international finance by jeff madura

international finance by jeff madura

Module 1: The World of International Finance and the Multinational Corporation

I. The World of International Finance and the Globalization of International Financial Markets:

A. The World of International Finance

B. Globalization of Capital Markets

II. The Multinational Corporation

A. The Multinational Corporation and its Goal

B. Conflicts and Constraints in Implementing the Goal

III. Theories of International Business

A. Theory of Comparative Advantage

B. Imperfect Markets Theory

C. Product Cycle Theory

IV. Methods of International Business

V. Multinational Firm versus Domestic Firm

A. Marginal Return on Projects

B. Marginal Cost of Capital

C. Size of the Firm

VI. Risks of International Business

A. Exchange Rate Risk

B. Business Risk

C. Political Risk

VII. Answers to Questions Raised in the Lecture

Module 2: Foreign Exchange Markets

I. Introduction

II. Need for Foreign Currencies

III. Spot Markets versus Forward Markets

IV. Direct Quotes versus Indirect Quotes

V. Computing Percent Change for a Foreign Currency

VI. Bid, Ask Prices and Bid/Ask Percent Spread

VII. Cross Exchange Rates

VIII. Currency Forward Contracts and Forward Premium/Discount

IX. Currency Futures

X. Currency Options

XI. Questions and Problems

Module 3: Arbitrage and the Theory of Interest Rate Parity

I. International Arbitrage and Interest Parity

A. International Arbitrage

1. Locational Arbitrage

2. Triangular Arbitrage

3. Covered Interest Arbitrage

B. Theory of Interest Rate Parity

II. Purchasing Power Parity

III. International Fisher Effect

Module 4: Forecasting Exchange Rates

I. Why Multinationals Forecast Exchange Rates?

II. Forecasting Techniques

A. Technical Forecasting

B. Fundamental Forecasting: Regression Approach

C. Market Based Forecasting

D. Mixed Forecasting

III. Forecast Performance of Consulting Firms

IV. Assessment of Forecast Accuracy Over Time

V. A Comprehensive Regression Example

VI. Forecasting Performance and Market Efficiency

VII. Questions and Problems

Module 5: Currency Futures, Forward Contracts, and Options

I. Currency Futures

A. Interpreting Currency Futures Quotes

B. Speculating with Currency Futures

C. Hedging with Currency Futures

II. Forward Contracts and Hedging

III. Currency Options

A. Call Options

1. Interpreting Currency Call Option Information

2. Speculating with Call Options

3. Hedging Payables with Call Options

4. Factors Affecting Call Option Premium

B. Put Options

1. Interpreting Currency Put Option Information

2. Speculating with Put Options

3. Hedging Receivables with Put Options

4. Factors Affecting Put Option Premium

Module 6: The Nature and Control of Foreign Exchange Risk

I. Foreign Exchange Risk and Types of Foreign Exchange Risk

II. Relevance of Exchange Rate Risk

III. Types of Foreign Exchange Risk

IV. Managing Transaction Exposure

A. Identification of Net Transaction Exposure

B. Forecast of Exchange Rates and the Decision to Hedge or not to Hedge

C. Techniques for Managing Transaction Exposure

D. Comprehensive Examples of Hedging Transaction Exposure

1. Hedging Payables

a. Forward Contract Hedge

b. Money Market Hedge

c. Currency Call Option Hedge

d. No Hedge

2. Hedging Receivables

a. Forward Contract Hedge

b. Money Market Hedge

c. Currency Put Option Hedge

d. No Hedge

E. Managing Long-term Transaction Exposure

F. Other techniques to Manage Transaction Exposure

V. Managing Economic Exposure

A. Diversifying Operations

B. Diversifying Financing Globally

VI. Questions and Problems

Module 7: Case Analysis of Foreign Exchange Risk Management: Lufthansa

I. Evaluation of Hedging Alternatives

A. Remaining Uncovered

B. Full Forward Cover

C. Partial Forward Cover

D. Foreign Currency Options

E. Buy Dollars Now

II. The Decision

A. The Rise of DM

B. The Fall of DM

C. How It Came Out?

D. Questions

Module 8: Corporate Use of Innovative Foreign Exchange Risk Management

Products

I. Characteristics of Respondent Corporations

II. Use of Foreign Exchange Risk Management Products

III. Differences Across Industries

IV. Influence of Firm Size and Degree of International Involvement

V. Summary

VI. Questions for Fxrisk News Group Discussion

Module 1 : The World of International Finance and Multinational Corporations

"What is prudence in the conduct of every private family can scarcely be folly in that of great kingdom If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in way in which we have some

advantage" (Smith, The Wealth of Nations, 1776)

Objectives and Theme:

Our first objective is to discuss the exciting world of Global Financial Markets; our second objective is to learn the Characteristics of the Multinational Corporation (MNC); we find that MNCs have goals similar to that of the purely Domestic Corporation (DC); however, they have a wider variety of opportunities around the globe With additional opportunities come increased potential returns and other forms of risk to consider The potential benefits and risks are introduced and explained

Globalization of Financial Markets

For more than 25 years, there has been an increasing globalization of the world financial markets A worldwide financial network of financial centers consisting of London, New York, Tokyo, Frankfurt, Zurich, Hong-Kong, Paris, Amsterdam etc., has evolved This has led to the global presence of international financial institutions, increased financial integration, and a rapid evolution of innovative new financial products

Increased flows of world capital intensifies competition among nations, leading to deregulation of domestic financial markets and further liberalization of capital movements around the globe Financial integration refers to the elimination of barriers between domestic and international financial markets and the development of many linkages between these market sectors As a result, financial capital flows unrestricted between the two markets, enhancing various borrowing, lending, and investing activities On the innovative side, there has been the creation of new financial instruments and technologies Some of these instruments include Eurodollar CDs, zero-coupon Eurobonds, syndicated Eurocurrency loans,

interest and currency swaps, and floating rate notes Technological innovations in telecommunications, information dissemination, and computers have accelerated and reinforced this trend toward globalization

The Multinational Corporation

Multinational Corporation (MNC) and its goal:

We can define an MNC simply as a corporation operating in more than one country

The goal or objective of the MNC should be the maximization of stockholders' wealth or the stock price This objective is the same for purely domestic corporations as well

Stockholder Wealth equals Stock Price * # of Shares Outstanding

Maximizing the Shareholders' Wealth confers the following Advantages:

1 It considers the Time Value of Money

How does the stock price maximization objective consider the time value of money ?

The answer to this question is at the end of this Module

2 It also considers the riskiness of the cash flows of the MNC

How does maximizing stock price consider the riskiness of cash flows ?

The answer to this question is at the end of this Module as well

An idea of the biggest Fortune 500 global industrial and service companies ranked by various criteria can

be obtained from visiting Fortune The global 500 corporations have been ranked by revenues; there is also a country wide ranking available using various criteria

Based on the information from the Fortune list of Global 500, please check your knowledge by answering the following questions

1 Can you name the company that recorded the highest profit increase within the lastest year or quarter?

2 Which company headed the list in terms of revenues? And how much was the revenue of that company?

3 Which US company had the highest revenue within the lastest year or quarter? What was its rank

in terms of revenue in the previous year or quarter?

4 In the Pharmaceuticals industry, which company led the list in terms of revenues for the latest year or quarter? And what was its revenue?

Conflicts and Constraints in Implementing the Goal

Conflicts: In the corporate form of organization, stockholders are the true owners of the corporation There

are often millions of stockholders for a given corporation, and, therefore, stockholders select managers to operate and manage the corporation from day-to-day In this setup, the stockholders are the principals, and the managers are the agents Thus, there is an agency relationship between the stockholders and the managers Sometimes the managers, instead of acting in the best interests of stockholders, may act

to maximize their own interests For example, the top manager may go for a corporate jet, install his office

in a penthouse suite overlooking the Hudson river, install plush carpeting, or hire a pretty secretary These problems are called agency problems, and the costs are called agency costs These agency costs affect the cash flows and, therefore, the stock price

Because MNCs have subsidiaries around the globe and often have several layers of management, the agency costs of an MNC are higher than for purely domestic corporations

Constraints: The constraints in implementing the goal of the MNC are:

1 Environmental: Each country imposes its own environmental regulations,

2 Regulatory: Each host country can enforce taxes, earnings remittance restriction, job protection, and

3 Ethical: There is no consensus standard of business conduct that applies to all countries A business practice that is considered to be unethical in the U.S may be totally ethical in another country

All of these constraints add additional costs to the MNC and increase the cost of doing business These constraints can act as a drag on the goal of maximizing stockholder wealth

Theories of International Business

Theory of Comparative Advantage - Specialization: Specialization of products and services can increase

both individual and global efficiency Since specialization in some products may result in no production of some goods in a given country, there is a need for international business or trade

For example, consider a two country world of the USA and Japan Let us assume that Japan can produce television sets of comparable quality at a cheaper price than the US Let us also assume that the US has cost advantages in the production of automobiles In this setup, the US will import television sets from Japan, while Japan will import automobiles from the US Since both products are produced at the lowest possible cost, global efficiency is enhanced

Imperfect Markets Theory: Due to imperfect markets and the resulting immobility of resources, resources

cannot be easily and freely retrieved by the MNC Consequently, the MNC must sometimes go to the resources rather than retrieve resources such as low cost land, labor etc

An example would be US auto manufactures setting-up factories in Mexico to take advantage of the cost labor there

low-Product Cycle Theory: A firm is likely to market its product first in the home country due to the ready

availability of information about markets and competitors As the market in the home country matures, the corporation, seeking foreign demand, initially exports its product After learning more about the foreign country and how to gain advantage over competitors in foreign countries, the firm opens production facilities overseas

Figure # 1 provides a flow chart of Product Cycle Theory

Note: This Figure is reproduced from permission from International Financial Management, Sixth Edition, Jeff Madura Copyright © 2000 by West Publishing Company All Rights Reserved.

Question: Do you think that the three theories of international business, Theory of Comparative Advantage, Imperfect Markets Theory, and Product Cycle Theory, are complementary or competitive? Provide justification for your answer

Methods of International Business

International Trade: Exporting: A business firm may maintain its production facilities within the territory of

its home nation and export its products to foreign countries Exporting is a safer way to break into a new market since there is less to lose if the strategy fails The advantage of this approach is lower fixed production costs; but, the disadvantage is higher transportation costs

Direct Foreign Investment (DFI): A business firm located in one country may acquire facilities that enable

it to produce a product or render a business service within the territory of another country An MNC may initiate DFI by either establishing a new subsidiary, opening a factory or purchasing an existing company

in that country An essential element of DFI is the investor's involvement in the management of the productive assets The investor has total managerial control

Licensing: In a licensing arrangement, one business firm, the licensor, makes certain resources or

"inputs" available to another business firm, the licensee The availability of these inputs makes it possible for the licensee to produce and market a product or service similar to that which the licensor has been producing As the goods are sold, or services rendered, a portion of the revenues, as specified by the agreement, are sent to the licensor Franchising is a form of licensing that has spread rapidly throughout the world in recent years The best-known and most successful international franchisors have been the fast-food chains such as Kentucky Fried Chicken, Burger King, and McDonald's

Advantages: 1) Low cost and 2) low risk

Disadvantages: 1) The local firm in the host country may attempt to export the goods to another country, which may reduce sales of the licensing corporation, 2) It is difficult to ensure quality control of the local firm's production process, and 3) Technology secrets provided to the local firm may leak out to competitive firms in that country

Joint Venture: In the case of joint venture, two or many firms combine to create a subsidiary Usually,

each firm provides the resources in which it has the advantage For example, a corporation in a developing country can combine with a US based MNC to gain technological advantages The US firm, in turn, gains a foothold in the country and gains a market share

Impact of Foreign Opportunities on Firm Size

MNCs have cost advantages over domestic corporations, and, therefore, the cost of capital for MNCs is cheaper than that for domestic corporations (DCs) Also, MNCs have greater opportunities for more profitable projects; that is, the marginal rate of return from a project is higher for the MNC as opposed to the DC Besides, MNCs have additional opportunities With higher return, lower cost, and additional opportunities, an MNC is likely to attain a larger size compared to a DC

Figure # 2 provides information on the marginal return and marginal cost for MNC and DC

Question: Do you know why the marginal cost of capital curve (MCC) is upward sloping?

The optimal size of an MNC will be determined by a variety of factors, such as the economic and political environment of the foreign governments, MNC's product line, operating characteristics, risk-return preference, and industry type, etc.

Risks of International Business

Exchange Rate Risk: Exchange Rate Risk is defined as the variability in home-country cash flows due to

the fluctuations in the host-country exchange rates This risk can affect both the revenues and costs of an MNC negatively For example, consider the following example:

ABC Corporation (US based MNC) has DM 100 million in 90-day payables owed to a German firm for imports from the firm Suppose, the exchange rate right now (t=0) = $0.661 per DM Based on this exchange rate, ABC anticipated an outflow of $66.1 million The exchange rate at t=+90 days when the payable bill was paid, turned out to be $0.75 per DM

Given:

ABC Corporation (US-based MNC) has DM 100 million in 90-day Payables

90-day Payables DM 100 Million

Spot Exchange Rate $/DM 0.661 0.75

In this case, ABC Corporation paid $ 8.9 million more than it anticipated to pay at time=0; the DM appreciated, thereby increasing the $ cost of the payables in DM This is the exchange rate risk that the MNCs face in handling their foreign currency flows This risk arises from the need to convert the cash flows from one currency to another If there is no need to convert the currency, MNCs will not face exchange rate risk

Question for interactive table above

Please change the t=+90 days exchange rate from $0.75 per DM to:

1 $0.50 per DM

2 $1.00 per DM

What happens to the $ outflow cost in 1 and 2 above? Does what unfolds in scenario #1 above constitute

an exchange rate risk?

Question: If there were a single Currency through out the globe, MNCs would not face the daunting problem of exchange rate risk What do you think of this idea? Is it feasible? Could it create other problems?

Political Risk: Some examples of political risk include: 1) nationalization or being taken-over without

receiving adequate compensation 2) Restrictions by host country governments on remittances to the parent company, 3) Change in taxation policies in mid-stream

In addition, the form of the government, its stability and the form of the legal system etc will affect the political risk of a country

Business Risk: Business risk arises from host country business and economic conditions Slowing or

weakening Japanese and European markets often leads to reduced demand for products of U.S MNCs

in these markets, thereby, contributing to the business risk of the U S MNCs

Summary

In this module, we learned about some features of the World of International Finance and we noted the increasing globalization trend sweeping the markets In addition, we looked at the characteristics of the Multinational Corporation and its objective; in the context of the MNC, we discussed the theories of international business: Theory of Comparative Advantage, Imperfect Markets Theory, and Product Cycle Theory In addition, we also compared and contrasted multinational corporations with purely domestic corporations with regard to return and risk; it turns out that multinational corporations enjoy higher possible returns, but they also face more risks

Answers to Questions Raised in the Lecture

1 How does the objective of stock price or stockholder wealth maximization consider the time value

of money?

Stock price is the present value of all expected future cash flows of the corporation Therefore, maximizing stock price automatically considers the time value of money

2 How does the objective of stock price or stockholder wealth maximization consider the riskiness

of cash flows as well?

In finding the present value of the cash flows to arrive at the stock price of the corporation, depending on the riskiness of the cash flows, one can use different discount rates: if the risk is higher, one can use a higher discount rate, and if the risk is lower, one can use a lower discount rate Thus, the objective of stock price maximization considers the riskiness of cash flows as well

3 Are the three theories of international business complementary or competitive?

The three theories are more complementary rather than competitive The three theories address different dimensions of international business

4 If there were a single currency throughout the globe, there would not be exchange rate risk What

do you think about its feasibility ? What other problems could that create?

If we had a single currency, the sovereignty of each country as we know it today would be violated The ability of the Central Bank of each country to control monetary policy and affect exchange rates, and inflation etc would be affected as well We are already witnessing these kinds of problems with the European integration and its single currency ECU evolution

5 Why is the marginal cost of capital (MCC) upward sloping?

If a corporation has debt in its capital structure, it is inherently risky, and, therefore, the banks will

be willing to lend additional money only at higher interest rates That is why the MCC is upward sloping

END OF MODULE 1

Module 2: Foreign Exchange Markets

Objectives and Theme:

This segment introduces foreign exchange markets The first objective here is to learn the characteristics

of Spot Markets and the Forward Markets; the second objective is to study the pricing of one currency relative to another in terms of direct and indirect quotes Thirdly, bid and ask prices are introduced and explained Finally, the concept of buying and selling currencies for future needs using Forward contracts, Futures contracts, and Options are briefly explained

Introduction:

Unlike stock markets, which have a physical location of their own, there is no one place where currencies trade In fact, currencies trade around the globe on a 24-hour basis According to Zaheer (1995), the foreign exchange market consists of:

1 a primary network of about 150 major international banks with 1000 affiliates spread around the globe; these major banks act as market makers by buying and selling various currencies, and by quoting two-way bid-ask prices all the time These banks also do speculative trading based on

"privately informed opinion about market expectations of price trends."

2 a secondary network of 4000 or so second tier banks, which are involved both in speculative trading and trading with customers

3 tertiary network of corporations, central banks, fund managers, and customers The participants

in this group buy and sell currencies essentially for their liquidity needs arising from trade and investment transactions

As of April 1998, the net turnover in the global foreign exchange market amounted to 1.5 trillion dollars a day!1 This compares with a market turnover of $820 billion in 1992 and 590 billion in 1989, representing

an annual growth rate of 12 percent and 14 percent per year respectively To understand the enormity of this market, it would be helpful to know that the US annual real GDP is about 6.82 trillion dollars! London, New York and Tokyo dominate the currency markets The US dollar accounts for 83 percent of all global foreign exchange transactions, followed by the German mark, which accounts for 30 percent of all transactions, and the Japanese yen with a share of 24 percent of all transactions

1Bank for International Settlements: Central Bank Summary of Foreign Exchange and Derivatives Market Activity, 1998

Need for Foreign Currencies

The need for foreign currency arises in the context of trade and investment needs of individuals, corporations, governments, and open market operations of central banks

Let us first consider a trade related foreign currency need Consider for example, ABC Corporation, a US based MNC, which has imported merchandise from a German firm; let us assume that these imports are denominated in German marks ABC Corporation has to resort to the foreign exchange market to buy the German marks to pay for its imports Similarly, XYZ Corporation located in London exported merchandise

to an Indian company; these exports are denominated in British pounds The Indian importer has to buy British pounds to pay for its imports

Now, let us look at an investment based need for foreign currencies If Japanese individuals and institutional investors want to invest in US bond market securities like T-bills, and T-bonds etc., they need

to convert the home currency, the Japanese yen, to US dollars before they can invest in the US Likewise,

if US individuals or institutional investors want to invest in Japanese stock markets, they have to convert the US dollar to the Japanese yen to do so

Foreign currency needs also arise for travel, education, and charitable giving needs, as well For example, if Korean nationals want to go to a US university for furthering their educations, they must convert their Korean Won to US dollars to do so Likewise, if someone from the US wants to travel in London for entertainment and shopping, he or she has to pay for the trip in British pounds, and, therefore, the US resident has to convert the US dollars to British pounds

Spot Markets versus Forward Markets

In Spot transactions, currencies are bought and sold for immediate conversion and delivery The market where Spot transactions occur is called the Spot market Currencies can also be bought and sold for deferred delivery in the future The markets where such deferred transactions occur are referred to as Forward markets Obviously, these markets are identified by the nature of transactions In other words, they do not trade in separate places ! You may wonder why anybody would want to buy or sell currencies

in the future Buying and selling currencies in the future is done based on future foreign currency needs The prices at which currencies are bought and sold for spot transactions in the Spot markets are called Spot prices, or quotes, while the prices at which currencies are bought and sold for future needs in the forward markets are called Forward prices, or quotes

Direct Quotes versus Indirect Quotes

There are two ways in which the price of one currency can be quoted relative to another currency For the

US, the home currency is the US dollar; with respect to the US dollar, the two types of Quotes are:

1 Direct Quote, also called US $ Equivalent, refers to the # of units of US dollar per one unit of the Foreign Currency To understand the Direct Quote, please look at the table Currency Trading: Exchange Rates This table is a reproduction of Exchange Rate Quotes from the Wall Street Journal of February 8,

2001

Table 2.1: Exchange Rate Quotes from WSJ, 2/8/2001

Country Thursday 2/8/2001 Wednesday 2/7/2001 Thursday 2/8/2001 Wednesday 2/7/2001

1-month forward 0.4699 0.4754 2.1280 2.10373-months forward 0.4704 0.4758 2.1259 2.10166-months forward 0.4710 0.4764 2.1233 2.0990

Poland (Zloty) [d] 0.2431 0.2468 4.1135 4.0520

US $ Equivalent for Thursday translates to US $ 0.4696 per Mark This means one Mark equals US $ 0.4696 Likewise, the quote of 0.4751 in US $ Equivalent for Wednesday should be read as US $0.4751 per Mark For another example, let us examine the French Franc Once again, the very first line for that country represents the Spot Quote Whenever a given country quote appears more than once, the very first line always represents the Spot Quote A quote of 0.1400 for France on Thursday should be read as

US $ 0.1400 per French Franc This means one French Franc is worth 0.1400 US dollar Likewise, considering the Direct Quotes for the British pound, a quote of US $ Equivalent of 1.4445 on Thursday should be read as US $ 1.4445 per British pound This means one British pound equals US $ 1.4445

2 The Indirect Quotes are presented in columns 4 and 5 of the Currency Trading: Exchange Rates table, under the heading Currency per US $ Once again, consider the Spot Quotes for Germany The quote of 2.1293 appearing across Germany (Marks) for Thursday under column 4 should be read as 2.1293 Mark (DM) per US dollar: this means one US dollar is worth 2.1293 DMs The indirect quote of 2.1050 of the

DM for Wednesday, read as 2.1050 DMs per US dollar, translates into a value of 2.1050 DMs for one US dollar In a similar fashion, the indirect Thursday quote of 7.1412 for France, read as Franc (FF) 7.1412/US$, means one US $ is worth 7.1412 French Francs A quote of 7.0598 for the FF on Wednesday means that one US $ is worth 7.0598 FF For the British pound, the Thursday Indirect Quote

is 0.6923, read as BP 0.6923 per US $, implying one US $ equals BP 0.6923

Given a Direct Quote, one can get the Indirect Quote by taking the reciprocal of the Direct Quote and vice-versa For example, we already know that the Direct Quote for the Mark on Thursday is 0.4696; if we take 1/0.4696, we get 2.1293, the Indirect Quote of the Mark for Thursday Similarly, if we take the reciprocal of the Indirect Quote of the FF for Thursday: 1/7.1412, we get 0.1400 , the Direct Quote for FF for the same day

The World Value of the US Dollar

The World Value of the US dollar for several global currencies are presented below Source: Wall Street Journal, February 16, 2001.

Table 2.2: World Value of the US Dollar from WSJ, 2/16/2001

Bouvet Island Norweg Krone 9.0083 8.8631

Chad C.F.A Franc 714.8226 713.9124

Euro Monetary Union EURO * 0.9177 0.9188

Nepal Rupee 74.4677 74.1637

Senegal C.F.A Franc 714.8226 713.9124

Vietnam Dong 14582.50 14578.00

The rates given are in terms of # of Units of Foreign Currency per one US dollar The values are given for two different dates: one for Friday, February 16th, and another for Friday, February 9th, 2001 For example, for the South Korean Won, the rate given for February 16th is 1251.50, which should be read as South Korean Won 1251.50 per one US dollar Please note the fact that this quote is in indirect form Can you compare the value of South Korean Won on February 16th with its value on February 9th, and figure out whether or not the Won appreciated or depreciated with respect to the US $? Remember to use direct quotes to do that; you can get the direct quotes for the Won by taking the reciprocals of the indirect quotes in this table

Further, take a few minutes to read and learn the currencies of the countries around the globe! Do you know the name of the Currency for Reunion, Ille de la? Or for that matter, can you name the currencies for Algeria, Bolivia, Chile, Denmark, Egypt, Finland, Germany, Holland, India, Jordan, Kenya, Libya, Madagascar, Nepal, Oman, Panama, Qatar, Singapore, Taiwan, Uganda, Vatican City, and Zaire?

By visiting the Foreign Exchange Rates site, you can convert one currency to another currency using the latest quotes Be sure to visit the site

Can you tell me the value or price of the Indian Rupee in terms of South Korean Won? That is, figure out how many Won equal one Indian Rupee? Then, get the value of South Korean Won in Rupees That is, get the value of # of Indian Rupees per South Korean Won

Computing Percent Change for a Foreign Currency

One can compute the Percent Change for a currency as follows:

Percentage Change for a Currency = (St - St-1 ) / St-1 * 100 ,

Where,

St = Spot Rate for more recent period t,

St-1 = Spot Rate for last period t-1

If percent change were positive, then it implies appreciation of the currency over time; and,

If percent change were negative, then it implies depreciation of the currency over time

In computing the percent change for a foreign currency from the US perspective, always use the direct quote Let us compute the percent change for the DM from Wednesday (t-1) to Thursday (t) :

Percent change in DM from Wednesday to Thursday from the WSJ (Table 2.1) =

[(0.4696-0.4751) / 0.4751] * 100 = -1.1577 percent

This means, the DM depreciated by 1.1577 percent with respect to the US $, over a one day period

If we were to compute the percent change in the US $ with respect to the DM for the same period, we should be using the indirect quotes for the same period:

Percent change in the US $ with respect to the Mark from Wednesday to Thursday =

[(2.1293-2.1050) / 2.1050] * 100 = + 1.1544 percent

Bid, Ask Prices, and Bid / Ask Percent Spread

At any given point in time, there are two separate prices quoted for currencies: one for buying and the other for selling Every time you buy a given currency, its buying price is always greater than its asking price Every time the currencies are bought and sold, the foreign exchange dealers make a profit The bid and ask prices are further explained below:

BID-ASK PRICES

Foreign Currency Bank Quotation

You/MNC Bank/Foreign Exchange Dealer

Suppose for example, the following are the Bid, Ask Prices quoted for the Mark:

Bid = $ 0.4664/DM

Ask= $ 0.4724/DM

If you want to purchase 100 Marks, it will cost you:

Ask Price * # of Marks being bought = 0.4724 * 100 = US $ 47.24

If you want to sell 100 marks, you will receive =

Bid price of 0.4664 * # Marks being bought = US $ 46.64

The Bid/Ask Percent Spread is given by:

[ (Ask - Bid) / Ask ] * 100 = [(0.4724 - 0.4664)/0.4724] * 100 = 1.2701 percent

This should be read as the Ask price being at a premium of 1.2701 percent with respect to the Bid price Obviously, one can compute the discount with respect to the Ask price, by dividing by the Bid price It is customary to express the Bid/Ask Percent spread as a premium with respect to the Bid Price

Cross Exchange Rates

Given the value of any two currencies in terms of the US dollar, one can calculate the value of those two currencies with respect to one another without the intervening dollar Important Cross Currency Rates are given below:

Key Currency Cross Rates

Wall Street Journal, February 08, 2001

Dollar Euro Pound SFranc Guilder Peso Yen Lira D-Mark FFranc CdnDlrCanada 1.5110 1.3880 2.1826 0.9048 62982 15604 01295 00072 70962 21159 France 7.1412 6.5599 10.3155 4.2762 2.9766 73746 06121 00339 3.3538 4.7261Germany 2.1293 1.9560 3.0758 1.2750 88754 21989 01825 00101 .29817 1.4092Italy 2108.0 1936.4 3045.0 1262.3 878.65 217.69 18.069 989.98 295.18 1395.1Japan 116.66 107.16 168.52 69.856 48.627 12.047 .05534 54.788 16.336 77.207Mexico 9.6835 8.8953 13.988 5.7985 4.0363 .08301 00459 4.5477 1.3560 6.4087Netherlands 2.3991 2.2038 3.4655 1.4366 .24775 02056 00114 1.1267 33595 1.5878Switzerland 1.67 1.5341 2.4123 .69609 17246 01432 00079 78430 23385 1.1052U.K .69230 6359 .4145 28856 07149 00593 00033 32512 09694 45816Euro 1.08860 1.5725 65186 45376 11242 00933 00052 51125 15244 72046U.S 9186 1.4445 59880 41682 10327 00857 00047 46964 14003 66181

The very first column refers to the US dollar If we read across France and down the Dollar column, the value given is 7.1412; this should be read as FF 7.1412 per US dollar Likewise, if we read across Germany and down the Dollar column, the quote given is 2.1293; this should be read as Marks 2.1293 per US dollar Both the FF and DM are in indirect form

The value of DM in terms of FF, that is the # of FFs per DM is calculated as:

2.1293 / 0.69230 = Marks 3.0758 per pound

If we look across Germany and down Pound in Table 5, we get the value of 3.0758 DMs per pound as well, the same # as we calculated just now

In these Cross Exchange Rate computations, we used Indirect Quotes Note the fact that the order in which the currencies are plugged in the numerator and denominator to arrive at the cross exchange rate

is in the same order as the currencies appear in the pricing of currencies However, if we are using the Direct Quotes, the order of currencies in the numerator and denominator will be reversed

Currency Forward Contracts, Forward Rates, and Forward Premium

The currencies can be bought and sold in Forward Markets The Forward Rate is the rate at which currencies are bought or sold for future delivery at an agreed upon price today The currency exchange does not take place when the contract is bought or sold Rather, the exchange occurs later Often, MNCs face future foreign currency outflow needs or receive foreign currency inflows in the future When MNCs expect future outflow needs like Bills Payable, they can buy the foreign currency at t=0 at the then prevailing forward rate and lock-in that rate, thereby avoiding the exchange rate risk A forward contract specifies the foreign currency to be bought or sold at a specified known rate today for a future settlement date

Forward rates for some currencies appear in Table 2.1 The most common maturities are 30-day, 90-day, and 180-day For the British pound (BP), the quoted 30-day forward rate is British pound 1.4443 per US dollar; the 90-day and 180-day forward rates are BP 1.4435 per US $ and BP 1.4422 per US $, respectively The spot rate is 1.4445 US $ per BP In this instance, all the three forward rates are below the spot rate, and therefore, forward market rates are at a discount with respect to the spot market rates

We can calculate the Forward Market Premium or Discount P as follows:

P = Forward Market Premium or Discount Percent =

= [( Forward - Spot) / Spot ] * (360/# of Days of the Contract) * 100

The multiplier (360/# of Days of the Contract) converts the P to an annual rate !

For example, the P for the 30-Day BP Rate will be computed as follows:

[ (1.4443-1.4445) / 1.4445 ] * (360/30)* 100 = -0.1661 %

The premium of - 0.1661 percent means that the 30-day forward rate is at a discount of 0.1661 percent with respect to the spot rate

Similarly, the Premium P for the BP 90-day and 180-day forward rates will be computed as :

Premium for 90-day forward rate:

[ (1.4435-1.4445) / 1.4445] * (360/90) * 100 = -0.2769 %

Premium for 180-day forward Rate:

= [ (1.4422-1.4445) / 1.4445] * (360/180) * 100= -0.3184 %

In some sense, forward rates convey information about the spot rates in the future Under certain conditions and assumptions, forward rates can act as predictors of spot rates in the future

Can you visit the Chicago Mercantile Exchange and find out what futures are and options are currently traded at the exchange? Who trades them? And why?

Currency Options

Currency options are rights which enable individuals, institutions, and MNCs to buy and sell currencies in the future at a specific price for a specified period of time These options are available for various currencies and trade in the Philadelphia Exchange These options can be used for hedging and speculation We will learn a lot about these instruments later in Module 5

Please visit the Introduction to Options site: Learn about Options Basics Also, learn about the classification types, classes, and series!

So, what are European Options? And what are American Options? What are calls, and what are puts?

Summary: In this module, we learned about the pricing of foreign currencies; the currencies can be

quoted in direct form as # of US $ per one unit of foreign currency and in indirect form as # of units of foreign currency per US $ We also learned about the ask and bid prices: the prices at which currencies are bought and sold, respectively There was a discussion on computing percent change of a given currency Also, we studied forward contracts and forward rates; forward rates are the rates at which contracts are entered into to buy and sell currencies in the future to meet future needs

Questions and Problems

1 State and explain the right objective for a multinational corporation What are the advantages of that objective?

2 What is an agency problem? What are agency costs? Are they higher or lower for MNCs ? And why?

3 State and explain the three theories of international business

4 State and explain the different methods of international business

5 What is exchange rate risk? Illustrate your answer with a suitable example Why is it important to manage it for an MNC?

6 Distinguish between spot and forward foreign currency markets

7 Identify the participants in the foreign exchange market and explain their roles

8 What is the difference between direct and indirect quotes? If you were to compute the percent change in a foreign currency, which quote would you use and why?

9 Define forward markets and forward rates

10 For what purposes and needs do the foreign exchange markets serve? Give suitable examples

11 What do bid and ask prices mean? Which is higher? And why?

12 Please refer to the Currency Trading: Exchange Rates table Using the information on Thursday's spot and forward rates for the French Franc, compute a) 30-day forward premium b) 90-day forward premium and c)180-day forward premium

13.Using the exchange rate information for Thursday in Table 2.1, compute the following:

a Cross Exchange Rate of the BP with respect to FF: # of FF per BP

b Cross Exchange Rate of the FF with respect to Canadian Dollar: # of Canadian Dollar per

FF

c Cross Exchange Rate of the SF with Respect to Swedish Krona: # of Krona per SF

d Cross Exchange Rate of the Italian Lira with Respect to Japanese Yen: # of Japanese Yen per Italian Lira

2 The following are the Ask and Bid Prices of the DM quoted by a bank:

3 Bid $ 0.6645 Per DM

Ask $ 0.6745 Per DM

a. If you have DM 2,000 how many US $, you will get?

b. If you want to buy DM 3,000 to visit Germany, how many US Dollars you need?

END OF MODULE 2

Module 3: Arbitrage and the Theories of Interest Rate Parity, Purchasing Power

Parity,

and International Fisher Effect

Objectives and Theme:

In this module, our objective is to study arbitrage and examine why and how three types of arbitrage take place in the foreign currency markets; we also explore the realignment of exchange rates due to arbitrage transactions Our second objective is to learn about the theories of Interest Rate Parity (IRP), Purchasing Power Parity (PPP), and International Fisher Effect (IFE)

International Arbitrage and the Theory of Interest Rate Parity:

Whenever there are discrepancies between quoted-rates and observed market rates in the foreign exchange markets, currency realignments will take place Market forces bring about the realignment of currencies through arbitrage Loosely, arbitrage can be defined as capitalizing on market discrepancies in the prices quoted in the foreign exchange markets by simultaneous buying and selling It can also involve simultaneous lending and borrowing in different currencies to take advantage of the higher interest rates

International Arbitrage

Types of Arbitrage Variables in the Discrepencies

Locational Foreign exchange rate among banksTriangular Cross exchange rates

Covered Interest Differential in interest rate and forward rate

Locational Arbitrage: Usually, locational arbitrage takes place when a particular currency can be sold at a

higher price compared to its buying price; undertaking such transactions yields profits In addition, locational arbitrage leads to the realignment of currency exchange rates as well

Example:

Bid Price DM $0.6405/DM $0.6610/DMAsk Price DM $0.6500/DM $0.6710/DM

Since Bid price of $0.6610 at Bank D > Ask price of $0.6500 at Bank C, there is an opportunity to engage

in locational arbitrage Arbitrageurs will buy at $0.650 from Bank C and sell to Bank D at $ 0.6610 per

DM Recall one buys at the ask price and sells at the bid price

If you have $ 10,000 and execute locational arbitrage, the following steps are involved:

Buy DM at $ 0.650 from Bank C = $ 10,000/$ 0.650 = DM 15384.6

Sell DM at $ 0.6610 to Bank D = DM 15384.6 * $ 0.6610 = $ 10169.23

Net Profit = $ 10,169.23 - $ 10,000 = $ 169.23

As a result of this locational arbitrage, the asked price at bank C will go up, and the bid price at bank D will go down

The locational arbitrage concept explains why prices between banks at different locations will not normally

differ by a significant amount

Triangular Arbitrage

Foreign exchange quotations are typically expressed in US $ regardless of the country where the quotation is provided Cross exchange rates are used to determine the relationship between two non-dollar currencies

If a quoted actual or market cross exchange rate differs from the appropriate theoretical or should be rate, triangular arbitrage becomes feasible

Suppose a bank quotes cross exchange of DM with respect to DM = 11 FF/DM

Since 1 DM = 11 FF at the bank (1 FF more than the theoretical cross exchange rate of 10 FF/DM), you can buy DM with US $, convert DM to FF, then sell FF for US $

There are three steps to follow:

Step 1: Determine amount of the DM to be received or sell US $ to get DM

risk-Because of these triangular arbitrage transactions, the exchange rates are affected as follows:

$2/DM ====> Since DMs are being bought, this rate goes up

11 FF/DM ===> Since FFs are being bought, this rate goes down

$0.20/FF ===> Since $s are being bought, this rate goes down

Covered Interest Arbitrage (CIA)

The opportunity to engage in Covered Interest Arbitrage arises when the interest rate difference between the home interest rate and foreign interest rate is not off-set by the forward premium or discount of the foreign currency in the forward market Covered interest arbitrage involves converting the home currency

to the foreign currency, investing in foreign currency and covering against exchange rate risk by selling forward the maturity value of the investment thereby locking-in a rate Covered interest arbitrage then involves interest arbitrage to take advantage of higher overseas interest rates and covering the foreign investment position by selling forward the maturity value of the investment

Example:

Amount to invest $1,000,000Current spot rate of DM = $2/DM90-day forward rate of DM = $2.1/DM90-day interest rate in the USA = 2%

90-day interest rate in Germany = 4%

Time=0:

1 Sell US $ and buy DM at the Spot rate of $2/DM

$1,000,000 /2= DM500,000

2 Invest in German T-Bill @ 4 % 90-day interest rate in Germany

Maturity Value of Investment in German Marks=500,000 (1 +0.04) = DM520,000

3 Sell 520,000 DM forward @ 90-day Forward Rate of $2.1/DM

The 9.2 % rate of return for investing in Germany has two components:

a German Interest Rate of 4 %

b DM Forward Premium of 5 %

Recall that the Forward Premium is computed as :

(Forward Rate - Spot Rate)/Spot Rate * 100

=(2.1-2.0)/2.0 * 100 = 5 %

Note that since interest rates are given for 90-day period, we computed the forward premium also for the 90-day period Normally, the forward premium is usually annualized, in which case, we would have used annualized interest rates

The sum of the 4 % interest rate and the forward premium adds up to 9.0 % which approximates the 9.2

% return on CIA we computed earlier Because we are using an approximation here, we observe the 0.20

% difference Later, we will be using the exact version to get the exact return

In this case, since US investors are earning a 7.2 % extra return from investing in Germany, US investors will be better off investing there Let us further develop the example on CIA we just now saw:

Covered Interest Rate Arbitrage Under Varying Forward Rate Regimes

Spot

DM $ per DM

90-day Forward Rate -DM $ per DM

Forward Premium or Discount (P)

Appropriate

Covered Interest Arbitrage

1 2% 4% $2 $2.10 5% 4 + 5 = 9%

In states 1 through 3, CIA (investing in Germany) is profitable In all those instances, the forward premium

of the DM was positive or 0, either adding to or maintaining the foreign interest rate of 4 % But, in scenario # 4, when the forward rate shows a discount of -2%, the return on CIA is the same as the return from investing in the US In this case, the interest rate advantage of 2 % for investing in Germany is exactly offset by the discount of -2% in the forward rate of the DM

Theory of Interest Rate Parity (IRP)

The Interest Rate Parity Theorem examines the impact of nominal interest rate differentials between two countries on the forward rate of the foreign currency

The approximate IRP equation is:

ih - if = p

where,

ih = Home Interest Rate

if = Foreign Interest Rate

p = Forward Premium or discount of the foreign currency

Recall that p is computed as:

(Fj - Sj)/Sj x 100

If the (Home Interest Rate - Foreign Interest Rate) interest differential exactly equals the forward premium

or discount, then there is Interest Rate Parity At that point, the interest advantage is offset by the forward discount In scenario #4 above, US investors earn 2% return regardless of where they choose to invest

Note that IRP does not imply that all country investors earn the same return at the point of IRP

In scenarios 1 through 3, US investors have an advantage in investing in Germany by CIA The concept

of IRP is further explained in Figure # 3

Note: This Figure is reproduced by permission from International Financial Management, Sixth Edition, Jeff Madura Copyright © 2000 by West Publishing Company All Rights Reserved

On the horizontal axis, the Forward premium or discount is given On the vertical axis, (Home Interest Rate - Foreign Interest Rate) interest rate difference is plotted Point #1 corresponds to scenario # 1 from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table As we already know, US investors make 4% on interest income and 5% by exchange gain as the forward rate shows a premium of 5% Likewise, in point #2 corresponding to scenario #2, US investors make 2 % more than what is available in the US, solely on the interest rate front Points #1 and #2 lie to the right of the IRP line and therefore we can generalize and conclude that at the points to the right of IRP line, it will be advantageous for US investors to invest overseas Similarly, at the points to the left of the IRP line, it will be advantageous for the foreign investors to invest in the US At all points on the IRP line, there is interest rate parity This means that a given country investor will get the same rate of return regardless of which country he chooses to invest in

The exact version of IRP equation is given by:

(1+ih)/(1+if) - 1 = p

Where,

ih = Home Interest Rate

if = Foreign Interest Rate

p = Forward Premium or discount of the foreign currency

The only difference here is that the interaction term (p*if) adds an extra component to the interest rate difference between home and foreign country Recall that in our State 1 example from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table, we had a 0.20 % difference on return to CIA in the approximate method in scenario #4 Given the German interest rate of 0.04 and premium of 0.05, (p*if) works out to 0.20 %, the difference we observed earlier

IRP holds true in the real world especially in the Eurocurrency markets Arbitrage transactions ensure that interest differentials in different segments of the Eurocurrency markets are off-set by corresponding

forward premiums or discounts IRP impacts on instruments of similar maturity and risk However, if capital controls and such are imposed, IRP may not hold true in the real world

Purchasing Power Parity (PPP)

PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country If inflation in the foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power

According to PPP, currencies in highly-inflated countries will be weaker causing the purchasing power of goods in the home country versus these countries to be similar When inflation is high in a particular country, foreign demand for goods in that country will decrease In addition, that country's demand for foreign goods should increase Thus, the home currency of that country will weaken; this tendency should continue until the currency has weakened to the extent that a foreign country's goods are no more attractive than the home country's goods Inflation differentials are offset by exchange rate change The approximate version of PPP equation is given by,

If - Ih = Ef

Where,

If = Inflation rate in the foreign country,

Ih = Inflation rate in the home country,

Ef = % Change in the Spot Rate of the Foreign Currency

Thus, currencies of countries with high inflation will depreciate by the inflation differential, while currencies

of countries having low inflation will appreciate by the inflation differential

International Fisher Effect (IFE)

IFE predicts the same magnitude and direction in the spot rate of a currency as PPP does, but IFE looks

at the nominal interest rate rather than inflation rate IFE argues that a currency's value will adjust to reflect the difference in nominal interest rates between countries

The rationale behind IFE is that if a currency exhibits a high nominal interest rate, it may anticipate high inflation Thus the inflation will put pressure on the currency's value causing a depreciation

Note: Nominal Interest Rate = Real Interest rate + Inflation Premium (approximate version)

The approximate version of IFE equation is given by

if - ih = Ef

Where,

if = Nominal interest rate in the foreign country,

ih = Nominal interest rate in the home country,

Ef = % Change in the Spot Rate of the Foreign Currency

Home: US Foreign: Japan

IFE will predict,

Ef (% Change, Spot, Foreign Currency) of 2%,

= the interest differential of (8-6) = 2%

According to both theories, the foreign currency should appreciate by 2% While IFE looks at the nominal interest rate (total picture), PPP looks at the inflation rate Both provide the same result; it is the same wine in different bottles! This means that if an American investor invests in the US, he or she will get 8%

in nominal return And if the investor invests abroad, he or she will get 6% return from interest income and

an additional 2% return from the appreciation of the foreign currency

Summary:

In this Module, we studied the concept of arbitrage and the types of arbitrage: 1) Locational, 2) Triangular and, 3) Covered Interest Arbitrage helps to bring about the re-alignment of the exchange rates We also discussed the theories of Interest Rate Parity, Purchasing Power Parity, and International Fisher Effect

END OF MODULE 3

Module 4: Forecasting Exchange Rates

Why Multinationals Forecast Exchange Rates ?

An assessment of the future exchange rates is required for several decisions of the MNCs Future exchange rates will affect all critical characteristics of the firm such as costs and revenues To be more specific, various operations of MNCs use exchange rate projections including:

1 Hedging: Hedging involves taking protective steps to safe-guard open currency positions from exchange rate risk The decision to hedge or not to hedge will depend on the forecast of the spot rate in the future

2 Short-term financing and investing and long-term financing and investing decisions: When borrowing in foreign currencies, either short or long-term, one would need a forecast of the exchange rates An appreciating foreign currency adds to the cost of borrowing; on the other hand, a depreciating foreign currency reduces the cost of borrowing When investing in foreign currency investments, one needs a forecast of the future spot exchange rate as well While an appreciating foreign currency adds a bonus to the foreign country return, a depreciating foreign

currency reduces the effective return on a foreign currency Therefore, before venturing into foreign currency borrowing or investing, it is a good idea to get the forecasts of the exchange rates

3 Capital budgeting decisions: Capital investments call for initial foreign currency outflows for the investment cost followed by foreign currency inflows during the life of the project; furthermore, those flows need to be converted to the home currency For this purpose, one also has to forecast the exchange rates and

4 Earnings assessment: In the preparation of consolidated financial statements, a forecast of the exchange rates is required

Therefore, such operations can be carried out more effectively if exchange rates are forecasted accurately

Forecasting Techniques

Forecasting will depend on the type of exchange rate regimes, like fixed rate system versus free-floating regime; it will also depend on the period of future forecast like short-term horizon versus long-term horizon Here, some methods are outlined without regard to those considerations

Technical Forecasting: Technical forecasting involves the review of historical exchange rates to search for

repetitive patterns which may occur in the future This pattern would be the basis for future exchange rate movements If the exchange rate of the dollar has decreased over the last week period, it may provide an indication of how the currency will move tomorrow Technical analysts often use time series models:

"three steps and stumble" means that the currency tends to decline in value after a rise in the moving average over three consecutive periods! Computer programs can be used to detect patterns and to compute moving averages etc

Fundamental Forecasting

Fundamental forecasting is based on underlying relationships between the currency's value and one or more economic factors like relative interest rates, inflation differentials, trade deficits, budget deficits, real GDP, money supply etc

Exchange rate forecasting is available at the Financial Forecast Center

What is the Bank of America medium term forecast for the U.S dollar-Yen exchange rate? How about the U.S dollar-Deutsche Mark exchange rate?

Often regression analysis is used in fundamental forecasting In a regression set-up, a dependent variable (effect) is forecast using an independent variable (cause); constant and slope coefficients for the straight line equation of the estimate of the dependent variable are obtained From the regression equation, one can forecast the dependent variable for a given time-period

If you want to forecast the value of the British Pound relative to the US $, the regression analysis will involve the following steps:

INTDIFFt = Interest rate differential between U.K and U.S interest rates (U.K rate - U.S rate)

2 Collect data on the above variables for a suitable number of periods like 20 or so quarters

3 Run the regression equation and get the estimate of "a" and "b"

4 From the estimate of the equation, plug in the value of future (forecasted) interest rate differential and arrive at the value of pound for the future period

Suppose, we obtained the following Regression Equation Model above

ERPD$t = 1.78 + 0.80 * INTDIFFt

Then, given the value of INTDIFF for the next period, we can forecast ERPD$

If the INTDIFF were 5% for the next period, then what is the forecasted value of ERPD$? Can you tell?Problems in fundamental forecasting:

1 Uncertain timing of the impact of any given variable on the forecasted variable: The impact might

be felt with a lag, and if so the regression equation specified is incorrect,

2 Omission of some relevant variables

3 Possible changes in the sensitivity or value of the coefficients over time, and

4 Forecasts are needed for factors with instantaneous impact

Market Based Forecasting

Here, market determined spot or forward exchange rates are used to predict the future spot rates These market based rates are good indicators of likely outcomes as otherwise, speculators will take positions to profit if deviations occur Thus spot rates will reflect the expectation of currency value in the immediate future and the forward rates will reflect the value of a currency in the future spot markets For example, if the 30-day forward rate of the Canadian dollar contains a 5% premium, one can predict that the Canadian spot rate 30 days from now will appreciate by 5% in 30 days time That kind of a forecast will be unbiased

in the sense that, 50% of time they will overshoot, and the remaining 50% of the forecasts will be below the actual outcomes!

Mixed Forecasting

Mixed forecasting involves a combination of two or more techniques Different weights adding up to 1 can

be assigned For example, if the following forecasts were obtained:

Technical Forecast of the BP for the next quarter: $ 1.55 per Pound.Fundamental Forecast of the BP for next quarter: $ 1.50 per Pound

If we assign a weight of 0.50 for each outcome, then the weighted average forecast will be:

1.55(0.50) + 1.50 (0.5) = $ 1.525 per pound Obviously, these weights are subjective

Forecast Performance of Consulting Firms

Forecasting firms often use two or more techniques They also provide other services like cash management, forecast of factors affecting exchange rates and an assessment of current and future exchange regulations The record of forecasting services is less than perfect and in fact poor

Assessment of Forecast Accuracy

Performance can be evaluated by computing the absolute forecast error as a % of the realized value for all forecast periods Then, an average of this type of error can be computed This average is then compared across different forecasting techniques or among different currencies

Absolute forecast error as a % of the realized value=

[|(Forecasted Value-Realized Value)/Realized Value|] * 100

An Example: The forecasted and realized values of South Korean Won for the last four quarters are given

in columns 2 and 3 The absolute values of the deviations appear in column 4

Forecast Error for the South Korean Won

Quarter Forecasted Value Realized Value Absolute Valueof Deviation (%)

A Comprehensive Regression Example:

A Regression Example for forecasting Spot BP using lagged 30-day forward rate of the BP is presented in the following tables Regression Data contains 21 daily data: the dependent variable is the Spot BP, and the independent variable is the 30-day lagged forward rate of BP The lagging has been done based on trading day

Using data for the first fifteen (observations # 1-15) days, a regression is run; the results are shown in Regression Results The resulting regression equation is of the form:

Future Spot Ratet = 0.481698 + [0.6994*30-day Forward Rate t-30]

The slope of 0.6994 means that for every 1% change in the forward rate, the spot rate of the BP changes

by 0.6994% in the same direction

This equation is used to forecast the spot BP for days 17-21, and the predicted spot, absolute error, and average error appear in Prediction

Forecasting Performance and Market Efficiency

Efficiency refers to the reflection of information in the pricing of currencies There are three forms of efficiency: 1) Weak-form, which argues that all historical pricing information, including volume and other technical factors, is reflected in currency pricing 2) Semi-strong form, which states that all publicly available information is reflected in currency pricing, and 3) Strong-form, which posits that both public and non-public private information are reflected in currency pricing Each form of efficiency subsumes the one below it

There is evidence supporting the fact that foreign exchange markets are semi-strongly efficient and, therefore, reflect all publicly available information and historical pricing information Still, MNCs need to forecast exchange rates and, in fact, use a variety of techniques to forecast the exchange rates under different economic scenarios That is the only way that MNCs can assess the degree to which their performance will be affected by exchange rate movements Also, corporations do not like uncertainty; with the exchange rate forecasts, they can estimate the cash flow estimates, thereby making the planning process easier

An anomaly called January Effect has been documented in the U.S dollar market by Rathinasamy, Mantripragada, and Loh (1992)

Summary:

In this Module, we studied the reasons for and techniques of forecasting exchange rates Specifically, we discussed technical and fundamental approaches to forecasting exchange rates We computed forecast errors and learned about the concept of efficiency in foreign exchange markets

Questions and Problems

1 Define arbitrage What purposes does arbitrage serve in currency markets?

2 What is locational arbitrage? Illustrate your answer with a suitable example

3 Locational Arbitrage:

Consider the following:

Bid price of FF per US $ 5.50 FF/$ 5.54 FF/$

Ask Price of FF per US $ 5.52 FF/$ 5.56 FF/$

If you have US $100,000 how would you go about executing a locational arbitrage? Outline the steps and show the results.

4 Triangular Arbitrage:

Consider the information on Cross Exchange Rates (Table 2.1) in Module 2

The cross exchange rate of the FF per SF is 4.2762; that is the rate given across France, and under SFRANC is 4.2762, read as FF 4.2762 per SF This is the theoretical rate Suppose, in the Market, this cross rate is FF 4.2993 per SF If you have $100,000, how would you go about executing triangular arbitrage? Outline the steps, profits, and compute the rate of return

5 Define Covered interest arbitrage

6 Covered interest arbitrage:

Consider the following information:

Spot Exchange Rate $1.535/Pound

180-days Forward Rate $1.566/Pound

180-days Interest Rate 6% (USA)

8% (UK)

i If you are a US investor with $1,000,000 on hand, how would you go about executing covered interest arbitrage ? Outline the steps, compute the profit, and return on investment

ii As a result of the covered interest arbitrage above, what will happen to:

a The spot exchange rate of $1.535 ?

b The forward exchange rate of $1.566 ?

c To the interest rates in the USA and Britain ?

7 Identify and explain the reasons for forecasting exchange rates

8 What is fundamental forecasting ? What variables are used in

3 0.009334 0.009226

4 0.009346 0.009387

Sum Average Fill-in the missing values in the last column and compute the average forecast error

Do you think that the consultant did a good job ?

END OF MODULE 4

Module 5: Currency Futures, Forward Contracts, and Options

Objectives and Theme:

In this module, our objectives are to study three major instruments in the foreign exchange markets: 1) currency futures contracts 2) currency forward contracts and 3) currency options and the use of these instruments for speculative and hedging purposes The use of these instruments depends on the firm's expectation about the future value of the particular foreign currency that the firm is interested in We also discuss the back-ground of these instruments, why a firm should use these instruments, and under what conditions they will be used

Currency Futures:

Currency futures are contracts specifying a standard volume of a particular currency to be exchanged for

a specific price on a specific settlement date

In 1972, the Chicago Mercantile Exchange (CME) established the International Money Market division (IMM) which allows trades in futures for some short term securities, gold, and seven widely traded foreign currencies

Visit the Future Contracts site in this link and examine the latest open, high, low, and close prices for the British Pound (BP) futures contract for the nearest month

A wealth of information on links about currency futures and options appears at this site, also

Interpreting Currency Futures Quotes

Futures page from the Wall Street Journal of February 08, 2001 are presented below:

Wall Street Journal February 08, 2001

LIFETIME OPEN

JAPANESE YEN (CME)-12.5 MILLION YEN; $ PER YEN (.00)

MAR 0.8764 0.8796 0.8726 0.8765 +.0003 1.0300 0.8414 89,936

JUNE 0.8850 0.8876 0.8845 0.8870 +.0004 1.0219 0.8590 2,878

SEPT 0.8968 +.0004 1.0050 0.8769 100

EST VOL 11,539; VOL MON 12,941; OPEN INT 93,017, +503

DEUTSCHEMARK (CME)-125,000 MARKS; $ PER MARK

EST VOL 3; VOL MON 1; OPEN INT 331, UNCH

CANADIAN DOLLAR (CME)-100,000 DOLLARS; $ PER CAN $

MAR 0.6621 0.6640 0.6615 0.6619 -.0021 0.7040 0.6415 46,671

JUNE 0.6625 0.6637 0.6615 0.6623 -.0021 0.6990 0.6425 4,846

SEPT 0.6626 0.6640 0.6623 0.6627 -.0021 0.6906 0.6445 1,545

EST VOL 5,857; VOL MON 9,955; OPEN INT 53,773, -1,902

BRITISH POUND (CME)-62,500 PDS.; $ PER POUND

MAR 1.4750 1.4750 1.4570 1.4584 -.0168 1.6050 1.4010 28,681 EST VOL 30,974; VOL TH 10,792; OPEN INT 74,908, +781

SWISS FRANC (CME)-125,000 FRANCS; $ PER FRANC

MAR 0.6119 0.6119 0.6042 0.6050 -.0069 0.6326 0.5541 47,387

JUNE 0.6100 0.6107 0.6073 0.6078 -.0070 0.6358 0.5585 451 EST VOL 11,255; VOL MON 8,076; OPEN INT 47,854, -1,532

AUSTRALIAN DOLLAR (CME)-100,000 DLRS.; $ PER A.$

MAR 0.5496 0.5512 0.5468 0.5488 -.0009 0.6390 0.5100 23,106 EST VOL 493; VOL MON 1,092; OPEN INT 20,205, -200

MEXICAN PESO (CME)-500,000 NEW MEX PESO, $ PER MP

EURO FX (CME)-EURO 125,000; $ PER EURO

MAR 0.9393 0.9400 0.9292 0.9308 -.0089 0.9999 0.8333 89,251

JUNE 0.9351 0.9351 0.9314 0.9321 -.0089 0.9784 0.8358 1,951

SEPT 0.9334 -.0089 0.9634 0.8379 851 EST VOL 13,310; VOL MON 18,079; OPEN INT 92,109, -264