Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA INTERNATIONAL FINANCE Professor Ivar Bredesen International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA What is special about international finance? International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA Foreign exchange rate risk Political risk Market imperfections Expanded opportunity set

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Course contents International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA The course is divided into three parts : –The International Financial Environment –Exchange Rate Behaviour –Exchange Rate Risk Management Workload – 7.5 ECTS –Examination (80 %) and assignments (20 %)

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Required reading Madura and Fox, 2nd ed. Good, intermediate level text in international finance

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA We will cover the following chapters: –1: Multinational Financial Management –2: International Flow of Funds –3: International Financial Markets –4: Exchange rate determination –5: Currency Derivatives –7: International arbitrage and interest rate parity

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA We will cover the following chapters: –8: Inflation, interest rates and exchange rates –9: Forecasting exchange rates –10: Measuring exposure to exchange rate fluctuations –11: Managing transaction exposure –12: Managing economic exposure and translation exposure Note that we will cover some chapters in more depth than the textbook. It is therefore important to read the lecture notes also.

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Financial Risk Management The field of financial risk management normally contain the following: –Interest rate risk –Commodity price risk –Equity risk –Currency risk This course will deal with currency risk We need to know some finance to assess the instruments used to hedge currency risk and some economics to understand exchange rate behaviour

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Foreign Exchange Risk –This is risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. –Suppose $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000 per share. One year later the investment is worth ten percent more in yen: ¥110,000. –But, if the yen has depreciated to $1 = ¥120, your investment has actually lost money in dollar terms. 1-8

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Europe’s Sovereign-Debt Crisis of 2010 In December of 2009 the new Greek government revealed that its budget deficit for the year would be 12.7% of GDP, not the 3.7% forecast. Investors sold off Greek government bonds and the ratings agencies downgraded them to “junk.” While Greece represents only 2.5% of euro-zone GDP, the crisis became a Europe-wide debt crisis. The challenge remains that fiscal indiscipline of one euro- zone country can escalate to a Europe-wide crisis. 1-9

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA The Greek Drama Greece paid no premium above the German rate until late fall The Greek interest rate rose until the bailout package on May

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Foreign Exchange Markets The FOREX market provides the physical and institutional structure through which –The money of one country is exchanged for that of another country –The rate of exchange between currencies is determined –Foreign exchange transactions are physically completed The FOREX market is extremely competitive and highly efficient

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Transactions in the Interbank Market Transactions within this market can be executed on a spot, forward, or swap basis –A spot transaction requires almost immediate delivery of foreign exchange –A forward transaction requires delivery of foreign exchange at some future date –A swap transaction is the simultaneous exchange of one foreign currency for another

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Outright Forward Transactions This transaction requires delivery at a future value date of a specified amount of one currency for another The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months –Terminology typically used is buying or selling forward –A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Swap Transactions A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Both purchase and sale are conducted with the same counterpart A common type of swap is a spot against forward –The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market –Since this transaction occurs at the same time and with the same counterpart, the dealer incurs no exchange rate exposure

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Size of the FOREX Market The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be US$4.0 trillion in April 2010, up from 3.2 trillion in 2007 –Spot transactions at $1,490 billion/day, up 48 % –Outright forward transactions at $475 billion/day –Swap transactions at $1,765 billion/day

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Global Foreign Exchange Market Turnover, April 2010 (daily averages, billions of U.S. dollars)

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Turnover by instrument

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Turnover by currency

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Top trading centers

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Norway April 2010 (million USD) total, USD, Euro, Yen, GBP, Swiss Francs

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Foreign Exchange Rates & Quotations Direct and Indirect Quotes –A direct quote is a home currency price of a unit of a foreign currency NOK 5/$ is a direct quote in Norway –An indirect quote measures how much foreign currency you can buy for one unit of your own NOK 0.2/$ is an indirect quote in the Norway, NOK 0.2/$ is a direct quote in the US and an indirect quote in Norway

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Foreign Exchange Rates & Quotations Interbank quotes are given as a bid and ask –The bid is the price at which a dealer will buy another currency and the ask or offer is the price at which a dealer will sell another currency –This is the bid/ask spread. bid/ask % spread = ask rate – bid rate ask rate –Example: ¥ ¥118.37/$ is the bid/ask for Japanese yen –Bid/Ask spread = ( – )/ = %

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Foreign Exchange Rates & Quotations Forward Quotations can be expressed in several ways –We will generally use the actual forward exchange rate – called an outright quote –Forward quotes are also quoted in terms of points i.e. how much they differ from the spot rate. A point is the last digit of a quotation, with convention dictating the number of digits to the right of the decimal –The difference between spot rates and forward rates can also be expressed as a % per-annum deviation from the spot rate (premium or discount)

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA BidAsk Outright spot: ¥ ¥ Outright forward: ¥ ¥ Plus points (3 months) Foreign Exchange Rates & Quotations Expressing Forward Quotations on a Points Basis –The yen is quoted only to two decimal points –A forward quotation is not a foreign exchange rate, rather the difference between the spot and forward rates –Example:

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Foreign Exchange Rates & Quotations Forward Quotations in Percentage Terms –For direct quotes (i.e. quote expressed in home currency terms), the formula is If > 0, the foreign currency is said to be trading with a premium, if < 0 the foreign currency is trading with a discount

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Euro spot and forward Jan 14 –

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Japanese yen¥110.73/$ Mexican pesoMXP /$ Foreign Exchange Rates & Quotations Cross Rates –Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency –Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (MXP) and Japanese yen (¥) are quoted in US dollars Assume the following quotes:

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Foreign Exchange Rates & Quotations Cross Rates –The Mexican importer can buy one US dollar for Mexican pesos and with that dollar buy ¥110.73; the cross rate would be –110.73/ = ¥9.6745/MXP

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Currency Futures and Options Market A currency futures contract specifies a standard volume of a particular currency to be exchanged on a specific settlement date. Unlike forward contracts however, futures contracts are sold on exchanges. Currency options contracts give the right to buy or sell a specific currency at a specific price within a specific period of time. They are sold on exchanges too.