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IF Cheat Sheet

International Finance (Nanyang Technological University)

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Ch.1: Introduction to International Finance *Many investors purchase stocks overseas because: 1) Expectations of favourable economic
Management Structure: Centralized(parent ctrls) vs Decentralized(subsidiary ctrls) Theory of Forward ( OTC: FX Dealer;High CP Future ( Foreign Exchange;Low CP Risk conditions in that particular country, 2) wish to acquire stocks denominated in currencies
Comparative Advantage: Specialize to increase production efficiency, rely on other countries Risk) ) expect to appreciate over time (enhance ROI), 3) means of diversifying their portfolio (less
to meet other needs e.g. Japan–Tech, China– Cheap labour sensitive to adverse stock market conditions in home country) Factors influencing trading
Specified amount, rate, date in future Standardized, exchange-traded, liquid activity:
Imperfect Markets Theory: Immobile factors of production provide incentives to seek out foreign
opportunity and encourages specialization i.e. work permit Product Cycle Theory: Firms Ch. 3: International Financial Markets 1) shareholders rights, 2) legal protection of shareholders, 3) enforcement of securities law
become established locally and seek opportunities overseas(outside domestic) to lower COP, Foreign Exchange Market (anticorruption), 4) accounting laws (financial disclosure & transparency)
expanding product specialization Attributes of Banks: Competitiveness of quote, Special Relationship, Execution Speed, Advice on current
market conditions, Forecasting advice *Bid (Buy) < Ask (Sell) Ch. 4: Exchange Rate Determination
How firms engage in International Business (Increasing risk & capital invested)
1. International Trade (Import / Export) – no capital, risk in default payments Askrate−Bidrate
2. Licensing (Technology for fees) – low capital, difficulty in quality control St−St−1
*covers bank’s cost Askrate
3. Franchise (Sales/service/initial investment for periodic fees) – low capital
Bid-ask percentage spread = Percentage ∆ in foreign currency value =
4. Joint Venture (Jointly-owned and operated by >= 2 firms) – competitive advs
5. Acquisitions (Full control over foreign business) – obtain large market share of conducting FX Factors that


6. Foreign subsidiary (New operations, large investment) – tailor to firms’ needs
1,2 not DFI, 3,4 limited, 5,6 largest portion of DFI
affect the spread:
Order costs, inventory costs, competition (↑, spread ↓) , volume (liquidity ↑, spread ↓), currency risk
St−1
Ch.2: International Flow of Funds Direct Quote: Value of foreign currency in dollars e.g. $1.40 per Euro Exchange rate equilibrium: (Qty DD of currency = the supply of currency for sale)
Components of Balance of Payments: **Debit – Outflows Credit - Inflows BOP – Indirect Quote: Number of units of a foreign currency per dollar e.g. £0.60 per dollar Increase in demand, Dd > Ss, shortage at prevailing rate, bank increase rates until DD=SS
 Indirect Quote = 1 / Direct Quote $1.55/
Summary of transactions between domestics and foreign residents Increase in supply, Ss > Dd, excess at prevailing rate, banks reduce rates until DD=SSs
1. Current Account (Trade Flows of Funds e.g. Goods & Services) Cross Rates: Value of foreign currency in another foreign currency *1,3,4 – Trade-related (Goods – less responsive) 2,5 – Financial-related (securities – more)
a. Balance of Trade (Service/Merchandise (X-M) aka net exports) e.g. Value of peso = $0.07; Value of C$ = $0.70
Factors that Influence Exchange Rates (x-axis – Qty of FX, y-axis – value of FX)
b. Factor Income payments (Income on foreign inv e.g. dividend, interest)
c. Transfer payments (Aids, grants, gifts) $0.07 1. Relative Inflation Rate (Increase US inflation, US demand for foreign good, demand
for foreign currency, FX) *decreases foreign demand for US goodsdecreases supply of FX
2. Capital Account (Asset transferred across countries)  Value of peso in C$ =
a. Value of financial asset transferred across country borders 2. Relative Interest Rate (Increase U.S. i/r, demand for U.S. deposits, decrease in
b. Patents and Trademarks = C$0.10 $0.70 demand for foreign deposits, demand for dollar, FX) *supply of FX to exchange for dollar
also increase
3. Financial Account (e.g. DFI, portfolio (LT) & capital (ST) investments) Forwards vs. Futures
4. Errors & Omissions and Reserves (offset to balance BOP) a. Fisher Effect: Real Interest Rate approx. = Nominal – Inflation
Outsourcing: Subcontracting services to 3rd party in another country lower COP 3. Relative Income Levels (Increase U.S. income, U.S. demand for foreign good,
May correct a BOT deficit automatically (deficit  depreciation  foreign demand for domestic goods) - demand for foreign currency, FX) Supply of FX unaffected, British income unchanged
Limitations: 1) Competition through lowered prices 2) Deficit with other countries as well 3) J-curve lag 4) 4. Government Controls (FX barriers, trade barriers, affecting macro variables e.g. 1-3)
Intracompany trade unaffected by currency fluctuations 5) Exchange rates & International Friction Currency Options Market (no obligation):
Call – Provides the buyer the right to buy currency at specified strike price within a specific period 5. Expectations (Favorable (i/r, FX ↑) – Invest; Unfavorable (i/r, FX ↓) –Downward pressure)
Factors affecting International Trade Flows: **Increase international flows (MS)  of time. *Hedge Future Payables
lower cost of borrowing (i/r)  Increase business investment Put – Provides the buyer the right to sell currency at specified strike price within a specific period Capitalizing on Expected Exchange Rate Movements
Cost of labour Inflation National Income of time. *Hedge Future Receivables 1. Speculating on expected foreign ccy appreciation/depreciation (not risk-free)
(lower, better) (Increase, CA fall) (Increase, CA fall) a. Borrow home currency at BORROWING rate, convert to foreign currency at spot
Credit conditions Govt. policy (import taxes & Exchange rate (Recession  tighten) quotas, b. Invest at LENDING rate for *period (e.g. 30 day period; convert annualized to 30-day)
International Money Market (ST maturity  no credit risk, only exchange rate risk)
export subsidies) (appreciate, CA fall) Factors affecting International Capital c. After period, receive investments and convert back to home currency at future spot
• Eurodollars: Dollar deposit in banks in Europe
Flows: d. Use investment receipts to repay home currency loan (at borrowed rate)
DFI: Restrictions (less), Privatization, Potential Economic Growth, Tax Rates (low), Exchange
• Asian dollar market: Dollar-denominated deposits in HK, SG Money
2. Carry trade – Capitalize on interest rate differential between 2 countries
rates (strengthen) market interest rates are dependent on demand for ST funds by borrowers,
a. Use own dollars + borrow euro with lower i/r, convert to £
International Portfolio Investment: Tax rates on dividend/interest (low), interest rates (high), relative to supply of ST funds provided by savers (demand ↑ or supply ↓  MM i/r ↑) b. Invest in £ (higher i/r) and receive returns on investment
exchange rates (strengthen)  MM interest rate among countries tend to be highly-correlated c. At end of period, use pound returns to repay euro loan (convert loan to £)
Agencies that facilitate International Flows  When economic conditions weaken, need for liquidity falls, aggregate demand
International Monetary Fund Encourage internationalization of business d. Convert held pounds into dollars (Profit = converted dollars – own dollars)
of ST funds and MM interest rates decline Rule of thumb: Borrow at depreciating currency, invest/lend appreciating
Provide temp funds to correct trade imbalance
 When economic condition strengthens, increase in corporate expansion,
World Trade Organisation Forum for multilateral trade negotiations
aggregate demand of ST funds & MM interest rates rise
Settle trade disputes according to GATT Ch. 5: Currency Derivatives (Purpose: Speculation & Hedging
International Bank for Reconstruction & Loans to countries to reduce poverty and
Development (Co-financing agreements) enhance economic development (SALs) International Credit Market (Medium-term maturity e.g. >1yr loans in EU; Euro-credits) exposure)
International Development Association Extend low-interest loans to poor nations that Commonly use floating rates tied to LIBOR to avoid interest rate risk Forward Market F: forward rate; S: Spot rate;
don’t qualify for loans from World Bank Basel III: Require banks to maintain higher levels of capital (for riskier assets)
(6% of risk-weighted assets, 2.5% as capital conservation buffer)
International Financial Corporation Promote private enterprise within countries;
Provide loan to corporations & purchases stocks
F−S (p: forward premium/discount influenced by i/r
Bank of International Settlements (lender
countries of last resort; during financial crisis)
Facilitate cooperation among
regarding international transactions
International Bond Market (Key: I/R, Liquidity, Credit, Exchange Rate risk)
Facilitates flow of LT funds between borrowers and investors differential360 )
Organization for Economic Cooperation & Facilitate governance in
governments and
> Yields for bonds vary (*risk premium that reflects credit risk of corporation)
Foreign bonds: Bonds issued by borrower foreign to the country where bond is placed F = S (1+p) p= x
Development corporations Eurobond (denominated in multiple currencies) issue increased market liquidity
Regional Agencies: Inter-American Development Bank, Asian Development Bank, African
Development Bank, European Bank for Reconstruction and Development
International Stock Market (stock market reflects prevailing economic conditions) S Maturity(¿days)
Risk premium links stock and credit(bond) market; affects rate of return required (e.g. under  If forward rate = spot rate and interest rates differ, arbitrage possible
favorable conditions, risk premium required is low  high valuation of debt securities & stocks)

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Currency Futures Market (Greater Liquidity due to Standardization) Buy Speculating with currency call options (long): (Expected Appreciation) Less: Premium paid for option ($0.04) ($1,250.00)
forward/futures to hedge payables; sell forward/futures to hedge receivables Per £ Per Contract (31,250) Net Profit / (loss) $0.06 $1,875
Most positions are closed out before settlement date. Selling price per £ (spot) $1.41 $44,062.50 Straddle strategy: Use both call and put option at same exercise price
e.g. Buy A$100,000 at $0.53 per A$ = $53,000 at settlement date Sell Less:Purchase price of £ ($1.40) ($43,750.00) Conditional option:
A$100,000 at $0.51 per A$ = $51,000 at settlement date (Net -$2k) (strike) Option premium conditioned
Speculation using futures: Expected Depreciation (sell futures) on actual movement in
Less: Premium paid for option ($0.012) ($375)
e.g. Sell 500,000 peso at $0.09 per peso = $45,000 at settlement date Buy currency’s value i.e. Paid on
Net Profit / (loss) ($0.02) ($62.50)
500,000 peso in spot market at $0.08 per peso = $40,000 paid (Net +$5k) trigger @ $1.74
 Breakeven where revenue from selling currency = payments made for option
currency + premium (Breakeven spot rate = Strike price + premium)
Currency Options Market (Purchased on Exchange & OTCs) Factors Factors affecting Currency Put Option Premiums
affecting Currency Call Option Premiums Spot price relative to Strike Price Lower spot relative to strike price, higher
Spot price relative to Strike Price Higher spot relative to strike price, the higher the (S – X) probability of exercising option (higher prem
(S – X) option price Length of time before expiration (T) Longer time, higher option premium
Length of time before expiration (T) Longer time, higher option price

Potential variability of currency ( Greater variability, higher probability spot rate σ¿ Potential variability of currency ( Greater variability, higher probability option may σ¿
be exercised
can rise above strike price Ch. 6: International Arbitrage and Interest Rate Parity
Speculating with currency put options (long): (Expected Depreciation)
 To hedge payables, project bidding to lock in rates, acquisition Locational Arbitrage (buy at cheap, sell at high)
Per £ Per Contract
Buy currency at lower ASK (Bank A); Sell currency at higher BID (Bank B)
(31,250) *Realignment: High demand at Bank A causes shortage  raise ASK price. Excess supply at Bank
Selling price of £ (strike) $1.40 $43,750.0 B causes surplus  lower BID price
Less: Purchase price of £ ($1.30) ($40,625.00) Triangular Arbitrage (capitalize on cross exchange rate discrepancies)
(spot)
Step 1: Buy currency A using home currency @ASK e.g. Buy £ using $ investments in risk-free bearing securities
Step 2: Sell currency A for currency B @BID e.g. Sell £ for MYR Variations in forward rates
Step 3: Sell currency B for home currency @BID e.g. Sell MYR for $ 1. Indirectly affected by factors affecting spot (inflation & interest rate differentials)
 Quoted market rate should be higher than implied cross rate for A/B 2. Change in forward premium
*Realignment: 1) raise ask price of £/$ due to shortage of pounds, 2) lower bid price of £/myr due Ch. 7: Relationship between Inflation, Interest Rates & Exchange Rates
to excess supply of pounds, 3) lower bid price of myr/$ due to excess supply of ringgit Absolute PPP: Consumers shift demand to wherever prices are lower (until price equals)
Covered Interest Arbitrage – ensures forward rate is properly priced > Prices of same basket of goods should equal when measured in common currency
(Capitalize on interest rate differential while covering exchange rate risk) Relative PPP: Prices not equal due to market imperfections BUT
e.g. Spot rate = forward rate; iUSD = 8%, iGBP = 16% > Rate of change in prices should be similar when measured in common currency
Day 1: Exchange USD for GBP, invest in GBP, sell GBP returns forward of amount to receive
Day 90: Exchange GBP for USD Purchasing Power Parity (more applicable when engaged in intensive intl trade)
If PPP holds, equilibrium exchange rate will adjust by same magnitude as the difference between

two countries’ inflation rate => Use relative PPP to estimate how exchange rate will respond to
Interest Rate Parity differential inflation rates between countries
If IRP holds, size of forward premium (or discount) should be equal to the interest
rate differential => Covered interest arbitrage not feasible since interest rate Sh/ f 1+I f S
advantage would be offset by discount on forward rate Y-axis: Inflation rate differential Ih- If X-axis: %
PPP line (left): Increased purchasing power of e=S'h/ f −1=1+Ie: Exchange rate h −1 S'h/f : Future spot rate
change in the foreign currency’s spot rate
foreign goods Right: Decreased PP of foreign good
Why PPP doesn’t hold: *To test PPP, regress historical exchange rate & inflation differentials
p= FSh/f −1=1+p: forward premium ihS−1 Fh/f : Forward rate 1. Confounding effects (spot rate is driven by other factors; factors that influence exchange rate);
2. Without substitutes domestically, consumers may not stop buying imported goods
3. Results vary with base period used (base period should reflect equilibrium position)

h/f 1+if
Right of IRP line, investors in home country
should consider using covered interest
arbitrage, since higher return than home
country is possible

Left of IRP line, foreign investors should

consider covered interest arbitrage, since
higher returns in the home country is possible

*IRP does not simply investors from different

countries earn the same returns. IRP reflects
the comparison between foreign and domestic

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International Fisher Effect (relies on Fisher Effect and PPP)

If IFE holds, one who periodically invests in interest-bearing foreign securities will, on average, Receive $142,000 in 6-mths Lending rate 4%, proceeds = $138,640
achieve return similar to domestic => Exchange rate of country with high inflation rate will
depreciate to offset the i/r advantage achieved by foreign investments 3. Put Option
Hedge
IFE line: left; higher returns investing in home deposits, right; higher returns investing in foreign (uncertain)

Y-axis: Interest rate differential ih- if X-axis: % change in the foreign currency’s spot rate Alternative Hedging Strategies
Step 1: Apply Fisher Effect to derive expected inflation rate of two countries 1. Pricing policy 2. Hedging with forwards 3. Purchasing foreign supplies
Step 2: Apply PPP to determine how exchange rate changes in response to inflation 4. Financing with foreign funds 5. Revising operations of other units
 Currency with high interest rate will have high expected inflation (FE), and the relatively high
inflation will cause currencies to depreciate (PPP effect)
Exposureofcurrency portfolio σ p W Managing 2 2Translation
2 2Exposure
1+I 1 w: Proportion of portfolio value in currency x or y =√ W x σ x + W y σ y + 2  Can be hedged with forwards / futures

Accounting distortions

e=h −1= +ihIi :−: Home interest rate

hh i Home inflation rate I 1 ::
ff
 Inaccurate earnings forecast σ : Standard deviation of percentage
Foreign inflation rate Foreign interest rate changes in currency x or y  Inadequate forward contracts for some currencies Increased transaction exposure

1+If 1+if Correl: Correlation coefficient of percentage changes in currencies x or y Ch. 11: International Capital Budgeting
Subsidiary versus Parent Perspective
1. Tax differentials make project feasible to subsidiary, but not parent
IFE Contradictions:
2. Government placing restrictions on remitted earnings / excessive remittances
1. Against how country with high IR attract more capital flows & strengthen local ccy
3. Earnings converted to currency of parent affected by exchange rate movements
2. Against how central banks raise IR to attract funds and strengthen local currency
Comparison of IRP, PPP, IFE
IRP: Focus on why forward rate differs from spot rate at a specific point in time
PPP: Suggests spot rate changes over time in accordance to inflation differentials
IFE: Suggests spot rate changes over time in accordance to interest rate differentials

Ch. 8: Measuring Exposure to Exchange Rate (FX) Fluctuations Economic Exposure

Transaction Exposure Sensitivity of firm’s cash flows to exchange rate movements (operating exposure)
Sensitivity of firm’s contractual transactions in foreign currencies to FX movements - Appreciation in local currency reduces both cash inflows and outflows
Long-term hedging instead of repeated short-term hedging - Depreciation of local currency increases both cash inflows and outflows

 Estimate net cash flows in each currency and measure effects of exposure Sensitivity Analysis
Leading (expect local ccy to depreciate) & Lagging (expect local ccy to appreciate) –
Adjust timing of payment to reflect expectations of future currency movements
3. Cross-hedging – Hedge using a currency that serves as a proxy for exposure
4. Currency diversification – Diversifying business among numerous countries
Ch. 10:
Managi
ng
Econo
mic
and
Transla CF SV
tion t n IO: Initial outlay SV: Salvage value
Expos
ure
t n
+¿
k: Required rate of return n: Project lifetime
Restru
cturing (1+k) (1+k)
Operati
Translation Exposure n
ons to

NPV=−IO+∑¿
Reduc
e Exposure of MNC’s consolidated financial statements to exchange rate fluctuations.
Econo
- Take the weighted average exchange rate to translate subsidiary earnings
mic
Expos - As translation exposure affect consolidated earnings, it affects MNC’s valuation t=1
*Determinants: 1) Proportion of biz by sub, 2) Location of sub, 3) Accounting methods
ure
Ch. 9: Managing Transaction Exposure
Strategi Factors to Consider: Exchange Rate Fluctuations
es to Hedging Exposure to Payables
hedge 1. Forward Hedge 2. Money Market Hedge
economBuy forward Borrow H Invest F €100,000 payable 1-year €100,000 payable 1-year
ic 1-year Euro forward Euro deposit rate 5% p.a.; Required Deposit €95,238
$1.20
exposur Spot rate(ask) of Euro = $1.18; Deposit amt = $112,381
e: Cost $120,000 in 1 year Borrowing rate = 8%; Cost $121,371 in 1 year
3. Call Option

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Hedge (uncertain) Hedging Exposure to Receivables

1. Forward/Future Hedge 2. Money Market Hedge
Factors to Consider: Hedged Sell forward Borrow F currency, use receivables to pay-off
Cash Flows CHF200,000 receivable 6- CHF200,000 receivable 6-mth
Real cost of hedging = Cost of hedging payables – Cost of payables if unhedged mth Borrowing rate 6%, amt to borrow = CHF194,175
6-mth CHF forward = $0.71 Current CHF spot (bid)= $0.70, loan amt = $135,922

Because
larger cash
flows +
larger
salvage
value
remitted to
parent will
der: Subsidiary and Parent Financing be more
d parent investment increases exchange rate exposure susceptible
der: Blocked Funds to
exchange
rate
fluctuations

der: Uncertain Salvage Value

n Other factors:
CF

]
t n
∑( 1+k) t
eliminate (1+k)
initiatives, real options e.g. opportunity to obtain or
real assets i.e. buy building at discount
=1
Impact on prevailing cash flows, host govt

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