Professional Documents
Culture Documents
Int. Financial Mgt. Updted - All in One
Int. Financial Mgt. Updted - All in One
An Overview
Objectives
• Identify the main goal of the multinational corporation (MNC) and conflicts
with that goal;
• Describe the key theories that justify international business; and
• Explain the common methods used to conduct international business.
1
The Multinational Company (MNC)- Introduction
• A multinational company (MNC) or Multinational Enterprise (MNE) is one
that owns or controls production or service facilities outside the country
in which it is based.
• MNC/MNE can also be defined as one that has operating subsidiaries,
branches or affiliates located in foreign countries.
• The ownership of some MNCs is so dispersed internationally that they are
known as transnational corporations.
• The transnationals are usually managed from a global perspective rather
than from the perspective of any single country.
1-2
MNC- Introduction
• The US, Europe and Japan are the major sources of Foreign Direct Investment
(FDI)
• Main recipients of FDI are in South East Asia, South America, Canada, and
Europe.
• More globalisation has been facilitated by deregulation, free movement of
capital, and telecommunications.
Multinationals benefit in various ways, including:
• economies of scale
• access to specialist labour
• access to cheaper labour and other resources
• closer to customers
• closer to suppliers
• access to grants / tax breaks
3
Goal of the MNC
• The commonly accepted goal of an MNC is to maximize shareholder
wealth.
4
Conflicts Against the MNC Goal
• For corporations with shareholders who differ from their managers, a
conflict of goals can exist - the agency problem. Managers pursuing their
interest and not that of Shareholders.
• Agency costs are normally larger for MNCs than for purely domestic
firms.
• The sheer size of the MNC.
• The scattering of distant subsidiaries.
• The culture of foreign managers.
• Subsidiary value versus overall MNC value.
5
Impact of Management Control
• The magnitude of agency costs can vary with the management style
of the MNC.
• A centralized management style reduces agency costs. However, a
decentralized style gives more control to those managers who are
closer to the subsidiary’s operations and environment.
6
Centralized Multinational Financial Management
for an MNC with two subsidiaries, A and B
Financing at A Financing at B
Financing at A Financing at B
9
Impact of Management Control
• Some MNCs attempt to strike a balance - they allow subsidiary
managers to make the key decisions for their respective operations,
but the decisions are monitored by the parent’s management.
10
Impact of Management Control
11
Impact of Corporate Control
12
Constraints Interfering with the MNC’s Goal
• As MNC managers attempt to maximize their firm’s value, they may
be confronted with various constraints.
• Environmental constraints.
• Regulatory constraints.
• Ethical constraints.
13
Theories of International Business
14
Theories of International Business - Market Imperfections:
1-15
Theories of International Business - Market Imperfections
• Strategic motives drive the decision to invest abroad and become a MNC
and can be summarized under the following categories:
• Market seekers
• Raw material seekers
• Production efficiency seekers
• Knowledge seekers
• Political safety seekers
• These categories are not mutually exclusive.
1-16
Theories of International Business
17
The International Product Life Cycle
18
International Business Methods
19
International Business Methods
• Licensing allows a firm to provide its technology in exchange for fees or
some other benefits. Licensing applies to the registered trademarks.
20
International Business Methods
• Firms may also penetrate foreign markets by engaging in a joint
venture (joint ownership and operation) with firms that reside in
those markets.
• Acquisitions of existing operations in foreign countries allow firms to
quickly gain control over foreign operations as well as a share of the
foreign market.
21
International Business Methods
• Firms can also penetrate foreign markets by establishing new foreign
subsidiaries.
• In general, any method of conducting business that requires a direct
investment in foreign operations is referred to as a direct foreign
investment (DFI).
• The optimal international business method may depend on the
characteristics of the MNC.
22
International Opportunities
• Investment opportunities - The marginal return on projects for an
MNC is above that of a purely domestic firm because of the
expanded opportunity set of possible projects from which to select.
23
International Opportunities
Cost-benefit Evaluation for Purely Domestic Firms versus MNCs
Purely
Investment
Domestic
Opportunities MNC
Marginal Firm
Return on
Projects MNC
Purely
Marginal Domestic
Cost of Firm
Capital
Financing Appropriate Size
Opportunities for Purely Appropriate Size
Domestic Firm for MNC
X Y Asset Level
of Firm 24
International Opportunities
• Opportunities in Europe
• The Single European Act of 1987.
• The removal of the Berlin Wall in 1989.
• The inception of the euro in 1999.
• Opportunities in Latin America
• The North American Free Trade Agreement (NAFTA) of 1993.
• The General Agreement on Tariffs and Trade (GATT) accord.
25
International Opportunities
• Opportunities in Asia
• The reduction of investment restrictions by many Asian countries during the
1990s.
• China’s potential for growth.
• The Asian economic crisis in 1997-1998.
Opportunities in Africa
• AU
• Ecowas
• AfCFTA
26
Exposure to International Risk
International business usually increases an MNC’s exposure to:
27
Overview of an MNC’s Cash Flows
28
Overview of an MNC’s Cash Flows
Profile B: MNCs focused on International Trade and
International Arrangements
29
Overview of an MNC’s Cash Flows
Profile C: MNCs focused on International Trade, International Arrangements, and Direct Foreign
Investment
31
Valuation Model for an MNC
• Domestic Model
n
E CF$, t
Value =
t =1 1 k
t
32
Valuation Model for an MNC
• Valuing International Cash Flows
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
E (CFj,t ) = expected cash flows denominated in currency j to be received by
the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be converted to
dollars at the end of period t
k = the weighted average cost of capital of the U.S. parent company
33
Valuation Model for an MNC
34
Valuation Model for an MNC
Impact of New International Opportunities
on an MNC’s Value
Exposure to
Foreign Economies Exchange Rate Risk
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
Political Risk
35
• Goal of the MNC
• Conflicts Against the MNC Goal
• Impact of Management Control
• Impact of Corporate Control
• Constraints Interfering with the MNC’s Goal
• Theories of International Business
• Theory of Comparative Advantage
• Imperfect Markets Theory
• Product Cycle Theory
36
Chapter Review
• International Business Methods
• International Trade
• Licensing
• Franchising
• Joint Ventures
• Acquisitions of Existing Operations
• Establishing New Foreign Subsidiaries
37
Chapter Review
• International Opportunities
• Investment Opportunities
• Financing Opportunities
• Opportunities in Europe
• Opportunities in Latin America
• Opportunities in Asia
38
Chapter Review
• Exposure to International Risk
• Exposure to Exchange Rate Movements
• Exposure to Foreign Economies
• Exposure to Political Risk
• Overview of an MNC’s Cash Flows
• Managing for Value
39
Chapter Review
• Valuation Model for an MNC
• Domestic Model
• Valuing International Cash Flows
• Impact of Financial Management and International Conditions on Value
• How Chapters Relate to Valuation
40
International Financial Markets
1
Objectives
2
Motives for Using
International Financial Markets
• The markets for real or financial assets are prevented from complete
integration by barriers such as tax differentials, tariffs, quotas, labor
immobility, communication costs, cultural differences, and financial
reporting differences.
• Yet, these barriers can also create unique opportunities for specific
geographic markets that will attract foreign investors.
3
Motives for Using
International Financial Markets
• Investors invest in foreign markets:
• when they expect foreign currencies to appreciate against their own; and
4
Motives for Using
International Financial Markets
• Creditors provide credit in foreign markets:
• when they expect foreign currencies to appreciate against their own; and
5
Motives for Using
International Financial Markets
• Borrowers borrow in foreign markets:
6
Foreign Exchange Market
• The foreign exchange market allows currencies to be exchanged in order to
facilitate international trade or financial transactions. This market allows currencies
to be exchanged in order to facilitate international trade or financial transactions
Balance of Payment, (BoP).
• Major FX centers: London, New York, Tokyo, Hong Kong, Singapore, and Dubai
7
Key Players in FX Markets
• Currency traders and FX brokers
• Major commercial banks
• Speculators
• Central Banks of countries
• Each of the above players has its own objective for participating in the
FX market.
8
Foreign Exchange Market
• The system for establishing exchange rates has evolved over time.
• From 1876 to 1913, each currency was convertible into gold at a specified rate, as
dictated by the gold standard.
• This was followed by a period of instability, as World War I began and the Great
Depression followed.
• The 1944 Bretton Woods Agreement called for fixed currency exchange rates.
• By 1971, the U.S. dollar appeared to be overvalued. The Smithsonian Agreement
devalued the U.S. dollar and widened the boundaries for exchange rate
fluctuations from ±1% to ±2%.
9
Foreign Exchange Market
• Even then, governments still had difficulties maintaining exchange rates within
the stated boundaries.
• In 1973, the official boundaries for the more widely traded currencies were
eliminated and the floating exchange rate system came into effect.
10
Foreign Exchange Transactions
• There is no specific building or location where traders exchange currencies.
Trading also occurs around the clock.
• The market for immediate exchange is known as the spot market. Cash
delivery for spot currency transactions is usually the standard settlement
date of two business days after the transaction date (T+2).
12
Foreign Exchange Transactions
• The following attributes of banks are important to foreign exchange
customers:
• competitiveness of quote
• special relationship between the bank and its customer
• speed of execution
• advice about current market conditions
• forecasting advice
13
Foreign Exchange Transactions
• Banks provide foreign exchange services for a fee: the bank’s bid (buy)
quote for a foreign currency will be less than its ask (sell) quote. This
is the bid/ask spread.
• bid/ask % spread = ask rate – bid rate
ask rate
• Example: Suppose bid price for £ = $1.52, ask price = $1.60.
bid/ask % spread = (1.60–1.52)/1.60 = 5%
14
Foreign Exchange Transactions
• The bid/ask spread is normally larger for those currencies that are less frequently
traded.
• The spread is also larger for “retail” transactions than for “wholesale”
transactions between banks or large corporations.
• The spread on currency quotations is positively influenced by
• order costs,
• inventory costs, and
• currency risk, and negatively influenced by
• competition, and
• volume.
• The spread for heavily traded currencies like the $, €, £, and ¥ are low because
of their liquidity.
15
Interpreting Foreign Exchange Quotations
16
Interpreting Foreign Exchange Quotations
• Direct quotations represent the value of a foreign currency in dollars for example $1:
Ghc8.2000 or
• indirect quotations represent the number of units of a foreign currency per dollar. Indirect
quotation = 1/direct quotation. Ghc1:$0.1220.
• The exchange rate has two components-the base currency and the counter currency. In
a direct quotation, the foreign currency is the base currency and the domestic currency is
the counter currency
• Note that exchange rate quotations sometimes include IMF’s special drawing rights (SDRs).
• Special Drawing Rights (SDRs) The SDR is an international reserve asset created by the IMF to
supplement the official reserves of its member countries. The SDR is not a currency. It is a
potential claim on the freely usable currencies of IMF members.
• The same currency may also be used by more than one country.
17
Interpreting Foreign Exchange Quotations
• A cross exchange rate reflects the amount of one foreign currency per
unit of another foreign currency.
• Value of 1 unit of currency A in units of currency B
Cross Rate= value of currency A in $
value of currency B in $
18
Interpreting Foreign Exchange Quotations
• A cross exchange rate reflects the amount of one foreign currency per unit of another foreign currency.
• Example Direct quote: $1.50/£, $.009/¥, what is the exchange rate between the ¥/£ that is value of £ in
¥.
• Two ways
• First use indirect quote ie reciprocal to get a common base currency, then work out the cross rates
Indirect quote: .67£/$, 111.11¥/$
The cross rate = 111.11/0.67= 165.67¥/£
• Value of £ in ¥ = value of £ in $
value of ¥ in $
• = $1.50/£
$.009/¥
= 166.67¥/£
19
Currency Futures and Options Market
• A currency futures contract specifies a standard volume of a particular
currency to be exchanged on a specific settlement date. Unlike
forward contracts however, futures contracts are sold on exchanges.
• Currency options contracts give the right to buy or sell a specific
currency at a specific price within a specific period of time. They are
sold on exchanges too.
20
Eurocurrency Market $
• U.S. dollar deposits placed in banks in Europe and other continents are
called Eurodollars.
• In the 1960s and 70s, the Eurodollar market, or what is now referred to
as the Eurocurrency market, grew to accommodate increasing
international business and to bypass stricter U.S. regulations on banks
in the U.S.
21
Eurocurrency Market $
• The Eurocurrency market is made up of several large banks called
Eurobanks that accept deposits and provide loans in various
currencies.
• For example, the Eurocurrency market has historically recycled the oil
revenues (petrodollars) from oil-exporting (OPEC) countries to other
countries.
22
Eurocurrency Market $
• Although the Eurocurrency market focuses on large-volume
transactions, there are times when no single bank is willing to lend
the needed amount.
• A syndicate of Eurobanks may then be composed to underwrite the
loans. Front-end management and commitment fees are usually
charged for such syndicated Eurocurrency loans.
23
Eurocurrency Market $
• The recent standardization of regulations around the world has promoted
the globalization of the banking industry.
• The Single European Act opened up the European banking industry and
increased its efficiency.
• The 1988 Basel Accord signed by G-10 central banks outlined common
capital standards, such as the structure of risk weights, for their banking
industries.
• The Basel Accord outlined risk-weighted capital adequacy requirements for
banks.
• The Basel II & III Accord attempts to account for operational risk and bank
capital adequacy.
24
Eurocurrency Market $
• The Eurocurrency market in Asia is sometimes referred to separately
as the Asian dollar market.
• The primary function of banks in the Asian dollar market is to channel
funds from depositors to borrowers.
• Another function is interbank lending and borrowing.
25
LOANS
Eurocredit Market
• Loans of one year or longer are extended by Eurobanks to MNCs or
government agencies in the Eurocredit market. These loans are
known as Eurocredit loans.
• Floating rates are commonly used, since the banks’ asset and liability
maturities may not match - Eurobanks accept short-term deposits but
sometimes provide longer term loans.
26
Syndicated Loans
• Sometimes a single bank is unwilling or unable to lend the amount
needed by a particular MNC or government agency.
• A lead bank may then organize a syndicate of banks to underwrite the
loan.
• Borrowers that receive a syndicated loan typically incur front-end
management and commitment fees, in addition to the floating rate
interest on the loan.
27
BONDS
Eurobond Market
There are two types of international bonds.
Bonds denominated in the currency of the country where they are
placed but issued by borrowers foreign to the country are called
foreign bonds or parallel bonds.
Bonds that are sold in countries other than the country represented
by the currency denominating them are called Eurobonds.
28
BONDS
Eurobond Market
• The emergence of the Eurobond market is partially due to the 1963
Interest Equalization Tax imposed in the U.S.
• The tax discouraged U.S. investors from investing in foreign
securities, so non-U.S. borrowers looked elsewhere for funds.
• Then in 1984, U.S. corporations were allowed to issue bearer bonds
directly to non-U.S. investors, and the withholding tax on bond
purchases was abolished.
29
BONDS
Eurobond Market
• Eurobonds are underwritten by a multi-national syndicate of
investment banks and simultaneously placed in many countries
through second-stage, and in many cases, third-stage, underwriters.
30
BONDS
Eurobond Market
• Interest rates for each currency and credit conditions in the Eurobond
market change constantly, causing the popularity of the market to vary
among currencies.
• About 70% of the Eurobonds are denominated in the U.S. dollar.
• In the secondary market, the market makers are often the same
underwriters who sell the primary issues.
31
Comparing Interest Rates Among Currencies
• Interest rates vary substantially for different countries, ranging from
about 0.5% sometimes (-ve) in Japan to about 60% in Russia.
• Interest rates are crucial because they affect the MNC’s cost of
financing.
• The interest rate for a specific currency is determined by the demand
for and supply of funds in that currency.
32
Why U.S. Dollar Interest Rates Differ from Brazilian Real
Interest Rates
Interest Interest S
Rate Rate
for $ S for Real
D
D
Quantity of $ Quantity of Real
• The curves are further to the right for the dollar because the U.S. economy is
larger.
• The curves are higher for the Brazilian Real because of the higher inflation in
Brazil.
33
Comparing Interest Rates Among Currencies
• As the demand and supply schedules change over time for a specific
currency, the equilibrium interest rate for that currency will also
change.
• Note that the freedom to transfer funds across countries causes the
demand and supply conditions for funds to be somewhat integrated,
such that interest rate movements become integrated too.
34
International Stock Markets
• In addition to issuing stock locally, MNCs can also obtain funds by
issuing stock in international markets.
• This will enhance the firm’s image and name recognition, and
diversify the shareholder base. The stocks may also be more easily
diversted.
• Note that market competition should increase the efficiency of new
issues.
35
International Stock Markets
• Stock issued in the U.S. by non-U.S. firms or governments are called
Yankee stock offerings. Many of such recent stock offerings resulted
from privatization programs in Latin America and Europe.
• Non-U.S. firms may also issue American depository receipts (ADRs),
which are certificates representing bundles of stock. ADRs are less
strictly regulated.
36
International Stock Markets
• The locations of the MNC’s operations can influence the decision
about where to place stock, in view of the cash flows needed to cover
dividend payments.
• Market characteristics are important too. Stock markets may differ in
size, trading activity level, regulatory requirements, taxation rate, and
proportion of individual versus institutional share ownership.
37
International Stock Markets
• Electronic communications networks (ECNs) have been created to
match orders between buyers and sellers in recent years.
• As ECNs become more popular over time, they may ultimately be
merged with one another or with other exchanges to create a single
global stock exchange.
38
Comparison of International Financial Markets
• The foreign cash flow movements of a typical MNC can be classified
into four corporate functions, all of which generally require the use of
the foreign exchange markets.
Foreign trade. Exports generate foreign cash inflows while imports
require cash outflows.
39
Comparison of International Financial Markets
Direct foreign investment (DFI). Cash outflows to acquire foreign
assets generate future inflows.
Short-term investment or financing in foreign securities, usually in
the Eurocurrency market.
Longer-term financing in the Eurocredit, Eurobond, or international
stock markets.
40
MNC Use of International Money and Capital Markets
41
Foreign Cash Flow Chart of an MNC
Foreign
MNC Parent Exchange
Transactions
Export/Import Dividend
Remittance Foreign
& Financing Exchange
Foreign
Medium- & Markets
Business Long-Term
Short-Term
Clients Financing
Investment Long-Term
Export/Import & Financing Financing
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
Cost of parent’s equity Cost of parent’s funds
in global markets borrowed in global markets
44
Exchange Rate Determination
Objectives
Value of £
S: Supply of £
$1.60
equilibrium exchange
$1.55
rate
$1.50
D: Demand for £
Quantity of £
Factors that Influence Exchange Rates
Assumption: Two Countries U.S. and Britain
Relative Inflation Rates
Expectations
Signal Impact on GHC
Poor Ghana economic indicators Weakened
BoG governor suggests MPC is Strengthened
unlikely to cut Ghana interest rates
A possible decline in German Strengthened
interest rates
Central banks expected to Weakened
intervene to boost the euro
Factors that Influence Exchange Rates
Interaction of Factors
• Trade-related factors and financial factors sometimes interact.
Exchange rate movements may be simultaneously affected by these
factors.
• For example, an increase in the level of income sometimes causes
expectations of higher interest rates.
Factors that Influence Exchange Rates
Interaction of Factors
• Over a particular period, different factors may place
opposing pressures on the value of a foreign
currency.
• The sensitivity of the exchange rate to these factors is
dependent on the volume of international
transactions between the two countries.
How Factors Can Affect Exchange Rates
Trade-Related
Factors
1. Inflation Ghana demand for foreign goods, i.e.
Differential demand for foreign currency
2. Income
Differential Foreign demand for Ghana goods, i.e.
3. Gov’t Trade supply of foreign currency
Restrictions
Exchange rate
between foreign
currency and the
Ghana cedi
m
n
E CFj , t ) E ER j , t )
j 1
Value =
t =1 1 k ) t
E (CFj,t ) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Practice Questions
1) Assume that a bank’s bid price for Canadian dollars is $.7938, while
its ask price is $.81. What is the bid/ask percentage spread?
2) Compute the forward discount or premium for the Mexican peso
whose 90-day forward rate is $0.102 and spot rate is $0.10. Sate
whether your answer is a discount or premium.
3) If a dollar is worth 1.7 Singapore dollars, what is the U.S dollar
value of a Singapore dollar?
4) Assume Poland’s currency (the zloty ) is worth $.17 and a Japanese
yen is worth $0.008. What is the cross rate of the zloty with respect
to yen? That is, how many yen equal a zloty?
Balance of Payment
• For a MNC both home and host country BOP data is important as:
• An indication of pressure on a country’s foreign exchange rate
• A signal of the imposition or removal of controls in various sorts of
payments (dividends, interest, license fees, royalties and other cash
disbursements)
• A forecast of a country’s market potential (especially in the short run)
4-24
Typical BOP Transactions
• Each of the following represents an international economic transaction that is
counted in and captured in BOP for Ghana:
• A Ghanaian subsidiary of a Japanese automobile manufacturer acts as a
distributor for the Japanese made automobiles in the Ghanaian market
• A Ghanaian-based firm manages the construction of a major water treatment
facility in an overseas country
• The Ghanaian subsidiary of a foreign firm pays profits (dividends) back to its
parent firm
• Overseas firms purchase raw materials in Ghana
• A Ghanaian tourist purchases souvenirs in an overseas country
• An overseas investor purchases a Ghanaian debt security through an investment
broker outside Ghana. Eurobond
IMF Balance of Payment Manual
• https://www.imf.org/en/Publications/Manuals-
Guides/Issues/2016/12/31/Balance-of-Payments-Manual-Sixth-
Edition-22588
• Section 152
Fundamentals of BOP Accounting
4-27
Fundamentals of BOP Accounting
• There are three main elements of the actual process of measuring
international economic activity:
1. Identifying what is and is not an international economic
transaction
2. Understanding how the flow of goods, services, assets, and
money create debits and credits to the overall BOP
3. Understanding the bookkeeping procedures for BOP accounting
• It is a daunting task to measure all international transactions that take
place in and out of a country over a year
4-28
The BOP as a Cash Flow Statement
• The BOP is often misunderstood as many people infer from its
name that it is a balance sheet, whereas in fact it is a cash flow
statement
• By recording all international transactions over a period of time
such as a year, it tracks the continuing flows of purchases and
payments between a country and all other countries
• It does not add up the value of all assets and liabilities of a
country on a specific date (as an individual firm’s balance sheet
would do)
4-29
The BOP as a Flow Statement
• Two types of business transactions dominate the balance of payments:
• Exchange of Real Assets (tangible assets, plant and Machinery)
• Exchange of Financial Assets ( financial securities, bonds etc)
• Although assets can be identified as belonging to distinct groups, it is
easier to think of all assets simply as goods that can be bought or sold (a
clock versus a bond)
4-30
The Accounts of the BOP
• The BOP is composed of two primary sub accounts, the
• Current Account and
• the Capital/Financial Account
• In addition, the Official Reserves account tracks government
currency transactions
• A fourth account, the Net Errors and Omissions account is produced
to preserve the balance of the BOP
4-31
Balance of Payments
• The current account summarizes the flow of funds between one
specified country and all other countries due to the purchases
of goods or services, the provision of income on financial
assets, or unilateral current transfers (e.g. government grants
and pensions, private remittances).
4-33
Balance of Payments
• The current account is commonly used to assess the balance of trade,
which is simply the difference between merchandise exports ( value of
goods provided to the rest of the world) and merchandise imports ( value
of goods received from the rest of the world).
Balance of Payments
• The new capital account includes unilateral current transfers ( one way
transfer of money) that are really shifts in assets, not current income. E.g.
debt forgiveness, transfers by immigrants, the sale or purchase of rights to
natural resources or patents.
• This account measures all international economic transactions of financial
assets. It is divided into two major components:
• The Capital Account
• The Financial Account
• The Capital Account is minor (in magnitude), while the Financial Account is
significant
Balance of Payments
• The financial account (which was called the capital account previously)
summarizes the flow of funds resulting from the sale of assets between
one specified country and all other countries.
• Assets include official reserves, other government assets, direct foreign
investments, investments in securities, etc.
• Financial assets can be classified in a number of different ways including
the length of the life of the asset (maturity) and the nature of the
ownership (public or private)
The Financial Account
• The Financial Account consists of three components;
• Direct Investment – in which the investor exerts some explicit
degree of control over the assets
• Portfolio Investment – in which the investor has no control over
the assets financial instruments
• Other Investment – consists of various short-term and long-term
trade credits, cross-border loans, currency deposits, bank deposits
and other Account receivable and Account payable related to
cross-border trade
4-37
Direct Investment
• This is the net balance of capital dispersed from and into Ghana for the purpose of
exerting control over assets.
• Foreign direct investment arises from 10% ownership of voting shares in a domestic
firm by foreign investors. The Ghana Investment Promotion Center (GIPC) has the
guidelines. Visit their website https://gipc.gov.gh/ for details and also GIPC Act, 2013
(Act 865).
• The source of concern over foreign investment in any country focuses on two topics:
control and profit.
• Some countries possess restrictions on what foreigners may own in their country.
• The general rule or premise is that domestic land, assets and industry should be
owned by residents of the country.
• Concerns over profit stem from the same argument.
4-38
Portfolio Investment
• The purchase of debt securities across borders is classified as
portfolio investment because debt securities by definition do not
provide the buyer with ownership or control.
4-39
Net Errors & Omissions / Official Reserves
Accounts
• The Net Errors and Omissions account ensures that the BOP actually balances.
• The Official Reserves Account is the total reserves held by official monetary
authorities within the country.
• These reserves are normally composed of the major currencies used in
international trade and financial transactions (hard currencies).
• The significance of official reserves depends generally on whether the country is
operating under a fixed exchange rate regime or a floating exchange rate system.
4-40
The BOP in Total
• A surplus in the BOP implies that the demand for the country’s
currency exceeded the supply and that the government should allow
the currency value to increase -in value - or intervene and accumulate
additional foreign currency reserves in the Official Reserves Account.
4-41
Year Variables ;Ghana Balance of Payment , source Bank of Ghana
2018 A. Current Account (US$'M) -2,043.90
2018 Merchandise Trade Balance (US$'M) 1,808.65
2018 Exports (f.o.b) (US$'M) 14,942.72
2018 Cocoa beans & Products (US$'M) 2,179.99
2018 Gold (US$'M) 5,435.71
2018 Timber & Timber Products (US$'M) 221.47
2018 Crude Oil (US$'M) 4,573.41
2018 Other Exports (US$'M) 2,532.14
2018 Imports (f.o.b) (US$'M) -13,134.07
2018 Non-oil (US$'M) -10,553.17
2018 Oil & Gas (US$'M) -2,580.90
2018 B. Balance on Services, Income and Transfers (US$'M) -3,852.55
2018 Services (net) (US$'M) -2,513.78
2018 Credit (US$'M) 7,571.99
2018 Debit (US$'M) -10,085.77
2018 Income (net) (US$'M) -3,921.81
2018 Credit (US$'M) 598.27
2018 Debit (US$'M) -4,520.09
2018 Transfers (net) (US$'M) 2,583.05
2018 Private (net) (US$'M) 2,564.34
2018 Official (net) (US$'M) 18.70
2018 C. Financial and Capital Account (US$'M) 1,500.42
2018 Capital (net) (US$'M) 257.76
2018 Direct investments (US$'M) 2,908.18
2018 Other investments (US$'M) -1,665.52
The BOP Interaction with Key Macroeconomic Variables
4-43
Factors Affecting-International Trade Flows
• Inflation
• A relative increase in a country’s inflation rate will decrease its
current account, as imports increase and exports decrease.
• National Income
• A relative increase in a country’s income level will decrease its
current account, as imports increase.
Factors Affecting International Trade Flows
• Government Restrictions
• A government may reduce its country’s imports by imposing tariffs on imported
goods, or by enforcing a quota. Note that other countries may retaliate by
imposing their own trade restrictions.
• Sometimes though, trade restrictions may be imposed on certain products for
health and safety reasons.
Factors Affecting International Trade Flows
• Exchange Rates
• If a country’s currency begins to rise in value, its current account balance will
decrease as imports increase and exports decrease.
• Note that the factors are interactive, such that their simultaneous
influence on the balance of trade is a complex one.
Correcting A Balance of Trade Deficit
• By reconsidering the factors that affect the balance of trade, some
common correction methods can be developed.
• For example, a floating exchange rate system may correct a trade
imbalance automatically since the trade imbalance will affect the
demand and supply of the currencies involved.
Correcting A Balance of Trade Deficit
• However, a weak home currency may not necessarily improve a trade
deficit.
• Foreign companies may lower their prices to maintain their competitiveness.
• Some other currencies may weaken too.
• Many trade transactions are prearranged and cannot be adjusted
immediately. This is known as the J-curve effect.
• The impact of exchange rate movements on intracompany trade is limited.
Trade Balance Adjustment to Exchange Rate Changes: The J-Curve
4-49
International Capital Flows
• Capital flows usually represent portfolio investment or direct foreign
investment.
• The Direct Foreign Investment (DFI) positions inside and outside the
Ghana have risen substantially over time, indicating increasing
globalization.
• In particular, both DFI positions increased during periods of strong
economic growth.
Factors Affecting DFI
• Changes in Restrictions
• New opportunities may arise from the removal of government barriers.
• Privatization
• DFI has also been stimulated by the selling of government operations.
• Potential Economic Growth
• Countries with higher potential economic growth are more likely to attract
DFI.
Factors Affecting DFI
• Tax Rates
• Countries that impose relatively low tax rates on corporate earnings are more
likely to attract DFI.
• Exchange Rates
• Firms will typically prefer to invest their funds in a country when that
country’s currency is expected to strengthen.
Factors Affecting International Portfolio Investment
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
E (CFj,t ) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
6
Government Influence On Exchange Rates
1
Chapter Objectives
• To describe the exchange rate systems used by various governments;
• To explain how governments can use direct and indirect intervention
to influence exchange rates; and
• To explain how government intervention in the foreign exchange
market can affect economic conditions.
2
Exchange Rate Systems
• Exchange rate systems can be classified according to the degree to
which the rates are controlled by the government.
• Exchange rate systems normally fall into one of the following
categories:
• fixed
• freely floating
• managed float
• pegged
3
Fixed Exchange Rate System
4
Online Application
• Find out more about the Bretton Woods conference and the
Smithsonian Agreement at:
• http://www.imfsite.org/origins/confer.html
• http://www.mises.org/money.asp
5
Fixed Exchange Rate System
• Pros: Work becomes easier for the MNCs.
• Cons: Governments may revalue their currencies. In fact, the dollar
was devalued more than once after the U.S. experienced balance of
trade deficits.
• Cons: Each country may become more vulnerable to the economic
conditions in other countries.
6
Freely Floating Exchange Rate System
• In a freely floating exchange rate system, exchange rates are determined
solely by market forces demand and supply.
• Pros: Each country may become more insulated against the economic
problems in other countries.
• Pros: Central bank interventions that may affect the economy unfavorably
are no longer needed.
• Pros: Governments are not restricted by exchange rate boundaries when
setting new policies.
• Pros: Less capital flow restrictions are needed, thus enhancing the
efficiency of the financial market.
7
Freely Floating Exchange Rate System
• Cons: MNCs may need to devote substantial resources to managing
their exposure to exchange rate fluctuations.
• Cons: The country that initially experienced economic problems (such
as high inflation, increasing unemployment rate) may have its
problems compounded.
8
Managed Float Exchange Rate System
• In a managed (or “dirty”) float exchange rate system, exchange rates are
allowed to move freely on a daily basis and no official boundaries exist.
However, governments may intervene to prevent the rates from moving
too much in a certain direction.
• Cons: A government may manipulate its exchange rates such that its own
country benefits at the expense of others.
9
Pegged Exchange Rate System
• In a pegged exchange rate system, the home currency’s value is
pegged to a foreign currency or to some unit of account, and moves
in line with that currency or unit against other currencies.
• The European Economic Community’s snake arrangement (1972-
1979) pegged the currencies of member countries within established
limits of each other.
10
Pegged Exchange Rate System
11
Pegged Exchange Rate System
12
Currency Boards
• A currency board is a system for maintaining the value of the local currency
with respect to some other specified currency.
• The currency board is a variant of the Pegged Exchange rate system
• Under a currency board, the management of the exchange rate and money
supply are given to a monetary authority that makes decisions about the
valuation of a nation's currency.
14
Exposure of a Pegged Currency to Interest
Rate Movements
• A country that uses a currency board does not have complete
control over its local interest rates, as the rates must be
aligned with the interest rates of the currency to which the
local currency is tied.
• Note that the two interest rates may not be exactly the same
because of different risks.
• A currency that is pegged to another currency will have to
move in tandem with that currency against all other
currencies.
• So, the value of a pegged currency does not necessarily reflect
the demand and supply conditions in the foreign exchange
market, and may result in uneven trade or capital flows.
15
Dollarization
16
A Single European Currency €
• In 1991, the Maastricht treaty called for a single European currency.
On Jan 1, 1999, the euro was adopted by Austria, Belgium, Finland,
France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal,
and Spain. Greece joined the system in 2001.
• By 2002, the national currencies of the 12 participating countries will
be withdrawn and completely replaced with the euro.
17
A Single European Currency €
• Within the euro-zone, cross-border trade and capital flows will occur
without the need to convert to another currency.
• European monetary policy is also consolidated because of the single
money supply. The Frankfurt-based European Central Bank (ECB) is
responsible for setting the common monetary policy.
18
A Single European Currency €
• The ECB aims to control inflation in the participating countries and to
stabilize the euro within reasonable boundaries.
• The common monetary policy may eventually lead to more political
harmony.
• Note that each participating country may have to rely on its own
fiscal policy (tax and government expenditure decisions) to help solve
local economic problems.
19
A Single European Currency €
• As currency movements among the European countries will be
eliminated, there should be an increase in all types of business
arrangements, more comparable product pricing, and more trade
flows.
• It will also be easier to compare and conduct valuations of firms
across the participating European countries.
20
A Single European Currency €
• Stock and bond prices will also be more comparable and there should
be more cross-border investing. However, non-European investors
may not achieve as much diversification as in the past.
• Exchange rate risk and foreign exchange transaction costs within the
euro-zone will be eliminated, while interest rates will have to be
similar.
21
A Single European Currency €
• Since its introduction in 1999, the euro has declined against many
currencies.
• This weakness was partially attributed to capital outflows from
Europe, which was in turn partially attributed to a lack of confidence
in the euro.
• Some countries had ignored restraint in favor of resolving domestic
problems, resulting in a lack of solidarity.
22
Government Intervention
23
Government Intervention
24
Government Intervention
25
Nonsterilized Intervention
Bank of Ghana
To $ GHC
Strengthen
the GHC: Banks participating
in the foreign
exchange market
Bank of Ghana
To Weaken $ GHC
the GHC:
Banks participating
in the foreign
exchange market 26
Sterilized Intervention
GHC
Bank of Ghana
To Weaken $ GHC Financial
T- securities
the GHC: institutions
Banks participating that invest
in the foreign in Treasury
exchange market securities
27
Government Intervention
28
Government Intervention
29
Government Intervention
• Governments may also use foreign exchange controls (such as
restrictions on currency exchange) as a form of indirect intervention.
30
Online Application
• During the 1997-98 Asian financial crisis, some governments
intervened in an attempt to control their exchange rates. Find out
more about the crisis (and the consequences of the intervention
efforts) at http://www.stern.nyu.edu/globalmacro/.
31
Exchange Rate Target Zones
• Many economists have criticized the present exchange rate
system because of the wide swings in the exchange rates of
major currencies.
• Some have suggested that target zones be used, whereby an
initial exchange rate will be established with specific
boundaries (that are wider than the bands used in fixed
exchange rate systems).
• The ideal target zone should allow rates to adjust to
economic factors without causing wide swings in
international trade and fear in the financial markets.
• However, the actual result may be a system no different
from what exists today.
32
Intervention as a Policy Tool
• Like tax laws and money supply, the exchange rate
is a tool which a government can use to achieve its
desired economic objectives.
• A weak home currency can stimulate foreign
demand for products, and hence local jobs.
However, it may also lead to higher inflation.
• A strong currency may cure high inflation, since the
intensified foreign competition (import increase)
should cause domestic producers to refrain from
increasing prices. However, it may also lead to
higher unemployment
33
Impact of Government Actions on Exchange Rates
Government
Monetary
and Fiscal Policies
Direct Intervention
Indirect Intervention
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent 35
Chapter Review
• Exchange Rate Systems
• Fixed Exchange Rate System
• Freely Floating Exchange Rate System
• Managed Float Exchange Rate System
• Pegged Exchange Rate System
• Currency Boards
• Exposure of a Pegged Currency to Interest Rate and Exchange Rate
Movements
• Dollarization
36
Chapter Review
37
Chapter Review
• Government Intervention
• Reasons for Government Intervention
• Direct Intervention
• Indirect Intervention
• Exchange Rate Target Zones
38
Chapter Review
39
Interest Rate Parity and International Arbitrage
1
Learning Objectives
To explain the conditions that will result in
various forms of international arbitrage, along
with the realignments that will occur in
response; and
To explain the concept of interest rate parity,
and how it prevents arbitrage opportunities.
2
International Arbitrage
• Arbitrage can be loosely defined as
capitalizing on a discrepancy in quoted prices
to make a riskless profit.
• The effect of arbitrage on demand and supply
is to cause prices to realign, such that no
further risk-free profits can be made.
3
International Arbitrage
• As applied to foreign exchange and
international money markets, arbitrage takes
three common forms:
– locational arbitrage
– triangular arbitrage
– covered interest arbitrage
4
Locational Arbitrage
• Locational arbitrage-The process of buying a currency
at location where it is priced cheaply and immediately
selling it at another location where the price is higher.
5
Triangular Arbitrage
• Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from spot rate quotes.
• Cross exchange rates represents the relationship between two currencies that are different from the chosen base currency.
Example Bid Ask
British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $.200 $.202
British pound (£) MYR8.10 MYR8.20
• Find the cross exchange rate
• If the rates are not equal then triangular arbitrage opportunity exist.
Bid
British pound (£) $1.60
Malaysian ringgit (MYR) $.200
British pound (£) MYR8.10
• There is a quotation for £ and MYR, test using the other rates
• Find the inverse form, $ in £ = 1/1.6=£0.625
$ in MYR=1/0.2=5MYR
Cross rate between £ /MYR
£0.625=5MYR make £ the subject
8MYR/£
Comparing £=8MYR to the quoted rate of MYR 8.1 presents arbitrage opportunity
6
Triangular Arbitrage
Example
a. What of $10,000 is at stake
1. Convert $10,000 to £ at 1.60=£6250
2. Sell £ for MYR at quoted 8.1= MYR 50625
3. Convert MYR 50,625 to $ at 0.2=$10125
Profit = $10125-$10,000
=$125
7
Triangular Arbitrage
US$
Value of £ in Value of
$ MYR in $
£ MYR
Value of
£ in MYR
9
Covered Interest Arbitrage
Example
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
Borrow $ at 3%, or use existing funds which
are earning interest at 2%.
Convert $ to £ at $1.60/£ and engage in a 90-day
forward contract to sell £ at $1.60/£.
Lend £ at 4%.
Note: Profits are not achieved instantaneously.
10
Question 1
• Suppose that the annual interest rate is 5% in
the US and 8% in UK and that the spot exchange
rate is $1.50/£. And the forward exchange rates,
with one year maturity is $1.48/£. Assume that
the arbitrager can borrow up to $1,000,000 or £
666,666, which is equivalent to $1,000,000 at
the current spot exchange rate.
a) Determine whether interest rate parity is currently
holding.
b) If IRP is not holding, how would you carryout CIA?
11
Solution
For( a)
Check if IRP exist
• (F/S)(1+i£)=(1.48/1.50)(1+8%)
• =(0.9866)(1.08)
• =1.0656
• Compared to 1.05≠1.0656 ie
• (1+i$)<(F/S)(1+i£),hence arbitrage exist
b)
Strategy borrower in US with low interest rate and lend /invest in the UK
• Borrow $1,000,000 at 5%=
Fv =1000000(1+5%)
=$1,050,000
• Covert to £ at spot rate 1.5= 1,000,000/1.5=£666,666.67
• Lend in UK @8% =£666,666.67(1+8%)=£720,000
Convert to $ at1.48=720,000*1.48=$1,065,600
Difference =$1,065,600-$1,050,000
Profit =$15,600
12
Question 2
• Suppose market condition is as follows:
• Three month interest in the US is 8% per annum.
Three month interest rate in Germany is 5% per
annum. Current spot exchange rate is €1.0114/$.
Three month forward exchange rate is €1.0101/$.
Assume that the arbitrager can borrow up to
$1,000,000 at the current spot exchange rate
equivalent € 1,011,400.
• What benefit can an Arbitrager make from this
market.
13
Interest Rate Parity (IRP)
• As a result of market forces, the forward rate
differs from the spot rate by an amount that
sufficiently offsets the interest rate
differential between two currencies.
• Then, covered interest arbitrage is no longer
feasible, and the equilibrium state achieved
is referred to as interest rate parity (IRP).
14
Derivation of IRP
• When IRP exists, the rate of return achieved
from covered interest arbitrage should equal
the rate of return available in the home country.
• End-value of a $1 investment in covered interest
arbitrage = (1/S)(1+iF)F
= (1/S)(1+iF)[S(1+p)]
= (1+iF)(1+p)
where p is the forward premium.
15
Derivation of IRP
• End-value of a $1 investment in the home
country = 1 + iH
• Equating the two and rearranging terms:
p = (1+iH) – 1
(1+iF)
i.e.
forward = (1 + home interest rate) – 1
premium (1 + foreign interest rate)
16
Determining Forward Premiums
Example
• Suppose 6-month ipeso = 6%, i$ = 5%.
• From the U.S. investor’s perspective,
p= (1+iH) – 1
(1+iF)
forward premium = 1.05/1.06 – 1 -.0094
• If S = $.10/peso, then
6-month forward rate = S (1 + p)
_
.10 (1 .0094)
$.09906/peso
17
Interest Rate Parity: Graphic Analysis
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
Z IRP line
2
B X
Forward -3 -1 1 3 Forward
Discount (%) Premium (%)
Y
A -2
W
-4 18
Interest Rate Parity: Graphic Analysis
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
Zone of potential covered
interest arbitrage by
foreign investors IRP line
2
Forward -3 -1 1 3 Forward
Discount (%) Premium (%)
-4 19
Test for the Existence of IRP
• To test whether IRP exists, collect actual
interest rate differentials and forward
premiums for various currencies, and plot
them on a graph.
• IRP holds when covered interest arbitrage is
not possible or worthwhile.
20
Interpretation of IRP
• When IRP exists, it does not mean that both
local and foreign investors will earn the same
returns.
• What it means is that investors cannot use
covered interest arbitrage to achieve higher
returns than those achievable in their
respective home countries.
21
Does IRP Hold?
• Various empirical studies indicate that IRP
generally holds.
• While there are deviations from IRP, they are
often not large enough to make covered
interest arbitrage worthwhile.
• This is due to the characteristics of foreign
investments, such as transaction costs,
political risk, and differential tax laws.
22
Relationships among Exchange Rates,
Inflation, and Interest Rates
23
Learning Objectives
24
Purchasing Power Parity (PPP)
• When a country’s inflation rate rises
relative to that of another country,
decreased exports and increased imports
depress the high-inflation country’s
currency.
• Purchasing power parity (PPP) theory
attempts to quantify this inflation –
exchange rate relationship.
25
PPP: Interpreting
• The absolute form of PPP is an extension of
the law of one price. It suggests that the prices
of the same products in different countries
should be equal when measured in a common
currency.
• The relative form of PPP accounts for market
imperfections like transportation costs, tariffs,
and quotas. It states that the rate of price
changes should be similar.
26
PPP Theory: Rationale
Suppose Ghanaian inflation > U.K. inflation.
Ghanaian imports from U.K. and
Ghanaian exports to U.K.
Upward pressure is placed on the £.
This shift in consumption and the £’s appreciation
will continue until
in Ghana: priceU.K. goods price Gh goods
in the U.K.: price Gh goods priceU.K. goods
27
PPP: Derivation
Assume that PPP holds.
Over time, inflation occurs and the exchange rate
adjusts to maintain PPP:
Ph Ph (1 + Ih )
where Ph = home country’s price index
Ih = home country’s inflation rate
Pf Pf (1 + If )(1 + ef )
where Pf = foreign country’s price index
If = foreign country’s inflation rate
ef = foreign currency’s % D in value
28
PPP: Derivation
PPP holds Ph = Pf and
Ph (1 + Ih ) = Pf (1 + If ) (1 + ef )
Solving for ef : ef = (1 + Ih ) – 1
(1 + If )
29
Simplified PPP Relationship
When the inflation differential is small, the PPP
relationship can be simplified as
e f Ih – If
Example: Suppose IG.H. = 9% and IU.K. = 5% .
Then eU.K. 9 – 5 = 4%
G.H consumers: D PG.H. = IG.H. = 9%
D PU.K. = IU.K. + eU.K. =5+4= 9%
U.K. consumers: D PU.K. = IU.K. = 5%
D PG.H. = IG.H. – eU.K. = 9-4=5%
30
Purchasing Power Parity: Graphic Analysis
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
4
PPP line
Increased
purchasing power C
of foreign goods
2 A
% D in the foreign
-3 -1 1 3
currency’s spot
Decreased rate
purchasing
-2 power of foreign
goods
B D
-4 31
PPP Theory: Testing
Conceptual Test
• Plot actual inflation differentials and exchange rate % changes
for two or more countries on a graph.
• If the points deviate significantly from the PPP line over time,
then PPP does not hold.
Statistical Test
• Apply regression analysis to historical exchange rates and
inflation differentials
32
PPP Theory: Testing
• Empirical studies indicate that the
relationship between inflation differentials
and exchange rates is not perfect even in
the long run.
• However, the use of inflation differentials
to forecast long-run movements in
exchange rates is supported.
33
Why PPP Does Not Occur
PPP does not occur consistently due to:
confounding effects
– Exchange rates are also affected by
differences in inflation, interest rates, income
levels, government controls and expectations
of future rates.
a lack of substitutes for some traded goods
34
International Fisher Effect (IFE)
• According to the Fisher effect, nominal risk-free
interest rates contain a real rate of return and
anticipated inflation.
35
International Fisher Effect (IFE)
• The international Fisher effect (IFE) theory
suggests that currencies with higher interest
rates will depreciate because the higher
nominal rates reflect higher expected inflation.
36
Derivation of the IFE
• According to the IFE, E(rf ), the expected effective
return on a foreign money market investment,
should equal rh , the effective return on a
domestic investment.
• rf = (1 + if )(1 + ef ) – 1
if = interest rate in the foreign country
ef = % change in the foreign currency’s value
• rh = ih = interest rate in the home country
37
Derivation of the IFE
• Setting rf = rh : (1 + if )(1 + ef ) – 1 = ih
• Solving for ef : e = (1 + ih ) _ 1
f
(1 + if )
% D in the foreign
-3 -1 1 3
currency’s spot
Higher returns from rate
investing in foreign
-2 deposits
B D
-4 40
Graphic Analysis of the IFE
• The point of the IFE theory is that if a firm
periodically tries to capitalize on higher
foreign interest rates, it will achieve a yield
that is sometimes above and sometimes
below the domestic yield.
41
Tests of the IFE
• If actual interest rates and exchange rate
changes are plotted over time on a graph, we
can see whether the points are evenly
scattered on both sides of the IFE line.
• Empirical studies indicate that the IFE theory
holds during some time frames. However,
there is also evidence that it does not hold
consistently.
42
Tests of the International Fisher Effect
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
IFE line
% D in the
-3 -1 1 3
foreign currency’s
spot rate
-2
-4 43
Tests of the IFE
• To test the IFE statistically, apply regression
analysis to historical exchange rates and
nominal interest rate differentials.
44
Why the IFE Does Not Occur
• Since the IFE is based on PPP, it will not hold
when PPP does not hold.
• In particular, if there are factors other than
inflation that affect exchange rates, exchange
rates may not adjust in accordance with the
inflation differential.
45
Comparison of the IRP, PPP, and IFE Theories
Purchasing
Power Parity (PPP)
46
Comparison of the IRP, PPP, and IFE Theories
47
Forecasting Exchange Rates
48
Learning Objectives
49
Why Firms Forecast
Exchange Rates
• MNCs need exchange rate forecasts for their:
– hedging decisions,
– short-term financing decisions,
– short-term investment decisions,
– capital budgeting decisions,
– earnings assessments, and
– long-term financing decisions.
50
Forecasting Techniques
• The numerous methods available for
forecasting exchange rates can be categorized
into four general groups:
technical,
fundamental,
market-based, and
mixed.
51
Technical Forecasting
• Technical forecasting involves the use of
historical data to predict future values.
– E.g. time series models.
• Speculators may find the models useful for
predicting day-to-day movements.
• However, since the models typically focus on the
near future and rarely provide point or range
estimates, they are of limited use to MNCs.
52
Fundamental Forecasting
• Fundamental forecasting is based on the
fundamental relationships between economic
variables and exchange rates.
– E.g. subjective assessments, quantitative
measurements based on regression models and
sensitivity analyses.
• Note that the use of PPP to forecast future
exchange rates is inadequate since PPP may not
hold and future inflation rates are also uncertain.
• “if the relative fundamentals are weak, the
exchange rate will expose you in the long run”
53
Fundamental Forecasting
• In general, fundamental forecasting is limited by:
– the uncertain timing of the impact of the factors,
– the need to forecast factors that have an immediate
impact on exchange rates,
– the omission of factors that are not easily quantifiable,
and
– changes in the sensitivity of currency movements to
each factor over time.
54
Market-Based Forecasting
• Market-based forecasting uses market
indicators to develop forecasts.
• The current spot/forward rates are often
used, since speculators will ensure that the
current rates reflect the market expectation
of the future exchange rate.
• For long-term forecasting, the interest rates
on risk-free instruments can be used under
conditions of IRP.
55
Mixed Forecasting
• Mixed forecasting refers to the use of a
combination of forecasting techniques.
• The actual forecast is a weighted average of
the various forecasts developed.
56
Forecasting Services
58
Forecast Performance Evaluation
• MNCs are likely to have more confidence in
their forecasts as they measure their forecast
error over time.
• Forecast accuracy varies among currencies. A
more stable currency can usually be more
accurately predicted.
• If the forecast errors are consistently positive
or negative over time, then there is a bias in
the forecasting procedure.
59
Graphic Evaluation of Forecast Performance
z
Region of
upward bias
(overestimation)
x
x z
Predicted Value
60
Graphic Evaluation
of Forecast Performance
• If the points appear to be scattered evenly on
both sides of the perfect forecast line, then
the forecasts are said to be unbiased.
• Note that a more thorough assessment can be
conducted by separating the entire period into
subperiods.
61
Comparison of Forecasting Methods
• The different forecasting methods can be
evaluated
– graphically – by visually comparing the
deviations from the perfect forecast line, or
– statistically – by computing the forecast errors
for all periods.
62
Forecasting Under Market Efficiency
• If the foreign exchange market is weak-form
efficient, then the current exchange rates
already reflect historical information. So,
technical analysis would not be useful.
63
Forecasting Under Market Efficiency
64
Forecasting Under Market Efficiency
• Nevertheless, MNCs may still find
forecasting worthwhile, since their goal is
not to earn speculative profits but to use
exchange rate forecasts to implement
policies.
• In particular, MNCs may need to determine
the range of possible exchange rates in
order to assess the degree to which their
operating performance could be affected.
65
Exchange Rate Volatility
66
Exchange Rate Volatility
67