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International Financial Management (IFM): An Overview

Background
Globalization
Meaning Firms are looking for strategic (created) assets worldwide taking the
advantages of mobility of factors of production like capital and organization. In
international production strategy, transportation is not a problem these days;
firms are more concerned about cost rather than location for raw materials or
natural resources.

New concepts of Global firms along with national firms, Global Economy or One
World Economy / Mega Trend Economy.

Factors and Forces in IFM: Surplus, Innovation, Competition, Information


Technology, Liberalization Supranational Organizations, NEP, etc.

Controversies? Prague, Berlin, Seattle, ..

Problems of Firms
Agency Problems -- Information Gap, Information Arbitrage, Lemon Market,
Maximizing firms wealth or shareholders wealth?

Externalities: Environment, Regulations, Ethiecal

Why IFM?
There is a misunderstanding among the managers in the domestic firms.
Sometimes, it is thought that managers of domestic firms do not need to know
IFM. International Financial Management is even important to companies that
have no intention of engaging in international business, since these companies
must recognize how their foreign competitors will be affected by the movements
in exchange rates, labor costs, and inflation. Such economic characteristics can
affect the foreign competitors cost of production and pricing policy.
Example: Indian goods in Bangladesh.
However, the following are the reasons to know about IFM:
To cope with NEP
To survive in competition
To take advantage of international financial intermediation
To reduce cost and to increase efficiency and quality
International diversification
To exploits strategic assets at anywhere in the world

International Trade and International Finance Flows


These two important dimensions of international business are so closely related
that sometimes these are interchangeably used. There are six international
business methods such as
a. International Trade
b. Licensing
c. Franchising
d. Joint Venture
e. Acquisition and Merger and
f. Establishing New foreign subsidiaries
The first two are directly related with international trade (Imports and Exports)
and the last four methods are used in international investment / borrowing. These
are the important factors of IFM.
Important to note, however, that there are different products in the global
financial markets that accelerate the flow of funds across national boundaries
with the help of IT. Investors / borrowers around the world can meet together at
any time without their physical presence to exploit the benefits from these
products.
Factors affecting the decisions for International Flows of Funds
Inflation
National Income and Growth
Government Restrictions
Exchange Rates.

Supranational Organizations Facilitating the Global Flows of Funds


IMF - The Bretton Woods institutions created in 1944 under UN to cooperate the
members, stabilize exchange rates, temporary funds for imbalance of payments,
etc.
The World Bank as like as the above but long term economic development like SAL
WTO GAAT accord in 1993, Uruguay Round of Trade Negotiations and created in
1995
IFC in 1956 with a view of economic development by private flows of funds
IDA started in 1960 for providing loans to developing nations
BIS (Basel, Switzerland) was created in the context of Young Plan in 1930 Regional
Organizations, etc.
International Financial Markets (IFMs)

Derivatives
Markets

Foreign Eurocurrency
Exchange Market
(ForEx) Market

IFMs Eurocredit
Market
Eurobonds
Market

International Stock
Exchanges

Some important Terminologies to know

1. Eurocurrency Deposits: Deposits at financial institutions


denominated in currencies other than those of the countries in which
the deposits are located. Same as Eurodollar deposits
2. Eurodollar Deposits: A US-dollar denominated bank deposit at a
financial institution located outside the United States, as like as
Eurocurrency Deposits.
3. Eurodollar: US-dollar deposits placed in banks located in Europe and
other continents became known as Eurodollar.
4. Eurodollar Bond / Eurobond: A US-dollar denominated bond sold
outside of the United States.
5. Eurodollar Market: The market outside of the US in which US-dollar
denominated loans are made and in which US dollars are deposited in
financial institutions.
6. Eurobanks: Those accept deposits and provide loans in various
currencies.
7. Euroyen / Euroswissfranc : A deposit of Japanese Yen or Swiss
Franc in Eurobanks.
8. Petrodollar: US-dollar deposits by OPEC countries are sometimes
referred to as Petrodollars.
Domestic and International Monetary Systems

Domestic: There are three main functions of this system:


providing money transfer of purchasing power, that is, money payments
to cover transactions,
providing a stable unit of value, and
providing a standard of deferred payments

The domestic monetary system generally works well in the absence of inflation. Inflation
is a particularly a serious problem with respect tot eh second and third functions of the
domestic monetary system. Given a high rate of inflation in Bangladesh, Taka will not
maintain a stable purchasing power and will not function as an adequate standard of
deferred payments.

International: The international monetary system (IMS) is analogous to the domestic


system. The same basic functions must be served by the international monetary system
as stated above. The major difference in the international monetary system is that
cross-border payments generally involve a foreign currency transaction for at least one
of the parties involved in the transaction. Foreign currency transactions generally are
channeled through the foreign exchange market. The foreign exchange markets is one
of the principal components of IMS. We shall discuss it later on.

Terminologies
Washington Consensus
Contagion Effect
Herding Effect
Volatility
Money Making Concept
Hedging
Arbitrage
Speculation

Washington Consensus
A plausible alternative concept would be that the Washington Consensus
consists of the set of policies endorsed by the principal economic institutions
located in Washington: the U.S. Treasury, the Federal Reserve Board, the
International Monetary Fund, and the World Bank.

Foreign Exchange (ForEx) Markets

Basic Commodity: Financial claims & sight deposits claims denominated in


foreign currency.

Example: from the perspective of a US investor / borrower, securities issued by


non-US borrowers denominated in foreign currency such as EU government
bonds denominated in Euro, Bill of Exchange calling for payment in .
Accordingly, in UK, US government securities in dollars, Bill of Exchange in
Japanese Yen, currency issued by non-British government such as those of
France, Italy, etc.

Mechanism: exchange of the currency of one country for the currency of


another.

Sight Deposits: This is the commodity traded in foreign exchange markets.

Mechanism of trading: Domestic banks . International centers.


Instructions F/D/D.
Market and Participants

Govt. Agencies

Non-Bank Dealers
TNCs
Dealer Banks

Investors
Financial Institutions

Importer & Exporters

System of Foreign Exchange Business

2. Full efficiency: the participants in this market must be equipped with


modern tools of communication and must be capable enough to
understand and use the available tools. Information is the driving
forces in the foreign exchange business. This is called information
arbitrage. Information of yesterday is treated as weak or historical
information. Information that is available to public just now is semi-
strong type information. Information of tomorrow is strong type
information. There are other types of information as well such as;
suppressed, delayed, misleading or overreactional information.
3. Talk to the counterparties: The participants need to have
telephonic talks to their counterparties in the rest of the world before
the opening of the local market.
4. Analysis: The development, trends, and happenings in the centers
in the rest of the world where trading has commenced.
5. Better understanding / Technical Analysis: Participants need to
combine the above information with technical analysis, data on
economic fundamentals, and changing political conditions to develop
a better understanding of the market conditions.

Characteristics of ForEx Markets

1. Different Type of Market: This is very much different as compared


to any other markets prevailing in the world. The participants
always meet together but they are physically separated from each
other.
2. Unorganized Market: ForEx market operates without the benefit of
a centralized trading facility like the NY Stock Exchange where
the buyers and sellers congregate (come together in a crowd) and
deal in full view of one another.
3. OTC Type Market: This is Over-the-Counter Market.
4. Prompt Market: This market works in a very quick manner as the
prices in the market can change very quickly.

Functions of ForEx Market


1. Money Transfer
2. Hedging
3. Clearing Mechanism
4. Source of Credits
Mechanics of the Market
Instruments

Cable or Electronic Transfers of sight deposit funds


Society for Worldwide Interbank Financial Telecommunication (SWIFT)
Head office in Brussels 2000 members, operation centers, Networks
Mail Transfer: Alternative to electronic transfer
Bankers sight drafts: When a foreign exchange bank issues draft drawn
against its foreign currency balances on deposit in a foreign financial
center.
Commercial Papers

Spot Exchange

Rate:
There are two methods of quotations of foreign currency.
The Direct Method of Quoting: Under this method foreign currencies are
quoted in domestic currency.

The Indirect Method: Under this system local currency is quoted in foreign
currencies, just a reciprocal rates.
Example:
Name of Foreign Currency Foreign Currency in Taka Taka in
Foreign currency
US$ 58.50 .0170
60.00 .0166
90.00 .0111

When Taka Price of $ is quoted, the denominator is $ = Tk.58.5/$1=Tk. 58.5


When Taka in $ price is quoted, the denominator is Taka = $1/Tk.58.5 = $.0170
(Reciprocal rates)
Cross rates:
When a rate is obtained by multiplying two foreign exchange rates
Formulae:
Value of 1 unit of Currency A (Home currency) in unit(s) of Currency B (desired
currency)
Value of Currency A in $
= ----------------------------------
Value of Currency B in $

Example:
If the peso is worth $ .07 and Canadian dollar is worth $.70, what is the value of
peso in Canadian Dollar (C$)?

Value of peso in $ $.07


Value of peso in C$ = ------------------------- = -------- = C$.10
Value of C$ in $ $.70

Thus, peso is worth C$.10. An alternative way of expressing the exchange rate is
as the number of peso equal to 1C$. The figure can be computed by taking the
reciprocal .70/.07= 10, that suggests that Canadian Dollar is worth about 10
pesos.

Spread = the difference between sell and buy price.

Forward Exchange Rate: Contract today to buy currency or sell for future
delivery.

Swap = Simultaneous buying spot and selling forward.

F-S 12
Cost of Swap = Annualized Discount = 100
S n

Problem 1: A New York investor is willing to gain from FOREX Swap. He sees that the interest
rates in New York and London are 3.19% and 5.32% respectively. The Spot rate of $/ is $1.2000
and 3-months forward rate is $1.1999. Find the net advantage of swap, in any.

Solution No.1:

1.199-1.2000 12
Cost of Swap = Annualized Discount = ----------- 100 = - 2.0%
1.2000 3

Net Advantage = (5.31% - 3.19%) 2% = 0.13%

Self -Test
1. A commercial bank quotes a bid rate of $0.784 for the Australian dollar and an ask rate of
$0.80. What is the bid / ask percentage spread?
2. A commercial bank quotes a spot rate of $0.190 for Peruvian currency (new sol) and a
90-day forward rate of $0.188. Determine the forward premium (or discount) of the new
sol on an annualized basis.
3. Assume that a banks bid price for Canadian dollars is $0.7938, while its ask price is
$0.81. What is the bid / ask percentage spread?
4. Compute the forward discount or premium for Mexican peso whose 90-day forward rate
is $0.102 and spot rate is $0.10. State whether your answer is a discount or premium.
5. If a dollar is worth 1.7 Singapore dollars, what is the US-dollar value of a Singapore
dollar?
6. Assume Polands currency (the zloty) is worth $0.17 and a Japanese yen is worth $0.008.
What is the cross rate of the zloty with respect to yen?
7. The Wolfpack Corporation is a US exporter that invoices its exports to the UK in British
pounds. If it expects that the pound will appreciate against the dollar in future, should it
hedge its exports with a forward contract? Explain.
Forward Quotation
The following is a chart showing a simplified spot forward quotation

Spot $1.7208/
30-day Forward $1.7090/
90-day Forward $1.6929/

However, conventionally, in case of inter-bank transaction, to quote all forward rates


in terms of the spot rate and number of swap points for the forward maturity in
question.

For example, the 180-day forward Canadian rate would conventionally be quoted as

Spot 180-day swap


--------------------------------------
1.3365.70 23-27

This means that the bid (buy) price on US$ is Can$1.3365 and the ask (sell) price on
US$ is Can$ 1.3370. The swap points 23-27 must be added and subtracted from the
spot bid and ask rates. The adding or subtracting depends on the ascending or
descending order of swap points. If the points are ascending, this must be added to
bid and ask rates respectively to get forward bid and ask prices. If these are
descending, the points are to be subtracted.

Problem for self-test in the class:

Suppose a market-making bank is quoting British pounds as


Spot 30-day swap 90-day swap 180-day swap
1.4780-85 19-17 55-50 95-85

What will be the forward rates for different periods?

Spread and Points?

The Concept on Speculation


Simply, speculation means gambling with securities or currencies or interest rates
without hedging or covering position.
The speculators in the financial market place gamble that security prices or interest rates will
move in a direction that will result in quick gains due to his or her ability to outguess the markets
collective judgement. Many speculators are risk seekers, will to gamble their funds even when the
probability of success is low. However, speculators perform an important function in the financial
markets by leveling out the prices of securities, buying those they believe are under priced and
selling securities thought to be overpriced.

The difference between speculation and hedging is that in case of hedging, risks are minimized
by selling or buying currency forwards (contract), whereas in case of speculation no forward
selling or buying is done.

Arbitrage
The purchase of securities or commodities on one market for immediate resale on another in
order to profit from a price discrepancy.

Arbitrage in ForEx Market


There are three types of arbitrage seen in this market:
Locational
Triangular
Covered Interest Arbitrage (CIA)

Locational
Example:
Triangular
When three currencies rates are quoted in such a way that there might be differences in value of
currencies compared to one single currency, this is called Triangular arbitrage.

Example: Suppose that pound sterling is bid at $1.9809 in NY and Singapore Dollar (S$) is
offered at $0.6251 in Singapore. At the same time, London banks are offering pounds sterling at
S$ 3.1651.

Triangular Currency Arbitrage


4. Net gain equals $1,242 in NY

Finish $ 1,001,242
Start
$1,000,000 1. Sell $1,000,000 in
S/Pore = $0.6251 for S$
1,599,744

Multiplied by
$1.9809/
Divided by $0.6251

3. Resell the in NY at
=$1.9809

Divided by
S$3.1650/

505,448 in London S$ 1,599,744 in S/Pore

2. Sell these S$ in London at = S$


3.1650 for 505,448

Covered Interest Arbitrage (CIA)

Covered Interest arbitrage involves swapping one currency into another. This involves
two steps: (1) Buying foreign currency spot and (2) selling foreign currency forward. By
these two steps the investor is swapped, and has no currency rate exposure. Without
hedging the position, the investor could take a substantial loss if the foreign currency
depreciates in value against the investors home currency.

Problem: The interest rate in Hong Kong Euro markets is 8% i.e. the euro dollar rate is
8% per annum. On the other hand, this is 5% for Euro Yen in Yen money market.
Morning, William Wong, an arbitrager for Hong Kong and Shanghai Banking
Corporation, Hong Kong arrives at works Tuesday morning to be faced with the currency
quotation. He has access to several major Eurocurrencies for arbitrage trading. He has
135,000,000. He sees the spot rate of against dollar is 135/$ while 180-days forward
rate is 134.5/$.

Calculate the profit or loss of the above CIA.

Parity Relationship
Normally, two types of Parity Relationships are discussed in the International Finance.
These are Interest Rate Parity (IRP) and Purchasing Power Parity (PPP).

Interest Rate Parity (IRP): Once market forces cause the interest rates and Exchange
rates such that CIA is no longer feasible, there is an equilibrium state referred to as
Interest Rate Parity (IRP). In equilibrium, the forward rate differs from the spot rate by a
sufficient amount to offset the interest rate differential between two currencies.

Derivation of Interest Rate Parity (IRP) :


The relationship between a forward premium (or discount) of a foreign currency and the
interest rates representing these currencies according to IRP can be determined as
follows. Consider a US investor who attempts to CIA. The return to a US investor from
using CIA can be determined given:
The amount of the home currency (US dollars in our example) that is initially
invested (Ah).
The spot rate (S) in dollars when the foreign currency is purchased.
The interest rate on the foreign deposit (if)
The forward rate (F) in dollars at which the foreign currency will be converted
back to US dollars.

The amount of the home currency received at the end of the deposit period due to such
a strategy (called An) is

An= (Ah /S) (1+ if) F

Since F = S(1+p) where p is the forward premium, we can rewrite the equation as

An = (Ah /S) (1+ if) [S(1+p)]


= Ah (1+ if) (1+p)

The rate of return from this investment ( R ) is as follows:

R = (An - Ah) / Ah
[Ah (1+ if) (1+p)] - Ah
= ----------------------------- = (1+ if) (1+p)] - 1
Ah
If interest rate parity exists, then the rate of return achieved from CIA (R) should be
equal to the rate available in the home country. Set the rate that can be achieved from
using CIA to the interest rate that can be achieved from an investment in the home
country (the return on a home investment is simply the home interest rate called ih) :

So, R = ih
By substituting the formula the way in which R is determined, we obtain:

(1+ if) (1+p)] 1 = ih

By rearranging the terms, we get:

(1+ ih )
p = --------- - 1
(1+ if)

Problem: Assume that the Mexican peso exhibits a six-month interest rate of 6
percent, while the US dollar exhibits a six-month interest rate of 5 percent. From
a US investors perspective, the dollar is the home currency. Applying IRP, what
should be the forward rate premium of the peso with respect to the US dollar?
Explain.

Solution:

(1+ ih ) (1+.05)
p = --------- = ----------- - 1
(1+ if) (1+.06)

p = -.0094 or -.94% (not annualized)

Thus, the peso should exhibit a forward discount of about 0.94%. This implies
that the US investor would receive 0.94% less when selling pesos six month from
now than the price they pay for pesos today at the spot rate. Such a discount
would offset the interest rate advantage of the peso. If the pesos spot rate is
$0.10, a forward discount of 0.94% means that the six-month forward rate is as
follows:

F = S(1+p) = $0.1(1-0.0094) = $ 0.09906

Problem: Use the above information to determine a US investors return from


using CIA and explain whether it is feasible or not. Assume that the investor
begins with $1,000,000 to invest.

Solution:
Step 1: Convert $1,000,000 into pesos(MXP) at $0.10 per peso
$1,000,000/$0.10 =MXP10,000,000

Step 2: Sell pesos six months forward. The number of pesos to be sold forward
is the anticipated accumulation of pesos over the six-month period, which is
estimated as

MXP 10,000,000 x (1+6%) = MXP 10,600,000

This means that after six months, the US investor withdraws the initial deposit of pesos
along with the accumulated interest, amounting to a total of 10,600,000 pesos. The
investor converts the pesos into dollars in accordance with the forward contract agreed
upon at a rate of $0.09906.

MXP10,600,000 = $ 1,050,036

Step 3: Explanation of the Result: The act of CIA achieves a return of about 5% here.
Rounding the forward discount at 0.94% causes the slight deviation from the 5% return.

The result suggests that, in this instance, using CIA generates a return that is
about what the US investors would have received anyway if they had simply invested
their funds domestically. This confirms that CIA is not worthwhile if interest rate parity
exists.

According to IRP,

FS
p = --------- = ih - if
S

Where
p= forward premium (or discount)
F = Forward rate in dollars
S = spot rate in dollars
ih = home interest rate
ih = foreign interest rate

Graphical Representation of IRP


ih - if (%) IRP Line

c *y
Forward Discount (%)
1. qqqq

-5 -4 -3 -2 -1 +1 +2 +3 +4 +5 Forward Premium (%)


b
*z
a
*x