CMA® > CMA® Part 2 > B.6. International Finance > Flashcards

B.6. International Finance Flashcards

Explore foreign exchange, cross-border financing, and managing international currency risk. (68 cards)

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1
Q

What is foreign direct investment?

(FDI)

A

An investment in production or a business made by an individual or a company in a different country from the country where the investment is located.

FDI involves investment in real assets and direct management of those assets by the company.

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2
Q

How does foreign direct investment differ from foreign portfolio investment?

A

Foreign direct investment is an active investment involving direct management of foreign operations, while foreign portfolio investment is a passive investment in securities.

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3
Q

What are the benefits of foreign direct investment?

A
  • Access to cheaper and/or more abundant resources
  • Access to technology or managerial expertise available in the foreign country
  • Job opportunities for locals
  • Overseas profits and proximity to consumers
  • Better political stability in developed countries
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4
Q

What are the risks associated with foreign direct investment?

A
  • Country risk, including political risk and financial risk
  • Exchange rate risk
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5
Q

Define:

Country risk

(in the context of foreign direct investment)

A

The impact on a multinational company’s cash flows caused by the environments in the foreign countries in which the company operates.

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6
Q

Political risk is a factor of country risk in the context of foreign direct investment. What are the types of political risk?

A
  • Government expropriation
  • Blockage of fund transfers or inconvertible currency
  • Government bureaucracy, regulations, and taxes
  • Corruption, such as bribery being used by competitors to get contracts
  • War
  • Consumer attitudes, such as preferring to purchase local products
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7
Q

Financial risk is a factor of country risk in the context of foreign direct investment. What does financial risk include?

A
  • The current and future state of the foreign country’s economy
  • Demand for the multinational company’s products in the foreign country
  • Interest rates in the foreign country
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8
Q

What is exchange rate risk?

(in the context of foreign direct investment)

A

Exchange rate risks arise because the parent company will most likely have operations in multiple currencies. Multiple currencies introduce the risk that exchange rates will move in the wrong direction, which can increase costs and/or decrease revenues and negatively impact the profits of the foreign operations.

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9
Q

How can international diversification reduce a company’s overall risk?

A

By stabilizing net cash flows from sales in several countries, reducing the variability in returns, and lowering the overall risk.

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10
Q

What should the primary motivation for foreign direct investment be?

A

The expectation of improved profitability and maximized shareholder returns due to increased demand and revenue, reduced costs, or both.

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11
Q

What is a multinational corporation?

(MNC)

A

A large company that has operations in more than one country.

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12
Q

What are the positive impacts of multinational corporations on the home country?

A
  • Higher profits leading to higher taxes
  • Positive balances of trade through exports
  • Attraction of other businesses
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13
Q

What are the positive impacts of multinational corporations on the host country?

A
  • Creation of local jobs
  • Investment of capital and technology by the MNC into the country
  • Improved balance of trade
  • Attraction of other MNCs
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14
Q

How are exchange rates determined?

A

By government (fixed rates), market forces (floating rates), or a combination of both (managed float rates).

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15
Q

What is a cross rate in foreign currency exchange?

A

The exchange rate between two currencies that are not frequently traded directly, calculated using a third currency with which both are more actively traded.

The third currency often used is the U.S. dollar.

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16
Q

What is the base currency in a currency exchange quote?

A

The currency listed first, which has the value of 1 currency unit.

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17
Q

How do you calculate a cross rate using a third currency?

A
  • Ensure the third currency is the currency with a value of 1 in both exchange rate quotes.
  • Divide the exchange rate with the third currency for one of the thinly traded currencies by the exchange rate with the third currency for the other thinly traded currency.
  • The denominator in that division calculation will be the currency with the value of 1 unit in the cross rate calculated.
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18
Q

What does a currency cross rate table show?

A

The exchange rates quoted with either one of each pair carrying the value of 1.

Different sources might present a cross-rate table differently, so it is important to pay attention to how rows and columns are labeled.

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19
Q

What happens when a currency appreciates relative to another currency?

A

Currency A appreciates relative to Currency B when one unit of Currency A can purchase more units of Currency B than it previously could.

This results in fewer units of Currency A being required to purchase one unit of Currency B.

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20
Q

What is the effect of currency appreciation on a country’s balance of trade?

A

It causes an increase in imports and a decrease in exports, resulting in a negative effect on the country’s balance of trade.

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21
Q

How does currency depreciation affect a country’s imports and exports?

A

It decreases imports and increases exports, creating a positive effect on the country’s balance of trade.

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22
Q

How is the rate of appreciation or depreciation of a currency (Currency A) against another currency (Currency B) calculated over time?

A
  1. Express the exchange rates for the two dates so that Currency A, the currency being evaluated for its percentage of appreciation or depreciation against Currency B, has the value of 1 unit.
  2. Use the formula: Er = (St+1 − S) / S

Where:

Er = Percentage of appreciation or (depreciation) of Currency A against Currency B

St+1 = Spot exchange rate at the end of the period

S = Spot exchange rate at the beginning of the period

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23
Q

What is the Interest Rate Parity Theorem?

A

It states that the difference between the spot rate and the forward rate for a currency is determined only by the difference in interest rates between the two countries.

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24
Q

Fill in the blank:

When the foreign interest rate is higher than the domestic interest rate, the forward foreign currency will sell at a ______________ (discount or premium) to the spot rate.

A

discount

A forward foreign currency sells at a discount to the spot rate when the foreign interest rate is higher than the domestic rate.

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25
# Fill in the blank: When the foreign interest rate is lower than the domestic interest rate, the forward foreign currency sells at a \_\_\_\_\_\_\_\_\_\_\_\_\_\_ (discount or premium) to the spot rate.
premium ## Footnote A forward foreign currency sells at a **premium** to the spot rate when the foreign interest rate is lower than the domestic rate.
26
# Fill in the blank: When the spot exchange rate of a foreign currency is higher than the forward exchange rate, the forward foreign currency sells at a \_\_\_\_\_\_\_\_\_\_\_\_\_\_ (discount or premium) to the spot rate.
discount
27
# Fill in the blank: When the spot exchange rate of a foreign currency is lower than the forward exchange rate, the forward foreign currency sells at a \_\_\_\_\_\_\_\_\_\_\_\_\_\_ (discount or premium) to the spot rate.
premium
28
How is the annualized percentage of a forward discount or premium calculated?
([Cforward − Cspot] / Cspot) × Number of forward periods in one year ## Footnote Where: Cforward = Cost of 1 unit of Currency A in terms of Currency B in the **forward** market Cspot = Cost of 1 unit of Currency A in terms of Currency B in the **spot** market
29
Large commercial banks serve as intermediaries for the sale and purchase of foreign currencies. How do the banks make money on foreign currency exchange?
Banks profit from the bid-ask spread, buying currency at the bid price and selling it at the ask price.
30
What are the four main ways exchange rates can be determined?
* Floating exchange rate * Fixed exchange rate * Managed float exchange rate * Pegged exchange rate
31
What is a **floating exchange rate**?
An exchange rate determined by the supply and demand for the currencies in the market.
32
What effect does an appreciating U.S. dollar have on **import and export prices**?
* Prices of imported goods fall in the U.S. * Prices of U.S. exports rise.
33
What factors influence the supply of and demand for currencies?
* Relative inflation rates * Relative interest rates * Relative income levels * Expectations of future exchange rates * Government controls
34
What is the effect of higher relative **inflation** on a country's currency?
The currency of a country with a higher relative inflation rate will **depreciate** against currencies of countries with lower relative inflation rates.
35
What is the effect of higher relative **interest rates** on a country's currency?
The currency of a country with higher relative interest rates will appreciate against currencies of countries with lower relative interest rates.
36
What is the effect of higher relative **income levels** on a country's currency?
The currency of a country with higher relative income levels will depreciate against a currency of a country with lower relative income levels.
37
What is the effect of expectations of future exchange rates on currency value?
If market participants expect a currency to appreciate, they may increase their purchases of that currency, thereby **causing** the expected appreciation. Conversely, if they expect a currency to depreciate, they may increase their sales of that currency, thereby **causing** the expected depreciation.
38
How can a government influence its currency's **exchange rate**?
A government can influence its currency's exchange rate through central bank operations, by buying and selling its own currency and increasing or decreasing market interest rates.
39
What is the **Purchasing Power Parity** (PPP) theorem?
It states that the relative price for a particular good should be the same in any country. ## Footnote According to the PPP, the difference in the prices between one country and another country for the same good should be accounted for by the exchange rate between the two currencies.
40
What is a **fixed exchange rate**?
One that is held constant or allowed to fluctuate within a narrow range by government intervention.
41
Under a **fixed exchange rate system**, when the fixed exchange rate is set above what the equilibrium rate would be in a free market, the currency is overvalued. What happens when a currency is **overvalued** under a fixed exchange rate system?
The government will face a deficit in its international transactions balance because its currency has a fixed market price that is too high. Demand for the country’s currency will decrease while the supply on currency markets will increase. To maintain the overvalued exchange rate, the government will need to use its reserves of foreign currency to buy its own currency in the market. ## Footnote Ultimately, the country may eventually run out of reserves and may need to devalue the currency to build up its reserves again.
42
Under a **fixed exchange rate system**, when the fixed exchange rate is set below what the equilibrium rate would be in a free market, the currency is undervalued. What is the effect of an **undervalued** currency under a fixed exchange rate system?
The country will have a trade surplus. Demand for the country’s currency will increase while the supply on currency markets decreases. To maintain the undervalued fixed exchange rate, the country will need to sell its own currency in the market and buy other currencies. ## Footnote Eventually, the country’s reserves of foreign currency will become so high that the government may no longer be interested in increasing them and will allow the fixed exchange rate to increase.
43
What is a **common currency** in the context of exchange rates?
A common currency such as the euro in the European Union is the most fixed of exchange rates because there are no exchange rates between the currencies of the countries that have adopted it.
44
What characterizes a **managed float** exchange rate system?
Exchange rates fluctuate in response to market forces, but the government intervenes to prevent excessive movement in one direction or the other. ## Footnote It combines elements of both floating and fixed exchange rate models.
45
What is a **pegged** exchange rate system?
A currency's value is fixed in terms of a foreign currency or a basket of currencies, and it moves with that currency against other currencies. ## Footnote Used by smaller countries, pegged systems require interventions similar to fixed exchange rates.
46
How can a company manage foreign exchange rate risk?
* Natural hedges * Operational hedges * International financing hedges * Currency market hedges using derivatives
47
What is a **natural hedge**?
If a company keeps its expenses and revenues denominated in the same currency, that provides a natural hedge to protect the company from changes in exchange rates. ## Footnote Strategic decisions affecting markets served, pricing, operations, or sources can serve as natural hedges.
48
What is an **operational hedge**?
Balancing monetary assets and liabilities denominated in a specific currency will neutralize as much as possible exchange-rate fluctuations. ## Footnote Includes maintaining a balance between payables and receivables in a foreign currency.
49
What is a **currency forward contract**?
An agreement between two parties to buy and sell a currency at a future date at a specified exchange rate. ## Footnote A currency forward contract is a currency derivative. Allows companies to lock in a future exchange rate for foreign-denominated payables or receivables.
50
How do currency futures differ from forward contracts?
Currency futures contracts are currency derivatives, as are currency forward contracts. The difference is that currency futures contracts are standardized and traded on organized exchanges, while forward contracts are private agreements between the contracting parties. ## Footnote Futures contracts are often closed out before expiration, offsetting spot rate fluctuations.
51
What is a currency swap?
An agreement between two parties to exchange future payments on loans denominated in different currencies. ## Footnote A currency swap is a currency derivative. Can involve swapping interest payments only or both interest and principal payments.
52
What are the **benefits** of currency swaps?
* Hedging exchange rate fluctuations * Lower borrowing costs if interest rates are more favorable in a foreign market than they are in the company’s domestic market * Facilitating expansion into new markets by accessing funding in foreign currencies ## Footnote Swaps provide certainty in cash requirements.
53
What is a **currency option**?
A financial instrument that gives the buyer the right, but not the obligation, to buy or sell a currency at a set price before a set date, for which the buyer pays a premium. ## Footnote Used to hedge against adverse currency movements.
54
What is a currency **call** option?
The right to buy a specific amount of a foreign currency at a set price on or before a set date. ## Footnote Used to protect against an increase in the exchange rate for foreign-denominated payables.
55
What is a currency **put** option?
The right to sell a specific amount of a foreign currency at a set price on or before a set date. ## Footnote Used to protect against a decrease in the exchange rate for foreign-denominated receivables.
56
What are the components of net profit or loss on a cross-border sale?
* Profit on the sale at the sale date based on the spot rate * Net gain or loss caused by changes in the spot rate during the holding period * Net gain or loss during the holding period on any hedge used
57
Why might a company choose to borrow in a foreign currency?
To take advantage of attractive interest rates on borrowings in the foreign currency.
58
What factors determine the **effective interest rate** on a loan in a foreign currency?
* The interest rate on the loan * The change in the borrowed currency’s value over the term of the loan
59
How is the effective interest rate on a foreign currency loan calculated in the U.S.?
Rf = (1 + If) × (1 + Ef) − 1 ## Footnote Where: Rf = The effective financing rate If = The interest rate of the foreign currency loan Ef = The percentage change in the foreign currency unit against the U.S. dollar
60
How is the percentage of change (appreciation or depreciation) in a foreign currency unit's value against the U.S. dollar, used in calculating the effective interest rate of a loan in a foreign currency, calculated in the U.S.?
Ef = (St+1 − S) / S ## Footnote Where: St+1 = The spot rate of the foreign currency in terms of U.S. dollars (the foreign currency having the value of 1) at the *end* of the financing period. S = The spot rate of the foreign currency in terms of U.S. dollars (the foreign currency having the value of 1) at the *beginning* of the financing period.
61
What is prepayment? | (in the context of international transactions)
The buyer pays for goods before they are received, eliminating risk for the seller but increasing risk for the buyer. ## Footnote It is a method of paying for international transactions.
62
What is an **open account** in international trade?
An arrangement where payment is made by the buyer to the seller on an agreed-upon future date, with the seller bearing the risk of non-payment. ## Footnote It is a method of paying for international transactions.
63
What is a **sight draft** as used in international trade?
A type of negotiable instrument (bill of exchange) that is payable immediately upon presentation to the importer, that is, "at sight." ## Footnote An exporter ships goods and submits the sight draft along with the shipping documents to their bank. The bank forwards the documents to the importer's bank, which presents the draft to the importer. The importer must pay the draft immediately in order to receive the shipping documents needed to take possession of the goods.
64
What is **countertrade** or barter in international trade?
An exchange of goods or services between two parties without using currency, often used when currency conversion is unavailable or exchange rates are unfavorable.
65
What is a commercial letter of credit?
A guarantee by the buyer’s bank to pay for merchandise, provided the seller presents required documents according to the terms of the letter.
66
What is **cross-border factoring**?
Selling a trade receivable to a third party, a factor. The exporter can eliminate the risk of the receivable not being paid if the exporter sells the receivable without recourse.
67
What is a **banker’s acceptance**?
A time draft drawn by the exporter on the importer’s bank. It can be used by an importer as financing for an international purchase, by an exporter as financing for the receivable created by the importer’s purchase, and by any investor as a short-term, money market investment.
68
What is **forfaiting**?
A form of factoring used for large transactions that are medium- to long-term in length. The forfaiting bank assesses the creditworthiness of the importer because it is in effect extending to the importer a term loan. ## Footnote Forfaiting transactions usually require a bank guarantee or letter of credit as a secondary repayment source.
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