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    International Financial Markets Part 2

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    truthoverlove
    This document discusses international financial management topics including exchange rates, forward exchange rates, interest rate parity, hedging international cash flows, and investing in foreign real assets.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd

    International Financial Markets Part 2

    Uploaded by

    truthoverlove
    3 views9 pages
    This document discusses international financial management topics including exchange rates, forward exchange rates, interest rate parity, hedging international cash flows, and investing in foreign real assets.

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    International Financial Markets part 2

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    This document discusses international financial management topics including exchange rates, forward exchange rates, interest rate parity, hedging international cash flows, and investing in foreign real assets.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    3 views9 pages

    International Financial Markets Part 2

    Uploaded by

    truthoverlove
    This document discusses international financial management topics including exchange rates, forward exchange rates, interest rate parity, hedging international cash flows, and investing in foreign real assets.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 9

    International Financial Management

    International Financial Mgmt


     If a company has monetary assets denominated in
    a foreign currency, it is exposed to the risk of
    exchange rate fluctuations.
     Purchasing power parity is an application of the
    assumption that free markets do not allow
    arbitrage opportunities to exist for long. Law of
    one price
     Exchange rates portray relationships in wealth
    exchanges across national borders in much the
    same manner as interest rates portray wealth
    exchanges across time.
    Exchange Rates
    Imperfections
    Frictions include:
     Transaction Cost
     Information Costs
     Perishability

     Even with its imperfections, there is an impressive


    elegance and consistency in exchange rates across
    currencies based on the general economics of
    international transactions.
    Forward Exchange Rates

    By entering a forward exchange contract, a trader


    commits to purchase or sell an amount of currency at a
    fixed rate at a fixed time in the future.
     The same result can be achieved by borrowing in the
    foreign currency, exchanging spot and investing the
    proceeds in the domestic currency. See example on
    page 11/7
    Interest Rate Parity
     Interest rate parity ensures that borrowing or lending in
    one currency at the interest rates applying to that currency
    will produce the same final wealth as borrowing or lending
    in any other currency at the interest rates applying to the
    other currencies. Stated that way, the concept is almost self
    evidently necessary: interest rates must adjust to ensure
    such parity or there will be arbitrage opportunities.
     Relative interest rates = Relative forward exchange discount
    or premium
    Forward Exchange, Interest Rates
    and Inflation Expectations
     Maintaining purchasing power across time
    requires that the forward exchange rates for any
    two currencies be consistent with the inflation
    expected in those currencies.
     Nominal interest rate = Real interest rate + Effect of
    inflation
     (1 + nominal rate)n = (1 + Real rate)n x (1 + inflation
    rate)n
     The connection is that interest rate differentials
    are caused by inflation differentials, which are the
    root cause of the observed discount or premium on
    forward exchange.
    Hedging International Cash Flows
     Forward Contract
     Covered Borrowing
     Foreign Exchange Options
    Investing in Foreign Real Assets
     The basic process of deciding upon the financial viability of a foreign
    investment is the same as a domestic one: estimate the expected cash
    flows from the investment and discount at the investment’s cost of
    capital (or use the cost of capital as a hurdle rate for IRR analysis).
    1. It can predict future exchange rates between sterling and Euro, apply
    those to the Euro future cashflow estimates, and discount future
    sterling cash flows to the present at the sterling discount rate.
    2. Or it can discount future Euro cashflow estimates at the Euro discount
    rate and translate these Euro values to sterling values using the spot
    exchange rate.
    Extra risks in foreign investment
    Financial Sources for Foreign
    Investment
     Monetary assets are those whose returns are
    expected to be fixed in monetary or money terms
    in the future, regardless of the inflation rate in the
    economy.
     Only these are serious candidates for the hedging of
    exchange risk.
     Real assets are not fixed in foreign currency
    value, but will increase in value with increases in
    foreign inflation.
     This applies to plant and equipment, but also other
    longer-term productive assets.

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