3 differences btw international finance management
International business finance is how nations interact through trade, flows of money and investments.
- foreign exchange risk and political risk
- market imperfections
- different accounting rules, legal frameworks, taxes etc
- expanded opportunity set.
- different stakeholders and consumers, new markets to explore
MNCs (companies operating in 2 countries or more) buy and sell many different currencies, which can force countries to manage their political risk, maintain stable currencies and forge international relations with foreign banks.
The history of currency valuation
The Gold Standard;
This was the emergence of monetary union and stable economic growth. Major countries pegged their currencies to gold, where the quantity of gold was defined per currency and the ratio of gold quantities = the exchange rate. Central banks import and export gold to maintain currency values, and current account imbalances are mitigated by gold inflows and outflows.
In the short run; high production costs limited switching
In the long run; the high production costs mean it's hard for countries to increase the supply of money, keeping money supply and currency valuation stable.
If there is a trade surplus, there will be a gold inflow. The gold inflow raises the supply of money, inflating prices which makes exports become more expensive. Exports fall and the trade surplus falls.
But a country's ability to increase money supply is limited by its balance of payments position, and the growth of the world is limited by the growth of new gold production.
Bretton Woods and the EMS, 1.
A dollar based gold exchange standard, where central banks held reserves of gold and currencies and pledged to maintain currency values. Each currency was assigned a fixed value against the dollar and the exchange rate was adjustable.
Worked for a while; currency convertibility was achieved and exchange rates were largely stable. But the US ran large account deficits and the dollar became overvalued.
The EMS (European Monetary System); an adjustable peg system with a band, where currencies are pegged against an artificial weighted basket of currencies.
Exchange rate systems
Freely floating; in which the exchange rate is determined purely by the free play of supply and demand. There is no intervention by money authorities and the forces are influenced by price levels, interest rates and economic growth.
Managed/dirty float; a limit on the extent to which a currency is allowed to float. The market forces will set rates unless market volatility occurs, then the central bank steps in.
Band float; market forces are constrained to the upper and lower range of exchange rates. Members to the arrangement adjust their national policies to maintain the band target.
Crawling peg/band; a fixed rate or range that adjusts periodically, maybe according to a pre-arranged schedule or market forces. The government maintains the target rate and if the target rate is threatened, the central banks will buy or sell currency.
Pegged currency system; value pegged to a stable currency such as the EUR or the USD, which offers relief to countries with a track record of high inflation and monetary mismanagement. The problem is that countries need to match their economic policies to the pegged country's.
- Supply; when an entity demands a foreign currency, that same entity supplies the domestic currency.
- Demand; MNCs and other countries require a foreign currency for trade, travel, investments etc.
- In theory, the currency's value echoes the underlying strength of the economy, but in the short run currency trader's expectations play a much more important role.
- Both current account and capital account variables affect currency values.
The forward and spot rate
The spot rate is the current exchange rate of one currency for another. The forward rate is an exchange rate involving the purchase/sale of a currency at an exchange rate established now but with payment and delivery at a specified time.
The difference between spot and forward rates is equal to the difference in interest rates, which is equal to the difference in expected inflation rates, which is the expected change in the spot exchange rates.
Forward premium/discount; premium is when the forward rate is greater than the spot rate and the discount is when the forward rate is less than the spot rate. A flat currency is when the forward and spot rate are equal.
A future is a contract designed by a third party for a certain amount of foreign currency delivered/recieved on a particular date . It can be bought and sold in markets and only the current owner of the conttract is obliged to fulfill the contract. It is similar to the forward market.
The purpose of a forward is hedging; the act of reducing exchange rate risk. Currency
Interest Rate Parity Theory
The expected return on a risk-free domestic asset will equal the expected return on risk-free foreign asset when both returns are expressed in the same currency.
The forward rate differs from the spot rate at equilibrium by an amount equal to the interest rate differential (i - i*) btw two countries.
The interest rate differential can also be described as the expected rate of change in the exchange rate.
In an equilibrium, returns on currencies will be the same. No profit will be realised and interest rate parity exists. Higher interest rates on a currency are offset by forward discounts, and lower interest rates are offset by forward premiums. If there isnt IRP, funds will move to a country w/ a more attractive rate and market pressures will develop to force the interest and forward rates to be in alignment btw two countries. As one currency is more demanded spot and sold forward, inflow of funds depresses interesr rares and parity is eventually reached.
Arbitrage is basically buying at a low price and selling at a higher one for profit.
Covered Interest Arbitrage; riskless activity in the FX market that equalizes the yield on a domestic financial asset w/ that of a similar foreign financial asset, where both yields are certain today. CIA isnt possible when there is IRP.
If IRP doesnt hold, then it is possible for a trader to make unlimited amounts of money exploiting the arbitrage opportunity. The trader can;
- invest in domestic currency risk-free bill
- or buy foreign currency, invest in foreign risk-free bill, and hedghe currency exposure in forward market.
The interest rate differential btw two assets, which are identical except for their currency denomination, should be zero once adjusted for the cost of forward FX cover (COVERED INTEREST PARITY).
A person may borrow from a high interest currency, rather than a low, because the rate of the currency's depreciation exceeds the interest rate differential.
In an equilibrium, CIA will stop being profitable because interest rates will change and currency values will change. The profit will equal 0 in an equilibrium.
The carry trade
This involves buying a currency w/ a high rate of interest and funding the purchase by borrowing in a currency with low rates of interest, without any hedging. Profitable as long as the interest rate differential is greater than the appreciation of the funding currency against the inventment currency.
- Invest in domestic currency risk-free bill
- Buy foreign currency, invest in foreign bill, and exchange proceeds at the expected future spot rate
Profitable carry-trade is possible but no risk-free; where there is risk there is a risk premium.
- borrow low interest rate currency (funding currency)
- exchange the proceeds into a high interest rate currency (investing currency)
- invest in an asset with maturity matching of the borrowing
- at maturity, exchange the proceeds of the investment back into the funding currency and repay the debt
- the surplus/deficit in the funding currency is then exchanged into base currency.
The carry trade 2
Returns from carry trade come from;
- the carry, when the interest differential is in your favour
- uncovered exchange rate position; spot rate change over the investment period can add to or subtract from returns
- accounting risk; a gain or loss in the funding currency has to be brought back into base currency
Profits come from the carry being small but consistently positive. On any day, the profit is
( i (inv) - i (fund) ) / 360. Uncovered exchange rate risk is typically much bigger, but depends on FX volatilities which can be for and against trade.
The FX market
The FX market is in equilibrium when deposits of all currencies offer the same expected rate of return.
- interest parity condition implies that deposits in all currencies are equally desirable assets
- and implied that arbitrage in the FX market isnt possible
Efficiency in the FX market implies that the expected rate of return to speculation in the forward foreign exchange market is zero (speculative efficiency) and the expected rate of return to covered or uncovered interest arbitrage in the financial markets is also 0 (arbitrage efficiency).
Purchasing power parity
PPP explains the relationship btw the prices of goods and services and exchange rates. It captures the connection btw goods market and FX market. If PPP holds over time, then the change in the real exchange rate = 0
The LOOP states that identical goods sell for the same price worldwide, in the absence of transaction costs and official trade barriers.
Absolute PPP; the exchange rate btw 2 currencies is = to the ratio of the price levels btw 2 countries. This is an extension of LOOP, bc it generalizes the price of a good to an overall price level in the country. Absolute PPP doesnt always hold due to;
- differentiated products (not comparable btw countries)
- transaction costs
- trade barriers
- some goods aren't tradable across borders (so low arbitrage activities) such as services
- local regulations and taxes
- consumer preferences differ in different countries
If the price of the domestic good rises faster than that of the foreign good, we would expect the foreign currency to appreciate.
Purchasing power parity 2. 7, 8.
Relative PPP means that any change in the inflation differential btw two countries is offset by an equal but opposite change in the spot rate. Currencies w/ high inflation should depreciate relative to currencies w/ low inflation.
It is often measured in terms of changes in the value of a basket of goods. Due to market imperfections, prices of the same basket of products in different countries wont always be the same, but the rate of change in prices should be similar when measured in common currency.
Relative PPP is a weaker condition than absolute PPP and holds better in the short run than absolute PPP.
But PPP is affected by things like transportation costs, the border effect, trade barriers and the importance of non-traded goods.
The real exchange rate 9, 10, 11, 12
The nominal exchange rate is the exchange rate that is actually observed in the FX market. Nominal depreciation in a country can make its inflation higher than its trading partners.
The real exchange rate is the nominal exchange rate after adjusting for inflation differential btw countries. If it falls beyond some point, the exchange rate is undervalued and vice versa. If absolute PPP holds, the real exchange rate would equal to 1.
The RER measures the true cost of one country's goods in terms of another and is used as an indicator for competitiveness of international trade of a currency.
If exchange rates adjust to inflation differential, PPP states that RERs stay the same. Meaning the competitive positions for domestic and foreign firms remain unaffected.
The real effective exchange rate measures the price of a home country's goods in terms of foreign goods. The REER index for a country is the weighted geometric average of a basket of currencies adjusted for relative price differential, using the annual value of a country's trade with other countries as its weights. Then converted to an index using a base year.
Exchange rate pass through
Incomplete exchange rate pass-through (ERPT) is one reason why a country's RER can deviate from its PPP equilibrium point.
Pass through is the degree to which the prices of imported and exported goods change as a result of exchange rate changes.
The degree of pass-through is measured by the proportion of the exchange rate change reflected in dollar prices.
The monetary approach to the exchange rate
The exchange rate is determined by relative money demand and money supply between two countries, where the money demand is derived from people's willingness to hold money, which is a constant proportion of their nominal income.
Flexible price model; in the short run, as money supply increases, income and price level are constant. So interest rates must fall to equate money demand and money supply. Assumes that PPP always holds.
The asset approach; assumes perfect capital mobility, that there are no barriers to international capital flows. The current spot rate is the sum of all discounted expected future stream of fundamentals, where discount rate is the interest-eleasticity of money demand. Now an exchange rate is given by discounting the expected future fundamentals. The approach suggests that whether foreigners are willing to hold claims in monetary gorm depends partly on relative real interest rates and partly on a country's outlook for economic growth.
Sticky price monetary model and the overshooting a
Prices are sticky in the short run but flexible in the long run. PPP doesnt hold in the short run, where money market equilibrium is achieved through variations in i and s. The exchange rate depends on relative money stocks and income, as well as interest rate differential.
The overshooting approach suggests that financial markets adjust to shocks far more rapidly than the goods markets. In the short run, financial markets have to overadjust in order to compensate for slugggish goods markets (overshooting).
With prices fixed in the short run, any change in the nominal money supply changes real balances, requiring the interest rate to adjust to clear the money market (liquidity effect). In the long run, prices adjust fully, returning all real variables to their pre-shock levels, but leaving the nominal exchange rate at the new equilibrium level predicted by the simple monetary model.
The overshooting approach can explain high exchange rate volatility.
Short run exchange rate equilibrium
When there is a shock, the assets markets adjust straight away, so the covered interest parity holds.
Exchange rate expectations mechanism; the expected exchange rate change is proportional to the current period's gap btw the actual exchange rate and its long-run equilibrium level.
Rate of reversion; an indicator of the speed of adjustment of the actual rate to deviations from its equilibrium level.
However, prices of goods and services adjust slowly to their new levels, so purchasing power parity doesnt hold in the short run.
The greater the ø, the more rapidly the exchange rate is expected to appreciate for a given undervaluation and the smaller the undershooting.
Micro-based exchange rate models
Market microstructure refers to the mechanics of how a marketplace operates. At the micro lecel, exchange rates can be determined by interactions among traders, and private info is an important determinant of spot exchange rates.
The bid-ask spreadsin the spot FX market will increase with FX exchange rate volatility and decrease with dealer competition. Agents in the FX market often become heterogenous because of risk aversion, asset preferences and beliefs, information and learning processes.
There are theee types of deals within the FX market; customer-dealer deals, interdealer (direct, bilateral transations where one dealer calls another dealer for a quote) and interdealer (brokered, where dealers trade with each other using a broker as a middle man).
Things like the inventory control effect (traders wanting to have no inventory at the end of the day) and asymmetric info effect (traders fear they are trading with agents who posess better info than themselves) will have an effect on the FX microstructure.
Equilibrium exchange rates are a function of FX prices set by dealers at any point in time and info on current and future macro fundamentals will only impact exchange rates if/when they affect dealer quotes.
Key features of FX trading
Dealers recieve info from either public news, private in house research or customer trades and dealer trades.
On the arrival of macro announcements, dealers may decide to react to this new public info by updating their quotes. This is the macro approach, where public info leads to a change in price.
The dealers may also update their quotes based on orders recieved from customers and other dealers, as well as private info. This is the micro structure approach, where private info changes the order flow, which then leads to changes in price. The order flow is buyer-initiated transactions minus seller-initiated transactions.
Firms trading internationally will suffer from foreign exchange risk, and will have a certain degree of foreign exchange risk exposure (the degree to which a company is affected by exchange rate changes). International assets and liabilities in foreign currencies could bring profits or losses to the firm, depending on the future directions of exchange rates.
Foreign exchange risk cont.
Translation exposure; this can also be called accounting exposure, and occurs when a foreign currency denominated balance sheet is translated into the parent company's home currency. When the foreign currency depreciates relative to the home currency, the owner's equity falls.
It is the risk that adverse currency movements, while not actually realised in cash value, will strongly affect the company's accounting performance, in particular its net.
Transaction exposure; contractual exposure from the uncertain currency value of a foreign-denominated transaction to be completed at some future date. It occurs when the firm commits to a future transaction w/out hedging a forward contract, and is the most direct and immediate risk from foreign currency fluctuation.
Economic exposure; this is exposure from changes in exchange rates on the firm's value (present value of future cash flows). The firm needs to incorp expectations about the risk into all basic decisions of the firm. It arises bc exchange rate changes alter the value of future revenues and expenses. It is the longer term impact of currency movement on competitiveness.
Operating exposure; begins the moment a firm starts to invest in a market subject to foreign competition or in sourcing goods or inputs abroad.
Foreign exchange risk cont.
If nominal rates change w/ an equal price change, there will be no alteration to cash flows. But if real rates change, it causes relative price changes, and changes in purchasing power. A decline in the real value of a currency makes exports cheaper, but imports more expensive, and vice versa. During an appreciation of home currencies, exporters are faced with the choice to keep prices constant (but lose sales) or adjust prices to foreign currency to maintain market share (lose profits).
4 ways to reduce risk;
- hedge in forward, futures, or options markets
- invoice in the domestic currency
- rush payments of currencies expected to appreciate
- rush collection of currencies expected to depreciate
3 types of premium;
- forward premium
- expected premium
- risk premium (forward premium - the expected premium must = the risk premium)
The simplest forecast is to use today's spot rate, but if a forward rate is available it could be a better forecast than the spot rate. If unavailable, it can be estimated either using parity conditions of fundamental methods.
Fundamental analysis involves econometrics to develop models that use a variety of explanatory variables. There are four steps;
- the identification of factors affecting the demand and supply of currencies.
- the estimation of the relationship btw the factors and the currency value, using econometric models.
- the forecast of the factors themselves over the period studied
- the forecast of the currency value is then performed using the forecast of the factors.
The technical approach; technical forecasting looks for systematic patterns in the past behaviour of exchange rates to determine trading decisions. Time series itself instead of economic factors become the determining factor. One strategy is to identify seasonality and long term trends in currency values y differentiating short term noise from long term trends.
In the short term, a variety of random events (noise) may cause currency values to deviate significantly from their long term fundamental path.
Efficient markets approach
An efficient market is one where prices reflect all available info and no unexploited profit opportunities are left, which means exchange rates will only change when new info arrives.
In the FX market this means that spot and forward exchange rates will adjust quickly to new info and that unbiased forward exchange rate equals expected spot rate when forward contract matures.
The random walk model is compatable with market efficiency and unbiasedness, however, efficiency may not require that the spot rate follows a random walk. Deviation from a random walk may be due to a risk premium of a nonzero expected return (depreciation).
With an efficient market, the forward rate can differ from expected future spot rate only by a risk premium. The FX risk premium is the difference btw the forward rate and the expected future spot rate.
Present value, 19, 20.
A dollar today is worth more than a dollar tomorrow, since the dollar today can be invested to start earning interest immediately.
The discount factor is the value today of $1 recieved in the future. The present value =
discount factor x future cash flow
The net present value;
= the present value - the required investment.
The internal rate of return;
A discount rate that makes the net present value from a particular project equal 0. It measures the profitability of potential investment.
The capital budgeting framework is to identify initial capital investment, forecast net ash inflows, including a terminal value or salvage value of investment, identify appropriate discount rate for NPV calculation and apply NPV or IRR analysis.
If capital budgeting is based on NPV, you accept the project if NPV > 0, and reject if NPV < 0. If capital budgeting is based on IRR, you accept the project is IRR > the discount rate, and reject if IRR < discount rate.
Multinational capital budgeting should be based on the parent company's perspective, since some projects that are feasible for the subsidiary may not be feasible for the parent. This is because of tax differentials, restrictions on remitted earnings and exchange rate movements.
There are two methods to multinational capital budgeting. The home currency method forecasts the exchange rate using covered intered parity and then coverts the cash flow to the home currency at the end of each period and calculates NPV. The foreign currency approach adjusts the discount rate by using the international Fisher effect and then calculates NPV in terms of foreign currency and convert the NPV into home currency.
To eliminate the risk of exchange rate fluctuations, the capital budgeting should incorporate scenario analysis or hedge against the expected cash flows of the new project.
Capital structure is how a firm should chose its debt-equity ratio, where the value of the firm is the value of the stocks plus the value of the debt.
External sources of debt;
- domestic bond offering (bond offering in home currency, with funds denominated in home currency)
- global bond offering (sell bonds denominated in the currencies of multiple countries)
- private placement of bonds (debt placed with a small number of large investors)
- loans from financial institutions
External sources of equity;
- domestic equity offering (list on the exchange of home country)
- global equity offering (list on the exchange of foreign country)
- private placement of equity (funds come from a limited numer of large investors)
Capital structure cont.
The cost of debt = the risk free rate of the funding country + a credit risk premium.
The cost of equity = the risk free rate of the funding country + an equity risk premium.
There will be country differences in the cost of debt, due to differences in the risk free rate (the interest charged on loans to a country's governement that is perceived to have no risk of defaulting on the loan) and differences in the credit risk preium (compensation for the creditor to take the risk that the company might not meet its debt obligations).
There will also be country differences in the cost of equity, due to differrences in the risk free rate and differences in the equity risk premium. Differences in the equity risk premium come from different investment opportunities in the country and different country risk. For example, in a country with a stable government local firms will be able to sell stock easier, or in a country with many investment opportunities; potential returns will be relatively high, meaning stock sells at a higher price.
Fundamental and other equilibrium exchange rates
- The fundamental equilibrium exchange rate (FEER) is the exchange rate which is consistent with a balance of supply and demand, measured on this basis.
- But trade balances, current account balances and capital account balances are subject to a large amount of statistical error, making it very difficult to calculate the FEER.
- PPP and covered interest prity can be used for the equilibrium exchange rate instead of the funamental approach.
Dealing with forex risks
Currency risk can be reduced by using various financial instruments (derivatives): currency forward contracts, futures contracts, and eve options and swaps on these contracts are available to control risk.
A derivative instrument is one derived from some underlying asset. The value of the contract is derived from the exchange of assets or commodities which is to take place at some point in the future.
A traditional currency forward contract is where the counterparties agree to swap currenies at a predetermined point in the future but at an exchange rate agreed now.
A non-deliverable forward contract just means that no exchange of currencies takes place. The partiews settle the contract in terms of an exchange btw the 'winner' and the 'loser'. For a currency futures contract the comparison is the same as it would be btw any forward and futures contract. The forward contract is usually private and difficult to value or sell on, but the futures contract is market traded.
Hedging with forwards and futures
Hedging is the process of managing your costs in the future and eliminating risk. Hedging against price risk is possible by buying into the opposite risk.
A difference btw forward contracts and futures, is that futures contracts will have an intermediary that creates a standardized contract. The intermediary is the Commodity Clearing Corp. They guarentee all trade and provide a secondary market for the speculation of Futures.
Swaps; an agreement btw 2 firms, in which each firm agrees to exchange the "interest rate characteristics" of two different financial instruments of identical principal. The swap gain is the fixed spread - the floating spread. Currency swaps are much like currency futures contracts, with the main dfiference being that swaps usually have small to medium firms as both counterparties, as it is based on a swap of normal business cash flow.
Leading and laggins refers to the practice of delaying or bringing forward payments and receipts in such a way as to minimise loss from currency swings. Netting is when MNCs aggregate intercompany forex transactions and settle the amount between international devisions.
Country risk = economic risk (changes in the macro-economic environment; exchange rate fluctiations) + political risk (affects cash flows; changes MNC valuation)
International investment and diversified portfolio
International currency investment is partly motivated by interest differentials among countries, and partly motivated by the desire to hold diversified portfolios.
Diversified portfolios are assets denominated in several currencies. By diversifying and selecting differrent assets (of different countries) for a portfolio, an investor can reduce the variability of the portfolio.
Risk aversion and asset allocation; the investor's objective is to maximize utility by selecting the fraction, z, of the investment budget to be invested in the risky portfolio, P, composed of domestic and international assets.
The optimal share of the risky asset; rises with increases in the market risk premium but falls with increases in the degree of risk aversion and market volatility.
BOP and the bid-ask spread
The bid-ask spread;
A dealer purchases at the bid rate and sells at the ask rate. The bid-ask spread is calculated by;
(ask - bid)/ ask x 100 = %
The balance of payments is a statistical record of a country's international transactions over a period of time. It consists of the current account and the capital account, which should be equal in size but opposite in sign to the official reserves.
Capital + current = - official reserves (this is the balance of payments identity). This is what it will look like in a flexible exchange rate regime, where the central banks dont touch the official reserves. In a fixed exchange rate regime however, the central bank will accommodate surpluses and deficits using the official reserves.