2. Ian Giddy

3. INTERNATIONAL
FINANCIAL
MANAGEMENT

7. International Financial Management
Prof. Ian Giddy
Stern School of Business,
New York University

8. International Financial Management
Management of international assets
Management of international liabilities
Management of cross-border financial risks
Cross-border funds transfers
These depend on the environmental features of international finance--notably, the global financial markets

9. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING
RISK MGT
PORTFOLIO
MEASUREMENT
CAPITAL
DEBT
EQUITY
M&A
TOOLS

10. What is Special about Corporate Finance in the International Environment?
Financial markets are partially linked, partially separated by national jurisdications
Exchange rate fluctuations affect revenues, costs and valuation of firms
The competitive international financial markets offer special tools, opportunities and risks

11. What are the Global Financial Markets?
The Foreign Exchange Market
The Derivatives
Domestic and International Money Markets
Domestic and International Capital Markets
Beyond the Money and Bond Markets: International Equity and Commodity Markets
Using the Global Capital Markets: Investors’ and Issuers’ Perspectives

12. Global Financial Markets: A Framework
Jurisdiction
1. Domestic
2. Foreign
3. External
Claims
1. Direct
2. Intermediated
3. Enhanced

13. Policies and Exchange Rate Regimes
Exchange rate systems--fixed vs floating
Managed floating
EMS-type currency blocs
De facto blocs--the dollar

14. The Eurocurrency Market
“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”
Separation of currency, institution and jurisdiction
Why do people want Eurocurrency deposits and loans?
Why is LIBOR the world’s key benchmark rate?

15. The Eurocurrency Market
“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”
Separation of currency, institution and jurisdiction
Why do people want Eurocurrency deposits and loans?
Why is LIBOR the world’s key benchmark rate?

16. Where the Eurocurrency Market Fits In
US Domestic German
Market EUR0CURRENCY MARKET Domestic Market
Euro-Deutsche Mark
Eurodollar Market
Market
Japanese
Euro-Yen Domestic
Market Market

17. Where the Eurocurrency Market Fits In
US Domestic German
Market EUR0CURRENCY MARKET Domestic Market
Euro-Deutsche Mark
Eurodollar Market
Market Foreign
Exchange
Market Japanese
Euro-Yen Domestic
Market Market
Euro-Commercial Euro-Floating Rate Straight
Paper Market Note Market Eurobond Market

18. Interest Rate Linkages in the International Money Market
Two stories to tell:
Domestic vs. Euro
Eurocurrency A vs. Eurocurrency B
Domestic Market A The Euromarkets Domestic Market B
Trea Bank Euro Euro Bank Trea-
sury Deposit Deposit Deposit Deposit sury
Bill Market Market Bill
Trea Corp Euro Euro Corp Trea-
sury orate Bond Bond orate sury
Bond Bond Market Market Bond Bond

19. Domestic versus Euro
The Eurodollar Premium
Market price of risk
versus
Cost of regulation
Eurodollar vs. U.S. Interest Rate
Effective cost of domestic deposit
= (interest rate + FDIC fees)
(1 - reserve requirement)
Capital controls and divided credit markets

20. Mechanics and calculations How banks make money How banks hedge
Foreign Exchange
Mechanics and calculations
How banks make money
How banks hedge
Tasks of the corporate FX manager

21. Foreign Exchange Mechanics and Calculations
“Money never leaves homes”
Funds transfer, chips, and timing
Relative interest rates
1. Forward premium or discount
2. Points
3. Spot and forward
Spot and forward
1. Points
2. Forward premium or discount
3. Relative interest rates

22. Foreign Exchange Quotations
Bid Offer
Spot
Forward points
Rule:
add if bid<offer,
subtract if bid>offer
Outright forward

23. How Banks Make Money
Speculative positioning in the interbank market
Arbitrage
1. Triangular
2. CIA
Bid-offer spread
“Customer trading”

24. Triangular Arbitrage
US dollars
Dutch Australian
guilders dollars

25. Covered Interest Arbitrage

26. The Dealing Room Diagram of a Dealing Room
Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.
The Dealing Room
CUS FOR Foreign TOMER SPOT WARD Exchange Dealing
Money
FUNDING EUROCURRENCY Market Dealing
The Dealing Room

27. Diagram of a Dealing Room
Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.
The Dealing Room
CUS FOR Foreign TOMER SPOT WARD Exchange Dealing
Money
FUNDING EUROCURRENCY Market Dealing

28. How Banks Hedge
SHORT LONG
Today
T+2
T+90
Methods:
- Spot + swap
- Spot + rollover swap
- Money market
- Outright forward

29. Linkages Between Eurocurrency Rates
Interest rate
differential
Forward
premium
Expected
% change in
exchange rate

30. Linkages Between Eurocurrency Rates
Interest rate
differential
Covered interest
rate parity
Forward
premium
Expected
% change in
exchange rate

31. Linkages Between Eurocurrency Rates
Interest rate
differential
Covered interest
rate parity
Uncovered interest
rate parity
Forward
premium
Expected
% change in
exchange rate

32. Linkages Between Eurocurrency Rates
Interest rate
differential
Covered interest
rate parity
Uncovered interest
rate parity
Forward
premium
Expected
% change in
exchange rate
Unbiased
forward rate

33. Interest-Rate Parity $1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt
where St is the spot exchange rate (dollars per British Pound) and Fnt is the forward rate.
to a close approximation,
(/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100
Interest-rate differential = forward
premium or
discount

34. Example: Anglo’s Funding
Anglo-American, the natural resources conglomerate, is seeking 3-month US$ funding.
Anglo can fund in the US CP market at 5.5%
Or in the Eurosterling market at 6.7%
The BP is:
spot $1.5484, 3-mo forward $1.5454
Which is cheaper?

35. It’s cheaper for Anglo-American to borrow in the US CP market. Reason:
Anglo’s Answer
It’s cheaper for Anglo-American to borrow in the US CP market. Reason:
US: simply borrow for 3 months
Cost: $1(1+5.5%/4) =
UK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3-mo forward rate to repay the pounds
Cost: ($1/1.5484)(1+6.7%/4) =

36. Unbiased Forward Rate Theory
EXCHANGE RATE
Spot
Forward
Actual
Today
TIME
In three
months

37. Unbiased Forward Rate Theory
Probability
EXCHANGE RATE
distribution
of actual
Spot
exchange rate
Forward
Actual
Today
TIME
In three
months

38. Forward premium or discount = Expected annual rate of change
Unbiased Forward Rate
Forward premium or discount
= Expected annual rate of change
of the exchange rate
That is,
P$/DM = E(R$/DM )

39. International Fisher Effect
INTEREST
RATE
DIFFERENTIAL

40. International Fisher Effect
/E$ = /EDM + E(R$/DM )
That is,
Interest-rate differential
equals
Expected annual rate of change of
exchange rate

41. Cost of Hedging

42. Corporate Hedging Decisions: Frutas Amazonas
Exporting bananas to Spain, get paid in Spanish pesetas. Funding is in U.S. dollars.

43. Corporate Hedging Decisions: Frutas Amazonas
Continue funding in U.S. dollars. The peseta might get stronger in the next three months, from $1=128 pesetas to $1=126 pesetas. This could be the cheapest
Switch funding to pesetas, despite the slightly higher cost
Borrow in dollars, but hedge the exchange risk in the forward market.

44. Frutas Amazonas

45. Frutas Amazonas

46. Law of One Price p=Sp* The Price of Tin
In New York On the Kuala On the
Lumpur London Metal
Market Metal
Exchange
273c per lb ringgit US$5830 per
= US$6.02 per kilogram tonne
per kilograma =US = US5.83
per kilogramb per kilogramc
a1 avoirdupois pound = kilograms
bUS$1 = Malaysian ringgit on the date of calculation
c 1 tonne = 1000 kilogram.
All data taken from the Commodities section
of the London Financial Times.

47. Purchasing Power Parity: Theory and Evidence
S t=1-St = I-I*
St I*
EXCHANGE-RATE CHANGE
MEXICO 1994
RELATIVE
INFLATION
JAPAN 1995

48. Deviations from Purchasing Power Parity
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

49. Deviations from Purchasing Power Parity
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

50. Inflation & Interest Rates
US Expected Inflation Rate 2%
Canadian Expected Inflation Rate 7%
US Interest Rate 5%
Canadian Interest Rate 10%

51. Inflation & Interest Rates
US Expected Inflation Rate 2%
Canadian Expected Inflation Rate 7%
US Interest Rate 5%
Canadian Interest Rate 10%
Expected Rate of Change
of the Exchange Rate

52. Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10%
Inflation & Interest Rates
Borrow at US Interest Rate 5%
Invest at Canadian Interest Rate 10%

53. Inflation & Interest Rates
Borrow at US Interest Rate 5%
Invest at Canadian Interest Rate 10%
Buy Canadian Dollars Forward
(at discount of 5%)

54. Inflation & Interest Rates
Borrow at US Interest Rate 5%
Invest at Canadian Interest Rate 10%
Buy Canadian Dollars Forward
(at discount of 5%)
Buy Canadian Dollar Futures
(at discount of 5%)

55. The Linkages Again 1 2 3 4 5 6 Relative excess money supply Relative
inflation
rates 2 3 4
Relative
interest
rates
Exchange
rate
change
Forward
exchange
premium
or discount 5 6

56. A Framework Country A Country B DOMESTIC DOMESTIC ECONOMIC ECONOMIC
POLICIES POLICIES
INFLATION INFLATION
RATE RATE
EXCHANGE
RATE
INTEREST INTEREST
FORWARD

57. Conclusion: Corporate Exchange Rate Risk
Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies

58. Conclusion: Corporate Exchange Rate Risk
Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies; but it’s tied to prices and to business risk.
Relative
monetary
and fiscal
policies
Relative
inflation
Exchange
rate
change

59. Turkey, 1995
Turkish Lira:
Down 33.5%

60. Turkey, 1995
Turkish prices:
up 83.8%!
Turkish Lira:
Down 33.5%

61. Waiting for Godot: Choices for Waterford Foods
“Clearly it’s of great importance to us to determine whether or not the punt will devalue within the next three months.
“We should systematically assemble the evidence and views on spot and forward exchange rates, on interest rates, inflation and other economic variables and decide what will happen.
“In particular, what’s the probability of a devaluation in the next three months, and how much?
“Then we must decide whether it’s worth covering our DM exposure, given the forward premium and relative interest rates.”

65. www.giddy.org Ian Giddy NYU Stern School of Business
Tel ; Fax