Week 1

Definition of International Finance:

International finance is concerned with the determination of real income and
allocation of consumption over time in economies linked to world markets.
International finance is used to analyse financial markets and instruments used
to facilitate trading investment activity on a global scale.
International finance economics (markets) is about how the international bond,
equity and foreign exchange market work.
International finance management is related to firm specific factors such as the
firms operations and how should individuals operate in the firm to achieve their
goals.
Role of International Financial Markets
(a) Closed economy No international link
- Transactions
- Transfer of savings Borrowers and Savers
- Risk shifting
(b) Open economy International linkage exists (includes all attributes of open
economy) and more:
- International Transaction Addition of foreign markets
- International Transfer of savings Government can borrow FC and other
government can also.
- International Risk shifting Addition of foreign exchange rate risk.
Classification of IFM
1. Transaction FX market
2. Transfer of savings International Borrowing/Lending:
- Money Market (Short-term)
- Capital Market (Long-term)
3. International risk shifting Using forwards, futures, swaps and options
Week 2
Balance of payment is a statistical statement of all economic transactions
between Australian residents and the rest of the world over a particular period.
Relationship of Balance of Payments and Macroeconomics:
(a) Closed economy: Y (output or source) = C (consumption) + I(investment) +
G(Government expenditure)
(b) Open economy: Y (output) = C + I + G + (X-M); where X-M = Balance of trade
If (X-M)>0; Balance of trade surplus and if (X-M) <0; Balance of trade deficit
The current account is the sum of Merchandise account (X-M), Net services
and Net income.
Capital A/C (Financial A/C) is devoted solely to Financial Transactions and
represents changes in asset value internationally. A positive entry in F A/C means

capital inflow that is used to finance the C A/C (negative entry) and means that
there is an increase in net foreign debt (more we owe to the world.
All items are flows and not stocks. (I.e. all items are changes in net )
Balance of Payment Items:
Exports (goods only)
Imports (goods only)
Merchandise account
Net services (Export of services Import of Services)
Net income (Always negative because it includes interest in our foreign debt)
Current Account
Financial Account
Balancing item
Net Income = Income received overseas Income paid overseas
Balance on Balance of Payments is the Current A/C not the balancing item
as the balancing item is just the errors and omission
If BoP surplus means ER of our currency increase
If BoP deficit means ER of our currency decrease
The global BoP C A/C is the sum of all C A/C surplus from country I to n = 0. But
in reality, it is large and negative due to tax evasion (where interest paid >
interest received) and corruption where (foreign aid paid > foreign aid received)
We have an item called Unrequited Transfers in the C A/C BoP which we use
for unilateral transactions (aid). When aid is given, there is an increasein foreign
asset (positive entry in the F A/C) and so a negative entry in Unrequited
Transfers.
(A) International Borrowing/Lending
Definition: The largest market where one currency is traded for another
currency in an over-the-counter market.
Market participants (4):
1. Customers (people, corporations and exports and imports where they are price
takers)
2. Financial Institutions:
Banks Commercial, Wholesale or Retail (price setters)
Non-Banks FIs Superannuation Fund, Hedge Fund and Insurance Firms (Nonprice setters)
3. Brokers (FX) needed for/so:
- Able to get best deals for customers and easy access for customers that
doesnt have time to do so
- Preserve anonymity of one or both parties.
4. Central Bank
- If government needs FC
-Also intervenes the FX market to control ER of their currency if there is a large
volatility in a FC (by reducing that amount of FC) and to strengthen/weaken own
ER if needed.
Development of FX market is largely due to introduction of Eurocurrency
markets and M&A.

Eurocurrency is a branch of the International Banking and is in turn the branch of

IF Money Markets.
Definition of International Banking: Banks borrow from or lend to residents
(FC) and non-residents (HC or FC)
1) Definition of Eurocurrency: Short-term borrowing/lending in a currency
other than the currency of the country of domicile
Short term loans and fixed term deposits.
Maturity usually 30 to 90 days
Interbank Market
- Involves the Eurocurrency with two banks
- Uses LIBOR and LIBID
Week 3
2) Euro commercial paper
-Definition A short term unsecured promissory note (IOU)
-Maturity is about 60~180 days and Interest is paid on maturity
-It is a bearer instrument the issuer doesnt keep track of who holds it; whoever
submits get $.
-ECP is issued in a currency other than that of the country in which the
paper is issued.
E.g. A firm in country A issuing ECP denominated in currency B in country C or
A firm in country A issuing ECP denominated in currency B in country A
-It exists as part of financial disintermediation (rather than borrowing from a
domestic bank; to get rid of the middle man fees so cheaper)
- Issuers are: Government, large banks and large corporations
- Holders are: Large banks, Central Bank and Non-Bank FIs (hedge fund etc)
3) Euro Notes
- Definition An unsecured promissory notes
- Maturity is about 2~4 years
- It is also a bearer instrument
- EN is issued in a currency other than that of the country in which the
notes is issued
- Issuers are: Government, Large banks and large corporations.
- Holders- Banks, Central banks and NBFIs
International Capital Market
4) International bonds
- Fixed interest securities and maturity period lasts for 5~10 years
- Issuers are: Government, Large banks and large corporations.
- Holders- Banks, Central banks and NBFIs
- Involves 2 categories:
(a) Foreign Bond
- Borrower issues a foreign bond in the foreign market and the bond is
denominated in the currency (FC) in which the market it is issued to

(E.g. Borrower issue bonds in the US market & the bonds must be denominated
in USD)
(b) Eurobonds
- Borrower issues a bond in a currency other than the currency of the
country/market in which it is issued. (E.g. AUS Borrower issues bond in US
market & the bonds must be denominated in HC (AUS) or any other FC except
USD) or
(AUS Borrower issues bond in the AUS market & the bonds must be denominated
in any other FC but not your HC (AUD))

Why use Euro Bonds?

Less regulation, disclosure requirements (if issued in own country) and
favourable tax treatment.
Domestic market is small
Overseas cost of borrowing may be lower
Euro Bonds better than Foreign Bonds because imagine that if you are a
borrower, you can issue US denominated Eurobond in any market but only can
issue US denominated foreign bond in US market.
Why Euro? It is because domestic banks are highly regulated to protect citizen
savings thus Euromarkets is introduced as there is less regulation (tax evasion
and low taxes)
5) International Equities
- There isnt one single international equity market that has all stocks but rather
a set of individual stock exchanges
- Holders Majority HC bias
- Issuers Normally not government obstacle but the stock exchange itself
(I.e. Listing requirements, disclosure requirements for each SX is different and
A/C standards; cost issues)
The Exchange Rate
#FC/HC Indirect quotes
If ER increases, the HC appreciates against the FC. If ER decreases, the HC
depreciates against the FC.
#HC/FC Direct quotes
If ER increases, the HC depreciates against the FC. If ER decreases, the HC
appreciates against the FC.
Tutorial Exercise 1
1.
- Capital mobility is the ability of capital to move from one country to another,
seeking investment opportunities. The degree to which it is mobile depends on
factors such as taxes, level of capital control, regulations and exchange rate

volatility that determines how difficult/expensive it is for capital to flow in and

out. (So immobility means expensive)
- Market integration is the degree to which capital is free to flow from one
financial market to another and domestic assets are a close (similar in risk and
price) substitute to foreign assets. We can measure this degree by comparing
prices of an asset among different locations to see if they follow similar patterns
over a period of time. If the prices often move proportionally to each other, then
the markets are very integrated and if it doesnt means market are segmented.
- Financial deregulation is the relaxation of measures used or abolishing
restrictions on external & domestic financial transactions to regulate financial
system.
- Securitization is the tendency to raise capital by issuing securities and is the
process of taking an illiquid financial asset, or group of assets and through
financial engineering, transforming them into a security.
Week 4
Trade weighted index (TWI) takes into account of an ER movement against all
currencies and is a measure of an effective ER (multilateral ER).
Effective ER is the measure of one value of a currency relative to more than one
other currency unadjusted for changes in price.
Two issues of effective ER to be fixed:
(a) Scale
Use ER relatives - Divide current spot rate of currency I by previous spot rate of
currency I.

ER relative = Vi,t = Si,t/Si,0 is an index of ER I with a base of t

=0
(b) Weight
Using weighted average to reflect some sort of importance of the individual
country (removes equal weighting of all countries)

Effective ER is then completed & is equal to Et = sum of

wiVi,t from i = 1 to n.
Effective ER (Et) is the weighted average of the individual countries exchange
rate relatives.
Wi = Sum of exports and imports of country i/ Total exports and imports of all
countries
Real ER is a nominal ER adjusted for changes in international prices (inflation).
Q(x/y) = S(x/y) * Py/Px where Py = price in country Y and Px = price in country
Xand S(x/y) is the nominal ER

% change in Q(x/y) = % change in S(x/y) + % change in Py - % change in Px

Real Effective ER:

Qt = Sum of wi * [Q(x/yi)t/Q(x/yi)0]

Week 5 (LO9&10)
3.3 The balance of payments and the foreign exchange market
By definition:
Demand for HC is equivalent to the supply of FC (since foreigners would have to
pay in their FC to get our HC)
Relationship between FX market and Balance of Payments is due to transactions
that involve trade and capital flows (such as sale of domestic securities and
purchase of foreign securities giving rise to demand for foreign currencies; vice
versa).
Three cases:
(a) Demand for FC = Supply for FC = equilibrium means there is no surplus or
deficit on BoP
(b) Demand for FC (excess) > Supply of FC = below equilibrium S 0 means there
is a deficit in BoP since your domestic people want FC more than HC
(c) Demand for FC < Supply of FC = above equilibrium S 0 means there is a
surplus in BoP
DF = P*M * QM (import expenditure)
As the direct ER increases, there is a decline in demand for imports (lower Q M
and so less demand for foreign exchange D F)
SF = P*X*QX (export revenue)
As the direct ER increases, there is an increase in demand for exports since
cheaper (FC appreciates against HC) and so there is a higher supply of FX
(increase in SF)
Imports and Exports (Trades) affect the movement along the curves while Capital
Flows (buying/selling financial assets) affect the curves by shifting it (affects both
FA and C/AC)
4.2 Factors affecting supply and demand on FX market (assuming all in real
terms)
(a) Relative Inflation Rates
If domestic inflation is higher than foreign inflation then domestic goods will be
more expensive relative to foreign goods so there will be an increase in demand
for foreign goods (increase in demand for foreign currency and decrease in
supply of foreign currency) while a decline in demand for domestic goods.
So demand curve move to right (increase) while supply curve move to left
(decrease) so new S(d/f) is higher means HC depreciate.
(b) Relative Interest Rates
If domestic interest rate is higher than foreign interest rate then domestic
financial assets are more attractive (since foreigners will convert their FC into HC
to earn a higher return) relative to foreign financial asset. So there is a decrease
in demand for FC and an increase in supply for FC.
So demand curve move to the left (decrease) and supply curve move to the right
(increase) means new S(d/f) is lower means HC appreciate

Changes in relative inflation affects current account (since its more on the
trading side? I.e. export and import) but changes in relative interest rate affects
financial account (since its more on the financial side I.e. investments financial
assets)
(c) Relative growth rates
For the current account (imports & exports)
If growth rate of domestic income is higher than that of foreign income then
imports grow faster (since cheaper for domestic consumers) than exports.
Demand for foreign currency increases faster than the supply so there will be a
rise in the exchange rate.
So the demand curve moves to the right while supply curve moves to the right
resulting in an increase in S (d/f) means HC depreciate.
Demand for FC exceeds supply of FC
For the financial account (financial assets)
If the economic growth rate of domestic is higher than that of foreign then
domestic markets are much more attractive for foreign investors so there will be
a net capital inflow.
Supply of FC increases more than the demand for FC as foreigners convert their
FC to the HC to invest there
So the demand curve moves to the right while the supply curve also moves to
the right resulting in a decrease in S(d/f) means HC appreciate.
Supply of FC exceeds demand of FC
5.2 Flexibility of ER as a criterion for classification
Fixed ER is often fixed at a level that makes the HC overvalued.
Perfectly flexible ER is where ER changes continuously according to the forces
of supply and demand in foreign exchange market
Fixed but adjustable ER is where the HC is adjusted through revaluation and
devaluation (large and discrete that is initiated by the policy decisions) while
appreciation and depreciation is used in flexible ER that represents small and
continuous and initiated by market forces.
Fixed ER and flexible with a band ER is allowed to fluctuate but within a band
around the par value/fixed value so they are fixed in this sense.
Crawling Peg A fixed ER but is different in the sense that the fixed value of
the ER is revised periodically according to average ER over a period of time or
due to inflation.
Dual ERs A commercial (fixed ER) is used for imports and exports (current
account transactions) while a financial (flexible ER) is used for trading in financial
assets (financial/capital account transactions)
Two problems is that the commercial rate can be fixed at very low rates so HC
overvalued and another is that the two foreign exchange market (financial and
commercial) must be segmented.

In other words the two rates must be very closely related for people to not take
advantage of it.
Managed Floating ERs are flexible but there is government intervention to
limit the frequency and amplitude of fluctuation
5.9 Fixed vs. Flexible ERs

Read ADRs Euro equity market

Week 6 (LO11)
4.4
Derivation of PPP
S~ = P~ - P~* where S~ is the rate of change of the ER, P~ is the domestic
inflation and P~* is the foreign inflation rate.
This equation represents the rate of change of the ER should be equal to the
inflation differential.
Exchange rate at time T = ST = S0 (1+PT~)/ (1+PT~*) where PT~ is equal to PT/P0
which is the domestic inflation rate and P T~* is equal to PT~*/P0~* which is the
foreign inflation.
PPP implies that the real exchange rate does not change because any change in
prices will be totally offset by changes in the nominal exchange rate.
11.3
Commodity arbitrage read notes
Summary of Week 5 + Week 6 Stuff
- Crucial difference between movement along the curve and shifts of the curve is
that movement along the curve results in an increase in quantity (supply) of FC
which is driven by an increase in price of FC (i.e. Affected by change in price of
FC). However shifts of the curve is an increase in the quantity (supply) of FC at a
given exchange rate (i.e. Affected by some changes in exogenous variable)
- An exogenous variable is a variable outside the model and is unexplained by
the model.
An endogenous variable is a variable determined by the model while exogenous
variables influence the model but are not determined by/influenced by the
model.
The exchange rate is flexible if it is determined by the market forces without any
intervention or regulation by the government or monetary authorities that is
acting on behalf of the government.
The exchange rate if fixed if the government or monetary authorities sets the
price of the domestic currency in terms of a foreign currency and stands ready to
support the exchange rate at the announced level.
Arbitrage process is the buying and selling of the same goods in different
markets with a view of deriving a profit from prices or return differences.
PPP is condition of equality price levels between 2 different countries once the
country currency difference has been taken into account using the exchange rate
LOP states that the same commodity sells for the same price in different markets
once we have converted the prices into a common currency using the exchange
rate.

Week 8
LO12 4.5 Monetary model of the exchange rates
LO13 11.4
Covered interest arbitrage is created due to violation of covered interest parity
condition (CIP). CIP states that when foreign exchange risk is covered in the
forward market, the rate of return of a domestic asset must be equal to that of a
similar foreign asset; if this isnt the case the CIA will continue till it leads to a
restoration of no-arbitrage condition (equilibrium)