International Financial Management: Exchange Rates, Triangular Arbitrage, Purchasing Power Parity, and Country Risk Analysis

This article discusses various concepts in international financial management, including exchange rates, triangular arbitrage, purchasing power parity, and country risk analysis. It explains the impact of inflation and interest rates on exchange rates and the importance of cross-currency exchange rates in triangular arbitrage. The article also highlights the difference between country risk analysis and exchange rate volatility and their respective impacts on business operations.

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International Financial Management

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Part A:
Question 1:
A:
Given Exchange Rate: EURUSD = 1.1 it means 1 Euro = 1 US Dollars
Increase of 2% value of dollar is equal to 1$ * 102% = $1.02
New Exchange rate: (Euro 1.1/US Dollar 1)* US Dollar 1.02 = 1.122/1 it means EURUSD =
1.1220 (Deegan, 2013)
B:
Exchange Rate given:
It means EUR/USD = 1.1043/1 and GBP/USD = 1.2970/1 (Berger and
Harjes, 2009)
Cross Exchange Rates= GBP/USD divided by EUR/USD which means 1.2970/1 divided by
1.1043/1 it can also be expressed as GBP/USD multiplied by USD/EUR (Jakab, Lukyantsau and
Wang, 2015)
So, on the basis of above calculation GBPEUR = 1.1745
EURUS
D
1.104
3
GBPUS
D
1.297
0
USDEU
R
0.905
6
GBPEU
R
1.174
5
EURUS
D
1.104
3
GBPUS
D
1.297
0

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C:
Triangular arbitrage occurs when there is discrepancy between three currencies (Foreign
Currencies) and currency exchange rates do not match up with each other. Arbitrage can be
referred to an opportunity that arises in the financial market when similar asset can be purchased
and sold at the same time in different prices due to exchange rate difference (Borio, 2014).
Triangular arbitrage is also known as three points arbitrage or cross currency arbitrage that can
provide profit to the arbitrator when he uses three or more currencies to make profits. There is
great role of cross currency calculation while arbitrator uses triangular arbitrage in order to make
more profits. The process performing the triangular arbitrage is given as under:
 Arbitrator has to find the opportunity of triangular arbitrage that involves minimum of
three interrelated currency pairs
 After that there is need to find out the cross currency rates and also the implied cross
rates.
 In case if arbitrator finds that there is difference in the rates in above step than he must
trade the home currency or base currency for a second currency in order to change the
currency value
 After changing the base currency in second currency, arbitrator must go for change of
second currency in third currency and this process is followed for number of currency
taken into consideration
 After all the conversion to the last currency, arbitrator arrives at the stage where he can
book the profits. The profit has been arises due to imbalance that exists in the exchange
rates across the three pairs of currencies taken into consideration
 At final stage arbitrator can take the profit through converting the third currency back
into the home currency. This process is very safe but requires complete knowledge of
arbitrage and cross currency exchange rates.
On the basis of above information it can be said that there is direct relation of cross
currency exchange rate and triangular arbitrage because without direct application of cross
exchange rates in the triangular arbitrage process. So it can be said that cross exchange rate

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calculation is required for doing the triangular arbitrage as there are three currencies involved in
triangular arbitrage and calculation to needed to find what benefit change from base currency to
third currency will provide to arbitrator (Madura, 2007).

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Part A:
Question 2:
A:
Purchasing power parity refers to the macro economic theory that shows that exchanges
rates between different currencies are at equilibrium when the purchasing power of these
currencies is same at each of two selected countries. In easy language it can be said that
exchange rate between any of the two selected countries must be equal to ratio of two countries
price structure that contains fixed level of basket of goods and services. To more simplify this
theory, it can be understand as when the price level in the domestic country is increasing (it
means that country experiences inflation) than in order to return to the purchasing power parity
exchange rate of that country must be depreciated in accordance to certain change exchange rate
during the period (Taylor, 2013).
Formula used in purchasing power parity= S1 / S0 = (1 + Iy) ÷ (1 + Ix)
Where:
 S0 refers to the currency exchange rate at the initial time period and it is measured as
foreign currency(Y) price for one unit of domestic currency (X)
 S1 refers to the spot currency exchange rate at closing period and it is measured as foreign
currency(Y) price for one unit of domestic currency (X)
 Iy refers to the inflation rate (Annually) in respect of country Y (Foreign Country). This
inflation rate is expected inflation rate for that period
 Ix Iy refers to the inflation rate (Annually) in respect of country X (Home Country). This
inflation rate is expected inflation rate for that period
Application of above formula to calculate the inflation rate:
Home Currency is US Dollar and home country is USA
Foreign Currency is EURO and foreign country is Europe

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= S1 / S0 = (1 + Iy) ÷ (1 + Ix)
Given data:
Date
Currenc
y Rate
Jan-17
EURUS
D 1.1000
Dec-
17
EURUS
D 1.1440
Applying in formula we get
= 1.144/1.100 = (1 + Iy) ÷ (1 + Ix)
Here y represent foreign country (Europe) and x represent home country (USA)
So it can be said that home country (USA) has higher inflation rate and it is 4% greater
than the domestic inflation rate (Ignatiuk, 2009).
B:
= S1 / S0 = (1 + Iy) ÷ (1 + Ix)
= S1 / 1.100 = (1+Y) ÷ (1 + 1.03Y)
So closing exchange rate will be EURUSD = 1.03 which means $1.03 can be received for
1 euro. Real Change in value of dollar will be 6.6%.
C:
The exchange rate is having an important role for the business companies involves in
trading of their products and services at a global level. The currency fluctuations are the outcome
of the floating exchange rate system as business conducts their operations in foreign currencies
other than domestic currency in varying countries. The price of a currency is dependent on the

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forces of demand and supply in the currency markets and thus change in these factors causes
fluctuations in the currency rates (Gills and Thompson, 2006).
The changes in the exchange rate have a direct impact on the price of goods and services
traded on an international level. For example, depreciation in the value of a foreign currency will
cause the exports to become cheaper and will make imports more expensive and vice-versa thus
there is a large implication of changes in the currency rate on the growth and development of
global business organizations. The exchange rate changes also have a direct impact on the rate of
inflation and thus impacting the economic growth and development of a country.
Business organization tend to mitigate the impact of changes in the real currency rate by
the use of hedging so that it does not cause a large impact o the operating profits. The changes in
currency rate directly impact the operating profit by increasing the operational cost and the prices
of the products and services manufactured (Fouejieu and Roger, 2013).
D:
The interest rates of any country are affected by number of factors. Among them inflation
rate is much impacted. Interest rate is directly proportional to the change in inflation rate. So it
can be said that if inflation rate rises it will also increase the interest rate of that particular
country and if there is decrease in the inflation rate than interest rate will also decreases. Rates of
interest in any country are very much impacted by the inflation and deflation. Inflation occurs
when there is decrease in purchasing power of money and people need to spend more to buy the
same of value of good that they are buying before the inflation has occurred. In inflation
condition people having the investment demands the higher rate of interest as it was asked prior
to inflation and this factor increases the rate of interest rate further as compared to expected rise
in interest rates. In case when there has been compared of two countries on the change of rate of
interest due to change in inflation rate than country with higher inflation rate will face higher
increase in interest rate as compared to country with lower rate of inflation. This is the reason
why domestic country (USA) has faced higher interest rate as compared to Euro area. The
exchange rate change clearly shows that USA has faced the higher rate of inflation as compared
to Euro area (Ignatiuk, 2009).
E:

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The interest rate of government bonds are not affected by the increase in inflation rate it
is because return on the government bonds are secured by the government itself and they bear
any difference due to inflation are bear by the government. This is the reason why in practice
there are changes in interest rate of bonds due to inflation but does not change in real world as it
is secured by the government (Wang, 2009).

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Part B
Answer 3:
Comparison and Contrast of Country Risk Analysis with Exchange Rate Volatility
The country risk is regarded as the significant risks associated with investing in a foreign
country. The major types of country risk include political uncertainty, fluctuations in exchange
rate, economic conditions and sovereign risk. This type of risk varies from one country to
another as the nature of uncertainties is different in various countries. The analysis of the risk
associated with a country is particularly conducted for examining the potential growth and
development of a business on carrying out its operations in the respective country. Thus, the
countries having excessive risk is often avoided for investment purpose by multinational
companies (Bouchet, Clark and Groslambert, 2003).
The conduction of business operations on an international level often induces various
types of risks that are not present in the domestic transactions. The risks are regarded a country
risk and one of the major risk that a global business has to face is of foreign exchange risk. The
risk occurs due to exposure of a corporation to fluctuations in the exchange rate as it conducts its
transactions in foreign currencies. The changes in the foreign exchange rate can have a large
impact on the value of assets and liabilities that are denominated in foreign currencies of a
business corporation. The exchange rate volatility can be regarded as the tendency of foreign
countries to appreciate or depreciate in the value and thereby impacting the profits realized from
carrying out business transactions in foreign currencies (Fouejieu and Roger, 2013).
The business investors need to examine primarily the exchange rate volatility as a major
contributor of country risks impacting the opportunities of business growth and success in a new
country. There is a large impact on the operating profit of multinational companies due to
fluctuations in the foreign exchange rates. The business managers need to take into account the
operating exposure to exchange rate volatility at the time of implementing the decisions of
expanding their products and services at an international level. The operating exposure to
floating exchange rates is becoming a matter of serious concern as the countries worldwide are
adopting the use of divergent monetary policies. These changes are largely impacting the
operating profits of multinational companies and as such increases the country risk for them.

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Also, the companies does not conduct their operations globally are also largely impacted with the
changes in the exchange rates. This is because these companies often face competition from the
foreign firms in the domestic market (Wagner, 2012).
The exchange rate volatility can be regarded as a most pertinent reason for country risks
but there is also a large difference between them. The exchange rate volatility represents only a
specific type of risk present within a country that can impact the profitability position of a
business due to changes in the currency rates. However, country risk includes other type of risk
as well in addition to exchange rate volatility such as political and economic uncertainty
impacting the operations of a business company. These types of uncertainties can also result in
causing instability within the operating environment of a country and can result in causing
market volatility. The presence of instability within the operating environment of a country due
to conditions such as political unrest, slower economic growth or sovereign risk can largely
impact the investment decisions of business managers. As such, the economies having the
presence of such risk are struggling to attract investors even if there is lower risk of fluctuations
in the foreign currency rate (Kosmidou, Doumpom and Zopounidis, 2010).
However, exchange rate volatility can be regarded as a major type of market risk that a
business corporation needs to analyze properly before investing in a country in comparison to
other type of risks. This is because it directly impacts the operating profit of a business entity and
is also largely uncontrollable. The business companies often adopt the use of sensitivity analysis
for predicting the changes in the foreign currencies and hedging contracts to manage it but the
risk have a large impact on the business operations. On the other hand, other type of county risk
can be controlled by making realize to the government of host country that the business company
would promote the economic growth and development of the country (Wagner, 2012). This
could promote the change in the government bodies and foreign policy providing the political
and economic support to the growth of the business. Also, the countries are involving id
developing a joint association such as European Union to promote free trade of goods and
services among the member countries. This would also help in reducing the political and
economic instability within the countries. Thus, it can be said that there country risk analysis
have a broad range of risk and the businesses need to adopt specific procedures for mitigating all

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of them as it would also help in reducing the exchange rate volatility (Kosmidou, Doumpom and
Zopounidis, 2010).
Answer 4
Promotion of Globalization by MNCs
Globalization process can be stated to be repaid integration of economy worldwide
promoting the interlinking between the various countries. It has facilitated improving the trade
flows between the different countries and promoting their economic growth and development.
Multi-national companies (MNCs) are the business enterprises carrying out their production sin
more than one country in order to gain location specific advantages. These specific advantages
can be economic labor, high availability of raw materials and supportive government policies
and regulations. Thus, the production and selling of products and services by the MNC’s at wide
level causes the economic linkage of various countries and thus supporting the globalization
process. The operation of multinational economies in different countries requires significant
investment known as foreign direct investment that will act as a major contributor of capital
inflows into the domestic economy. The global capital flows in turn promotes the
interconnections between the world economy and support the process of globalization (Gills and
Thompson, 2006).
In addition to promoting the trade flows, the buying and selling of products and services
by multinational corporations also promotes the process of globalization. The outsourcing of
production processes to lesser developed countries for realizing operational cost benefits also
increases the interconnectedness between the different countries. Therefore, it can be said that
multinational corporations are causing the flow of more goods and services, investments and
technologies and leading to developed of an advanced and integrated economies around the
world. This is largely due to greater availability of products from any part of the world into a
respective country. For example, business corporations such as Ford and Hyundai by carrying
out their production functions in less developed countries such as India is causing greater
availability of cars within these countries. The greater movement of labor and raw materials
across the world due to operations of MNCs is responsible for development of better links across
the various countries (Benedek, Feyter and Marrella, 2007).

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The increased communication between different countries due to operations of a
multinational corporation is leading to the development of an integrated economy. The increased
trade flows, rapid access to technology, media, education, healthcare, products and other
resources are promoting the economic growth of the countries at a global level. The process of
globalization supported by the operations of MNCs is causing the reduction in global poverty
and is also helpful in reducing the political and economic instability with uniform distribution of
resources. It also provides more employment opportunities to the people worldwide and leading
to facilitating the economic growth of the countries. However, there are also some negative
effects associated with the globalization that also need to be taken into consideration. It has been
regarded that globalization is a major contributor of increasing the environmental pollution due
to increased number of business activities that produces larger amount of waste and release of
harmful substances into the atmosphere. The environmental degradation caused due to business
activities of multinational companies is the most serious issues that need to be tackled for
realizing the large benefits of the globalization process (Brooks, 2011).
In addition to this, it can also cause exploration of domestic economies by negatively
impacting the growth rate of domestic business entities. Also, the multinational corporations
have also lead to an increase of social injustice within the countries due to their unhealthy
working conditions that can often cause health issues among the workforce diversity employed
within these companies. These types of issues have been highlighted in various types of
companies such as Toyota, Samsungs and other larger manufacturing companies. In this context,
it is essential by the government of various countries to implement strict rules and regulations for
monitoring the business activities of multinational companies. This is essential to keep a track of
their business operations on the environmental and community so that the sustainability risk can
be reduced to a larger extent. The multinational companies should be mandated to comply with
all the rule sad regulations in the country of its operations to ensure that the negative effect of its
functions can be reduced to a large extent. This is essential so that the host economy realizes
larger benefits from the process of globalization in comparison to its negative impacts (Blanco,
and Razzaque, 2011).
Globalization can be attributed to be associated with both types of outcomes that can be
good or bad. The force of globalization promoted by multinational companies is good in the

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sense that it is leading to the development of an integrated economy facilitating better exchange
of resources between them. Thus, people living in a developing economy can utilize the products
and services of a developed economy and thus can improve their living conditions. The greater
employment opportunities tend to increase the purchasing power of consumers and leading to the
business growth and development. However, there are also some negative effects of the process
as discussed that need to be overcome by the MNCs to ensure that it only have a positive effect
on the world economies (Gills and Thompson, 2006).

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