International Finance: Exchange Rates, PPP, and Arbitrage Concepts

Direct Quote

Home currency per unit of foreign currency (e.g., $1.10/€ in the U.S.)

Indirect Quote

Foreign currency per unit of home currency (e.g., €0.91/$ in the U.S.)

Fixed Exchange Rate Regime

Central bank maintains currency value at a set rate through intervention

Floating Exchange Rate Regime

Currency value determined by market supply and demand

Law of One Price

Identical goods should cost the same in different countries when expressed in a common currency

Law of One Price (London Shirt Example)

If a shirt is £50 in London and $60 in New York, the exchange rate should be $1.20/£

Theory of Comparative Advantage (David Ricardo)

Countries gain by specializing in goods with the lowest opportunity cost

Fisher Effect

Nominal interest rate = real rate + expected inflation; (1+i) = (1+r)(1+π)

Absolute Purchasing Power Parity (PPP)

Identical goods should have the same price globally when converted into a common currency

Relative Purchasing Power Parity (PPP)

Exchange rate changes reflect inflation differentials between countries

Quantity Theory of Money

MV = PY; increases in money supply cause proportional increases in prices if output and velocity are constant

Wealth Maximization

The goal of financial management is to maximize firm or shareholder value

Bretton Woods System

Post-WWII system ******* currencies to USD, which was convertible to gold at $35/oz; collapsed in 1971

Impossible Trinity (Trilemma)

A country cannot have fixed exchange rates, free capital mobility, and independent monetary policy simultaneously

Spot Exchange Rate

The current price at which one currency can be exchanged for another

Bid Quote

The price a dealer is willing to pay for a foreign currency

Ask Quote

The price at which a dealer sells a foreign currency

Arbitrage

Risk-free profit from price discrepancies in different markets

Cross Rate

Exchange rate between two currencies derived from their relationships with a third currency

Wealth Maximization (in international finance)

Managing exchange rate risk and capital decisions to enhance firm value globally

Bretton Woods Collapse

Broke down when U.S. ended gold convertibility due to inflation and deficits; replaced by floating exchange rates

Trilemma Example

Country can choose only two of: (1) fixed rate, (2) free capital flows, (3) independent monetary policy

Cross Rate Example

$1 = ¥150 and €1 = $1.25 ⇒ €1 = ¥187.50

Arbitrage Example

£1 = $1.60 in London, £1 = $1.62 in New York, $1,000,000 yields $12,500 profit

Forward Premium/Discount Formula

((Forward − Spot) / Spot) × 100

Forward Premium Example

(147−150)/150 × 100 = −2%; yen at 2% forward premium

Nominal Interest Rate Formula (Fisher)

(1+i) = (1+r)(1+π); e.g., r=3%, π=5% ⇒ i=8.15%

Future Spot vs. Forward Rate

If forward < expected future spot, foreign currency is expected to appreciate

Interest Rate Parity Formula

F = S × (1 + i_home) / (1 + i_foreign)

IRP Example

S = 1.50, i_US=4%, i_UK=2% ⇒ F = 1.5294 ($/£) removes arbitrage

Quantity Theory of Money Equation

MV = PY; link between money supply and inflation

Law of One Price Calculation

£50 = $60 ⇒ $1.20/£

Wealth Maximization Definition

Maximizing long-term firm value rather than short-term profit

Direct vs. Indirect Summary

Direct = domestic/foreign; Indirect = foreign/domestic

Fixed vs. Flexible Summary

Fixed = central bank control; Flexible = market forces

Forward Premium Definition

When foreign currency buys more of home currency in forward market

David Ricardo's Contribution

Developed comparative advantage theory explaining trade benefits

Extra Credit (Forward Rate Neutralization)

Use IRP: F = S × (1 + i_home)/(1 + i_foreign) to find forward rate that removes profit

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