic exposure to the
customer depends on the nature of product or service and also on
intensity of competition
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 Summary
 It is useful to hedge when the real cost of hedging is negative and
useless to hedge when the real cost of hedging is negative.
However calculating these costs can only be done using probability
• Translation methods include Current/Noncurrent Method,
Monetary/Nonmonetary Method, Temporal Method and Current
Rate Method
 A money market hedge involves taking one or more money market
position to cover a transaction exposure

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 Topic 8 – Options, Futures and Forwards

Session Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Topic Objectives
Options, Futures and Forwards

At the end of this topic, students will be able to:

 Discuss the construct of an options contract and its payoff
 Explain the use of a forward and the associated payoff
 Describe the use of a futures contract in the context of foreign
exchange transactions
 Illustrate the use of a currency swap

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 Recognizing Transaction Exposure
 Aspen Skiing Company owns and operates ski resorts in
Colorado
• Uses only American labour and materials
• Nonetheless, hurt by a strong dollar that made
American skiers opt for the French Alps or the
Canadian Rockies, and foreign skiers stay at home
 So, even a domestic firm with zero transaction exposure to
exchange rates can be vulnerable to exchange rate risk

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 Techniques to Eliminate Transaction Exposure

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 Techniques to Eliminate Transaction Exposure

Hedging Payables Hedging Receivables

Futures Purchase currencySell currency
hedgefutures contract(s) futures contract(s)
Forward Negotiate forwardNegotiate forward
hedge contract to buy contract to sell
foreign currency foreign currency
Money Borrow local Borrow foreign
market currency. Convert currency. Convert
hedgeto and then invest to and then invest
in foreign currency in local currency
Currency Purchase currencyPurchase currency
option call option(s) put option(s)

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 Techniques to Eliminate Transaction Exposure

• A comparison of hedging techniques should focus on minimizing

payables, or maximizing receivables
• Note that the cash flows associated with currency option hedging and
remaining unhedged cannot be determined with certainty

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 Techniques to Eliminate Transaction Exposure

• In general, hedging policies vary with the MNC management’s degree of

risk aversion and exchange rate forecasts
• The hedging policy of an MNC may be to hedge most of its exposure, none
of its exposure, or to selectively hedge its exposure

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 Transaction Exposure elimination: Example on Hedging
 Assume Boeing is expected to receive 10m GBP (£) in one
years time.
 Available information:
 one-year forward rate: US$1.46/£
 spot rate: US$1.50/£
 put option on pounds expires in one year with strike of
US$1.46 and premium of US$0.02
 interest rates:
US: 6.10% per annum
UK: 9.00% per annum

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 Boeing’s Forward Hedge
 Forward Hedge: By selling GBP forward, Boeing locks in the
US$ receivable at $14.6m (£10m * $1.46/£)

Unhedged position

$14.6m
Forward Hedge

ST
F = $1.46 $/₤

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 Transaction Exposure elimination: Buy Put option
 Options Hedge: Has the right to sell £ @ $1.46/GBP – will
receive $14.6m if exercised.
 Note: A premium of $200,000 (£10m * $0.02) was paid up-front. We
need to take into account time-value of money. Therefore, the upfront
cost is $212,000 ($200,000 * 1.061) after one year.

Buy Put Option

Un Hedged Position

$14.6m Forward Hedge

$14.38m Put Option

X = $1.46 ST* = $1.48

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 Transaction exposure elimination:
Futures Introduction
• Futures are derivative contracts , used for speculation and hedging
• Is standardized and exchange-traded
• Standardization is through contract size and maturity date
• Futures are settled-up or marked-to-market on a daily basis
• A buyer of a futures contract has a positive settlement for a day if the day’s
closing price exceeds the previous day closing price
• An initial margin (generally about 2 percent) must be deposited into a
collateral account to establish a futures position
• Before maturity if the margin drops to below 75 percent of initial margin
then variation margin must be added to bring it up to maintenance margin
• A reversing trade can be made in a future (or forward) to close out or
neutralize a position

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 Transaction exposure elimination:
Futures Introduction
• The commission that buyers pay to transact in futures is a single amount is a
single amount which pays for the round-trip of initiating and closing
positions
• The clearinghouse serves as a third party to all transactions. The clearing
house is made up of clearing members, Brokers who are not clearing
members work through these clearing members
• Frequently, futures exchange may have a daily price limit. (Trading is halted
when this price limit is reached

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 Currency Futures Illustration
Spot rate = .
6200
Long position
implies profit
of .0136
USD/CDN x
CDN 100,000
= 1,360 USD,
while Short
position
implies –
1,360 USD

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 Transaction exposure elimination:
Futures vs Forwards

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 Limitations of Hedging

• S 264
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 Limitations of Hedging

• I 265
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 Hedging Long-Term
Transaction Exposure

• M 266
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 Hedging Long-Term
Transaction Exposure

• L 267
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 Hedging Long-Term
Transaction Exposure
• A Parallel loan, or back-to-back loan, involves an exchange of
currencies between two parties, with a promise to re-exchange
the currencies at a specified exchange rate and future date

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 Alternative Hedging Techniques

• S 269
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 Alternative Hedging Techniques

• T 270
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 Alternative Hedging Techniques

• W 271
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 Alternative Hedging Techniques

• W 272
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 Exposure Netting

• M 273
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 Should the Firm Hedge?

• N 274
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 Should the Firm Hedge?

• I 275
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 Should the Firm Hedge?

• T 276
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 What Risk Management Products do Firms Use?

• M 277
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 What is a SWAP?

A swap is an agreement between counter-parties to exchange cash

flows at specified future times according to pre-specified conditions

A swap is equivalent to a coupon-bearing asset plus a coupon-bearing

liability. The coupons might be fixed or floating

A swap is equivalent to a portfolio, or strip, of forward contracts--

each with a different maturity date, and each with the same forward
price

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 Currency Swaps

• There are four types of basic currency swaps:

 fixed for fixed
 fixed for floating
 floating for fixed
 floating for floating

• Note: It is the interest rates that are fixed or floating

• Typically, the Notional Principal (NP) is exchanged at the

swap’s initiation and termination dates

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 Typical Uses of a Currency Swap

To convert a liability in one currency into a liability in another

currency

To convert an investment (asset) in one currency to an

investment in another currency

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 An Example of a Fixed for Fixed Currency Swap

An agreement to pay 1% on a Japanese Yen principal of

¥1,040,000,000 and receive 5% on a US dollar principal of $10,000,000
every year for 3 years
In a currency swap, the principal is exchanged at the beginning
and at the end of the swap
Note that in currency swaps, the direction of the cash flows at time
zero is the opposite of the direction of the subsequent cash flows in
the swap (see the next slide)

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 Cash Flows in a Fixed-for-Fixed Currency Swap
At origination:
$10,000,000
Party A Party B
¥1,040,000,000

At each annual settlement date:

$500,000
Party A Party B
¥10,400,000

At maturity:
$10,000,000
Party A Party B
¥1,040,000,000
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 Cash Flows in a Fixed-for-Floating
Currency Swap

• On the origination date:

 The fixed rate payer pays $10,000,000 to the fixed rate receiver
 The fixed rate receiver pays ¥1,040,000,000 to the fixed rate payer

$10,000,000
Fixed rate payer
Fixed rate Receiver
(Floating rate
(Floating Rate
Receiver)
Payer)
¥1,040,000,000

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 Calculating Subsequent Cash Flows for this Fixed-for-
Floating Currency Swap

 Tenor is three years. NP1 = ¥1,040,000,000 yen, and r1 = 1% fixed in yen. NP2
= $10,000,000, and r2 = 6 month $-LIBOR (floating). Settlement dates are
every 6 months, beginning 6 months hence
 On the origination date, 6 month LIBOR is 5.5%.
 Assume that subsequently, 6 mo. LIBOR is:
Time 6 mo. LIBOR
0.5 5.25%
1.0 5.50%
1.5 6.00%
2.0 6.20%
2.5 6.44%

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 All Cash Flows for this Fixed-for-Floating Currency Swap

6-mo. Fixed rate Floating rate

time LIBOR Payment Payment
0.0 5.50% $10M ¥1,040M
0.5 5.25% ¥5.2M $275,000
1.0 5.50% ¥5.2M $262,5001
1.5 6.00% ¥5.2M $275,000
2.0 6.20% ¥5.2M $300,000
2.5 6.44% ¥5.2M $310,000
3.0 ---- ¥5.2M $322,000
¥1,040M $10M

N.B. The time t floating cash flow is determined using the time t-1 floating rate.
1
Time 1.0 floating rate payment is (0.0525/2)($10,000,000) = $262,500.

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 Credit Risk: Currency Swaps

• Note that there is greater credit risk with a currency

swap when there will be a final exchange of principal

• This means that there is a higher probability of a large

buildup in value, giving one of the counter-parties (the
one who is losing) the incentive to default

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 Credit Risk

• No credit risk exists when a swap is first created

• The credit risk in a swap is greater when there is an exchange of
principal amounts at termination
• Only the winning party (for whom the swap is an asset) faces credit
risk. This risk is the risk that the counter-party will default
• Many vehicles exist to manage credit risk:
 Collateral (or collateral triggers)
 Netting agreements
 Credit derivatives
 Marking to market

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 Other Currency Swap Structures

 See the different interest rate swap structures presented earlier. They
all apply to currency swaps, too

• Index differential swaps, or “diff” swaps:

 The cash flows are based on two floating rates in different
countries, but they are applied to the NP of one of the currencies
 For example, pay €-based LIBOR, and receive $-based LIBOR, on a
NP of $20M. All payments are in $

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 Summary
• Futures and Options are tools to hedge currency exposure. Both are
traded in the stock exchange in the commodities and derivatives
market respectively
• Payables can be hedged by borrowing in the home currency, and
investing in the foreign currency
• Receivables can be hedged by borrowing in the foreign currency,
and investing in the home currency
• Alternative techniques of hedging include Leading and lagging,
Cross-hedging, or Currency diversification

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 Summary
• When there is information asymmetry or high degree of variability
in earnings due to progressives taxation, it is better for the firm to
hedge
• Most firms use forward, option and swaps for hedging currency
positions
• Types of swaps include fixed for fixed, fixed for floating, floating for
fixed, floating for floating
• The methods of containing credit risk include
 Collateral (or collateral triggers)
 Netting agreements
 Credit derivatives
 Marking to market

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 Module Code: FMT503
Module Title: International Financial Management

Session 9 – Management of Foreign Exchange Exposure

Session Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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 Session Objectives
Management of Foreign exchange exposure
At the end of this session, students will be able to:
• Discuss the composition of interest rate risk
• Explain how to convert fixed interest rate loan to floating and vice-
versa
• Describe the construct and application of a Forward Rate
Agreement (FRA)
• Plot an interest rate collar diagram

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 Interest Rate Risk

• All firms – domestic or multinational, small or large, leveraged, or

unleveraged – are sensitive to interest rate movements in one
way or another
• The single largest interest rate risk of the nonfinancial firm (our
focus in this discussion) is debt service; the multicurrency
dimension of interest rate risk for the MNC is of serious concern
• The second most prevalent source of interest rate risk for the
MNC lies in its holdings of interest-sensitive securities

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 Management of Interest Rate Risk

• Before they can manage interest rate risk, treasurers and

financial managers of all types must resolve a basic
management dilemma: the balance between risk and return
• Treasury has traditionally been considered a service center
(cost center) and is therefore not expected to take positions
that incur risk in the expectation of profit (treasury
management practices are rarely evaluated as profit centers)
• Treasury management practices are therefore predominantly
conservative, but opportunities to reduce costs or actually earn
profits are not to be ignored

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 Management of Interest Rate Risk

• Both foreign exchange and interest rate risk management must focus on
managing existing or anticipated cash flow exposures of the firm
• As in foreign exchange management exposure, the firm cannot
undertake informed management or hedging strategies without forming
expectations – a directional and/or volatility view – of interest rate
movements
• Fortunately, interest rate movements have historically shown more
stability and less volatility than foreign exchange rate movements
• Once management has formed expectations about future interest rate
levels and movements, it must choose the appropriate implementation,
a path that includes the selective use of various techniques and
instruments

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 Management of Interest Rate Risk

• Prior to describing the management of the most common

interest rate pricing risks, it is important to distinguish between
credit risk and reprising risk
• Credit risk, sometimes termed roll-over risk, is the possibility
that a borrower’s credit worthiness, at the time of renewing a
credit, is reclassified by the lender (resulting in changes to fees,
interest rates, credit line commitments or even denial of credit)
• Reprising risk is the risk of changes in interest rates charged
(earned) at the time a financial contract’s rate is reset

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 Management of Interest Rate Risk

• As an example, a US MNC has taken out a three-year,

floating-rate loan in the amount of US$10 million (annual
interest payments)
• Some alternatives available to management as a means to
manage interest rate risk are as follows:
 Refinancing
 Forward rate agreements
 Interest rate futures
 Interest rate swaps

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 Carlton Corporation:
Swapping to Fixed Rates
• The US MNC existing floating-rate loan is now the source of some
concern
• Recent events have led management to believe that interest rates,
specifically LIBOR, may be rising in the three years ahead
• As the loan is relatively new, refinancing is considered too expensive but
management believes that a pay fixed/receive floating interest rate swap
may be the better alternative for fixing future interest rates now
• This swap agreement does not replace the existing loan agreement; it
supplements it
• Note that the swap agreement applies only to the interest payments on
the loan and not the principal payments

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 Management of Interest Rate Risk

• A forward rate agreement (FRA) is an interbank-traded contract to buy or

sell interest rate payments on a notional principal
• These contracts are settled in cash
• The buyer of an FRA obtains the right to lock in an interest rate for a
desired term that begins at a future date
• The contract specifies that the seller of the FRA will pay the buyer the
increased interest expense on a nominal sum (the notional principal) of
money if interest rates rise above the agreed rate, but the buyer will pay
the seller the differential interest expense if interest rates fall below the
agreed rate

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 Management of Interest Rate Risk

• Unlike foreign currency futures, interest rate futures are

relatively widely used by financial managers and treasurers of
nonfinancial companies
• Their popularity stems from the relatively high liquidity of the
interest rate futures markets, their simplicity in use, and the
rather standardized interest-rate exposures most firms possess
• The two most widely used futures contracts are the Eurodollar
futures traded on the Chicago Mercantile Exchange (CME) and
the US Treasury Bond Futures of the Chicago Board of Trade
(CBOT)

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 Management of Interest Rate Risk

• Interest rate futures strategies for common exposures:

 Paying interest on a future date (sell a futures contract/short
position)
• If rates go up, the futures price falls and the short earns a profit
(offsets loss on interest expense)
• If rates go down, the futures price rises and the short earns a
loss
 Earning interest on a future date (buy a futures contract/long
position)
• If rates go up, the futures price falls and the long earns a loss
• If rates go down, the futures price rises and the long earns a
profit

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 Management of Interest Rate Risk
• Swaps are contractual agreements to exchange or swap a series of
cash flows
• These cash flows are most commonly the interest payments
associated with debt service, such as the floating-rate loan described
earlier
 If the agreement is for one party to swap its fixed interest rate
payments for the floating interest rate payments of another, it is
termed an interest rate swap
 If the agreement is to swap currencies of debt service obligation, it
is termed a currency swap
 A single swap may combine elements of both interest rate and
currency swaps

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 Currency and Interest Rate Swaps

This section discusses currency and interest rate swaps, which

are relatively new instruments for hedging long-term interest
rate risk and foreign exchange risk.
Types of Swaps
• Size of the Swap Market
• The Swap Bank
• Interest Rate Swaps
• Currency Swaps

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 Swap Market

• In a swap, two counterparties agree to a contractual

arrangement wherein they agree to exchange cash flows at
periodic intervals.
• There are two basic types of swaps:
– Single Currency Interest rate swap
• “Plain vanilla” fixed-for-floating swaps in one currency.
– Cross Currency Interest Rate Swap (Currency swap)
• Fixed for fixed rate debt service in two (or more) currencies.
• 2006 Notional Principal for:
– Interest rate swaps: US$ 229.2 trillion !!
– Currency swaps: US$ 10.8 trillion

• The most popular currencies are: US$, Yen, Euro, SF, BP

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 The Swap Bank

• A 305
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 Interest Rate Swap

• U 306
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 Interest Rate Swap

Swap Pay fixed

Pay floating
Bank

Company A Receive Receive Company B

prefers floating fixed Floating prefers fixed

Issue fixed Issue floating

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 An Example of an Interest Rate Swap

• Bank A is a AAA-rated international bank located in the UK and wishes to raise $10M
to finance floating-rate Eurodollar loans.
– It would make more sense for the bank to issue floating-rate notes at LIBOR to finance
floating-rate Eurodollar loans.
– Bank A can issue 5-year fixed-rate Eurodollar bonds at 10 %
• Firm B is a BBB-rated U.S. company. It needs $10 M to finance an investment with a
five-year economic life.
– Firm B can issue 5-year fixed-rate Eurodollar bonds at 11.75 %
– Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR +
0.50 percent.
– Firm B would prefer to borrow at a fixed rate because it locks in a financing cost.
The borrowing opportunities of the two firms are:

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
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 The Quality Spread Differential
• QSD represents the potential gains from the swap that can be
shared between the counterparties and the swap bank.
• QSD arises because of a difference in default risk premiums for
fixed (usually larger) and floating rate (usually smaller) instruments
for parties with different credit ratings
• There is no reason to presume that the gains will be shared equally,
usually the company with the higher credit rating will take more of
the QSD.
• In the above example, company B is less credit-worthy than bank A,
so they probably would have gotten less of the QSD, in order to
compensate the swap bank for the default risk.

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 An Example of an Interest Rate Swap

Swap The swap bank makes this offer to Bank

A: You pay LIBOR per year on $10 million
Bank for 5 years and we will pay you 10.50% on
10.50% $10 million for 5 years

LIBOR
Bank
A
COMPANY B BANK A
Issue $10M debt Fixed rate 11.75% 10%
at 10% fixed-rate Floating rate LIBOR + .5% LIBOR

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 An Example of an Interest Rate Swap

0.50% of $10,000,000 =
$50,000. That’s quite a Here’s what’s in it for Bank A: Bank A
Swap can borrow externally at 10% fixed
cost savings per year for 5
years. Bank and have a net borrowing position of
10.50% -10.50% + 10% + LIBOR =
LIBOR – 0.50% which is 0.50 % better
LIBOR than they can borrow floating without
Bank a swap.
10%
A

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

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 An Example of an Interest Rate Swap

The swap bank makes

Swap
this offer to company B: Bank
You pay us 10.75% per 10.75%
year on $10 million for 5
years and we will pay LIBOR
you LIBOR per year on Company
$10 million for 5 years. B
Issue $10M debt at
LIBOR+0.50% floating-rate
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR 312
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 An Example of an Interest Rate Swap

0.5 % of $10,000,000 =
Swap $50,000 that’s quite a cost
savings per year for 5 years.
Here’s what’s in it for Firm B: Bank
Firm B can borrow externally at 10.75%
LIBOR + .50 % and have a net
LIBOR
borrowing position of
10.75 + (LIBOR + .50 ) - LIBOR = 11.25% which is 0.50 %
Company LIBOR
better than they can borrow floating (11.75%). + .50%
B

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
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 An Example of an Interest Rate Swap

.25% of $10 million = $25,000

The swap bank makes Swap per year for 5 years.
money too.
Bank
10.50% 10.75%

LIBOR LIBOR
Bank Company
LIBOR+10.75%– LIBOR-10.50%=0.25%
A B

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
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 An Example of an Interest Rate Swap

The swap bank makes .25%

Swap
Bank
10.50% 10.75%

LIBOR LIBOR
Bank Company
A B
A saves .50% B saves .50%
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
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 Example: Interest Rate Swap
• Company A can borrow at 8% fixed or LIBOR + 1% floating (borrows fixed)
• Company B can borrow at 9.5% fixed or LIBOR + .5% (borrows floating)
• Company A prefers floating and Company B prefers fixed
• By entering into the swap agreements, both A and B are better off then they would be
borrowing from the bank and the swap dealer makes .5%

Pay Receive Net

Company A LIBOR 8% -(LIBOR+.25)
Swap Dealer w/A 7.75% LIBOR
Company B 8.25% LIBOR -8.75%
Swap Dealer w/B LIBOR 8.5%
Swap Dealer Net LIBOR+7.75% LIBOR+8.25% +0.50%

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 Currency Swaps
• Most often used when companies make cross-border
capital investments or projects.
– Ex., U.S. parent company wants to finance a project
undertaken by its subsidiary in Germany. Project proceeds
would be used to pay interest and principal.
– Options:
1. Borrow US$ and convert to Euro – exposes company to exchange rate
risk.
2. Borrow in Germany – rate available may not be as good as that in the
U.S. if the subsidiary is relatively unknown.
3. Find a counterparty and set up a currency swap.

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 Currency Swaps

Swap
pay foreign
Pay foreign Bank

Company Receive Receive Company

A local local B

Issue local Issue local

• T 318
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 An Example of a Currency Swap

• Suppose a U.S. MNC wants to finance a €40,000,000 expansion of a

German plant.
• They could borrow dollars in the U.S. where they are well known
and exchange for dollars for euros.
– This will give them exchange rate risk: financing a euro project
with dollars.
• They could borrow euro in the international bond market, but pay
a premium since they are not as well known abroad.
• If they can find a German MNC with a mirror-image financing need
they may both benefit from a swap.
• If the spot exchange rate is S0($/ €) = $1.30/ €, the U.S. firm needs
to find a German firm wanting to finance dollar borrowing in the
amount of $52,000,000.

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 An Example of a Currency Swap

• Consider two firms A and B: firm A is a U.S.–based multinational and

firm B is a Germany–based multinational.
• Both firms wish to finance a project in each other’s country of the
same size. Their borrowing opportunities are given in the table below.

$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%

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 An Example of a Currency Swap

Annual Annual
Interest
Swap
Interest
$4.16M Bank $4.16M
$8% $8%

€ 6% € 6%
$8% Firm Annual Annual Firm € 6%
Interest Interest
Borrow A €2.4 M €2.4 M B Borrow
$52M € 40M
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%

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 An Example of a Currency Swap

A’s net position is to borrow Swap B’s net position is to

at € 6% borrow at $8%
Bank
$8% $8%

€ 6% € 6%
$8% Firm Firm € 6%
A B
$52M € 40M
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%
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 Swap Market Quotations
• Swap banks will tailor the terms of interest rate and currency swaps to customers’
needs. They also make a market in “plain vanilla” and currency swaps and
provide quotes for these. Since the swap banks are dealers for these swaps, there
is a bid-ask spread.
• Interest Rate Swap Example:
• Swap bank terms: USD: 2.50 – 2.65
Means that the bank is willing to pay fixed-rate 2.50% interest against receiving LIBOR
OR bank is willing to receive fixed-rate 2.65% against paying LIBOR.
• Currency Swap Example:
• Swap bank terms: USD 2.50 – 2.65
Euro 3.25 – 3.50
Means that bank is willing to make fixed rate USD payments at 2.5% in return for
receiving fixed rate Euro at 3.5% OR the bank is willing to receive fixed-rate USD
at 2.65% in return for making fixed-rate Euro payments at 3.25%

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 Risks of Interest Rate
and Currency Swaps
Interest Rate Risk
• Interest rates might move against the swap bank after it has only gotten half
of a swap on the books, or if it has an unhedged position.
Basis Risk
• Floating rates of the two counterparties being pegged to two different
indices
Exchange rate Risk
• Exchange rates might move against the swap bank after it has only gotten
half of a swap set up.
Credit Risk
• This is the major risk faced by a swap dealer—the risk that a counter party
will default on its end of the swap.
Mismatch Risk
• It’s hard to find a counterparty that wants to borrow the right amount of
money for the right amount of time.
Sovereign Risk
• The risk that a country will impose exchange rate restrictions that will
interfere with performance on the swap.

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 Another Example of a SWAP

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 Management of Interest Rate Risk

• The swap itself is not a source of capital, but rather an

alteration of the cash flows associated with payment
• What is often termed the plain vanilla swap is an
agreement between two parties to exchange fixed-rate
for floating-rate financial obligations
• This type of swap forms the largest single financial
derivative market in the world

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 Management of Interest Rate Risk

• Since all swap rates are derived from the yield curve in each
major currency, the fixed- to floating-rate interest rate swap
existing in each currency allow firms to swap across currencies
• The usual motivation for a currency swap is to replace cash flows
scheduled in an undesired currency with flows in a desired
currency
• The desired currency is probably the currency in which the firm’s
future operating revenues (inflows) will be generated
• Firms often raise capital in currencies in which they do not
possess significant revenues or other natural cash flows (a
significant reason for this being cost)

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 Management of Interest Rate Risk
Interest Rate Cap
• An interest rate cap is an option to fix a ceiling or
maximum short-term interest-rate payment
• The contract is written such that the buyer of the cap
will receive a cash payment equal to the difference
between the actual market interest rate and the cap
strike rate on the notional principal, if the market rate
rises above the strike rate
• Like any option, the buyer of the cap pays a premium to
the seller of the cap up front for this right

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 Management of Interest Rate Risk
Interest Rate Cap
• No theoretical limit exists to the specification of caps and
floors
• Most currency cap markets are liquid for up to ten years in
the over-the-counter market, though the majority of trading
falls between one and five years
• An added distinction that is important to understanding cap
maturity has to do with the number of interest rate resets
involved
• A common interest rate cap would be a two-year cap on
three-month LIBOR
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 Management of Interest Rate Risk
Interest Rate Floor

• An interest rate floor gives the buyer the right to receive the
compensating payment (cash settlement) when the reference interest
rate falls below the strike rate of the floor
• Interest rate floors are basically call options on an interest rate, and
equivalently, interest rate caps are put options on an interest rate
• A floor guarantees the buyer of the floor option a minimum interest
rate to be received (rate of return on notional principal invested) for a
specified reinvestment period or series of periods
• The pricing and valuation of a floor is the same as that of an interest
rate cap

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 Profile of an Interest Rate Cap
Interest Rate
Payment (%)

7.50

Uncovered interest
7.00
rate payment

6.50
The effective “cap”

6.00
Capped interest
rate payment
5.50
Actual 3-month LIBOR on reset date (%)

5.00
5.50 6.00 6.50 7.00 7.50 8.00
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 Profile of an Interest Rate Floor
6.50
German firm’s effective
investment rate (%)
Uncovered interest
earnings
6.00

5.50 The effective “floor”

Interest earnings
5.00
with floor

4.50
6-month DM LIBOR on reset date (%)

4.00
4.50 5.00 5.50 6.00 6.50 7.00

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 Profile of an Interest Rate Collar
Firm’s interest Uncovered interest
rate payment (%) rate payment

9.00
Floor strike Cap strike
rate rate
8.00

7.00

6.00

5.00 Interest rate floor

4.00 Interest rate cap

3.00

2.00

1.00 Actual market interest rate (%)

0.00
0.5 1.5 2.5 3.5 4.5 5.5 6.5
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 Management of Interest Rate Risk
Interest Rate Collar
• An interest rate collar is the simultaneous purchase
(sale) of a cap and a sale (purchase) of a floor
• The firm constructing the collar earns a premium from
the sale of one side to cover in part of in full the
premium expense of purchasing the other side of the
collar
• If the two premiums are equal, the position is often
referred to as a zero-premium collar

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 Swap: Basic Motivation to enter

One basic reason for a counterparty to enter into a currency

swap is to exploit the comparative advantage of the other in
obtaining debt financing at a lower interest rate than could be
obtained on its own

A second basic reason is to lock in long-term exchange rates in

the repayment of debt service obligations denominated in a
foreign currency

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 Uses for Interest Rate Swaps
Portfolio management
• Interest rate swaps allow portfolio managers to add or subtract
duration, adjust interest rate exposure, and offset the risks posed
by interest rate volatility
• By increasing or decreasing interest rate exposure in various parts
of the yield curve using swaps, managers can either ramp-up or
neutralize their exposure to changes in the shape of the curve, and
can also express views on credit spreads
• Swaps can also act as substitutes for other, less liquid fixed income
instruments
• Moreover, long-dated interest rate swaps can increase the duration
of a portfolio, making them an effective tool in Liability Driven
Investing, where managers aim to match the duration of assets
with that of long-term liabilities
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 Uses for Interest Rate Swaps

• Speculation. Because swaps require little capital up front, they give

fixed-income traders a way to speculate on movements in interest
rates while potentially avoiding the cost of long and short positions
in Treasuries
• For example, to speculate that five-year rates will fall using cash in
the Treasury market, a trader must invest cash or borrowed capital
to buy a five-year Treasury note
• Instead, the trader could “receive” fixed in a five-year swap
transaction, which offers a similar speculative bet on falling rates,
but does not require significant capital up front

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 Uses for Interest Rate Swaps

• Corporate finance. Firms with floating rate liabilities, such as loans

linked to LIBOR, can enter into swaps where they pay fixed and
receive floating, as noted earlier
• Companies might also set up swaps to pay floating and receive fixed
as a hedge against falling interest rates, or if floating rates more
closely match their assets or income stream

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 Uses for Interest Rate Swaps

• Risk management. Banks and other financial institutions are

involved in a huge number of transactions involving loans,
derivatives contracts and other investments
• The bulk of fixed and floating interest rate exposures typically
cancel each other out, but any remaining interest rate risk can be
offset with interest rate swaps

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 Uses for Interest Rate Swaps

• Rate-locks on bond issuance. When corporations decide to issue

fixed-rate bonds, they usually lock in the current interest rate by
entering into swap contracts
• That gives them time to go out and find investors for the bonds.
Once they actually sell the bonds, they exit the swap contracts
• If rates have gone up since the decision to sell bonds, the swap
contracts will be worth more, offsetting the increased financing cost

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 What are Depositary Receipts?

“a security designed to make investing outside of one’s home

country easier”
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 Depositary Receipt (DR)

Three forms
1. American Depositary Receipt (ADR)
2. Global Depositary Receipt (GDR)
3. International Depositary Receipt (IDR)

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 History of the Depositary Receipt

• 1927: Regulation on British Companies

• What did this mean for U.S. investors?
 Selfridge Stores in the U.K.
• Creation of the first ADR by JP Morgan
 Primary use of an ADR
 Use of an ADR since the 1990’s

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 History (cont’d)

1990: Citibank issued the first GDR

 Samsung Corporation
 European and U.S. Markets could be reached simultaneously
Currently….
 DR Programs in over 70 countries with over 2,250 programs
 Before participation it is necessary to look at the benefits

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 ADR and GDR

American Depository Receipt Global Depository Receipt

• American Depository Receipt • Global Depository receipt
• Non US company trading in US • Unsecured security
financial markets • May be converted to shares
• Unsecured security • Traded and settled
• Can be a fraction or a multiple independently from underlying
of underlying share share in international exchange
• Denominated in USD
• Normally 1 GDR = 10 shares (not
always)

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 Company Benefits of DRs

 Expanded market share through broadened and more diversified

investor exposure with potentially greater liquidity, which may
increase or stabilize the share price
 Enhanced visibility and image for the company’s products, services
and financial instruments in a marketplace outside its home
country
 Flexible mechanism for raising capital and a vehicle or currency for
mergers and acquisitions
 Enables employees of U.S. subsidiaries of non-U.S. companies to
invest more easily in the parent company

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 Investor Benefits of DRs

• Quotation in U.S. dollars and payment of dividends or interest in

U.S. dollars (or in general, a persons home currency)

• Diversification without many of the obstacles that mutual funds,

pension funds and other institutions may have in purchasing and
holding securities outside of their local market

• Elimination of global custodian safekeeping charges, potentially

saving Depositary Receipt investors up to 10 to 40 basis points
annually

• Familiar trade, clearance and settlement procedures

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 Types of ADRs
Non-Sponsored
 The underlying company has no commitment
 Traded on the OTC market
 No formal agreement between bank and company
Sponsored
 Varying degrees of commitment a company can make to the DR
Program (Level 1: Limited reporting, most common. Level 2: Listed and
annual reporting required, under SEC regulation. Level 3: Same level
scrutiny like any US company

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 Depositary Receipts today

 The Bank of New York Mellon is currently the largest DR bank in the
world
 In the GDR market, the London Stock Exchange dominates
 The number of programs has increased dramatically since the
1990’s, rising from 352 programs to over 2,250 programs in 2007

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 DRs Today (cont’d)

• Recent explosion in use of DR Programs is credited to:

 Ease of information flow in technology era
 Investor desire to diversify internationally
 Increased liquidity in market due in large part to light regulatory
procedures of the International Order Book trading platform
 Perceived success of DR Programs internationally
 Decreased cost of programs by standardization

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 Conclusion

Depositary Receipt Programs are an effective strategy for

international investment, while using procedures that the
investor is comfortable with and accustomed to. But, as
with any investment, all the risks of investing are not
eliminated.

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 Summary
• All firms – domestic or multinational, small or large, leveraged, or
unleveraged – are sensitive to interest rate movements in one way
or another
• Credit risk, sometimes termed roll-over risk, is the possibility that a
borrower’s credit worthiness, at the time of renewing a credit, is
reclassified by the lender (resulting in changes to fees, interest
rates, credit line commitments or even denial of credit)
• A forward rate agreement (FRA) is an interbank-traded contract to
buy or sell interest rate payments on a notional principal
• Swaps are contractual agreements to exchange or swap a series of
cash flows
• If the agreement is for one party to swap its fixed interest rate
payments for the floating interest rate payments of another, it is
termed an interest rate swap
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 Summary

 If the agreement is to swap currencies of debt service obligation,

it is termed a currency swap
 A single swap may combine elements of both interest rate and
currency swaps
 An interest rate cap is an option to fix a ceiling or maximum
short-term interest-rate payment
 An interest rate floor gives the buyer the right to receive the
compensating payment (cash settlement) when the reference
interest rate falls below the strike rate of the floor
 An interest rate collar is the simultaneous purchase (sale) of a
cap and a sale (purchase) of a floor

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 Topic 9 – Management of Foreign Exchange Exposure

Session Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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 Topic Objectives
Management of Foreign exchange exposure
At the end of this topic, students will be able to:
• Discuss the composition of interest rate risk
• Explain how to convert fixed interest rate loan to floating and vice-
versa
• Describe the construct and application of a Forward Rate
Agreement (FRA)
• Plot an interest rate collar diagram

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 Interest Rate Risk

• All firms – domestic or multinational, small or large, leveraged, or

unleveraged – are sensitive to interest rate movements in one
way or another
• The single largest interest rate risk of the nonfinancial firm (our
focus in this discussion) is debt service; the multicurrency
dimension of interest rate risk for the MNC is of serious concern
• The second most prevalent source of interest rate risk for the
MNC lies in its holdings of interest-sensitive securities

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 Management of Interest Rate Risk

• Before they can manage interest rate risk, treasurers and

financial managers of all types must resolve a basic
management dilemma: the balance between risk and return
• Treasury has traditionally been considered a service center
(cost center) and is therefore not expected to take positions
that incur risk in the expectation of profit (treasury
management practices are rarely evaluated as profit centers)
• Treasury management practices are therefore predominantly
conservative, but opportunities to reduce costs or actually earn
profits are not to be ignored

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 Management of Interest Rate Risk

• Both foreign exchange and interest rate risk management must focus on
managing existing or anticipated cash flow exposures of the firm
• As in foreign exchange management exposure, the firm cannot
undertake informed management or hedging strategies without forming
expectations – a directional and/or volatility view – of interest rate
movements
• Fortunately, interest rate movements have historically shown more
stability and less volatility than foreign exchange rate movements
• Once management has formed expectations about future interest rate
levels and movements, it must choose the appropriate implementation,
a path that includes the selective use of various techniques and
instruments

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 Management of Interest Rate Risk

• Prior to describing the management of the most common

interest rate pricing risks, it is important to distinguish between
credit risk and reprising risk
• Credit risk, sometimes termed roll-over risk, is the possibility
that a borrower’s credit worthiness, at the time of renewing a
credit, is reclassified by the lender (resulting in changes to fees,
interest rates, credit line commitments or even denial of credit)
• Reprising risk is the risk of changes in interest rates charged
(earned) at the time a financial contract’s rate is reset

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 Management of Interest Rate Risk

• As an example, a US MNC has taken out a three-year,

floating-rate loan in the amount of US$10 million (annual
interest payments)
• Some alternatives available to management as a means to
manage interest rate risk are as follows:
 Refinancing
 Forward rate agreements
 Interest rate futures
 Interest rate swaps

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 Carlton Corporation:
Swapping to Fixed Rates
• The US MNC existing floating-rate loan is now the source of some
concern
• Recent events have led management to believe that interest rates,
specifically LIBOR, may be rising in the three years ahead
• As the loan is relatively new, refinancing is considered too expensive but
management believes that a pay fixed/receive floating interest rate swap
may be the better alternative for fixing future interest rates now
• This swap agreement does not replace the existing loan agreement; it
supplements it
• Note that the swap agreement applies only to the interest payments on
the loan and not the principal payments

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 Management of Interest Rate Risk

• A forward rate agreement (FRA) is an interbank-traded contract to buy or

sell interest rate payments on a notional principal
• These contracts are settled in cash
• The buyer of an FRA obtains the right to lock in an interest rate for a
desired term that begins at a future date
• The contract specifies that the seller of the FRA will pay the buyer the
increased interest expense on a nominal sum (the notional principal) of
money if interest rates rise above the agreed rate, but the buyer will pay
the seller the differential interest expense if interest rates fall below the
agreed rate

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 Management of Interest Rate Risk

• Unlike foreign currency futures, interest rate futures are

relatively widely used by financial managers and treasurers of
nonfinancial companies
• Their popularity stems from the relatively high liquidity of the
interest rate futures markets, their simplicity in use, and the
rather standardized interest-rate exposures most firms possess
• The two most widely used futures contracts are the Eurodollar
futures traded on the Chicago Mercantile Exchange (CME) and
the US Treasury Bond Futures of the Chicago Board of Trade
(CBOT)

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 Management of Interest Rate Risk

• Interest rate futures strategies for common exposures:

 Paying interest on a future date (sell a futures contract/short
position)
• If rates go up, the futures price falls and the short earns a profit
(offsets loss on interest expense)
• If rates go down, the futures price rises and the short earns a
loss
 Earning interest on a future date (buy a futures contract/long
position)
• If rates go up, the futures price falls and the long earns a loss
• If rates go down, the futures price rises and the long earns a
profit

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 Management of Interest Rate Risk
• Swaps are contractual agreements to exchange or swap a series of
cash flows
• These cash flows are most commonly the interest payments
associated with debt service, such as the floating-rate loan described
earlier
 If the agreement is for one party to swap its fixed interest rate
payments for the floating interest rate payments of another, it is
termed an interest rate swap
 If the agreement is to swap currencies of debt service obligation, it
is termed a currency swap
 A single swap may combine elements of both interest rate and
currency swaps

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 Currency and Interest Rate Swaps

This section discusses currency and interest rate swaps, which

are relatively new instruments for hedging long-term interest
rate risk and foreign exchange risk.
Types of Swaps
• Size of the Swap Market
• The Swap Bank
• Interest Rate Swaps
• Currency Swaps

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 Swap Market

• In a swap, two counterparties agree to a contractual

arrangement wherein they agree to exchange cash flows at
periodic intervals.
• There are two basic types of swaps:
– Single Currency Interest rate swap
• “Plain vanilla” fixed-for-floating swaps in one currency.
– Cross Currency Interest Rate Swap (Currency swap)
• Fixed for fixed rate debt service in two (or more) currencies.
• 2006 Notional Principal for:
– Interest rate swaps: US$ 229.2 trillion !!
– Currency swaps: US$ 10.8 trillion

• The most popular currencies are: US$, Yen, Euro, SF, BP

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 The Swap Bank

• A 368
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 Interest Rate Swap

• U 369
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 Interest Rate Swap

Swap Pay fixed

Pay floating
Bank

Company A Receive Receive Company B

prefers floating fixed Floating prefers fixed

Issue fixed Issue floating

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 An Example of an Interest Rate Swap

• Bank A is a AAA-rated international bank located in the UK and wishes to raise $10M
to finance floating-rate Eurodollar loans.
– It would make more sense for the bank to issue floating-rate notes at LIBOR to finance
floating-rate Eurodollar loans.
– Bank A can issue 5-year fixed-rate Eurodollar bonds at 10 %
• Firm B is a BBB-rated U.S. company. It needs $10 M to finance an investment with a
five-year economic life.
– Firm B can issue 5-year fixed-rate Eurodollar bonds at 11.75 %
– Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR +
0.50 percent.
– Firm B would prefer to borrow at a fixed rate because it locks in a financing cost.
The borrowing opportunities of the two firms are:

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
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 The Quality Spread Differential
• QSD represents the potential gains from the swap that can be
shared between the counterparties and the swap bank.
• QSD arises because of a difference in default risk premiums for
fixed (usually larger) and floating rate (usually smaller) instruments
for parties with different credit ratings
• There is no reason to presume that the gains will be shared equally,
usually the company with the higher credit rating will take more of
the QSD.
• In the above example, company B is less credit-worthy than bank A,
so they probably would have gotten less of the QSD, in order to
compensate the swap bank for the default risk.

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 An Example of an Interest Rate Swap

Swap The swap bank makes this offer to Bank

A: You pay LIBOR per year on $10 million
Bank for 5 years and we will pay you 10.50% on
10.50% $10 million for 5 years

LIBOR
Bank
A
COMPANY B BANK A
Issue $10M debt Fixed rate 11.75% 10%
at 10% fixed-rate Floating rate LIBOR + .5% LIBOR

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 An Example of an Interest Rate Swap

0.50% of $10,000,000 =
$50,000. That’s quite a Here’s what’s in it for Bank A: Bank A
Swap can borrow externally at 10% fixed
cost savings per year for 5
years. Bank and have a net borrowing position of
10.50% -10.50% + 10% + LIBOR =
LIBOR – 0.50% which is 0.50 % better
LIBOR than they can borrow floating without
Bank a swap.
10%
A

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

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 An Example of an Interest Rate Swap

The swap bank makes

Swap
this offer to company B: Bank
You pay us 10.75% per 10.75%
year on $10 million for 5
years and we will pay LIBOR
you LIBOR per year on Company
$10 million for 5 years. B
Issue $10M debt at
LIBOR+0.50% floating-rate
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR 375
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 An Example of an Interest Rate Swap

0.5 % of $10,000,000 =
Swap $50,000 that’s quite a cost
savings per year for 5 years.
Here’s what’s in it for Firm B: Bank
Firm B can borrow externally at 10.75%
LIBOR + .50 % and have a net
LIBOR
borrowing position of
10.75 + (LIBOR + .50 ) - LIBOR = 11.25% which is 0.50 %
Company LIBOR
better than they can borrow floating (11.75%). + .50%
B

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
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 An Example of an Interest Rate Swap

.25% of $10 million = $25,000

The swap bank makes Swap per year for 5 years.
money too.
Bank
10.50% 10.75%

LIBOR LIBOR
Bank Company
LIBOR+10.75%– LIBOR-10.50%=0.25%
A B

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
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 An Example of an Interest Rate Swap

The swap bank makes .25%

Swap
Bank
10.50% 10.75%

LIBOR LIBOR
Bank Company
A B
A saves .50% B saves .50%
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
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 Example: Interest Rate Swap
• Company A can borrow at 8% fixed or LIBOR + 1% floating (borrows fixed)
• Company B can borrow at 9.5% fixed or LIBOR + .5% (borrows floating)
• Company A prefers floating and Company B prefers fixed
• By entering into the swap agreements, both A and B are better off then they would be
borrowing from the bank and the swap dealer makes .5%

Pay Receive Net

Company A LIBOR 8% -(LIBOR+.25)
Swap Dealer w/A 7.75% LIBOR
Company B 8.25% LIBOR -8.75%
Swap Dealer w/B LIBOR 8.5%
Swap Dealer Net LIBOR+7.75% LIBOR+8.25% +0.50%

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 Currency Swaps
• Most often used when companies make cross-border
capital investments or projects.
– Ex., U.S. parent company wants to finance a project
undertaken by its subsidiary in Germany. Project proceeds
would be used to pay interest and principal.
– Options:
1. Borrow US$ and convert to Euro – exposes company to exchange rate
risk.
2. Borrow in Germany – rate available may not be as good as that in the
U.S. if the subsidiary is relatively unknown.
3. Find a counterparty and set up a currency swap.

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 Currency Swaps

Swap
pay foreign
Pay foreign Bank

Company Receive Receive Company

A local local B

Issue local Issue local

• T 381
Faculty of Management and Commerce Ramaiah University of Applied Sciences
 An Example of a Currency Swap

• Suppose a U.S. MNC wants to finance a €40,000,000 expansion of a

German plant.
• They could borrow dollars in the U.S. where they are well known
and exchange for dollars for euros.
– This will give them exchange rate risk: financing a euro project
with dollars.
• They could borrow euro in the international bond market, but pay
a premium since they are not as well known abroad.
• If they can find a German MNC with a mirror-image financing need
they may both benefit from a swap.
• If the spot exchange rate is S0($/ €) = $1.30/ €, the U.S. firm needs
to find a German firm wanting to finance dollar borrowing in the
amount of $52,000,000.

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 An Example of a Currency Swap

• Consider two firms A and B: firm A is a U.S.–based multinational and

firm B is a Germany–based multinational.
• Both firms wish to finance a project in each other’s country of the
same size. Their borrowing opportunities are given in the table below.

$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%

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 An Example of a Currency Swap

Annual Annual
Interest
Swap
Interest
$4.16M Bank $4.16M
$8% $8%

€ 6% € 6%
$8% Firm Annual Annual Firm € 6%
Interest Interest
Borrow A €2.4 M €2.4 M B Borrow
$52M € 40M
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%

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 An Example of a Currency Swap

A’s net position is to borrow Swap B’s net position is to

at € 6% borrow at $8%
Bank
$8% $8%

€ 6% € 6%
$8% Firm Firm € 6%
A B
$52M € 40M
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%
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 Swap Market Quotations
• Swap banks will tailor the terms of interest rate and currency swaps to customers’
needs. They also make a market in “plain vanilla” and currency swaps and
provide quotes for these. Since the swap banks are dealers for these swaps, there
is a bid-ask spread.
• Interest Rate Swap Example:
• Swap bank terms: USD: 2.50 – 2.65
Means that the bank is willing to pay fixed-rate 2.50% interest against receiving LIBOR
OR bank is willing to receive fixed-rate 2.65% against paying LIBOR.
• Currency Swap Example:
• Swap bank terms: USD 2.50 – 2.65
Euro 3.25 – 3.50
Means that bank is willing to make fixed rate USD payments at 2.5% in return for
receiving fixed rate Euro at 3.5% OR the bank is willing to receive fixed-rate USD
at 2.65% in return for making fixed-rate Euro payments at 3.25%

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 Risks of Interest Rate
and Currency Swaps
Interest Rate Risk
• Interest rates might move against the swap bank after it has only gotten half
of a swap on the books, or if it has an unhedged position.
Basis Risk
• Floating rates of the two counterparties being pegged to two different
indices
Exchange rate Risk
• Exchange rates might move against the swap bank after it has only gotten
half of a swap set up.
Credit Risk
• This is the major risk faced by a swap dealer—the risk that a counter party
will default on its end of the swap.
Mismatch Risk
• It’s hard to find a counterparty that wants to borrow the right amount of
money for the right amount of time.
Sovereign Risk
• The risk that a country will impose exchange rate restrictions that will
interfere with performance on the swap.

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 Another Example of a SWAP

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 Management of Interest Rate Risk

• The swap itself is not a source of capital, but rather an

alteration of the cash flows associated with payment
• What is often termed the plain vanilla swap is an
agreement between two parties to exchange fixed-rate
for floating-rate financial obligations
• This type of swap forms the largest single financial
derivative market in the world

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 Management of Interest Rate Risk

• Since all swap rates are derived from the yield curve in each
major currency, the fixed- to floating-rate interest rate swap
existing in each currency allow firms to swap across currencies
• The usual motivation for a currency swap is to replace cash flows
scheduled in an undesired currency with flows in a desired
currency
• The desired currency is probably the currency in which the firm’s
future operating revenues (inflows) will be generated
• Firms often raise capital in currencies in which they do not
possess significant revenues or other natural cash flows (a
significant reason for this being cost)

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 Management of Interest Rate Risk
Interest Rate Cap
• An interest rate cap is an option to fix a ceiling or
maximum short-term interest-rate payment
• The contract is written such that the buyer of the cap
will receive a cash payment equal to the difference
between the actual market interest rate and the cap
strike rate on the notional principal, if the market rate
rises above the strike rate
• Like any option, the buyer of the cap pays a premium to
the seller of the cap up front for this right

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Management of Interest Rate Risk
Interest Rate Cap
• No theoretical limit exists to the specification of caps and
floors
• Most currency cap markets are liquid for up to ten years in
the over-the-counter market, though the majority of trading
falls between one and five years
• An added distinction that is important to understanding cap
maturity has to do with the number of interest rate resets
involved
• A common interest rate cap would be a two-year cap on
three-month LIBOR
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Management of Interest Rate Risk
Interest Rate Floor

• An interest rate floor gives the buyer the right to receive the
compensating payment (cash settlement) when the reference interest
rate falls below the strike rate of the floor
• Interest rate floors are basically call options on an interest rate, and
equivalently, interest rate caps are put options on an interest rate
• A floor guarantees the buyer of the floor option a minimum interest
rate to be received (rate of return on notional principal invested) for a
specified reinvestment period or series of periods
• The pricing and valuation of a floor is the same as that of an interest
rate cap

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Profile of an Interest Rate Cap
Interest Rate
Payment (%)

7.50

Uncovered interest
7.00
rate payment

6.50
The effective “cap”

6.00
Capped interest
rate payment
5.50
Actual 3-month LIBOR on reset date (%)

5.00
5.50 6.00 6.50 7.00 7.50 8.00
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Profile of an Interest Rate Floor
6.50
German firm’s effective
investment rate (%)
Uncovered interest
earnings
6.00

5.50 The effective “floor”

Interest earnings
5.00
with floor

4.50
6-month DM LIBOR on reset date (%)

4.00
4.50 5.00 5.50 6.00 6.50 7.00

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Profile of an Interest Rate Collar
Firm’s interest Uncovered interest
rate payment (%) rate payment

9.00
Floor strike Cap strike
rate rate
8.00

7.00

6.00

5.00 Interest rate floor

4.00 Interest rate cap

3.00

2.00

1.00 Actual market interest rate (%)

0.00
0.5 1.5 2.5 3.5 4.5 5.5 6.5
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 Management of Interest Rate Risk
Interest Rate Collar
• An interest rate collar is the simultaneous purchase
(sale) of a cap and a sale (purchase) of a floor
• The firm constructing the collar earns a premium from
the sale of one side to cover in part of in full the
premium expense of purchasing the other side of the
collar
• If the two premiums are equal, the position is often
referred to as a zero-premium collar

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 Swap: Basic Motivation to enter

One basic reason for a counterparty to enter into a currency

swap is to exploit the comparative advantage of the other in
obtaining debt financing at a lower interest rate than could be
obtained on its own

A second basic reason is to lock in long-term exchange rates in

the repayment of debt service obligations denominated in a
foreign currency

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 Uses for Interest Rate Swaps
Portfolio management
• Interest rate swaps allow portfolio managers to add or subtract
duration, adjust interest rate exposure, and offset the risks posed
by interest rate volatility
• By increasing or decreasing interest rate exposure in various parts
of the yield curve using swaps, managers can either ramp-up or
neutralize their exposure to changes in the shape of the curve, and
can also express views on credit spreads
• Swaps can also act as substitutes for other, less liquid fixed income
instruments
• Moreover, long-dated interest rate swaps can increase the duration
of a portfolio, making them an effective tool in Liability Driven
Investing, where managers aim to match the duration of assets
with that of long-term liabilities
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Uses for Interest Rate Swaps

• Speculation. Because swaps require little capital up front, they give

fixed-income traders a way to speculate on movements in interest
rates while potentially avoiding the cost of long and short positions
in Treasuries
• For example, to speculate that five-year rates will fall using cash in
the Treasury market, a trader must invest cash or borrowed capital
to buy a five-year Treasury note
• Instead, the trader could “receive” fixed in a five-year swap
transaction, which offers a similar speculative bet on falling rates,
but does not require significant capital up front

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 Uses for Interest Rate Swaps

• Corporate finance. Firms with floating rate liabilities, such as loans

linked to LIBOR, can enter into swaps where they pay fixed and
receive floating, as noted earlier
• Companies might also set up swaps to pay floating and receive fixed
as a hedge against falling interest rates, or if floating rates more
closely match their assets or income stream

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 Uses for Interest Rate Swaps

• Risk management. Banks and other financial institutions are

involved in a huge number of transactions involving loans,
derivatives contracts and other investments
• The bulk of fixed and floating interest rate exposures typically
cancel each other out, but any remaining interest rate risk can be
offset with interest rate swaps

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 Uses for Interest Rate Swaps

• Rate-locks on bond issuance. When corporations decide to issue

fixed-rate bonds, they usually lock in the current interest rate by
entering into swap contracts
• That gives them time to go out and find investors for the bonds.
Once they actually sell the bonds, they exit the swap contracts
• If rates have gone up since the decision to sell bonds, the swap
contracts will be worth more, offsetting the increased financing cost

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 What are Depositary Receipts?

“a security designed to make investing outside of one’s home

country easier”
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 Depositary Receipt (DR)

Three forms
1. American Depositary Receipt (ADR)
2. Global Depositary Receipt (GDR)
3. International Depositary Receipt (IDR)

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 History of the Depositary Receipt

• 1927: Regulation on British Companies

• What did this mean for U.S. investors?
 Selfridge Stores in the U.K.
• Creation of the first ADR by JP Morgan
 Primary use of an ADR
 Use of an ADR since the 1990’s

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 History (cont’d)

1990: Citibank issued the first GDR

 Samsung Corporation
 European and U.S. Markets could be reached simultaneously
Currently….
 DR Programs in over 70 countries with over 2,250 programs
 Before participation it is necessary to look at the benefits

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 ADR and GDR

American Depository Receipt Global Depository Receipt

• American Depository Receipt • Global Depository receipt
• Non US company trading in US • Unsecured security
financial markets • May be converted to shares
• Unsecured security • Traded and settled
• Can be a fraction or a multiple independently from underlying
of underlying share share in international exchange
• Denominated in USD
• Normally 1 GDR = 10 shares (not
always)

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Company Benefits of DRs

 Expanded market share through broadened and more diversified

investor exposure with potentially greater liquidity, which may
increase or stabilize the share price
 Enhanced visibility and image for the company’s products, services
and financial instruments in a marketplace outside its home
country
 Flexible mechanism for raising capital and a vehicle or currency for
mergers and acquisitions
 Enables employees of U.S. subsidiaries of non-U.S. companies to
invest more easily in the parent company

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Investor Benefits of DRs

• Quotation in U.S. dollars and payment of dividends or interest in

U.S. dollars (or in general, a persons home currency)

• Diversification without many of the obstacles that mutual funds,

pension funds and other institutions may have in purchasing and
holding securities outside of their local market

• Elimination of global custodian safekeeping charges, potentially

saving Depositary Receipt investors up to 10 to 40 basis points
annually

• Familiar trade, clearance and settlement procedures

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 Types of ADRs
Non-Sponsored
 The underlying company has no commitment
 Traded on the OTC market
 No formal agreement between bank and company
Sponsored
 Varying degrees of commitment a company can make to the DR
Program (Level 1: Limited reporting, most common. Level 2: Listed and
annual reporting required, under SEC regulation. Level 3: Same level
scrutiny like any US company

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 Depositary Receipts today

 The Bank of New York Mellon is currently the largest DR bank in the
world
 In the GDR market, the London Stock Exchange dominates
 The number of programs has increased dramatically since the
1990’s, rising from 352 programs to over 2,250 programs in 2007

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 DRs Today (cont’d)

• Recent explosion in use of DR Programs is credited to:

 Ease of information flow in technology era
 Investor desire to diversify internationally
 Increased liquidity in market due in large part to light regulatory
procedures of the International Order Book trading platform
 Perceived success of DR Programs internationally
 Decreased cost of programs by standardization

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 Conclusion

Depositary Receipt Programs are an effective strategy for

international investment, while using procedures that the
investor is comfortable with and accustomed to. But, as
with any investment, all the risks of investing are not
eliminated.

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 Summary
• All firms – domestic or multinational, small or large, leveraged, or
unleveraged – are sensitive to interest rate movements in one way
or another
• Credit risk, sometimes termed roll-over risk, is the possibility that a
borrower’s credit worthiness, at the time of renewing a credit, is
reclassified by the lender (resulting in changes to fees, interest
rates, credit line commitments or even denial of credit)
• A forward rate agreement (FRA) is an interbank-traded contract to
buy or sell interest rate payments on a notional principal
• Swaps are contractual agreements to exchange or swap a series of
cash flows
• If the agreement is for one party to swap its fixed interest rate
payments for the floating interest rate payments of another, it is
termed an interest rate swap
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 Summary

 If the agreement is to swap currencies of debt service obligation,

it is termed a currency swap
 A single swap may combine elements of both interest rate and
currency swaps
 An interest rate cap is an option to fix a ceiling or maximum
short-term interest-rate payment
 An interest rate floor gives the buyer the right to receive the
compensating payment (cash settlement) when the reference
interest rate falls below the strike rate of the floor
 An interest rate collar is the simultaneous purchase (sale) of a
cap and a sale (purchase) of a floor

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 Topic 10 – International Project Appraisal

Session Delivered by

Mr. Uday kumar Jagannathan

[Link]@[Link]

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 Topic Objectives
International Project Appraisal
At the end of this topic the student will be able to:
• Discuss the issues in valuing international projects
• Explain the application of real and nominal interest rate in the
context of cash flow
• Evaluate the appropriate risk level of the firm in an international
setting
• Calculate the IRR and NPV of international projects

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 Review of Domestic Capital Budgeting

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 Review of Domestic Capital Budgeting

The basic net present value equation is

T
CFt TVT
NPV     C0
t 1 (1  k ) (1  k )
t T

Where:
CFt = expected incremental after-tax cash flow in year t
TVT = expected after tax terminal value including return of net working
capital
C0 = initial investment at inception
k = weighted average cost of capital
T = economic life of the project in years
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 Review of Domestic Capital Budgeting

The NPV rule is to accept a project if NPV  0

T
CFt TVT
NPV     C0  0
t 1 (1  k ) (1  k )
t T

and to reject a project if NPV  0

T
CFt TVT
NPV     C0  0.
t 1 (1  k ) (1  k )
t T

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 The Adjusted Present Value Model

T (OCFt)(1 – t) T
t Dt
NPV = S
t=1 (1 + k)
t
+ S
t=1 (1 + k)t
+
TVT
(1 + k) T
– C0
Can be converted to adjusted present value (APV)

T (OCFt)(1 – t)
t Dt t It
APV =
t=1
S
(1 + ku) t
+
(1 + i)t
+
(1 + i) t
+
TVT
(1 + ku)T
– C0

By appealing to Modigliani and Miller’s results.

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 The Adjusted Present Value Model

T (OCFt)(1 – t) t Dt t It
APV = S
t=1 (1 + ku)t
+
(1 + i)t
+
(1 + i) t
+
TVT
(1 + ku)T
– C0

The APV model is a value additivity approach to capital budgeting.

Each cash flow that is a source of value to the firm is considered
individually.
Note that with the APV model, each cash flow is discounted at a rate
that is appropriate to the riskiness of the cash flow.

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 Domestic APV Example

Consider this project, the timing and size of the incremental

after-tax cash flows for an all-equity firm are:
-$1,000 $125 $250 $375 $500

0 1 2 3 4
The unlevered cost of equity is r0 = 10%:
CF0 = –$1000 The project would be rejected by an
CF1 = $125 all-equity firm:

CF2 = $250 I = 10
CF3 = $375 CF4= 500 NPV = –$56.50
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 Domestic APV Example (continued)

• Now, imagine that the firm finances the project with

$600 of debt at r = 8%.
• The tax rate is 40%, so they have an interest tax
shield worth t×I = .40×$600×.08 = $19.20 each year.

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 -$1,000 $125 $250 $375 $500

0 1 2 3 4
The APV of the project under leverage is:
T (OCFt)(1 – t) t It TVT
APV = Σ
t=1 (1 + ku) t
+
(1 + i)t
+
(1 + ku) T
– C0

$125 $250 $375 $500

APV = + + +
1.10 (1.10) 2
(1.10) 3
(1.10)4
$19.20 $19.20 $19.20 $19.20
+ + + + – $1,000
1.08 (1.08) 2
(1.08) 3
(1.08) 4

APV = $7.09 The firm should accept the project if it finances with debt.
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Capital Budgeting from the Parent Firm’s Perspective

• The APV model is useful for a domestic firm analyzing a

domestic capital expenditure or for a foreign subsidiary of a
MNC analyzing a proposed capital expenditure from the
subsidiary’s viewpoint.
• The APV model is NOT useful for a MNC in analyzing a
foreign capital expenditure from the parent firm’s
perspective.

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Capital Budgeting from the Parent Firm’s Perspective

One recipe for international decision makers:

1. Estimate future cash flows in foreign currency.
2. Convert to the home currency at the predicted exchange rate.
Use PPP, IRP et cetera for the predictions.
3. Calculate NPV using the home currency cost of capital.

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 Capital Budgeting from the Parent Firm’s Perspective:
Example

• A 429
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 Capital Budgeting from the Parent Firm’s
Perspective: Example

A U.S. MNC is considering a European opportunity. The

size and timing of the after-tax cash flows are:

–€600 €200 €500 €300

0 1 2 3
The inflation rate in the euro zone is € = 3%, the inflation rate in
dollars is p$ = 6%, and the business risk of the investment would lead
an unlevered U.S.-based firm to demand a return of kud = i$ = 15%.

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 Capital Budgeting from the Parent Firm’s
Perspective: Example

–€600 €200 €500 €300

0 1 2 3
$1.25
The current exchange rate is S0($/€) =
€
Is this a good investment from the perspective of the U.S.
shareholders?

To address that question, let’s convert all of the cash flows to

dollars and then find the NPV at i$ = 15%.
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 Capital Budgeting from the Parent Firm’s
Perspective: Example

–$750
–€600 €200 €500 €300

0 1 2 3

CF0 = (€600)× S0($/€) =(€600)× $1.25

= $750
€

Finding the dollar value of the initial cash

$1.25
flow is easy; convert at the spot rate: S0($/€) =
€
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Capital Budgeting from the Parent Firm’s
Perspective: Example

–$750 $257.28
–€600 €200 €500 €300

0 1 2 3
The exchange rate expected to prevail in the first year, S1($/€),
can be found with PPP:
1 + $ 1.06 $1.25
S1($/€) = 1 +   S0($/€) =  = $1.2864/€
€ 1.03 €

CF1 = €200 × S1($/€) = €200 × $1.2864/€ = $257.28

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Capital Budgeting from the Parent Firm’s
Perspective: Example

–$750 $257.28 $661.94

–€600 €200 €500 €300

0 1 2 3

1.06 1.06 $1.25

CF=2    €500 = $661.94
1.03 1.03 €

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 Capital Budgeting from the Parent Firm’s
Perspective: Example

–$750 $257.28 $661.94 $408.73

–€600 €200 €500 €300

0 1 2 3

1.06 1.06 1.06 $1.25

CF=3     €300 = $408.73
1.03 1.03 1.03 €

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Capital Budgeting from the Parent Firm’s
Perspective: Alternative

Another recipe for international decision makers:

1. Estimate future cash flows in foreign currency.
2. Estimate the foreign currency discount rate.
3. Calculate the foreign currency NPV using the foreign cost of
capital.
4. Translate the foreign currency NPV into dollars using the spot
exchange rate

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Foreign Currency Cost of Capital Method

– €600 €200 €500 €300

0 1 2 3

€ = 3% Let’s find i€ and use that on the euro

cash flows to find the NPV in euros.
i$ = 15%
Then translate the NPV into dollars at
p$ = 6% the spot rate.
$1.25
The current exchange rate is S0($/€) =
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Foreign Currency Cost of Capital Method

• Before we find i€ let’s use our intuition.

• Since the euro-zone inflation rate is 3% lower than the
dollar inflation rate, our euro denominated discount rate
should be lower than our dollar denominated discount
rate.

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Finding the Foreign Currency Cost of Capital: i€

Recall that the Fisher Effect holds that

(1 + e) × (1 + $) = (1 + i$)

real inflation nominal

rate rate rate
So for example the real rate in the U.S. must be 8.49%

(1 + i$) 1.15
(1 + e) = e= – 1 = 0.0849
(1 + $) 1.06
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Finding the Foreign Currency Cost of Capital: i€

If Fisher Effect holds here and abroad then

(1 + i$) (1 + i€)
(1 + e$) = and (1 + e€) =
(1 + $) (1 + €)

If the real rates are the same in dollars and euros (e€ = e$)
we have a very useful parity condition:
(1 + i$) (1 + i€)
=
(1 + $) (1 + €)
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 Finding the Foreign Currency Cost of Capital: i€

If we have any three of these variables, we can find the fourth:

(1 + i$) (1 + i€)
= In our example, we want to find i€
(1 + $) (1 + €)
(1 + i$) × (1 + €)
(1 + i€) =
(1 + $)
(1.15) × (1.03)
i€ = –1
(1.06)
i€ = 0.1175
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 International Capital Budgeting: Example

– €600 €200 €500 €300

0 1 2 3

Find the NPV using i€ = 11.75%:

CF0 = –€600 I = 11.75
CF1 = €200 NPV = €194.39
CF2 = €500
$1.25 = $242.99
CF3 = €300 €194.39 ×
€
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 – €600 €200 €500 €300

0 1 2 3
€200 €500 €300
NPV = –€600 + + + = €194.39
1.1175 (1.1175)2 (1.1175)3

$1.25 = $242.99
€194.39 ×
€

–$750 $257.28 $661.94 $408.73

0 1 2 3
$257.28 $661.94 $408.73
NPV = –$750 + + + = $242.99
1.15 (1.15) 2
(1.15) 3
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 International Capital Budgeting

• You have two equally valid approaches:

– Change the foreign cash flows into dollars at the exchange
rates expected to prevail. Find the $NPV using the dollar cost
of capital.
– Find the foreign currency NPV using the foreign currency cost
of capital. Translate that into dollars at the spot exchange rate.
• If you watch your rounding, you will get exactly the same answer
either way.
• Which method you prefer is your choice.

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 Computing IRR

Recall that a project’s Internal Rate of Return (IRR) is the discount rate
that gives a project a zero NPV.

€200 €500 €300

NPV = –€600 + + + = €0
1+IRR€ (1+IRR€) 2
(1+IRR€) 3

IRR€ = 28.48%

$257.28 $661.94 $408.73

NPV = –$750 + + + = $0
1+IRR$ (1+IRR$) 2
(1+IRR$) 3

IRR$ = 32.23%
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 Computing IRR
• Easily done with the IRR function

€200 €500 €300

NPV = –€600 + + + = €0
1+IRR€ (1+IRR€) 2
(1+IRR€) 3

CF0 = –€600 IRR€ = 28.48%

CF1 = €200
CF2 = €500
CF3 = €300 IRR€ = 28.48%

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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Computing IRR
• Easily done with the IRR function in EXCEL

$257.28 $661.94 $408.73

NPV = –$750 + + + = $0
1+IRR$ (1+IRR$)2 (1+IRR$)3

IRR$ = 24.85%
CF0 = –$750
CF1 = $257.28
CF2 = $661.94
CF3 = $408.73 IRR = 32.23%

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 Converting from IRR$ to IRR€

1+IRR$ 1+IRR€ In our example, it was easy to find IRR€

=
(1 + $) (1 + €) Finding IRR$ without converting all cash
flows into dollars is straightforward:

(1+IRR€)(1 + $) (1.2848)(1.06)

(1+IRR$) = i€ = –1
(1 + €) (1.03)

€ = 3%, p$ = 6% IRR$ = 32.23%

• U 448
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 Risk Adjustment in the Capital Budgeting Process

• C 449
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 Sensitivity Analysis

• I 450
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 Real Options

• T 451
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 Summary
• The Basic NPV equation can be converted to the APV equation by
adding terms related to cash flow from Tax shield
• It is possible that a project financed purely with equity may fail the
NPV test but may pass the APV test if the same project is financed
using debt
• The APV model is useful for a domestic firm analyzing a domestic
capital expenditure or for a foreign subsidiary of a MNC analyzing a
proposed capital expenditure from the subsidiary’s viewpoint
• Method useful in calculating project value
1. Estimate future cash flows in foreign currency
2. Convert to the home currency at the predicted exchange rate.
Use PPP, IRP et cetera for the predictions.
3. Calculate NPV using the home currency cost of capital
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Faculty of Management and Commerce Ramaiah University of Applied Sciences
 Summary

• There are two equally valid approaches:

– Change the foreign cash flows into dollars at the exchange rates
expected to prevail. Find the $NPV using the dollar cost of
capital.
– Find the foreign currency NPV using the foreign currency cost
of capital. Translate that into dollars at the spot exchange rate.
• The foreign currency cost of capital can be found using the Fischer
effect (the inflation rates in the two countries)
• IRR can be calculated in local currency as well as in foreign
currency
• IRR can be converted from home to foreign and vice versa

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 Summary

• Clearly risk and return are correlated.

• Political risk may exist along side of business risk, necessitating an
adjustment in the discount rate
• In sensitivity analysis, different estimates are used for expected
inflation rates, cost and pricing estimates, and other inputs to give
the manager a more complete picture of the planned capital
investment.
• The application of options pricing theory to the evaluation of
investment options in real projects is known as real options.
– timing option, growth option, suspension option, abandonment
option

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