1. International Financial Management21
International Financial Management

2. Introduction
This chapter explores the factors that determine exchange rates, the ways to forecast future exchange rates, the aspects of foreign exchange risk, and the ways of managing that risk.
It looks at the determinants of foreign currency exchange rates and considers options open to multinational firms who must compete globally in a currency marketplace characterized by rapid change in relative values.

3. Factors Affecting Exchange Rates
Supply and Demand
Economic Conditions
Inflation
Interest rates
Government trade policies
Political stability
Expropriation

4. Why Do Exchange Rates Fluctuate Over Time ?
Theories of currency fluctuation
IRP
PPP ET
IFE
Absolute
Relative

5. Foreign Exchange Terminology
Check out the Global Forex Web site for foreign exchange terminology:

6. Interest Rate Parity
Forward rate will differ from spot rate to offset interest rate differences.
If not covered, interest arbitrage will move rates back to parity.

7. Purchasing Power Parity
PPP
Relative
Absolute
Absolute Purchasing Power Parity
Relative Purchasing Power Parity

8. Absolute PPP: The Law of One Price
Prices for a good will be the same after currency conversion.
It holds loosely for commodities.
Trade restrictions and taxes keep prices different between countries.
Consider the “Big Mac” index.

9. Relative Purchasing Power Parity
Different rates of inflation will be offset by equal but opposite changes in expected future spot exchange rates.
Less restrictive than absolute PPP
If inflation is higher in Germany than in the United States, then the DM weakens relative to the U.S. dollar.

10. PPP Analysis
Check out the PPP analysis of living standards in developing countries on this Web site:
www1.oecd.org/std/ppp1.pdf

11. Expectations Theory
The forward rate reflects the market expectation of the future spot rate.
Provides an unbiased estimate of the future spot rate
Implication for managers
Exchange rate forecasts are provided free from the marketplace.
Hedging is cost effective.

12. International Fisher Effect
Nominal (quoted) interest rates consist of a real interest rate plus the expected inflation rate.
IFF holds that in equilibrium real interest rates will be equal in different countries.
If not, then capital will flow to the currency with the higher real interest rate until it reaches equilibrium.

13. Example If: U.S. rate = 6% Japan rate = ½% Time horizon = 1 year
Difference = 5½%
IFE says the inflation rates differ by 5½%.
The one-year future spot rate is 5½%
—the dollar weakens to a strengthen yen.
IRP says the dollar will sell at a 5½% discount.
RPPP says U.S. higher inflation rates will cause a
lower U.S. dollar.

14. Exchange Rates
Exchange rates fluctuate over time in response to changing supply and demand.
In the case of the Peso
Demand for Pesos decreased
Supply of Pesos increased
Value of Pesos decreased in relation to other currencies
Exchange rate conversion tool:

15. Foreign Exchange Risk Transaction Economic Translation
The potential for a change in value of a foreign-currency denominated transaction due to foreign exchange risk
Economic
Changes to a firm’s cash flow due to changes in real exchange rates
Translation
Changes in the value of assets and liabilities due to foreign exchange changes

16. Managing Transaction Exposure
Do nothing
Works for multinationals with many different FX exposures
Invoice in U.S. dollars
Shift the risk to other party
Hedge
Forward
Money market

17. Managing Economic Exposure
Shift production
Increase productivity
Outsource
Reduce price sensitivity
Change to markets with strong currencies

18. Translation Risk FASB - Financial Accounting Standards Board Assets &
Liabilities
converted to exchange rate at date
of balance sheet
converted on date of transaction
or a weighted average of
exchange rates
Income
Statement
Equity Accounts converted at historical rates.
Gains and losses are not recognized on the income
statement until a subsidiary is sold or liquidated.