The document is a chapter from a corporate finance textbook that discusses managing international risks. It covers several topics related to foreign exchange markets including the relationship between interest rates and exchange rates, how forward premiums relate to changes in spot rates, how exchange rates are affected by inflation rates, and how companies can hedge currency risks using tools like forward and options contracts. It also discusses political risks that multinational firms may face abroad such as risks posed by changes in policies or political instability in foreign markets.

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2. Chapter 27Principles
of
Corporate
Finance
10th Edition
Managing
International Risks
Respected Sir:
Javaid Iqbal
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw Hill/Irwin
Slides by
M. Sajid
Hassan Shah

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Topics will Cover…
 The Foreign Exchange Market
 Some Basic Relationships
 Interest Rates and Exchange Rates
 The Forward premium and Changes in Spot Rates
 Changes in the Exchange Rate and Inflation Rates
 Interest Rates and Inflation Rates
 Hedging Currency Risks
 Political Risk

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Foreign Exchange Market

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Foreign Exchange Market
 A stock market in which the currencies of
other countries are bought and sold
 Example.
An American company that imports goods
from France may need to buy euros to pay for
the purchase. An American company
exporting to France may receive euros,
which it sells in exchange for dollars. Both
firms make use of the foreign exchange
market. The foreign exchange market has
no central marketplace.

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Foreign Exchange Market
 In London in 2010 $1, 854 billion of
currency changed hands each day.
 That is equivalent to an annual
turnover of about $460 trillion
($460,000,000,000,000).
 New York and Tokyo together
accounted for a further $1,216 billion
of turnover per day.

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Some Basic Relationships
Interest Rates and Exchange Rates
The Forward premium and Changes in
Spot Rates
Changes in the Exchange Rate and
Inflation Rates
Interest Rates and Inflation Rates

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Interest Rates and Exchange Rates
Suppose that you have $1,000 to invest for six
month. Indian rupee deposits are offering an
interest rate of 9.4%per annum; U.S. dollars
deposits are offering (an attractive?) 0.75%.
Where should you put your money? Does the
answer sound obvious? Let’s check;
• Rupee deposit. The rate of interest on six-
month rupee deposits is 9.4%. Therefore at the
end of the six month period, you get
₹1,000x(1+9.4%/2)= ₹1,047.

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• Dollar deposit. The current exchange rate is
₹61.938/$. Therefore, for ₹1,000, you can
buy ₹1,000/61.938=$16.145. The rate of
interest on a one-year dollar deposit is
0.75%. Therefore at the end of the year you
get $16.145x(1+0.75%/2)=$16.206.
• Of course, you don’t know what the
exchange rate is going to be in six month’s
time.
Interest Rates and Exchange Rates

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• You can fix today the price at which you
sell your dollars. The six-month forward
rate is ₹64.625/$. Therefore, by selling
forward, you can make sure that you will
receive 64.625x16.206= ₹1047.3 at the end
of the six month.
Interest Rates and Exchange Rates

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The Forward premium and Changes in Spot Rates
 How the forward premium is related to
changes in spot rates of exchange. The
forward rate of exchange would depend
solely on what people expected the spot
rate to be. For example, if the six-month
forward rate on dollar is ₹64.625/$, that
could only be because traders expect the
spot rate in six month’s time to be
₹64.625/$. If they expected it to be say,
₹65/$, nobody would be willing to sell
dollar forward.

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They could get more rupees for their dollar
by waiting and buying spot.
The Forward premium and Changes in Spot Rates

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Changes in the Exchange Rate and Inflation Rates
If silver a troy ounce bought in U.S $1000
Sell in India ₹90,000
So, 90,000/1000 = 90 Rupees per ounce
Than, Indian take ₹61938000/61.938/ $
= $10,00,000
90 ounce purchase in U.S. and sell in India
= ₹90,000,000
= ₹90,000,000- ₹61938000
= ₹28062000

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Interest Rates and Inflation Rates
 The Interest rate is the amount a
lender charges for the use of assets
expressed as a percentage of the
principal.
 Inflation is a quantitative measure of
the rate at which the average price
level of a basket of selected goods and
services in an economy increases over
a period of time.

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In general, as interest rates are lowered,
more people are able to borrow more
money. The result is that consumers have
more money to spend, causing the
economy to grow and inflation to
increase.
Interest Rates and Inflation Rates

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Hedging Currency Risks
Hedging is a way for a company to
minimize or eliminate foreign exchange risk
(also called a FOREX hedge).
Two common hedges are;
1. Forward contracts
2. Options contracts.

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 A forward contract will lock in an exchange rate
today at which the currency transaction will occur
at the future date.
 An options contract is an agreement between a
buyer and seller that gives the purchaser of the
option the right to buy or sell a particular asset at a
later date at an agreed upon price. Options
contracts are often used in securities,
commodities, and real estate transactions
Hedging Currency Risks

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Political Risks
Political risk is a type of risk faced
by investors, corporations,
and governments that political decisions,
events, or conditions will significantly affect
the profitability of a business actor or the
expected value of a given economic
action. Political risk can be understood and
managed with reasoned foresight and
investment.

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For example, political decisions by
governmental leaders about taxes,
currency valuation, investment, wage
levels, labor laws, environmental
regulations and development priorities,
can affect the business conditions and
profitability.
Example of Political Risks

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Political Instability
Political risk faced by firms can be defined
as "the risk of a financial, or personnel loss
for a firm because of such as social policies
or events related to political instability
(terrorism, riots, coups, and civil war).

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Conclusion

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