International Financial Management

Nitte Meenakshi Institute of Technology

(An Autonomous Institute under VTU, Belagavi)
Yelahanka, Bengaluru – 560 064.
Department of Management Studies
4th Semester MBA(2018-20)
Study Material
Subject: INTERNATIONAL FINANCIAL MANAGEMENT Sub Code:18MBAFM401

UNIT II
Foreign Exchange Market: Function and Structure of the Forex markets, Foreign
exchange market participants, Determination of Exchange rates in Spot markets.
Exchange rates determinations in Forward markets. Exchange rate behaviour-Cross
Rates- Arbitrage profit in foreign exchange markets, Swift Mechanism. Triangular
and locational arbitrage.
Note: Study Material is only for academic and internal reference only.

FOREIGN EXCHANGE

Foreign Exchange refers to foreign currencies possessed by a country for

making payments to other countries. It may be defined as exchange of money or credit in one
country for money or credit in another. It covers methods of payment, rules and regulations of
payment and the institutions facilitating such payments.
A. FOREIGN EXCHANGE MARKET

A foreign exchange market refers to buying foreign currencies with domestic

currencies and selling foreign currencies for domestic currencies. Thus it is a market in which
the claims to foreign moneys are bought and sold for domestic currency. Exporters sell foreign
currencies for domestic currencies and importers buy foreign currencies with domestic
currencies.

According to Ellsworth, "A Foreign Exchange Market comprises of all those

institutions and individuals who buy and sell foreign exchange which may be defined as foreign
money or any liquid claim on foreign money". Foreign Exchange transactions result in inflow &
outflow of foreign exchange.

The FX market is almost a 24 hour market.

The major foreign exchange trading centers are in

London, New York, and Tokyo ---60%

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
Zurich, Singapore, and Hong Kong --- 20%
B. FUNCTIONS OF FOREIGN EXCHANGE MARKET
Foreignb exchange is also referred to as forex market. Participants are importers, exporters,
tourists and investors, traders and speculators, commercial banks, brokers and central banks.
Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are the important
foreign exchange instruments used in foreign exchange market to carry out its functions. The
Foreign Exchange Market performs the following functions.

1. Transfer Of Purchasing Power I Clearing Function: The basic function of the foreign
exchange market is to facilitate the conversion of one currency into another i.e. payment
between exporters and importers. For eg. Indian rupee is converted into U.S. dollar and vice-
versa. In performing the transfer function variety of credit instruments are used such as
telegraphic transfers, bank drafts and foreign bills. Telegraphic transfer is the quickest method of
transferring the purchasing power.

2. Credit Function
The foreign exchange market also provides credit to both national and
international, to promote foreign trade. It is necessary as sometimes, the international payments
get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are used in
international payments, a credit for about 3 months, till their maturity, is required.

For eg. Mr. A can get his bill discounted with a foreign exchange bank in New
York and this bank will transfer the bill to its correspondent in India for collection of money
from Mr. B after the stipulated time.

3. Hedging Function
A third function of foreign exchange market is to hedge foreign exchange risks. By
hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange
rates. Under this function the foreign exchange market tries to protect the interest of the persons
dealing in the market from any unforseen changes in exchange rate. The exchange rates under
free market can go up and down, this can either bring gains or losses to concerned parties.
Hedging guards the interest of both exporters as well as importers, against any changes in
exchange rate.
Hedging can be done either by means of a spot exchange market or a forward exchange
market involving a forward contract.

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Structure of Forex Market

PARTICIPANTS IN FOREIGN EXCHANGE MARKET

Foreign exchange market needs dealers to facilitate foreign exchange

transactions. Bulk of foreign exchange transaction are dealt by Commercial banks & financial
institutions. RBI has also allowed private authorised dealers to deal with foreign exchange
transactions i.e buying & selling foreign currency. The main participants in foreign exchange
markets are
1. Retail Clients
Retail Clients deal through commercial banks and authorised agents. They
comprise people, international investors, multinational corporations and others who need foreign
exchange.
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2. Commercial Banks
Commercial banks carry out buy and sell orders from their retail clients and of
their own account. They deal with other commercial banks and also through foreign exchange
brokers.
3. Foreign Exchange Brokers
Each foreign exchange market centre has some authorised brokers. Brokers act as
intermediaries between buyers and sellers, mainly banks. Commercial banks prefer brokers.
4. Central Banks
Under floating exchange rate central bank does not interfere in exchange market.
Since 1973, most of the central banks intervened to buy and sell their currencies to influence the
rate at which currencies are traded.
From the above sources demand and supply generate which in turn helps to
determine the foreign exchange rate.
B. TYPES OF FOREIGN EXCHANGE MARKET
Foreign Exchange Market is of two types retail and wholesale market.
1. Retail Market
The retail market is a secondary price maker. Here travellers, tourists and people
who are in need of foreign exchange for permitted small transactions, exchange one currency for
another.
2. Wholesale Market
The wholesale market is also called interbank market. The size of transactions in this
market is very large. Dealers are highly professionals and are primary price makers. The main
participants are Commercial banks, Business corporations and Central banks. Multinational
banks are mainly responsible for determining exchange rate.
3. Other Participants
a) Brokers
Brokers have more information and better knowledge of market. They provide
information to banks about the prices at which there are buyers and sellers of a pair of
currencies. They act as middlemen between the price makers.
b) Price Takers
Price takers are those who buy foreign exchange which they require and sell what
they earn at the price determined by primary price makers.
c) Indian Foreign Exchange Market
It is made up of three tiers
Here dealings take place between RBI and Authorised dealers (ADs) (mainly commercial
banks).
ii. Here dealings take place between ADs
iii. Here ADs deal with their corporate customers.

Types of Transactions in Forex Market

The following types of transactions in the foreign exchange market are available :
 TOD - currency exchange transaction involving the supply of currency on the day
of transaction conclusion
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
 TOM - currency exchange transaction involving the supply of currency on the
next working day

 SPOT - currency exchange transaction involving the supply of currency in 2
working days

 FORWARD - OTC currency exchange transaction involving the future supply of
currency on the fixed date with the transaction rate agreed on the day of
transaction

 FUTURES - standardized exchange contract, involving the future supply of currency
on the fixed date with the transaction rate agreed on the day of transaction

 SWAP - a combination of two opposite currency exchange transactions for the
same amount with different valuation dates

 OPTION - a contract that provides the buyer with the right to buy or sell a
certain amount of currency at a certain date and price fixed by the contract


Three major types of transactions

1. Spot
2. Forward
3. Swap
Spot transaction

An agreement on price today, with settlement usually two business days later.

Settlement = actual delivery of currency for currency

In the case of the US dollar for the Canadian dollar (or the Mexican peso), settlement
is on the next day of the transaction.
Forward transaction
An agreement on price today for settlement at some date (called the “value date”) in the future
(one or two weeks, or 1 ~ 12 months).
ExampleExxon has a scheduled payment of £25 million in 8 months and buys that amount of
British pounds forward today. No money will change hands now.
Swap: A sale (purchase) of a foreign currency with a simultaneous agreement to repurchase
(resell) it at some date in the future. Usually in the inter-bank market
ExampleCitibank buys DM 2.5 million from Deutsch Bank for $1 million, with a simultaneous
agreement to sell the DM back in 6 months for $1.05 million. $50,000 = swap rate.

FX transaction

65% of transactions: spot

33% of transactions : swap
 2%: (outright) forward

Types of Settlement Dates

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The date by which an executed security trade must be settled. That is, the date by which a
buyer must pay for the securities delivered by the seller.
The standard settlement timeframe for foreign exchange spot transactions is T + 2 days; i.e.,
two business days from the trade date. A notable exception is the USD/CAD currency pair,
which settles at T + 1.
Execution methods
Common methods of executing a spot foreign exchange transaction include the following:
Direct – Executed between two parties directly and not intermediated by a third
party. For example, a transaction executed via direct telephone communication or
direct electronic dealing systems such as Reuters Conversational Dealing
Electronic broking systems – Executed via automated order matching system for
foreign exchange dealers. Examples of such systems are EBS and Reuters Matching
2000/2

Electronic trading systems – Executed via a single-bank proprietary platform or a

multibank dealing system. These systems are generally geared towards
customers. Examples of multibank systems include Integral, FXall, Currenex, FX
Connect, Globalink, and eSpeed

Voice broker – Executed via telephone with a foreign exchange voice broker

Exchange rate quotations

1. For interbank Quotation
a. American terms
example: $.5838/dm
b. European terms
example: dm1.713/$

2. Direct and Indirect Quotation

Direct quote gives the home currency price of one unit of foreign currency. A foreign
exchange rate quoted as the domestic currency per unit of the foreign currency. In other
words, it involves quoting in fixed units of foreign currency against variable amounts of
the domestic currency.
EXAMPLE: DM 0.25/FF

An indirect quote is a foreign currency price of a unit of home currency.
In the US, a direct quote for the CAD is USD 0.6341 / CAD

This quote would be an indirect quote in Canada.

Direct quotation: This is also known as price quotation. The exchange rate of the domestic
currency is expressed as equivalent to a certain number of units of a foreign currency. It is
usually expressed as the amount of domestic currency that can be exchanged for 1 unit or 100
units of a foreign currency. The more valuable the domestic currency, the smaller the amount
of domestic currency needed to exchange for a foreign currency unit and this gives a lower

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exchange rate. When the domestic currency becomes less valuable, a greater amount is needed
to exchange for a foreign currency unit and the exchange rate becomes higher.
Under the direct quotation, the variation of the exchange rates are inversely related to the
changes in the value of the domestic currency. When the value of the domestic currency rises,
the exchange rates fall; and when the value of the domestic currency falls, the exchange rates
rise. Most countries uses direct quotation. Most of the exchange rates in the market such as
USD/JPY, USD/HKD and USD/RMD are also quoted using direct quotation.
Indirect quotation: This is also known as the quantity quotation. The exchange rate of a foreign
currency is expressed as equivalent to a certain number of units of the domestic currency. This
is usually expressed as the amount of foreign currency needed to exchange for 1 unit or 100
units of domestic currency. The more valuable the domestic currency, the greater the amount of
foreign currency it can exchange for and the lower the exchange rate. When the domestic
currency becomes less valuable, it can exchange for a smaller amount of foreign currency and
the exchange rate drops.
Under indirect quotation, the rise and fall of exchange rates are directly related to the changes in
value of the domestic currency. When the value of the domestic currency rises, the exchange
rates also rise; and when the value of the domestic currency falls, the exchange rates fall as well.
Most Commonwealth countries such as the United Kingdom, Australia and New Zealand use
indirect quotation. Exchange rates such as GBP/USD and AUD/USD are quoted indirectly.
Direct Quotation Indirect Quotation
USD/JPY = 134.56/61 EUR/USD = 0.8750/55
USD/HKD = 7.7940/50 GBP/USD = 1.4143/50
USD/CHF = 1.1580/90 AUD/USD = 0.5102/09
There are two implications for the above quotations:
(1) Currency A/Currency B means the units of Currency B needed to exchange for 1 unit
of Currency A.
(2) Value A/Value B refers to the quoted buy price and sell price. Since the difference between
the buy price and sell price is not large, only the last 2 digits of the sell price are shown. The
two digits in front are the same as the buy price.

Defintion of “pip” in foreign exchange rates quotation

Based on the market practice, foreign exchange rates quotation normally consists of 5
significant figures. Starting from right to left, the first digit, is known as the “pip”. This is the
smallest unit of movement in the exchange rate. The second digit is known as “10 pips”, so on
and so forth.
For example: 1 EUR = 1.1011 USD; 1 USD = JPY 120.55
If EUR/USD changes from 1.1010 to 1.1015, we say that the EUR/USD has risen by 5 pips.
If USD/JPY changes from 120.50 to 120.00, we say that USD/JPY has dropped by 50 pips.
3.Bid-Ask Quotation
Spread is used to calculate the fee charged by the bank. It is the difference between bid and Ask
Bid = the price at which the bank is willing to buy
Ask = the price it will sell the currency
Factors That Affect the Spread. The spread on currency quotations is influenced by the
following factors:
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• Order costs. Order costs are the costs of processing orders, including clearing costs and the
costs of recording transactions.

• Inventory costs. Inventory costs are the costs of maintaining an inventory of a particular
currency. Holding an inventory involves an opportunity cost because the funds

could have been used for some other purpose. If interest rates are relatively high, the
opportunity cost of holding an inventory should be relatively high. The higher the inventory
costs, the larger the spread that will be established to cover these costs.
• Competition. The more intense the competition, the smaller the spread quoted by
intermediaries. Competition is more intense for the more widely traded currencies because there
is more business in those currencies.

• Volume. More liquid currencies are less likely to experience a sudden change in price.
Currencies that have a large trading volume aremore liquid because there are numerous buyers and
sellers at any given time. This means that the market has sufficient depth that a few large
transactions are unlikely to cause the currency’s price to change abruptly.

• Currency risk. Some currencies exhibit more volatility than others because of
economic or political conditions that cause the demand for and supply of the currency

to change abruptly. For example, currencies in countries that have frequent political crises are
subject to abrupt price movements. Intermediaries that are willing to buy or sell these currencies
could incur large losses due to an abrupt change in the values of these currencies.
Factors Influencing Forward Exchange Rate

i) Interest rates.
ii) Degree of speculation in foreign exchange market.
iii) Inflation rate.
iv) Foreign investor’s confidence in domestic country.
v) Economic situation in the country.
vi) Political situation in the country.
vii) Balance of payments position etc.

Determination of Exchange rates in Spot markets

Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a
comparison of the currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these factors are in no
particular order; like many aspects of economics, the relative importance of these factors is
subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of the
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twentieth century, the countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those countries with higher
inflation typically see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates.
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing interest
rates impact inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract foreign capital
and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates tend to decrease exchange rates.
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and dividends. A deficit in the
current account shows the country is spending more on foreign trade than it is earning, and that it
is borrowing capital from foreign sources to make up the deficit. In other words, the country
requires more foreign currency than it receives through sales of exports, and it supplies more of
its own currency than foreigners demand for its products. The excess demand for foreign
currency lowers the country's exchange rate until domestic goods and services are cheap enough
for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large
public deficits and debts are less attractive to foreign investors. The reason? A large debt
encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off
with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but
increasing the money supply inevitably causes inflation. Moreover, if a government is not able to
service its deficit through domestic means (selling domestic bonds, increasing the money
supply), then it must increase the supply of securities for sale to foreigners, thereby lowering
their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country
risks defaulting on its obligations. Foreigners will be less willing to own securities denominated
in that currency if the risk of default is great. For this reason, the country's debt rating (as
determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its
exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments. If the price of a country's exports rises by a greater rate than that of
its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater
demand for the country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the currency's value). If
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the price of exports rises by a smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk. Political turmoil,
for example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.
Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases the
purchasing power of income and capital gains derived from any returns. Moreover, the exchange
rate influences other income factors such as interest rates, inflation and even capital gains from
domestic securities. While exchange rates are determined by numerous complex factors that
often leave even the most experienced economists flummoxed, investors should still have some
understanding of how currency values and exchange rates play an important role in the rate of
return on their investments.

Cross Exchange Rates.

Most tables of exchange rate quotations express currencies relative to the dollar, but in some
instances, a firm will be concerned about the exchange rate between two nondollar currencies.
For example, if a Canadian firm needs Mexican pesos to buy Mexican goods, it wants to know
the Mexican peso value relative to the Canadian dollar. The type of rate desired here is known as
a cross exchange rate, because it reflects the amount of one foreign currency per unit of another
foreign currency.

Cross exchange rates can be easily determined with the use of foreign exchange quotations. The
value of any nondollar currency in terms of another is its value in dollars divided by the other
currency’s value in dollars.

Arbitrage profit in foreign exchange markets,

Arbitrage is the act of simultaneously buying a currency in one market and selling it in another
to make a profit by taking advantage of exchange rate differences in two markets. If the
arbitrages are confined to two markets only it is said “two-point” arbitrage. If they extend to
three or more markets they are known as “three-point” or “multi-point” arbitrage. Those who
deal with arbitrage are called arbitrageurs.
A Spot sale of a currency when combined with a forward repurchase in a single transaction is
called “Currency Swap". The Swap rate is the difference between spot and forward exchange
rates in currency swap.
Arbitrage opportunities may exist in a foreign exchange market.. Suppose the rate of exchange is
1 US $ = `. 50 in US market and 1 US $ = `. 55 in Indian Markets, then an arbitrageur can buy
dollars in US market and sell it in Indian market and get a profit of `. 5 per dollar..
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In today’s modern well connected and advanced markets, arbitrageurs (which are mainly banks)
can spot it quickly and exploit the opportunity. Such opportunities vanish over a period of time
and equilibrium is again maintained.
For Eg.
Bank A / $ = 50.50 / 50.55
Bank B / $ = 50.40 / 50.45
The above rates are very close. The arbitrageur may take advantage and he can purchase $
1,00,000 from Bank B at `. 50.45 / a dollar and sell to it to Bank A at `. 50.50, thus making a
profit of 0.05. The total profit would be (1,00,000 x 0.05) = `. 5,000. The profit is earned without
any risk and blocking of capital.
B. ARBITRAGE.AND INTEREST RATE
Interest arbitrage refers to differences in interest rates in domestic market and in overseas
markets. If interest rates are higher in overseas market than in domestic market, an investor may
invest in overseas market to take the advantage of interest differential. Interest arbitrage may be
covered and uncovered.
1) Uncovered Arbitrage
In this system, arbitrageurs would take a risk to earn profit by investing in a high interest bearing
risk free securities in a foreign market. His earnings would be according to his calculations if the
currency of foreign market where he invested does not depreciate. If depreciation is
equal to the difference in interest rate, the investor would not incur loss. However, if
depreciation is more than interest rate, then the arbitrageur will incur loss
For Eg. In New York interest rate on 6 month Treasury Bill is 6% and in Spain it
is 8%. An US investor may convert US dollars in EURO and invest in Spain, thereby taking an
advantage of +2% interest rate. Now when bill matures, US investor will convert EURO into
dollars. However, by that time EURO may have depreciated the US investor will get less dollars
per EURO. If EURO depreciates by 1%, US investor will gain only +1% (+2 – 1%). If EURO
depreciates by 2% or more, US investor will not gain anything or incur loss. If EURO
appreciates, US investor will gain, +2% and interest rate differential

2) Covered Arbitrage
International investors would like to avoid the foreign exchange risk, thus interest arbitrage
is usually covered. The investor converts the domestic currency for foreign currency at the
current spot rate for the purpose of investment. At the same time, investor sells forward the
amount of foreign currency which he is investing plus the interest that he will earn so as to
coincide with maturity of foreign investment.
The covered interest arbitrage refers to spot purchase of foreign currency to make
investment and offsetting simultaneous forward sale of foreign currency to cover foreign
exchange risk. When treasury bills mature, the investor will get the domestic currency equivalent
of foreign investment plus interest without a foreign exchange risk.

SWIFT MECHANISM
A member-owned cooperative that provides safe and secure financial transactions for its
members. Established in 1973, the Society for Worldwide Interbank Financial
Telecommunication (SWIFT) uses a standardized proprietary communications platform to
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facilitate the transmission of information about financial transactions. This information,

including payment instructions, is securely exchanged between financial institutions.
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) provides a
network that enables financial institutions worldwide to send and receive information about
financial transactions in a secure, standardized and reliable environment. Swift also sells
software and services to financial institutions, much of it for use on the SWIFTNet Network, and
ISO 9362. Business Identifier Codes (BICs) are popularly known as "SWIFT codes".
The chairman of SWIFT is Yawar Shah, who is from Pakistan.[1] The CEO is Gottfried
Leibbrandt, who is from the Netherlands.
The majority of international interbank messages use the SWIFT network. As of September
2010, SWIFT linked more than 9,000 financial institutions in 209 countries and territories, who
were exchanging an average of over 15 million messages per day (compared to an average of 2.4
million daily messages in 1995). SWIFT transports financial messages in a highly secure
way[how?] but does not hold accounts for its members and does not perform any form of clearing
or settlement.
SWIFT does not facilitate funds transfer; rather, it sends payment orders, which must be settled
by correspondent accounts that the institutions have with each other. Each financial institution,
to exchange banking transactions, must have a banking relationship by either being a bank or
affiliating itself with one (or more) so as to enjoy those particular business features.
SWIFT hosts an annual conference every year called SIBOS which is specifically aimed at the
financial services industry.
SWIFT is a cooperative society under Belgian law and it is owned by its member financial
institutions. It has offices around the world. SWIFT headquarters, designed by Ricardo Bofill
Taller de Arquitectura are in La Hulpe, Belgium, near Brussels.
SWIFT means several things in the financial world:
1. a secure network for transmitting messages between financial institutions;
2. a set of syntax standards for financial messages (for transmission over SWIFTNet or
any other network)
3. a set of connection software and services, allowing financial institutions to
transmit messages over SWIFT network.

Triangular arbitrage
Triangular arbitrage (also referred to as cross currency arbitrage or three-point arbitrage)
is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three
different currencies in the foreign exchange market.[1][2][3] A triangular arbitrage strategy
involves three trades, exchanging the initial currency for a second, the second currency for a
third, and the third currency for the initial. During the second trade, the arbitrageur locks in a
zero-risk profit from the discrepancy that exists when the market cross exchange rate is not
aligned with the implicit cross exchange rate.

Locational Arbitrage:

A strategy in which a trader seeks to profit from differences in the exchange rate offered by
different banks on the same currency. These differences are small and short-lived.
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Locational arbitrage can occur when the spot rate of a given currency varies among locations.
Specifically, the ask rate at one location must be lower than the bid rate at another location. The
disparity in rates can occur since information is not always immediately available to all banks. If
a disparity does exist, locational arbitrage is possible; as it occurs, the spot rates among locations
should become realigned.

UNIT III
International Parity Relationships & Forecasting Foreign Exchange rate: - Measuring
exchange rate movements-Exchange rate equilibrium – Factors effecting foreign exchange rate-
Forecasting foreign exchange rates .Interest Rate Parity, Purchasing Power Parity &
International Fisher effect. Covered Interest Arbitrage
Foreign Exchange exposure: - Management of Transaction exposure- Management of
Translation exposure- Management of Economic exposure- Management of political Exposure-
Management of Interest rate exposure.

PARITY CONDITIONS IN INTERNATIONAL FINANCE AND CURRENCY FORECASTING

Meaning of arbitrage: - It is simultaneous purchase and sale of the same assets or commodities on
different markets to profit from price discrepancies.
Law of one price: - In competitive markets characterized by numerous buyers and sellers, having low cost
access to information exchange adjusted prices of identical tradable goods and financial assets must be
within transition costs of equality worldwide.
International arbitrageurs who follow the principle of “Buy low and sell high” enforce the above rule of
law of one price.
Forward Premium and Discount: - A foreign currency is said to be at premium if forward rate expressed
is terms of home currency is greater than spot rate or else it is said to be at discount.
Annualized % of forward = FR – SR × 360 .
Premium or Discount SR Forward contract period in days
The following five economic relationships arise due to the prevalence of “law or one price” and
international arbitraging opportunities.
1. PURCHASE POWER PARITY (PPP)
2. FISHER EFFECT (FE)
3. INTERNATIONAL FISHER EFFECT (IFE)
4. INTEREST RATE PARITY(IRP)
5. FORWARD RATES AS UNBIASED PREDICTORS OF FUTURE SPOT RATES (UFSR)

If inflation in US is expected to exceed inflation in India by 2 % for the coming year then the US
dollar should decline in value by 2 % relative to Rupee by the same rate, the one year USD forward
should sell at a 2 % discount relative to the Indian Rupees. Similarly, 1-year interest rates in US should
be about 2 % higher than one-year interest rates on securities of comparable risk in India.

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PURCHASING POWER PARITY [PPP]

If international arbitrage enforces the law of one price, then the exchange rate between the home currency
and domestic goods must be equal to the exchange rate between home currency and foreign goods.
In other words, one unit of home currency should have the same purchasing power worldwide. Ex: - If a
pen costs Rs 50 in India and the same model pen costs $1 in US, then exchange rate shall be $1 = Rs 50.
For same purchasing power to remain constant world wide, the foreign exchange rate must change
approximately the same as difference between the domestic and foreign rates of inflation.
Swedish economist ‘Gustav Cassel’ first stated purchasing power parity in a rigorous manner in 1918. He
used it as the basis for recommending a new set of official exchange rates at the end of World War Ι.
Purchasing power parity in its absolute version states that price levels should be same world wide when
expressed in common currency. A unit of home currency should have the same purchasing power
worldwide. This theory is application of law of one price to national price levels or else arbitrage
opportunities would exist. However, absolute PPP ignores the effects of transportation costs, tariffs
quotas and other restrictions and product differentiations in free trade.
The relative version of PPP states that the exchange rate between the home currency and foreign currency
will adjust to reflect changes in the price levels of two countries. Ex: - If inflation in India is 5 % and in
US is 2% then the rupee value of the USD must rise by about 3 % to equalize the Rupee price of goods in
both the countries.
If ih and if are inflations of home country and foreign country respectively, e0 is home currency value of 1
unit of foreign currency at the beginning of the period and et is the spot exchange rate in period t, then
et = (1 + ih)t
e0 (1 + if)t
et = e0 (1 + ih)t
(1 + if)t
The value of et represents PPP rate.
Note: - the above formula works for direct quote. In case of indirect quote the formula shall be

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et = e0 (1 + if)t
(1 + ih)t
Ex: - The US (hc) and Switzerland (fc) are running annual inflation rates of 5 % and 3 % respectively
and the spot rate is SFr 1 = $0.75 then calculate the PPP rate after 1,2 and 3 years
et = e0 (1 + ih)t
(1 + if)t
e1 = 0.75 (1 + 0.05)1 = $0.7646
(1 + 0.03)1
e2 = 0.75 (1 + 0.05)2 = $0.7794
(1 + 0.03)2
e3 = 0.75 (1 + 0.05)3 = $0.7945
(1 + 0.03)3
Thus according to PPP the exchange rate change during a period should be equal to the inflation
differential for the same time-period. In effect, PPP says that currencies with high rates of inflation
should devalue relative to currencies with lower rate of inflation.
Inflation change of 2 % more in US should result in devaluation of USD by 2 %.
Therefore e1 = $ 0.75 × 102 % = $ 0.765
Point ‘A’ on the parity line is an equilibrium point wherein 3 % change in inflation is offset by 3 %
appreciation in foreign currency, whereas Point ‘B’ is at disequilibrium since 3 % change in inflation is
offset just by 1 % appreciation in foreign currency.

Real Exchange rate: -

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The real exchange rate is the nominal exchange rate adjusted for changes in the relative
purchasing power of each currency since some base period
ét = et × Pf
Ph
By indexing these price levels to 100 as of the base period their ratio reflects the change in the relative
purchasing power of these currencies since time 0. Increase in foreign price level and foreign currency
depreciation have offsetting effects on the real exchange rate and similarly home price level increases and
foreign currency appreciation offset each other.
An alternative way to represent the real exchange rate is to directly reflects the change in relative
purchasing powers of these currencies by adjusting the nominal exchange rate for inflation in both
countries since time 0 (base period).
ét = et × (1 + ih)t
(1 + if)t
Note: - et shall be in direct quote.
Empirical Evidence: -
The strictest version of PPP, that all goods and financial assets obey the law of one price is
demonstrably false. The risk and costs of shipping goods internationally as well as government erected
barriers to trade and capital flows, are at times high enough to cause exchange adjusted prices to
systematically differ between countries.
The general conclusion from empirical study of PPP is that theory holds up well in long run, but
not as well over shorter time-periods. Thus in long run the real exchange rate tends to revert to its
predicted value of e0. That is if ét > e0, then the real exchange rate should fall over time towards e0. Where
as if ét < e0 the real exchange rate should rise over time towards e0.
THE FISHER EFFECT: (∆ NIR = ∆ EXPECTED INFLATION)
The real interest rate shall be adjustable to reflect expected inflation to obtain the nominal interest rate.
According to Fisher effect the interest rate(r) is made of two components
a) Real interest rate (a)
b) Expected inflation rate (i)
Therefore
(1 + Nominal interest rate) = (1 + real interest rate) (1 + expected inflation rate)
(1 + r) = (1 + a) (1 + i)
(1 + r) = 1 + a + i + ai
r = a + i + ai
However often approximated ‘r’ is calculated as equal to ‘a + i’.
Ex: If required real interest rate is 3 % and expected inflation rate is 10 %. Calculate the nominal interest
rate
(1 + r) = (1 + a) (1 + i)
(1 + r) = (1 + 0.03) (1 + 0.10)

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(1 + r) = 1.133
r = 0.133 or 13.3 %
Alternatively
r = a + i + ai
r = 0.03 + 0.10 + (0.03) (0.10) = 0.133 or 13.3 %
According to FE the lender should not only be compensated for interest (3 %) but also for depreciation in
principal value by (10.3 %) for passage of time
“According to generalized version of FE the real returns are equalized across the countries
through arbitrage” i.e. ah = af. If expected real returns were higher in one currency than the other, capital
would flow from the second to the first currency.
In an equilibrium with no government interference, the nominal interest rate differential will
approximately equal the anticipated inflation differential between the two currencies.
rh – rf = i h – if
∆ NIR = ∆ Inflation
Where rh and rf represents nominal interest rate at home country and foreign country respectively,
ih and if represents inflation at home country and foreign country respectively.
In other words, according to FE,
(1 + rh)t = (1 + ih)t
(1 + rf)t (1 + if)t

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THE INTERNATIONAL FISHER EFFECT [IFE]

It is the combination of Purchasing power parity (PPP) and generalized Fisher Effect (FE) which
gives way to International Fisher Effect (IEF)
According to PPP
∆ ER = ∆ IR
et = (1 + ih)t …………………………(1)
e0 (1 + if)t
According to FE
(1 + NIR) = (1 + RIR) (1 + IR)
(1 + r) = (1 + a) (1 + i)
Therefore ∆ NIR = ∆ Expected Inflation rate
(1 + rh)t = (1 + ih)t ……………………(2)
(1 + rf)t (1 + if)t
Equation 1 and 2 gives
et = (1 + rh)t
e0 (1 + rf)t
i.e. ∆ ER = ∆ NIR
Therefore et = e0 (1 + rh)t
(1 + rf)t
According to IFE, the interest rate differential between any two countries is an unbiased predictor of the
future change in spot exchange rate. Hence currency with higher interest rates will depreciate and those
with low interest rates will appreciate.
Point ‘A’ on parity line is at equilibrium whereas point ‘B’ outside the parity line is not at equilibrium.

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INTEREST RATE PARITY THEORY [IRP]

According to IRP theory, the interest differential should be equal to the forward differential i.e.
the currency of the country with a lower interest rate should be at a forward premium in terms of the
currency of the country with higher interest rate. If the above condition is satisfied, the forward rate is
said to be at interest rate parity and equilibrium prevails in money market.
Covered Interest Differential:
Interest parity ensures that the return on a hedged or covered foreign investment will just equal
the domestic interest rate on investment of identical risk or else it gives rise to covered interest arbitrage.
The process of covered interest arbitrage continues until interest parity holds, unless there is government
interference.

THE RELATIONSHIP BETWEEN THE FORWARD RATE AND FUTURE SPOT RATE
An unbiased nature of forward rate is that the forward rate should reflect the expected future spot rate on
the date of settlement of the forward contract.
Ft = ēt
Where Ft = forward rate at time‘t’.
ēt = expected future spot rate
Equilibrium is achieved only when the forward differential equals the expected change in
the exchange rate.

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PARITY CONDITIONS
I. PURCHASING POWER PARITY [PPP]
∆ ER = ∆ IR
et = (1 + ih)t
e0 (1 + if)t
et = e0 (1 + ih)t
(1 + if)t
II. FISHER EFFECT [FE]
∆ NIR = ∆ Expected Inflation rate
(1 + NIR) = (1 + RIR) (1 + IR)
(1 + r) = (1 + a) (1 + i)
(1 + r) = 1 + a + i + ai
r = a + i + ai
III. INTERNATIONAL FISHER EFFECT [IFE]
∆ ER = ∆ NIR
et = (1 + rh)t
e0 (1 + rf)t
et = e0 (1 + rh)t
(1 + rf)t

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IV. INTEREST RATE PARITY [IRP]

Forward rate differential = Interest differential
Ft = (1 + rh)t
e0 (1 + rf)t
V. UNBIASED FORWARD RATES [UFR]
Ft = ēt
Ft – e0 = ēt –e0
e0 e0

Exercise Problems:
1 Spot quotation of Singapore $ is Rs 25. Interest rate in Singapore is 6 % and interest
rate in India is 10 %. What shall be the forward rate a year latter, also calculate 270-
day forward rate
2
Calculate the nominal interest rates using Fisher effect from the following data given
below
Real interest rate = 8 %
Inflation rate = 3.5 %
3 Given the following date calculate any arbitrage possibility is available
Spot rate: Rs 42.0010 = $ 1
6 months forward rate: Rs 42.8020 = $1
Annualized interest rate on 6 months dollar = 8 %
Annualized interest rate on 6 months Rupees = 12 %
4 Given the following date calculate any arbitrage possibility is available
Spot rate: $ 1 = Rs 44.0030
6 months forward rate: $1 = Rs 45.0010
Annualized interest rate on 6 months Rupees = 12 %
Annualized interest rate on 6 months Dollars = 8 %
5 Given the following date calculate any arbitrage possibility is available
Spot rate: ₣ 6 = $ 1 (₣ = French Franc)
6 months forward rate: ₣ 6.0020 = $1
Annualized interest rate on 6 months USD = 5 %
Annualized interest rate on 6 months FFR = 8 %
6 Assume the buying rate for DM (Dutch Mark) spot in New York is $ 0.40
a) What would you expect the price of USD to be in Germany?
b) If the dollar to be quoted in Germany at DM 2.6 how is the market supposed
to react?
7 You have called your foreign exchange trader and asked for quotation on the spot, 1-
month, 3-month and 6-month forward rate. The trader has responded with the
following
$ 0.2479/81, 3/5, 8/7, 13/10

a) What does this mean in terms of dollars per Euros?

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b) If you wished to buy spot Euros, how much would you pay in Dollars?
c) If you wanted to purchase spot USD, how much would you have to pay in
Euro?
d) What is the premium or discount in the 1, 3, 6 month forward rate in annual
percentage?
8 An American firm purchases $ 4000 worth of perfume (₣ 20000) from a French firm,
the American distributor must make the payment in 90 days in French Franc the
following quotations and expectations exists for the French Franc
Spot rate = $ 0.200, 90-day forward rate = $ 0.220, interest rate in US = 15 %,
interest rate in France = 10 %.
Your expectation of spot rate 90 days hence is $ 0.240
a) What is the premium on the forward French Franc? What is the interest
rate differential between France and US? Is there an incentive for covered
interest arbitrage?
b) If there is a covered interest arbitrage how can an arbitrager take
advantage of given situation assume the arbitrager is willing to borrow $
4000 or French Franc (₣) 20000 and there are no transaction costs.
c) If transaction costs are $ 50 would an opportunity still exists for covered
interest arbitrage.
d) Calculate the cost covered interest arbitrage and suggest whether covered
interest arbitrage was required considering above cost of hedging.
9 Is covered interest arbitrage possible in the following situation? If so calculate
arbitrage profit
a) Spot rate Canadian dollar = 1.317/USD, Canada interest rate = 6 %
6-month forward rate = C$ 1.2950/USD, US interest rate = 10 %.
b) Spot rate 100 Yen = Rs 35.002, Indian interest rate = 12 %
6-month forward rate = Rs 35.9010/100 Yen, Japan interest rate = 7 %.
10 Following are rates quoted in Mumbai for British Pound Rs/BP = 52.60/70 and three
month forward rate 20/70, interest rate in India is 8 %, interest rate in London is 5 %.
Verify weather there is any scope for Covered interest arbitrage if you borrow in RS
(India).
11 A foreign exchange trader quotes for Belgium Franc spot, 1-month, 3-month and 6-
month forward rate to US based treasurer
$ 0.02478/80, 4/6, 9/8, 14/11
a) Calculate the outright quote for 1, 3, 6 month forward.
b) If treasurer wished to buy Belgium Franc 3-months forward, how much would
you pay in Dollars?
c) If you wanted to purchase USD 1-month forward, how much would you have
to pay in Belgium Franc?
d) Assuming Belgium Franc was brought what is the premium or discount in the
1, 3, 6 month forward rate in annual percentage?
e) What do the above quotations imply in respect of term structure of interest in
USA and Belgium?
12 Dutch Mark spot was quoted at $0.4/DM in New York, the price of Pound Sterling was
quoted at $1.8/£
a) What would you expect the price of Pound to be in Germany?
b) If the Pound were quoted in Frank Fort at DM 4.40/£ what would you do
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to profit from the above situation

An Indian Company AB limited imports machinery worth of £ 2 million and is to make

the payment after 6 months the current rates are
Spot rate = Rs66.96/£
6-month forward rate =Rs67.50/£
a) What should AB limited do if they expect that in 6 months time the pound
will settle at Rs67.15/£?
b) What are the options available to the company in case of an expected
appreciation or depreciation in Rupee?
13 A trader works for New York bank, the spot exchange rate against Canadian dollar is
USD 0.9968 and 1-month and 1-year forward rates are USD 0.9985 and USD 1.0166
respectively. Twelve-month interest rate in USA and Canada may be taken as 6.45 %
and 4.46 % respectively.
a) What is the forward premium as annual percentage?
b) Which currency is at a premium? Why?
The trader becomes party to some insider information which suggests
the US interest rate will rise by 1 % pa during the next month. The bank
has a rule that in foreign exchange markets “Buy equals Sell” this
means that for any currency the total of long positions must be equal
to the total of short positions but this aggregation disregards maturity.
c) Indicate the mechanism of two operations by which you may trade in
expectation of profit for the bank. Should the insider information turns out
to be well founded
14 Your company has to make USD 2 million payment in 3 months time, the dollars are
available now. You decide to invest them for 3 months and you are given the
following information.
 The US deposit rate is 8 % pa
 The sterling deposit rate is 9 % pa
 The spot expected rate is $ 1.81/£
 The 3-month forward rate is $ 1.78/£
a) Where should your company invest for better returns?
b) Assume that the US interest rates and the spot expected return remain as
above, what forward rate would yield an equilibrium situation?
c) Assuming that the US interest rate, Spot and forward rates remains as in the
original question, where would you invest if the sterling deposit rate is
14 % pa?
d) With the originally stated spot and forward rates and the same dollar deposit
rate, what is the equilibrium sterling deposit rate?
15 In Frank Fort the French Franc is selling for DM 0.4343 spot and the 3-month forward
rate is DM 0.4300. The 3-month Euro DM inter bank rate is 5.75 % and the Euro
French inter bank rate is 9 %.
a) Are exchange rate and money market rate in equilibrium? Why?
b) Is there any way to take advantage of the situation? If so how?
c) What rate trends would appear in the market if a large number of
operators took the action indicated in (B) above?
16 Bruin Herbal products located in India is an old line producer of herbal teas and
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medicines, their products are marketed throughout India and Europe

Bruin Herbal generally invoices in rupees when it sells to foreign customers in order
to guard against exchange rate changes however company has received an order
from large wholesaler in France for ₣ 40 lakhs of its product. The condition is that the
delivery should be in 3 months time and order invoiced in French Franc. The manager
decides to contact firm’s bankers for suggestions about hedging the exchange rate
exposure.
The banker informs company that spot rate is 1 ₣ = Rs 6.60 thus invoice amount
should be Rs 26400000. The 90-day forward rate for Rs and ₣ and USD are 1₣ = Rs
6.50 and 1$ = 42.0283. The banker offers to setup Forward hedge for selling FFr
receivable for Rupee based on cross forward exchange rates implicit in forward rate
against dollar, what would be your decision if you were manager of Brun Herbal?
Show the relevant calculations
Interest rates in India and France are 9 % Pa and 12 % Pa respectively.

Foreign Exchange Risk Management

Exposure: - Exposure refers to the level of commitment and degree to which a company is affected by
exchange rate movements.
Types of Exposure
1. Accounting Exposure/Translation Exposure
2. Economic Exposure
a) Operating Exposure
b) Transaction Exposure

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Accounting Exposure: - It is also called as translation exposure where in the measurement of exposure is
retrospective in nature. It is based on the past activities and it measures the effect of exchange rate
changes on published financial statements, it effects both income statement and balance sheet statement.

Economic Exposure: - Operating exposure and transaction exposure together constitutes a firm’s
economic exposure. It is the extent to which the value of the firm measured by its present value of
expected cash flow changes with changes in exchange rate movements (i.e. NPV).

Operating Exposure: - It measures the extent to which currency exposure can alter a company’s
future operating cash flows the measurement of operating exposure is prospective in nature and it is
based on future activities of the firm it affects revenues and costs associated with future sales.

Transaction Exposure: - It arises due to changes in the value of outstanding foreign currency
denominated contracts. The measurement of transaction exposure is both retrospective and
prospective in nature because it is based on activities that occurred in the past but will be settled in
the future.

Methods of Accounting Exposure (Translation Exposure)

1. Current and Non Current Method

Under this method all current assets and current liabilities of foreign affiliated are
translated into home currency at the current exchange rate while the non current assets and non
current liabilities are translated at historical rate.
2. Monetary and Non Monetary method
According to this method all monetary assets and monetary liabilities are translated at
current rates where as non monetary assets and non monetary liabilities are translated at historical
rates.
Monetary items are those items which represent a claim to receive or an obligation to pay
a fixed amount of foreign currency units.
Eg: - Cash, accounts receivable (Debtors + Bills Receivable), accounts payable (Creditors + Bills
Payable), other current liabilities, long term debts etc.
Non Monetary items are those items that do not represent a claim to receive or an
obligation to pay a fixed amount of foreign currency units.
Eg: - Stock, fixed assets, equity shares, preference shares etc.
3. Temporal Method
It is a modified version of monetary and non monetary method the only difference
between monetary and non monetary method is valuation of stock.
Under monetary and non monetary method, stock is considered as non monetary assets
and it is valued at historical rate where as under temporal method stock is valued at historical rate
if it is shown at cost price or valued at current rate if it is shown at market price.
4. Current Rate Method

Under this method all balance sheet items are translated at current exchange rate except
for shareholders equity (Share Capital + Reserve & Surplus) which is translated at historical rate.

Exchange Rate under Accounting Exposure Method

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Items Current/ Non-current Monetary/Non- Temporal Current Rate

Method monetary Method Method Method

Cash CR CR CR CR

Receivables CR CR CR CR

Inventory CR HR HR /CR CR

Fixed Assets HR HR HR CR

Payables CR CR CR CR

Long term Debt HR CR CR CR

Net worth HR HR HR HR

CR = Current Rate, HR = Historical Rate

Foreign exchange risk

Foreign exchange risk is your exposure to fluctuating exchange rates. Foreign Exchange
Markets are volatile and are constantly moving. These movements can have implications for
any business that has receipts and/or payments in a foreign currency. On conversion, these
receipts/payments can change in value from one day to the next, depending on the rate at
which they are exchanged.
1.The risk of an investment's value changing due to changes in currency exchange rates. 2.
The risk that an investor will have to close out a long or short position in a foreign currency
at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or
"exchange-rate risk".

This risk usually affects businesses that export and/or import, but it can also affect investors
making international investments. For example, if money must be converted to another
currency to make a certain investment, then any changes in the currency exchange rate will
cause that investment's value to either decrease or increase when the investment is sold and
converted back into the original currency.

Problems on Foreign Exchange Risk Management

1 Assume that a foreign subsidiary of US multinational has the following

Particulars Amount
Cash FC 100
Account Receivable FC 150

Inventory FC 200

Fixed Assets FC 250

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Current Liabilities FC 100

Long term Debt FC 300

Net worth FC 300

Assume historical exchange rate is $2 = FC 1, current exchange rate is $1= FC 1 and
inventory is carried at market price. Calculate the gain or loss under different translation
methods
2 Farm products is Canadian affiliate of US manufacturing company, its balance sheet in
thousands of Canadian dollar for 01/01/2017 is shown below

Liabilities CAN$ Assets CAN$

Cash 100000
Current Liabilities 60000
Account Receivables 220000
Long term Debt 160000
Inventory 320000
Capital Stock (Net worth) 620000
Net Plant & Machinery 200000
Total 840000 Total 840000

The Expected return as on 01/01/2017 was CAN$ 1.6 per USD determine Farm product
accounting exposure on 01/01/2018 using current rate method and monetary and non-
monetary method.

Calculate Farm product contribution to its parents accounting loss if the expected return
on 31/12/2017 was CAN$ 1.8 per USD. Assume all account to remain as they were in
beginning of the year
3 Suppose Boing airlines sell A-747 to Garuda, the Indonesian airlines in Rupaiah (RP) at a
price of RP 140 billion. To help to reduce the impact on Indonesian balance of payment
Boing agrees to buy parts from various Indonesian companies worth RP 55 billion

a) If the spot rate is $ 0.004/RP what is Boing’s net Rupaiah transaction

exposure?
b) If the Rupaiah depreciates $ 0.0035/RP what is Boing’s transaction loss?
Explain the functions of IMF.

Write a short note on Balance of Payment

Briefly explain the International Monetary system.

Discuss the factors to be considered in country-risk analysis
What is the difference between ADR and GDR?
Explain the Participants of Foreign exchange markets in detail.
What is the difference between FDI and FII?
Briefly explain the components of Balance of Payment.

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Write a short note on Purchasing power parity

 Pepsi Company would like to hedge its CAN $ 40 million payable to ‘A’
limited, a Canadian aluminum producer which is due in 90 days suppose it
faces the following exchange and interest rates.

Spot rate $ 0.7307/12 per CAN $

Forward rate (90 days) $ 0.7320/41 per CAN $
CAN $ 90 day interest rate (annualized) 4.71 % - 4.64 %
US $ 90 day interest rate (annualized) 5.50 % - 5.35 %

Which hedging alternative would you recommend? The first rate is the
borrowing rated and second rated is the lending rate.

 Company A and company B have been offered the following rates pa

on a $ 20 million 5 year loan

Company Fixed rate Floating rate

A 12 % LIBOR + 0.1 %
B 13.4 % LIBOR + 0.6 %

Company A requires floating rate loan and company B requires a fixed rate
loan. Design a swap agreement that will net a bank acting as intermediary
0.1 % pa and that will appear equally attractive to both the companies

Probems on SWAPS
Two companies have following borrowing rate applicable to them.
Company Fixed market Floating market
X T LIBOR+0.2
Y T+1.5 LIBOR+0.75
Company X plans to borrow floating rate and Y at fixed rate. Bank acts as inter-mediatory,
and two companies sign a contract. X will pay to bank LOBOR+0.25 and T will pay to it
T+0.75. Bank has 0.3% profit. Design swap and show.

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