Chapter 19 - Multinational Financial Management
Chapter 19 - Multinational Financial Management
Chapter 19 - Multinational Financial Management
Exchange Rate
The number of units of a given currency that can be purchased for one unit of
another currency
• Floating rate
o Freely floating - Occurs when the exchange rate is determined by supply
and demand for the
o Managed floating - Occurs when there is significant government
intervention to control the exchange rate via manipulation of the currency’s
supply and
• Fixed rate
o No local currency - occurs when another country’s currency as its legal
tender due to lack of local currency
o Currency board arrangement - occurs when a country has its own
currency but commits to exchange it for a specified foreign money unit at a
fixed exchange rate and legislates domestic
o Fixed-peg arrangement - occurs when a country locks its currency to a
specific currency or basket of currencies
• Freely floating
o Exchange rate determined by the market’s supply and demand for the
currency. Governments may occasionally intervene and buy or sell their
currency to stabilize fluctuations.
• Managed floating
o Significant government intervention manages the exchange rate by
manipulating the currency’s supply and demand. The target exchange
rates are kept secret to prevent currency speculators from profiting from it.
• No local currency
o The country uses either another country’s currency as its legal tender (like
the U.S. dollar in Ecuador) or else belongs to a group of countries that
share a currency (like the euro).
• Currency board arrangement
o The country technically has its own currency but commits to exchange it
for a specified foreign currency at a fixed exchange rate (like Argentina
before its January 2002 crisis).
• Fixed peg arrangement
o The country “pegs” its currency to another (or a basket of currencies) at a
fixed rate. Slight fluctuations are okay, but the rate must stay within a
desired range. For example, the Chinese yuan is pegged to a basket of
currencies.
US $ to Buy 1 Unit
Japanese Yen 0.009
Australian dollar 0.650
• Since they are prices of foreign currencies expressed in dollars, they are
direct quotations.
1. Assume that today 1 Japanese yen is worth .01095 US dollar. How many
Japanese yen would you receive for 1 US dollar?
Answer1 /.01095= 91.32
2. Assume that 1 US dollar can be exchanged for 105 Japanese yen or for
.80 euro. What is the euro/yen exchange rate?
Answer .007619/Japanese yen
• Indirect quotation
o The number of units of a foreign currency needed to purchase one
U.S. dollar, or the reciprocal of a direct quotation.
• American Terms: The foreign exchange rate quotation that represents the
number of American dollars that can be bought with one unit of local
currency.
• European Terms: The foreign exchange rate quotation that represents the
units of local currency that can be bought with one US dollar
• Direct quotation: The home currency price of one unit of the foreign currency
• Indirect quotation: The foreign currency price of one unit of the home
currency.
• Spot Rate: The effective exchange rate of a foreign currency for delivery on
(approximately) the current day.
• Forward Exchange Rate: An agreed-upon price at which two currencies will
be exchanged at some future date.
• Discount on Forward Rate: The situation when the spot rate is less than the
forward rate
• Premium on Forward Rate: The situation when the spot rate is greater than
the forward
When is the forward rate at a premium?
• If the U.S. dollar buys fewer units of a foreign currency in the forward than
in the spot market, the foreign currency is selling at a premium.
• In the opposite situation, the foreign currency is selling at a discount.
• The primary determinant of the spot/forward rate relationship is relative
interest rates.
• A concept that specifies that investors should expect to earn the same return
in all countries after adjusting risk
• A principle that holds the relationship between spot and forward exchange
rates and interest rates
• Formula:
Forward exchange rate = (1 + rh)
Spot exchange rate = (1 + rf)
• Purchasing power parity implies that the level of exchange rates adjusts so
that identical goods cost the same amount in different countries.
• Formula
Ph = Pf (e0 ) or e0 = Ph / Pf
Spot rate = Ph / Pf
Where:
Ph is the price of goods on the home country
Pf is the price of goods on the foreign country
Exchange Rate
• The risk that the value of a cash flow in one currency translated to another
currency will decline due to a change in exchange rates.
• For example, in the application for determining profit, a
weakening/strengthening Australian dollar would impact the dollar profit.
• Eurocredits
o Fixed term, floating-rate bank loans with no early repayment.
o An example is a eurodollar deposit, which is U.S. dollars deposited in a
bank outside the U.S.
• Eurodollar
o A US dollar deposited in a bank outside the United States.
• Eurobonds
o Medium-to long-term international market for fixed-and floating-rate debt.
o Underwritten by an international bank syndicate and sold to investors in
countries other than the one in whose currency the bond is denominated.
• Foreign bonds
o Issued in a capital market other than the issuer’s.
o The only thing foreign about it is the borrower’s nationality.