CHAPTER 1: MULTINATIONAL FINANCIAL
MANAGEMENT: AN OVERVIEW
Agency problem: conflict of goals between a
firms managers and shareholders
Agency costs: ensuring that managers
maximize shareholder wealth
- agency costs are normally larger for
MNC than for purely domestic firms for
several reasons:
MNCs with subsidiaries scattered
around the world may experience
larger agency problems because
monitoring the managers of
distant subsidiaries in foreign
countries is more difficult
Foreign subsidiary managers who
are raised in diff cultures may not
follow uniform goals
The sheer size of the larger
MNCs can also create significant
agency problems
Some non US managers tend to
downplay the short term effects of
decisions which may result in
decisions for foreign subsidiaries
of US based MNCs that maximize
subsidiary values or pursue other
goals
PARENT CONTROL OF AGENCY
PROBLEMS
- proper governance
- clearly communicate the goals for each
subsidiary to ensure that all of them
focus on maximizing the value of MNC
- through implementing compensation
plans that reward managers who satify
MNC goals
- provide MNCs stock or options to buy
as part of compensation
MANAGEMENT STRUCTURE OF AN MNC
- centralized management style:
reduces agency costs because it
allows managers of the parent to control
foreign subsidiaries and thus reduces
the power of subsidiary managers
- however, parents managers may make
poor decisions for the subsidiary if they
are less informed than the subsidiarys
managers about its setting and financial
characteristics
- decentralized management style:
more likely to result to higher agency
costs because subsidiary managers
may make decisions that fail to
maximize the value of the entire MNC
- some MNCs attempt to achieve
advantages of both by allowing
subsidiary managers to make the key
decisions while parents management
monitors those decisions to ensure they
are in the MNCs best interest.
WHY FIRMS PURSUE INTERNATIONAL
BUSINESS
o THEORY OF COMPETITIVE ADVANTAGE
- specialization by countries can increase
production efficiency
- a country that specializes in some
products may not produce other
products, so trade between countries is
essential
- allows firm to penetrate foreign markets
o IMPERFECT MARKETS THEORY
- factors of production are somewhat
immobile
- there are costs and often restrictions
related to the transfer of labor and other
resources used for production
- MNCs often capitalize on a foreign
countrys particular resources
- Imperfect markets provides incentive for
firms to seek out foreign opportunities
o PRODUCT CYCLE THEORY
- firms become established in the home
market as a result of some perceived
advantage over existing competitors
- foreign demand will initially be
accommodated by exporting
- then produce product in foreign market
to reduce transpo costs
- as a firm matures, it may recognize
additional opportunities outside its home
country
HOW FIRMS ENGAGE IN INTERNATIONAL
TRADE
o International trade
- relatively conservative approach that
can be used by firms to: penetrate
markets (by exporting) or to obtain
supplies at a low cost (by importing)
- minimal risk because firms doesnt place
any of its capital at risk
o Licensing
- arrangement whereby one firm provides
its technology (copyrights, patents,
trademarks, or trade names) in
exchange for fees or others
- Allows firms to use their technology in
foreign markets without a major
investment and without transportation
costs that result from exporting
- Major disadvantage: difficult to ensure
quality control in foreign production
process
o Franchising
- one firm provides a specialized sales or
service strategy, support assistance,
and possibly an initial investment in the
franchise in exchange for periodic fees
- allows firms to penetrate markets
without major investment in foreign
countries
o Joint ventures
- venture that is jointly owned and
operated by two or more firms
- A firm may enter the foreign market by
engaging in a joint venture with firms
that reside in those markets.
 - Allows two firms to apply their respective
cooperative advantages in a given
project.
o Acquisitions of Existing Operations
- means of penetrating foreign markets
- give firms full control over their foreign
businesses and enable the MNC to
quickly obtain a large portion of foreign
market share
- however, it can lead to large losses
because of the large investment
required
- some engage in partial international
acquisitions in order to obtain a toehold
or stake in foreign operations, this
approach lessen the risk because of a
smaller investment requirement but the
firm will not have complete control
-
o Establishment of New foreign
subsidiaries
- requires large investment
- firms can penetrate markets by
establishing new operations in foreign
countries.
- Requires a large investment
- Acquiring new as opposed to buying
existing allows operations to be
tailored exactly to the firms needs.
- May require smaller investment than
buying existing firm.
SUMMARY OF METHODS
- Any method of increasing international
business that requires a direct
investment in foreign operations is
referred to as direct foreign
investment (DFI)
- International trade and licensing usually
not included
- Franchising and joint ventures then to
require some investment but only to a
limited degree
- Foreign acquisition and establishment of
new foreign subsidiaries represent the
largest portion of DFI.
VALUATION MODEL FOR AN MNC
o Domestic Model: not engaged in any foreign
transactions
- present value of its expected cash
flows
- dollar cash flows: funds received by the firm
minus funds needed to pay expenses or taxes
or to reinvest in the firm (such as an investment
to replace old computers or machinery)
- this is estimated from knowledge about
various existing projects
- all other things constant, an increase in
expected cash flows over time increase the
value of a firm
- cost of capital: required rate of return
- weighted average of the cost of capital
based on all of the firms project
- all other things constant, an increase in
the firms required rate of return will
reduce the value of the firm because
expected cash flows must be discounted
at a higher interest rate
o Multinational Model: cash flows may be
coming from various countries and so may
be denominated in different foreign
countries
Valuation of an MNC that uses two
currencies
- Could measure its expected dollar cash
flows in any period by multiplying the
expected cash flow in each currency by
the expected exchange rate at which
that currency would be converted to
dollars and then summing those two
products.
Valuation of an MNC that uses
multiple currencies
- derive an expected dollar cash flow
value for each currency
- combine cash flows among currencies
within a given period
Valuation of an MNCs cash flows over
multiple periods
- apply single period process to all future
periods
- discount the estimated total dollar cash
flow for each period at the weighted cost
of capital
UNCERTAINTY SURROUNDING MNC
CASH FLOWS
o Exposure to international economic
conditions
- If economic conditions in a foreign
country weaken, purchase of products
decline and MNC sales in that country
may be lower than expected.
o Exposure to international political risk
- A foreign government may increase
taxes or impose barriers on the MNCs
subsidiary.
o Exposure to exchange rate risk
- If foreign currencies related to the MNC
subsidiary weaken against the U.S.
dollar, the MNC will receive a lower
amount of dollar cash flows than was
expected.
HOW UNCERTAINTY AFFECTS THE MNCS
COST OF CAPITAL
- A higher level of uncertainty increases
the required rate of return of investors,
thus the MNCs cost of obtaining capital,
which lowers the firms valuation.
SUMMARY:
The valuation model of an MNC shows that the
MNCs value is favorably affected when its
expected foreign cash inflows increase, the
currencies denominating those cash inflows
increase, or the MNCs required rate of return
decreases. Conversely, the MNCs value is
adversely affected when its expected foreign
cash inflows decrease, the values of currencies
denominating those cash flows decrease
(assuming that they have net cash inflows in
foreign currencies), or the MNCs required rate
of return increases.
1) Direct foreign investment
CHAPTER 2: INTERNATIONAL FLOW OF
FUNDS
BALANCE OF PAYMENTS
- summary of transactions between
domestic and foreign residents for a
specific country over a specified
period of time.
- Transactions by businesses,
2) Portfolio investment
individuals, and the government
Current account: summary of
the flow of funds between one
specified country and all other
countries due to purchases of
goods and services or to the cash
flows generated by income-
producing financial assets
Capital account: summary of the
flow of funds resulting from the
sale of assets between one
specified country and all other
countries over a specified period
of time, new foreign investments
made by a country
Financial account- special
types of investments (DFI and
portfolio investment)
For all accounts, inflow of funds
generate positive numbers (credits);
for the countrys balance whereas
transactions that reflect outflows of
funds generate negative numbers
(debits)
Current account
1) Payments for merchandise
(goods) and services
- Tangible products that are
transported between countries
- Services represent tourism and other
services such as legal, insurance,
and consulting services provided for
customers in other countries
- Diff between total exports and
imports is referred to as the balance
of trades
- Exports= inflow of funds; import=
outflow of funds
2) Factor income
- Interest and dividend payments
received by investors on foreign
investments in financial assets
- Income received= inflow; income
paid= outflow
3) Transfer payments
- Aid, grants, and gifts from one
country to another
Capital account
- Originally included in the financial
account
- Patents and trademarks
- Minor account items compared to
financial account items
Financial account
- Investment in fixed assets that can
be used to conduct business
operations
- Acquisition of a foreign company
- Construction of a new manufacturing
plant
- Expansion of plant in a foreign
country
 - Transactions involving long term
financial assets such as stocks and
bonds that do not affect the
transfer of control
- Represents purchase of foreign
financial assets without changing
control of the company
3) Other capital investments
- Transactions involving short term
financial assets such as money
market securities between countries
4) Errors and omissions and reserves
IMPACT OF OUTSOURCING ON TRADE
o Outsourcing: process of subcontracting to
a third party in another country to provide
supplies or services that were previously
produced internally
- increases international trade activity
- allows MNCs to conduct operations
at a lower cost
FACTORS AFFECTING INTERNATIONAL
TRADE FLOWS
Cost of labor
- firms in countries where labor costs
are low typically have an advantage
when competing globally, especially
in labor-intensive industries
Inflation
- if a countrys inflation rate increases
relative to the countries with which it
trades, then its current account
should decrease, other things equal
- consumers and corporations in that
country will most likely purchase
more goods overseas because of
high inflation and the countrys
exports to other countries will decline
National income
- if a countrys national income level
increases by a higher percentage
than those of other countries, then its
current account should decrease,
other things being equal
- as income rises, so does
consumption of goods, increased
demand for foreign goods
Credit conditions
- credit conditions tend to tighten when
economic conditions weaken
because corporations are then less
able to repay debt
- banks are less willing to provide
financing to MNCs, reducing
corporate spending
- As MNCs reduce spending, they also
reduce demand for imported supplies
resulting to a decline in international
trade flows
Government policies
- each countrys govt wants to
increase exports because more
exports lead to more production and
income and may also create jobs.
- There are several types of policies
often used to improve balance of
trade and thereby create jobs within
a country:
Restrictions on imports
- when govt imposes tax on imported
goods (tariffs) and maximum limit
that can be imported (quotas) to
discourage imports
Subsidies for exporters
- offer subsidies to its domestic firms
so that they can produce products at
a lower cost than their global
competitors
- dumping: exporting of products that
were produced with the help of
government subsidies
Restrictions on Piracy
- a govt that doesnt act to minimize
piracy may indirectly reduce imports
and may even discourage MNCs
from exporting to that market
Environmental restrictions
- when a govt imposes environmental
restrictions, local firms experience
higher costs of production
Labor laws
- more restrictive laws, higher
expenses for labor, other factors
being equal
Business laws
- more restrictive laws, not able to
compete globally
Tax breaks
- govt financial support that could
benefit firms that export products
Country trade requirements
- a govt may require that MNCs
complete various forms or obtain
licenses before they can export
products to its country
- causes inefficiency and delays
Government Ownership or
subsidies
- some govts maintain ownership in
firms that are major exporters
Country security laws
- Governments may impose certain
restrictions when national security is
a concern, which can affect on trade.
Policies to Punish Country
Governments
- Many expect countries to restrict
imports from countries that...
- Fail to enforce environmental laws
and child labor laws
- Initiate war against another
country
- Unwilling to participate in a war
EXCHANGE RATES
- If a countrys currency begins to rise
in value against other currencies
then its current account balance
should decrease, other things being
equal.
- As the currency strengthens, goods
exported by that country will become
 more expensive to the importing
countries and so the demand for
such goods will decrease
HOW EXCHANGE RATES MAY CORRECT A
BALANCE OF TRADE DEFICIT
- When a home currency is exchanged
for a foreign currency to buy foreign
goods, then the home currency
faces downward pressure, leading
to increased foreign demand for the
countrys products.
WHY EXCHANGE RATES MAY NOT
CORRECT A BALANCE OF TRADE DEFICIT
- Exchange rates will not automatically correct
any international trade balances when other
forces are at work.
LIMITATIONS OF A WEAK HOME
CURRENCY SOLUTION
o Competition: when a countrys currency
weakens, foreign companies may lower
their prices to remain competitive.
o Impact of other currencies: a country that
has balance of trade deficit with many
countries is not likely to solve all deficits
simultaneously.
o Prearranged international trade
transactions: international transactions
cannot be adjusted immediately. The lag is
estimated to be 18 months or longer,
leading to a J-curve effect.
o Intracompany trade: Many firms purchase
products that are produced by their
subsidiaries. These transactions are not
necessarily affected by currency
fluctuations.
EXCHANGE RATES AND INTERNATIONAL
FRICTION
All governments cannot weaken their
home currencies simultaneously.
Actions by one government to weaken
its currency causes another countrys
currency to strengthen.
Government attempts to influence
exchange rates can lead to international
disputes.
INTERNATIONAL CAPITAL FLOWS
FACTORS AFFECTING DFI
o Changes in restrictions: lowered
restriction, more DFI
o Privatization: selling of some of their
operations to corporations and investors
o Potential Economic Growth: greater
potential, more likely to attract DFI
o Tax rates: countries that impose lower
tax rates, attract DFI
o Exchange rates: firms typically pursue
DFI in other countries where local
currency is expected to strengthen
against their own
FACTORS AFFECTING INTERNATIONAL
PORTFOLIO INVESTMENT
o Tax rates on Interest/ Dividends:
investors prefer to invest in country
where taxes interest/dividend income
from investments are relatively low
o Interest rates: money tends to flow to
countries with high interest rates as long
as the local currencies are not expected
to weaken
o Exchange rates: if a countrys home
currency is expected to strengthen, then
foreign investors may be willing to invest
in that countrys securities in order to
benefit from the currency movement
CHAPTER 3: INTERNATIONAL FINANCIAL
MARKETS
Foreign exchange market: allows exchange
of one currency for another
- large banks serve this market by
holding inventories of each currency
so that they can accommodate
requests by individuals or MNCs
HISTORY OF FOREIGN EXCHANGE
o Gold standard: from 1876 to 1913,
exchange rates were dictated by the
gold standard, thus, rate between two
currencies was determined by their
relative convertibility rates per ounce of
gold
o Agreements on Fixed Exchange
Rates
- Bretton woods agreement:
agreement that calls for fixed
exchange rates between currencies,
this lasted until 1971
- Smithsonian agreement: US dollar
became overvalued so officials reset
it
o Floating Exchange Rate System
- currencies have been allowed to
fluctuate in accordance with market
forces; however, their respective
central banks are periodically
intervening to stabilize exchange
rates
Foreign exchange dealers: serve as
intermediaries in the foreign exchange market
by exchanging currencies desired by MNCs or
individuals.
Spot market: most common type of forex
transaction, immediate exchange, exchange
rate is known as spot rate
- often completed electronically
- currencys liquidity affects the ease
with which it can be bought or sold
by an MNC
Interbank market: when a bank begins to
experience shortage of a particular foreign
currency, it can purchase that currency from
other banks

Attributes of Banks that provide FOREX
o Competitiveness of quote
o Special relationship with the bank:
bank can offer cash management
services or be willing to make a special
effort to find currencies for the
corporation
o Speed of execution
o Advice about current market
condition
o Forecasting advice
FOREIGN EXCHANGE QUOTATIONS
- at any moment, exchange rate
between two currencies should be
similar across various banks that
provide FOREX services
Bid/Ask Spreads of Banks
- commercial banks charge fees for
conducting foreign exchange
transactions; thus, they buy a
currency from customers at a slightly
lower price than the price at which
they sell it
- banks bid price (buy quote) for a
foreign currency will always be less
than its ask price (sell quote)
- normally expressed as a percentage
of the ask quote
that they need not to worry about
= fluctuations in the spot rate until the
- spread is larger for illiquid currencies
that are less frequently traded
FACTORS THAT AFFECT THE SPREAD
o (+) Order costs: clearing costs and
recording transactions
o (+) Inventory costs: cost of maintaining
an inventory of a particular currency
- holding an inventory involves an
opportunity costs because the funds
could have been used for some other
purpose. If interest rates are high,
then the opportunity cost of holding
an inventory should be relatively
high.
o (-) Competition: the more intense the
competition, the smaller the spread
quoted by intermediaries
o (-) Volume: currencies that are more
liquid are less likely to experience a
sudden change in price
- currency that have a large trading
volume are more liquid, it has
enough depth that a few large
transactions are unlikely to cause the
currencys price to change abruptly
o (+) Currency risk: some currencies
experience more volatility because
economic or political conditions that cause
the demand for and supply of the currency
to change abruptly
INTERPRETING FOREIGN EXCHANGE
QUOTATIONS
Direct quotations: quotations that report the
value of a foreign currency in dollars
Indirect quotation: number of units of a
foreign currency per dollar, reciprocal of the
direct quotation
- if a currencys direct exchange rate is rising
over time, then its indirect exchange rate must
be declining over time
Cross exchange rate: reflects the amount of
one foreign currency per unit of another foreign
currency
CURRENCY DERIVATIVE
- contract with a price that is partially
derived from the value of the
underlying currency that it
represents.
o Forward contracts
- agreement between an MNC and a
forex dealer that specifies the
currencies to be exchanged, forward
rate, and the date at which the
transaction will occur
- MNCs use this to hedge future
payments that they expect to make
or receive in a foreign currency so
time of their future payments
o Forward market
- Market in which forward contracts
are traded, OTC market, and its main
participants are the foreign exchange
dealers and the MNCs that wish to
obtain a forward contract
- hedge receivables and payables
o Futures contract
- specifies a standard volume of a
particular currency to be exchanged
on a specific settlement date at the
futures rate
o Options contract: offer more flexibility
than forward or futures contracts because
they are not obligations
Call option: provides the right to buy
a specific currency at a specific price
called the strike price or exercise
price within a specific period of time
- used to hedge future payables
Put option: provides the right to sell
a specific currency at a specific price
within a specific period of time
- used to hedge future receivables
CHAPTER 4: EXCHANGE RATE
DETERMINATION
Cash flows are highly dependent on
exchange rates
MEASURING EXCHANGE RATE
MOVEMENTS
Exchange rate: measures value of one
currency in units of another currency
Depreciation: decline in currencys
value
Appreciation: increase in currencys
value
PERCENT CHANGE IN FOREIGN
CURRENCY VALUE= S- St-1/St-1
- Positive percentage change indicate that
currency has appreciated and vice versa
Forex movements tend to be larger for
longer time horizons
EXCHANGE RATE EQUILIBRIUM
- Price of a currency is determined by the
demand for that currency relative to its
supply
- A currency should exhibit the price at
which demand equals supply
US DOLLAR vs. BRITISH POUND
DEMAND FOR A CURRENCY
- Schedule is downward sloping
- Because corporations and individuals in
the US would purchase more british
goods when pound is worth less and
vice versa
SUPPLY OF A CURRENCY
- Upward sloping
- Because when the pounds value is
high, british consumers and firms are
more willing to exchange their pounds
for dollars to purchase US products or
securities
EQUILIBRIUM
- Shortage: quantity demanded exceeds
supply
- Surplus: quantity demanded is less
than the supply
CHANGE IN THE EQUILIBRIUM EXCHANGE
RATE
- Exchange rate varies because banks
that serve as intermediaries in the
foreign exchange market adjust the
price of which they are willing to buy and
sell a particular currency in the face of a
sudden shortage or excess of that
currency
o INCREASE IN DEMAND SCHEDULE
- Demand can change any time
- If demand increases, outward shift in
the schedule (ceteris paribus), there
will be a shortage
- Banks will respond by raising the
exchange rate of the pound resulting to
a decrease in the quantity demanded in
the forex market as well as an increase
in the amt of pounds supplied (sold) in
the market.
o DECREASE IN DEMAND SCHEDULE
- If demand decreases, inward shift in
the schedule, there will be surplus
- Banks will respond by lowering the
exchange rate of the pound resulting to
increase in the quantity demanded and
decrease in amount of pounds sold in
the market
o INCREASE IN SUPPLY SCHEDULE
- Supply increases because of British
demand for US dollars, outward shift in
supply schedule, resulting to surplus
- Banks will respond by lowering
exchange rate of the pound
o DECREASE IN SUPPLY SCHEDULE
- Suppy decrease because of british firms
needing fewer dollars, inward shift in
supply schedule, there will be shortage
- Banks will respond by increasing the
exchange rate of the pound
FACTORS THAT INFLUENCE EXCHANGE
RATES (affects demand and supply)
o RELATIVE INFLATION RATES
- Changes can affect international trade
activity
- A sudden jump in US inflation cause
some US consumers to buy more British
products instead of US products. There
would be an increase in the US demand
for British goods, which represents an
increase in the US demand for British
pounds.
- In addition, it would also reduce the
British desire for US goods therefore
reducing supply of pounds for sale at
any given exchange rate
o RELATIVE INTEREST RATES
- Changes can affect investment in
foreign securities
- If US interest rates rise while british
rates remain constant, US investors will
likely reduce their demand for pounds,
since US rates are now more attractive
- Since US rates will be more attractive,
supply of pounds for sale by british
investors should increase as they
establish more bank deposits in the US
- There will be an inward shift in demand
for pound and outward shift in the supply
of pounds for sale, the equilibrium
exchange rate should decrease
o REAL INTEREST RATES
- A relatively high interest rate may attract
foreign inflows to invest in securities
offering high yields, that high rate may
reflect expectations of relatively high
inflation
- High inflation can place downward
pressure on the local currency, some
foreign investors may be discouraged
 from investing in securities denominated
in that currency
- In such cases, it is useful to consider
real interest rates, which adjusts the
nominal interest rate for inflation
REAL INTEREST RATE = NOMINAL
INTEREST RATE INFLATION RATE
o RELATIVE INCOME LEVELS
- Income can affect the amount of imports
demanded, it can also affect exchange
rates
- Increase income levels reflect favorable
economic condition, hence, British firms
would probably increase their
investments in US if income level
increases there. As a result, supply of
British pounds in the market will
increase (shift outward)
- an increase in US income levels could
also have an indirect effect on the
pounds exchange rate by influencing
interest rates
- Under economic growth, business
demand for loans tends to increase and
thus cause a rise in interest rates
higher interest rates attract foreign
investors; this is another reason why the
supply schedule of british pounds may
increase enough to offset any effect of
increased US income levels on the
demand schedule
o GOVERNMENT CONTROLS
1) through imposing foreign exchange
barriers
2) imposing foreign trade barriers
3) intervening (buying and selling
currencies) in the forex market
4) affecting macro variables such as
inflation, interest rates, and income
levels
o EXPECTATIONS
Impact of favorable expectations
- ex: investors may temporarily invest
funds in Canada if they expect Canadian
interest rates to increase, such rise may
cause further capital flows into Canada,
which would place upward pressure on
the Canadian dollars value
- expectations can influence exchange
rates because they commonly motivate
institutional investors to take foreign
currency positions
Impact of Unfavorable expectations
- just as speculators can place upward
pressure on a currencys value when
they expect it to appreciate, they can
place downward pressure on a currency
when they expect it to depreciate.
- Expectations of a crisis may lead to an
increase in the supply of the countrys
currency for sale in the forex market
because foreign investors who
previously invested in the country now
want to get out
Impact of Signals on Currency
Speculation
- day to day speculation on future
exchange rate movements is typically
driven by signals of future interest rate
movements
- speculative positions in currencies may
adjust quickly, increasing exchange rate
volatility
INTERACTION OF FACTORS
o TRADE FLOWS
- generally less responsive to news
- inflation, income, trade restrictions
o FINANCIAL FLOWS
- extremely responsive to news
- interest rate, capital flow, exchange rate
The sensitivity of an exchange rate to these
factors depends on the volume of international
transactions between the two countries
INFLUENCE OF FACTORS ACROSS
MULTIPLE CURRENCY MARKETS
- each exchange rate has its own market,
meaning its own demand and supply
conditions
- value of the british pound in dollars is
influenced by the US demand for
pounds and the amounts of pounds
supplied to the market
IMPACT OF LIQUIDITY ON EXCHANGE
RATE ADJUSTMENT
- liquidity of a currency affects exchange
rates sensitivity to specific transactions
- if currencys spot market is liquid then its
exchange rate will not be highly
sensitive to a single large purchase or
sale, so change in equilibrium exchange
rate will be relatively small
CAPITALIZING ON EXPECTED EXCHANGE
RATE MOVEMENTS
o Institutional speculation based on
expected appreciation
- if they believe that a particular currency
is presently valued lower than it should
be in the foreign exchange market, they
may consider investing in that country
now before it appreciates
- then they would liquidate their
investment in that currency after it
appreciates to benefit from selling it for a
higher price than they paid
HOW?
1) Borrow money.
2) Convert the money into the currency
that will appreciate.
3) Invest the converted money at the
lending rate of the country that is
expected to appreciate.
4) Use the proceeds from the converted
money to repay the borrowed money at
the borrowing rate.
 5) Subtract to get speculative profit
o Institutional speculation based on
expected depreciation
- if they believe that a particular currency
is presently valued higher than it should
be in the FOREX market, they may
borrow funds in that currency now and
convert it to their local currency now
- the plan is to repay the loan in that
currency after it depreciates
HOW?
1) Borrow the currency that is about to
depreciate.
2) Convert it to your local currency.
3) Lend the money at your country.
4) Use the proceeds to repay the borrowed
currency.
5) Subtract to get speculative profit.
The potential returns from foreign currency
speculation are high for financial institutions
that have large borrowing capacity.
THE CARRY TRADE
- investors attempt to capitalize on the
difference in interest rates between two
countries
- borrowing a currency with low interest
rate and investing the funds in a
currency with a high interest rate
- the term was derived from cost of carry
which in financial markets represents
the cost of holding (or carrying) a
position in some asset
RISK OF THE CARRY TRADE
- exchange rates may move opposite to
what the investors expected, which
would cause a loss. Just as financial
leverage can magnify gains from a carry
trade, it can also magnify losses from a
carry trade
CHAPTER 5: CURRENCY DERIVATIVES
FORWARD MARKET
- facilitates trading of forward contracts on
currencies
- not used by consumers or small firms
- MNCs use forward contracts to hedge
their imports
- Ability of a forward contract to lock in an
exchange rate can create an opportunity
cost in some cases
BID/ASK SPREAD
- tends to be wider for forward contracts
that have an obligation further into the
future
- longer contract leaves the bank more
exposed to the risk of appreciation of a
certain currency
- because market for short term forward
contracts tends to be more liquid, which
means that banks can more easily
create offsetting positions for a given
forward contract
PREMIUM OR DISCOUNT ON THE
FORWARD RATE
= (1 + )
360
=
o Forward premium: percentage by which
the forward rate exceeds the spot rate
- when forward rate < spot rate, forward
premium is negative, and the forward
rate exhibits a discount
ARBITRAGE
- forward rates typically differ from the
spot rate
- If forward rate were the same as the
spot rate then some investors could use
arbitrage to earn higher returns than
would be possible domestically and
without incurring additional risk
- that is why forward rate contains a
premium or discount that reflects the
difference between home interest rate
and foreign interest rate
OFFSETTING A FORWARD CONTRACT
- the MNC can negotiate the forward sale
with the same bank with which it
negotiated the forward purchase to
simply offset, the bank will charge a fee
for the service, which will be the
difference between the forward rate at
the time of the forward purchase and the
time it will be offset
USING FORWARD CONTRACTS FOR SWAP
TRANSACTIONS
- a swap transaction involves a spot
transaction along with a corresponding
forward contract that will ultimately
reverse the spot transaction
- these do not expose the firm to
exchange rate movements because it
has locked in the rate at which the
pesos will be converted back to dollars
Non-deliverable forward contract (NDF):
agreement regarding a position in a specified
amount of a specified currency, a specified
exchange rate, and a specified future
settlement date.
- it does not result to actual exchange of
the currencies; no delivery
- instead, one party makes a payment to
the other party based on the exchange
rate at the future date
- even though an NDF does not involve
delivery, it can effectively hedge future
foreign currency payments anticipated
by an MNC
CURRENCY FUTURES MARKET
o Currency futures contracts: specifying a
standard volume of a particular currency
 to be exchanged on a specific settlement o Closing Out a Futures Position
date - close out a position by selling an
- used by MNCs to hedge their foreign identical futures contract
currency positions - gain or loss will depend on the price of
- traded by speculators who hope to purchasing futures versus selling futures
capitalize on their expectations of - price of a futures contract changes over
exchange rate movements time in accordance with movements in
the spot rate and also with changing
Forward Futures expectations about what the spot rates
Size of Customized Standardized value will be on settlement date
contract - if spot rate increases, then futures
Delivery date Customized Standardized
Participants Banks, brokers, Banks, brokers, price is likely to increase as well,
and MNCs. and MNCs. hence, purchase and subsequent
Public Qualified public sale would be profitable
speculation not speculation - most currency futures contracts are
encouraged. encouraged.
closed out before settlement date
Security None as such, Small security
deposit but deposit required
compensating SPECULATION WITH CURRENCY FUTURES
balances or lines - some attempts to capitalize on their
of credit expectations of a currencys future
required
movement
Clearing Handling Handled by
operation contingent on exchange - If they expect a currency to appreciate,
individual banks clearinghouse. they can purchase a futures contract
and brokers. No Daily settlements that will lock in the price at which they
separate to the market buy it, and then sell these at the
clearinghouse price.
prevalent spot rate if their expectation
function.
Marketplace Telecomm Central exchange happened
network floor with
worldwide comm EFFICIENCY OF THE CURRENCY FUTURES
Regulation Self- regulating Commodity MARKET
Futures Trading
Commission
- if a currency futures market is efficient,
Liquidation Most settled by Most by offset; then at any time the futures price for a
actual delivery; very few delivery currency should reflect all available info.
some by offset, Hence, price should represent an
but at a cost unbiased estimate of the currencys spot
Transaction Set by the Negotiated
rate on the settlement date.
costs spread between brokerage fees
banks buy and - There should not be abnormal profits
sell prices
CURRENCY OPTIONS MARKET
PRICING CURRENCY FUTURES
- normally similar to forward rate for a o OVER THE COUNTER MARKET
given currency and settlement date o CURRENCY CALL OPTION
because of potential arbitrage if not o FACTORS AFFECTING CURRENCY
- futures contract and forward contracts of CALL OPTION PREMIUM
a given currency and settlement date HOW FIRMS USE CURRENCY CALL
should have the same price, or else OPTIONS
guaranteed profits are possible (assume o Using Call options to hedge payables
no transaction costs) o Using Call Options to Hedge Project
Bidding
CREDIT RISK OF CURRENCY FUTURES o Using Call Options to Hedge Target
CONTRACTS Bidding
- neither party needs to worry about credit
risk of the counterparty SPECULATING WITH CURRENCY CALL
- imposing margin requirements to cover OPTIONS
fluctuations in the value of a contract
HOW FIRMS USE CURRENCY FUTURES CURRENCY PUT OPTIONS
o Purchasing Futures to Hedge Payables FACTORS AFFECTING CURRENCY PUT
- locks in the price at which a firm can OPTION PREMIUMS
purchase a currency so that we dont HEDGING WITH CURRENCY PUT OPTIONS
have to worry about changes in the spot
rate CHAPTER 6: GOVERNMENT INFLUENCE
o Selling Futures to Hedge Receivables ON EXCHANGE RATES
- locks in the price at which a firm can sell CHAPTER 7: INTERNATIONAL ARBITRAGE
a currency AND INTEREST RATE PARITY
- appropriate if you expect the foreign
currency to depreciate against its home
currency