International Finance

1
Contents
Question 1 ...................................................................................................................................2
Foreign exchange arbitrage .........................................................................................................2
Two type of arbitrage ..................................................................................................................2
Effective Exchange Rate .........................................................................................................3
Depreciation and Devaluation of a currency ............................................................................5
Impact of currency devaluation on countries balance of payments ...........................................5
Question 2 ...................................................................................................................................6
Types of currency risks ...............................................................................................................6
Using inflation to forecast exchange rate .....................................................................................7
Expected staling receipts in one month and in three month (forward market)...............................8
Risks arising from granting credit to foreign customers ...............................................................9
Question 3 ................................................................................................................................. 10
Expected sterling receipts in three months (money market hedge) ......................................... 10
Sterling currency future contacts to hedge three month dollar receipt .................................... 11
Currency hedging to reduce firms cost of capital ................................................................... 12
Bibliography ............................................................................................................................. 13

Abdul Razzaq
 International Finance

Question 1
2

Foreign exchange arbitrage

“Arbitrage is an activity through which individuals seek immediate profit based on price
differentials or in its simplest terms, means “buy low – sell high”.” (OUM, 2010)

To the reference for the arbitrage, the foreign exchange arbitrage is, buying currency from one
market at a cheaper rate and selling it to another market for a high price.

Two type of arbitrage

1. Locational arbitrage: “..is the act of profiting from exchange rate differences that exist
in different markets. It means that the transaction is conducted across location and
currency’s exchange rate in one market must be different from the exchange rate in other
market”. (OUM, 2010)
In Maldives if we can get INR 3 per MRF, and in India the rate is INR 4 per MRF, than
an arbitrageur can purchase INR in India at the rate of INR 4 per MRF and resell it in
Maldivian market at the rate of INR 3 per MRF, resulting a profit of MRF 0.08 for every
INF. When these amounts are big in numbers than the amount of profit increases.
2. Triangular arbitrage: “refers to transactions involving three different currencies in
order to gain profit from price differentiation” (OUM, 2010)
Let’s take the previous example of MRF and Indian Rupees, and this time an addition of
USD.
It will be as;
INR 45.12619 per USD (India)
USD 0.077821 per MRF (US)
MRF0.333 per INR (Maldives)
Base on the information, if a Maldivian investor has MRF 1 million the he can generate
profit of MRF 169,417.8223
 At first he will buy Dollar at USD 0.077821 per MRF and get USD 77821
(MRF 1000000 x 0.077821 = USD 77,821)

Abdul Razzaq
 International Finance

 Than convert USD to INR in India (USD 77,821 x INR 45.12619 = INR
3
3,511,765.232)
 Convert INR to MRF in Maldives for MRF 0.333 per INR (3,511,765.232 x 0.333
= 1,169,417.822)

This arbitration activity generate a profit of MRF 169,417.822

Effective Exchange Rate

“effective exchange rate is a measure of the weighted average value of its bilateral nominal
exchange rates relative to a selected group of currencies” (OUM, 2010)

To create an affective exchange rate, 3 steps need to be taken.

Step1. Prepare basket currencies; currency basket is a group of currencies providing benchmark
for the local currency. To prepare basket currencies, first need to select the currencies to be
included. The best currency that can include in the basket will be the largest trading partner’s
currency.

Step2. Selection of base year; it is a reference point in time and equals to 100.

Step3. Calculation of weighted average;

For example; in Maldives, the biggest two trading partners of Maldives are India and US. During
the year 2009, the Maldivian exports to India were MRF20,000 million and imports were MRF
95,000 million. In the year 2009 Maldivian export to US were MRF 82,000 million and imports
were MRF 45,000 million. To calculate the weight of Indian rupees and US dollar we can use
the following formula.

𝑏
(𝑋𝑈𝑆 + 𝑀𝑈𝑆 )
𝑊𝑈𝑆 =
𝑋𝑈𝑆 + 𝑀𝑈𝑆 + ( 𝑋𝐼 + 𝑀𝐼 )

𝑏
(𝑀𝑅𝐹82000 + 𝑀𝑅𝐹45000)
𝑊𝑈𝑆 =
𝑀𝑅𝐹82000 + 𝑀𝑅𝐹45000 + (𝑀𝑅𝐹20000 + 𝑀𝑅𝐹95000)

𝑏
𝑊𝑈𝑆 = 0.52

Abdul Razzaq
 International Finance

(𝑀𝑅𝐹20000 + 𝑀𝑅𝐹95000)
𝑊𝐼𝑏 = 4
𝑀𝑅𝐹20000 + 𝑀𝑅𝐹95000 + (𝑀𝑅𝐹82000 + 𝑀𝑅𝐹45000)

𝑊𝐼𝑏 = 0.48

This is the weight of total Maldivian trade with India and US; the sum is equal to one. Than the
exchange rate should be divided by the base year.

For example; the US dollar per Maldivian rufiyaa for 2008 was $0.0784/MRF and for 2010 is
$0.0778/MRF. As for Indian rupees per Maldivian rufiyaa for 2008 was INR0.25/MRF and for
2010 is INR0.33/MRF. Therefore, exchange rate for US$ and Indian rupees relative to base year
are;

𝐸𝑅𝑡
𝑒𝑟 =
𝐸𝑅𝑏𝑎𝑠𝑒

0.0778 0.33
For US$ are ( ) = 0.99 and for Indian rupees ( ) = 1.32.
0.0784 0.25

With this available information an effective exchange rate can be calculated. For calculating
EER the following formula is used;

𝐸𝐸𝑅𝑡 = 𝑊𝑢𝑠 𝑒𝑟𝑢𝑠 + (𝑊𝐼 )(𝑒𝑟𝐼 ) × 100

Therefore, an effective exchange rate for year 2010 is;

𝐸𝐸𝑅2010 = 0.52 0.99 + (0.48)(1.32) × 100 = 114.84

This value indicates that the average value of the MRF against US dollar and the Indian rupees
for 2010 was 114.84% of the value for 2008. At the same time, it means that the MRF are
appreciated on average to both currency at the amount of appreciate of 14.84% (114.84 -100).

Abdul Razzaq
 International Finance

Depreciation and Devaluation of a currency

5
1. Depreciation is the decline in a value of a currency based on market factors like supply
and demand. The control of currency depreciation is totally in the hand of market. It is
depend on the economic situation of the country, if even the country has a stable
government or a strong export, it does not meter. The depreciated currency value makes
the export cheaper, resulting higher export in future.
2. Devaluation occurs when the country purposefully decrees the value of its currency. In
this case the government is in total control of the situation. It gives several advantages to
countries like, increasing export and increasing demand for domestic products in the
country.

Impact of currency devaluation on countries balance of payments

As stated, devaluation is a reduction in the value of currency with respect to other monetary
units. Balance of payment is the summary of all the international transaction occur between other
countries. These transactions include import and export of the country. If the imports are more
than the country’s export than the balance of payment will be deficit (negative).

To overcome the problem of deficit, the central bank will reduce the price of currency, making
the exchange rate fixed for a certain period of time (until the country recover from the deficit).
The impacts are on import and export of the country.

Imports; when the country decreases its money value, than the domestic price level of imported
goods will rise accordingly with the market value. It also reduces the purchasing power of
people, resulting an inflation in the country. The increase of value in import may adversely affect
the development plans undertaken by the government.

The devaluation also will result of exiting the foreign investors form the country. It is because of
the inflation and the expensive import for their production. This creates opportunity for domestic
production to grow. Resulting a recovery from the devalue price rate to an equilibrium exchange
rate.

Exports; the devaluation will increase the import, as the purchasing power of foreign currency
increases the quantity of purchasing will increase simultaneously. This will increase the
countries production in order to meet the demand of the foreign customers. When the export and
Abdul Razzaq
 International Finance

the countries production increases the purchasing power of the country will start to raise. So the
balance of payment of the country will be deficit.
6

Question 2

Types of currency risks

Transaction risk;

“.... refers to the potential change in the value of outstanding obligations due to changes in the
exchange rate between the inception of a contract and future settlement of the contract or receipt
denominated in other currency.” (OUM, 2010)

This is the result of changing the exchange rate during the transaction of money transfer from
one country to another.

If the exchange rate moves unfavourably during the transaction, the profit for the company will
decrease sometime creating a huge loss.

Economic risk;

“...refers to the change in the present value of company resulting from changes in future
operating cash flows of the company caused by an unexpected change in exchange rate.” (OUM,
2010)

This will affect the long run earning of a company and the effect is not visible always.

The risk value depends on the effect of the exchange rate on future sales, price and cost value.

In the economic risk the timing and the amount of the flows are uncertain and are non
contractual.

The economic risk focuses on the expected future cash flows that might change because a change
in the exchange rate has altered the international competitiveness.

Abdul Razzaq
 International Finance

Translation risk;
7
“...measures the effect of an exchange rate change on published financial statements of a
company.” (OUM, 2010)

It occurs when the company’s translate its foreign subsidiary company’s financial statement to
local currency.

This is more of an accounting transaction and do not effect directly to the company.

Using inflation to forecast exchange rate

“The exchange rate is defined as the price of one currency expressed in terms of another
currency.” (OUM, 2010)

This means the value of one currency is estimated from another currency. For example in
Maldives, in exchange rate the value of one US$ is expressed in terms of MRF (US$1 = MRF
12.85).

“Inflation is an economic condition wherein the price of the goods and services increase
steadily measured against standard level of purchasing power, whereas the supply of the goods
and services decline along with the devaluation of money.” (economywatch)

The inflation can be express as when the supply of money in the economy increases along with
the spending of people. Than the businesses will increase the prices of the goods, this will result
in decreasing the value of the currency as the consumers are unable to buy as much as goods
before there were buying.

To determine the exchange rate using the inflation rate of the country there are various methods.
From that if it is to find spot rat, the absolute purchasing power parity provides a solution.

In absolute purchasing power parity the spot exchange rate is determined by identical products of
similar baskets of goods. The absolute PPP work as the long run equilibrium exchange rate at a
point in time can be taken from the relative prices between domestic and foreign currencies.
When the country’s inflation increases than the country’s exchange rate must depreciated in
order to return to PPP equilibrium state.

Abdul Razzaq
 International Finance

If the company needs to determine the exchange rate changes over the period, than relative PPP
explains way to determine it.
8

The relative PPP shows the change in prices between two countries over a period of time
determining the changes in the exchange rate over that period. Simply to say it measure the
exchange rate changes over time based on expected inflation rate differentials.

Expected staling receipts in one month and in three month (forward market)

1 month; expected receipt of $ 240,000

1 month; expected payment of $ 140,000

3 months; expected receipts of $ 300,000

One month forward rate ($ per £); 1.7829 ± 0.0003

Three months forward rate ($ per £); 1.7846 ± 0.0004

Receipts in one month

240,000 − 140,000 = 100,000 (1.7829 + 0.0003) = 1.7832

100,000
Net receipt =
1.7832
= 56,078.96

Receipts in three months

(1.7846 + 0.0004) = 1.7850

300,000
= 168,067
1.7850

Abdul Razzaq
 International Finance

Risks arising from granting credit to foreign customers

9
There are several risks involve in giving credit to foreign customers. From that some risk
involve;

Foreign exchange risk: the exchange rate is the price of one country’s currency in terms of
another currency. The fluctuation in exchange rate creates an uncertainty in the foreign business
transaction.

For example: a Maldivian company sell $100,000 worth of tuna to US company for credit with a
maturity of 6 months. At the time the rate for MRF to dollar is 12.85 per $. But during the period
of 6 months the value of $ depreciated to MRF 9.75 per $. Therefore the Maldivian company has
to take a loss of MRF 310,000.

To eliminate the risk of foreign exchange, the Maldivian company can take a loan of $100,000
from a bank in US and ask the client to pay that loan instead of paying the Maldivian company.
This will eliminate the risk as the money for the company already has been taken and for the
client it will be easy for him as the client has to pay the local bank.

The risk of bad debts; there always is a risk of not paying by the customer either it’s a foreign
or a local customer. If a foreign customer refuses to pay the bills, than it will be almost
impossible to get the money back. So to overcome this risk the company can put agents in the
countries where most of the customers are placed. This will allow the company to have a face to
face conversation with their customers. The deals will be made as in a local business. The agents
can estimate the credit worthiness of the customer, so when entering into business transaction
these information are that makes changers in receiving or defaulting the payment.

Abdul Razzaq
 International Finance

Question 3
10

Expected sterling receipts in three months (money market hedge)

Three months expected receipts; $ 300,000

One year sterling interest rate (deposit); 4.6%

One year dollar interest rate (borrowing) 5.4%

Spot rate ($ per £) 1.7820 ± 0.0002

5.4 ÷ 4 = 1.35 ÷ 100 = 0.0135

4.6 ÷ 4 = 1.15 ÷ 100 = 0.0115

𝐹𝑉
𝑃𝑉 =
(1 + 𝑟 𝑛 )

300,000
= 296,004
(1+0.0135)
296,004
= 166,089
(1.7822)

When depositing
166,089 x (1+ 0.0115)
= 167,999

From the calculations the forward contract gives 168,067 and money market hedge allow having
167,999. Therefore an increase of 68 was provided by the forward market. Base on this the
forward market is recommended to use. As in the case of this where currency values are
changing dramatically, the effects of the currency radically alter asset value. The forward market
is actually reducing the risk of the company’s financial distress.

Abdul Razzaq
 International Finance

Sterling currency future contacts to hedge three month dollar receipt

11
“Futures contract is an agreement to deliver to or take delivery from another party a given
amount of a standardised commodity at a designated futures date.” (OUM, 2010)

It means that a contract is made between two parties to deliver an asset at a futures date at a pre
agreed price.

For example; mifco make a contract with a US buyer to deliver two container of fish after 6
months period at the spot rate of MRF 12.85 per US$. Even though during the time period of 6
month the rate appreciate or depreciate the exchange rate for this contract will be MRF 12.85 per
US$.

When the sterling currency future contract is used to hedge dollar receipt in 3 months period, the
amount that will receive and the amount the contract can sell in future date is pre determine. It is
because the transaction will be on an agreed exchange rate.

For example; STO is expecting receipts of $ 300,000 in three months time, at the rate of 1.7822
US$/pound. The STO is expecting a total receipt of £168,331. In order to reduce the loss when
exchanging US dollar to sterling pound, the STO hedge the UK pound in futures. Each UK
pound future contract is worth $60,000 and every basis point change in the futures price is equal
to $25.

In the transition STO will enter to purchase 5 UK pound future contracts. If the UK pound
appreciates within the next three months, the future contract will gain $125 for every basis point
decrease in the USD/pound exchange rate. But if the pound depreciates than the STO has to bear
the loss of $125.

The exchange rate is unpredictable there for the changes in exchange rate make the future
contract hedging secure in some extent. It provides profit when the home currency depreciates
and when the currency appreciates there will be a loss. It’s like a probability of loosing equals to
probability of making a profit. But if the prediction is made that in future exchange rate will fall
than its better to enter into a future contract.

Abdul Razzaq
 International Finance

Currency hedging to reduce firms cost of capital

12
“Currency hedging refers to a strategy that strives to minimise the exposure to exchange rate
fluctuation, thereby minimising the uncertainty of future transactions denominated in a foreign
currency and providing some stability to earnings and cash flows.” (OUM, 2010)

Hedging strategy help insulate the investor from occurrence of event that will make a loss in his
investment. When it comes to currency hedging, the investor will convert the currency to the
origin currency of investment he plans to invest and then make the investment.

The capital of company includes equity and debt. Cost of capital is the rate of return which the
capital providers demand for. The return which equity providers demand for will be the shear
premium. And the debt financer will ask for the interest on the loan he provided.

In order to meet these demands the company has to make some profit in future cash flows. Since
the cash flow stability is crucial to the business operation, many firms attempt to manage the risk
by hedging.

Hedging is done by minimising the uncertainty of future transaction by foreign currency and
providing some stability to earnings and cash flows.

When the risk is reduced in future cash flows, it will provide an opportunity for the business to
plan for the future investments. Meaning to promise more return for the capital providers.

Along with the risk reduction the financial distress will also reduce. When the hedging is done it
will reduce the distress level with generating money to pay the debt.

When the contact of a foreign currency is hedge to a contract the company can gain from the
changers occur in the exchange rate.

Abdul Razzaq
 International Finance

Bibliography
bankislam. (n.d.). profile. Retrieved march 05, 2011, from www.bankislam.com. 13

Batada, b. R. (2001, march 5). devaluation and its impact. Retrieved march 12, 2011, from
www.pakistaneconomist.com.

docstoc. (n.d.). banking managemant. Retrieved march 2, 2011, from www.docstoc.com.

docstoc. (n.d.). operational problems. Retrieved march 2, 2011, from www.docstoc.com.

duport. (n.d.). staff issues. Retrieved march 10, 2011, from www.duport.co.uk.

economywatch. (n.d.). Definition of Inflation. Retrieved march 15, 2011, from

www.economywatch.com.

imf. (n.d.). operational issues. Retrieved march 04, 2011, from www.imf.org.

islam, s. (2007). bank managemant. open university.

Lister, J. (2011, january 9). difference between devaluation and depreciation. Retrieved march
12, 2011, from www.ehow.com.

OUM. (2010). international finance. OUM.

wrmea. (n.d.). bank issues. Retrieved march 07, 2011, from www.wrmea.com.

Abdul Razzaq