International financial management and the forex market
Exchange rates link prices and interest rates across countries. PPP ties them to inflation, interest rate parity to interest rates, and firms hedge transaction, translation and economic exposure.
Forex market terms
| Term | Meaning |
|---|---|
| Spot rate | Rate for delivery, normally two business days after the deal (T+2) |
| Forward rate | Rate agreed today for delivery on a future date |
| Direct quote | Units of home currency per unit of foreign currency, e.g. ₹ per US$ in India |
| Indirect quote | Units of foreign currency per unit of home currency; the reciprocal of the direct quote |
| Bid and ask | The dealer buys the base currency at the bid and sells at the ask; ask − bid = spread |
| Cross rate | Rate between two currencies worked out through a third, usually the US$ |
| Forward premium or discount | The foreign currency's forward rate is above (premium) or below (discount) its spot rate |
| Swap | A spot deal combined with an opposite forward deal |
Worked example 1: forward premium
Spot is ₹80.00 per US$ and the 3-month forward is ₹80.80 per US$. Find the annualised forward premium on the dollar.
- Premium = (F − S) ÷ S × (12 ÷ months) × 100.
- = (80.80 − 80.00) ÷ 80.00 × (12 ÷ 3) × 100 = 0.01 × 4 × 100 = 4% a year.
The dollar is at a 4% annual forward premium, so the rupee is at a forward discount.
Worked example 2: interest rate parity and arbitrage
Spot is ₹80 per US$. One-year interest rates are 7% in India and 3% in the US. Find the one-year forward rate under IRP. What if the market forward rate is ₹82.50?
- F = S × (1 + iINR) ÷ (1 + iUSD) = 80 × 1.07 ÷ 1.03 = 85.60 ÷ 1.03 = ₹83.11.
- Shortcut: F ≈ S × (1 + 7% − 3%) = 80 × 1.04 = ₹83.20, close to the exact value.
- A market forward of ₹82.50 is below parity, so dollars are cheap forward. Covered arbitrage: borrow $1 at 3%, convert to ₹80 and invest at 7% to get ₹85.60.
- Buy $1.03 forward at ₹82.50 to repay the loan: cost = ₹84.975. Riskless profit = 85.60 − 84.975 = ₹0.625 per dollar borrowed.
Parity forward rate ₹83.11. Arbitrage pushes the market rate back towards it.
Worked example 3: PPP and cross rates
(a) Spot is ₹80 per US$. Expected inflation is 6% in India and 2% in the US. Find the expected spot rate in one year. (b) ₹80 = US$1 and US$1.10 = €1. Find the rupee-euro cross rate.
- (a) Relative PPP: S1 = 80 × 1.06 ÷ 1.02 = 84.80 ÷ 1.02 = ₹83.14 per US$.
- The dollar's rupee price is expected to rise by about 3.9% (the rupee loses about 3.8%), close to the 4-point inflation gap.
- (b) ₹ per € = (₹ per $) × ($ per €) = 80 × 1.10 = ₹88 per euro.
- Direct to indirect: ₹80 per $ means 1 ÷ 80 = $0.0125 per rupee.
(a) ₹83.14 per US$ (b) ₹88 per euro.
Parity conditions
| Condition | Links | Formula (direct quotes) |
|---|---|---|
| Absolute PPP (law of one price) | Price levels and spot rates | The same good costs the same everywhere after conversion (e.g. the Big Mac index) |
| Relative PPP | Inflation and changes in spot rates | E(S1) ÷ S0 = (1 + home inflation) ÷ (1 + foreign inflation) |
| Interest rate parity | Interest rates and forward rates | F ÷ S = (1 + home interest) ÷ (1 + foreign interest) |
| International Fisher effect | Interest rates and expected spot rates | E(S1) ÷ S0 = (1 + home interest) ÷ (1 + foreign interest) |
| Fisher effect | Nominal rate, real rate and inflation | (1 + nominal) = (1 + real) × (1 + inflation) |
| Unbiased forward rate | Forward and expected spot rates | F = E(S1) |
Foreign exchange exposure
| Exposure | What is at risk | Example |
|---|---|---|
| Transaction | Value of foreign-currency cash flows already contracted | An exporter's dollar receivable due in 90 days |
| Translation (accounting) | Reported values when a foreign subsidiary's accounts are consolidated | A UK subsidiary's assets shown in rupees in the group accounts |
| Economic (operating) | Present value of future cash flows and competitive position | A domestic firm losing sales to cheaper imports after the rupee rises |
Hedging and international finance
- Hedging tools: forward contracts, currency futures and options, money-market hedges and swaps.
- Internal techniques: leading and lagging payments, netting, matching receipts with payments, invoicing in the home currency.
- Money-market hedge for a dollar receivable: borrow dollars now, convert at spot and invest in rupees; repay the loan with the receivable.
- International sources: ADRs (US market), GDRs (other markets such as London or Luxembourg), ECBs, FCCBs and masala bonds (rupee-denominated bonds issued abroad, so the foreign investor bears the currency risk).
- International capital budgeting: discount foreign-currency cash flows at a foreign rate and convert at spot, or convert them at expected rates and discount at the home rate; allow for political risk and limits on remitting funds.
- Monetary history: classical gold standard (to 1914), Bretton Woods fixed rates (1944), Smithsonian Agreement (1971), Jamaica Accord accepting floating rates (1976).
- India: FEMA 1999 replaced FERA 1973; the rupee has been convertible on current account since 1994 but only partly on capital account.
NET asks you to tell direct from indirect quotes, compute forward premium, IRP forward rates, PPP rates and cross rates, and match exposure types and international finance terms (ADR, GDR, masala bonds).
Typical MCQ: “Spot is ₹80 per US$; inflation is 6% in India and 2% in the US. By relative PPP, does the rupee rise or fall?” It falls, to about ₹83.14 per $: the higher-inflation currency loses value. Trap: inverting the ratio gives ₹76.98.
Typical MCQ: “An Indian exporter has a dollar receivable due in 3 months. Which exposure is this, and how can it be hedged?” Transaction exposure. Sell the dollars forward, or use a money-market hedge or a put option on the dollar.
Direct = Domestic per foreign. Parity trio: PPP = prices, IRP = interest and forward rate, IFE = interest and expected spot. Exposure: transaction is cash, translation is accounts, economic is the future.