INTERNATIONAL FINANCIAL

MANAGEMENT
MCM.572
INTERNATIONAL FINANCIAL ENVIRONMENT
At the end of the Second World War, the international
economic system was in a state of collapse.
International markets for trade in goods, services, and
financial assets were essentially nonexistent.
The new beginning started in the formation of
International Monetary Fund for world level monetary
standard. It also led in the establishment of various
other international institutions like the International
Bank for Reconstruction and Development, General
Agreement on Trade and Tariff etc. Those institutions
have contributed in the integration of world economy.
After the World War II, most national governments
began to lower their entry barriers, to make them more
permeable for world trade.
The years between 1970 and 1990 have witnessed the most
remarkable institutional harmonization and economic integration
among nations in the world history. The decade of 1980,
witnessed the integration of the communist world with the world
economy as capitalism spread to their economies. The decade of
1980s also witnessed the practice of open economy
macroeconomic policies by many developing countries. Several
Latin American and Asian Countries had implemented financial
reform policies or eliminated Government control of domestic
interest rates, credit allocation and exchange rate etc. Countries
like Korea, Malaysia, Chile, Argentina, Uruguya, Japan, Hong
Kong, India and China have liberalized their economies. They
have undertaken many policy decisions to reform their financial
markets. One of the primary aims of financial reforms programme
of these countries has been to integration of the various
segments of financial markets.
The decade of 1990s is generally considered as the
decade of re-unification of global economy. The
world reached its climax in the process of
integration of developed and developing worlds.
Disintegration of the Soviet Union, the emergence
of market-oriented economies in Asia, the creation
of a single European market, formation of new era
of trade liberalization through World Trade
Organization etc., are few events of 1990s which
led to global financial and economic integration.
Development of IT-based communication system
and services have significantly contributed in the
further expansion of global financial system.
 EXPERIENCES FROM INDIA
 Prior to colonial rule, India was known as the hub of manufacturing
goods and artifacts. During the colonial rule India was converted to
a raw materials suppliers to rest of the World.
 On the eve of independence in 1947, foreign trade of India was
typical of a colonial and agricultural economy.
 From 1947 till mid-1990s, India, with some exceptions, always faced
deficit in its balance of payments, i.e. imports always exceeded
exports. This was characteristic of a developing country struggling
for reconstruction and modernisation of its economy.
 Beginning mid-1991, the government of India introduced a series of
reforms to liberalize and globalize the Indian economy. Reforms in
the external sector of India were intended to integrate the Indian
economy with the world economy. India's approach to openness has
been cautious, contingent on achieving certain preconditions to
ensure an orderly process of liberalization and ensuring
macroeconomic stability
INTERNATIONAL FINANCE
 We live in a globalized world. Every country is
dependent on another country in some other means.
Developed countries look for the cheap workforce from
developing countries and developing countries look for
services and products from developing countries.
When a trade happened between two countries as in
this case, there are many factors that come into the
picture and have to be considered while the execution
of the trade so that no violation of regulation happens.
For any economy international finance is a significant
critical factor, the local government should accordingly
execute the policies so that the local players are not
facing severe competition from the non-local players.
International Finance deals with the management of finances in
a global business. It explains how to trade in international
markets and how to exchange foreign currency, and earn
profit through such activities. In fact, international Finance is
an important part of financial economics. It mainly discusses
the issues related with monetary interactions of at least two or
more countries. International finance is concerned with
subjects such as exchange rates of currencies, monetary
systems of the world, foreign direct investment (FDI), and
other important issues associated with international financial
management.
International Finance is a section of financial economics which
deals with the macroeconomic relation between two countries
and their monetary transactions. The concepts like interest
rate, exchange rate, FDI, FPI and currency prevailing in the
trade come under this type of finance.
NATURE OF INTERNATIONAL FINANCE

 Foreign exchange risks

 Political risks

 Expanded opportunity sets

 Market imperfections
NEED FOR FOREIGN CAPITAL

 a. Inadequacy of domestic capital

 b. The technology gap

 c. The initial risk

 d. Development of basic infrastructure

 e. Balance of payment support.

 International business: Any business
transaction between parties from more than
one country is a part of international
business.
 International trade : International trade is
the exchange of goods and services between
countries.
 International finance : International finance
is the study of monetary interactions that
transpire between two or more countries. ·
WHY FIRMS PURSUE INTERNATIONAL
BUSINESS?

The firms become motivated to expand their

business internationally are
(1) the theory of comparative advantage,

(2) the imperfect markets theory, and

(3) the product cycle theory

INTERNATIONAL BUSINESS METHODS

Exporting
Licensing
Franchising
Foreign Direct Investment (FDI)
EMERGING CHALLENGES IN INTERNATIONAL
FINANCE
Varied Economic System
Tariff and non-tariff trade
barriers
Political Risks
Environmental safeguards
Dumping
Cultural differences
Language differences
Intellectual property rights
Cyber crimes
Transfer Pricing
International Taxation
Economic and Currency
Crisis
Interest Rates Charging
Foreign Exchange Risk
Cold war between countries
International business cycle
Operational risk
International terrorism
International Cash
Management
Creditworthiness
Methods of Payment
THE INTERNATIONAL FINANCIAL MANAGER
MUST CONSIDER

Politicalrisks
Variations in sources of funding
Foreign exchange rate fluctuations
Restrictions on capital, exchange and profit flows
Differences in tax systems faced
Variations in economic systems and economic
conditions
Differences in inflation
Varying interest and discount rates
HOW MUCH PROFITS SHOULD YOU BRING HOME?

Opportunities for growth outside

country profits earned in
HOW MUCH PROFITS SHOULD YOU BRING HOME?
Firms objectives
HOW MUCH PROFITS SHOULD YOU BRING HOME?

Availability of capital from local sources

HOW MUCH PROFITS SHOULD YOU BRING HOME?

Stability of currency exchange

HOW MUCH PROFITS SHOULD YOU BRING HOME?
Economic and political conditions at home and abroad
HOW MUCH PROFITS SHOULD YOU BRING HOME?
Host government restrictions on remittance
HOW MUCH PROFITS SHOULD YOU BRING HOME?

Tax systems in host and home country

HOW MUCH PROFITS SHOULD YOU BRING HOME?
Impact on image in
host country
 FOREIGN EXCHANGE MARKET

- allows for the exchange of one currency for another

- where currency trading takes place
- where banks, companies, exporters, importers, fund
managers, individuals, central banks of different countries
buy and sell of foreign currencies
- forex rates are quoted in pairs, e.g. Euro/US$,
US$/Japanese Yen, US$/INR, etc
- a trader trading in forex sells one of the currency pair and
buys the other.
- It is an ongoing 24-hour, 365 days year market
- It is one of the largest and liquid financial markets in the
world
- Individuals rely on the foreign exchange market when
they travel to foreign countries
INDIAN FOREX MARKET
 EXCHANGE RATE DETERMINATION

Financial managers of MNCs that conduct

international business must continuously
monitor exchange rates because their cash
flows are highly dependent on them. They need
to understand what factors influence exchange
rates so that they can anticipate how exchange
rates may change in response to specific
conditions.
 HOW EXCHANGE RATE MOVEMENTS ARE
MEASURED
An exchange rate measures the value of one currency in units of another
currency. As economic conditions change, exchange rates can change
substantially.
A decline in a currency’s value is often referred to as depreciation.
When the British pound depreciates against the U.S. dollar, this means that
the U.S. dollar is strengthening relative to the pound.
The increase in a currency value is often referred to as appreciation.
EXCHANGE RATE EQUILIBRIUM
FACTORS THAT INFLUENCE EXCHANGE RATES

Home and foreign Country’s

 inflation

 interest rate

 income level

 change in government

 change in expectations of future exchange rates

IMPACT OF RISING INFLATION
IMPACT OF RISING INTEREST RATES
IMPACT OF RISING INCOME LEVELS
 IMPACT OF GOVERNMENT CONTROLS
The governments of foreign countries can influence the equilibrium
exchange rate in many ways, including (1) imposing foreign exchange barriers,
(2) imposing foreign trade barriers, (3) intervening (buying and selling
currencies) in the foreign exchange markets, and (4) affecting macro variables
such as inflation, interest rates, and income levels.
Some governments attempt to use foreign exchange controls (such as
restrictions on the exchange of the currency) as a form of indirect intervention
to maintain the exchange rate of their currency. Under severe pressure,
however, they tend to let the currency fl oat temporarily toward its market-
determined level and set new bands around that level.
i.e.,During the mid-1990s, Venezuela imposed foreign exchange
controls on its currency (the bolivar). In April 1996, Venezuela removed its
controls on foreign exchange, and the bolivar declined by 42 percent the next
day. This result suggests that the market-determined exchange rate of the
bolivar was substantially lower than the exchange rate at which the government
artificially set the bolivar
 IMPACT OF EXPECTATIONS OF FUTURE
EXCHANGE RATES
Investors may temporarily invest funds in Canada if they
expect Canadian interest rates to increase. Such a rise may
cause further capital flows into Canada, which could place
upward pressure on the Canadian dollar’s value. By taking a
position based on expectations, investors can fully benefit
from the rise in the Canadian dollar’s value because they
will have purchased Canadian dollars before the change
occurred. Although the investors face an obvious risk here
that their expectations may be wrong, the point is that
expectations can influence exchange rates because they
commonly motivate institutional investors to take foreign
currency positions.
 FACTORS AFFECTING FOREIGN EXCHANGE
MARKET
 Inflation Rates
 Interest Rates

 Country’s Current Account / Balance of

Payments
 Government Debt

 Terms of Trade

 Political Stability & Performance

 Recession

 Speculation
 INTERNATIONAL ARBITRAGE
Capitalizing on a discrepancy in quoted prices by making a riskless
profit.
Example: Two coin shops buy and sell coins. If Shop A is willing to sell a
particular coin for $120, while Shop B is willing to buy that same coin
for $130, a person can execute arbitrage by purchasing the coin at
Shop A for $120 and selling it to Shop B for $130. The prices at coin
shops can vary because demand conditions may vary among shop
locations. If two coin shops are not aware of each other’s prices, the
opportunity for arbitrage may occur.
The act of arbitrage will cause prices to realign. In this example,
arbitrage would cause Shop A to raise its price (due to high demand
for the coin). At the same time, Shop B would reduce its bid price
after receiving a surplus of coins as arbitrage occurs
Type of arbitrage
 Locational arbitrage

 Triangular arbitrage

 Covered interest arbitrage

CURRENCY QUOTES FOR LOCATIONAL ARBITRAGE EXAMPLE
 TRIANGULAR ARBITRAGE
 Cross exchange rates represent the relationship between two currencies
that are different from one’s base currency
CURRENCY QUOTES FOR A TRIANGULAR ARBITRAGE EXAMPLE
CURRENCY QUOTES FOR A TRIANGULAR ARBITRAGE EXAMPLE
 COVERED INTEREST ARBITRAGE

 It is the process of capitalizing on the interest

rate differential between two countries while
covering your exchange rate risk with a
forward contract. The logic of the term
covered interest arbitrage becomes clear
when it is broken into two parts: “interest
arbitrage” refers to the process of capitalizing
on the difference between interest rates
between two countries; “covered” refers to
hedging your position against exchange rate
risk.
COMPARING ARBITRAGE STRATEGIES
CLASS DISCUSSION
 PARITY CONDITIONS IN INTERNATIONAL FINANCE

Parity refers to the exchange rate between the currencies of

two countries making the purchasing power of both
currencies substantially equal.
Parity Conditions provide an intuitive explanation of the
movement of prices and interest rates in different markets in
relation to exchange rates.
The derivation of these conditions requires the assumption of
Perfect Capital Markets (PCM).
 no transaction costs
 no taxes
 complete certainty
NOTE – Parity Conditions are expected to hold in the long-
run, but not always in the short term.
The three theories of exchange rate
determination are:
 Purchasing Power Parity (PPP), which links
spot exchange rates to nations’ price levels.
 The Interest Rate Parity (IRP), which links spot
exchange rates, forward exchange rates and
nominal interest rates.
 The International Fisher Effect(IFE), which
links exchange rates to nations’ nominal interest
rate levels.
PURCHASING POWER PARITY (PPP)
The theory aims to determine the adjustments needed to be
made in the exchange rates of two currencies to make them
at par with the purchasing power of each other. In other
words, the expenditure on a similar commodity must be
same in both currencies when accounted for exchange rate.
The purchasing power of each currency is determined in the
process.
Example: Let's say that a pair of shoes costs Rs 7500 in India.
Then it should cost $100 in America when the exchange
rate is 75 between the dollar and the rupee.
The Purchasing Power Theory(PPT) has been presented in
two types
 Absolute Version of Purchasing Power Parity and

 Relative Version of Purchasing Power Parity.

ABSOLUTE PURCHASING POWER PARITY

 The absolute purchasing power parity theory stresses

that the exchange rates should normally reflect the
relation between the internal purchasing power of the
various national currency units.
 The price of a tradable commodity in one country
should theoretically be equal to the price of
the same commodity in another country, after adjusting
for the foreign exchange rate.
 The theory is known as the international law of one
price. When the international law one price
applied to the representative good or basket of goods, it
is called the absolute purchasing power
parity condition.
Let us assume that a representative collection of goods costs
Rs.9,625/- in India and US$ 195 in USA. As per the
Absolute PPP theory, the exchange rate between US$ and
Indian Rupee is the ratio of two price indices.
 Spot price (In Indian Rupee) = Price Index of India /
Price Index of USA
 Spot Rate = P Rupee / P USA

As per the example mentioned above, the exchange rate

would be;
Spot (in Rupee) = 9625/195 = Rs.47.5128
 RELATIVE PURCHASING POWER PARITY
Purchasing Power for two currencies can be different not
because of differences in their internal purchasing power, but
some other factors also. Relative purchasing power parity
relates the change in two countries' expected inflation rates to
the change in their exchange rates. Inflation reduces the real
purchasing power of a nation's currency. If a country has an
annual inflation rate of 5%, that country's currency will be able
to purchase 5% less real goods at the end of one year.
Relative purchasing power parity examines the relative
changes in price levels between two countries and maintains
the exchange rates, which will compensate for inflation
differentials between the two countries.
The relationship can be expressed as follows, using indirect
quotes:
St / S0 = (1 + iy) ÷ (1 + ix) t
The annual inflation rate is expected to be 8% in the
India and that for the US is 3%. The current
exchange rate is Rs.46.5500/- per US $. What
would the expected spot exchange rate be in six
months for Indian Rupee relative to US$.
So the relevant equation is:
St / S0 = (1 + iy) ÷ (1 + ix)
S6month ÷ Rs.46.5500 = (1.08 ÷ 1.03)0.5
Which implies S6month = (1.023984) × Rs.46.550 =
Rs.47.6665.
So the expected spot exchange rate at the end of six
months would be Rs.47.6665 per US$.
GRAPHIC ANALYSIS OF PPP
The Purchasing Power Parity theory which helps us to assess
the potential impact of inflation on exchange rates. The
vertical axis measures the percentage appreciation or
depreciation of the foreign currency relative to the home
currency while the horizontal axis measures the percentage
by which the inflation in the foreign country is higher or
lower relative to the home country. The points in the diagram
show that given the inflation differential between the home
and the foreign country, say by X per cent, the foreign
currency should adjust by X per cent due to the differential
in inflation rates. The diagonal line connecting all these
points together is known as the PPP line and it depicts the
equilibrium position between a change in the exchange
rates and relative inflation rates.
Assume that the Canadian dollar’s spot rate is
$.85 and that the Canadian and U.S. inflation
rates are similar. Then assume that Canada
experiences 4 percent inflation, while the
United States experiences 3 percent
inflation. According to PPP, what will be the
new value of the Canadian dollar after it
adjusts to the inflationary changes?
 Class Discussion 3
Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk?
Yes. Studies have shown that exchange ratemovements are related to inflation
differentials in the
long run. Based on PPP, the currency of a high inflation country will depreciate
against the dollar. A subsidiary in that country should generate inflated revenue from
the inflation, which will help offset the adverse exchange effects when its earnings
are remitted to the parent. If a firm is focused on long-term performance, the
deviations from PPP will offset overtime. In some years, the exchange rate effects
may exceed the inflation effects, and in other years the inflation effects will exceed
the exchange rate effects.
No. Even if the relationship between inflation and exchange rate effects is consistent,
this does not guarantee that the effects on the firm will be offsetting. A subsidiary in a
high-inflation country will not necessarily be able to adjust its price level to keep up
with the increased costs of doing business there. The effects vary with each MNC’s
situation. Even if the subsidiary can raise its prices to match the rising costs, there
are short-term deviations from PPP. The investors who invest in an MNC’s stock may
be concerned about short-term deviations from PPP because they will not
necessarily hold the stock for the long term. Thus, investors may prefer that firms
manage in a manner that reduces the volatility in their performance in short-run and
long-run periods.
Who Is Correct? Use the Internet to learn more about this issue. Which argument do you
support? Offer your own opinion on this issue
INTEREST RATE PARITY (IRP)
Spot price and the forward or futures price of a currency
pair would be governed by interest rate differentials
between the two currencies.
i.e., Let us assume that interest rate prevailing in India is 8% per
year while in USA it is 3% per year. Suppose the spot rate INR
47/USD. The interest parity says, that
one year forward rate would be governed by the interest rate
differential.
 Suppose spot rate prevailing on today is
INR47/USD. A person intends to invest INR 47 for year at 8%
interest in India. Otherwise, he can convert INR 47 to 1 USD
and invests in USA at 3% per annum and
simultaneously buys a forward cover to sell 1.03 USD after a
year. In both options, the
investor should have the same return.

If the actual forward rate differs from the interest rate parity, the
arbitrage will happen. Now let us take two scenarios: actual
forward rate is either INR 50.25/USD or INR 48/USD and see
forex traders can avail the interest rate arbitrage.
 COVERED INTEREST RATE PARITY
 Forward rate governed by Interest Rate Parity: INR49.28/USD.
 Scenario 1: Actual forward rate prevailing: INR 50.25/USD.
 When actual forward rate INR 50.25/USD, an investor converting INR to
USD and investing in US market and then selling USD forward is better off
compared to investing in India at 8% interest rate.
 INR 47 investment in India at a rate of 8% results in INR 50.76. However, if
investor converts it to USD and invests in US market, the investor receives
USD1.03. The investor sells in forward market at a rate of Rs.50.25, he
receives INR 51.75. Hence, everybody would like to borrow money in
Indian market, sell INR and buy USD, invest in USD and simultaneously
enter into a contract to sell USD forward. With many investors trying to
benefit from the arbitrage, borrowing in INR would increase. Hence interest
rate prevailing in India would increase. Simultaneously, interest
in USA would go down and many arbitrageurs would be willing to lend
USD. Simultaneously investors in USA would also be entering into contract
to sell USD forward thus reducing the forward rate. This would result in
adjustment in spot rate, interest rates prevailing in both countries as well as
the forward rate.
 Scenario 2: Actual forward rate prevailing: INR 48/USD.
 When actual forward rate INR 50.25/USD, an investor converting borrowing
in USD and converting INR at the spot rate and buying forward USD
(equivalent to selling forward INR) is better off compared to investing in
USA at 3% interest rate.
 Suppose an investor borrows 1 USD. He has to pay USD 1.03 after 1 year.
He converts 1 USD to INR 47 at the prevailing spot rate. Invests in India at
a rate of 8%.Earns INR50.76.Converts INR to USD at a rate INR 48/USD.
Receives USD1.0575.Pays back USD 1.03 to the US lender. Makes a
profit of USD0.0275 for every 1USD. If he borrows
1mn USD, he would make neat profit of USD 27,500.
 With many investors trying to benefit from the arbitrage, borrowing in USD
would increase USD interest rate. Hence interest rate prevailing in USA
would increase. Simultaneously, interest in India would go down and many
arbitrageurs would be willing to lend INR. Simultaneously investors in USA
would also be entering into contract to sell INR forward thus reducing the
forward rate. This would result in adjustment in spot rate,
interest rates prevailing in both countries as well as the forward rate.
 As in both scenarios, the arbitrage benefit accrues to investors only when
they take forward cover, this parity condition is known as “covered
interest rate parity”.
 UNCOVERED INTEREST RATE PARITY
Even without a active forward market, interest parity still holds. This is known
as “uncovered interest rate parity”. If uncovered interest rate parity does
not hold true, then traders all over the world undertake carry trade.
 Though not a parity condition in true sense of the word, forward exchange
rate can be used as predictor of future spot rate. That gives rise to a
concept called “forward exchange rate to be unbiased predictor of
future exchange rate”.
 Uncovered interest rate parity asserts that, if an investor borrows money
from the country with lower nominal interest rate, converts and invests in
the currency with higher interest rate, the investor will not be better off
position. Why? When the investors reconverts the invested currency to
borrowed currency, the exchange rate would have moved in such a manner
that, he earns exactly the same amount as if he has invested in the lower
interest rate.
Uncovered interest rate parity is represented by
i.e., Assume the nominal interest rate in the US is 6% per
annum, and the nominal interest rate in India is 14% per
annum. Since the nominal interest rate in India is higher, the
investor will perceive it to be beneficial to borrow in USD and
invest that in INR, and then reconvert the investment proceeds
to USD to make a profit from the difference.
Say, for example, the investor borrows USD1,800 and converts it
in INR at a spot rate of INR70/USD. Hence, he would need to
repay USD1,860 after a year. Hence, he invests INR126,000
at a rate of 14% per annum. Hence, by the end of the year, he
will receive INR143,640.
Now, when he tries to reconvert the investment proceeds back to
USD, the uncovered interest rate parity condition will come
into play, and the nominal interest rate difference will rise in
order to eliminate the difference. The investor will then neither
be better off nor worse off and will not make any profit as the
difference in interest rates will be adjusted according to the no-
arbitrage condition of UIRP.
 FISCHER EFFECT
The relationship between the real interest rate, nominal interest
rate and inflation is known as “Fischer Effect”.
(1+i) = (1+r)(1+Inflation Rate)
Where i= nominal interest rate and r = real interest rate.
Nominal Interest Rate = Real Interest Rate + Inflation rate.
When Nominal interest rate is 10%, expected inflation rate during
this period is 6%, the real interest rate is 4%. If the expected
inflation rate increases to 13%, then real interest rate is -3%.
 REAL INTEREST RATE PARITY
Real interest rate parity (RIRP) hypothesis postulates that real interest
rates should equalize across countries. In other words, the real
rates of return on essentially identical assets should be same across
countries. It states that

 Where r domestic and r foreign are expected real interest rate at

home and foreign country
respectively.
 For example, Government of India 1 year G-Sec is giving nominal
rate of return of 12%. Inflation in India is 5.5%. US Government
paper with 1 year maturity offers 6% nominal
rate of return with US inflation rate with 2%.
 From the above detail, the real rate of return in USA and in India is
3.92% and 6.16%. In this case the real interest rate parity does not
hold true. It can only hold true if the real rate of return is same for
both these instruments.
 INTERNATIONAL FISCHER EFFECT(IFE)
International Fisher Effect postulates that the estimated change
in the current exchange rate between any two currencies
is directly proportional to the difference between the two
countries' nominal interest rates at a particular time. In
other words, the percentage change in the spot exchange rate
over time is governed by the difference between the nominal
interest rate for the two currencies.
International Fischer effect is expressed as:
For example, if the nominal interest rate in India is 12% per annum and it is
8% in USA, then INR is expected to depreciate vis-a vis USD.

Suppose a Government of India issued a G-Sec on 1st January 2010

having a maturity of 1 year has a coupon rate of 12% per annum. Govt.
of USA paper with a maturity of 1 year is available at 8%. The differential
in the nominal interest rate prevailing in Indian and USA indicates that
INR will depreciate by 3.57% by the end of one year i.e, 1st January
2011.

Spot rate after a year will be INR 41.48 Intuitively, International Fisher
effect works like this:
 Suppose on 1st January 2010, the exchange rate is INR
40/USD. On this date an investor invest INR 1600 at his
disposal. He invests INR 800 on a Govt. of India paper at
12% interest per annum. He converts the other INR 800 to
USD (USD 20) and invests in Govt. of USA paper for 1 year.
After a year, he has INR 896 and USD21.6 from INR and
USD investment respectively.
 According to the International Fisher’s effect, the spot
exchange rate on 1st January 2011 will be decided by these
two investment returns i.e USD 21.6 = INR 896. Hence the
spot rate on 1st January 2011 will be INR41.48/USD.
what would be the % appreciation/depreciation of
USD/INR. The nominal interest rate in India is 12%
per annum and it is 8% in USA, then USD is
expected to appreciate.
The USD appreciation amount is governed by
 USD is expected to appreciate by 3.7%. Suppose on 1st January 2010, the
exchange rate is INR 40/USD or USD 0.025/INR. On this date an investor
invest INR 1600 at his disposal. He invests INR 800 on a Govt. of India
paper at 12% interest per annum. He converts the other INR 800 to USD
(USD 20) and invests in Govt. of USA paper for 1 year. After a year, he has
INR 896 and USD21.6 from INR and USD investment respectively.
According to the international Fisher’s effect, the spot exchange rate on 1st
January 2010 will be INR 41.48/USD or USD0.024108/INR.

The International Fisher’s effect relates the nominal interest rate

between two countries and the movement of exchange rate between
the currencies of two countries. It indicates that the country with
lower nominal (higher) interest rate will appreciate (depreciate)
compared to the other currency.
EXCHANGE RATE FORECASTING
FORECASTING TECHNIQUES
(1) Technical,
(2) Fundamental,
(3) Market based, and
(4) Mixed
Technical Forecasting
Technical forecasting involves the use of historical exchange rate data to
predict future values
The head-and-shoulders pattern
Fundamental Forecasting
Fundamental forecasting is based on fundamental relationships between
economic variables and exchange rates
Market-Based Forecasting
The process of developing forecasts from market indicators, known as
market-based forecasting, is usually based on either (1) the spot rate or
(2) the forward rate.
Mixed Forecasting
No single forecasting technique has been found to be
consistently superior to the others, some MNCs prefer to
use a combination of forecasting techniques. This method is
referred to as mixed forecasting.
Various forecasts for a particular currency value are developed
using several forecasting techniques. The techniques used
are as signed weights in such a way that the weights total
100 percent, with the techniques considered more reliable
being assigned higher weights. The actual forecast of the
currency is a weighted average of the various forecasts
developed.
College Station, Inc., needs to assess the value of the Mexican
peso because it is considering expanding its business in
Mexico. Notice that, in this example, the forecasted direction
of the peso’s value is dependent on the technique used. The
fundamental forecast predicts the peso will appreciate, but the
technical forecast and the market-based forecast predict it will
depreciate. Also, notice that even though the fundamental and
market-based forecasts are both driven by the same factor
(interest rates), the results are distinctly different.
Sometimes MNCs assign one technique a lower weight when
forecasting in one period, but a higher weight when
forecasting in a later period. Some fi rms even weight a given
technique more for some currencies than for others at a given
point in time. For example, a fi rm may decide that a market-
based forecast provides the best predic tion for the pound, but
that fundamental forecasting works best for the New Zealand
dollar, and technical forecasting for the Mexican peso.