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  • Topic 8: Managing International Business Finance

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    Managing International Business Finance 

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    1. Topic Discussion notes: 
      Read the Discussion notes (adapted from Alstrom & Brunton 2010 by Dr Ian Cook) for this topic.

    Here re some of the Financial Implication of International Business:

    •Foreign exchange market: a market for converting the currency of one country into the currency of another.

    •Exchange rate: the rate at which one currency is converted into another

    •Foreign exchange risk: the risk that arises from changes in exchange rates

    The Foreign exchange market serves two main functions:

    -Convert the currency of one country into the currency of another

    -Provide some insurance against foreign exchange risk…

    •Foreign exchange risk: the adverse consequences of unpredictable changes in the exchange rates


    Currency Conversion

    •Consumers can compare the relative prices of goods and services in different countries using exchange rates

    •International businesses have four main uses for foreign exchange markets

    -To exchange currency received in the course of doing business abroad back into the currency of its home country

    -To pay a foreign company for its products or services in its country’s currency

    -To invest excess cash for a short term in foreign markets

    -To profit from the short-term movement of funds from one currency to another in the hope of profiting from shifts in exchange rates, also called currency speculation
    Insuring against Foreign Exchange Risk
    •Forward exchanges occur when two parties agree to exchange currency and execute the deal at some specific date in the future
    -Exchange rates governing such future transactions are referred to as forward exchange rates
    -For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future
    •When a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed
    •Currency swap: the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
    •Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk
    The Nature of the Foreign Exchange Market
    •The foreign exchange market is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems
    •The most important trading centers include: London, New York, Tokyo, and Singapore
    •London’s dominance is explained by:
    -History (capital of the first major industrialized nation)
    -Geography (between Tokyo/Singapore and New York)
    •Two major features of the foreign exchange market:
    -The market never sleeps
    -Market is highly integrated
    Economic Theories of Exchange Rate Determination
    •Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another
    •Price and exchange rates:
    -Law of One Price
    -Purchasing Power Parity (PPP)
    -Money supply and price inflation
    •Interest rates and exchange rates
    •Investor psychology and “Bandwagon” effects
    Law of One Price
    •In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency
    •Example: US/French exchange rate: $1 = .78Eur  

      A jacket selling for $50 in New York should retail for  39.24Eur in Paris (50x.78)

    Purchasing Power Parity
    •By comparing the prices of identical products in different currencies, it should be possible to determine the ‘real’ or PPP exchange rate - if markets were efficient
    •In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be roughly equivalent in each country
    •PPP theory predicts that changes in relative prices will result in a change in exchange rates
    -A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate
    -Inflation occurs when the money supply increases faster than output increases.
    Exchange Rate Forecasting
    •Individuals that believe in the efficient market theory believe that prices reflect all available public information
    -Forward rates should be unbiased predictors of future spot rates
    •Individuals that feel there is an inefficient market believe that prices do not reflect all available information
    -Forward exchange rates will not be the best possible predictor of future spot exchange rates
    -If this is true, it may be worthwhile for international businesses to invest in forecasting services
    Currency Convertibility
    •Governments can place restrictions on the convertibility of currency
    -A country’s currency is said to be freely convertible when the country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it
    -A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations
    -A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency
    •Government restrictions can include:
    -A restriction on residents’ ability to convert the domestic currency into a foreign currency
    -Restricting domestic businesses’ ability to take foreign currency out of the country
    •Governments will limit or restrict convertibility for a number of reasons that include:
    -Preserving foreign exchange reserves
    -A fear that free convertibility will lead to a run on their foreign exchange reserves – known as capital flight
    Implications for Managers
    •It is critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals
    -Adverse changes in exchange rates can make apparently profitable deals unprofitable
    •The risk introduced into international business transactions by changes in exchange rates is referred to as foreign exchange risk
    -Foreign exchange risk is usually divided into three main categories: transaction exposure, translation exposure, and economic exposure
    •Transaction exposure: the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
    •Translation exposure: the impact of currency exchange rate changes on the reported financial statements of a company
    •Economic exposure: the extent to which a firm’s future international earning power is affected by changes in exchange rates

    Topic readings:

    Required readings: Complete the required readings.

    Optional readings: Also browse through any of the optional readings that might be of interest.



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