Topic 8: Currency Markets synergies will likely be achieved if the firm can obtain what
it needs from a supplier that also operates in the same set
The International Monetary System
• Every nation has a monetary system and a monetary
authority. In the Philippines, the Bangko Sentral is the
monetary authority which is tasked by the law to promoting
economic stability and growth as discussed in Topic 1.
• Countries trade with one another, hence they need a
payments facility that connects these nations
International Monetary System
• The framework within which exchange rates are
determined.
• Multinational companies also took advantages of these
technology-advanced system
multinational companies (MNCs)
• also known as global firms or transnational corporations
• they international assets and operations in foreign
markets and they earn part of their total revenue and profits
from those markets.
Primary reasons why companies go “global”:
A. To broaden markets.
• Based on economic product life-cycle theory, a
company must first produce in its domestic market, to
develop its product and satisfy local customers. However,
as the domestic market matures, the growth of total
demand slows, and competition becomes more intense
and stiffer. This is the time demand for the product
develops can be expand abroad, which creates conditions
favoring production in foreign countries.
B. They seek efficiency in production.
• assuming an adequate supply of labor and an
transportation infrastructure, companies based in high-cost
countries shift production to lower cost regions.
C. Avoid political, trade, and regulatory hurdles.
• To circumvent government restrictions, such as
but not limited to tariffs, quotas, and other restrictions on
imported goods and services, firms often develop
production facilities abroad.
D. Seek raw materials and new technology.
• companies must go where the materials are
found since supplies of many essential raw materials are
geographically dispersed
E. Diversification
• companies can cushion the effect of adverse
economic conditions in a single country by establishing
worldwide production facilities and markets
• companies investing overseas can benefit from
diversification in the same way that individuals benefit from
investing in a broad portfolio of stocks.
F. Retain customers
• Managing the relationship with customers will
be much easier and economies of scale and other
of countries.
G. Protect processes and products.
• property rights involving intangible assets are
often difficult to protect particularly in foreign markets.
• In order to protect the secrecy of their
production processes, distribution systems, or the product
itself, firms often invest abroad rather than license local
foreign firms.
Five factors to consider when companies operate globally:
1. Political risk.
• constraints on the transfer or use of corporate
resources, including various regulations and tax rules
• these must be addressed explicitly in any
financial analysis.
2. Economic and legal ramifications.
• Each country has its own economic and legal
systems. These differences should be taken in to
consideration since it may cause significant problems when
a firm tries to coordinate its global operations
• Such differences can restrict global
corporations’ flexibility in deploying resources
3. Different currency denominations.
• exchange rates must be included in all financial
analysis of multinational companies because cash flows in
various parts within a multinational corporate system will be
denominated in different currencies.
4. Language and cultural differences.
• Multinational companies find these matters i.e.
goals of the firm, performance evaluation, attitudes toward
risk, compensation systems, interactions with employees,
and the ability to curtail unprofitable operations vary
dramatically from one country to another.
5. Role of governments.
• Traditional financial models have to include
political and other non-economic aspects in the decision
• Essentially, a political process in which the
terms under which companies compete, the legal or illegal
actions, and the terms of trade are determined not in the
marketplace but by negotiation between host governments
of a particular country and the multinational entities
Terminologies
These words are frequently encountered when dealing with
international markets
Exchange rate
• it is the number of units of a particular currency that can
be purchased for one unit of another currency.
• the price of one country’s currency in terms of another
country’s currency
spot exchange rate
• quoted price for a unit of foreign currency to be delivered
“on the spot” or within a short span of time
forward exchange rate
• quoted price for a unit of foreign currency to be delivered
in the future at a particular date
fixed exchange rate
• currency is set by the government and allowed to
fluctuate slightly around the desired at set rate, the par
value
floating or flexible exchange rate
• not regulated by the government
• the supply and demand in the market determine the
currency’s value
CROSS RATES
• The exchange rate between any two currencies.
• Example:
o a German executive is flying to Tokyo for a
business trip. The exchange rate in which he or she is
interested is not euros or yen per dollar, but the issue is
how many yen can be purchased with a euro. Use this
table:

Devaluation of a currency
• refers to a decrease in the stated par value of a currency
whose value is fixed
• this decision is made by the government

Depreciation of a currency
• a decrease in the foreign exchange value of a floating
currency
• this is caused by market forces

revaluation of a currency
• refers to an increase in the stated par value of a currency
whose value is fixed
• this decision is made by the government
Solution:
appreciation of a currency • For the German executive, the cross rates are
• an increase, respectively, in the foreign exchange value determined:
of a floating currency
• this is caused by market forces
• Cancelling the dollar signs will get the number of euros
Foreign Exchange Rate Quotations that 1 yen could buy:

Direct quote • Finding the number of yen that 1 euro could buy:
• the number of units of domestic currency corresponding
or in equivalent to 1 unit of foreign currency
• home or domestic currency price of one unit of the foreign
currency.
• It is the norm in all countries, except in the Australia, UK,
New-Zealand, Canada and the Eurozone • The two cross rates are reciprocals of each other.
• Examples (for a Swiss Franc based investor):
o 0.99 CHF = 1 USD Trading in Foreign Exchange
o 1.08 CHF = 1 EUR • The Foreign exchange rate or the so-called Forex market
is the largest financial market.
Indirect quote
• the number of units of foreign currency corresponding or
in equivalent to 1 unit of domestic currency
• The foreign currency price of one unit of the home or
domestic currency.
• this is the norm in UK, New-Zealand, Australia, Canada
and the Eurozone
• Examples:
o 1 EUR = 1.09 USD
o 1 AUD = 0.71 USD
SPOT RATES AND FORWARD RATES
Spot rates
• rate paid for delivery of the currency “on the spot”
• in reality, no more than 2 days after the day of the trade
forward exchange rate
• the buy or sell of currencies for delivery at an agreed-
upon future date which is usually 30, 90, or 180 days from
the negotiated day of the transaction
Example:
Observe:
a. Selling at a discount: forward Australian dollars
• a dollar buys more Australian dollars in the forward
market than in the spot market
b. Selling at premium: forward pounds, yen, and Swiss
francs
• a dollar buys less pounds, yen, and Swiss francs in the
forward market than in the spot market
Interest Rate Parity
• Specifies that investors should expect to earn the same
return in all countries after adjusting for risk.
• recognizes that when you invest in a country other than
your home country, you are affected by two forces—returns
on the investment itself and changes in the exchange rate
• Equation:
Illustration:
The nominal annual interest rate on 6-month U.S.
Treasuries is 1.5%. The spot rate of the British pound is
$1.2881 (£0.7763 per U.S. dollar) and the 6-month forward
rate of the British pound is $1.2960 (£0.7716 per U.S.
dollar). If interest rate parity holds, what is the nominal
annual interest rate on default-free 6-month British bonds?
Step 1: Substitute the variables on the problem to the
formula
• the semiannual return on 6-month U.S.
Treasuries is 0.75%
Step 2: Solve
• Hence, the nominal annual interest rate on a 6-
month default-free British bond is: 2*0.135861% =
0.2717%. It is multiplied by 2 to annualize the interest rate
on default-free 6-month British bonds.
Purchasing Power Parity
• a theory stating that these two things should be
equivalent:
o Buying a good in a given currency
o Using this money to exchange it into another
currency and then buy the same good in the country of this
other currency
• sometimes referred to as the law of one price
• The relationship in which the same products cost roughly
the same amount in different countries after taking into
account the exchange rate.
• Equation:
𝑊ℎ𝑒𝑟𝑒:𝑃ℎ=𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡𝑒ℎ 𝑔𝑜𝑜𝑑 𝑖𝑛 𝑡ℎ𝑒 ℎ𝑜𝑚𝑒
𝑐𝑜𝑢𝑛𝑡𝑟𝑦;𝑃𝑓=𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡𝑒ℎ 𝑔𝑜𝑜𝑑 𝑖𝑛 𝑡ℎ𝑒 𝑓𝑜𝑟𝑒𝑖𝑔𝑛
𝑐𝑜𝑢𝑛𝑡𝑟𝑦
Illustration:
A U.S. customer observes that a tennis racket costs $200.
1 euro, in the spot market, can be exchanged for $1.1924.
How many euros is expected to be paid for the same tennis
racket in Europe under the purchasing power parity theory?
Solution:
Analysis:
• If purchasing power parity holds, the price of the tennis
racket in the European market should be €167.7290.
• The U.S. customer has $200 that either:
o could be used the $200 to buy the golf club in
the U.S. market, or
o could be exchanged for €167.7290 and buy the
tennis racket that cost €167.7290, when purchasing power
parity would hold.
• It would be better to buy the tennis racket in the United
States if the tennis racket sold for more than €167.7290 in
Europe otherwise if the tennis racket sold for less than
€167.7290 in the Eurozone, it would make sense to buy the
tennis racket in Europe.
International Credit Markets
Major types of international credit markets:
1. Eurocredits
• Floating-rate bank loans, available in most major trading
currencies
• The oldest example of a eurocredit is a eurodollar
deposit, which is a U.S. dollar deposited in a bank outside
the United States. Today eurocredits exist for most major
trading currencies.

2. Eurobond market
• Eurobond
o An international bond underwritten by an
international syndicate of banks and sold to investors in
countries other than the one in whose money unit the bond
is denominated.

3. Foreign bond market

• Foreign Bonds
o A type of international bond issued in the
domestic capital market of the country in whose currency
the bond is denominated and underwritten by investment
banks from the same country
o the headquarters of the borrower is in a
different country.

International Stock Markets

New issues of shares are sold in international markets for a
various reason:
a. Create an equity market presence to
accompany its operations in other country; and
b. Tap a much larger source of capital

Gold market
Gold, as a financial asset, has been used as:
• Investment
• Store of value
• Money (either as coins or as backing to Fiat
currency systems like the gold standard)

Gold can be used to hedge against:

• A collapsing currency
• Political tensions
• Inflation
• Stock market crashes
• The sudden loss of faith in a fiat currency
system