Unit 1 Complete PPT

MSD519
International Finance
Preeti Roy
Assistant Professor
IIT(ISM) Dhanbad
[email protected]
Jan 2024 - Apr 2024
Preeti Roy (IIT(ISM) Dhanbad) IF - DE course by DMS&IE Jan 2024 - Apr 2024 1 / 92
The required reference books:
• 9th edition by Madura, J.

∗ International Financial Management,
• 2nd edition by Bekaert, G. and Hodrick, R.
• 3rd edition by Resnick-Eun
• Availability - Fri (4:00 to 5:00 pm) at Room No 108.
Course Grading
• Quizzes 02 - 15% (15 marks)
• Case Study - 15% (15 marks)
• Mid-term - 40% (28 marks)
• Final-term - 60% (42 marks)
Teaching Assistants:
• Swati Mohapatra
• A. Pranay Kumar
• Sudhir Kumar Biswal
Case Studies to discuss
• Discussion on the International Financial System of the World
∗ USA
∗ UK
∗ Germany
∗ France
∗ Japan
∗ Saudi Arabia
∗ Ukraine
∗ Brazil
∗ China
∗ Russia
∗ South Africa
• 11 Harvard Cases according to the unit
Need to Study?
• Well, let me narrate a story for you!
• We live in a highly globalized and integrated world economy.

∗ Consumption Patterns
− Americans purchase oil imported from Saudi Arabia and Nigeria, TV
sets and camcorders from Japan, automobiles from Germany, garments
from China, shoes from Indonesia, pasta from Italy, and wine from France.
− Foreigners purchase American-made aircraft, software, movies, jeans,
wheat, and other products.
∗ Production Patterns
− IBM personal computers sold - world market; assembled - Malaysia
with Taiwanese-made monitors, Korean-made keyboards, U.S.-made chips,
and preinstalled software packages jointly developed by U.S. and Indian
engineers.
Concept of MNCs & Global Company
• MNC - is a business organization that produces, sells, and provides a
service in two or more countries.
∗ International Opportunists
∗ Multi-domestic Competitors
∗ Global Competitors
• Global Company - Company with following characteristics:
∗ Have a worldwide presence in its market.
∗ Integrate its operations worldwide.
∗ Standardize operations in one or more of the company’s functional
areas.
∗ For example: IBM follows R-O-I framework i.e., Repeatable processes,
Optimized assets and Integrated operations.
∗ Financial markets have integrated.
What is Really in the word International?
• Suppose Vardhman Textile company contracts to sell 10 million meters
of 100% cotton fabric to Mexico. Price of 1 meter is 400 MXN.
• Mexican peso depreciates drastically against the U.S. dollar, as it did in
December 1994.
• The current exchange rate were as follows: 1 USD = 20 MXN; New ex-
change rate turned to 1 USD = 25 MXN; 1 USD = 80 INR; 1 MXN = 4 INR
earlier and now 1 MXN = 3.2 INR
• Mexico has to pay 400 X 25 X 10 MXN = 100,000 million instead of
80,000 million; Loss of 20,000 million
• Vardhman co. will incur a loss of 400 X (4 - 3.2) X10 = INR 3,200 million
• If Vardhman had export relations with Thailand, Korea and Indonesia,
then the loss emanating from Asian Currency Crisis, 1997 would have
been enormous.
• Currently, the exchange rates among such major currencies as the U.S.
dollar, Japanese yen, British pound, and euro fluctuate continuously in
an unpredictable manner.
This is the foreign exchange risk!!!
• In 1992, for example, the Enron Development Corporation, a subsidiary
of a Houston-based energy company, signed a contract to build India’s
largest power plant. After Enron had spent nearly $300 million, the
project was canceled in 1995 by nationalist politicians in the Maharash-
tra state who argued India didn’t need the power plant.
• This is Political Risk!
∗ Political risk ranges from unexpected changes in tax rules to outright
expropriation of assets held by foreigners.
∗ Political risk arises because a sovereign country can change the
“rules of the game,” and the affected parties may not have effective
recourse.
• Geo-political Risk: potential political, economic, military, and social
risks that can emerge from a nation’s involvement in international af-
fairs.
∗ Political risk: disputes over territory, resources, or ideology.
∗ Notable hotspots include the South China Sea, the Middle East, and Eastern Europe.
∗ Economic risk: Commodities prices can be volatile, disruptions to the supply of key resources,
trade policy.
∗ Example: Tension between United States, Taiwan, and China.
∗ Societal risk: environmental risks (conflict of interest), health risks, and safety risks (terrorism and
civil unrest).
∗ Example: Arab Spring uprisings that took place across the Middle East and North Africa in 2010
and 2011 led to a number of changes in government, as well as an increase in instability in the region.
Israel Palestine Conflict in October 2023.
∗ Legal and regulatory risk: changes in the laws of a country, restrictive business practices against
foreign companies.
∗ Cyber risks: fraud, identity theft, and espionage.

∗ Example: Transfer fraud via compromised SWIFT servers: 2016 Bangladesh Bank - US$81 million
from the central bank of Bangladesh.
Expanded Opportunity Set
• Firms can locate production in any country or region of the world to
maximize their performance and raise funds in any capital market where
the cost of capital is the lowest.
• Individual investors can also benefit greatly if they invest internation-
ally rather than domestically.
• Scope of international diversification.
• If you diversify internationally, the resulting international portfolio may
have a lower risk or a higher return (or both) than a purely domestic
portfolio.
• This can happen mainly because stock returns tend to covary much
less across countries than within a given country.
Expanded Opportunity Set
Goals of IFM
• Shareholder wealth maximization vs Stakeholder wealth maximization
− Anglo-Saxon countries like Australia, Canada, the United Kingdom, and especially the United
States follow capitalist market orientation.
− Non Anglo-Saxon countries like France and Germany, where shareholders are stakeholders.
− European managers tend to consider the promotion of the firm’s stakeholders’ overall welfare
as the most important corporate goal.
− In Japan, on the other hand, many companies form a small number of interlocking business
groups called keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, which arose from consolidation of
family-owned business empires and hence maximize market share.
• Importance of Corporate governance

− It is the financial and legal framework for regulating the relationship between a company’s man-
agement and its shareholders.
− Need is more for emerging and transition economies such as India, China, Indonesia, Russia,
where legal protection of shareholders is weak or non-existent.
Overview of International Finance
Foreign Exchange Rate Market
• One currency is exchanged for another currency on the foreign ex-
change market.
• The U.S. dollar is involved in a majority of all transactions in the foreign
exchange market, and in 2001 the most traded currency pair was the
U.S. dollar/euro, accounting for 30% of average daily turnover.
• The largest trading center is the United Kingdom with 31% of foreign
exchange turnover in 2001. The U.S. has a 16% share of foreign ex-
change trading, and Japan has a 9% share.
• Australia, Hong Kong, Singapore, Switzerland, and Germany are also
large centers for foreign exchange trading.
Foreign Exchange Rate Market
• Most Important Cities:
∗ London, New York, Tokyo, Frankfurt, Hong Kong, Sydney.
• FX operates 24 hrs/day (opening time Sunday 5 p.m. to 4 p.m. on Fri-
day)
Foreign Exchange Rate Market Participants
• FX Dealers - Market makers
∗ Attempt to sell high and buy low and make profit
• FX Brokers - They match buyers and sellers but do not put their own
money at risk.
∗ Foreign exchange dealers often use these brokers to unwind very
large positions in a particular currency in order to preserve their anonymit
• Central Banks
• MNCs
• Institutional Investors
• Hedge funds
Foreign Exchange Rate Market Participants
• Example:
Indiana Co. purchases supplies priced at 100,000 euros (€) from Belgo,
a Belgian supplier, on the first day of every month. Indiana instructs
its bank to transfer funds from its account to the supplier’s account on
the first day of each month. It only has dollars in its account, whereas
Belgo’s account is in euros. When payment was made one month ago,
the euro was worth $1.08, so Indiana Co. needed $108,000 to pay for
the supplies (€100,000 X $1.08 = $108,000). The bank reduced Indi-
ana’s account balance by $108,000, which was exchanged at the bank
for 100,000. The bank then sent the 100,000 electronically to Belgo by
increasing Belgo’s account balance by 100,000. Today, a new payment
needs to be made. The euro is currently valued at $1.12, so the bank
will reduce Indiana’s account balance by $112,000 (€100,000 X $1.12 =
$112,000) and exchange it for €100,000, which will be sent electroni-
cally to Belgo.
• Here what sort of functions does the bank perform?
eFX Platform
• An ECN electronically collects and matches buy and sell orders, display-
ing the best available prices.
∗ Ensures price transparency
∗ Possibility of straight-through processing (STP)
∗ Enhanced liquidity and reduced trading costs
∗ Three categories of eFX: single bank–sponsored platforms (or “por-
tals”), multi-bank portals, and independent companies offering elec-
tronic trading.
• Story of Currenex
∗ Anonymous trading platform
∗ Clearing house and counterparty
∗ Preferred by hedge funds and algorithmic traders
∗ Small institutions, mutual funds, pension funds, and retail investors
What is Foreign Exchange Rate?
• Exchange rates that are listed in the form of “U.S. $ Equivalent” are
called direct quotes, and give the price of a unit of foreign currency
in U.S. dollars, or how many U.S. dollars it costs to buy a unit of the
foreign currency.
• Rates listed in the form of “Currency per U.S. $” are called indirect
quotes, and give the price of one U.S. dollar in the foreign currency,
or the number of units of foreign currency required to buy one U.S.
dollar.
• General Motors has a project in Brazil and needs to buy materials from
Brazilian suppliers. The company will need 1,000,000 Brazilian reals to
buy its materials. How many U.S. dollars does General Motors need in
order to purchase the reals?
Cross-Exchange Rates
• Certain occasions require exchange rates for two non-U.S. dollar cur-
rencies. These rates are called cross-exchange rates.
• If a Japanese company and a Chinese company anticipate a business
transaction, they would be interested in the yen-yuan renminbi ex-
change rate rather than the yen-U.S. dollar or the yuan renminbi-U.S.
dollar rate.
• A Mexican traveler wants to go hiking in the Nepalese Himalayas and

would like to change his pesos (MXN) for Nepalese rupees (NPR). Given
the USD-MXN exchange rate (0.09760 USD = 1 MXN) and the USD-NPR
exchange rate (0.01358 USD = 1 NPR), find the MXN-NPR cross rate.
Triangular Arbitrage using Cross-Exchange Rates
• is a process that keeps cross-rates published in line with exchange
rates quoted relative to the U.S. dollar or exchange rates determined
using USD-referenced ER.
• If a quoted cross-exchange rate differs from the appropriate cross-
exchange rate (as determined by the preceding formula), you can at-
tempt to capitalize on the discrepancy.
• We use Triangular Arbitrage conducted in the spot market involving
three currencies.
• Example 1: 1£ = $1.60; MYR = $.20; Cross-rates are quoted at £1 =
MYR8.1. You have 10,000£. Can you make a triangular arbitrage profit?
Triangular Arbitrage using Cross-Exchange Rates
• Example 2: Bank A: 82 JPY/USD

• Bank B: 1.6 USD/GBP
• Bank C: 128 JPY/GBP
• You have 100,000,000 JPY. Can you make a triangular arbitrage profit?
Bid-Ask Spread
• When banks or brokers facilitate currency transactions such as the ones
discussed above, they charge a fee for their services. In many cases
part of this fee comes from the difference between the bank’s bid and
ask quotes, called the bid/ask spread.
• Calculate Bid/Ask Spread.
• You plan to take a business trip to Europe and want to convert $1,000
to euros. The U.S. bank quote for the euro is $1.23-31, meaning the
bank will buy euros at $1.23 and sell euros at $1.31. The bank sells you
$1000 worth of euros at its sell price of $1.31 and you receive € 763.36.
• On your trip, you complete all of your business in the U.K. and there-
fore use none of your euros. When you return to the U.S., you want to
change your euros back to dollars. You note that the bank’s quote for
euros is unchanged at $1.23-31. The bank buys your euros at its bid
price of $1.23, and for your euros you receive $938.93.
Bid-Ask Spread
• Assume that the prevailing quote for wholesale transactions by a com-
mercial bank for the euro is $1.0876/78. This means that the commer-
cial bank is willing to pay $1.0876 per euro. Alternatively, it is willing to
sell euros for $1.0878.
• Calculate Bid/Ask Spread.
• Factors That Affect the Spread:
• Spread = f (Order costs (+), Inventory costs (+), Competition (-), Volume
(-), Currency risk (+)
• Determining whether a currency has appreciated or depreciated
• Calculating the percentage fluctuation of an exchange rate.

• Consider the movement of the Mexican peso (MXN)/U.S. dollar (USD)
exchange rate from 10 to 20.
Foreign Exchange Transactions
• Five main groups of transactions are covered in this note: spot trans-
actions, forwards, swaps, futures, and options, i.e., Derivatives.
• They are used to manage foreign exchange risk or take speculative po-
sitions on currency movements.
• Spot Transactions
∗ The daily exchange rates quoted in The Wall Street Journal and other
news sources are called spot rates – market rates that hold for trans-
actions that take place on the “spot.”
• Forwards
∗ The types of transactions that take place in the future are called
forward transactions, and the rate used is called the forward rate.
∗ Forward Premium: F greater than S(t+1)
∗ Forward Discount: F less than S(t+1)
• Forwards
• A U.S. auto importer buys 4 Rolls Royces from a manufacturer in England at £ 250,000 per car. The
U.S. firm puts in the order, but does not have to pay the British manufacturer until it receives the
cars in 3 months. Upon receiving the cars, the U.S. importer will have to pay the British manufacturer
£1,000,000 (4 x £ 250,000).
• The U.S. importer decides to enter into a forward contract to lock in a rate for its currency transaction.
• Forwards - Example
• The current spot exchange rate is $1.55/£ and the three-month for-
ward rate is $1.50/£. Based on your analysis of the exchange rate, you
are pretty confident that the spot exchange rate will be $1.52/£ in three
months. Assume that you would like to buy or sell £1,000,000.
∗ Calculate Forward Discount/ Premium?
∗ What actions do you need to take to speculate in the forward mar-
ket? What is the expected dollar profit from speculation?
∗ What would be your speculative profit in dollar terms if the spot
exchange rate turns out to be $1.46/£.
Spot−Forward
• Spot
360
X days = 12.62%
• Buy 1,000,000£ forward contract for dollars.
• Swaps
∗ For example, a U.S. firm that anticipates receiving annual payments
in krona from a subsidiary in Sweden might enter a swap agreement
with a Swedish firm that receives regular fees in U.S. dollars for work
done in the U.S. Swaps are arranged by brokers and banks.
∗ A swap enables two parties who have complementary foreign ex-
change exposure/obligations to pair up and trade their currencies pri-
vately.
∗ Swaps and forwards differ in that a swap contract typically covers
multiple future transactions and can have anywhere between five and
ten years until maturity, whereas a forward contract is drawn for one
transaction and usually has a shorter maturity.
• Futures
∗ Futures contracts specify a standard volume of a currency to be ex-
changed on a settlement date sometime in the future.
• Options: Contracts that allow their owners to either buy or sell a cur-
rency at a designated price within a specific period of time.
∗ A U.S. construction company puts in a bid to build a 42-hectare software park for the Vietnamese
government. If the company gets the bid, it will have to purchase materials and hire workers in Viet-
nam, which will require approximately 17 billion Vietnamese dong (VND). However, if the company
does not get the bid, it will not need to purchase anything in Vietnam, and therefore will not need
any Vietnamese currency.
∗ A French biotech company hires an American company to build its advanced science laboratories
in Paris. At the request of the French company, the American company accepts payment in euros.
The American company might have the opportunity to use its euros on a different project in the near
future and therefore does not want to exchange its euros for dollars immediately. If the company
does not use the euros it receives, it wants to insulate itself against the possible depreciation of the
euro.
• Options
• An American option can be exercised anytime during the contract pe-
riod.
• A European option can only be exercised on the date the contract ex-
pires.
∗ How much is the premium on a 3-month put option for euros at a
strike price of US$1.07?
• Evaluating Foreign Exchange Instruments
• Thriller Driller Corporation (TDC) of Massachusetts places a bid on an
oil drilling contract off the coast of Russia in March of 2003. If it wins the
bid, it will need approximately 62,000,000 rubles to purchase Russian
materials and services. However, it will not know if the bid is accepted
until June of 2003 (3 months after placing the bid). The company con-
siders four different strategies to obtain the rubles it might need, and
considers the benefits and risks of each strategy:
∗ Purchase rubles at today’s spot rate.
∗ Purchase rubles at the June spot rate.
∗ Purchase a forward contract for rubles.
∗ Purchase a ruble call option.
• Payoffs from each strategy
Exchange Rate Determinants
• ER = f (inflation, interest rate, relative income, government controls, expectation)
• Government Intervention
• Why do they intervene?
∗ To smooth exchange rate movements.
∗ To establish implicit exchange rate boundaries.
∗ To respond to temporary disturbances.
− News that oil prices might rise could cause expectations of a fu-
ture decline in the value of the Japanese yen because Japan exchanges
yen for U.S. dollars to purchase oil from oil-exporting countries.
• Two ways of intervention
∗ Direct Intervention
∗ Indirect Intervention
Government Interventions
• Direct Intervention
∗ If the Fed desires to strengthen the dollar:
∗ It can exchange foreign currencies for dollars in the foreign exchange
market, thereby putting upward pressure on the dollar
− Japan’s central bank, the Bank of Japan, intervened on several
occasions to lower the yen’s value in 2004.
• Caveats:
∗ Coordinated effort among central banks.
∗ Reliance on Reserves - China.
• Types:
∗ Nonsterilized intervention: FX intervention without adjusting for
the change in the money supply.
∗ Sterilized intervention: FX intervention and simultaneously offset-
ting transactions in the Treasury securities markets. As a result, the
dollar money supply is unchanged.
∗ Can speculation happen?
Government Intervention
• Indirect Intervention
∗ ER = f (inflation, interest rate, relative income, government controls, expectatio
∗ In October 1997, there was concern that the Asian crisis might ad-
versely affect Brazil and other Latin American countries.
∗ The central bank of Brazil responded at the end of October by dou-
bling its interest rates from about 20 percent to about 40 percent.
• U.S. bond prices are normally inversely related to U.S. inflation. If the
Fed planned to use intervention to weaken the dollar, how might
bond prices be affected?
Government Intervention
• Interventions may not work well due to interacting factors
∗ What would be the case if the income level of a country increases?
• Example of Speculating Activity on anticipated exchange rate
∗ Chicago Bank expects the exchange rate of the New Zealand dollar
(NZ$) to appreciate from its present level of $.50 to $.52 in 30 days.
∗ Chicago Bank is able to borrow $20 million on a short-term basis
from other banks.
∗ Present short-term interest rates (annualized) in the interbank
market are as follows:
Currency Lending Rate Borrowing Rate
USD 6.72% 7.20%
NZ $ 6.48% 6.96%
∗ Derive a speculative profit from this scenario?
Interest Rate Parity
• Interest rates are said to be the time values of monies.
• IRP is a no-arbitrage relationship between spot and forward exchange
rates and the two nominal interest rates associated with these curren-
cies.
• In international money markets, the interest rate differential between
two currencies approximately equals the percentage spread between
the currencies’ forward and spot rates.
Involves three steps:
• Borrowing the low-interest rate currency.
• Lending the high-interest-rate currency.
• Covering the foreign exchange risk.
Intuition behind IRP:
∗ Forward exchange rates allow investors to contract to buy and sell
currencies in the future.
∗ Future value of one unit of currency depends on the interest rate
for that currency.
− The forward exchange rate must be linked to the current spot
exchange rate and to the nominal interest rates in the two currencies.
• Suppose that you have $1 to invest over, say, a one-year period.
• Consider two alternative ways of investing your fund:
∗ invest domestically at the U.S. interest rate, or, alternatively,
∗ invest in a foreign country, say, the U.K., at the foreign interest rate
and hedge the exchange risk by selling the maturity value of the foreign
investment forward.
• Because Alternatives 1 and 2 are both made with one unit of
domestic currency and because both provide a certain return of
domestic currency at the end of the investment period, the domestic
currency returns must be equal.
[1 + i] = 1/S X [1 + i ∗ ] X F Eq1.
h ∗i
i−i F −S

1+i ∗ = S Eq2.
• Example: Suppose that the annual interest rate is 5 percent in the U.S.
and 8 percent in the U.K., and that the spot exchange rate is $1.50/£
and the forward exchange rate, with one-year maturity, is $1.48/£. In
terms of our notation, i$ = 5%, i£ = 8%, S = $1.50, and F = $1.48. Assume
that the arbitrager can borrow up to $100 million
• Arbitrage profit of $1.565 million.

• The arbitrager borrowed at one interest rate and simultaneously lent
at another interest rate, with exchange risk fully covered via forward
hedging — Covered Interest Arbitrage
• How long it will last?
∗ The interest rate will rise in the United States.
∗ The interest rate will fall in the U.K.
∗ The pound will appreciate in the spot market.
∗ The pound will depreciate in the forward market.
• Practice: Three-month interest rate in the United States: 8.0% per
annum.
Three-month interest rate in Germany: 5.0% per annum.
Current spot exchange rate: €1.0114/$.
Three-month forward exchange rate: €1.0101/$.
Ans: €538.8 or $669
Interest Rate Parity Line
• Graphical Analysis of IRP
Interest Rate Parity Line
• Suppose British investors in the U.K., whose interest rate is 1% higher
than the U.S. interest rate and the forward rate is at 3% discount.
• Arbitrage would be: convert the pounds with dollars at spot rate, in-
vest in dollar denominated securities and engage in forward contract
to purchase pounds forward.
Purchasing Power Parity
• Goods that are freely traded should cost the same everywhere,
measured in the same currency.
• The exchange rates between currencies, therefore, should be such
that the currencies have equivalent purchasing power.
• Exchange rates change, over the long term, because the purchasing
power of one currency increases (or decreases) relative to another
currency.
h i
Ph
S= Pf
Here, h: home country; f: foreign country;
S: exchange rate between home and foreign country
The Economist Big Mac Index
Big Mac Prices Implied PPP Actual dollar ER Under(-)/ over(+)
In local currency In dollars of the dollar on April 22, 2003 valuation against
United States $2.71 2.71 the dollar (%)
China Yuan 9.90 1.20 3.65 8.28 -56
Denmark Krone 27.75 4.10 10.20 6.78 +51
Japan Yen 262 2.19 96.7 120 -19
Source: “McCurrencies,” The Economist, April 24, 2003, p. 80.
• Taking Japan as an example, the table is read as follows: In the U.S., a
Big Mac costs $2.71. The price of a Big Mac in Japan is ¥262. In dollars,
the cost is $2.19, using the actual dollar exchange rate of 120
yen/dollar (262/120= $2.19).
• Since a Big Mac in Japan has a price of ¥262, the implied PPP of the
dollar is 96.7 yen (262/2.71=96.7). The implied PPP is the exchange
rate that would give the Big Mac the equivalent price in both
currencies.
• Comparing the implied PPP exchange rate and the actual exchange
rate for the yen to the dollar suggests that the yen is undervalued by
19% relative to the dollar, calculated from the actual exchange rate
and the implied PPP exchange rate (120-96.7/120).
Relative Purchasing Power Parity
• According to PPP theory, the percentage change in the foreign
currency (ef ) should change to maintain parity in the new price
indexes of the two countries. We can solve for (ef ) under conditions
of PPP by setting the formula for the new price index of the foreign
country equal to the formula for the new price index of the home
country, as follows:
[Pf (1 + If )(1 + ef )] = [Ph (1 + Ih )]
Ideally:

1 + Ih
[ef ] = −1
1 + If
If Ih > If , then ef should be positive.
This implies that the foreign currency will appreciate when the home
country’s inflation exceeds the foreign country’s inflation.
Relative Purchasing Power Parity - Example
• Asume that the exchange rate is in equilibrium initially. Then the
home currency experiences a 5 percent inflation rate, while the
foreign country experiences a 3 percent inflation rate. According to
PPP, how should the foreign currency will adjust?
International Fisher Effect
• It uses interest rate rather than inflation rate differentials to explain
why exchange rates change over time, but it is closely related to the PPP
theory because interest rates are often highly correlated with inflation
rates.
• Nominal risk-free interest rates contain a real rate of return and antic-
ipated inflation.
• If investors of all countries require the same real return, interest rate
differentials between countries may be the result of differentials in ex-
pected inflation.
• The IFE theory suggests that foreign currencies with relatively high
interest rates will depreciate because the high nominal interest rates
reflect expected inflation.
International Fisher Effect - Example
• The nominal interest rate is 8 percent in the United States.
• Investors in the United States expect a 6 percent rate of inflation.
• The nominal interest rate in Canada is 13 percent.
• Given that investors in Canada also require a real return of 2 percent,
the expected inflation rate in Canada must be 11 percent.
• According to PPP theory, the Canadian dollar is expected to depreciate
by approximately 5 percent against the U.S. dollar since the Canadian
inflation rate is 5 percent higher.
Derivation- International Fisher Effect
Return form a foreign bank:
r = (1 + if )(1 + ef ) − 1
According to the IFE, the effective return on a foreign investment should,
on average, be equal to the interest rate on a local money market
investment:
r = ih
(1+if )(1 + ef ) − 1 = ih
h i
Ih
[ef ] = 1+1+I −1
f
If Ih > If , then ef should be positive.

This implies that the foreign currency will appreciate when the foreign
interest rate is lower than the home interest rate.
IFE - Example 1
• Assume that the interest rate on a one-year insured home country
bank deposit is 11 percent, and the interest rate on a one-year insured
foreign bank deposit is 12 percent. For the actual returns of these two
investments to be similar from the perspective of investors in the home
country, how would the foreign currency would have to change over
the investment horizon?
IFE - Example 2
The one-year risk-free interest rate in Mexico is 10 percent. The one-year
risk-free rate in the United States is 2 percent. Assume that interest rate
parity exists. The spot rate of the Mexican peso is $0.14.
• What is the forward rate premium?
• What is the one-year forward rate of the peso?
• Based on the international Fisher effect, what is the expected change
in the spot rate over the next year?
• If the spot rate changes as expected according to the IFE, what will be
the spot rate in one year?
• Compare your answers to (b) and (d) and explain the relationship.
Balance of Payments
Balance of Payments - Usage!
• Provides detailed information concerning the demand and supply of a
country’s currency.
• Signal its potential as a business partner for the rest of the world.
• Balance-of-payments data can be used to evaluate the performance of
the country in international economic competition.
Balance of Payments- Terms
• Accounting statement that summarizes all the economic transactions
between residents of the home country and residents of all other coun-
tries.
• Major accounts of the Balance of Payments:
∗ Current account
− Imports / exports (Goods and services)
− Income flows (From ownership of foreign assets)
− Transfers of money
∗ Capital account
− Purchases / sales of foreign assets
∗ Official settlements / reserves account

• Double-entry accounting system
∗ Each transaction gives rise to a credit (inflows) and a debit (out-
flows), both of equal value.
Balance of Payments - Usage!
• For example, suppose that Boeing Corporation exported a Boeing 747
aircraft to Japan Airlines for $50 million, and that Japan Airlines pays
from its dollar bank account kept with Chase Manhattan Bank in New
York City.
• Suppose, for another example, that Boeing imports jet engines pro-
duced by Rolls-Royce for $30 million, and that Boeing makes payment
by transferring the funds to a New York bank account kept by Rolls-
Royce.
• Suppose that Ford acquires Jaguar, a British car manufacturer, for $750
million, and that Jaguar deposits the money in Barclays Bank in London,
which, in turn, uses the sum to purchase U.S. treasury notes.
Balance of Payments- Terms
• An intuitive rule for determining credits and debits.
∗ Credit transactions give rise to conceptual inflows or sources of for-
eign exchange.
∗ Debit transactions give rise to conceptual outflows or uses of for-
eign exchange.
Balance of Payments- Summary of U.S. BOP
accounts
Debits (recorded with a -) Credits (recorded with a +)
I. CURRENT ACCOUNT
(A) TRADE BALANCE (Transactions in goods, services, and transfers)
Imports to the United States Exports from the United States
(B) INVESTMENT INCOME ACCOUNT
Payment by the United States of dividends and Receipt by the United States of dividends and interest
interest to foreigners from foreigners
II. CAPITAL ACCOUNT
Capital Outflows Capital Inflows
Increase in U.S. ownership of foreign assets Increase in foreign ownership of U.S. assets
Decrease of foreign ownership of U.S. assets Decrease in U.S. ownership of foreign assets
III. OFFICIAL RESERVES ACCOUNT
Increase in official reserves of the U.S. central bank Decrease of official reserves of the U.S. central bank
Decrease in dollar reserves of foreign central banks Increase in dollar reserves of foreign central banks
Factors Affecting International Trade Flows
• Inflation
• National Income
• Government Policies
∗ Subsidies for Exporters
∗ Restrictions on Importers
• Exchange Rate
Official Reserve Account
• Gold
• Foreign currencies
• Special Drawing Rights (SDRs)
• Reserve positions in the International Monetary Fund (IMF)
• What is SDR?
∗ Basket currency comprising major individual currencies of coun-
tries that can be used to make international payments.
∗ Weights are based on relative importance of each country in the
world trade of goods and services and the amount of the currencies
held as reserves by the members of the IMF.
∗ November 2015, the Chinese Renminbi (RMB) joined the SDR bas-
ket.
Official Reserve Account- SDR
Surpluses and Deficits in the Balance of Payment
Accounts
• Surplus/deficit
∗ Surplus results when the credit exceed the debit transactions.
∗ Deficit results when the debits exceed the credit transactions.
• An important Balance of Payments identity:
∗ Current Account + Capital Account = 0
∗ Implication is current account deficits must have a capital account
surplus.
• If the sum of private and government transactions on the current and
regular capital accounts is:
∗ Positive:
− The central bank must have increased its foreign money hold-
ings.
∗ Negative:
− The central bank must have decreased its foreign money hold-
ings.
Balance of Trade Deficit Corrections
• Weak home currency is not always a perfect solution:
∗ Counterpricing by Competitors.
∗ Impact of Other Weak Currencies.
∗ Intracompany Trade.
∗ Prearranged International Transactions
− A depreciation will begin to improve the trade balance immedi-
ately if imports and exports are responsive to the exchange rate changes.
Let’s think!
• Is it possible for a country to have a trade balance deficit while still
having a balanced current account?
∗ Example: Japan!
Savings, Investment, Income, and the BOP
• Linking the Current Account to National Income
∗ Gross National Income = GDP + Net Foreign Income
∗ Subtracting expenditures (consumption, investment and government
purchases) and using:
GDP = C + I + G + NX to obtain:
GNI - (C + I + G) = GDP + NFI - (C + I + G) = NX + NFI
• Gross National Income - National Expenditure = Current Account
∗ If a country has a CA surplus, income exceeds expenditures
∗ If a country has a CA deficit, expenditures exceed income Current
Account = Change in Net Foreign Assets
∗ If country has a CA surplus, it is acquiring assets
∗ If country has a CA deficit, it is losing assets
• National Savings, Investment, and the Current Account
• National Savings = Gross National Income - Consumption
∗ If a country spends more than its income, its savings are negative.
∗ Using the definitions of GNI and GDP we can rearrange terms to
find that
− National Saving - National Investment = Current Account
− If a country’s purchases of investment goods are more than its
savings, the country must run a current account deficit; that is, the
country’s investment spending must be financed from abroad with a
capital account surplus.
• So what causes Current Account deficits and surpluses?
∗ Government financing
∗ Consumer choices about consumption and savings
∗ Investment spending decisions are intertemporal and pro-cyclical
International Monetary System
Evolution of International Monetary System
• International monetary system can be defined as the institutional frame-
work within which international payments are made, movements of
capital are accommodated, and exchange rates among currencies are
determined.
• Stages of the evolution of IMS summarized as follows:
• These include:
− Bimetallism: Before 1875.
− Classical gold standard: 1875–1914.
− Interwar period: 1915–1944.
− Bretton Woods system: 1945–1972.
− Flexible exchange rate regime: Since 1973.
1. Bimetallism: Before 1875.
• A double standard in that free coinage was maintained for both gold
and silver.
• In Great Britain - bimetallism was maintained until 1816 (after the con-
clusion of Napoleonic Wars). In the United States - bimetallism from
1792 and until 1873. China, India, Germany, and Holland, - silver stan-
dard.
• Exchange rates among currencies were determined by either their gold
or silver contents.
• These countries experienced Gresham’s law phenomenon.
− If a gold coin is worth $5 and silver coin is worth $0.50, people will
hoard gold coin and exchange 10 silver coins, which will draw out of
circulation of gold (good money).
− In this way bad money drives out the good money.
− This also leads to the concept of seigniorage as gold becomes worth
more even though its face value is equal to 10 silver coins.
1. Bimetallism: Before 1875.
• Gresham’s Law in modern day economy. Applied to different curren-
cies’ value in global markets.
• In situation of hyperinflation like in Zimbabwe, inflation reached 250
million% in July 2008 with 98% daily jump in inflation level. Zimbabwe’s
dollar lost its value rapidly enough, that people started using the US
dollar, a more stable currency eventually forcing the government for
dollarization of the economy.
• Here Gresham’s law operated in the reverse order. Good money drove
bad money out of circulation.
• In global markets, stronger currencies such as Euro and US dollars are
regarded as international medium of exchanges and used for interna-
tional pricing reference largely for globally traded commodities.
• Long-term debt contracts are dollar-denominated contracts.
2. Classical gold standard: 1875–1914
• During this period, London became the center of the international fi-
nancial system, reflecting Britain’s advanced economy and its preemi-
nent position in international trade.
• An international gold standard can be said to exist when:
− Gold alone is assured of unrestricted coinage,
− There is two-way convertibility between gold and national currencies at a stable ratio,
− Gold may be freely exported or imported; and the domestic money stock should rise and fall as
gold flows in and out of the country.
• Under the gold standard, the exchange rate between any two curren-
cies will be determined by their gold content.
• Suppose, 1 oz of gold = 6 £; 1 oz of gold = 12 FF, then:
• ER between them will be 2 FF/£.
2. Classical gold standard: Positives
• Under the gold standard, misalignment of the exchange rate will be auto-
matically corrected by cross-border flows of gold.
− Suppose, 1 £ = 1.80 FF
− People will buy pounds with francs.
− For people who need francs, it would be cheaper first to buy gold
from the Bank of England and ship it to France and sell it for francs.
− Suppose you need to buy 1,000 francs using pounds.
− There would be two alternatives:
∗ To buy francs at the prevailing ER.
∗ To buy Gold first via BoE and ship it to France and sell it.
What would be the payoffs in each case??
2. Classical gold standard: Positives
• Under the gold standard, international imbalances of payment will also
be corrected automatically.
− Consider a situation where Great Britain exported more to France
than the former imported from the latter.
− Net export from Great Britain to France will be accompanied by a
net flow of gold in the opposite direction.
− This flow of gold will lead to a lower price level in France and, at the
same time, a higher price level in Great Britain.
− The resultant change in the relative price level, in turn, will slow ex-
ports from Great Britain and encourage exports from France. As a re-
sult, the initial net export from Great Britain will eventually disappear.
− This adjustment mechanism is referred to as the price-specie-flow
mechanism.
2. Classical gold standard: Positives & Negatives
• Gold is considered as natural hedge against inflation.
Negatives
• The supply of newly minted gold is so restricted that the growth of
world trade and investment can be seriously hampered for the lack
of sufficient monetary reserves, causing deflationary pressures.
• It can be abandoned at any moment when the government finds it po-
litically necessary to pursue its national objectives.
3. Interwar Period: 1915-1944
• After the war, many countries, especially Germany, Austria, Hungary,
Poland, and Russia, suffered hyperinflation.
• The United States, which replaced Great Britain as the dominant finan-
cial power, spearheaded efforts to restore the gold standard. In Great
Britain, Winston Churchill, the chancellor of the Exchequer, played a
key role in restoring the gold standard in 1925.
• Pound was pegged at £4.25 per ounce of gold. This priced British goods
out of the market, and pushed the economy into great depression.
• Foreign holders lost confidence in Britain’s promise to maintain its cur-
rency’s value, and converted pound holdings to gold.
• This would have led to the depletion of British gold reserves, if its con-
vertibility was not stopped.
• Major countries gave priority to the stabilization of domestic economies
by following a policy of sterilization of gold - matching inflows and out-
flows of gold respectively with reductions and increases in domestic
money and credit.
Automatic adjustment mechanism was unable to work.
Practice Questions
• Prior to the 1870s, both gold and silver were used as international
means of payment and the exchange rates among currencies were de-
termined by either their gold or silver contents. Suppose that the dollar
was pegged to gold at $20 per ounce, the French franc is pegged to gold
at 100 francs per ounce and to silver at 8 francs per ounce of silver, and
the German mark pegged to silver at 2 mark per ounce of silver. What
would the exchange rate between the U.S. dollar and German mark be
under this system?
• Suppose that the pound is pegged to gold at £10 per ounce and the
dollar is pegged to gold at $18 per ounce. If the current market ex-
change rate is $2.00 per pound, how would you take advantage of this
situation? Assuming that you have $360 available for investment.
Practice Questions
• Suppose that the British pound is pegged to gold at £6 per ounce,
whereas one ounce of gold is worth €18. Under the gold standard,
any misalignment of the exchange rate will be automatically corrected
by cross border flows of gold. Calculate the possible gains for buying
€900, if the British pound becomes undervalued and trades for €2.80.
(Assume zero shipping costs).
4. Bretton Woods system: 1945–1972
• Postwar international monetary system - Central question was how can
the country recover if they can’t devalue their currency?
• how to prevent the recurrence of economic nationalism with destruc-
tive “beggar-thy-neighbor” policies.
• John Maynard Keynes proposed an international clearing union that
would create an international reserve asset called “bancor”.
• Each country established a par value in relation to the U.S. dollar, which
was pegged to gold at $35 per ounce. Each country was responsible for
maintaining its exchange rate within +/- 1 percent of the adopted par
value by buying or selling foreign exchanges as necessary.
• The U.S. dollar was the only reserve currency that was fully convertible
to gold; other currencies were not directly convertible to gold. Coun-
tries held U.S. dollars, as well as gold, for use as an international means
of payment.
4. Bretton Woods system: Issues!
• Major problem was identified by Professor Robert Triffin.
• To satisfy the growing need for reserves, the United States had to run
balance-of-payments deficits continuously - triggering a run on the dol-
lar.
• Dilemma faced by reserve-currency country is that in order to make
the world happy they have to expose their domestic monetary policy
to international market, forgoing their national sovereignty.
Solutions:
• Imposing Interest Equalization Tax (IET) on US purchase of foreign se-
curities to regulate the outflow of dollars,
• Foreign Credit Restraint Program (FCRP) regulated amount of dollars
banks could lend to MNCs. This led to growth of Eurodollar market.
• Creation of new reserve asset, Special Drawing Rights (SDRs) in 1970,
by IMF.
4. Bretton Woods system: Collapse!
• Vietnam War and the Great Society program in the US, dollar-based
gold-exchange standard turned out to be ineffective in the face of ex-
pansionary monetary policy and rising inflation.
• It became clear that the dollar was overvalued, especially relative to
the mark and the yen.
• In February 1973, the dollar came under heavy selling pressure, again
prompting central banks around the world to buy dollars. The price of
gold was further raised from $38 (revised under Smithsonian Agree-
ment) to $42 per ounce.
• By March 1973, European and Japanese currencies were allowed to
float, completing the decline and fall of the Bretton Woods system.
5. Flexible Exchange Rate: Since 1973
• January 1976 when the IMF members met in Jamaica, with new set of
agreements:
∗ Flexible exchange rates were declared acceptable to the IMF mem-
bers, and central banks were allowed to intervene in the exchange mar-
kets to iron out unwarranted volatilities.
∗ Gold was officially abandoned (i.e., demonetized) as an international
reserve asset. Half of the IMF’s gold holdings were returned to the
members and the other half were sold, with the proceeds to be used
to help poor nations.
∗ Non-oil-exporting countries and less-developed countries were given
greater access to IMF funds.
Fixed vs Flexible Exchange Rate
• Suppose a country is experiencing a balance-of payments deficit at the
moment.
∗ Under a flexible exchange rate regime, the external value of the country’s currency will simply
depreciate to the level at which there is no excess supply of the country’s currency. At the new ex-
change rate level, the balance-of-payments disequilibrium will disappear.
∗ With flexible exchange rates, therefore, the government can use its monetary and fiscal policies
to pursue whatever economic goals it chooses.
∗ Exchange rate uncertainty cannot be eliminated.
• Under a fixed rate regime, however, the government may have to take
contractionary (expansionary) monetary and fiscal policies to correct
the balance-of-payments deficit (surplus) at the existing exchange rate.
∗ The government loses its policy autonomy under a fixed exchange rate regime.
∗ Exchange rate uncertainty and hence its impact on international trade can be reduced via fixed
exchange rate.
The choice between the alternative exchange rate regimes is likely to in-
volve a trade-off between national policy independence and international
economic integration.
Managed Float vs Pegged ER Systems
• Managed Float/ Dirty Float: governments can and sometimes do in-
tervene to prevent their currencies from moving too far in a certain
direction.
• Brazil, Russia, South Korea, and Venezuela have imposed bands around
their currency to limit its degree of movement.
• Pegged ER: Home currency’s value is pegged to a foreign currency or
to some unit of a foreign currency. It moves in line with that currency
against other currencies.
• From 1996 until 2005, China’s yuan was pegged to be worth about $.12
(8.28 yuan per U.S. dollar). Its value remained low even if United States
was experiencing a trade deficit of more than $100 billion per year with
China.
∗ While countries with a pegged exchange rate may attract foreign investment because the ex-
change rate is expected to remain stable, weak economic or political conditions can cause firms and
investors to question whether the peg will hold.
Thank You
Open for Questions/ Comments

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MSD519

Jan 2024 - Apr 2024

• 9th edition by Madura, J.

• Availability - Fri (4:00 to 5:00 pm) at Room No 108.

• Quizzes 02 - 15% (15 marks)

• Case Study - 15% (15 marks)

• Mid-term - 40% (28 marks)

• Final-term - 60% (42 marks)

• Discussion on the International Financial System of the World

• 11 Harvard Cases according to the unit

• We live in a highly globalized and integrated world economy.

∗ Cyber risks: fraud, identity theft, and espionage.

• Importance of Corporate governance

• A Mexican traveler wants to go hiking in the Nepalese Himalayas and

• Example 2: Bank A: 82 JPY/USD

• Calculating the percentage ﬂuctuation of an exchange rate.

• Arbitrage proﬁt of $1.565 million.

Big Mac Prices Implied PPP Actual dollar ER Under(-)/ over(+)

United States $2.71 2.71 the dollar (%)

China Yuan 9.90 1.20 3.65 8.28 -56

Denmark Krone 27.75 4.10 10.20 6.78 +51

Japan Yen 262 2.19 96.7 120 -19

Source: “McCurrencies,” The Economist, April 24, 2003, p. 80.

If Ih > If , then ef should be positive.

∗ Oﬃcial settlements / reserves account

(A) TRADE BALANCE (Transactions in goods, services, and transfers)

Imports to the United States Exports from the United States

(B) INVESTMENT INCOME ACCOUNT

interest to foreigners from foreigners

II. CAPITAL ACCOUNT

Capital Outﬂows Capital Inﬂows

III. OFFICIAL RESERVES ACCOUNT

∗ Exchange rate uncertainty cannot be eliminated.

Open for Questions/ Comments

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