This document provides an overview of key concepts related to globalization and international financial management. It discusses factors influencing globalization such as trade agreements and technology. Several theories of international trade are described, including comparative advantage and theories based on factor endowments. The roles of multinational corporations in facilitating globalization and risks they face are outlined. Governance models in the US and Asia are compared. Finally, structure and participants in foreign exchange markets are reviewed.

1. Chapter 1
Introduction
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2. Learning Objectives
A. Explain globalization and discuss Factors.
B. Discuss theories of trade. Distinguish.
C. Discuss how MNCs facilitate
globalization and special risks faced by
them.
D. Compare US and other governance
models.
E. List international financial management
issues.
1-2

3. A1. What is Globalization?
 Movement of Goods: worldwide
integration of producers and consumers
 Movement of Services: cross-border flow
of services (e.g., tourism, consulting)
 Movement of People: migration toward
work
 Movement of Money: investments across
borders
1-3

4. A2. Factors Influencing
Globalization
 End of World War II: unprecedented era of
peace helped the global economy
 Trade Agreements: WTO, NAFTA, etc.
 Dismantling of Socialist Systems:
liberation of E. Europe
 Rise of Asia: China, India and other
economic power
1-4

5. A3. Technology, Innovation &
Globalization
 Telecommunications Revolution: allows
low-cost contact and spurs business
activity
 Internet: a post-1980 phenomenon,
radically transforms ability of parties to
conduct business across borders (e.g.,
outsourcing)
 Sea and Air Shipping: containerization and
other innovations brought down cost
1-5

6. B1. Trade: Classical Theory
 Theory of comparative advantage (David
Ricardo, 19th
century)
 Labor productivity differs within country and
across countries because of varying technology
 Nations have relative advantages in certain
products (e.g., Portugal had advantage in wine
and England had advantage in cloth)
 Countries benefit by shifting production and
making products where they have an
advantage and by trading with other countries
(e.g., Portugal produces more wine and
England produces more cloth)
1-6

7. B2. Trade: Neoclassical Theory
 Heckscher and Ohlin (HO) model:
 Focus on factor abundance, rather than
technology, as explanation for productivity
differences
 Countries with relatively more capital will
focus on capital intensive industries (e.g.,
automobile, steel)
 Countries with relatively more labor will focus
on labor intensive industries (e.g., textiles,
agriculture)
1-7

8. B3. Other Theories of Trade
 Imperfect Markets: Factors of production
(e.g., labor, capital) cannot easily move
across borders, so countries specialize
using what they have.
 Gravity: More trade occurs between
countries of similar size and of close
proximity
 Firm-level Product Cycle: Over time, to
increase scale, firms export
 New Trade: Consumers seek variety and
producers seek scale. This theory is unique
is explaining why a country may
simultaneously import and export the same
product 1-8

9. B4. Location Theories
 Industry Agglomeration: Positive
externalities such as knowledge spillover,
labor market pooling and development of
ancillaries help ‘agglomerate’ an industry
in one location (e.g., computer industry in
Silicon Valley)
 Porter’s Diamond: Explains why nations
have advantage in certain products:
 Factor conditions
 Demand conditions
 Related and Supporting Industries
 Firm Strategy, Structure and Rivalry
1-9

10. C1. Why Firms Become MNCs?
 OLI model:
 Ownership Advantages: firm has specialized
assets
 Location Advantages: input availability, low
taxes, etc.
 Internalization Advantages: in-sourcing more
advantageous than outsourcing
 Knowledge-Capital model:
 Knowledge capital can be transferred cross-
border much easier than physical capital
(foreign subsidiaries can be created easily)
 Skilled labor is important, usually abundant in
the home country of MNC
1-10

11. C2. MNCs Facilitate
Globalization
 MNCs are skilled in moving and selling
goods in foreign markets (helps
international trade)
 MNCs are skilled in making investments in
foreign real assets (helps FDI)
 MNCs are skilled in business contracting
(helps trade as well as FDI)
1-11

12. C3. Special Risks Faced by
MNCs
 Currency Risk: affects transactions, assets
and operations
 Economic Risk: macro-economic variables
such as inflation are highly variable
 Political and Regulatory Risk: MNCs deal
with foreign governments and regulatory
bodies
 Variation in Business Processes: business
is often conducted using different methods
globally
1-12

13. C4. MNCs and the Agency
Problem
 MNCs wish to maximize shareholder
wealth
 Difficulties arise because:
 MNCs are large with dispersed operations
(monitoring and control are difficult)
 MNCs produce and sell a large number of
products (complexity provides opportunity for
managers to deviate from overall goals)
 MNCs are typically highly de-centralzied
(unit-level managers have more power, can be
abused)
1-13

14. D1. US Governance Model
 Independent board of directors
 Incentive contracts for managers
 Accounting procedures are geared toward
reasonably transparent reports for the
benefit of external investors
 Vigilant markets
 Vigilant regulators
1-14

15. D2. Governance in Asia
 Family Control
 Boards dominated by insiders
 Mergers are infrequently used to discipline
poor management
 Accounting reports not always transparent
 Minority shareholder rights not always
respected
1-15

16. E. International Financial
Management Issues
 Understanding the environment: global
markets, especially currency related
markets
 Managing currency risk: measure and
manage risk, understand multiple methods
of risk control
 International Project Analysis: understand
various nuances in capital budgeting
 Global Financing: how to source capital
globally and decrease the cost of capital
 Global Operations: methods of conducting
global business and penetrating new
markets
1-16

17. Chapter 02
International Financial
Markets: Structure and
Innovation
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

18. Learning ObjectivesLearning Objectives
A.A. Describe FX markets, structure andDescribe FX markets, structure and
participants.participants.
B.B. Use FX direct and indirect quotes,Use FX direct and indirect quotes,
compute transaction costs and calculatecompute transaction costs and calculate
cross rates.cross rates.
C.C. Classify international bankingClassify international banking
transactions.transactions.
D.D. Describe Euro-markets (short- and long-Describe Euro-markets (short- and long-
term) and global equity markets.term) and global equity markets.
2-18

19. A1. Foreign Exchange (FX):A1. Foreign Exchange (FX):
OverviewOverview
 Focus on spot market (current exchange ofFocus on spot market (current exchange of
one currency for another) in this chapterone currency for another) in this chapter
 Large market with daily volume greaterLarge market with daily volume greater
than that of any other financial marketthan that of any other financial market
 3 reasons for transactions:3 reasons for transactions:
 MNCs and other entities have business relatedMNCs and other entities have business related
needs to convert currencyneeds to convert currency
 Banks and other intermediaries ‘service’ othersBanks and other intermediaries ‘service’ others
by converting currenciesby converting currencies
 Investment funds have portfolio related needsInvestment funds have portfolio related needs
to convert currenciesto convert currencies
2-19

20. A2. FX Markets: MNCA2. FX Markets: MNC
ParticipationParticipation
 MNCs convert currencies to facilitateMNCs convert currencies to facilitate
transactions with subsidiaries, affiliates,transactions with subsidiaries, affiliates,
suppliers and customerssuppliers and customers
 3 specific ways of participation:3 specific ways of participation:
 MNCs purchase inputs/components fromMNCs purchase inputs/components from
foreign suppliersforeign suppliers
 MNCs sell goods and services in foreignMNCs sell goods and services in foreign
marketsmarkets
 MNCs make cross-border investments in realMNCs make cross-border investments in real
assetsassets
2-20

21. A3. FX: Banks & OtherA3. FX: Banks & Other
ParticipantsParticipants
 Banks: most important players, make upBanks: most important players, make up
the Interbank marketthe Interbank market
 Other financial institutions: mutual funds,Other financial institutions: mutual funds,
hedge fundshedge funds
 Governments: not the largest player, butGovernments: not the largest player, but
very influentialvery influential
 Individuals: tourism and investment needsIndividuals: tourism and investment needs
met through currency transactionsmet through currency transactions
2-21

22. A4. FX Markets: Size &A4. FX Markets: Size &
StructureStructure
 Overall size is USD 3 trillion a day ofOverall size is USD 3 trillion a day of
which USD 1 trillion is spot (rest ‘future’which USD 1 trillion is spot (rest ‘future’
contracts)contracts)
 Average transaction size is USD 4 millionAverage transaction size is USD 4 million
 Major currencies are USD, EUR, JPY andMajor currencies are USD, EUR, JPY and
GBPGBP
 USD in 86% of all transactionsUSD in 86% of all transactions
 Large banks serve as market-makersLarge banks serve as market-makers
 Markets are over-the-counter (OTC)Markets are over-the-counter (OTC)
electronic marketselectronic markets
 Settlement is electronically conducted. USSettlement is electronically conducted. US
systems include Fedwire and CHIPSsystems include Fedwire and CHIPS
2-22

23. B1. FX: Direct vs. Indirect QuoteB1. FX: Direct vs. Indirect Quote
2-23

24. B2. FX: Bid and AskB2. FX: Bid and Ask
 EURUSD is quoted at 1.5511-1.5514EURUSD is quoted at 1.5511-1.5514
 The bank is willing to purchase EUR by payingThe bank is willing to purchase EUR by paying
USD 1.5511USD 1.5511
 The bank is willing to sell EUR by receiving USDThe bank is willing to sell EUR by receiving USD
1.55141.5514
%.01934.0
5514.1
5511.15514.1
EURUSDforask-bidPercent =
−
=
2-24

25. B3. FX: Transaction CostsB3. FX: Transaction Costs
EXAMPLE: A Brazilian firm wishes toEXAMPLE: A Brazilian firm wishes to
purchase USD 400,000. It approachespurchase USD 400,000. It approaches
Unibanco for a quote. Unibanco quotesUnibanco for a quote. Unibanco quotes
USDBRL at 1.4015 – 1.4037. AlsoUSDBRL at 1.4015 – 1.4037. Also
Unibanco imposes a commission of BRLUnibanco imposes a commission of BRL
200 on each transaction.200 on each transaction.
Firm Pays =Firm Pays =
680,5612004037.1000,400 BRL=+×
2-25

26. B3. FX: Transaction Costs (cont.)B3. FX: Transaction Costs (cont.)
If there are no transaction costs, firm wouldIf there are no transaction costs, firm would
pay =pay =
Transaction Costs =Transaction Costs =
Transaction Costs % =Transaction Costs % =
640040,561680,561 =−
040,561
2
4037.14015.1
000,400 BRL=
+
×
%114.0
040,561
640
=
2-26

27. B4. FX: Cross RatesB4. FX: Cross Rates
EXAMPLE: The EUR is quoted directly andEXAMPLE: The EUR is quoted directly and
indirectly relative to USD at 1.5514 andindirectly relative to USD at 1.5514 and
0.64458 respectively. The JPY is quoted0.64458 respectively. The JPY is quoted
directly and indirectly relative to the USD atdirectly and indirectly relative to the USD at
0.0100 and 100.00 respectively. Calculate the0.0100 and 100.00 respectively. Calculate the
cross rate between EUR and JPY using one ofcross rate between EUR and JPY using one of
the following two approaches.the following two approaches.
SolutionSolution::
Value of EUR expressed in JPY = EURJPYValue of EUR expressed in JPY = EURJPY
= Direct quote of EUR / Direct quote of= Direct quote of EUR / Direct quote of
JPYJPY
= 1.5514 / 0.0100= 1.5514 / 0.0100
= 155.14= 155.14
2-27

28. C1. International BankingC1. International Banking
Classification of Banking Positions
Residents Non-Residents
DomesticCurrency A B
ForeignCurrency D C
B+C = external orcross-borderpositions
C+D = foreign currencypositions (also known as Eurocurrency)
B+C+D =international positions
A+B+C+D = global positions
Source: BIS, Guide to the International Banking Statistics, 2003
2-28

29. C2. Classifying deposits,C2. Classifying deposits,
ExampleExample
EXAMPLE: Consider the following transactions ofEXAMPLE: Consider the following transactions of
a French bank. It accepts two deposits from aa French bank. It accepts two deposits from a
French citizen: EUR 5,000 and USD 10,000. ItFrench citizen: EUR 5,000 and USD 10,000. It
also accepts two deposits from a Japanesealso accepts two deposits from a Japanese
citizen: JPY 2,500,000 and EUR 8,000. Classifycitizen: JPY 2,500,000 and EUR 8,000. Classify
these deposits.these deposits.
SolutionSolution::
External positions = JPY 2,500,000 + EUR 8,000External positions = JPY 2,500,000 + EUR 8,000
Foreign currency positions = USD 10,000 + JPYForeign currency positions = USD 10,000 + JPY
2,500,0002,500,000
International positions = USD 10,000 + JPYInternational positions = USD 10,000 + JPY
2,500,000 + EUR 8,0002,500,000 + EUR 8,000
Global positions = USD 10,000 + JPY 2,500,000 +Global positions = USD 10,000 + JPY 2,500,000 +
EUR 13,000EUR 13,000
2-29

30. D1. Eurodollars & LIBORD1. Eurodollars & LIBOR
 Eurocurrency or foreign currencyEurocurrency or foreign currency
transactions in the USD are calledtransactions in the USD are called
EurodollarEurodollar transactionstransactions
 The key indicator for this market is theThe key indicator for this market is the
London Inter Bank Offer RateLondon Inter Bank Offer Rate (LIBOR)(LIBOR),,
the rate offered by Eurobanks for loans tothe rate offered by Eurobanks for loans to
other institutionsother institutions
 LIBOR rates are compiled by the BritishLIBOR rates are compiled by the British
Banker’s Association, and disseminated atBanker’s Association, and disseminated at
11 AM Greenwich Mean Time, reflect11 AM Greenwich Mean Time, reflect
rates at which banks are willing to lend torates at which banks are willing to lend to
each othereach other
2-30

31. D2. LIBOR ConventionD2. LIBOR Convention
MNC deposits $3 million for 60 days at aMNC deposits $3 million for 60 days at a
LIBOR rate of 5%. LIBOR uses simpleLIBOR rate of 5%. LIBOR uses simple
interest ‘actual/360’ basisinterest ‘actual/360’ basis
.000,025,3
360
60
%51000,000,3FV =





×+×=
%.178.51
000,000,3
000,025,3
returnannualEffective
60/365
=−





=
2-31

32. D3. Eurocurrency MarketsD3. Eurocurrency Markets
 Eurodollar, Euroyen, Europound and otherEurodollar, Euroyen, Europound and other
instruments make up the Eurocurrencyinstruments make up the Eurocurrency
markets (move toward renaming to foreignmarkets (move toward renaming to foreign
currency markets, because of confusioncurrency markets, because of confusion
with EUR)with EUR)
 Eurdollar origins:Eurdollar origins:
 Regulation Q (investors searched abroad forRegulation Q (investors searched abroad for
better interestbetter interest
 External holdings of USD (current accountExternal holdings of USD (current account
deficits)deficits)
 Innovation by Midland Bank in 1955,Innovation by Midland Bank in 1955,
thwarting regulation and creating this marketthwarting regulation and creating this market
2-32

33. D4. EurocreditsD4. Eurocredits
 Medium-term marketsMedium-term markets
 Main instrument is Floating Rate NoteMain instrument is Floating Rate Note
(FRN)(FRN)
 Coupon specified as ‘LIBOR + X’Coupon specified as ‘LIBOR + X’
 At any point in time, only the next couponAt any point in time, only the next coupon
is known, others depend on future valuesis known, others depend on future values
of LIBORof LIBOR
 Term Structure models or prices fromTerm Structure models or prices from
futures markets may be used to infer futurefutures markets may be used to infer future
values of LIBORvalues of LIBOR
 Fixed rate instruments known as EuronotesFixed rate instruments known as Euronotes
2-33

34. D5. EurobondsD5. Eurobonds
 Mismatch between country of issue andMismatch between country of issue and
currency denomination (e.g., USD bondscurrency denomination (e.g., USD bonds
issued outside of US)issued outside of US)
 First Eurobond issued in 1963 by AutostradeFirst Eurobond issued in 1963 by Autostrade
 Traditionally, Eurobonds were bearer bondsTraditionally, Eurobonds were bearer bonds
 Main currencies: USD, EUR, JPYMain currencies: USD, EUR, JPY
 Median issue: USD 100 millionMedian issue: USD 100 million
 Most are fixed rate instrumentsMost are fixed rate instruments
 Development: Global bonds, issuedDevelopment: Global bonds, issued
simultaneously around the world, often USDsimultaneously around the world, often USD
1 billion or greater1 billion or greater
2-34

35. D6. Global EquityD6. Global Equity
 US equity markets are important part ofUS equity markets are important part of
global equity markets (1/3 of valueglobal equity markets (1/3 of value
approximately)approximately)
 NYSE and NASDAQ continue toNYSE and NASDAQ continue to
innovate and lead trading practicesinnovate and lead trading practices
 Emerging markets are becoming moreEmerging markets are becoming more
importantimportant
 Electronic trading is becoming moreElectronic trading is becoming more
importantimportant
 Cross-border listing is increasingCross-border listing is increasing
2-35

36. Chapter 03
Currency and
Eurocurrency Derivatives
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

37. Learning Objectives
A. Describe derivatives markets, structure
and participants.
B. Describe FX forwards and futures;
calculate prices.
C. Describe FX options; calculate payoff
and profit; distinguish between calls and
puts.
D. Price an FX option.
3-37

38. A1. What are Derivatives?
 Derivatives are financial contracts whose
cash flows and value derives from some
underlying financial asset or commodity or
indicator. For example, stock options
provided to managers.
 Underlying assets may be financial assets,
commodities, currencies, etc.
 Counterparties are typically known as
buyer (long) and seller (short).
 Forwards and Options are the most
contract type
3-38

39. A2. Derivatives Markets
Notional Value of Derivatives in 2007, USD Billions
Exchange Traded Derivatives:
Interest Rate Futures 26,787
Currency Futures 159
Equity Futures 1,133
Interest Rate Options 44,308
Currency Options 133
Equity Options 8,103
OTC:
Currency Contracts 60,091
Interest Rate contracts 346,937
Equity contracts 9,202
Commodity contracts 7,567
Credit-default swaps 42,580
Source: BIS, 2007 Statistics
3-39

40. B1. Currency Forwards
 The exchange of one currency for another
at a future date using a pre-determined
exchange rate
 At inception, the two parties—long and
short—simply agree on the forward price.
 At maturity, the short delivers the
contracted units of the base currency and
in return the long makes payment using the
terms currency.
 Certain currency forwards do not entail
actual delivery of the foreign currency and
are known as non-deliverable forwards
(NDF).
3-40

41. B2. Forward Price and Forward
Premium
 Price is calculated using the following
equation:
 Premium (or discount) is calculated as
follows:
t
r
r
SF 



+
+
×= *
1
1
1
*1
1
1 −



+
+
=−=
t
r
r
S
F
FP
3-41

42. B3. Forward Pricing Example
 S = 0.02174 (INRUSD)
 r = 5% (US interest rate)
 r* = 10% (Indian interest rate)
 t = 2 (years)
.01981.0
%101
%51
02174.0
2
=



+
+
×=F
%88.81
02174.0
01981.0
1 −=−=−=
S
F
FP
3-42

43. B4. Currency Futures
 A currency futures contract is an
exchange traded version of the currency
forward contract.
 Futures are standardized. For instance, the
GBP futures traded in the Chicago
Mercantile Exchange has very specific
maturities (every 3 months) and size
(62,500 currency units).
 Futures may be priced using the forward
pricing equation since futures and forwards
are very similar instruments.
3-43

44. B4. Currency Futures (cont.)
 Daily settlement of profits and losses in
margin accounts eliminates counterparty
risk
 The CME lists more than 20 futures
contracts in various currencies, cross-
currencies and currency indexes. This list
includes the major currencies—JPY, GBP,
EUR and CHF—as well as emerging
markets currencies such as the Chinese
Renminbi, South African Rand and the
Russian Ruble (CNY, ZAR and RUB
respectively).
3-44

45. C1. Currency Options
 Provides the right but not the obligation to
purchase (or sell) the underlying or base
currency at a future date at a pre-specified
strike price denominated in the terms
currency.
 Options may be calls (allowing purchase)
or puts (allowing sale).
 Unlike forwards and futures, an option
may only be acquired by paying a
premium.
 Currency options are traded in the PHLX
and CME.
3-45

46. C2. Call Option Payoff & Profit
Call Option: Payoff & Profit to Long (Buyer)
Call Parameters: C = 0.06, X =1.25
All Values in USD
At Contract
Inception Cash Flows At Maturity
Overall
Result
Currency
Value at
Maturity Premium Paid
Exercise Price
Paid Value Received Payoff Profit
1.16 0.06 No Exercise No Exercise 0 -0.06
1.19 0.06 No Exercise No Exercise 0 -0.06
1.22 0.06 No Exercise No Exercise 0 -0.06
1.25 0.06 No Exercise No Exercise 0 -0.06
1.28 0.06 1.25 1.28 0.03 -0.03
1.31 0.06 1.25 1.31 0.06 0.00
1.34 0.06 1.25 1.34 0.09 0.03
1.37 0.06 1.25 1.37 0.12 0.06
Note: Payoff & Profit to Short (Seller) is the exact opposite (that is, positive values are
negative and negative values are positive)
3-46

47. C3. Call Option Diagram
3-47

48. C4. Put Option Payoff & Profit
Put Option: Payoff & Profit to Long (Buyer)
Call Parameters: P = 0.03, X =1.25
All Values in USD
At Contract
Inception Cash Flows At Maturity
Overal
l
Result
Currenc
y Value
at
Maturity
Premium
Paid
Exercise Price
Received
Value Given
Up Payoff Profit
1.16 0.03 1.25 1.16 0.09 0.06
1.19 0.03 1.25 1.19 0.06 0.03
1.22 0.03 1.25 1.22 0.03 0.00
1.25 0.03 No Exercise No Exercise 0 -0.03
1.28 0.03 No Exercise No Exercise 0 -0.03
1.31 0.03 No Exercise No Exercise 0 -0.03
1.34 0.03 No Exercise No Exercise 0 -0.03
1.37 0.03 No Exercise No Exercise 0 -0.03
Note: Payoff & Profit to Short (Seller) is the exact opposite (that is, positive
values are negative and negative values are positive)
3-48

49. C5. Put Option Diagram
3-49

50. C6. Summary of Option Payoff &
Profit
Summary of Option Payoff & Profits
Call Option Put Option
Long
(Buyer)
Long pays premium upfront
Long exercises by buying
currency
Payoff =
Profit =
Long gains when currency rises
Long pays premium upfront
Long exercises by selling
currency
Payoff =
Profit =
Long gains when currency falls
Short
(Seller)
Short receives premium upfront
Short responds to exercise by
selling currency
Payoff =
Profit =
Short gains when currency falls
Short receives premium upfront
Short responds to exercise by
buying currency
Payoff =
Profit =
Short gains when currency rises
CXSMax t −− ),0(
),0( tSXMax −
PSXMax t −− ),0(
),0( XSMax t −− ),0( tSXMax −−
PSXMax t +−− ),0(
),0( XSMax t
−
CXSMax t
+−− ),0(
3-50

51. D1. Option Pricing Formula
.
,
2
*ln
,
),()(
12
2
1
21
*
tdd
and
T
trr
X
S
d
where
dNXedNSeC rttr
σ
σ
σ
−=






+−+





=
−= −−
3-51

52. D2. Option Pricing Example
USE PAST DATA TO CALCULATE σ
Date EURUSD % change
1/8/2008 1.4708 n/a
1/15/2008 1.4804 0.65%
1/22/2008 1.4631 -1.17% OBTAIN OPTION PARAMETERS
1/29/2008 1.4775 0.99% Option is 90-day option on EUR
2/5/2008 1.4648 -0.86% X = 1.55 Strike Price
2/12/2008 1.4584 -0.44% t = 90/365 Maturity
2/19/2008 1.4725 0.97%
2/26/2008 1.4975 1.69% +
3/4/2008 1.5216 1.61%
3/11/2008 1.5344 0.84% OBTAIN CURRENCY SPOT
3/18/2008 1.5731 2.52% S = 1.5992 Spot Currency
3/25/2008 1.5423 -1.96%
4/1/2008 1.5615 1.25%
CONTINUOUSLY
COMPOUNDED RATES
4/8/2008 1.5711 0.61% r (USD) = 2.9%
4/15/2008 1.5790 0.51% r*(EUR) = 3.8%
4/22/2008 1.5992 1.28%
Weekly σ 1.20%
Annual σ *SQRT(52) 8.62%
3-52

53. D2. Option Pricing Example
(Cont.)
0552.0
7443.055.17579.05992.1
)()(
7443.0)(
7579.0)(
6568.0
365/900862.06996.0
6996.0
365/900862.0
365
90
2
0862.0
038.0029.0
55.1
5992.1
ln
,
)
2
*()ln(
)365/90(029.0)365/90(038.0
21
*
2
1
12
2
2
1
=
×−×=
−=
=
=
=
×−=
−=
=
×





+−+





=
+−+
=
−
−−
ee
dNXedNSeC
dN
dN
tdd
and
t
trr
X
S
d
rttr
σ
σ
σ
3-53

54. Chapter 04
Currency Systems and
Valuation
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

55. Learning Objectives
A. Describe the history of currency systems:
gold standard to EMU.
B. Describe the continuum of systems, fixed
to floating.
C. Discuss general current and financial
account factors affecting currency values.
D. Discuss why and how governments
influence currency values.
4-55

56. A1. Overview of History
 Gold Standard (1870-1915)
 (The two World Wars)
 Bretton Woods (1944-1971)
 Smithsonian (1971-)
 The Euro (2000-)
4-56

57. A2. Gold Standard
 Not new, has existed for millennia
 Classical gold standard (1870-1915)
 Major nations (US, UK, France) backed
their currencies using gold
 Emergence of monetary unions
 Period of economic growth
4-57

58. A3. How does the gold standard
work?
 Quantity of gold (grams) defined per
currency
 Ratio of gold quantities = exchange rate
(mint parity)
 Central banks import and export gold to
maintain currency values
 Gold points (bracketing the mint parity)
defines trigger points for import or export
 Current account balances mitigated by
gold flows (gold inflows in surplus
countries, money supply rises, inflation
rises, deters exports)
 War and resulting high inflation brought
an end to this era 4-58

59. A4. Bretton Woods
 Followed World War II and had these
objectives:
 Multilateral Cooperation
 Currency Convertibility
 Key Provisions:
 USD 35 = 1 ounce of gold
 Central banks held reserves of gold and
currencies and pledged to maintain currency
values
 International Monetary Fund (IMF) created
4-59

60. A5. Bretton Woods: The Success
 Currency convertibility was achieved, at
least for major nations, by 1958
 Currency rates were stable and
international trade blossomed
 Major nations also reduced capital controls
 Boom in FDI (birth of MNCs)
4-60

61. A6. Demise of Bretton Woods
 In 1960s, the USD became overvalued
 The US ran large current account deficits
(imports greater than exports)
 Large amounts of USD were held by
external parties in excess of gold reserves
of the US
 Germany had the opposite problem, was an
export machine, but upward pressure was
placed on German mark, also inflation was
a threat
 Germany experimented with floating the
mark
 US closed the “gold window” and placed a
10% import tax 4-61

62. A7. Smithsonian Agreement
 Group of ten nations (largest contributors
to IMF) produced agreement in December
1971
 Although hailed by President Nixon as a
major agreement, Smithsonian was mostly
a stop-gap agreement and perpetuated the
fixed regime
 USD was devalued and certain other
currencies (German mark) were valued
higher
 But problems persisted (e.g., GBP crisis in
1972)
 By end of 1973, most major currencies
were floating
4-62

63. A8. European Monetary Union
 European Commission (EC) and the
European Monetary Union (EMU) resulted
from Treaty of Rome (1957) and
subsequent agreements. This was the
informal creation of the European Union
(EU).
 The “snake” currency system (each
currency linked to another) was introduced
in 1971. Strong sentiment to keep
currencies aligned
4-63

64. A8. European Monetary Union
(cont.)
 In 1979, the European Monetary System
(EMS) as created along with the European
Currency Unit (ECU) the precursor to the
EUR.
 European Union (EU) and the European
Central Bank (ECB) formally created by
the Maastricht treaty of 1992.
 The EUR was created in 2000.
4-64

65. B1. IMF Classification of
Currency Systems
 Currency Board: extremely rigid, foreign
currency holdings (usually EUR or USD)
are matched against money supply, fixed
exchange rate rigorously upheld
 Conventional Fixed Peg: Narrow band of
+-1% is used.
 Pegged with Horizontal Bands: Looser
band of up to 2%.
4-65

66. B1. IMF Classification of
Currency Systems (cont.)
 Crawling Peg: Currency values adjusted
over time at fixed rate (it crawls along!)
 Managed Floating: frequent intervention
 Independent Floating: infrequent
intervention
4-66

67. B2. Floating Currency Systems
 Requires investments in monetary and
market infrastructure
 Country needs an open economy to act as a
shock absorber
 Most industrialized nations adopt this
system
 In 2006, 88 nations followed this system
 Countries can pursue independent macro
policy
 MNCs need to be adept at managing risk in
this setting
4-67

68. B3. Pegged Currency System
 Value pegged to a stable currency such as
EUR or USD
 Offers relief to countries with track record
of high inflation and monetary
mismanagement
 Problem: need to match macro policies
with the country of the peg
 Small countries, already economically tied
to a large economy peg their currencies to
the currency of the larger economy
 Relinquish monetary policy tools for
managing the economy
4-68

69. C1. Currency Valuation
 Demand: MNCs and other entities require
a foreign currency for trade, investment,
travel or other purpose.
 Supply: This is the flip side of demand.
When an entity demands a foreign
currency, that entity supplies the domestic
currency.
4-69

70. C1. Currency Valuation (cont.)
 Equilibrium: Based on demand and supply,
the currency rate is determined.
 This is a very rough model. We study
specific models later in this chapter and in
chapter 5.
 In this chapter, we study current account
and capital account variables that affect
currency values
4-70

71. C2. Current Account Analysis
 Inflation: A higher rate of inflation in a
country makes that country’s products less
competitive and reduces demand and value
for that country’s currency.
 National Income: Higher income means
more imports, means a lowering of one’s
currency
 Productivity: A country with higher
productivity will face rising global demand
for its goods and its currency will rise in
value.
 Consumer Preferences: If consumers
prefer foreign goods, the country’s
currency loses value.
4-71

72. C3. Financial Account Analysis
 Interest Rate: A country with a high
interest rate attracts investment flows. Its
currency rises in value.
 Investors will focus on real and not
nominal rates.
 Investors also forecast future currency
values: this is a topic we discuss in chapter
5.
 Corporate Management and Governance:
Investment will flow toward countries
which provide a good setting for
management and governance.
4-72

73. D. Government Intervention
 Governments buy and sell currencies to
manipulate exchange rates
 Intervention is sterilized when money
supply effects are neutralized (through
purchases and sales of securities)
 Other than currency spot markets,
governments may use the following
markets:
 Forwards
 Foreign Exchange Swaps
 Options
 Governments may also use capital controls
and currency controls
4-73

74. Chapter 05
Currency Parity Conditions
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

75. Learning Objectives
A. Discuss parity conditions and how they
relate to arbitrage.
B. Discuss and apply three kinds of currency
arbitrage: locational, triangular and
covered interest.
C. Describe and apply interest rate parity
(IRP).
5-75

76. Learning Objectives (cont.)
D. Describe and apply purchasing power
parity (PPP).
E. Describe the Fisher effect and its link to
other parities.
F. Discuss and apply methods of deriving
currency forecasts and methods of
assessing forecasting accuracy.
5-76

77. A1. Overview of Parity
Conditions
 Parities relate currency values to
fundamental variables such as interest rates
and inflation
 Two important parities are the Interest
Rate Parity (currencies and interest rates)
and the Purchasing Power Parity
(currencies and inflation rates)
 Parities help managers forecast future
currency values
 Parities arise because of money or products
moving to locations offering greater value
5-77

78. A2. Overview of Arbitrage
 When financial assets (or currencies) are
mispriced in markets, arbitragers exploit
discrepancies by buying (at low prices)
and selling (at high prices)
 Currency markets offer the following types
of arbitrage opportunities:
 Locational: when currencies trade at different
values at different locations
 Triangular: when the cross-rate of a currency
pair is not in synch with the separate quotes for
the two currencies
 Covered Interest: when a foreign money
market offers an attractive interest rate
premium that is not entirely offset by projected
decline in the foreign currency
5-78

79. B1. Locational Arbitrage
5-79

80. B2. Triangular Arbitrage
5-80

81. B3. Covered Interest Arbitrage
5-81

82. B4. Covered Interest Arbitrage:
Another Example (using equation
approach)
 This example illustrates CIA where
borrowing occurs in the high-interest
currency. Assume S = 0.75, F = 0.70, r =
6%, r* = 10%. Calculate profit per unit of
currency borrowed.
 Arbitrage occurs because the rate of
currency depreciation (s = 6.7%) exceeds
the interest differential (4%).
03571.0
%)101(
70.0
1
%)61(0.75Profit
=
+−×+×=
*)1(
1
)1(SProfit r
F
r +−×+×=
5-82

83. C1. Interest Rate Parity
 CIA will cease to be profitable in equilibrium
because:
 Interest rates will change (e.g., a heavy demand
for a funding currency will raise interest rates)
 Currency values (spot and forward) will change
(e.g., heavy demand for a funding currency will
increase the spot rate)
0)1(*)1(
S
1
Profit =+−×+×= rFr
S
F
r*
r
=
+
+
1
1
5-83

84. C2. IRP Application: Find the
Forward Rate
S
F
t
r*
t
r
=
×+
×+
360
1
360
1
00923.0
360
180
%11
360
180
%41
110
1
360
1
360
1
=
×+
×+
×=
×+
×+
×=
t
r*
t
r
SF
The 180-day LIBOR rates for USD and JPY are 4% and 1%
respectively (actual/360 convention). The spot rate is as
follows: USDJPY = 110. Estimate the 180-day forward rate for
JPY. Adjust the IRP equation for LIBOR.00
5-84

85. C3. Impediments to IRP
 When default risk varies, the interest levels
in various countries may reflect not only the
forward premium but also differential levels
of default risk.
 Transactions costs for conducting covered
interest arbitrage may be high enough to
prevent arbitrage from occurring even when
there are deviations from parity.
 Political risk or country risk would also
cause deviations from IRP.
 Taxations and other market imperfections
that hinder the free movement of capital
across borders.
5-85

86. C4. Empirical Evidence on
IRP
 Overall, IRP theory works quite well especially
with major currencies.
 Tests use two approaches:
 Simulation Tests: The actual arbitrage strategy is
simulated with available data to determine whether
profits are available. Profits are typically calculated
net of the costs of the following transactions: (a)
selling a domestic security or borrowing money (b)
purchase of spot foreign exchange (c) forward
contract (d) buying a foreign security.
 Regression Tests: The dependent variable (Y
variable) is the ratio of forward-to-spot (or
equivalently the natural log of forward minus the
natural log of spot). The independent variable (X
variable) is the interest differential (specification
differs depending on whether logs are used for the
Y variable). IRP requires an intercept of one.
5-86

87. D1. Law of One Price
 The ability of goods to move freely
across borders would mean that their
prices in various locations should be
similar.
 Imagine that 5 lbs of sugar sells for
USD 3.00 in the US and GBP 1.50 in
the UK. The law of one price relies on
the currency rate to makes these prices
equal. This implies that the spot rate
GBPUSD = 2.00.
 SPP GBPUSD
×=
5-87

88. D2. Purchasing Power Parity
 The law of one price, when applied to
national price indexes, is known as
purchasing power parity theory (PPP).
 The relative version of PPP is a less
restrictive and perhaps more useful version
of the theory. While the absolute version
of PPP requires equivalent prices, relative
PPP only requires that price changes are
harmonized with currency changes.
 Absolute PPP focuses on price levels,
relative PPP focuses on price changes or
inflation.
5-88

89. D3. PPP Equation
S
SE
i*
i )(
1
1
=
+
+
Ratio of Inflation Ratio of Expected Spot
Rate Factor to Spot
5-89

90. D4. PPP Example
 Starting values for CPI: US CPI = 300 and
Canadian CPI = 250.
 Spot CADUSD = 1.10.
 A year later CPI levels are expected to rise
to 309 (US) and 255 (Canada).
 What are inflation rates in the US and
Canada? What is expected ending value of
CADUSD? What is its change?
5-90

91. D4. PPP Example (CONT.)
%21
250
255
*
%31
300
309
=−=
=−=
i
i
1108.1
%21
%31
10.1
1
1
)( *
=
+
+
×=
+
+
×=
i
i
SSE
%98.01
10.1
1108.1
=−=s
5-91

92. D5. Impediments to PPP
 Taxes differ between countries, and can
cause major deviations in prices between
countries. For example, value-added taxes
often lead to higher prices in Europe
compared to the US.
 Transportation costs can be prohibitive and
can discourage cross-border transactions.
For example, durable goods like cars and
washing machines can sometimes incur
transportation costs of more than 5% of
value.
 National consumption preferences can
differ. Because even similar products are no
longer substitutes in the minds of
consumers, they may trade at different
prices. 5-92

93. D6. Empirical Evidence on PPP
 Tests involve calculation of real exchange
rates to see if they are constant.
 There are numerous difficulties
constructing tests including differences in
national CPI indexes, non-traded goods
and sticky prices.
 Absolute PPP is rejected (e.g., Big Mac
tests!)
 Relative PPP is somewhat supported. In
the long-term currency values converge
toward PPP. Deviations from PPP appear
to decrease at a rate of about 15% a year.
5-93

94. E1. Fisher Effect: National
 Denoting the nominal rate, the real rate and
the rate of inflation as r, rr and i
respectively, the Fisher effect (FE) is
given by:
( ) ( ) )1(11 irrr +×+=+
5-94

95. E2. Fisher Effect: International
Ratio of Interest Ratio of Expected Spot
Rate Factor to Spot
S
SE
r*
r )(
1
1
=
+
+
5-95

96. E3. Overview of Parity
Conditions
5-96

97. F1. Currency Forecasting
 FX theories and parities are useful to MNC
managers in deriving currency forecasts
 The simplest forecast is today’s spot.
 If a forward rate is available, it could be a
better forecast than the spot rate. If
unavailable, try to estimate the forward
using parity conditions.
 Fundamental methods may also be used to
forecast currencies.
5-97

98. F2. Forecasting using Parities
 A UK based MNC wishes to forecast the
value of JPY in 7 years time. GBP and JPY
denominated risk-free (government) debt
instruments have yields of 6% and 3%
respectively. If JPYGBP = 0.0075 now,
what is the expected future spot?
00917.0
%31
%61
0075.07)(JPYGBP
7
=





+
+
×=year
5-98

99. F3. Assessing Forecast Accuracy:
Methods
SS ˆAFE −=
∑= AFE
N
MAFE
1
( ) ∑∑ =−= 22 1ˆ1
AFE
N
SS
N
RMSE
5-99

100. F4. Forecast Accuracy Example
(Inputs)
Pre-forecast spot Post-forecast spot Forecast A Forecast B
1.44 1.49 1.52 1.55
1.31 1.29 1.33 1.26
1.52 1.53 1.51 1.54
1.41 1.40 1.38 1.44
5-100

101. F5. Forecast Accuracy Example
(Solution)
A B
AFE
Succes
s AFE Success
1.44 1.49 1.52 0.03 0.0009 Y 1.55 0.06 0.0036 Y
1.31 1.29 1.33 0.04 0.0016 N 1.26 0.03 0.0009 Y
1.52 1.53 1.51 0.02 0.0004 N 1.54 0.01 0.0001 Y
1.41 1.40 1.38 0.02 0.0004 Y 1.44 0.04 0.0016 N
MAF
E 0.028 0.035
RMS
E 0.0287 0.0394
SR 50% 75%
0S 1S Sˆ2
AFESˆ
2
AFE
5-101