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• International Finance is an area of financial

economics that deals with and examine:
• monetary interactions between two or more
countries
• international monetary systems
• foreign direct investment
• dynamics of the global financial system
• balance of payments
• exchange rates
• international risks such as political risk and foreign
exchange risk, including transaction exposure, economic
exposure, and translation exposure.
 Access to capital markets across the world enables a
country to borrow during tough times and lend during
good times.
 Promotes the integration of economies, facilitating
the easy flow of capital.
 Leads to healthy competition and hence a more
effective banking system.
 Provides information on the vital areas of
investments and leads to effective capital allocation
 Fostering relations and goodwill amongst countries.
 Helps financial managers in making decision to
exploit opportunities at an international.

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 In July 1944, a worldwide system of fixed exchange
rates between countries was first established. Gold was
the benchmark against which the US$ was rated. All
other currencies were pegged to the US$ at a fixed
exchange rate.
 The fixed exchange rate system was later changed to
the floating exchange rate system in 1976 when
exchange rates became more volatile and less
predictable due to various problems. The problems
were a rise in inflation in the US, deterioration of the US
trade balance, speculation in the foreign exchange
market and the devaluation of the US$. The rise in oil
prices in 1971 and 1979 were also a trigger.

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In the floating exchange rate system, major
currencies such as the US$ move
independently of the other currencies and can
be traded by anyone. The value of the
currency is based on the demand and supply
forces in the market. The free floating
currencies are the highest in demand.
Currencies can also be pegged to the US$ and
not entirely free floating but be under a
managed float.

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• The exchange of one currency for another, or
the conversion of one currency into another
currency.
• Usually abbreviated as "forex" and occasionally
as "FX.“
• Foreign exchange transactions encompass
everything from the conversion of currencies by
a traveler at an airport kiosk to billion-dollar
payments made by corporate giants and
governments for goods and services purchased
overseas.
• The market in which participants are able to buy, sell,
exchange and speculate on currencies.
• Foreign exchange markets are made up of banks,
commercial companies, central banks, investment
management firms, hedge funds, and retail forex brokers,
currency speculators and investors.
• Foreign exchange market is not a single exchange, but is
constructed of a global network of computers that
connects participants from all parts of the world i.e. it is
an over-the-counter market.
• According to the Bank for International Settlements, forex
trading increased to an average of $5.3 trillion a day
which the averages out to be $220 billion per hour.
Roughly 90% of this volume is generated by currency
speculators capitalizing on intraday price movements.
 Traders from other markets are attracted to the
Forex because of this extremely high levels of
liquidity. Liquidity is important as it allows traders
to get in and out of a position at with ease 24
hours a day 5 ½ days a week
 Without a doubt, the foreign exchange market is
the world’s largest financial market.
 In this market, one country’s currency is traded for
another’s.

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 Most of the trading takes place in a few currencies:
◦ U.S. dollar ($)
◦ British pound sterling (£)
◦ Japanese yen (¥)
◦ Euro (€)

 Market participants include international banks,

commercial companies, central banks, investment
management firms, hedge funds, and forex
brokers, currency speculators and investors.

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 The price of one country’s currency in terms
of another.
 Most currency is quoted in terms of dollars.
 Consider the following quote:
◦ Euro 1.3679 .7310
◦ The first number (1.3679) is how many U.S.
dollars it takes to buy 1 Euro
◦ The second number (.7310) is how many
Euros it takes to buy $1
◦ The two numbers are reciprocals of each
other (1/1.3679 = .7310)

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 Suppose you have $10,000. Based on the
rates in Figure 11.1, how many Swiss Francs
can you buy?
◦ Exchange rate = 0.8799 Francs per dollar
◦ Buy 10,000(0.8799) = 8,799 Francs
 Suppose you are visiting Bombay and you
want to buy a souvenir that costs 1,000 Indian
Rupees. How much does it cost in U.S. dollars?
◦ Exchange rate = 46.650 rupees per dollar
◦ Cost = 1,000 / 46.650 = $21.44

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 If a foreign currency depreciates it is now worth
less in our home currency. Let us say the foreign
currency is €.
◦ Receipt in € - will receive less in your home currency.
◦ Payment in €- will end up paying less in your home
currency.
 If a foreign currency appreciates, it is simply
worth more in our home currency.
◦ Receipt in €- will receive more in your home currency.
◦ Payment in €- will end up paying more in your home
currency.

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 Let us say the current exchange rate between the
US dollar and the UK pound is $1.60 /£. This
means that a $10m cash flow would equate to
£6.25m.
 Now let's say the exchange rate moves to $1.50 /

£. In this case, the $ has appreciated (you would

have to sell fewer $s to get one pound). The
same $10m cash flow now equates to £6.67m. If
you are a UK company receiving $10m, this is
obviously good news. However, if you need to
pay $10m, this will now cost you more.

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 A movement in the opposite direction, to say $1.70 /
£ reflects a depreciation in the US dollar (you would
need to sell more $s to get one pound). The$10m
cash flow now equates to £5.88m. For a UK company,
this would be bad news if you were receiving the
money but good news if you were making a payment.
 If a currency appreciates, companies complain that
they cannot sell their goods abroad and workers
agitate about losing their jobs.
 If a currency depreciates, consumers are unhappy
because inflation is imported and their money travels
less far when they go abroad.

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 What would a strong pound mean for companies in the UK pricing transactions in foreign currency (in this case the €)
if they were a: 1) UK exporter? 2) UK importer?
 Solution:
 The pound has appreciated against €, therefore € has depreciated relative to the pound:
 UK exporters: Bad news; receipts in currency that is depreciating; receive fewer pounds.
 UK importers: Good news; payments in currency that is depreciating; pay fewer pounds.
 Note: the alternative for the UK exporter is to put the price up in the foreign currency, but exports then become
uncompetitive.

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 What would a weak Euro mean for companies in the Eurozone pricing transactions in foreign currency if
they were a: 1) European exporter?
2) European importer?
 Solution:
 The euro has depreciated €, therefore other foreign currencies have appreciated relative to the euro.
 European exporters: Good news; receipts in currencies that are appreciating; receive more euros.
 European importers: Bad news € payments in currencies that are appreciating against €; pay more euros.

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 Banks dealing in foreign currency quote two prices for
an exchange rate:
 A lower 'bid' price

 A higher 'offer' price

 For example, a dealer might quote a price for US$/£

of 1.340 - 1.345:
  The lower rate, 1.340, is the rate at which the dealer
will sell the variable currency (US$) in exchange for
the base currency (sterling).
 The higher rate, 1.345, is the rate at which the dealer
will buy the variable currency (US$) in exchange for
the base currency (sterling).

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 This quote might also be written as a mid-
price with an adjustment, for example:

 US$/£ 1.3425 ± 0.0025

 This tells you to add $0.0025 to get the

buying rate ($1.3425 +$0.0025 = $1.345) or
subtract $0.0025 to get the selling rate
($1.3425 -$0.0025 = $1.340).

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 To remember which of the two prices is
relevant to any particular foreign exchange
(FX) transaction, remember the bank will
always trade at the rate that is more
favourable to itself.
 If in doubt, work out which rate most favour

the bank or remember the rules:

 Bank buys high (bye bye)
 Bank sells low (cello)

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 The US$ rate per £ is quoted as 1.4325 -
1.4330.

 Company A wants to buy $100,000 in

exchange for sterling.
 Company B wants to sell $200,000 in

exchange for sterling.

 What rate will the bank offer each company?

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 Company A wants to buy $100,000 in
exchange for sterling (so that the bank will be
selling dollars):
 If we used the lower rate of 1.4325, the bank

would sell them for £69,808

 If we used the higher rate of 1.4330, the

bank would sell them for £69,784.

 Clearly the bank would be better off selling

them at the lower rate

 RULE=> Bank sells lower

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 Company B wants to sell $200,000 in
exchange for sterling (so the bank would be
buying dollars):
 If we used the lower rate of 1.4325, the bank

would buy them for £139,616

 If we used the higher rate of 1.4330, the

bank would buy them for £139,567

 The bank will make more money buy at the

higher rate:
 RULE =>Bank buys high

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 The price quoted for immediate settlement
on a commodity, a security or a currency. 
The spot rate, also called “spot price,” is
based on the value of an asset at the moment
of the quote

The spot market is where you can buy and

sell a currency now (immediate delivery), i.e.
the spot rate of exchange

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 The cross rate is the exchange rate between
currency A and currency C derived from actual
exchange rate between currency A and currency
B and between currency B and currency C.
 Sometimes cross rate is referred to an
exchange rate between two currencies not
involving the US dollar.
 Currency vendor provides quotes for only the
most liquid currencies such as the US dollar,
Euro, Pound Sterling, Swiss Franc, etc. 

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 Exchange rates between other currencies is
normally calculated as the cross rates using
the quotes for major currencies.

 Formula A/C = A/B x B/C

Where,
A/C = units of currency A per unit of currency
A/B = units of currency A per unit of currency
B/C = units of currency B per unit of currency

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 As at 27 December 2012, the exchange rate between
Euro and US dollar is 0.75 € per US$. Exchange rate
between US$ and Swiss Franc is 1.09 US$ per Swiss
Franc. Find the exchange rate between € and Swiss
Franc in € per Swiss Franc.
€ per Swiss Franc = 0.75 € per US$ × 1.09 US$ per Swiss
Franc = 0.8175 € per Swiss Franc

 Finding the same exchange rate in Swiss Franc per €

would involve taking a reciprocal of the
exchange rate calculated above.
Swiss Franc per € exchange rate would be 1.223 Swiss Francs
per € (1 ÷ (0.8175 € per Swiss Franc)).

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 The forward market is where you can buy and sell a
currency, at a fixed future date for a predetermined
rate, i.e. the forward rate of exchange.
 A forward exchange contract is:
 (a)An immediately firm and binding contract, e.g. between a
bank and its customer.
 (b)For the purchase or sale of a specified quantity of a stated
foreign currency.
 (c)At a rate of exchange fixed at the time the contract is made.
 (d)For performance (delivery of the currency and payment for
it) at a future time which is agreed when making the contract
(this future time will be either a specified date, or any time
between two specified dates).

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 Flexibility with regard to the amount to be
covered.
 Relatively straightforward both to

comprehend and to organize.

 Contractual commitment that must be

completed on the due date.
 No opportunity to benefit from favourable

movements in exchange rates.

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 It is now 1 January and X Co will receive $10
million on 30 April.

 It enters into a forward contract to sell this

amount on the forward date at a rate of
$1.60/£. On 30 April the company is
guaranteed £6.25 million.

 The risk has been completely removed.

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The current spot rate for US dollars against UK sterling is
1.4525 – 1.4535 $/£ and the one-month forward is quoted as
1.4550 – 1.4565. A UK exporter expects to receive $400,000 in
one month. If a forward contract is used, how much will be
received in sterling?

Solution:
The exporter will be selling his dollars to the bank and the

bank buys high at 1.4565.

Theexporter will therefore receive = 400,000 ÷ 1.4565 =

£274,631.

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 Currency risk occurs in three forms:
◦ transaction exposure (short-term),
◦ economic exposure (effect on present value of
longer term cash flows)
◦ and translation exposure (book gains or losses).

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 Transaction risk is the risk of an exchange rate changing
between the transaction date and the subsequent settlement
date, i.e. it is the gain or loss arising on conversion.
 It arises primarily on import and exports.
 A firm decides to hedge – take action to minimize – the risk, if
it is:
◦ (a) a material amount
◦ (b) over a material time period
◦ (c) thought likely exchange rates will change significantly.
 As transaction risk has a potential impact on the cash flows of
a company, most companies choose to hedge against such
exposure. Measuring and monitoring transaction risk is
normally an important component of treasury management.


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A UK company, buy goods from Redland which cost 100,000
Reds (the local currency). The goods are re-sold in the UK for
£32,000. At the time of the import purchases the exchange rate
for Reds against sterling is 3.5650 – 3.5800.
Required:

(a) What is the expected profit on the re-sale?

(b) What would the actual profit be if the spot rate at the
time when the currency is received has moved to:
(i) 3.0800 – 3.0950
(ii) 4.0650 – 4.0800?
Ignore bank commission charges.

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  a) The UK company must buy Reds to pay the
supplier, and so the bank is selling Reds. The
expected profit is as follows.

  £
Revenue from re-sale of goods 32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 3.5650) 28,050.49
Expected profit 3,949.51

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 (b)(i)If the actual spot rate for the UK
company to buy and the bank to sell the Reds
is 3.0800, the result is as follows.

  £
Revenue from re-sale of goods 32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 3.0800) 32,467.53
Loss (467.53)

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  (b)(ii)If the actual spot rate for the UK
company to buy and the bank to sell the Reds
is 4.0650, the result is as follows.

  £
Revenue from re-sale of goods 32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 4.0650) 24,600.25
Profit 7,399.75

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 Economic risk is the variation in the value of the
business (i.e. the present value of future cash flows) due
to unexpected changes in exchange rates. It is the long-
term version of transaction risk.
 For example, a UK company might use raw materials
which are priced in US dollars, but export its products
mainly within the EU. A depreciation of sterling against
the dollar or an appreciation of sterling against other EU
currencies will both erode the competitiveness of the
company. Economic exposure can be difficult to avoid,
although diversification of the supplier and customer
base across different countries will reduce this kind of
exposure to risk.

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 This is the risk that the organization will
make exchange losses when the accounting
results of its foreign branches or subsidiaries
are translated into the home currency.
Translation losses can result, for example,
from restating the book value of a foreign
subsidiary’s assets at the exchange rate on
the statement of financial position date.

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 Changes in value due to political actions in the foreign
country
 Investment in countries that have unstable
governments should require higher returns.
 The extent of political risk depends on the nature of
the business:
 The more dependent the business is on other operations
within the firm, the less valuable it is to others.
 Natural resource development can be very valuable to
others, especially if much of the ground work in
developing the resource has already been done.
 Local financing can often reduce political risk.
 Large multinational firms may need to manage
the exchange rate risk associated with several
different currencies.
 The firm needs to consider its net exposure to
currency risk instead of just looking at each
currency separately.
 Hedging individual currencies could be
expensive and may actually increase exposure.
 Inflation
 Interest rates
 Current account deficit
 Public debt
 Term of trade
 Political stability and performance
 Government control
 Political stability

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The equilibrium exchange rate will change over time as
supply and demand schedules change.
 Relative Inflation Rates: Increase in inflation rates leads to lower in
currency value as purchasing power decreases in relative to foreign
currency and vice versa.

 Relative Interest Rates: Increase in interest rates leads to increase in

demand for deposits leading to a higher in currency value dollars in
relative to foreign currency.

 Relative Income Levels: Increase in income levels leads to increase in
demand for foreign goods and increased demand for foreign currency and
an increase in the exchange rate for the foreign currency.

 Expectations: If investors expect interest rates in one country to rise, they

may invest in that country leading to a increase in the demand for foreign
currency or rise its currency value.
 Impact of signals on currency speculation. Speculators may overreact
to signals causing currency to be temporarily overvalued or
undervalued.
Factors That Influence
Exchange Rates
 Government Controls via:
Imposing foreign exchange barriers
Imposing foreign trade barriers
Intervening in foreign exchange markets
Affecting macro variables such as
inflation, interest rates, and income
levels.
1) Balance of payments
2) Capital movements
3) Purchasing power parity theory (PPP)
4) Interest rate parity theory (IRP)
5) Expectations theory
6) The International Fisher Effect
7) Four-way equivalence

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 Changes in exchange rates result from changes in the
demand for and supply of the currency. These changes may
occur for a variety of reasons, e.g. due to changes in
international trade or capital flows between economies.
 Balance of payments – Since currencies are required to
finance international trade, changes in trade may lead to
changes in exchange rates. In principle:
◦ (a) demand for imports in the US represents a demand for foreign currency
or a supply of dollars.
◦ (b) overseas demand for US exports represents a demand for dollars or a
supply of the currency.
 Thus a country with a current account deficit where imports
exceed exports may expect to see its exchange rate
depreciate, since the supply of the currency (imports) will
exceed the demand for the currency (exports).

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 There are also capital movements between
economies. These transactions are effectively
switching bank deposits from one currency to
another. These flows are now more important than
the volume of trade in goods and services.
 Thus supply/demand for a currency may reflect
events on the capital account. Several factors may
lead to inflows or outflows of capital:
◦ (a)changes in interest rates: rising (falling) interest rates will
attract a capital inflow (outflow) and a demand (supply) for the
currency
◦ (b)inflation: asset holders will not wish to hold financial assets
in a currency whose value is falling because of inflation.

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  PPP claims that the rate of exchange between two currencies
depends on the relative inflation rates within the respective
countries. In equilibrium, identical goods must cost the same,
regardless of the currency in which they are sold.
 PPP predicts that the country with the higher inflation will be
subject to a depreciation of its currency.
 Formally, if you need to estimate the expected future spot rates,
PPP can be expressed in the following formula:
S1 /S0 = (1 + hc ) / (1+ hb )
Where:
S0 = Current spot rate
S1 = Expected future rate
hb = Inflation rate in country for which the spot is quoted (base country)
hc = Inflation rate in the other country (country currency).
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 PPP can be used as our best predictor of future spot rates;
however it suffers from the following major limitations:
(a)the future inflation rates are only estimates
(b) the market is dominated by speculative transactions
(98%) as opposed to trade transactions; therefore PPP breaks
down
(c)government intervention – governments may manage
exchange rates, thus defying the forces pressing towards PPP.
 However, it is likely that the PPP may be more useful for
predicting long-run changes in exchange rates since these
are more likely to be determined by the underlying
competitiveness of economies, as measured by the model.

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An item costs $3,000 in the US. Assume that sterling
and the US dollar are at PPP equilibrium, at the
current spot rate of $1.50/£, i.e. the sterling price x
current spot rate of $1.50 = dollar price.
The spot rate is the rate at which currency can be
exchanged today.
 
The US   The UK
market market
Cost of item now $3,000 $1.50 £2,000
Estimated 5%   3%
inflation
Cost in one year $3,150   £2,060

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The law of one price states that the item must
always cost the same. Therefore in one year:
$3,150 must equal £2,060, and also the
expected future spot rate can be calculated:

$3,150 / £2,060 = $1.5291/£

By formula:
S1 /S0 = (1 + hc ) / (1+ hb )
S1 /1.50 = (1 + 5% ) / (1+ 3% )
S1 = $1.5291

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 The dollar and sterling are currently trading
at $1.72/£. Inflation in the US is expected to
grow at 3% pa, but at 4% pa in the UK.Predict
the future spot rate in a year’s time.

S1 /S0 = (1 + hc ) / (1+ hb )
S1 /1.72 = (1 + 3% ) / (1+ 4% )
S1 = $1.7035

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 An amusing example of PPP is the Economist’s Big
Mac Index. Under PPP movements in countries’
exchange rates should in the long-term mean that
the prices of an identical basket of goods or
services are equalized. The McDonalds Big Mac
represents this basket.
 The index compares local Big Mac prices with the
price of Big Macs in America. This comparison is
used to forecast what exchange rates should be,
and this is then compared with the actual exchange
rates to decide which currencies are over and
under-valued.

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 The IRP claims that the difference between the spot and the
forward exchange rates is equal to the differential between
interest rates available in the two currencies.
 IRP predicts that the country with the higher interest rate
will see the forward rate for its currency subject to a
depreciation.
 If you need to calculate the forward rate in one year’s time:
F0 /S0 = (1 + ic ) / (1+ ib )
Where:
F0 = Forward rate
S0 = Current spot rate
ib = interest rate for base currency
ic = interest rate for counter currency

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The IRPT generally holds true in practice. There
are no bargain interest rates to be had on
loans/deposits in one currency rather than
another. However, it suffers from the following
limitations:
(a) government controls on capital markets
(b) controls on currency trading
(c) intervention in foreign exchange markets.

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The interest rate parity model shows that it may be
possible to predict exchange rate movements by
referring to differences in nominal exchange rates. If
the forward exchange rate for sterling against the
dollar was no higher than the spot rate but US
nominal interest rates were higher, the following
would happen:
◦ (a)UK investors would shift funds to the US in order to
secure the higher interest rates, since they would suffer no
exchange losses when they converted $ back to £.
◦ (b)the flow of capital from the UK to the US would raise UK
interest rates and force up the spot rate for the US$.

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UK investor invests in a one-year US bond with a 9.2% interest
rate as this compares well with similar risk UK bonds offering
7.12%. The current spot rate is $1.5/£. When the investment
matures and the dollars are converted into sterling, IRP states
that the investor will have achieved the same return as if the
money had been invested in UK government bonds.

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 In 1 year, £1.0712 million must equate to $1.638
million so what you gain in extra interest, you lose
on an adverse movement in exchange rates.
 The forward rates moves to bring about interest

rate parity amongst different currencies:

$1.638 ÷ £1.0712 = $1.5291
By Formula:
F0 /1.5 = (1 + 9.2% ) / (1+7.12%)
F0 = $1.5291

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 The expectations theory claims that the
current forward rate is an unbiased predictor
of the spot rate at that point in the future.
 If a trader takes the view that the forward rate

is lower than the expected future spot price,

there is an incentive to buy forward. The
buying pressure on the forward rates raises
the price, until the forward price equals the
market consensus view on the expected
future spot price.

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 The International Fisher Effect claims that the interest rate differentials between
two countries provide an unbiased predictor of future changes in the spot rate of
exchange.
 The International Fisher Effect assumes that all countries will have the same real
interest rate, although nominal or money rates may differ due to expected
inflation rates. Thus the interest rate differential between two countries should be
equal to the expected inflation differential. Therefore, countries with higher
expected inflation rates will have higher nominal interest rates, and vice versa.
 The currency of countries with relatively high interest rates is expected to
depreciate against currencies with lower interest rates, because the higher interest
rates are considered necessary to compensate for the anticipated currency
depreciation.
 Is an economic theory that states that an expected change in the current 
exchange rate between any two currencies is approximately equivalent to the
difference between the two countries' nominal interest rates for that time. 

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 Given free movement of capital internationally,
this idea suggests that the real rate of return in
different countries will equalize as a result of
adjustments to spot exchange rates. The
International Fisher Effect can be expressed as:
(1 + ia ) / (1+ ib ) = (1 + ha ) / (1+ hb )
Where:
ia = the nominal interest rate in country a
ib = the nominal interest rate in country b
ha = the inflation rate in country a
hb = the inflation rate in country b

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The four theories can be pulled together to show the overall
relationship between spot rates, interest rates, inflation rates and
the forward and expected future spot rates. As shown above,
these relationships can be used to forecast exchange rates.

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