MIB 2022 - Grenoble

International Financial
Risk Management
Mohamad Hassan Abou Daya
Email: Mohamad-hassan.abou-daya@grenoble-em.com

1
 Aims of the module
 To describe the multinational environment
 To focus on the financial risks inherent in
international business and the available opportunities
 To understand key issues and concepts of foreign
exchange and derivatives markets
 To familiarize with the hedging and financing using
derivatives in the multinational environment context
 To give tools to deal with the foreign exchange and
to manage the currency exchange risk

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 Outline
 Part 1 (6h) – chapters 1-2-4 (Shapiro, 9th or 10th ed)
Multinational corporation (MNC), arbitrage relationships

 Part 2 (6h)–chapters 7-8-9 (Shapiro, 9th or 10th ed)

Risks can be covered by derivatives. Foreign exchange
markets, foreign currency derivatives
(Session 3 on forward contracts; Session 4 on options)

 Part 3 (3h) – chapter 10 (Shapiro, 9th or 10th ed)

Foreign exchange risks fluctuations
3 – Example, Wrap-up, Q&A, sample final exam.
 Assessment

 Individual assessment – 50%

• Assign. 1- Due date OCT 8th (15%)
• Assign. 2 on Part 1 only: Due date OCT 12th(15%)
• Assign. 3 on all material: Due date OCT 27th (15%)
• A grade for in-class quizzes out of 20 (based on
the 5 sessions we have together)
• 1.5 hour exam OCT 13th(Last
session) – 40%
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 Reading list

 Textbook: Shapiro, A. Multinational financial

management, John Wiley.
 Additional reading material:
Eiteman, D., Stonehill, A. and Moffett, M.
Multinational Business Finance.

Slides follow the textbook and are developed

from slides of J.F. Greco, California State
5 University provided by J. Wiley & Sons.
 CHAPTER 1

Introduction: Multinational
Enterprise and Multinational
Financial Management

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 THE RISE OF THE MULTINATIONAL
CORPORATION

The MNC: A Definition

– a company with production and distribution facilities in more than
one country.
– with a parent company located in the home country and at least five
or six foreign subsidiaries
– high degree of strategic interaction.

The MNC’s Evolution - Reasons to Go Global:

1. More raw materials
2. New markets
3. Minimize costs of production
4. Share risks and profit
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 THE RISE OF THE MULTINATIONAL
CORPORATION

1- RAW MATERIAL SEEKERS

exploit markets in other countries
historically first to appear
British Petroleum
Exxon (previously known as Standard Oil)

2- MARKET SEEKERS
Produce and sell in foreign markets
Have heavy foreign direct investors
Represented today by firms such as:
88 IBM, MacDonald’s, Nestle, Levi Strauss
 THE RISE OF THE MULTINATIONAL
CORPORATION

3- COST MINIMIZERS - PRODUCTION

EFFICIENCY SEEKERS
seek lower-cost production abroad
Their motive: to remain cost competitive
Represented today by firms such as:
Texas Instruments
Intel
Seagate Technology
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 THE PROCESS OF OVERSEAS
EXPANSION

OVERVIEW:
A. Informal Exporting
B. Sales Subsidiary Creation of
Distribution System
C. Overseas Production
D. Licensing

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 THE PROCESS OF OVERSEAS
EXPANSION

A. Exporting
1. Minimal cost and risks
2. Low profits
3. Get to know the market
B. Sales Subsidiary / Creation of a Distribution System
1. Local office, warehouse system
2. Greater customer service, new service
facilities set up
3. Increased communication, marketing
activities within a company’s own distribution
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system
 THE PROCESS OF OVERSEAS
EXPANSION

C. Overseas Production
1. Realize full sales potential
2. Keep abreast of market developments
3. Fill orders faster
4. Greatest risk with greatest potential for profit
D. Licensing
1. Alternative to setting up local production (less
risk)
2. Relatively lower cash flow
12 3. Faster market entry time
 What is different about
International Financial Management?

MNC National Corporation

Culture Each foreign country’s culture is unique and Known culture
may be hard to understand
Corporate All regulations and institutional practices are Regulations are well-
Governance uniquely different known
Foreign High exposure to foreign exchange risk: Only through
Exchange Risk import/export/subsidiaries import/export
Political Risk High exposure Negligible
Complexity What Modified
is different
financeabout
theoriesInternational
like cost of capital Standard theories
computations
Financial to account for foreign
Risk Management? apply. No need for
complexities, use of derivatives, options, complex derivatives
futures, swaps…

Goal is still to maximize shareholder’s wealth

13 We focus on financial risk, currency risk, foreign exchange risk…
 CHAPTER 2

The Determination of
Exchange Rates
 Equilibrium Exchange Rates

The exchange rate

is the price of one unit of foreign currency
expressed as a certain price in local currency
For example, $.99/€ means the euro in the U.S. is worth $.99

Transactions Costs: Bid-Ask Spread used to

calculate the fee charged by the bank
 Spot rate: price of the currency for immediate
delivery
 Forward rate: price at which foreign exchange is
quoted for delivery at a specified future date
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 Travelex at Lyon Saint Exupery…

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 Equilibrium Exchange Rates

“Supply/demand” equilibrium
Foreign Currency Demand: derived from the demand
for foreign country’s goods, services, and financial
assets.
e.g., Americans demand German goods such as Mercedes autos
Foreign Currency Supply for euros:
- interpreted also as the demand for U.S.$
- derived from the demand of the Eurozone for
U.S. goods.
e.g. German demand for US goods such as Dell computers means
17 Germans must convert euros to US $ in order to buy.
 Equilibrium Exchange Rates

How Exchange Rates Change

1. Increased demand as more foreign goods are
demanded, more of the foreign currency is demanded
2. The price of the foreign currency in local currency
increases.
3. Home Currency Depreciation
a. Foreign currency more valuable than the home currency.
b. Conversely, the foreign currency’s value has appreciated
against the home currency.
Factors: Inflation rates, Interest rates, GNP growth rates
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 Equilibrium Exchange Rates

Example: Computing a Currency Appreciation or

depreciation of Euro against $
= (e1 - e0)/ e0
where e0 = value at 0 of 1 euro in dollars
e1 = value at 1 of 1 euro in dollars
 If it is positive: appreciation

 If it is negative: depreciation
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 Sample Problem

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 Sample Problem

If a currency falls by 20%, by how

much should it increase to get back
to the same level?

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 CHAPTER 4

Parity Conditions in International

Finance and Currency
Forecasting
 ARBITRAGE
AND THE LAW OF ONE PRICE

LAW OF ONE PRICE

Identical goods sell for the same price worldwide.
Also known as “no arbitrage condition”, “no free
lunch”, “arbitrage-free market”

Theoretical basis: If the prices after exchange-rate

adjustment were not equal, arbitrage for the goods
worldwide ensures that eventually they will.
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 ARBITRAGE
AND THE LAW OF ONE PRICE

Parity Conditions
1. Purchasing Power Parity (PPP)
2. Fisher Effect (FE)
3. International Fisher Effect (IFE)
4. Interest Rate Parity (IRP)

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 PURCHASING POWER PARITY

It states that spot exchange rates between currencies will

change to the differential in inflation rates between countries.
(relative version of PPP, most commonly used)
In other words, the exchange rate of one currency against
another will adjust to reflect changes in the price levels of the
two countries
In mathematical terms: et

1  ih 
t

e0 1  i f t

where et = future spot rate, e0 = spot rate,

ih = home inflation (price level increase in home country),
25 if = foreign inflation, t = the time period.
 EXAMPLE: Application of PPP

 Assume that US and Switzerland are running

inflation rates of 5% and 3% respectively, and
the spot rate is SFr1=$0.75

 Then, compute the best prediction for the

value in dollars of 1 SFr in 3 years using the
PPP relationship.

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 PURCHASING POWER PARITY
If purchasing power parity is expected to hold, then the
best prediction for the one-period spot rate should be

A more simplified but less precise relationship for 1 year

period is

that is,
the percentage change should be approximately
equal to the inflation rate differential.
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 EXAMPLE: Approximated PPP

 Assume that US and Switzerland are running

inflation rates of 5% and 3% respectively, and
the spot rate is SFr1=$0.75

 Then, compute the best prediction for the

value in dollars of 1 SFr in 1 year using the
PPP relationship and its approximation.

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 PURCHASING POWER PARITY
Implications of PPP:
the currency with the higher inflation
rate is expected to depreciate relative to
the currency with the lower rate of inflation

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 THE FISHER EFFECT (FE)

THE FISHER EFFECT (FE)

Definition:
states that nominal interest rates (r) are a
function of the real interest rate (a) and a premium (i)
for inflation expectations.

Exact (1+r)=(1+a)(1+i)
Approximate: r = a + i

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 THE FISHER EFFECT (FE)

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 THE FISHER EFFECT

Real Rates of Interest:

1. Should tend toward equality everywhere through arbitrage.
2. With no government interference nominal rates vary by
inflation differential or
rh - r f = i h - i f

According to the Fisher Effect: countries with higher inflation

rates have higher interest rates.
(The nominal interest rate differential should reflect the inflation
rate differential and expected rates of return are equal in the
32 absence of government intervention)
 THE INTERNATIONAL FISHER EFFECT

IFE STATES:
the spot rate adjusts to the interest rate differential
between two countries
IFE = PPP + FE
et (1  rh ) t

e0 (1  r f ) t

Simplified IFE equation (approximation) if rf is relatively small

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 SAMPLE QUESTION

Using IFE to forecast US$ and SFr rates

1 year interest rate is 2% on Swiss francs
and 7% on U.S. dollars.
1) If the current exchange rate is Sfr 1 =$0.91,
what is the expected future exchange rate in
one year?
2) If a change in expectations regarding future U.S.
inflation causes the expected future spot rate to
rise to Sfr 1 =$ 1.00, what should happen to the
U.S. interest rate (assuming swiss interest does
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not change)?
 THE INTERNATIONAL FISHER EFFECT

Implications of IFE
1. Currency with the lower
interest rate is expected to appreciate
relative to the one with a higher rate
2. Financial market arbitrage:
insures interest rate differential is an
unbiased predictor of change in future
spot rate.
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 INTEREST RATE PARITY THEORY

Forward rate F and spot rate S : where rh =

the home rate
rf = the foreign rate
 This formula can be easily interpreted / proved.
How?
The Theory states that approximately:
The forward premium or discount equals the
interest rate differential.
(F - S)/S = rh - rf
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 SAMPLE QUESTION

 Interest rates in the U.S. is 10% per annum

 Interest rates in Japan is 7% per annum
 Spot rate for Yen is 0.003800 $ per Yen
 What is the 90-day forward rate of Yen?

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 INTEREST RATE PARITY THEORY

Covered Interest Arbitrage

1. Conditions required: interest rate differential does not
equal the forward premium or discount
2. Funds will move to a country with a more attractive
rate.
Market pressures develop:
a. As one currency is more demanded spot and sold
forward
b. Inflow of fund depresses interest rates
38 c. Parity eventually reached
 COVERED INTEREST ARBITRAGE

Example of covered arbitrage

- Interest on British pounds is 12% in London
- Interest on U.S. $ is 7% in New York
- British pound spot rate is $1.95
- 1-year forward is $1.87

Assuming borrowing rate=lending rate, no bid-ask

spread on the spot and forward, explain how an
arbitrager can take to profit the discrepancy in rates
based on $1,000,000 or a 1,000,000 pounds
transaction and a one year horizon.
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 CHAPTER 7

The Foreign Exchange Market

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 INTRODUCTION

The Currency Market

Definition: a place where money denominated
in one currency is bought and sold with money
denominated in another currency

Participants in Spot and Forward Markets

commercial banks, brokers, customers of
commercial and central banks, arbitrageurs,
traders, hedgers, speculators

Most transactions come from electronic trading

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 ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET

SIZE OF THE MARKET

A. Largest financial market in the world
2007: US$3.2 trillion/day, US$800
trillion/year
B. Market Centers by Size (2007), daily turnover:
#1: London = $1.359 trillion

#2: New York= $664 billion

42 #3: Zurich= $242 billion
 THE MARKET

QUOTATIONS
1. Quotes can be found in all major newspapers,
and on data providers (bloomberg)
2. Major currencies have 4 different quotes:
a. spot price
b. 30-day forward
c. 90-day forward
d. 180-day forward
3. Direct/indirect quotes: Direct quote gives the
home currency price (always in the numerator)
of one unit of foreign currency. Example:
$1.81/£ (direct quote in the U.S. for the pound)
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 THE SPOT MARKET

Calculating Cross Rates (example)

Suppose you want to calculate the £/€ cross rate.
You know £.5556/US$ and €.8334/US$
then £ ______ / €

Currency Arbitrage (SPOT transactions)

1. If cross rates differ from one financial center
to another, and profit opportunities exist.
2. Buy cheap in one int’l market, sell at a higher
price in another
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 TRIANGULAR Currency Arbitrage

Example:
 Pound sterling is at $1.9422 in New York
 Euro is offered at $1.4925 in Frankfurt
 At the same time, London offers pounds at
1.2998Euros
Find an arbitrage strategy for a trader starting with
1,000,000 U.S. dollars.

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46
 THE FORWARD MARKET
Definition of a Forward Contract: an agreement
between a bank and a customer to deliver
- a specified amount of currency against another
currency
- at a specified future date and
- at a fixed exchange rate
Covered Interest arbitrage (Forward market arbitrage
strategy)
Main purpose of a Forward: Hedging

47 the act of reducing risk exposure

 Example:
Hedging with a Forward Contract

 U.S company buys textile from England

with 1,000,000 pounds due in 90 days.
 Spot price for pounds is $1.97
 Exposure to risk of a raise of the pound
against the dollar.
 Importer can hedge by immediately
negociating a 90 day forward at say $1.98
 Then, importer has to pay $1.98 million in
90 days.
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49
 FUTURES CONTRACTS

International Monetary Market (IMM) 1972: opened by

the Chicago Mercantile Exchange provides an outlet for
hedging currency risk with futures contracts.
Definition of a Futures Contract: contracts written
requiring a standard quantity of an available currency at
a fixed exchange rate at a set delivery date.
Available Futures: up to 20 different currencies
Transaction costs: commission
Maintenance Margins: When the account balance
falls below the maintenance margin, a margin call may
be necessary to maintain the minimum balance
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 FUTURES CONTRACTS

Global futures exchanges:

1. Chicago Mercantile Exchange (CME)
2. London International Financial Futures Exchange
(L.I.F.F.E.)
3. Chicago Board of Trade (C.B.O.T.)
4. Singapore International Monetary Exchange
(S.I.M.E.X.)
5. Deutsche Termin Bourse (D.T.B.)
6. Hong Kong Futures Exchange (H.K.F.E.)
51 7. New York Mercantile Exchange (NYMEX)
 FUTURES CONTRACTS

Forward vs. Futures Contracts

Basic Differences:
1. Trading Locations 5. Quotes
2. Regulation 6. Margins
3. Delivery 7. Credit risk
4. Size of contract 8. Transaction Costs

Advantages of Futures: Disadvantages of Futures:

1.) Easy liquidation 1.) Limited to major currencies
2.) Well-organized market 2.) Limited dates of delivery
52 3.) Low credit risk 3.) Rigid contract sizes
 Additional Example
 A Chinese company sells goods in the US
and will receive 100,000USD upon delivery in
6 months.
 Futures quotes: 180d Chinese
Renminbi/USD Futures 0.1566 USD/RMB
($1,000/contract)
 Spot price of 6.44 RMB/$
 What is the risk exposure of the Chinese
company?
53  How to hedge using futures?
CHAPTER 8

Options Markets
 Example of call option

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 CURRENCY OPTIONS

OPTIONS
Currency options offer another method to hedge
exchange rate risk
Definition: a contract from a writer (seller) that gives the
right not the obligation to the holder (buyer) to buy or sell
a standard amount of an available currency at a fixed
exchange rate for a fixed time period
Types:
- Calls give the owner the right to buy the currency
- Puts give the owner the right to sell the currency
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 CURRENCY OPTIONS
What is the premium?
the price of an option that the writer charges the buyer
Exercise Price
a. Sometimes known as the strike price.
b. The exchange rate at which the option holder can buy
or sell the contracted currency
Status of an option
a. In-the-money
Call: Spot > strike
Put: Spot < strike
b. Out-of-the-money
Call: Spot < strike
Put: Spot > strike
c. At-the-money
57 Spot = the strike
 CURRENCY OPTIONS

Expiration Dates of Currency Options (can be ignored

for the exam. All options in the class are European)
a. American: exercise date may occur any time up to the expiration
date.
b. European: exercise date occurs only at the expiration date and not
before.

Why Use Currency Options?

a. For the firm hedging foreign exchange risk when a future event is
very uncertain.
b. For speculators who profit from favorable exchange rate changes.

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 From a final exam (1/2)
 Carrefour will receive ¥125 million (Japanese yen) in
three months.
 It is thinking of buying 1 yen put option (contract size is
¥125 million) at a strike price of €0.008/ ¥ and with
maturity 3 months in order to protect against the risk of
changes in the value of the yen. The premium is €0.0005
per yen.
 Alternatively, Carrefour could take a short position in a
three‑month yen futures (contract size is ¥125 million) at
a price of €0.0079 per yen.
59  The current spot rate is ¥1 = €0.0078.
 From a final exam (2/2)

Suppose Carrefour 's treasurer believes that the most likely

value for the yen in 90 days is €0.00795, but the yen could
go as high as €0.009 or as low as €0.007.
a. Diagram Carrefour 's revenue in Euros with the strategy
with the put option and with the strategy with futures
within its range of expected prices
(€0.007/yen-€0.009/yen). Ignore transaction costs and
margins.
b. Calculate what Carrefour would gain or lose on the option
60 and futures positions if the yen settled at its most likely
 Two Additional Questions

 Redo the Example of the Chinese Company

at the end of previous chapter.
- Option to sell 100,000$ at 650,000RMB in 6
months is available for a premium of
13,000RMB

 How can the US company importing textile

from the UK implement a hedge using
options?
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Wrap Up Session

Risk Management of
Currency Risk
 Objectives of this last chapter

 Transaction and translation exposure

 Identify basic hedging strategies to manage
these risks.
– Forward market hedge
– Money market hedge
– Option market hedge
 Describe each strategy, its cost and future
cash flows, pros and cons

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 How does transaction risk arises?
(Chapter 10 – Shapiro)
1. Accounting or Translation Exposure:
arises when reporting and
consolidating financial statements
require conversion
from subsidiary to parent currency.

2. Transaction risk Exposure:

arises because exchange rate
changes alter the value of
future revenues and costs.
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 How Translation Risk Arises

 Translation Risk

Japan United States

£ Headquarters' £ Subsidiary
Subsidiary
Financials Consolidated Financials
Financials
¥ $
£

Subsidiary Financials Germany

65 €
 DESIGNING A HEDGING STRATEGY

DESIGNING A HEDGING STRATEGY

A. Hedging Strategy: a management
objective
B. Hedging: basic objective: Example:
reduce/eliminate volatility of earnings as a result of
exchange rate changes
C. Hedging exchange rate risk
1. Hedging is a cost, not a profit-center
2. Hedging should be evaluated as a
66 purchase of insurance.
 MANAGING TRANSACTION
EXPOSURE

METHODS OF HEDGING:
A. RISK SHIFTING, RISK SHARING
1. home currency invoicing
2. common in global business
3. firm will invoice exports in strong
currency, import in weak
currency
4. Drawback:
it is not possible with informed
67 customers or suppliers.
 MANAGING TRANSACTION
EXPOSURE
B. EXPOSURE NETTING: Money Market
Hedge (trident example, Chinese company
example hereafter):
a. offsetting exposures in one currency with
exposures in the same currency: gains and
losses on the two currency positions will offset
each other.
b. One cash flow can be offset by the same cash
flow of the opposite sign: Money market hedge.
C. USE OF CURRENCY DERIVATIVES: Forward
market hedge, Foreign currency options: Example of
Trident and sample exam
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