The World of International Finance
- International finance has unique dimensions that cannot be learnt
by simply applying concepts and theories from domestic finance.
- Why do countries trade with each other?
- Why are there firms that span countries?
- Absolute Advantage
- Comparative Advantage
- Theory of Factor Proportions
- Overlapping Product Ranges Theory
- Product Cycle Theory
- Porter's Comparative Advantage of Nations
The Market for Foreign Exchange
- Who are the different participants in the Foreign Exchange market?
- How does CHIPS work?
- What is the difference between CHIPS and FedWire?
- What is the difference between a direct and an indirect quote?
- What is the bid-ask spread?
- How does currency arbitrage work? If you were a trader, how would
you determine if profitable arbitrage opportunities exist, at any point
- What is settlement risk/Herstatt risk ?
- How do you compute a cross-rate?
- What is the difference between one-way arbitrage and triangular arbitrage?
- How are forward rates quoted?
- How is hedging with forward contracts accomplished?
- Different systems of quoting
You should know:
- How to convert from direct to indirect quotes
- How to compute cross quotes
- How to convert from forward quotes in points to outright forward quotes
- How to determine if arbitrage is possible
The Determination of Exchange Rates
- What are the factors that determine the exchange rate?
- How do you compute a change in exchange rates?
- Why is central bank independence and reputation important for the
value of a currency?
- How do exchange rates affect competitiveness?
- Factors affecting supply of foreign currency
- Calculating Exchange Rate Changes
- Asset Market Model of Exchange Rates
- The Nature of Money and Currency Values
The Fundamental International Parity Conditions
- Why would you expect purchasing power parity to hold?
- Why does it not always hold?
- Why would you expect covered interest rate parity to hold?
- Why might covered interest rate parity not always hold?
- What is the difference between the nominal and real changes in the
- What will happen to interest rates and exchange rates if there is
a one-time 10% increase in the money supply?
- Why would you expect the real interest rate to be equal across countries?
- Purchasing Power Parity
- Static Form
- Dynamic Form
- Expectations Form
- Covered Interest Rate Parity
- Uncovered Interest Rate Parity
- Fisher Open Condition
- International Fisher Effect
- Unbiased Expectations Hypothesis
You should know:
- How to check if covered interest parity is violated
- How to use covered interest rate parity to infer forward rates or
interest rate differentials.
- How to use PPP to estimate inflation rates
- How to use the International Fisher equation to infer expected changes
in exchange rates from interest rate differentials.
- How to use the Fisher Open Condition to infer inflation rates from
interest rate differentials.
Foreign Exchange Exposure and Risk
- What is foreign exchange exposure?
- What is foreign exchange risk?
- How do we measure foreign exchange risk and foreign exchange exposure?
- What factors contribute to risk and exposure?
Accounting Exposure and Real Exposure
- What is accounting exposure?
- How does it differ from economic/operating exposure?
- Real changes in exchange rates
- How accounting rules contrast with the measurement of real changes
in exchange rates
- The implications of exchange rates for the revenues, costs, and profits
of companies invovled in international commerce.
- Factors affecting the impact of exchange rates on profits
- elasticity of demand for a company’s products,
- the types of inputs used,
- The use of internationally traded inputs
- Flexibility of production to meet changes in demand
- Time span consdiered
- Degree of competition faced in markets where the goods are sold
- Even a company with hedged receivables and payables can be affected
by foreign exchange exposure.
Hedging Risk and Exposure
- Should firms hedge forex risk?
- How do firms hedge transactions exposure using forwards, futures,
swaps and options?
- How can firms hedge operating exposure?
- Estimating the cost of hedging with forwards
- Hedging with futures versus forward contracts
- The cost of hedging with swaps (or money market hedging)
- Hedging: taking steps to reduce exposure to risk; in our case, exposure
to risk of foreign exchange rate fluctuations.
- Cost of hedging: the expected difference in cashflow between hedging
now and doing nothing.
- Forward Contracts: contracts for future delivery and future payment
(where the commodity being delivered and paid for, in this case, is
a foreign currency)
- Futures Contracts: these are standardized forward contracts that are
usually traded on an exchange, where the opposite side of the transaction
is taken by a clearing house and there is daily settlement.
- Risk Premium in forward markets: the expected difference in cashflow
between hedging in the forward markets and doing nothing (i.e. transacting
later in the spot market)
- Accounts payable: monies that are owed to other parties and that will
have to be paid in the future, possibly in other currencies.
- Accounts receivables: monies that are owed to the firm by other parties
and that will be paid in the future, possibly in other currencies.
- Bid price: the price at which a currency dealer is willing to buy
a foreign currency
- Ask price: the price at which a currency dealer is willing to sell
a foreign currency
- Bid-ask spread: the difference between the ask price and the bid price
- (Currency) Swap: the simultaneous purchase and sale of a currency
on the spot or forward market.
- Swap hedging (Importer): Importers are short the foreign currency;
they can hedge with a swap by borrowing in the home currency, buying
the foreign currency spot, and investing in the foreign currency.
- Swap hedging (Exporter): Exporters are long the foreign currency;
the can hedge by borrowing in the foreign currency, buying the home
currency spot, and investing in the home currency: the loan is repaid
from the export proceeds.
- Currency of Invoicing: The currency in which the invoice is denominated;
payment is supposed to be made in that currency.
- Risk-sharing: in the case of currency risk, this refers to an agreement
between a seller and buyer, where the seller is interested in receiving
one currency and the buyer is interested in paying in another currency.
The agreement stipulates some form of sharing of the currency risk between
- reinvoicing center: a separate corporate subsidiary that manages in
one location all transaction exposure from intracompany trade.
- leads and lags: this refers to the time interval before accounts payable
and accounts receivable have to be settled. For example, if exchange
rates are expected to move in certain directions, it might be advantageous
to settle accounts payable early (leading; if the local currency is
expected to weaken) or hold off on settling accounts receivable (lagging;
if the local currency is expected to strengthen)
- outsourcing: the practice of moving out operations from within the
firm and contracting for their provision with outside entities. These
entities may be in other countries, in which case the practice is often
known as outshoring.
- currency matching: the practice of matching inflows and outflows in
a given currency, so that the net flow is close to zero. This minimizes
exposure to that currency.
Capital Budgeting for Foreign Investments
- How is Capital Budgeting in an international context different?
- What is the traditional notion of Cost of Capital?
- How do we estimate the cost of equity and the cost of debt in a domestic
- What is the relevance of who “owns” the company?
- How do we use proxy companies in estimating cost of equity?
- What is the relevance of country risk?
- How do we estimate country risk?
- Cost of capital: the cost of obtaining funding for a project -- usually
used to denote the cost of funding the portfolio of all of a firm's
- The return approach: the minimum return required to induce an investor
to invest in a certain project
- The cost approach: the cost paid by a corporation to obtain funds
for investing in a certain project
- CAPM: the Capital Asset Pricing Model; this model describes the expected
premium required by investors to invest in a certain project as the
product of its beta and the market risk premium
- beta: a measure of market (or non-diversifiable) risk
- market portfolio: the portfolio of all available assets in the economy
- global market portfolio: the market portfolio which includes all assets
in the global economy.
- Market Risk Premium: the expected excess over the risk free rate that
is available to investors investing in the market portfolio.
- yield-to-maturity: the return of return available on a bond if it
is held to maturity and the bond does not default.
- synthetic bond ratings: bond ratings implied by corporate indicators
like the interest coverage ratio.
- WACC: the weighted average cost of capital; the average of the cost
of equity capital and debt capital weighted by their relative market
proportions in the firm's financing.
- debt ratio: the ratio of the debt of the firm to its total assets.
- marginal tax rate: the increase in the taxes paid by the firm due
to the increase in its taxable income by one dollar.
- diversification: strategies that remove non-market risk from a portfolio;
a standard technique is to invest in many different securities, instead
of a single one.
- Modigliani-Miller theorem on capital structure: the hypothesis that
in the absence of frictions, the capital structure of a firm does not
affect its value.
- country risk premium: the risk premium required by investors for investing
in projects in a specific country, over and above its beta risk.
- skewness: this is a measure of the non-symmetry of a probability distribution.
It is computed as the expected value of the cube of the deviation of
a random variable from its mean.
- catastrophic risk: the risk that the realized return will deviate
from its mean by a large amount due to an infrequent occurrence.
- market skewness premium: the expected excess return required by investors
because of the skewness of the market portfolio over and above the market
beta risk premium.
- co-skewness coefficient: the extent to which addition of an asset
will increase or decrease market skewness if added to the market portfolio.
- volatility ratio: the ratio of std. devn. of local equity returns
to the std. devn. of world equity returns
- integrated capital markets: the extent to which the price of risk
is the same in different capital markets; depends on access of international
investors to capital markets in different countries.