Putra Business School GSM5480 International Finance MBA Quick Notes

1. C1: MNC Management 1
Agency Theory / Problem / Cost
 Conflicting goals owner v managers
 Agency Cost: Cost to ensure managers
maximize S/H wealth
MNC Agency Cost Larger & More Complicated
1) Logistics / Geographical
2) Size of Larger MNC
3) Foreign Goal e.g. employees / country
Controls:
1) Corporate Governance
= Protect Stakeholders’ Rights
e.g. Sarbanes-Oxley Act (SOX) – 2002
2) Communicate / align goals for max value
3) Compensation / Reward Plan
4) Stock options, e.g. ESOS
International Risks / Uncertainties
P5F: Micro (Industry)
PESTLE: Macro (Country, International)
1. Political (Policies, Tax, Interest)
2. Economy (ER, Inflation, Financial)
3. Social (Ethics, Culture, Education, Skills)
4. Technology (Infrastructure)
5. Legal (Laws)
6. Environmental (Restrictions)
Other Constraints & Issues:
1. Abuse ER as policy
2. Outsourcing
3. Trade Policies for Political Reasons
Multi-National Companies (MNC)
Goal = Maximize Shareholders Wealth
(Capital Gains & Dividends)
 Madura 2012: has operating subsidiaries,
branches & affiliates in foreign countries
 Shapiro 2006: has 50% of its operating assets in
foreign countries
 Aggrawal 2002: exports its product or services
to foreign countries
Events that increase International Trade
1) General Agreement on Tariffs and Trade
GATT 1947 (125 countries)
• Trade Fairness = Eliminate Trade Restriction
(tariff, subsidies, bail-out quota)
• Enforce Patent, Trademark, Copyright
2) European Union EU 1951 (28 countries)
• Free movement products, services & funds
• Eurodollar = $ deposits in European banks
3) Single European Act 1987
• Uniform Regulation & Remove Tax
4) NAFTA 1993:
• Eliminated trade barrier US & Mexico
• Implicate US Walmart Jobs
International Agencies
1) International Monetary Fund (1944)
• Cooperation between countries
on international monetary issues
• Stability in Exchange Rate
• Temporary funds to correct imbalance in
international payments / financial instability
(Special Drawing Rights SDR)
• Reduce impact of financial instability
2) World Bank (1944)
• Loans for LT Economic Development
• Structural Adjustment Loans (SAL)
• Co-financing agreements
(WB and Investment Banks)
3) World Trade Organization (1995)
• Promote Free Trade (Origin GATT)
• Forum for Multilateral Trade
Negotiations & Settle Disputes
International Credit Market
 Syndicated Loan for Large Loans
• Few Banks merge loan facility
 EURO Credit Loan >1yr
• Bank to MNCs or Gov’ Agency in Europe
• Based on LIBOR Floating Rate
e.g. reset every 6mths plus 3%
• Immediate ER
 LIBOR = Intercontinental Exchange London
Interbank Offered Rate. Benchmark rate for
short-term loans between banks.
Why International
1) Theory of Comparative Advantage
• Adam Smith 1776
• Country Specialization increase Efficiency
e.g. Japan tech, Vietnam labour, Malaysia
rubber, Tax Holiday, Facilities, Special Skills,
Cheaper Commodity, Industry Advantage
2) Theory of Imperfect Market
• Production Resources for Real Market
e.g. labour, raw material, funds, others
• Immobile due to Restriction & Transfer Cost
3) Theory of Product Cycle
• Create Local Demand
 Export to accommodate demand
 Establish subsidiary presence
 Control & Reduce Cost
• Market Expansion: Local & Export Demand
• Product Expansion
• Product Differentiation

2. C3: International Finance Market & C2: Flow of Funds
FOREX: Foreign Exchange Market
1) Competitive Quote
2) Relationship with banks
• Cash management Services
• Source limited Currencies
3) Efficient Order
4) Advice Current Market Condition
5) Advice Forecast: Foreign Economy & ER
Bid / Ask Spread
 Ask Price = Sell Price
 Bid Price = Buy Price
 Spread = Bank Fees to conduct FOREX
Spread =
𝐴𝑠𝑘 − 𝐵𝑖𝑑
𝐵𝑖𝑑
× 100%
Factors to Spread (OICVR)
1) Order Cost
• Clearing + Recording
2) Inventory Cost
• Maintaining / Holding Currency
(Opportunity Cost)
3) Competition
• Competition↑ = Spread↓
4) Volume
• Currency Liquidity↑ = Sudden Change↓
5) Risk
• Volatility due to Economics & Political
Correcting Trade Deficit
Weak Home Currency may not necessarily
improve trade deficit
1) Revised Pricing Policy by foreign competitor
2) Weakening Currencies of trading partners
3) Trade Agreements, e.g. cannot limit parts
4) Intra-Company Trade, e.g. can obtain raw
material from subsidiary located abroad
2
GDP = C + I + G + ( X – M )
Current Account ∝ Inflation ∝ Exchange Rate ∝ Export ∝ (-Imports)
Balance of Payment (BOP)
Summary of Transaction between Domestic &
Foreign Residents over Specific Period of Time
 CURRENT ACCOUNT
CA = Export - Import
1) Tangible Goods
2) Financial Services Income
e.g. dividend & interest
3) Services Balance
e.g. royalties, consultation fees
4) Unilateral Transfer
e.g. foreign aid, grant, gifts
 CAPITAL ACCOUNT
1) Foreign Investment
e.g. JV, Takeover, Licensing
2) Portfolio Investment
e.g. Stocks, Bonds
3) Other Capital Investment
e.g. transaction currency, bank deposit
Factors to International Trade Flows
1) Inflation: Inflation ↑ ⇒ Price Local Goods ↑
⇒ DD Foreign Goods ↑ ⇒ CA ↓
2) Income: Income ↑ ⇒ Purchasing Power ↑
⇒ DD Foreign Goods ↑ ⇒ CA ↓
3) Exchange Rate: ER ↑ ⇒ DD Foreign Goods ↑
⇒ Imports ↑ ⇒ CA ↓
4) Government Intervention
i. Restriction on Imports
 Tariff / Levies ⇒ Price ↑ ⇒ DD ↓
 Quota ⇒ Volume of Inputs ↓
ii. Subsidies, government scheme to support
firms reduce costs against competitors
iii. Tax Breaks, government scheme to
support firms to export products
iv. Labour Law, e.g. Less restrictive LL not
applicable globally
v. Business Law, e.g. Bribery Law
vi. Country Security Law, e.g. National
security can affect trade
Factors to FDI
1) Change in Restrictions – removal of Barriers
2) Privatization – movement of Free Enterprise
3) Economic Growth – counters with strong
fundamentals attracts more FDI
4) Tax Rate – country with low Tax Rate
5) Exchange Rate – expected to strengthen
against investor currency
Factors to International Portfolio
1) Tax Rates Hi on Interest & Dividend
2) Interest Rates Hi
3) Exchange Rates expected to strengthen

3. Exchange Rate (ER)
 FOREX: Foreign Exchange Market
 Value of One Currency expressed in another Currency
 Appreciate = ↑ ER ⇒ Imports ↑
 Depreciate = ↓ ER ⇒ Exports ↑
 ER Equilibrium: Currency Qty Supply = Demand
 ER = f(Δinflation, Δinterest, Δincome, Δgovernment, Δexpectation)
Demands Foreign Currency
1. UK Consumers Buy / Import US Foreign Goods
2. UK Investors Invest in US Foreign Assets
3. UK Governments / Central Banks
↑ Demand ⇒ Value ↑ = Appreciate
Supplies for Exchange Currency
1. Foreign Consumers Buy Domestic Goods
2. Foreign Investors Invest in Domestic Assets
3. Foreign Governments / Centrals Banks
↑ Supplier ⇒ Value ↓ = Depreciate
3C4 Exchange Rate | Demand Supply
Value
$ / £
Market for £ in US
S£0
S£1
Qty £
R0: $2.5/£1
R1: $2.0/£1
£ Depreciate
⇒ $ Appreciate
e.g. UK Consumer Buy More Foreign Goods
ERE1
ERE0
D£0
S$0
D$1
D$0
Value
£ / $
Market for $ in UK
Qty $
R1: £0.5/$1
R0: £0.4/$1
$ Appreciate
⇒ £ Depreciate
e.g. UK Consumer Buy More Foreign Goods
ERE0
ERE1
Scenario US Foreign
Euro Tourist to US ↑ DD $↑ = $ App SS ↑ Dep
Recession ↑ in Asia DD $↓ = $ Dep DD ↑ App
↑ Inflation in US SS $↑ = $ Dep DD ↑ App
US Tourist to Taiwan ↑ SS $↑ = $ Dep DD ↑ App
US ↓ Income Tax SS $↑ = $ Dep DD ↑ App
↑ Inflation in Europe DD $↑ = $ App SS ↑ Dep
↑ Interest Rate in UK SS $↑ = $ Dep DD ↑ App
M’sia ↑ Import Tariff DD $↓ = $ Dep SS ↓ App
Recession ↑ in US SS $↑ = $ Dep DD ↓ Dep

4. Inflation = Price Level = Purchasing Power
Rise in US Relative Inflation Rate
 US DD ↑ for Cheaper UK goods
 UK DD ↓ for Expensive US goods
 US DD £ ↑ ⇒ SS £ ↓
 UK SS $ ↑ ⇒ DD $ ↓
 $ Depreciate = £ Appreciate
Sol: US SS £ ↑ ⇒ DD £ ↓
Inflation Rate Interest Rate Income Level 4
Cost of Capital, Cost of Doing Business
Rise in US Relative Interest Rate
 UK Investment ↑ in US
 US Investment ↓ in UK
 US SS £ ↑ ⇒ DD £ ↓
 UK DD $ ↑ ⇒ SS $ ↓
 $ Appreciate = £ Depreciate
Recession = Less Income
Rise in US Income Level
 US DD ↑ for Superior UK goods
 No Effect to People in UK
 US DD £ ↑ ⇒ SS £ No Change
 UK SS $ ↑ ⇒ DD $ No Change
 S1: £ Appreciate = $ Depreciate
 S2: Confidence ⇒ $ Appreciate
Value
$ / £
S£1
S£0
D£1
D£0
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Appreciate
$ Depreciate
ERE0
ERE1
Market for £ in US
Value
£ / $
S$0
S$1
D$0
D$1
Qty $
R0: £0.5/$1
R1: £0.4/$1
$ Depreciate
£ Appreciate
ERE1
ERE0
Market for $ in UK
Value
$ / £
S£0
S£1
D£0
D£1
Qty £
R0: $2.5/£1
R1: $2.0/£1
£ Depreciate
$ Appreciate
ERE1
ERE0
Market for £ in US
Value
£ / $
S$1
S$0
D$1
D$0
Qty $
R1: £0.5/$1
R0: £0.4/$1
$ Appreciate
£ Depreciate
ERE0
ERE1
Market for $ in UK
Value
$ / £
S£0
D£1
D£0
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Appreciate
$ Depreciate
ERE0
ERE1
Market for £ in US
Value
£ / $
S$0
S$1
D$0
Qty $
R0: £0.5/$1
R1: £0.4/$1
$ Depreciate
£ Appreciate ERE1
ERE0
Market for $ in UK

5. Institutional investors reaction
to anticipated change
Tighter Monetary Policy in UK
 High Interest Rate in UK
 US Investment ↑ in UK
 US DD £ ↑ ⇒ SS £ ↓
 UK SS $ ↑ ⇒ DD $ ↓
 £ Appreciate = $ Depreciate
Inflation, Money Supply, Interest, Income
High Inflation Rate in the US
 US DD ↑ for Cheaper UK goods
 UK DD ↓ for Expensive US goods
 UK SS $ ↑ ⇒ $ Depreciate
Sol: US Interest Rate ↑
 Foreign Investment ↑
 UK DD $ ↑ ⇒ $ Appreciate
Trade Barrier / Capital Flow Restriction
Tax/Tariff/Levies/Quota on Imported Goods
 US DD ↓ for UK import goods
 US DD ↑ for Cheaper US goods
 No Effect to People in UK
 DD £ ↓ ⇒ SS £ No Change
 DD $ No Change ⇒ SS $ ↓
 $ Appreciate = £ Depreciate
Expectations Interactions Government Ctrl5
Value
$ / £
S£1
S£0
D£1
D£0
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Appreciate
$ Depreciate
ERE0
ERE1
Market for £ in US
Value
£ / $
S$0
S$1
D$0
D$1
Qty $
R0: £0.5/$1
R1: £0.4/$1
$ Depreciate
£ Appreciate
ERE1
ERE0
Market for $ in UK Value
$ / £
S£0
S£1
D£0
D£1
Qty £
R0: £2.5/$1
R1: £2.0/$1
£ Depreciate
$ Appreciate
ERE1
ERE0
Market for £ in US
Value
$ / £
S£0
D£0
D£1
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Depreciate
$ Appreciate
ERE1
ERE0
Market for £ in US
Value
£ / $
S$1
S$0
D$0
Qty $
R0: £0.5/$1
R1: £0.4/$1
$ Appreciate
£ Depreciate ERE0
ERE1
Market for $ in UK
Value
$ / £
S£1
S£0
D£1
D£0
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Appreciate
$ Depreciate
ERE0
ERE1
Market for £ in US
?
Favourable
Unfavourable

6. Fixed / Constant Pegged Free Float Managed Float
• Bretton Wood (1944-1971)
• US Gold Standard $35/oz; UK,
France, Italy, Japan, Holland
• 1971 US High Inflation
o Vietnam War
o Countries sell US$ for Gold
• Fixed with foreign currency e.g.
trade partner
• Group e.g. Euro Dollar
• Market Forces
• Free Market
• Fluctuate Freely but Dirty as Gov’ Intervenes
(1) Smoothen Disturbance / Volatility
(2) Tackle Inflation
• Beneficial to Country but
at Expense of Other Countries
• Explicit Boundaries:
 Floor = Limit to Depreciation
 Ceiling = Limit to Appreciation
Pros 1.MNC no ER Risk
2.Managerial Duty↓
• Stabilize Value
Cons Push Inflation
e.g. US Inflation ↑
⇒ US import ↑ cheaper UK Goods
⇒ UK SS Goods ↓ Shortage
⇒ US Push Inflation to UK
1.Interest Rate Movements of
Pegged Currency; i.e. no full
control on local interest rates, &
interest rates must be aligned to
pegged currency.
2.ER Movements of Pegged
Currency; i.e. tandem effects
with other currencies.
3.Recession / weak economy /
politics force break peg.
Currency depreciate drastically.
Intervention usually superficial.
Severe Inflation
e.g. US Inflation ↑
⇒ US import cheaper
UK Goods↑
⇒ US DD £ ↑ ⇒ SS £ ↓
⇒ £ Appreciate
⇒ US import ↓ Expensive
⇒ UK Goods No Shortage
⇒ No Push Inflation to UK
BUT, US Competition ↓
⇒ US Goods Price ↑
⇒ US Inflation ↑
 Direct Intervention
Forced appreciation / depreciation
using Central Bank Reserves or
Government Securities
 Indirect Intervention
Through intervention influence
1. Interest Rate
2. Income Levels
3. Inflation (Weaken Local Economy)
4. Capital Flow Restriction / Controls
5. FOREX Barriers
6. Trade Restriction on Imports
 Tax / Tariff / Levies ⇒ Price ↑ ⇒ DD ↓
 Quota ⇒ Volume of Inputs ↓
Stimulate Economy
 DI: USD purchase Foreign Currency
⇒ US Dollar ↓ ⇒ US Export ↑
 IDI: ↓ Interest Rate
⇒ Financing Cost ↓ + US Dollar ↓
⇒ Borrowing ↑
Decrease Inflation
 DI: USD purchase Dollar
⇒ US Dollar ↑ ⇒ Cost Import
+ ↓ Competition
 IDI: ↑ Interest Rate
⇒ Financing Cost ↑ + US Dollar ↑
⇒ Borrowing ↓
6
RC: RM4.1/$1
⇒ RM Depreciate
R0: RM3.9/$1
RF: RM3.8/$1
⇒ RM Appreciate
Value
RM / $
Qty
RM
S$0
D$0
Market for $
in Malaysia
D$C
D$F
ER
Floor
ER
Ceiling
Sell
T-Bills
Excess
Funds
Excess
Funds
Financial
Institution
Contraction
Monetary
Policy
Loans ↑
⇒ Economy ↑
⇒ Inflation ↑
Central
Bank
Shortage
Funds
Funds
Buy
T-Bills
Expansion
Monetary
Policy
Loans ↓
⇒ Interest ↑
⇒ Economy ↓
Financial
InstitutionCentral
Bank
C6 Government Influence
STERILIZE INTERVENTION
Level of Domestic Money Supply
Foreign
Currency
Local
Local
Currency
Foreign

7. C19: Country Risk 7
FINANCIAL
def: current/potential state of economy with adverse impact on MNC
1) Financial Distress @ Government Policies
 Monetary Controls
 Fixed / Pegged / Managed Float Currency
 Limit Market Penetration, e.g. Campaign on Local Products
2) Economic Growth influenced by Inflation
 Purchasing Power Currency ⇒ Demand for MNC Product
 Affects Interest Rate + Currency Exchange Rate
3) Economic Growth influenced by Interest Rate
 High Interest Rate discourage economic growth = reduce spending
= reduce demand for expensive imported products
 Low Interest Rate encourage economic growth = increase spending =
increase borrowings = increase business competition
4) Economic Growth influenced by Exchange Rate
 Import/Export ⇒ Int Trade Flows ⇒ Productivity ⇒ Net Income
 Currency↑ ⇒ Export↓ ⇒ Import↑ ⇒ Productivity↓ ⇒ Net Income↓
ASSESSMENT
1) Checklist approach
 Judgement call on Political & Financial Factors
 From typical experience, public study/survey, e.g. CIA, WorldBank
2) Inspection visits
 Qualitative input by travel to country & meet government, company,
business, consumers to clarify specific uncertainties
3) Quantitative analysis
 Characteristics that influence country risk
 Risk Factors that affect company performance
 Regression Analysis y=mx+c.
Coefficient = Slope, m = Relationship between 2 or more variables.
Positive m = Tandem, e.g. GDP & Sales
Negative m = Inverse, e.g. Inflation / Purchase Power & Sales
4) DELPHI technique
 Collection of Independent Opinions
 Subjective | Expensive Consultant
5) Combination technique
P OLITIC AL
def: events/scenario/system with LR adverse impact on MNC
1) Consumer Attitude in Host Country
 Loyalty on local products
 Beneficial with Local JV & Market (instead of export)
2) Government Action / Intervention in Host Country
 Local Rules / Controls / Standards
 Corporate Tax, With-holding Tax (Before Remittance), Exit Tax
3) Fund Transfer Restriction / Blockage
 Subsidiary / Employees send money back to home country
 Force subsidiary into less optimal project / securities
4) Currency Inconvertibility
 Blocked Currency Exchange
5) Government Bureaucracy
 Difficulty in Doing Business, Inefficiency, delays, red-tape,
 Extra effort / resources / cost
6) Corruption Malaysia #62 at 47pts vs New Zealand #1 89pts
 Unfair competition
 Increased cost of conducting business
7) War / Unrest – safety, security, business volatility, uncertain cashflow
EXP ROPRIAT ION
1) Short Term Horizon
 Recover Investment quickly
 Minimize unnecessary expenses, e.g. expansion, maintenance
 Sell assets to local investor / government in stages
2) JV / Partnership with Local Entity
3) Unique Suppliers / Technology
 Proprietary material / technology that cannot be duplicated
4) Hire Local Labor / Workforce
 Locals as stakeholders @ Implication on job security
5) Local Financing
 Local Bank / Investors as stakeholder @ Interest on firm’s performance
6) Insurance
 Cover risk of appropriation
• Anticipate uncertainties in proposed project
• Avoid countries with excessive risk
• Observe current status of countries
WHY
Incorporated as higher
Required Rate of Return

8. C5&12: Derivatives 8
FORWARD Contract
Forward Contract (FC)
Agreement with commercial bank to exchange
specific amount of specific currency at
specific Forward Rate on specific Future Date
Process: Import / Export Transaction
 Lock Forward Rate
 Engage Forward Contract with Bank
 Exchange at Forward Rate
Non-Delivery FC (NDF)
Agreement where currencies not actually
exchanged. On settlement day, net payment
is made based on contracted rate, and
difference to spot rate is offset by NDF
Process: Import / Export Transaction
 Lock Reference Rate
 Engage NDF Contract with Bank
 Transact at Future Spot Rate
 Receive/Pay Offset from/to Bank
Key DIFFERENCE
1.Contract Obligation / Regulation
•Forward: Obligated / Self
•Futures: Obligated / Commodity Futures Trd
Commission / National Future Association
•Option: Optional / Clearinghouse
2.Currencies
•Forward: Almost all currencies
•NDF / Futures / Option: Commonly traded
currencies
3.Size of Contract
•Forward: Tailored to individual needs
•Futures: Standardized, useless if excess
•Option: Matching Concept
FUTURES Contract
 Contract traded between firms or individuals
on Trading Floor of Exchange
e.g. Chicago Mercantile Exchange
 Standard volume of particular currency
at Future Rate on Settlement Date
3rd Wed @ Mar, Jun, Sep, & Dec
Process:
 Lock Future Rate
 Order Contract via Broker
 Trading Floor of Exchange
 Matched order sent to ClearingHouse
 Pay initial Margin (10% of total cost)
 Delivery of currencies at ClearingHouse
OPTION Contract
 Standard Option offered on Trading Floor of
Exchange through brokers and Over Counter
 Standard volume of particular currency at
Exercise Price (EP) / Strike Price on Delivery Date
CALL Option
Grants right to BUY specific currency
at Exercise Price within specific time period
Process:
 Buy Call Option = Rights to buy foreign
currency at fixed exchange rate
 Spot ER increase ⇒ Payable Hedged
 Spot ER decrease ⇒ Let contract expire/void
• At the Money: Future Spot Rate > EP+Prem
• On the Money: Future Spot Rate = EP+Prem
• Out the Money: Future Spot Rate < EP+Prem
PUT Option
Grants right to SELL specific currency
at Exercise Price within specific time period
Process:
 Buy Put Option = Rights to sell foreign
currency at fixed exchange rate
 Spot ER decrease ⇒ Receivable Hedged
 Spot ER increases ⇒ Let contract expire/void
• At the Money: Future Spot Rate < EP-Prem
• On the Money: Future Spot Rate = EP-Prem
• Out the Money: Future Spot Rate > EP-Prem
Premium on Call / Put Option
= Service Charge
1. Spot Price relative to EP ∝ Premium
2. Time Period before Expiry Date ∝ Premium
3. Variability of Currency
Translation Fear @ Local Currency Futures Option
Import Payable Depreciate ⇒ Pay More Buy | Long | Take Delivery Call
Export Receivable Appreciate ⇒ Receive Less Sell | Short | Make Delivery Put
 Lock future Receivable / Payable
 Subject to Amount, Rate and Period
4.Delivery Date (popular with Forward)
•Forward: Tailored to needs
•Futures: Standardized
•Option: : Tailored to needs
5.Market Place / Clearing Operations
•Forward: Major Banks & Brokers
•Futures: Matching @ Central Exchange Floor
•Option: Central Exchange Floor
6.Others
•Forward: Not regulated
•Futures: More complex but least expensive
•Option: Premium charges
•Futures & Option: Opportunity for Speculators
Hedger / Speculator

9. C8: Relationship Inflation, Interest & Exchange Rate 9
Purchasing Power Parity (PPP)
 2 countries which trade heavily with one another
 Law of one Price: Two similar products in two different
countries should have equal price due to demand
& exchange rate adjustment
 Currency with higher INFLATION rate
will experience currency depreciation
 %Δf in value of foreign currency =
𝑛 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 =
1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛(ℎ𝑜𝑚𝑒)
1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛(𝑓𝑜𝑟𝑒𝑖𝑔𝑛)
− 1
International Fisher Effect (IFE)
 2 countries which trade heavily with one another
 Currency with higher NOMINAL INTEREST rates
reflects higher expected INFLATION
and will experience currency depreciation
 Investors which hope to capitalize on higher foreign
interest rate would earn a return no higher than what
they would earn domestically.
 Δ Inflation Rate ∝ Δ Interest Rate (Positive Correlation)
Nominal Interest Rate = Real Interest Rate + Inflation Rate
 RIR: shields deferring current consumption
& not able to enjoy current utility
most of the time same for all countries
 IR: shields from inflation fluctuation
 NIR: Hi NIR reflect Hi expected INFLATION
 %Δf in value of foreign currency =
𝑛 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 =
1 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡(ℎ𝑜𝑚𝑒)
1 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡(𝑓𝑜𝑟𝑒𝑖𝑔𝑛)
− 1
INTERESTINFLATION
INFLATION
 Usually Long Term
 Hi Surplus Money
 Products prices are inflated / more expensive
 Higher Cost of Living
 Higher Imports → Higher Currency Outflow
 Economist believe solution in Efficiency
by Increase Supply of Goods at Lower Cost &
Reduce Circulation of Money
 Exchange Rate Depreciate
 Lose on currency exchange
 Higher Inflation in Home Country:
1) Product Prices in Home Country are higher
2) Demand ↑ for cheaper Foreign products
3) Demand ↑ for Foreign Currency
4) Buying product in Foreign Currency will offset the
gain from buying in Home Currency by %Δf
5) Foreign Currency will appreciate by +%Δf
to converge to Foreign Currency
(-%Δf = depreciate)
6) Buying Foreign products not worthwhile / stops;
product prices of Home & Foreign are indifferent
Higher Inflation in Foreign Country:
1) Product Prices in Home Country are lower
2) Demand ↑ for cheaper Home products
3) Demand ↑ for Home Currency
4) Buying product in Home Currency will offset the
gain from buying in Foreign Currency by %Δh
5) Home Currency will appreciate by +%Δh
to converge to Foreign Currency
(-%Δh = depreciate)
6) Buying Home products not worthwhile / stops;
product prices of Home & Foreign are indifferent

10. C7: Arbitrage & Interest Rate Parity 10
Arbitrage Pricing Model (APT)
Capitalizing / Exploiting from Discrepancies / Disparity / Abnormal Return
Covered Interest Arbitrage (CIA)
def: Capitalizing from Interest Rate Difference between 2 countries
while covering Exchange Rate Risk
1) Convert to Foreign Currency using current rate
• $100k / $1.60/DM = DM62.5k
2) Establish Forward Contract to sell Accumulated Currency after 90 days
3) Invest Foreign Currency over 90-day interest rate @ 4%
• DM62.5k X 1.04 = DM65k
4) Use Forward Rate to convert accumulated Foreign Currency to Original
• DM65k x $1.60/DM = $104k
5) Investment Profit = Final Amount – Initial Investment = $4k
Realignment:
 At Forward Market for DM: DM Supply ↑ ⇒ DM Forward Rate ↓
Interest Rate Parity (IRP)
def: IRP is the equilibrium state caused by market forces
 FORWARD RATE differ from SPOT RATE by sufficient premium
which offsets INTEREST RATE differential between 2 countries
 With IRP abnormal return from CIA diminish to equate to returns at home
 Sometimes, deviations in IRP not large enough for CIA to be worthwhile:
Characteristics of Foreign Investment, Transaction Costs, Political Risk,
Default Risk, Differential Tax Law, With-holding Tax
1) Calculate Forward Premium, changes in Foreign Currency Forward Rate
FP =
1 + Interest(Home)
1 + Interest(Foreign)
− 1
 +ve Ef @ Foreign Currency Forward Rate ↑
 –ve Ef @ Foreign Currency Forward Rate ↓
Simpler Formula for %Δ Foreign Currency Forward Rate
FP = Interest Home − Interest Foreign
2) Calculate Adjusted Forward Rate
= Spot Rate (1 + FP)
3) Calculate using Covered Interest Arbitrage Step1
4) Compare with Returns at Home
Triangular Arbitrage (TA)
def: Capitalize differences between Intrinsic & Quoted Rate
1) Cross Rate for same denomination as Spot Rate
:
:
=
USD0.90/
USD0.30/
= NZD3.00/CAD
2) Arbitrage Possibility: Spot Rate vs Cross Rate
Spot Rate for CAD > Cross Rate for CAD
CAD Overvalue & NZD Undervalue
3) Convert to Overvalue Currency CAD
• USD10k / USD0.90/CAD = CAD11111
4) Convert to Undervalue Currency NZD
• CAD11111 x NZD3.02/CAD = NZD33555
5) Convert to Original Currency USD using NZD
• NZD33555 x USD0.30/NZD = USD10066
6) Investment Profit = Final Amount – Initial Amount = USD66
Location Arbitrage (LA)
def: Capitalizing from differences between Supply and Demand
1) Buy from Lower Selling / ASK Price
• $10k x £0.64/$ = £15624
2) Sell to Higher Buying / BID Price
• £15624 x $0.645/£ = $10078
3) Profit = Final Amount – Initial Amount = $78
Realignment:
 At Selling Location: £ Demand ↑ ⇒ £ Ask Price ↑
 At Buying Location: £ Supply ↑ ⇒ £ Bid Price ↓
Discrepancies / Disparity / Abnormal Returns will diminish due to
Realignment / Readjustments by market forces in Forward Market
Over
Value
Original
Under
Value
U
CN
Spot Rate
NZD3.02/CAD
Cross Rate
NZD3.00/CAD
Microsoft Excel
Worksheet

11. Location Arbitrage (LA)
Bank X Bank Y STEPS
Sell / Bid USD/NZD $0.401 $0.398 (1) Buy from Lower ASK PRICE
Buy / Ask USD/NZD $0.404 $0.400 (2) Sell to Higher BID PRICE
(3) Investment Profit
Original Currency 1,000,000.000$
Buy Lower Ask Price 0.400 /NZD$ 2,500,000.000NZD
Sell Higher Bid Price 0.401 /NZD$ 1,002,500.000$
Profit 2,500.000$
Triangular Arbitrage (TA)
STEPS
5,051,035.53$ 5,000,000.00$ Profit= $51,035.525 (1) Cross Rate to Spot Rate denomination
(2) Arbitrage Possibility
SF 1.1806 /€ € 0.7627 /$ (3) Convert to Overvalue Currency
SF Cross Rate € 0.6460 /SF (4) Convert to Undervalue Currency
Undervalue Currency S E Overvalue Currency (5) Convert to Original Currency
SF 5,963,252.54 € 3,813,500.00 (6) Investment Profit
SF Spot Rate € 0.6395 /SF
:: SF Spot Rate < SF Cross Rate
:: SF Spot Rate Undervalue & EUD Spot Rate Overvalue
:: Convert to Overvalue Currency EUD
WRONG
5,000,000.00$ 4,949,480.14$ Loss= -$50,519.864
SF 1.1806 /€ € 0.7627 /$
Cross Rate € 0.6460 /SF
S E
Spot Rate € 0.6395 /SF
Triangular Arbitrage (TA) with Bid-Ask Spread
Spot Rate
USD/EUD
Spot Rate
USD/GBP
Spot Rate
GBP/EUD
Cross Rate
GBP/EUD STEPS
Sell / Bid 1.1779 1.6953 0.6955 0.6948 (1) Cross Rate to Spot Rate denomination
Buy / Ask 1.1776 1.6955 0.6960 0.6945 (2) Arbitrage Possibility
(3) Use Ask Rate if Divide. Use Bid Rate if Multiply.
Or; Ask-Bid-Bid
10,012,577.70$ 10,000,000.00$ Profit= $12,577.700 (4) Convert to Overvalue Currency
Spot Rate (5) Convert to Undervalue Currency
$ 1.6953 /£ $ 1.1776 /€ (6) Convert to Original Currency
EUD Cross Rate £ 0.6948 /€ Investment Profit
Undervalue Currency G E Overvalue Currency
5,906,080.16£ € 8,491,847.83
EUD Spot Rate £ 0.6955 /€
:: EUD Spot Rate > EUD Cross Rate
:: EUD Spot Rate Overvalue & GBP Spot Rate Undervalue
:: Convert to Overvalue Currency EUD
U
U
U
Original Currency
Original Currency
Original Currency
SF 5,903,000.00 € 3,774,968.50

12. C14 Capital Budgeting 11
Pro ConNPV
 Easy understand & comms
 All cash flows not earnings
 Discounts / TVM
 Future cashflow is greater than
initial investment
 Discount Rate is real market rate
Inconsistent with IRR decision in
Re-Investment / Non-Conventional Cash Flow
(Sign Change in Cashflow)
Mutually Exclusive Projects
(Different initial investment or timing)
IRR
 Easy understand & comms
 Discount Rate when NPV=0
 Discounts / TVM
All CF assumed reinvested at the IRR
IRR Rate is not real nor practical
Does not link to wealth maximization
Do not distinguish between Borrowing & Lending
Scale Problem ⇒ Incremental IRR / NPV
Timing Problem if Mutually Exclusive ⇒ Crossover
Rate
PBP
 Easy understand & comms
 Biased toward Liquidity
commitments, e.g. bonds, coupon
repayment
Ignores CF after PBP
Ignores TVM
Discriminate long-term projects
Arbitrary acceptance criteria
May not even have NPV>0
Project Evaluation
Necessary to channel resources
into steams which give the
highest return @ maximize
wealth in the long run
Discount Factor
= Interest Rate
= Cost of Capital
derived from Country Risk,
Financial Risk & Political Risk
Factors for MNCs
1. Exchange Rate Fluctuations
2. Financing Arrangement
3. Blocked Funds
4. Impact of New Competitors
on Prevailing Cashflows
5. Uncertain Salvage Value
Input for MNCs
1. Initial Investment
2. Consumer Demand
3. Product Price
4. Variable Cost
5. Fixed Cost
6. Project Lifetime
7. Salvage / Liquidation Value
8. Fund Transfer Restriction
9. Tax Laws
10. Exchange Rate
11. Working Capital
Payback Period PBP
Time to recover initial outlay
Shortest / Minimum PBP or DPBP
Net Present Value, NPV
= -Initial Outlay + Future Cashflows +
Salvage or Terminal Value
Internal Rate of Return, IRR
Multiple Cash Flow CFj
:: i/Yr when NPV = 0
Choose NPV if NPV & IRR conflicts due to
Initial Cost, Project Timing, or Cash Flow.
Mutually
Exclusive
Highest +ve NPV
Highest IRR
Independent
Decision
+ve NPV
IRR > WACC