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International Finance Issues and ScopeInternational finance deals with the management of international financial flows, institutions, and foreign exchange rate between the two currencies.Functions of International Finance: Investment Decisions-Investment decisions deals with the investing efficiently in overseas markets.Finance decisions-Finance decisions deals with the raising of finance from international markets.

International Monetary SystemThe international monetary system refers to the policies, institutions, practices, regulations and mechanism that determines the rate at which one currency is exchanged for another. The International Monetary System ConsistsPolicies related to the foreign exchange rateInstitutions which monitor the exchange ratePractices regarding the management of forex rateRegulation regarding the management of forex rateMechanism of the management of the forex rate

History of International Monetary SystemClassical gold StandardUnder the gold standard, the currency which was in circulation consist or represents certain amount of gold.

It was the oldest system which was in operation till the beginning of the 1st world war (1931). Under this system, the actual currency in circulation consists of coins with a fixed gold content.

Determination of Exchange Rate under Gold StandardExchange rate determination depends upon, currencies consist how much gold.

Suppose, a pound sterling is worth 0.05 ounces of gold in the UK, and dollar is worth equal to 0.00125 ounces of gold in the US. Then the exchange rate between pound sterling and dollar would be 4.00dollar equal to 1 sterling pound.

International Monetary SystemThe Bretton Wood System (1946-1971)To come up the depressed economy after world war 2nd, the US and UK and other countries agreed to overhaul the world monetary system to accelerate the international trade.

The outcome was so called Bretton Wood System which become the cause of establishing International Monetary Fund (IMF) and World Bank in 1946.

The Bretton Wood SystemcontThe exchange rate regime that was put in place can be characterized as the Gold Exchange Standard continued till 1971. Under this system the main mechanism of exchange rate was:

The US govt. undertook to convert the US dollar freely into gold at a fixed parity of $35 per ounce. Other member of IMF agrees to fix the exchange rate of their currencies against dollar with the variation within 1% on either side of the central parity being permissible.

International Financial InstitutionsUnder the Bretton Wood System two major financial institutions were established in 1946.

International Monetary FundInternational Bank for Reconstruction and Development (World Bank)

Post Bretton Wood System-Alternative Foreign Exchange Rate SystemForeign exchange rate system deals with how foreign exchange rate between two currencies is determined.Foreign Exchange rate systemFloating Exchange rate systemManaged Float systemMixed Exchange rate systemFixed Exchange Rate system

Fixed Exchange rate systemFixed exchange rate system is that exchange rate system where exchange rate is directly regulated by central bank, and it is determined accordingly. Under fixed exchange rate system, demand and supply forces have no role in determine the exchange rate.D-forexS-forexReserve of Forex$/Re$/Re

Floating Exchange rate systemFloating exchange rate system is that exchange rate system where exchange rate is directly determined by demand and supply forces. D-forexS-forexReserve of Forex$/Re$/ReDemand for Foreign currency-1.Importers2. Gifts to abroad3. Remittance to abroad4.Financial Assistance to abroad.5. Investment in foreign currency denominated assets.Supply for foreign currency-Exporters.2. Gifts to home country.3. Remittance to home country.4. Financial assistance to home country.5. Investment in home country .

Managed Float Exchange Rate SystemManaged float exchange rate system is that exchange rate system wherein the exchange rate is deliberately determined or fixed. Generally it is of two types-Crawling Peg exchange rate system-Target Zone exchange rate system-

Crawling Peg Exchange Rate SystemCrawling peg exchange rate system is also called managed float exchange rate system. It is that exchange rate system where foreign exchange is directly determined by central bank of the country. But in this exchange rate system, exchange rate is frequently adjusted depending upon the market requirements.

Targeted Zone Exchange Rate System In targeted Zone Exchange Rate System, Exchange Rate is kept at desired level by adjusting the all economic and commercial policies.D-forexS-forexReserve of Forex45/1$$/Re52/1$

Mixed Foreign Exchange Mixed exchange rate system is combination of fixed exchange rate system and floating exchange rate system. Under this system imports and exports of some items are subject of fixed exchange rate and imports and exports of some items are subject of floating exchange rate.

For example-In India the imports and exports of current a/c items are subject of floating rate. Importers and exporters are free to purchase and sell the foreign currency from open market.

The imports and exports of capital a/c items are subject of fixed exchange rate. Importers and exporters have to purchase and sell the foreign currency at govt. determined exchange rate.

European Union and Monetary SystemThe European Monetary System began operating in 1979. Its objective was to foster monetary stability in the European Union. European Union consists 25 member countries. As of January 1999, common currency called Euro introduced in 11 courtiers for the purpose of commercial transactions and to accelerate the international trade among the member countries.

Of late by June 2002, one more country currency replaced with Euro. The 12 countries are-Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, and Spain.

Impact of Single Currency on EU1.Impact on European Monetary PolicyThe euro allows for a single money supply throughout much of Europe, rather than a separate money supply for each member countries. The common currency promoted the political and economic ties among the member countries. The introduction of euro calls establishment of European Central Bank in Frankfurt and is responsible for setting monetary policy for all member countries.

Impact of Single Currency on EUcont.2. Impact on European BusinessAdoption of common currency eliminated the currency movements among European countries, and also encourages more long term business arrangements between companies of two countries.Trade flows between member countries have increased because exporters and importers can conduct trade without having concern about exchange rate fluctuations.

Impact of Single Currency on EUcont.3. Impact on Financial MovementsA single euro forces the interest rate on govt. securities identical among the member countries. Any mismatch in interest rate foster the fund movements from one country to another country. Stock prices in member countries are also comparable because they are denominated in the same currency.

Impact of Single Currency on EUcont4. Impact on Exchange Rate RiskAdoption of common currency is the advantage of elimination of foreign exchange rate risk. Besides it, the foreign exchange transactions cost have also eliminated.

Foreign Exchange MarketForeign exchange market is that market where foreign currencies are traded at spot price or future price.Participants in Foreign Exchange Market-

Participants in Foreign Exchange Market-

Foreign Exchange Brokers- Foreign Exchange brokers are those entities which are ready to buy and sell the foreign currency.

Arbitrageurs- Arbitrageurs are those entities which take advantage of foreign exchange rate differential in two markets. USA Forex Market-For example in USA lets assume-Re.48/ $1 and in India Forex Market-Re.50/$1then arbitrageurs will start to purchase dollar in U.S stock market and sell it in Indian forex market. Speculators- Speculators are those who take advantage of speculation in Forex Market.

Traders- These are entities which are in the business of export and import.

Hedgers- mostly multinational firms, engage in forward contracts to protect the value of outstanding contracts.

Transactions in Fx MarketAll the transactions in foreign exchange market either take place at spot rate which is called spot market or forward rate which is called forward foreign exchange market.Foreign Exchange MarketSpot Foreign Exchange MarketForward Foreign Exchange Market

Transactions in Spot MarketSpot foreign exchange market is that market where currency is delivered at prevailing foreign exchange rate.

Spot Quotations in Foreign Exchange MarketDirect Quotations-In foreign exchange market direct quotations exist when value of one unit of foreign currency is expressed in certain units of domestic currency. For example Re. 50/1$

Indirect Quotations-In foreign exchange market direct quotations exist when value of one unit of domestic currency is expressed in certain units of foreign currency. For example $0.02/Re 1

Transactions in Forward foreign exchange marketForward foreign exchange market is that market where currency is delivered at some future date at an agreed price.

Forward QuotationsForward quotations refers the way in which the value of foreign currency is expressed in some future date.

Forward PremiumWhen dealing with foreign exchange(FX), forward premium is a situation where thefuturesexchange rate, with respect to the domestic currency, is trading at a higher spot exchange rate. In other words forward rate is higher than the spot rate.Suppose spot Yen on Dec 3, 2001 sold at $0.008058, whereas 180 days forward Yen were priced at $0.008135. It means Yen is quoted 77 point premium. The annualized forward premium is:

Forward DiscountWhen dealing with foreign exchange(FX), forward discount is a situation where thefuturesexchange rate, with respect to the domestic currency, is trading at a lower spot exchange rate.Suppose the British pound was quoted $1.4248 while the 90 days forward pound was quoted at $1.4179. It means the pound is quoted 69 point discount. The annualized discount is:

Bid is that quotation at which foreign currency is purchased.Ask is that quotation at which currency is sold. Suppose pound is quoted at $1.4419-28. It means that banks are ready to purchase pound at $1.4419 and ready to sell at $1.4428.Spread is the difference between the bid price and ask price. For example if ask price for pound is $1.4428 and Bid price is $1.4419, then the spread will be:

Bid, Ask and Spread

Calculation of Forward rate from spot ratesWhat will be 30days and 60days forward rates ? Spot rate 30days 60 days($/Bp): 2.20-30 10-20 30-20

Ans. 30 days forward rates will be: ($/BP): 2.30/2.5060 days forward rates will be: ($/BP): 1.90/2.10

Notes: if exchange rates are expressed in such a manner, it is also called swap rates or outright rates.If swap rates are in increasing order just like in the case of 30 days. Then then points are added in spot bid and ask rate respectively.On the other hand if swap rates are in decreasing order, just like in the case of 60 days, then swap points are deducted from spot rates respectively.

Cross Rates with zero transaction costCross Rates refers when exchange rate between two currencies is determined with the help of third currency with which the two currencies have exchange rate.If $0.90/ , then 1.11/ 1$, in the same way if $0.60/SFr, then SFr1.66/1$The exchange rate between Euro and Swiss Franc will be-- 1.11=SFr1.66 or SFr1.49/1$

Cross Rates with positive transaction costQ. 1. spot rates are given as: $/euro: 1.3520/1.3550 $/BP: 2.0250/2.0285What will be cross/synthetic rates ?

Cross/synthetic rates will be: BP/euro: BP0.6665/0.6691

Cross Rates with positive transaction costQ. 1. spot rates are given as: $/Bp: 1.4419-36 $/SFr: 0.6250-67What will be cross/synthetic rates ?

Cross/synthetic rates will be: SFr/BP: 2.3007/2.3097

Currency ArbitrageCurrency arbitrage is a situation which involves purchasing a currency from a market where it is available at cheap rate, and selling the same currency where it is trading at higher rate. Type of arbitrage:1 One point arbitrage:2. Two point arbitrage3. Three point arbitrage:

One point arbitrageOne point arbitrage implies purchasing currency at lower price and selling the same currency at the higher price in the market. If USD/BP :1.24/1.30It means arbitrage can purchase 1 BP at 1.24 and sell at 1.30 for one dollar. The profit of arbitrageur from this arbitrage is USD0.06.

Indirect quotes and Two Point ArbitrageBank A is quoting in USA:USD/BP: 1.4550/1.4560 It means bid rates of banks are $1.4550 for 1BP, and $1.4560 is ask rate for 1BPBank B is quoting in UKUSD/BP: 1.4538/1.4548 It means bid rates of banks are $1.4538 for 1BP, and $1.4548 is ask rate for 1BPNow arbitrate opportunities are there, arbitrageur will purchase 1BP from UK at $1.4548 and sell at $1.4550 in USA.Net profit will be (1.4550-1.4548)=$0.0002

Triangular ArbitrageSuppose pound is bid at $1.5422 in New York and euro is offered at $0.9251in Frankfurt. At the same time London banks are offering pound at Euro1.6650. $1.5422/1BP (New York) 1$0.9251/1Euro (Frankfurt) 2Euro1.6650/1BP (London) 3

Lets examine whether arbitrage opportunities exist or not:As we known 1 and 3 are equal.$1.5422=Euro1.6650 or $0.9260/1EuroBut in Frankfurt the exchange rate between dollar and euro is $0.9251, it means arbitrage opportunities exists.

Triangular ArbitragecontNew York $1.5422/1BP

Frankfurt$0.9251/1EuroLondon Euro1.6650/1BPArbitrager acquires $1million in New YorkSells $10,00,000 in Frankfurt at $0.9251/1euro for euro 1,080964.22 (10,00,000*1.080964)Sells euro1,080964.22 in London at euro1.6650/1pound for Pound649227.76 (1080964.22*0.600)Sells Pound in New York at $1.5422/1Pound for $1,001,239.05 (649227.76*1.5422)Net Profit from Arbitrage=$1,001,239.05-10,00,000=$1239.05

Triangular Arbitrage With bid and ask rates USD/BP: 1.60/1.61USD/MYR: 0.200/201MYR/BP: 8.10/8.20

Use USD 10,000 and purchase BP at USD1.61, the investor will have BP6211=(10.000x1/1.61).Sell BP6211 at MYR 8.10, investor will have MYR 50310=(6211x8.10)Sell MYR 50310 at USD 0.200, investor will have USD 10062=(50310x0.200)Net profit=USD10062-10000=USD62

Triangular Arbitrage with positive transaction costThe bid and ask rates of different currencies are given in three different markets. Is there any arbitrage opportunities?JY/$:110.25/111.10R/$:1.6520/1.6530JY/R:68.30/69.50

Use JY10,000 and purchase USD at 111.0 investor will have USD 90.00=(JY10,000x111.10)Sell USD 90.00 at 1.6520 investor will have R148.69=(90.00x1.6520)Sell R 148.69 at 68.30 investor will have JY10155=(148.69x68.30)

Net profit=JY10155-10000=JY155

Foreign Exchange Derivative MarketForeign exchange derivative market is that market where such kind of financial instruments are traded which are used to hedge the foreign exchange risk.MNCs which have global business operation are getting their sales in multiple currencies. So large and unexpected fluctuations in exchange rate between domestic currency and host currency will expose the company to the foreign exchange risk. To the hedge the foreign exchange risk MNCs and other investors purchase derivative contracts.

Forward MarketA forward contract is a contract in which currency is delivered in future date at an agreed price.Features-1. Non Standardized Contracts.2. Traded at over the counter the market.3. Fear of Default.4. No involvement of third party.5. Party known to each other very well.

Futures ContractA future contract is contract in which seller agrees to make delivery of specified amount of currency at specified future date at specified exchange rate. A Future contract is stated in details. Under Future contract both the parties have to put a margin money to clearing house. In case of default the margin of the respective party is seized.

Features 1. Standardized Contract.2. Between two parties who not necessarily known to each other. 3. No default, guarantee for performance by a clearing corporation or clearing house.4. Margin placement to the clearing house.

Future ContractsFuture ContractsCommodity FutureFinancial FutureFutures on StocksStock Index FuturesForeign Ex. FuturesInterest rate Futures

Motives for purchasing Future ContractsHedgingHedging involves wherein exporters, importers and firms need foreign currency purchase future contract to avoid the unexpected fluctuations in the forex markets.TradingFuture contracts are financial products which are used for trading purposes. Traders are purchasing and selling future contracts mearly for trading purpose.

Motives for purchasing Future ContractscontSpeculation Speculators take advantage of Forex market fluctuations by purchasing the currency futures. International SpreadingWhen there are expectations that two Forex will not co-vary in the same directions then International spreading like Straddle or Strangle can be created to utilize this situations.Arbitrage Between two stock ExchangesArbitrager is a process of taking advantage of price differential of two Forex markets.

OptionsCall Option on Currency A call option is that agreement in which the writer or seller gives the right to purchase a specified amount of currency at specified exchange rate to the option buyer or investor. A call option is purchased to minimize the risk of hiking the price of underlying currency.Call Options are purchased to hedge the upside risk.

Calculation of Profit/Loss of Investor on Call OptionCall Option-Contract Size $10,000, Exercise Price 50/$, Option Premium 2/$, Maturity Period 3 months.56Profit/Loss of Investor

Spot Ex. RateGross Profit/LossNet Profit/Loss44/$-20000-2000046/$-20000-2000048/$-20000-2000050/$-20000-2000052/$20000054/$400002000056/$6000040000

Calculation of Profit/Loss of Writer on Call Option

Profit/Loss of WriterCall Option-Contract Size $10,000, Exercise Price 50/$, Option Premium 2/$, Maturity Period 3 months.

Spot Ex. RateGross Profit/LossNet Profit/Loss44/$200002000046/$200002000048/$200002000050/$200002000052/$-20000054/$-40000-2000056/$-60000-40000

Put OptionA put option is that agreement in which the writer gives the right to sell the specified amount of foreign currency at specified exchange rate to the option seller or writer. A put option is purchased to minimize the risk of declining the price of underlying currency.Put Options are purchased to hedge the downside side.

Put OptionContract Size $10,000Exercise Price 45/$Option Premium Rs 4/$Maturity Period 3 months

Contract size $10,000, Exchange rate 52/$, Option Premium, 2/$, Maturity Period 3 months.Profit/Loss of InvestorCalculation of Profit/Loss of Investor on Put Option

Spot Ex. RateGross Profit/LossNet Profit/Loss46/$600004000048/$400002000050/$20000052/$-20000-2000054/$-20000-2000056/$-20000-2000058/$-20000-20000

Calculation of Profit/Loss of writer on Put OptionProfit/Loss of WriterContract size $10,000, Exchange rate 52/$, Option Premium, 2/$, Maturity Period 3 months.

Spot Ex. RateGross Profit/LossNet Profit/Loss46/$-60000-4000048/$-40000-2000050/$-20000052/$200002000054/$200002000056/$200002000058/$2000020000

American option-American option can be exercised at any time with the maturity period.European option-European option can not be exercised before the maturity period.European Call OptionsTypes of Options

*Trading StrategiesSpread (1)- Spread involves taking position, i.e., short or long over a two or more options of similar kind over same stock. Vertical Spread (2)- Vertical Spread involves selling or purchasing of two or more options of similar kind with same maturity period but with different exercise price.

Horizontal Spread (3)- Horizontal Spread involves selling or purchasing of two or more options of similar kind with same exercise price but with different maturity period.

Combination (4) Combination involves selling or purchasing or two or more different types of options.

*Bull SpreadA bull spread is created by taking position, i.e., short or long over a two or more options of similar kind over same stock. A bull spread is created when there are more chances that stock market will go up.A bull spread is created by purchasing a call/put option with lower exercise price and selling a call/put option over the same stock with higher exercise price.

*Bull Spread Using of Call Option Mr. X Purchased Call Sold Call Size $1000, Exercise Price- JY100/$ Size $1000, Exercise Price JY110/$ Maturity Period 3 moths, Op-JY10/$ Maturity Period 3 months, Op-JY5/$ +20K + 10KP/L on long callP/L on short callNet P/L

Spot PriceP/LShortCallP/LLongCallNetP/L90 100 110115120130+5000+5000 +5000 0-5000-15000-10000-100000+5000+10000+20000-5000-5000+5000+5000+5000+5000

*Bull Spread Using of Call Option Mr. X Purchased Call Sold Call Size $1000, Exercise Price-JY100/$ Size of contract $1000, Exercise Price JY110/$ Maturity Period 3 moths, Op- JY10/$ Maturity Period 3 months, Op-JY5/$ Question-Find out the maximum loss, maximum profit and the break even price?Maximum loss=Lower strike premium to be received-higher strike premium to be paid. = 5-10= -5*1000= -5000Maximum profit=higher strike price-lower strike price-net premium paid=110-100-5=5*1000=5000Break even price=lower strike price +Net premium paid.=100+5=105

*Bull Spread Using of Put Option Mr. X Purchased Put Sold Put Size- JY10000, Exercise Price- JY100/$ Size JY1000, Exercise Price JY110/$ Maturity Period 3 moths, Op- JY5/$ Maturity Period 3 months, Op-JY10/$ +20K + 10KP/L on long putP/L on short putNet P/L

Spot PriceP/LShort PutP/LLong PutNetP/L90 100 110120130-100000 +10000+10000+10000+5000-5000-5000-5000-5000-5000-5000+5000+5000+5000

*Bull Spread Using of Put Option Mr. X Purchased Put Sold Put Size of contract JY1000, Exercise Price- JY100/$ Size -JY1000, Ex. Price- JY110/$ Maturity Period 3 moths, Op- JY5/$ Maturity Period 3 months, Op-JY10/$ Question-Find out the maximum loss, maximum profit and the break even price?Maximum loss=higher strike price - lower strike price-net premium received = 110-100-5=5*1000= 5000Maximum profit=premium received on selling option-premium paid on buying option=10-5=5*1000=5000Break even price=higher strike price -Net premium received.=110-5=105

*StraddleA straddle consists of buying a call and put option both with identical exercise price and maturity period. A straddle is created when there are expectations that stock market will go to either side to extreme level. i.e. either market will appreciate or depreciate.Straddle topStraddle top is created by selling a call and put on the same share with the same exercise price and expiration date. It is created by seller. Straddle bottomStraddle top is created by purchasing a call and put on the same share with the same exercise price and expiration date. It is created by buyer (investor).

*Straddle BottomPurchased Call Purchased Put Size JY1000, Exercise Price- JY110/$ Size JY1000, Exercise Price JY110/$ Maturity Period 3 months, Op- JY5/$ Maturity Period 3 months, Op-JY10/$ P/L on long callP/L on long putNet P/L

Spot PriceP/LLong CallP/L LongPutNetP/L90 100 110120130-5000-5000 -5000+5000+15000+100000-10000-10000-10000+5000-5000-15000-5000+5000

*Straddle TopSold Call Sold Put Size-JY1000, Exercise Price- JY110 Size JY1000, Exercise Price-JY100 Maturity Period 3 moths, Op-JY5/$ Maturity Period 3 months, Op-JY10/$

Spot PriceP/LLong CallP/L LongPutNetP/L90 100 11012013050005000 5000-5000-15000-100000100001000010000-50005000150005000-5000

*StripsA strips involves taking a long position in one call coupled with two put with same exercise price and maturity period. A strip is created when there are expectations that stock market will go to either side to extreme level but decline the stock price is more likely than the increase.

*StripsPurchased Call (1) Purchased Put (2) Size JY1000, Exercise Price- JY130 Size JY1000, Exercise Price- JY130 Maturity Period 3 moths, Op-JY4/$ Maturity Period 3 months, Op-JY10/$

*Strips

Spot pricep/l on callp'l on putNet90-40200160100-4010060110-400-40120-40-100-140130-40-200-24014060-200-140150160-200-40160260-20060170360-200160

*Factors affecting Option price1.Price of underlying security If the security is highly worth full for the investors and high in demand, then the option available under the security will be high.2.Interest rateInterest rate is negatively related to option price, if the interest rate high in the economy, then investors will not be motivated to invest in options rather they will prefer to invest in debt market.

*Factors affecting Option pricecont3.Volatility in the marketHigh volatility is the indication of high uncertainty in the market. If the market is highly volatile, then option price will be more because seller and investors will prefer to cover there risk.4.Maturity Period If the maturity period is high, then option premium will be more. It is because uncertainty increases with increase the time duration.

Factors affecting Option pricePrice of underlying security- If the security is highly worth full for the investors and high in demand, then the option available under the security will be high.Interest rate-Interest rate is negatively related to option price, if the interest rate high in the economy, then investors will not be motivated to invest in options rather they will prefer to invest in debt market.

Factors affecting Option pricecontVolatility in the market-High volatility is the indication of high uncertainty in the market. If the market is highly volatile, then option price will be more because seller and investors will prefer to cover there risk.Maturity Period- If the maturity period is high, then option premium will be more. It is because uncertainty increases with increase the time duration.

Option valueIntrinsic Value of option-Intrinsic value refers to the amount by which the option is in the money.

Call option will be in the money when exercise price will be lower than the future spot price.Put option will be in the money when exercise price will be greater than the future spot price.

Time Value of option-Time value of option refers the difference between the premium of the option and intrinsic value of the option. Time value of option will be positive if intrinsic value will be more than the option premium, and vice versa.

Financial swaps is a process in which two business organization change their financial obligation. Financial swaps are widely used by MNCs, Banks and Govts. Minimize the credit and currency risk. Financial swaps take place against a notional amount. Financial Swaps

Theories of Exchange Rate DeterminationThere are two theories which empirical examines how the exchange rate between two currencies are determined. These theories are:Purchasing power parity theoryInterest rate parity theory

Purchasing power parity theory of Exchange RateThe theory of purchasing power parity (PPP) explains movements in the exchange rate between two currencies by changes in the price levels of respective countries.The exchange rate between two counties currencies equals the ratio of the counties price levels.It compares average prices across countries.It predicts a Re/dollar exchange rate of:

Absolute PPP and Relative PPPAbsolute PPPIt states that exchange rates equal relative price levels.For example if in USA a basket of goods can be purchased by one dollar, and the basket of same goods can be purchased in India by Rs 50/-, the exchange rate between rupee and dollar will be 50/1$.Likewise if Burger in USA cost USD2.43 and the same burger is of BP 1.90 in England then the exchange rate between USD and BP is USD2.43/BP1.90=USD1.29/BP1Purchasing Power Parity

Purchasing power parity theory of Exchange Ratecont.Relative PPPIt states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels.Where et is forward rate, Ph is price level in the home country, Pf is the price level in the home country.

Relative PPP exampleFor example if inflation in USA is 5%, and it is 10% in UK. The spot exchange rate is USD1.6/BP 1. Then the future spot exchange rate between the two currencies will be:It means the BP will depreciate by 4.5%. In other words, USD 1.6/1.045 or USD 1.53/BPSo, the exchange rate between USD and BP will be USD1.53/BP.

Relative PPP exampleFor example if inflation in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. Then the one year forward rate between the two currencies will be:It means the SFr will appreciate by 1.94%. In other words, USD 0.75/0.986 or USD 0.760/SFrSo, the exchange rate between USD and SFr will be USD0.760/SFr.

Relative PPP exampleFor example if inflation in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. What will be 90 forward rate between the two currencies will be:

3 month inflation in US will be = 5*3/12=1.25%3 month inflation in Switzerland = 3*3/12=0.75%It means the SFr will appreciate by 0.50%. 90 days forward rate will be USD 0.75/0.995 or USD 0.753/SFrSo, the 90 days forward rate will be USD 0.753/SFr.

Real Exchange Rate

The real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currencies. In other words real exchange rate is inflation adjusted exchange rate.Where et is real exchange rate, eo is spot exchange rate, ih is inflation rate in home country, if is inflation in foreign country, t is time period. Alternatively when some exchange rate is adjusted with some price index like WPI or CPI, then the real exchange rate will be:Where et is real exchange rate, eo is spot exchange rate, Ph is inflation rate in home country, Pf is inflation in foreign country, t is time period.

Calculating the Real exchange rate between USD and Japanese YenBetween 1980 and 1995, the USD/JY moved from JY 226.63/USD 1 to JY93.96. During this 15 years, the consumer price index (CPI) in Japan rose from 91.0 to 119.2, and CPI in USA rose from 82.4 to 152.4. Q. 1. if PPP had held over the period, what would the USD/JY exchange rate in 1995?

Calculating the Real exchange rate between USD and Japanese YencontQ.2. What happened to the real value of the yen in terms of dollars during this time period?

International Fisher EffectInternational Fisher effect integrates the purchasing power parity theory and Fisher effect in explaining the behavior of exchange rate between two currencies. PPP states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels.On the other hand Fisher effect states that with no government intervention, the nominal interest rate differential will approximately equal the anticipated inflation differential between the two countries.

International Fisher EffectThe interest rates which are quoted for financial contracts are stated in nominal terms. According to fisher effect, the real interest rate must be adjusted to reflect the expected inflation. It states that nominal interest rate is made up of two components real required rate of return and inflation premium equal to the expected amount of inflation. The fisher equation is:R=Required rate of return + Expected inflation R=a + i If required rate of return is 3% and inflation is 10%, then nominal interest rate must be 13%.

Fisher Effect.contFisher effect states that the real rate of return on financial contracts are equal across the countries that is: af=ahIf expected real returns is higher in one currency than another than capital flow would flow from the second country to first country. In equilibrium then no government intervention, the nominal interest rate differential will approximately equal the anticipated inflation differential between the two countries. If inflation rates in the USA and UK are 4% and 7% respectively, then Fisher effect states that nominal interest rate in UK should be 3% higher then USA. .

Fisher Effect.contIn conclusion International fisher effect states that higher interest rate in the home country will lead depreciation in the value of the home country, on the other hand a lower interest rate in the home country will lead appreciation in the value of the home currency.This relationship can be shown in the following equation and diagram.

Fisher Effect.cont1%1234-1-2-3-4Interest rate differential in favour of home country Appreciation/Depreciation of home currencyParity Line C2%3%4%5%-1%-2%-3%-4%-5%BA

Fisher Effect.contAt point A, interest rate differential is 1% in favour of home country, it will lead 1% market appreciation of the home currency. At point C interest rate differential is -2%, it means home interest rate is 2% more than the interest rate of foreign country. As a result the home currency will depreciate by 2%.

IFEexampleFor example if interest rate in USA is 5%, and it is 10% in UK. The spot exchange rate is USD1.6/BP 1. Then the future spot exchange rate between the two currencies will be:It means the BP will depreciate by 4.5%. In other words, USD 1.6/1.045 or USD 1.53/BPSo, the exchange rate between USD and BP will be USD1.53/BP.

IFEexampleFor example if interest rate in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. Then the one year forward rate between the two currencies will be:It means the SFr will appreciate by 1.94%. In other words, USD 0.75/0.986 or USD 0.760/SFrSo, the exchange rate between USD and SFr will be USD0.760/SFr.

IFEexampleFor example if interest in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. What will be 90 forward rate between the two currencies will be:

3 month interest in US will be = 5*3/12=1.25%3 month interest in Switzerland = 3*3/12=0.75%It means the SFr will appreciate by 0.50%. 90 days forward rate will be USD 0.75/0.995 or USD 0.753/SFrSo, the 90 days forward rate will be USD 0.753/SFr.

Interest Rate Parity TheoryAccording to IRP theory spot and forward rates are closely related to each other and it is the interest rate differential between the two currencies which creates the opportunities for arbitrage. In other words interest rate differential should be equal to the forward rate differential.Interest rate parity ensures that the return on a hedged (covered) foreign investment will just equal the domestic interest rate on investment of identical risk. When this condition holds the covered interest rate differential will be zero.

Interest Rate Parity Theory.contThe covered interest arbitrage relationship can be explained as follow:Let eo is current spot rate, et is forward rate, if rh and rf is prevailing interest rate in New York and London respectively, then one dollar invested today in NY will yield 1+rh at the year end. The same dollar invested in London will be worth (1+rf)et/eo. Now Funds will flow from New York to London, if following situation happens: Now Funds will flow from London to NY, if following situation happens:

Covered Interest ArbitrageThe interest rate on pound is 12% in London, and 7% on USD in New York on comparable investment. The pound spot rate is $1.75 and the one year forward rate is $1.68. It means funds will flow from New York to London.Borrow USD10,00,000 in New York at an interest rate of 7%.This means at the year end arbitrager will have to repay USD10,70,000.Convert the USD 10,00,000 to pound at the spot rate $1.75 for pound 571428.57 (10,00,000/1.75).Invest pound 571428.57 at 12% for one year in London which will yield pound 640000 to arbitrageur after one year. Simultaneously sell pound 640000 one year forward contract at a rate of $1.68, which will yield USD10,75,200. Net profit=10,75,200-10,70,000=USD 5200.

IRP and Covered Interest ArbitrageThe interest rate on USD is 8% per annum in New York and 6% per annum on euro in London. The current spot rate is euro1.13110/USD1, and the 90 days forward rate is euro1.12556/USD1. Show the covered interest arbitrage regardless of currency choice of the investor?Investor starts with $ 10,00,000 in New York.He will convert $10,00,000 to euro at euro1.13110/USD1 for euro11,13,100 (10,00,000*1.13110) in London.He will invest euro 11,13,100 at 1.5% for 90 days, yielding him euro 11,48,066.50.Simultaneously with euro investment, sell the euro 11,48,065.50 forward contract at rate of euro1.12556/USD1 for delivery in 90days, and receive $10,20,000Net profit $10,00,000-$10,20,000=$20,000

International ExposureForeign Exchange Risk refers to which a company is affected by changing in exchange rates. A large number of factors affects the exchange rate between home currency and host currency which in turn affect the market value of the company.

International ExposureTranslation Exposure or Accounting Exposure- Changes in income statement items and the book value of balance sheet assets and liabilities that are caused by an exchange rate change. Operating Exposure- Changes in operating cash flows caused by an exchange rate change. Transaction Exposure- Changes in the value of outstanding foreign currency denominated contracts.Operating and Transaction exposure combined together is also called economic exposure.

Currency Translation MethodCompanies with international operations will have foreign currency denominated assets and liabilities, revenues and expenses. However, they have to assigned home currency values to all the foreign currency denominated assets and liabilities, revenues and expenses.In other words, financial statements of an MNCs subsidiary must be translated from host currency to home currency before consolidated with the parent co. financial statements.

Methods of Translation or Accounting Exposure

Methods of Translation or Accounting ExposurecontCurrent/Non Current Method- With this method, all the foreign subsidiarys current assets and liabilities are translated into home currency at the current exchange rate. Each non current assets and liabilities are translated into home currency at its historical exchange rate-that is at the rate when these assets/liabilities acquired. The income statement is translated at the average exchange rate of the period except for those revenues and expenses items associated with non current assets or liabilities.

Methods of Translation or Accounting ExposurecontMonetary/Non Monetary Method- This method differentiates between monetary assets and liabilities- that is those items that represents a claim to receive or an obligation to pay a fixed amount of foreign currency units-and non monetary or physical assets and liabilities. Monetary assets/liabilities are translated at the current rate and non monetary assets/liabilities for example inventory, fixed assets and long term investment are translated at historical rate.

Income statement items are translated at the average exchange rate during the period, except for revenue and expense items related to non monetary assets and liabilities.

Methods of Translation or Accounting ExposurecontTemporal Method- It is similar to monetary/non monetary method. The only difference is that monetary/non monetary method; inventory is translated at historical rate. Whereas in Temporal method inventory is translated at current rate if the inventory is shown on the balance sheet at market value. Current Rate Method- All balance sheet items and income statement items are translated at the current rate.

After devaluation LC5/$1LCLC4/$1Monetary/TemporalCurrent/Current ratesNonmonetaryNoncurrentAssetsCash2600650520520520520Inventory3600900900720720720Prepaid expenses2005050504040Total current Assets640016001470129012801280Fixed AssetsAccumulated depreciation3600900900900900720Goodwill1000250250250250200Total Assets1100027502620244024302200LiabilitiesCurrent Liabilities3400850680680680680Long term debt3000750600600750600Deferred income tax500125100100125100Total Liabilities690017251380138015551380Capital Stock1500375375375375375Retained earnings2600650865685500445Total equity4100102512401060875820Total equity+Total liabilities1100027502620244024302200Translation gain/loss21535-150-205

How to manage Translation Exposure ?1.Fund adjustmentFund adjustment involves the altering the amounts or the currencies of the planned cash flows of parent or its subsidiaries to reduce the firm local currencies exposure. If an local currency depreciation/devaluation is expected, fund adjustment methods include pricing exports in hard currencies and imports in the local currencies, investing in hard currency securities and replacing the hard currency borrowings into local currency borrowings.

How to manage Translation Exposure ?...cont2. Forward/Options Market Hedge-Micro Soft USA has the currency exposure of INR and Indian Companies have the exposure of US dollar. To hedge their situations Micro Soft USA would like to purchase a put/call option over INR to limit its downside/Upside risk. On the contrary, Indian Companies would like to purchase call/Put option over dollar to limit their upward/upside risk.

How to manage Translation Exposure ?...cont3. Selecting Convenient CurrencySelecting less risky currencies for invoicing exports and imports and adjusting transfer prices are also the good techniques to reduce the translation exposure.4. Exposure netting-This techniques is based on cross hedging. It techniques involves offsetting exposure in one currency with exposure in the another currency such that loss from host currency can be off setted by gain from another currency.

Translation MethodsCurrent/Noncurrent MethodMonetary/Nonmonetary MethodTemporal MethodCurrent Rate Method

Current/Noncurrent MethodThe underlying principal is that assets and liabilities should be translated based on their maturity.Current assets translated at the spot rate.Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books.This method of foreign currency translation was generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective.

Current/Noncurrent MethodCurrent assets translated at the spot rate.e.g. DM2=$1Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books. e.g. DM3=$1

Sheet1

Balance SheetLocal CurrencyCurrent/ NoncurrentMonetary/ NonmonetaryTemporalCurrent Rate

Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750

Net fixed assets3,000 DM$1,000$1,000$1,000$1,500

Total Assets6,600 DM$2,800$2,550$2,950$3,300

Current liabilities1,200 DM$600$600$600$600

Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900

Retained earnings900 DM$700$150$550$360

CTA--------------------------------$540

Total Liabilities and Equity6,600 DM$2,800$2,550$2,950$3,300

Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400

Net operating income 1,500$667$1,167$667$600

Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360

Foreign exchange gain (loss)$300-$550$150

Net income 900$700$150$550$360

Dividends 0$0$0$0$0

Addition to Retained earnings 900$700$150$550$360

Income StatementLocal CurrencyCurrent/ NoncurrentMonetary/ NonmonetaryTemporalCurrent Rate

Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400

Net operating income1,500.00 DM$667$1,167$667$600

Income tax (40%)600.00 DM$267$467$267$240

Profit after tax900.00 DM$400$700$400$360

Foreign exchange gain (loss)$300$(550)$150

Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0

Addition to Retained Earnings900.00 DM$700$150$550$360

Total Liabilities and Equity

Sheet2

Sheet3

Monetary/Nonmonetary MethodThe underlying principal is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes.All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate. All other (nonmonetary) balance sheet accounts (owners equity, land) are translated at the historical exchange rate in effect when the account was first recorded.

Monetary/Nonmonetary MethodAll monetary balance sheet accounts are translated at the current exchange rate. e.g. DM2=$1All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. e.g.DM3=$1

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0



Balance SheetLocal CurrencyMonetary/ Nonmonetary

Cash2,100 DM$1,050

Inventory1,500 DM$500

Net fixed assets3,000 DM$1,000

Total Assets6,600 DM$2,550

Current liabilities1,200 DM$600

Long-Term debt1,800 DM$900

Common stock2,700 DM$900

Retained earnings900 DM$0

CTA----------------

Total Liabilities and Equity6,600 DM$2,400

Sheet2

Sheet3

Temporal MethodThe underlying principal is that assets and liabilities should be translated based on how they are carried on the firms books.Balance sheet account are translated at the current spot exchange rate if they are carried on the books at their current value.Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books.

Temporal MethodItems carried on the books at their current value are translated at the spot exchange rate.e.g. DM2=$1Items that are carried on the books at historical costs are translated at the historical exchange rates. e.g. DM3=$1

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0



Balance SheetLocal CurrencyMonetary/ Nonmonetary

Cash2,100 DM$1,050








CTA----------------


Balance SheetLocal CurrencyTemporal

Cash2,100 DM$1,050








CTA----------------


Sheet2

Sheet3

Current Rate MethodAll balance sheet items (except for stockholders equity) are translated at the current exchange rate.Very simple method in application.A plug equity account named cumulative translation adjustment is used to make the balance sheet balance.

Current Rate MethodAll balance sheet items (except for stockholders equity) are translated at the current exchange rate.A plug equity account named cumulative translation adjustment is used to make the balance sheet balance

Sheet1


Cash 1,050.00$1,050$1,050$1,050$1,050

Inventory 750.00$750$562.50$750

Net fixed assets 1,000.00$750$750$1,000

Total Assets 2,800.00$2,550$2,362.50$2,800

Current liabilities 600.00$600$600$600

Long-Term debt 600.00$450$525$600

Common stock 900.00$675$675$675

Retained earnings 700.00

CTA------------------------$225

Total Liabilities and Equity 2,800.00$2,550$2,362.50$2,800

Balance SheetLocal CurrencyCurrent Rate

Cash1,050 DM$1,050

Inventory750 DM$750



Current liabilities600 DM$600

Long-Term debt600 DM$600

Common stock900 DM$675

Retained earnings700 DM

CTA--------$225


Balance SheetLocal CurrencyCurrent Rate

CashDM2,100$1,050

InventoryDM1,500$750

Net fixed assetsDM3,000$1,500

Total AssetsDM6,600$3,300

Current liabilitiesDM1,200$600

Long-Term debtDM1,800$900

Common stockDM2,700$900

Retained earningsDM900$360

CTA--------$540

Total Liabilities and EquityDM6,600$3,300

Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Spot exchange rateearnings

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0

Addition to Retained earnings900.00 DM$700$150$550$360

Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Book value of inventory at spot exchange rateBook value of inventory historic rateCurrent value of inventory at spot exchange rate.earnings

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0


Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1historic ratespot exchange rate.earnings

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0


Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1spot rateearnings

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0


Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1spot ratehistorical rateearnings

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0


Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1historical rateearnings

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0


Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1From income statementearnings

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0


Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Under the current rate method, a plug equity account named cumulative translation adjustment makes the balance sheet balance.earnings

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000.00 DM$4,000$4,000$4,000$4,000

COGS7,500.00 DM$3,000$2,500$3,000$3,000

Depreciation1,000.00 DM$333$333$333$400


Income tax (40%)600.00 DM$267$467$267$240



Net income900.00 DM$700$150$550$360

Dividends0.00 DM0.00.00.00.0


Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1For notes, see Exhibit 14.1Sales translate at average exchange rate over the period, DM2.50 = $1

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000 DM$4,000$4,000$4,000$4,000

COGS7,500 DM$3,000$2,500$3,000$3,000

Depreciation1,000 DM$333$333$333$400

Net operating income1,500 DM$667$1,167$667$600

Income tax (40%)600 DM$267$467$267$240

Profit after tax900 DM$400$700$400$360


Net income900 DM$700$150$550$360

Dividends0 DM$0$0$0$0

Addition to Retained Earnings900 DM$700$150$550$360


Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1For notes, see Exhibit 14.1Translate at DM2.50 = $1Translate at new exchange rate, DM2.00 = $1

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000 DM$4,000$4,000$4,000$4,000

COGS7,500 DM$3,000$2,500$3,000$3,000

Depreciation1,000 DM$333$333$333$400


Income tax (40%)600 DM$267$467$267$240



Net income900 DM$700$150$550$360




Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1For notes, see Exhibit 14.1Translate at DM3 = $1Translate at average exchange rate, DM2.5 = $1

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000 DM$4,000$4,000$4,000$4,000

COGS7,500 DM$3,000$2,500$3,000$3,000

Depreciation1,000 DM$333$333$333$400


Income tax (40%)600 DM$267$467$267$240



Net income900 DM$700$150$550$360




Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1For notes, see Exhibit 14.1Note the effect on after-tax profit.

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000 DM$4,000$4,000$4,000$4,000

COGS7,500 DM$3,000$2,500$3,000$3,000

Depreciation1,000 DM$333$333$333$400


Income tax (40%)600 DM$267$467$267$240



Net income900 DM$700$150$550$360




Sheet2

Sheet3

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1For notes, see Exhibit 14.1Note the effect that foreign exchange gains (losses) has on net income.

Sheet1


Cash2,100 DM$1,050$1,050$1,050$1,050

Inventory1,500 DM$750$500$900$750


Total Assets6,600 DM$2,800$2,550$2,950$3,300


Long-Term debt1,800 DM$600$900$900$900

Common stock2,700 DM$900$900$900$900


CTA--------------------------------$540


Income Statement

Sales 10,000$4,000$4,000$4,000$4,000

COGS 7,500$3,000$2,500$3,000$3,000

Depreciation 1,000$333$333$333$400


Income tax (40%) 600$267$467$267$240

Profit after tax 900$400$700$400$360


Net income 900$700$150$550$360

Dividends 0$0$0$0$0



Sales10,000 DM$4,000$4,000$4,000$4,000

COGS7,500 DM$3,000$2,500$3,000$3,000

Depreciation1,000 DM$333$333$333$400


Income tax (40%)600 DM$267$467$267$240



Net income900 DM$700$150$550$360




Sheet2

Sheet3

Managing Operating ExposureCurrency risk affects all facets of a company operations, it should not be the concern of financial manager alone. Operation manager should develop marketing and production strategy to minimize the impact of host currency risk.

Managing Operating ExposurecontMarketing Management of Exchange RiskMarketing strategy calls designing the marketing strategy to minimizing the currency risk.Market Selection-MNC should select that market whose currency is not so sensitive to global economic and non economic shocks.2. Pricing Strategy-Co should keep the price of its product less where the currency is very soft. On the other hand, co. should keep the price high very currency is hard.

Managing Operating Exposurecont3. Product Strategy-Companies often respond to exchange risk by altering their product strategy, which deals with such areas as new product introduction, product line decisions, and product innovation.

Managing Operating ExposurecontProduction Management of Exchange RiskMNC can manage the currency risk by working on product sourcing and plant location.Input Mix-MNC can outsource the inputs from the countries where value of the currency is low and sell the final product to the countries where the value of the currency is high.

Managing Operating Exposurecont2.Shifting the Production among the Plants-MNCs can relocate their production among their plants in line with the changing dollar costs of production, increasing the production in a nation whose currency has devaluated and decreasing the production in the nation whose currency has been revaluated. 3. Plant location-Shifting the plant to the countries where currency is hard.

Managing Operating ExposurecontFinance Strategy-1. Company should purchase call option if company has payables. 2. Company should purchase put options if company has receivables.

Techniques to Manage the Transactions ExposureIf an MNC decides to hedge part or whole of all its transaction exposure, it may select from the following techniques:Futures hedgeForward hedgeMoney market hedgeCurrency Options

Future HedgeCurrency futures can be used by firms that desire to hedge transaction exposure.Purchasing currency futureA firm which has to make some payments in the future date in foreign currency can purchase future contract on that currency from the future market. By purchasing the future contract on foreign currency, it locks in the amount of foreign currency needed to make the payment.Selling currency futureA firm which is expected to receive payment in foreign currency is facing downside risk. Firm can sell future contract in the market over the currency which is expected to receive.

Forward HedgeIf the parent co. has the receivable than co. can take short position over the forward/future contract. On the other hand if the co. has payable than co. can take long position over the contract covering the underlying currency.Calculating the Real Cost of Hedge:A forward hedge will be more costly than the no hedge can be estimated by calculating the real cost of hedging payables (RCH). The RCH measures the additional expenses beyond those incurred without hedging. RCH=NCH-NC

Where, NCH is nominal cost of hedging payables, NC is nominal cost of payables without hedging.

Forward HedgeexampleDurham Co. will need BP1,00,000 in 90 days for British imports. Today 90 days forward rate of the BP is $1.40. What is the real cost of hedging is spot rate of BP is either at $1.38 or $1.42 after 90 days?Real cost of hedging when exchange rate $1.38:NCH = BP1,00,000x$1.40=$1,40,000NC = BP1.00,000x$1.38=$1,38,000RCH = $1,40,000-$1,38,000=$2000Real cost of hedging when exchange rate $1.42:NCH = BP1,00,000x$1.40=$1,40,000NC = BP1.00,000x$1.42=$1,42,000RCH = $1,40,000-$1,42,000=-$2000When real cost of hedging is more favorable, when real cost of hedging is negative.

Forward HedgeexampleDurham Co. will need BP1,00,000 in 90 days for British imports. Today 90 days forward rate of the BP is $1.40. what will be the expected value of the real cost hedge if following spot rates exists in next 90 days ?Spot ex. Rates $1.38 1.32 1.43 1.36 1.38 1.40 1.42 1.45 Probability 5% 10% 15% 20% 20% 15% 10% 5%

Spot rateprobabilityNCH.PNC.PRCH.P1.35%$1,40,000$1,30,000$10,000 1.3210%$1,40,000$1,32,000$8,000 1.3415%$1,40,000$1,34,000$6,000 1.3620%$1,40,000$1,36,000$4,000 1.3820%$1,40,000$1,38,000$2,000 1.415%$1,40,000$1,40,000$0 1.4210%$1,40,000$1,42,000($2,000)1.455%$1,40,000$1,42,000($5,000)

Forward HedgeexampleThe expected value of the real cost of hedging can be measured as follow:E(RCH)= 0.05($10000)+0.10($8000)+0.15($6000)+0.20($4000)+0.20(2000)+0.15(0)+0.10(-$2000)+0.05(-$5000)=$2,950

Money market HedgeA money market hedge involves taking money market position to cover a future payables or receivables position. Money Market hedge on Payables:If a firm has excess cash, it can create a short term cash deposit in the foreign currency that will be need in the future.Example-Micro soft Inc needs NZ$10,00,000 in New Zealand in after 30 days. Banks in New Zealand are offering 6% annual (0.5% monthly) interest rate. The exchange rate between USD and NZD is USD0.65/NZD1. Now much USD will be need to have NZ$1000000 after one month?

Money market HedgeAmount need today to have NZD1000000=1000000/1+0.005=NZD995025If exchange rate USD0.65/NZD1, then USD needed= 995025x0.65=646766. It means Microsoft needs today USD646766 have NZD 1000000 after one month.lets assume Microsoft does not have excess cash. So it can borrow from bank and can create cash deposits in host county.Example-Micro soft Inc needs NZ$10,00,000 in New Zealand in after 30 days. Banks in New Zealand are offering 6% annual (0.5% monthly) interest rate. The interest rate in US is 8.4% annual (0.7% monthly). The exchange rate between USD and NZD is USD0.65/NZD1. Now much USD will be need to have NZ$1000000 after one month?

Money market HedgeAmount need today to have NZD1000000=1000000/1+0.005=NZD995025If exchange rate USD0.65/NZD1, then USD needed= 995025x0.65=646766. It means Microsoft needs today USD646766 have NZD 1000000 after one month.Microsoft can borrow this amount at 0.7% monthly interest rate today after one month will pay principal amount and interest= 646766x1.007=USD651293.

Money market HedgeMoney Market hedge on Receivables:If firm expects cash receivables in a foreign currency, it can hedge this position by borrowing the currency now and converting it to dollar. This receivables can be used to set off the loan.Example-Bakersfield Co. is US firm that exports goods to Singapore and expects to receive SD 400000 in 90 days. The annualized interest rate in US is 8% (2% on 90days) over the amount of Singapore dollars to be borrowed to hedge the future receivables. The exchange rate between USD and SD is SD0.80/USD1. how much USD Bakersfield can have to set off the loan?

Money market HedgeSD which can be borrowed SD400000=400000/1+0.02=SD392157Bakersfield will borrow SD392157 today will covert it into USD.If exchange rate SD0.80/USD1, company will have USD =USD490196.25. it means if Bakersfield have SD 400000 receivable, it can create money market hedge and can use USD 490196.25 to set off some loan.lets assume Microsoft does not have to set off any loan. Then Bakersfield can invest this amount in US securities.Example-Bakersfield Co. is US firm that exports goods to Singapore and expects to receive SD 400000 in 90 days. The annualized interest rate in US is 8% (2% on 90days) over the amount of Singapore dollars to be borrowed to hedge the future receivables. . The US banks offering 12% annual (2% 90days) interest rate. The exchange rate between USD and SD is SD0.80/USD1. how Bakersfield will have after 90 days?

Money market HedgeSD which can be borrowed SD400000=400000/1+0.02=SD392157Bakersfield will borrow SD392157 today will covert it into USD.If exchange rate SD0.80/USD1, company will have USD =USD490196.25. it means if Bakersfield have SD 400000 receivable, it can create money market hedge and can use USD 490196.25.Now USD 490196.25 can be invested for 90 days at 2% 90days interest rate, and Bakersfield will have 490196.25x1.02=USD500000.18.

Options HedgeOptions Hedge-If the parent co. has the receivable than co. can purchase put option over the underlying currency. On the other hand if the co. has payable than co. can purchase call option over the underlying currency.

Some Alternative techniques of management of Transaction ExposureRisk ShiftingRisk shifting is not reduce the currency risk, but it shift currency risk exposure from one co. to another by invoicing the payments in convenience currency or home currency. For example if Pepsi (USA) accept all its receivables from Pepsi (India), it means Pepsi (USA) has shifted dollar exposure to Pepsi (India).

Some Alternative techniques of management of Transaction ExposureExposure netting-It techniques involves offsetting exposure in one currency with exposure in the another currency such that loss from host currency can be off setted by gain from another currency.Cross hedging-When derivative contracts are not availabe over some particular currency, but a company has exposure in that currency, then co. hedge its exposure through by purchasing derivative contracts over some another currency, this process is called cross hedging.

Some Alternative techniques of management of Transaction ExposureCurrency risk sharing-Currency risk sharing can be implemented by developing a customized hedge contract embedded in the underlying trade transactions. The hedge contract takes the form of a price adjustment., whereby a base price is adjusted to reflect certain exchange rate changes. For example, the base price is $10m, but trading parties would share the currency risk beyond a neutral zone. The neutral zone represents the currency range in which risk is not shared.

Economic ExposureEconomic exposure is based on the extent to which the value of the firm as measured by the present value of its expected future cash flows, will change with the fluctuations in the exchange rate. Economic exposure can be separated into two components-transaction exposure and operating exposure.

Management of Economic ExposureTechniques of management of economic exposure:Option market hedgeFuture market hedgeForward market hedgeSelection of convenient currencySelection of some hard market where value of the currency of that country does not change much.

Economic exposure..exampleThe revenue and cost information of XYZ ltd is given as follow. Q. How the cost and revenue and earning of XYZ will change under three different exchange rates scenarios?

C$=%0.75C$=$0.80C$=$0.85USA (in $)Canada(in C$)USA (in $)Canada(in C$)USA (in $)Canada(in C$)Sale300430443074Cost of good sold502005020050200Operating expensesUS: Fixed op300300300Variable 10% of total sale0 10% of total sale 10% of total saleInterest expenses 310310310

Economic exposure..exampleNote: Variable expenses-0.10*303=30.30.10*307.2=30.720.10*310=31Canada business is translated into the US dollar the consolidated balance sheet of the XYZ ltd ltd will be under the three exchange rate scenarios.

C$=$0.75C$=$0.80C$=$0.85SaleUS300304307Canada(inUS$)33.23.4Total303307.2310Cost of Good soldUS505050Canada(inUS$)150160170Total200210220Gross Profit10397.290.4Operating expensesUS: Fixed303030US: variable 10% of total sale30.330.7231.04Total60.360.7261.04EBIT42.736.4829.36Interest expensesUS333Canada(inUS$)7.588.5Total10.51111.5EBT32.225.4817.86

Economic exposure..exampleThe revenue and cost information of ABC ltd is given as follow. Q. How the cost and revenue and earning of ABC will change under

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Documents

determination of exchange

exchange ratepractices

gold exchange standard

world monetary system

oldest system

international markets

international trade

international finance