International Financial Management .

This article discusses international financial management, including exchange rates, purchasing power parity, interest rates, and country risk analysis. It also compares and contrasts country risk analysis with exchange rate volatility and provides information on managing exchange rate volatility.

Running head: INTERNATIONAL FINANCIAL MANAGEMENT
Economics
Name of the Student:
Name of the University:
Author’s Note:

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Table of Contents
Part A...............................................................................................................................................2
Question 1....................................................................................................................................2
Question 2....................................................................................................................................3
Part B...............................................................................................................................................7
Question 3....................................................................................................................................7
Question 5....................................................................................................................................9
References......................................................................................................................................12

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Part A
Question 1
a) The new exchange rate will be determined after taking the 2% increase in the spot rate.
The spot rate of the EUR/USD was around 1.1. The 2% increase value would be as
follows:
Change in EUR/USD
Particulars Amount ($)
Spot Rate $1.10
Increase in the Spot Rate 2%
Expected Spot Rate $ 1.1220
b) The GBP/EUR rate can be determined with the help of the cross currency formula where
the common currency that is the USD will be eliminated for the purpose of getting the
cross exchange rate. The cross rate was computed as follows:
Computation of GBP/EUR
Cross Rate
EUR/USD 1.1043
GBP/USD 1.2970
GBP/EUR =1.1043/1.297
GBP/EUR 0.851426369
c) It is quite often that we may require numbers and currency value for the purpose of
trading but we might not get directly. The same can be related with the help of the above
example where the required exchange rate was for the GBP/EUR. However, on the other
hand side we were having EUR/USD, which was equal to 1.1043, and GBP/USD, which
was 1.2970. Therefore, now comes the cross rate which would be helping us get the
desired exchange rate by eliminating the common currency. In the above case, the

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common trading was the USD dollar and the same was removed (de Paula, Fritz &
Prates, 2017).
Triangular Arbitrage also referred to as Cross Currency arbitrage or three-point arbitrage. It
involves three trades/ currency where by the first currency is exchanged for a second one and the
second one exchanged for third, the third one will now be exchanged for the initial one. The
concept and the motive of the triangular arbitrage is to earn a risk free profit by finding a
difference between the implied exchange rate. The Triangular Arbitrage would be possible only
if the exchange rate between the interbank market and third party account (dealer) would be
simultaneously different (Hale, Jones & Spiegel, 2016).
The arbitrage is a forex strategy trying to find and reduce mispricing’s amongst currencies.
The Triangular arbitrage tends to explore the inefficiencies in the market whereby one is
undervalued and the other is overpriced (Bénétrix, Lane & Shambaugh, 2015). From the example
given above:
EURUSD 1.1043 means $ 1.1043 for 1 euro
GBPUSD 1.2970 means $ 1.2970 for 1 GBP
After the calculations, we conclude that GBPEUR 0.8514 means for EUR0.8514 for 1 GBP
Question 2
a) According to the purchasing power, parity it is assumed that the difference between the
exchange rate observed between the two pairs of currency is due to inflation gap
difference between the two economies. If the inflation is higher in the price currency then
the EUR currency will be having a higher inflation rate (Eichengreen, Chiţu & Mehl,
2016). The given exchange rate in January 2017 is around EUR/USD 1.100 and the

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inflation in EUR will be greater as observed that the currency is a forward discount. In
December 2017 the EUR/USD rate was around 1.144, that shows that the same was due
to the change in the inflation rate which was around 4% (Dua & Tuteja, 2016).
Purchase Power Parity
Date
Curren
cy
Exchan
ge Rate
January 2017
EUR/
USD 1.1000
December 2017
EUR/
USD 1.144
Inflation Rate 4.00%
b) According to purchase power parity the level of inflation will be higher in the Euro Zone
by around 4% and the level of inflation in the US market would be somewhat less than
the Euro Zone. However, in the given case it was seen that the inflation level was around
3% higher in the US region and the same could be well attributed to the excess positive
inflation in the US region making the units and commodities costlier in the US region
(Shu, He & Cheng, 2015).
If US inflation is 3% higher than in the euro area,
Hence this would be 1.1 = 100%
Inflation of 3% higher means 1.1 * .97 = 1.067
In January 2017 EURUSD 1.067
Inflation decreases the value of the dollar over time (Shu, He & Cheng, 2015). The
concept of time value of money describes the value of money available to you today is
worth more the same in future. Essentially, it means that the dollar you have now will be
of low value a year from today (Shambaugh, 2015).

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Over time, inflation does increase the price of goods and services, thereby reducing the
quantity of goods and services you can buy with the dollar in years to come. Since wages
are likely to remain the same, it will take a large chunk of one’s income to purchase
similar goods or services in years to come. An item costing a dollar today would simply
cost 2 dollars in a few years. High inflation rate in the US means prices in the US rise
faster than those in EURO, making US goods more expensive both abroad and
domestically. In essence, high prices mean that US goods become less competitive as
compared to the euro goods. Euro consumers will want less of the US goods hence
affecting the exchange rate, less dollars will be exchanged for the euros to buy the
imported goods.
From the Euro consumers, with rise of domestic prices, goods from the US will be
cheaper. More euros will be exchanged for dollars, so they can purchase more imported
goods thereby increasing the supply of euros, which will eventually lead to decrease of
the value and exchange rate.
c) The change in the exchange rate could be well attributed either due to change in the
interest rate level in the economy or due to the difference of inflation between the two
trading currency. However there could be several impact which can be observed if the
exchange rate in an economy changes and the same could be as follow:
 Change in the prices of imported goods and services – an increase in the exchange
rate will reduce the price of imported consumer goods, capital goods and also raw
materials thereby have an impact on the consumer price index.
 Change in commodity prices – many goods and products are costed in dollars, so a
change in dollar exchange rate will have a direct effect on the prices of commodities
such as foodstuff and oil. A stronger dollar will make it expensive for other countries
to import products and services

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 Changes in the growth of exports – a high exchange rate makes it difficult to sell
items to other countries because of rise in prices. When exports slow down due to
high exchange rate, exporters will be forced to cut their prices and thereby cutting on
employment levels.
d) The interest rate in the US would be consequently much higher in the US economy for
contradicting the higher inflation rate in the Euro Zone. In accordance with the interest
rate parity on a real term basis the interest rate across the global should remain the same.
In the above given quotation it could be well observed that the Euro is at a forward
premium due to the higher inflation expectation and in order to contradict the same the
interest rate in the US has to be higher than the Euro Zone. It is also essential that the
Interest rate in the US so that the interest rate parity holds good.
e) It is expected that the real interest rate remains the same across the Euro Zone however,
when other factors are accounted like inflation rate, credit risk, liquidity risk there
sometimes comes a difference, and the same is well assorted with the help of higher risk
premium demanded by the investors. The key component driving the interest rate while
valuation or pricing of a bond is the risk free rate of return + liquidity or credit risk.
However, when accounting for the government bonds it is essential to note that the
government bonds are the liquid assets or securities in the economy, which removes the
need for liquidity. Credit risk is also not a very crucial matter when accounting for
valuation of the government bonds. Thus, the interest rate on the government bonds can
however remain the same when the accounting for valuation or pricing in the Euro Zone.
However it is crucial to note that there might be sometimes differences which may be
recorded in the interest rate as the perception and required rate of return from an
investment may vary from investor to investor’s perspective.

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In Euro area the rates and market forces are always set by the European Central
Bank which helps in collaborating ensuring there are divergence of the interest rates. In
case differences are there the markets would make use of the triangular arbitrage bringing
the interest rates to be similar
The difference in interest rates comes in after adjusting for inflation, the real interest rate
diverges in the wrong direction resulting to bust cycles and boom. Inflation rates are
different across countries which has a direct effect on the real interest rate bringing about
a difference in the interest rates in euro zone areas.
Part B
Question 3
Compare and contrast country risk analysis with exchange rate volatility
Country risk refers to business, economic and political risks that are specific to different
countries, which may result in unexpected loss investment. Economic risk occurs when a country
is not able to pay back its debts. On the other hand, Political risk refers to decisions made by a
politician which may result in unanticipated loss for investors. There are times that the country’s
economy may be strong, but if the political climate is unfriendly to foreign investors, the country
may not be a hub for investment. Political risks would include regulations imposed, restrictions
on foreign investment and government expropriation. In most countries political risk has been
reduced by acceptance of new markets and change of perception into beliefs that investment and
trade across nations are one of the ways for economic growth (Destais, 2016).
Exchange is the conversion of one currency into another at the ruling market price. On the other
hand, volatility is how fast the rate fluctuates. Exchange can be described as either fixed or

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floating. Fixed exchange rate does remain fixed for a long time while floating do float, they
either move up and down or down and up from time to time (Caporale et al. 2017). Fixed rates
do not change hence they are not volatile, a floating rate may or may not be volatile it just
depends with the amount. Volatile exchange rates do make it hard for foreign investors to make
decision in terms of investment since volatility increases exchange rate risk. Exchange rate for
investors, creates risk for international investors (Lustig & Verdelhan, 2016). When faced with a
floating exchange rate, it appears riskier than fixed rate since they are floating with movements
of up down. Hence countries choose fixed exchange rates to lower volatility and thereby
encouraging international investment. Both the country risks and exchange rate volatility can be
managed (Hale, Jones & Spiegel, 2017). Below is a look at how exchange rate volatility can be
managed:
Timing of Investment – Foreign investors should be keen with direct investment and consider
times when the exchange rate is not volatile. This can be done by considering the country’s
inflation over a period and its other partners (Moore, Schrimpf & Sushko, 2016)
One can also borrow locally and invest to avoid the risk of exchange rate exposure. Though this
does expose the business to an increase of interest rates because of central bank’s exchange rate
devaluation.
One could also spread the purchase price over a period, making the domestic currency to be
bought at a lower cost (Antonakakis & Kizys, 2015).
One could also consider the initial investment; the risk of exchange rate exposure would be low.
Another focus would be on performing a study on devaluation risk among countries for
investment. Some countries are less risky as compared to others

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Both the exchange rate and country risk have one common factor that is they tend to influence
the business of the day thereby affecting investments. In terms of differences the exchange rate
volatility will only affect investors involved in more than one medium of exchange but those in
local arena platform. Exchange rate volatility can be reduced in the following ways:
Matching up your costs and revenues – one of the sources of volatility is having your revenues
and expenses in different currencies. The idea is to match up the two and have them in the same
currency form.
Having a Financial derivatives
Passing the Volatility onto your customers
Political risk can be managed by having agreements that limit political risks. Some of the
countries have signed agreements that promise investors financial compensation for corporates
based in their countries. Examples of these countries are Canada and US.
Question 5
a) The net payout from the Purchased Call Option at the Strike Price of 67 Pence would be
as follows:
Net Payout from C+ @67
Maturity Strike Price of Dollar Cash Outflow Cash Inflow Net Payout
55 -4.5 0 -4.5
60 -4.5 0 -4.5
65 -4.5 0 -4.5
70 -4.5 3 -1.5
75 -4.5 8 3.5
Where Strike Price Taken was around 67 and the net cash outflow was taken at -4.5.

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b) The net payout from Writing an Put Option at the Strike Price of 66 Pence would be as
follows:
Net Payout from P- @66
Maturity Strike Price of Dollar Cash Inflow Payoff Net Payout
55 4.5 -11 -6.5
60 4.5 -6 -1.5
65 4.5 -1 3.5
70 4.5 0 4.5
75 4.5 0 4.5
Where strike rate was taken at 66 Pence at the initial cash inflow from the sales of the put
option would be around 4.5.
c) The total cost of the dollar if the MNC were to implement part a and part b of this
question for the following maturity prices: 55p, 60p,65p,70p,75p will be as follows:
Total Dollar Cost
Maturity Strike Price of Dollar Payout from C+ Payout from P- Net Payout
55 -4.5 -6.5 -11
60 -4.5 -1.5 -6
65 -4.5 3.5 -1
70 -1.5 4.5 3
75 3.5 4.5 8
d) Every trading strategy undertaken by the company should be evaluated based on the
return and risk generated from the same so that the same can be taken for the purpose of
consideration of investment or hedging. Buying a calling and writing a put option is
betting on the upside movement of the dollar price. However, when accounting for the
pay-off and the risk involved in the option bought and sold they differs (Gabaix &

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Maggiori, 2015). The maximum profit a writer of put can earn is the put premium, the
maximum loss in the case of put writer from the above example can be considered when
the dollar price reaches zero, and the righter of the option will pay the difference. On the
contrary, side the call option will be the safest bet for the company where the loss would
be limited to the amount of option premium paid and maximum profit would not be
capped in terms of payoff. The key disadvantage of writing a put option would be that the
investor is betting on the volatility expectation would be low and if the same does not
happens then the MNC would be having a major loss as both the option are against the
upward movement of the dollar price.

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References
de Paula, L. F., Fritz, B., & Prates, D. M. (2017). Keynes at the periphery: Currency hierarchy
and challenges for economic policy in emerging economies. Journal of Post Keynesian
Economics, 40(2), 183-202
Bénétrix, A. S., Lane, P. R., & Shambaugh, J. C. (2015). International currency exposures,
valuation effects and the global financial crisis. Journal of International Economics, 96,
S98-S109.
Eichengreen, B., Chiţu, L., & Mehl, A. (2016). Network effects, homogeneous goods and
international currency choice: New evidence on oil markets from an older era. Canadian
Journal of Economics/Revue canadienne d'économique, 49(1), 173-206.
Dua, P., & Tuteja, D. (2016). Financial crises and dynamic linkages across international stock
and currency markets. Economic Modelling, 59, 249-261.
Shu, C., He, D., & Cheng, X. (2015). One currency, two markets: the renminbi's growing
influence in Asia-Pacific. China Economic Review, 33, 163-178.
Shambaugh, J. C. (2015). International Currency Exposures, Valuation Effects, and the Global
Financial Crisis (No. 2015-3).
Destais, C. (2016). Central bank currency swaps and the international monetary system.
Emerging Markets Finance and Trade, 52(10), 2253-2266.
Caporale, G. M., Ali, F. M., Spagnolo, F., & Spagnolo, N. (2017). International portfolio flows
and exchange rate volatility in emerging Asian markets. Journal of International Money
and Finance, 76, 1-15.

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Lustig, H., & Verdelhan, A. (2016). Does incomplete spanning in international financial
markets help to explain exchange rates? (No. w22023). National Bureau of Economic
Research.
Hale, G., Jones, P., & Spiegel, M. (2017). Home Currency Issuance in International Bond
Markets. Mimeo.
Moore, M., Schrimpf, A., & Sushko, V. (2016). Downsized FX markets: causes and
implications.
Antonakakis, N., & Kizys, R. (2015). Dynamic spillovers between commodity and currency
markets. International Review of Financial Analysis, 41, 303-319.
Gabaix, X., & Maggiori, M. (2015). International liquidity and exchange rate dynamics. The
Quarterly Journal of Economics, 130(3), 1369-1420.
Hale, G., Jones, P., & Spiegel, M. M. (2016, May). The rise in home currency issuance. Federal
Reserve Bank of San Francisco.