International Finance
Lecture 1 – International Finance
Risks and opportunities of international finance
1. Foreign exchange (FX) risk: an unanticipated movement in the exchange rate can hurt
foreign currency profits or investment returns.
2. Political risk: unanticipated changes in laws (e.g. taxes): changing the rules of the game.
3. Role of market imperfections.
Frictions in the markets for goods and services
- Legal restrictions to the movement of goods and people across borders
- Cultural barriers
- Transaction (and transportation) costs
Frictions in the capital markets
- Information asymmetries
- Taxation, regulations
4. Expanded opportunity set for investors and firms
Potential benefits for the firm:
- Production markets
- Sales markets
- Capital markets
- Economies of scale and scope
Potential benefits for individual investors
- Increased investment and diversification opportunities
An objective for international finance: manage risk exposure and market frictions, in order to extract
the most benefits from an expanded opportunity set. For many firms the goal of international
financial management is shareholder wealth maximization. Corporate governance is the financial
and legal framework for regulating the relationship between a company’s management and its
shareholders.
Globalization: emergence of globalized markets, trade liberalization and economic integration,
emergence of the Euro, privatization (selling of state-owned enterprises to investors).
According to the theory of comparative advantage, it is mutually beneficial for countries if they
specialize in the production of those goods they can produce most efficiently and trade those goods
among them.
Trade barriers are used to discriminate foreign firms through laws that only apply to other country’s
products in order to protect the home economy. Tariffs induce inefficient production and decrease
the overall welfare of countries while protecting the home economy. Imposing tariffs is a prisoner’s
dilemma. Imposing tariffs is good for each individual country given that the other countries don’t
impose tariffs. Given that the other countries will typically reciprocate, imposing tariffs is not good
for the individual country. Quotas limit the amount of foreign products allowed to be imported.
Subsidies make the home industry more competitive. Technical trade barriers impose restrictions on
product specifications. Transatlantic Trade and Investment Partnership (TTIP) reduces tariffs between
the EU and USA. It creates a common regulatory and legal environment.
The international monetary system is the institutional framework within which international
payments are made, movements of capital are accommodated, and exchange rates among
currencies are determined.
1
,Lecture 2 – The FX market part 1 – Spot and forward market
Foreign exchange market
1) Interbank market (wholesale): a network of correspondent banking relationships. Large
commercial banks maintain deposit accounts with each other, called correspondent banking
accounts.
2) Client market (retail, bank customers)
Spot foreign exchange market
Direct quotation (American terms): USD per 1 foreign currency e.g. $/€ or $/£.
Indirect quotation (European terms): currency per dollar €/$ or £/$.
Direct and indirect quotes are reciprocal.
The bid price is the price a market maker is willing to pay for a currency. The ask price is the amount
the market maker wants the buyer to pay for the currency. Bid price < ask price. The bid-ask spread
is the difference between the bid and ask prices. The ask price is the reciprocal of the bid price and
a 1
the other way around. S ($/£) = b
S ¿¿
A cross rate is the exchange rate between two currencies computed using a third currency, usually
the US dollar.
S ( $ /£)
S(€/£) = or S ¿ ¿
S ($ / € )
S(€/£) = S($/£) * S(€/$)
Triangular arbitrage is the process of exploiting the difference in the direct rate and the cross rate to
make a profit.
Forward foreign exchange market
A forward is an agreement to buy or sell an asset in the future at a price agreed upon today. An FX
forward is an agreement to buy or sell a certain amount of currency in the future at a price agreed
upon today. If you have agreed to sell asset X, you are short in X. If you have agreed to buy asset X,
you are long in X. It is a zero-sum game: the profit of the long position equals the loss of the short
position. The forward rate has a premium or discount compared to the spot rate, it is the annualized,
relative deviation from the spot rate. If the forward rate has a positive deviation from the spot rate it
is a premium, if it is a negative deviation it is a discount.
Forward rate: FN (j/k) = F N ¿ ¿ ¿ or F N ¿ ¿ ¿
Forward premium / discount:
360
- American terms: fN,j = F N ¿ ¿ ¿ *
days
360
- European terms: fN,$ = F N ¿ ¿ ¿ *
days
An outright forward transaction is an uncovered speculative position in a currency. Swap
transactions provide a means for the bank to mitigate the currency exposure in a forward trade. A
forward swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a
forward purchase (or sale) of approximately an equal amount of the foreign currency.
Lecture 3 – The FX market part 2 – Parity relationships
Interest rate parity (IRP) is a no-arbitrage condition, no-arbitrage implies IRP.
Arbitrage: Making positive profit for sure and strictly positive profit with positive probability.
Efficient market hypothesis: Prices are right and thus there are no arbitrage opportunities.
2
, Behavioural finance: Prices may be wrong, but still there is no arbitrage.
F 1+ i $
IRP: (1 + i$) = (1 + i £) or F = S ( )
S 1+ i £
The payoffs of an investment over the same time should be equal for IRP:
If IRP fails to hold there is an opportunity for covered interest arbitrage (CIA).
For any given forward rate, the spot rate is affected by the relative interest
rates. For any given interest rates, the forward rate determines the spot
rate.
Why might IRP be violated:
Transactions costs
o The interest rate available to an arbitrageur for borrowing (ib) may exceed the rate
he can lend at (il).
o There may be bid-ask spreads to overcome, Fb/Sa < F/S
Capital controls
o Governments sometimes restrict import and export of money through taxes or
outright bans.
Other (competing) theories of how exchange rates are determined (like the PPP).
Purchasing power parity (PPP): the exchange rate between two currencies should equal the ratio of
P$
the countries’ price levels. S$/£ =
P£
If this is not true, then commodity arbitrage will occur. Products will be bought where are cheaper
and sold where they are more expensive.
Relative PPP = the expected rate of change in the exchange rate E(e) is equal to the difference in the
rates of inflation.
≈ π$ - π€
The Fisher effect holds that an increase (decrease) in the expected inflation rate in a country will
cause a proportionate increase (decrease) in the interest rate in the country:
i$ ≈ ⍴$ + E[ππ$]
i$ - ⍴$ ≈ E[ππ$]
⍴$: expected “real” U.S. interest rate
E(π$): expected rate of U.S. inflation
i$: nominal U.S. interest rate
The International Fisher effect suggests that the nominal interest rate
differential reflects the expected change in exchange rate:
The forward expectations parity (FEP) states that any forward premium or discount is equal to the
expected change in the exchange rate. F – S / S = (i $ - i€) / (1 + i€) = E€
Forecasting exchange rates
Efficient markets approach: financial markets are efficient if prices reflect all available and
relevant information It at time t:
Fundamental approach
o Analyse economic data (balance sheet figures,
macroeconomic conditions, local market conditions)
3
Lecture 1 – International Finance
Risks and opportunities of international finance
1. Foreign exchange (FX) risk: an unanticipated movement in the exchange rate can hurt
foreign currency profits or investment returns.
2. Political risk: unanticipated changes in laws (e.g. taxes): changing the rules of the game.
3. Role of market imperfections.
Frictions in the markets for goods and services
- Legal restrictions to the movement of goods and people across borders
- Cultural barriers
- Transaction (and transportation) costs
Frictions in the capital markets
- Information asymmetries
- Taxation, regulations
4. Expanded opportunity set for investors and firms
Potential benefits for the firm:
- Production markets
- Sales markets
- Capital markets
- Economies of scale and scope
Potential benefits for individual investors
- Increased investment and diversification opportunities
An objective for international finance: manage risk exposure and market frictions, in order to extract
the most benefits from an expanded opportunity set. For many firms the goal of international
financial management is shareholder wealth maximization. Corporate governance is the financial
and legal framework for regulating the relationship between a company’s management and its
shareholders.
Globalization: emergence of globalized markets, trade liberalization and economic integration,
emergence of the Euro, privatization (selling of state-owned enterprises to investors).
According to the theory of comparative advantage, it is mutually beneficial for countries if they
specialize in the production of those goods they can produce most efficiently and trade those goods
among them.
Trade barriers are used to discriminate foreign firms through laws that only apply to other country’s
products in order to protect the home economy. Tariffs induce inefficient production and decrease
the overall welfare of countries while protecting the home economy. Imposing tariffs is a prisoner’s
dilemma. Imposing tariffs is good for each individual country given that the other countries don’t
impose tariffs. Given that the other countries will typically reciprocate, imposing tariffs is not good
for the individual country. Quotas limit the amount of foreign products allowed to be imported.
Subsidies make the home industry more competitive. Technical trade barriers impose restrictions on
product specifications. Transatlantic Trade and Investment Partnership (TTIP) reduces tariffs between
the EU and USA. It creates a common regulatory and legal environment.
The international monetary system is the institutional framework within which international
payments are made, movements of capital are accommodated, and exchange rates among
currencies are determined.
1
,Lecture 2 – The FX market part 1 – Spot and forward market
Foreign exchange market
1) Interbank market (wholesale): a network of correspondent banking relationships. Large
commercial banks maintain deposit accounts with each other, called correspondent banking
accounts.
2) Client market (retail, bank customers)
Spot foreign exchange market
Direct quotation (American terms): USD per 1 foreign currency e.g. $/€ or $/£.
Indirect quotation (European terms): currency per dollar €/$ or £/$.
Direct and indirect quotes are reciprocal.
The bid price is the price a market maker is willing to pay for a currency. The ask price is the amount
the market maker wants the buyer to pay for the currency. Bid price < ask price. The bid-ask spread
is the difference between the bid and ask prices. The ask price is the reciprocal of the bid price and
a 1
the other way around. S ($/£) = b
S ¿¿
A cross rate is the exchange rate between two currencies computed using a third currency, usually
the US dollar.
S ( $ /£)
S(€/£) = or S ¿ ¿
S ($ / € )
S(€/£) = S($/£) * S(€/$)
Triangular arbitrage is the process of exploiting the difference in the direct rate and the cross rate to
make a profit.
Forward foreign exchange market
A forward is an agreement to buy or sell an asset in the future at a price agreed upon today. An FX
forward is an agreement to buy or sell a certain amount of currency in the future at a price agreed
upon today. If you have agreed to sell asset X, you are short in X. If you have agreed to buy asset X,
you are long in X. It is a zero-sum game: the profit of the long position equals the loss of the short
position. The forward rate has a premium or discount compared to the spot rate, it is the annualized,
relative deviation from the spot rate. If the forward rate has a positive deviation from the spot rate it
is a premium, if it is a negative deviation it is a discount.
Forward rate: FN (j/k) = F N ¿ ¿ ¿ or F N ¿ ¿ ¿
Forward premium / discount:
360
- American terms: fN,j = F N ¿ ¿ ¿ *
days
360
- European terms: fN,$ = F N ¿ ¿ ¿ *
days
An outright forward transaction is an uncovered speculative position in a currency. Swap
transactions provide a means for the bank to mitigate the currency exposure in a forward trade. A
forward swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a
forward purchase (or sale) of approximately an equal amount of the foreign currency.
Lecture 3 – The FX market part 2 – Parity relationships
Interest rate parity (IRP) is a no-arbitrage condition, no-arbitrage implies IRP.
Arbitrage: Making positive profit for sure and strictly positive profit with positive probability.
Efficient market hypothesis: Prices are right and thus there are no arbitrage opportunities.
2
, Behavioural finance: Prices may be wrong, but still there is no arbitrage.
F 1+ i $
IRP: (1 + i$) = (1 + i £) or F = S ( )
S 1+ i £
The payoffs of an investment over the same time should be equal for IRP:
If IRP fails to hold there is an opportunity for covered interest arbitrage (CIA).
For any given forward rate, the spot rate is affected by the relative interest
rates. For any given interest rates, the forward rate determines the spot
rate.
Why might IRP be violated:
Transactions costs
o The interest rate available to an arbitrageur for borrowing (ib) may exceed the rate
he can lend at (il).
o There may be bid-ask spreads to overcome, Fb/Sa < F/S
Capital controls
o Governments sometimes restrict import and export of money through taxes or
outright bans.
Other (competing) theories of how exchange rates are determined (like the PPP).
Purchasing power parity (PPP): the exchange rate between two currencies should equal the ratio of
P$
the countries’ price levels. S$/£ =
P£
If this is not true, then commodity arbitrage will occur. Products will be bought where are cheaper
and sold where they are more expensive.
Relative PPP = the expected rate of change in the exchange rate E(e) is equal to the difference in the
rates of inflation.
≈ π$ - π€
The Fisher effect holds that an increase (decrease) in the expected inflation rate in a country will
cause a proportionate increase (decrease) in the interest rate in the country:
i$ ≈ ⍴$ + E[ππ$]
i$ - ⍴$ ≈ E[ππ$]
⍴$: expected “real” U.S. interest rate
E(π$): expected rate of U.S. inflation
i$: nominal U.S. interest rate
The International Fisher effect suggests that the nominal interest rate
differential reflects the expected change in exchange rate:
The forward expectations parity (FEP) states that any forward premium or discount is equal to the
expected change in the exchange rate. F – S / S = (i $ - i€) / (1 + i€) = E€
Forecasting exchange rates
Efficient markets approach: financial markets are efficient if prices reflect all available and
relevant information It at time t:
Fundamental approach
o Analyse economic data (balance sheet figures,
macroeconomic conditions, local market conditions)
3
