Some netiquette for this

Lecture...
▪ We want to see and hear you.
▪ When you're not speaking, please mute your
microphone.
▪ When you want to contribute by talking on the
microphone, please raise the hand icon or get
our attention in the chat.
▪ We strongly encourage your participation using
the chat, reactions, or the microphone.
▪ Very importantly, try and be in class!
Participation, engagement and practice are
requisite sine qua non for success in
FINA1141.
International
Business
Finance
(FINA1141)

Workshop 6:
Business
Internationalization
and the Exchange
Rate Markets
 Learning objectives

❑Analyse business internationalisation and the function

of foreign exchange markets.

❑Evaluate the relationship between the law of one price,

Purchasing Power Parity and Interest Rate Parity.

❑Examine the relationship between foreign exchange

markets and the risks of internationalisation.
Nature of the international business
 Nature and Meaning of Business Internationalisation

Business internationalization is the process through which a

company expands its operations beyond its domestic market to
engage in activities across borders. This can include various
strategies such as exporting products, establishing foreign
subsidiaries or branches, forming strategic alliances with foreign
partners, or setting up production facilities in other countries. The
goal of internationalization is typically to tap into new markets,
access resources, reduce costs, or diversify risks.
Examples of Internationalised companies:
1. Toyota Motor Corporation
2. Unilever
3. McDonald's Corporation
4. Samsung Electronics
5. Nestlé S.A.
6. Huawei Technologies Co., Ltd.
7. Apple Inc.
These companies have utilized various strategies to internationalize their operations, such as
forming joint ventures, establishing subsidiaries, acquiring local companies, and adapting their
products and marketing strategies to fit local cultures and preferences.
WHY DO BUSINESSES INTERNATIONALISE?
Presumably, businesses become international in a bid to achieve their
corporate objective of shareholder wealth maximisation. Here are some key
motivations:
▪ Market Expansion
▪ Resource Access
▪ Competitive Advantage
▪ Brand Recognition and Prestige
▪ Risk Management
▪ Strategic Alliances and Partnerships
 Foreign Exchange (Forex)
Foreign Exchange (Forex)
Foreign exchange, often abbreviated as Forex or FX, refers to the global
marketplace for buying and selling currencies. It involves the exchange of one
currency for another and plays a crucial role in international trade and
investment. Foreign exchange is essential for businesses, investors,
governments, and individuals who need to convert one currency to another for
various purposes, such as travel, commerce, or investing in foreign assets.

The forex market operates 24 hours a day, five days a week, across major
financial centres in different time zones, including London, New York, Tokyo,
and Sydney. Participants in this market include banks, financial institutions,
corporations, governments, central banks, hedge funds, and individual traders.
Foreign Exchange Rate (Forex Rate)
The foreign exchange rate, or forex rate, is the price at which one currency can be exchanged for
another. It indicates how much of one currency you need to pay to buy a unit of another currency.
Exchange rates are determined by various factors, including supply and demand dynamics in the
forex market, interest rates, inflation rates, political stability, economic performance, and market
speculation.
Example - Let's use the exchange rate of 1 GBP = 106 INR for this example.
Suppose you're a traveller from the UK visiting India, and you want to exchange 100 British pounds
into Indian rupees.
Using the given exchange rate:
100 GBP * 106 INR/GBP = 10,600 INR
So, with the exchange rate of 1 GBP = 106 INR, you'll receive 10,600 Indian rupees in exchange for
your 100 British pounds.
 How are foreign exchange rates determined?

Foreign exchange rates are determined by a variety of factors that reflect the
complex interplay of economic conditions, market sentiment, and geopolitical
developments. Here, we will explore how foreign exchange rates are influenced by
the supply and demand for currencies, the balance of payments, and interest rates.
1. Currencies Supply and Demand
Supply of Currency:
Exports and Imports: When a country exports goods and services, foreign buyers
must convert their currency into the exporter's currency, increasing demand for the
exporter’s currency. Conversely, when a country imports, it needs to exchange its
currency for the exporter's currency, increasing the supply of its own currency.
Demand for Currency:
Trade Flows: Higher demand for a country’s goods and services leads to higher
demand for its currency.
2. Balance of Payments
The balance of payments (BoP) is a comprehensive record of a country's economic transactions with the rest of the
world. It consists of two main accounts:
Current Account:
• Trade Balance: The difference between exports and imports of goods and services. A surplus (more exports
than imports) typically strengthens a currency, while a deficit (more imports than exports) weakens it.
• Net Income: Earnings on foreign investments minus payments made to foreign investors.
• Current Transfers: Includes remittances, foreign aid, and other unilateral transfers.
Capital and Financial Account:
• Capital Transfers: Capital Transfers: These involve the transfer of ownership of fixed assets or funds linked to
the purchase/sale of fixed assets. It also includes transfers such as the forgiveness of debt by one country to
another
• Financial Account: Records investments in financial assets, such as direct investment (FDI) and portfolio
investment. Inflows into the financial account can increase demand for the currency, while outflows can increase
supply.
3. Interest Rates
Interest rates, set by central banks, play a crucial role in determining foreign
exchange rates through their influence on investment flows and economic activity.
Influence of Interest Rates:
• Higher Interest Rates: Typically attract foreign capital seeking higher returns on
investments, increasing demand for the country's currency and potentially
leading to appreciation.
• Lower Interest Rates: Tend to deter foreign investment and can lead to
depreciation of the currency as investors seek higher returns elsewhere.
 THE RELATIONSHIP BETWEEN THE LAW OF ONE PRICE, PURCHASING POWER PARITY AND
INTEREST RATE PARITY.

The Law of One Price (LOP), Purchasing Power Parity (PPP), and Interest Rate
Parity (IRP) are fundamental concepts in international finance and economics that
describe the relationship between prices, exchange rates, and interest rates in
different countries.
Law of One Price (LOP)
The Law of One Price states that identical goods should sell for the same price when
expressed in a common currency, assuming no transportation costs or trade barriers.
If a good is priced differently in two countries, arbitrage opportunities will arise,
driving prices toward equality.
Let's consider a basic commodity like wheat. Suppose the current market price of wheat in Chicago is $5
per bushel, while in New York it's $5.50 per bushel. According to the Law of One Price, assuming no
transportation costs or other barriers to trade, these two prices should converge to be the same.
Now, if the price in Chicago remains at $5, but in New York, it rises to $6 per bushel, an arbitrage
opportunity arises. A trader could buy wheat in Chicago for $5 per bushel, transport it to New York, and
sell it for $6 per bushel, making a profit of $1 per bushel. This action would increase demand in
Chicago, causing prices there to rise, and increase supply in New York, causing prices there to fall, until
the prices in both cities converge to a single price, say $5.50 per bushel.

This example demonstrates how the Law of One Price works in an idealized market scenario. In
reality, factors like transportation costs, trade barriers, taxes, and different market conditions can
cause deviations from the one-price rule. However, the concept remains fundamental in
understanding market efficiency and arbitrage opportunities.
Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies
through a "basket of goods" approach. According to PPP, in an ideal market, the exchange rate between
two countries' currencies should equalize the price of a basket of goods and services in each country.
PPP is about figuring out what exchange rate would make the price of the basket of goods the same in
both countries.
Imagine you have £100. In the London, you might use this £100 to buy a certain basket of goods—say, a
mix of groceries, a movie ticket, and some household items. Now, if you were in another country, like
India, the same basket of goods might cost you the equivalent of 200 Indian Rupees.
So, if the basket costs £100 in London and 200 Indian Rupees in India, PPP would suggest that the
exchange rate should be 1 British pound sterling to 2 Indian Rupees.
Cost in India (INR) 200 INR
PPP Exchange Rate = = = 2 INR
Cost in London(In GBP) 100 USD
This means that 1 British Pound should have the same purchasing power as 2 Indian Rupees.
Interest Rate Parity (IRP) is a financial theory that suggests that the difference in interest rates between
two countries should equal the difference between the forward exchange rate and the spot exchange
rate. In other words, IRP posits that in a world with perfect capital mobility, investors should not be
able to earn arbitrage profits by borrowing in one currency, converting it at the spot rate, investing it in
another currency at the prevailing interest rate, and then converting it back to the original currency at
the forward rate.
Example- Imagine you have $100, and you're considering two options:
1. Option A: You could deposit your $100 in a US bank account that offers a 3% annual interest rate.
2. Option B: You could convert your $100 into euros and deposit it in a European bank account that
offers a 1% annual interest rate.
Now, let's assume a spot exchange rate of 1 USD = 1 EUR and a forward exchange rate of 1 USD =
1.02 EUR.
According to IRP, the difference in interest rates between the US and Europe (2%) should equal the
difference between the forward and spot exchange rates (0.02 EUR).
Let's calculate the returns for each option:
1. Option A: You deposit $100 in the US bank account at a 3% interest rate for a year. After one year, you will
have $103.
2. Option B: You convert your $100 into euros at the spot exchange rate of 1 USD = 1 EUR, giving you €100. You
deposit €100 in the European bank account at a 1% interest rate for a year. After one year, you'll have €101.
Now, you convert your euros back into dollars at the forward exchange rate of 1 USD = 1.02 EUR, giving you
approximately $103.02
Now, let's compare the differences:
• Difference in interest rates: 3% - 1% = 2%
• Difference between forward and spot exchange rates: 1.02 - 1 = 0.02 EUR
• Option A (US bank account): $103
• Option B (European bank account with currency conversion): $103.02
In this example, both options yield similar returns, demonstrating the principle of Interest Rate Parity (IRP), where
the difference in interest rates between two countries equals the difference between the forward and spot exchange
rates.
The Relationship Between the Law of One Price, Purchasing Power Parity
And Interest Rate Parity.
Purchasing Power Parity and Interest Rate Parity are both based on the idea of
arbitrage – the process of exploiting price differences between markets. When
exchange rates or interest rates deviate from what the theories suggest they should
be according to PPP and IRP, arbitrage opportunities arise. Traders will buy and
sell currencies or financial assets to take advantage of these deviations, which
should eventually bring prices, exchange rates, and interest rates back into
alignment with the principles of PPP and IRP. Thus, the three concepts are
interconnected through the broader idea of market efficiency and the tendency of
markets to correct deviations from equilibrium.
 THE RELATIONSHIP BETWEEN FOREIGN EXCHANGE MARKETS AND THE
RISKS OF INTERNATIONALISATION.
1. Currency Risk
Risk:
• Exchange Rate Fluctuations: Changes in exchange rates can significantly impact
the value of international investments, affecting revenues, expenses, and
profitability.

Hedging Strategies:
Forward Contracts: With a forward contract, you agree on an exchange rate now
for exchanging your money in the future. This means you "lock in" the rate, so even if
the value of your money changes later, you'll still get the agreed-upon rate.
2. Political and Regulatory Risk
Risk:
• Political Instability: Changes in government policies, regulations, or
geopolitical events can impact the stability and profitability of international
operations.
Hedging Strategies:
• Political Risk Insurance: Purchase insurance to protect against losses due to
political events
• Diversification: Spread investments across multiple countries to reduce
exposure to any single country’s political and regulatory risks.
3. Economic Risk
Risk:
• Economic Downturns: Economic cycles and recessions in foreign markets can impact
consumer demand, business investment, and overall economic conditions.

Hedging Strategies:
• Macro-Economic Analysis: Monitor economic indicators and forecasts in target markets
to anticipate economic trends and adjust investment strategies accordingly.
4. Operational Risk
Risk:
• Supply Chain Disruptions: Complex international supply chains are vulnerable to disruptions
from logistical challenges, political events, natural disasters, or labor disputes.

Hedging Strategies:
• Supply Chain Diversification: Diversify suppliers and logistics partners across different
regions to reduce the risk of disruptions.