Lecture Notes for International Finance FIN Currency Risk by mikeholy

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									                   Lecture Notes for International Finance (FIN 435)

                CH 1. GLOBALIZATION AND THE MULTINATIONAL FIRM

* WHY BUSINESS?

To make money

* WHAT NEEDED?

2) Money = Capital = Resources

Need money to make money? Sounds contradictory? Capitalism – Capital = Ism according to Rev Jesse
Jackson. In Communism, the government provides resources, but less incentive to do a project. Here,
strong incentives, but difficult to get started.

1) Idea(s) = Project(s)

* MAJOR FINANCIAL DECISIONS?

1) Examine whether the idea(s) you have is “good” or which one(s) is the best= Capital Budgeting.
Capital Budgeting techniques: NPV (take +NPV projects or the highest NPV), IRR (or MIRR) (take if
IRR>WACC, or the one with the highest IRR(?)), Payback Period (take if PB < the maximum period
allowed or the one with the shortest PB).

2) How to come up with the money = how to finance (fund) the project(s) = how much from Equity
(owner’s contribution) and Debt = Capital Structure

        Ex. $50 million, 40% equity => $30 million from debt.

3) Short-term (working capital) and long-term (investment) management

       Working capital management is for day to day activities like A/R, A/P, Inventory, etc
       Strategic investment is M&As, issuing new shares, etc
4) What to do with profits (net earnings)? Dividends or addition to retained earnings? = Dividend Policy

        Ex. $5 million net earnings, $3 million dividends => 60% dividend payout ratio
        Aside) (Net)Sales=Revenue > Gross Margin>EBIT>EBT>Net earnings(=Net income)
        Aside) EBITDA=EBIT+DA or GM-Cash Expenses. Ex. GM=$10m, Cash exp=$6m, Non-cash
        exp=$1m, then EBIT=$10-($6+$1)=$3m. EBITDA=$3+$1=$4m
        or $10-$6=$4m. This is similar to have a discounted price or regular price + a rebate.
        *finance.yahoo.com

* WHY INTERNATIONAL BUSINESS?

– MORE OPPORTUNITIES: INCREASED REVENUE AND/OR REDUCED COSTS =>
MULTI-NATIONAL CORPORATIONS (MNCs)
* WHAT MAKES INTERNATIONAL BUSINESS UNIQUE?

 1. EXPANDED OPPORTUNITY SET and COMPARATIVE ADVANTAGE (David Ricardo)

  - Gains from trade are from the Absolute Advantage (which country is more efficient in the
production of a particular product – one industry at a time) according to Adam Smith vs. Gains are
from the Comparative Advantage based on the production efficient across industries. Eg., Country
A may be more efficient in both textiles and food. Yet, gains of trade exist as Country A is much
stronger in textiles. Another example can be found in the relationship between a lawyer and a
secretary as the lawyer may be better in both legal expertise and typing.

 2. ADDITIONAL RISKS

        2.1 EXCHANGE RISK: AN ELEMENT OF CASHFLOW VARIABILITY THAT IS DUE
        TO CURRENCY FLUCTUATIONS. $ VALUE OF FOREIGN CURRENCY
        DENOMINATED CASHFLOWS CHANGES (amount of money in FC (#TWs) is
        unchanged, but the $ amount changes)

        ASIDE: EXCH. RATE? : Relative value of two currencies

                Also note the difference between American terms ($/FC) and European terms (FC/$)

     Example: 800 won/$ IN NOVEMBER 1997 AND 1600 won/$ IN DECEMBER 1997. IF A
US FIRM MADE A $ 1M SALE (=800 MILLION won) IN NOVEMBER, 1997 AND
RECEIVED AN A/R DENOMINATED IN won THAT MATURED IN DECEMBER 1997,
THEN HOW MUCH DID THE COMPANY LOSE?

        2.2 POLITICAL RISK: ARISES SINCE A SOVERIGN COUNTRY CAN CHANGE THE
        “RULES OF THE GAME”

3. MARKET IMPERFECTIONS: INTERNATIONAL MARKET IS NOT PERFECT IN THE
SENSE THERE ARE MANY MARKET FLICTIONS SUCH AS TRANSACTIONS COSTS
(E.G., TRANSPORTATION COSTS), GOVERNMENT REGULATIONS, DIFFERENT
TAXES, TARIFFS, AND RESTRICTIONS ON FOREIGN INVESTMENTS.

        Example: Nestlé HAS BEARER SHARES AND REGISTERED SHARES.

* MNC GOAL: MAXIMIZING THE VALUE OF THE ENTIRE MNC!

 - AGENCY CONFLICTS: The agent (managers) may not work in the best interest of the principal
(owners)

 -What to do to mitigate the conflict? 1) active monitoring=direct shareholder intervention, performance
based incentives such as stock shares or stock options (to buy shares), hostile takeover threats when
market value (price) is less than the intrinsic value.
* WORLD ECONOMY: RECENT TRENDS

 - EMERGENCE OF GLOBALIZED MARKETS

 - LIBERALIZATION

 - ECONOMIC INTEGRATION

 - PRIVATIZATION

 - TECHNOLOGY (Internet)

* MNC: A most advanced form of the multinational enterprise, incorporated in one country and
doing business in several other countries via global coordination by a single centralized
management. Examples: GE, FORD, ROYAL DUTCH/SHELL, - - -

* MULTINATIONAL FINANCIAL MGT

 - FIRMS HAVE TO MAKE THE FOLLOWING DECISIONS: CAPITAL BUDGETING AND
INVESTMENTS, CAPITAL STRUCTURE, WORKING CAPITAL MGT, DIVIDEND
POLICY AND REINVESTMENT. MNCs DO THE SAME, BUT ALL SUBJECT TO
UNIQUE ASPECTS OF INTERNATIONAL BUSINESS:

* MNC PATTERNS:

 1. RAW-MATERIALS SEEKERS:

  2. MARKET SEEKERS: OFTEN IN RESPONSE TO ANY RESTRICTIONS ON THEIR
EXPORTS TO THE MKT.

 3.COST MINIMIZERS: PRODUCE GOODS IN LOWER-COST AREAS OVERSEAS IN
ORDER TO BE COST-COMPETITIVE.

* EVOLUTION:

 INTL TRADE (IMPORT/EXPORT) => SETTING UP A FOREIGN SALES SUBSIDIARY FOR
DISTRIBUTION => SECURING LICENSING AGREEMENTS => FRANCHISING => JOINT
VENTURES => EVENTUALLY ESTABLISHING A FOREIGN SUBSIDIARY

REF) MOVING TO NEXT STAGE => RISKIER, BUT MORE OPPORTUNITIES

* IMPORTANT CONCEPTS OF FINANCIAL MGT (FIN331-333)

 1. ARBITRAGE; ACTIONS TO MAKE PROFITS WITHOUT TAKING ADDITIONAL RISK
=> IF THE MKT IS PERFECT, THERE IS NO ARBITRAGE IE, LAW OF ONE PRICE
PREVAILS.
 2. MKT EFFICIENCY: NEW INFO IS READILY INCORPORATED IN SECURITY PRICES.
=> NO ABNORMAL RETURNS

 3. CAPITAL ASSET PRICING: SECURITIES ARE VALUED IN TERMS OF THEIR
EXPECTED RISKS AND RETURNS.

* MULTINATIONAL FINANCIAL MGT

 1. MECHANISM OF FINANCIAL TRANSACTIONS WITHIN THE MNC: IT CAN EASILY
MOVE GOODS, SERVICES, CAPITAL, AND PROFITS AMONG ITS VARIOUS AFFILIATES
AND SUBSIDIARIES THROUGH THE INTERNAL INTERNATIONAL TRANSFER
MECHANISM TO MAXIMIZE THE GLOBAL VALUE OF THE FIRM.

      1) MODE OF TRANSFER: Freedom in the selection of financial channels.

      2) TIMING FLEXIBILITY: Payment schedule can be accelerated or delayed.

      3) REDUCTION OF GLOBAL TAX PAYMENTS: Shifting profits from high-tax to lower-
      tax nations to reduce its global tax payments.

 2. FACTORS TO CONSIDER AS A CFO IN MNC – UNIQUE ASPECTS OF INTL BUSINESS

* INTL OPPORTUNITIES AND EXPOSURE TO INTL RISKS

* VALUATION MODEL FOR AN MNC




             USING THE QUOTATION TABLE (pacific.commerce.ubc.ca/xr/)

1. WHAT IS THE NATIONAL CURRENCY OF INDIA, JAPAN, RUSSIA, SOUTH KOREA,
and SPAIN?

2. US $ EQUIV. (S) VS. FOREIGN (LOCAL) CURRENCY (FC) PER US $ (1/S)?

        EX1) WHAT IS THE yen/US $ RATE OF MAY 28, 2010?

        EX2) US $/euro ?

        NOTE: CURRENCIES WHICH HAVE “S” GREATER THAN 1? MEANING?

3. APPRECIATION OF A FC (AGAINST US $): (S1-S0)/S0

        (USE oanda.com, for % changes)
        EX) euro APPRECIATION (VIA-A-VIS US $) FROM 5/24 TO 5/28?



        <=> US $ APPRECIATION (VIS-A-VIS LC) = (1/S1 - 1/S0) / (1/S0) = (S0-S1)/S1



        EX) US $ APPRECIATION AGAINST euro FROM 5/24 TO 5/28?

        NOTE: FC APPRECIATION RATE AND US $

        APPRECIATION RATE AGAINST THE FC IS DIFFERENT.

        EX) $/TW FROM .4 TO .8?

4. SDR: SPECIAL DRAWING RIGHTS (read the PACIFIC)

  euro: EU’s

5. CURRENCY CROSS-RATES.

        FC1/FC2 = (FC1/$)*($/FC2) = (1/S1)*S2

        EX) £/¥ AT THIS MOMENT (finance.yahoo.com)? of 8/27 (oanda.com)?

         EX)

6. FWD RATE (from PACIFIC to bmo.com/economic/regular/fxrates.html)

 - FWD CONTRACT: A COMMITMENT TODAY TO TRANSACT IN THE FUTURE AT THE
TODAY'S AGREED-UPON TERMS. MONEY DOES NOT CHANGE HANDS TODAY IE,
NO INVESTMENTS
                     CH2. INTERNATIONAL MONETARY SYSTEM

* ALTERNATIVE EXCHANGE RATE SYSTEMS

 1. FREE FLOAT: EXCH RATES ARE DETERMINED SOLELY BY THE INTERACTION OF
CURRENCY SUPPLY & DEMAND (OR MKT FUNDAMENTALS)

-EXCHANGE RATE EQUILIBRIUM AND FREE FLOAT: EXCH RATES ARE DETERMINED
BY THE INTERACTION OF CURRENCY SUPPLY & DEMAND (OR MKT
FUNDAMENTALS)

  => EXTERNAL SHOCKS: INFLATION RATES, INTEREST RATES, INCOME LEVLES,
GOVERNMENT CONTROLS, EXPECTATIONS, ETC.

*Difference between a shift in demand/supply separately in response to a non-price external shock
and a move along the curve.

 - e.g., external shock (e.g., new discovery of nutritional facts about TWs) => increased demand
shift for TWs => increased price of TW and equilibrium quantity of TWs sold(bought) without a
change in supply curve. A shift in dd curve is not affecting the ss curve! An increase in the
quantity sold (demand induced increase in supply) is not due to a change (or shift) in the supply
curve!

*INTERACTION OF FACTORS.

*FOREIGN CURRECNY INDEX

  2. MANAGED FLOAT: BASICALLY, A FLOATING SYSTEM. GOVERNMENTS
INTERVENE IN THE FOREIGN EXCH MARKET TO SMOOTH OUT EXCH RATE
FLUCTUATIONS.

 3. TARGET-ZONE ARRANGEMENT: COUNTRIES UNDER THIS ARRANGEMENT
MAINTAIN THEIR EXCH RATES WITHIN A SPECIFIC MARGIN AROUND AGREED-
UPON FIXED EXCH RATES.

  EG. EMS (EUROPEAN MONETARY SYSTEM) -> EU, Snake -> One Currency

 4. FIXED-RATE SYSTEM: GOVERNMENTS ARE COMMITTED TO MAINTAINING
TARGET EXCH RATES

  EG, THE BRETTON WOODS SYSTEM

 5. THE CURRENT SYSTEM
*A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

1. PRIOR TO 1875: BIMETALLISM OR SILVER STD.

  2. 1875-1914: THE CLASSICAL GOLD STD: ALL CURRENCIES ARE FULLY
CONVERTIBLE INTO GOLD.

  -PRICE-SPECIE-FLOW MECHANISM

3. 1915-1945: NO COHERENT SYSTEM

   4) 1945-1972: THE    GOLD-EXCHANGE      (THE   BRETTON   WOODS,   IMF)
SYSTEM $35/OUNCE

  -TRIFFIN PARADOX

  -SDRs

5) 1973- : FLEXIBLE EXCH RATES

* EUROPEAN MONETARY SYSTEM

* EURO AND EUROPEAN MONETARY UNION

* THE MEXICAN CRISIS, THE ASIAN CRISIS

* FIXED VS. FLEX EXCHANGE RATE SYSTEM
                                CH 3. BALANCE OF PAYMENTS



1. BALANCE OF PAYMENTS ACCOUNTING

        - The Current Account

        - The Capital Account

        - Other issues

2. INTERNATIONAL CAPITAL FLOWS (Ch15 and Ch16)

* DFI

     - FACTORS AFFECTING DFI: MARKET SIZE AND GROWTH, TRADE BARRIERS,
STEADY SUPPLY OF RAW MATERIALS, COST ADVANTAGES, GOVERNMENT
REGULATIONS, TAXES, EXCHANGE RATES, ETC

* PORTFOLIO INVESTMENT

        - RETRUNS (CAPITAL GAINS AND INCOME), EXCHANGE RATES



                   CH 4. INTERNATIONAL CORPORATE GOVERANCE



1. GOVERANCE OF THE PUBLIC CORPORATION

        - KEY ISSUES

        - AGENCY PROBLEM

        - Other issues

2. CORPORATE GOVERANCE REFORM
             CH 5. FOREIGN EXCHANGE MARKETS (CURRENCY MARKETS)

1. ORGANIZATION OF THE FOREIGN EXCHANGE (FOREX) MARKET

* OTC (time line between time 0 and 1)

 1) SPOT MKT: Currencies are traded for immediate delivery.

 2) FWD MKT (& FUTURES):

  3) OPTIONS: rights to buy (Call) or to sell (Put) a specified amount of foreign currency at
specified price (exercise exchange rate) at no later the specified date (expiration date).

 ref) rain check.

* PARTICIPANTS AND SIZE OF THE FOREIGN EXCHANGE MKT.

2. THE SPOT MKT

 1) QUOTATIONS

            - TRANSACTION COSTS

             BID-ASK SPREAD

            - CROSS-RATES

 2) TRIANGULAR (CURRENCY) ARBITRAGE

       a.    SIMPLE ARBITRAGE: $.4/TW vs. $.5/TW

       b. How about DM instead of TW?

       c. Caveats: “$ prices” and the same FC!!

       d. Inconsistent with the “perfect market” idea

                EG, $/£=2.809 IN NY, $/ARP=.251 IN BUENOS AIRES, AND ARP/£=11.18 IN
                LONDON

                Hint: $/BP=2.809 vs 2.806 or $/ARP=.251 vs .2513,3.984>0.3564 >1.00113

3. THE FORWARD MARKET:
EG, A US firm buys plug trays from England with payment of one million BPs due in 90 days. The
present exchange rate is So=$1.71/BP and S1 could be as high as $2/BP or as low as
$1.6/BP. F=$1.72/BP. Probability Distribution: S1=$2/BP with 30% Prob, and $1.6/BP with 70%
Prob.

    Four alternatives to secure one million BPs.

       a.   Buy now

       b.    Buy later at the future spot rate (S1)

       c.   Buy forward at F

       d.    Options

 1) FOUR IMPORTANT POINTS:

      a. NOT AN INVESTMENT

       b. GAIN/LOSS ON THE FWD CONTRACT IS NOT DIRECTLY RELATED TO S0.

      c. IT'S NO OPTION

 2) PARTICIPANTS:

  ARBITRAGEURS, TRADERS, HEDGERS, AND SPECULATORS

 3) QUOTATIONS

      - Bid/Asked Spread

       a. Customers are quoted the outright rate, or actual price (WSJ quotations).

       b. Dealers quote in terms of fwd points, which are either added or subtracted from the
       spot rate (So) or as a premium or discount on the spot rate (the PACIFIC):

               (fwd diff/S0)*(12/contract length in months).

                            ref) fwd diff=swap rate=F - S0.
             CHs. 6 PARITY CONDITIONS & CURRENCY FORECASTING

- ARE TO DESCRIBE THE RELATIONSHIPS AMONG KEY MACROECONOMIC
VARIABLES OF OUR INTEREST. MOST PARITIES ARE DERIVED FROM THE NO
ARBITRAGE CONDITION (THE LAW OF ONE PRICE).

* ARBITRAGE

 - Examples (with and without bid-asked spreads)

 - Triangular Arbitrage, Cross Exchange Rates

 - Interest Arbitrage: BOA 4% vs Nations 5%

 - International Interest Arbitrage: US 2% vs UK 4%?

 - Covered Interest Arbitrage: hedging against exchange rate risk – Example: ius = 4%, iuk = 5%,
So = 2, F=2.01, then (1/So)(1+iuk)F=1.055 or 5.5% $ rate of return vs. 4%

1. CIRP: FROM THE NO ARBITRAGE CONDITION

IDEA: ONE $ INVESTED ANYWHERE IN THE WORLD SHOULD YIELD THE SAME
$ RATE OF RETURN => ONE $ INVESTED IN THE US T-BILLS SHOULD YIELD THE
SAME RETURN AS AN INVESTMENT MADE IN UK T-BILLS IN $ TERMS BY THE
TIME THE INVESTMENTS MATURE.

 - Parity Equation: Formalize based on the example in Covered Interest Arbitrage above),
Relationship between CIRP and forward premium

 - Extra Example: US 4% vs UK 5%, S0 = $2/BP => Implied F = $1.981/BP, Actual NE (not equal
to) Implied?

 -THREE ASSUMPTIONS:

 1) THE SAME RISK

 2) NO TRANSACTION COSTS

 3) NO RESTRICTIONS ON FOREIGN INVESTMENTS INCLUDING NO OR IDENTICAL
TAXES

 - EMPIRICAL EVIDENCE

2. PPP
IDEA:ONE $ (BP) SHOULD HAVE THE SAME PURCHASING POWER AROUND THE
WORLD. =>PRICES OF CONSUMPTION BASKETS (or THE PRICE LEVELS) BEING THE
SAME BETWEEN THE US AND UK WHEN PRICES ARE MEASURED IN A COMMON
CURRENCY ($ or BP).

 - Example: Big Mac Meal: euro 4 in France vs. $3.40 in Baltimore, inconsistent with this
concept?

=> Prices of twinkies/bagels/cars/--- in the US and UK should be the same after making an
adjustment for the different currency values i.e., exchange rates. Or $ (BP) prices should be the
same.

$CPI's IN TWO COUNTRIES SHOULD BE EQUAL.

=> $ (BP) Living costs are the same!

 - ABSOLUTE VERSION: S0 = Pus/Puk

 - RELATIVE VERSION: e = Ius – Iuk



 -THREE ASSUMPTIONS:

 1) IDENTICAL CONSUMPTION PATTERNS ACROSS THE BORDER

 2) NO TRANSPORTATION COSTS, 3) ALL GOODS ARE TRADABLE



 - EMPIRICAL EVIDENCE

3. THE FISHER EFFECT

 1) THE FISHER EFFECT (CLOSED or DOMESTIC VERSION)

THE NOMINAL INTEREST RATE IS EQUAL TO A REAL INTEREST RATE PLUS AN
EXPECTED RATE OF INFLATION. ius = pus + E(Ius) (simple one)

 - Example

 2) THE FISHER OPEN (or THE INTERNATIONAL FISHER EFFECT)

ASSUMING THAT THE REAL INTEREST RATES ARE EQUAL ACROSS COUNTRIES,
THE NOMINAL INTEREST DIFFERENTIAL SHOULD BE EQUAL TO THE EXPECTED
INFLATION DIFFERENTIAL, WHICH AGAIN SHOULD EQUAL THE CHANGE IN THE
EXCHANGE RATE (FROM THE RELATIVE PPP). e = ius – iuk



4. FORWARD PARITY: THE FWD DIFFERENTIAL EQUALS THE EXPECTED CHANGE IN
THE EXCH RATE. OR, THE FWD RATE IS AN UNBIASED PREDICTOR OF THE FUTURE
SPOT EXCH RATE. F = E(S1)

 *EMPIRICAL EVIDENCE

* Comparison of the (C)IRP, PPP, IFE, and Fwd Parity

* FORECASTING EXCHANGE RATES

* Why a firm needs to forecast exchange rates? – Exchange rate changes can affect very
substantially cashflows (directly like contractual amount or indirectly via changes in firm’s
competitive position), discount rates, and eventually the value of the firm.

*Forecasting Techniques:

 1) Technical Forecasting (“history repeats itself”)

–using historical data (e.g., pacific), statistical tools, and charts to extract patterns/trends.

  - Moving Average?

  - Limitations

 2) Fundamental Forecasting – based on fundamental relationships between economic variables and
exchange rates.

  - Using key economic variables (e.g., yardeni.com) from economic theories, sensitivity analyses,
and parity conditions. (traditional flow model, asset market model, and parity conditions)

  - Limitations

  3) Efficient Market-Based Forecasting – Using the current spot rates (Random Walk
Hypothesis) or the forward rates.

 4) Mixed Forecasting and Exchange Rate Forecasts (e.g., biz.yahoo.com/ifc)

* Evaluation of Forecast Performance

* Exchange Rate forecasting in a fixed-rate system
                              CH 7 CURRENCY DERIVATIVES

* EFFECTIVE HEDGING AND SPECULATIVE TOOLS DEPENDING ON TRADER’S
POSITION, TAKING AN OPEN POSITION vs COVERING THEIR CURRENCY POSITION.

* CURRENCY FORWARD MARKET: OTC, BUY OR SELL FORWARD

*CURRENCY FUTURES: CONTRACTS FOR SPECIFIC QUANTITIES OF GIVEN
CURRENCIES: THE EXCH RATE IS FIXED AT THE TIME THE CONTRACT IS ENTERED
INTO.

*IMPORTANT DIFFERENCES BETWEEN FORWARD AND FUTURES:

 1. OTC vs. Exchange (CME open hours 7:20am to 2pm CST)

 2. CONTRACTS ARE REGULATED AND STANDARDIZED:

  A. REGULATION (CFTC vs. SEC)

 B. PRICE FLUCTUATIONS or daily price limit. When the price limit is hit, trading will halt.

  C. CONTRACT SIZE

  D. DELIVERY DATE: the third Wednesday of the expiration month for CME

 3. AVAILABLE FOR A FEW MAJOR CURRENCIES

 4. TRADERS CHARGE MINIMAL COMMISSIONS for the round-trip.

 5. A CLEARING HOUSE: a futures market serves as a clearing house, where all the orders are
collected and cleared. CME, SIMEX, PBOT

 6. MARGIN REQUIREMENTS (AVERAGE ABOUT 2% OF THE VALUE OF THE
FUTURES CONTRACT) => HIGH LEVERAGE, initial margin, maintenance margin (75% of the
initial), and variation margin.

       - MARGIN: your equity or % of the value of investments financed by equity

 Example: 100% margin=no borrowing, 60% margin=can borrow up to 40%, stock margin

       - VARIATION MARGIN: equity amount to be added to the account to bring it back to
       the initial margin.

  7. MARKING TO MARKET (DAILY SETTLEMENT): Practice of taking a profit or loss at the
end of each trading day to prevent any trader from building up a huge loss, which cannot be covered.
       Example: Short (Long) in 3 contracts of Sept 18th of SF Futures with an initial margin to
meet the 2% requied+$500 (+$300). f1day, 10am CST=$.6230/SF, f1day, 2pm CST=.6270,
f2day, 2pm=.6340, f3day, 2pm=.6120.

       * Futures Settlement Excel Exercise

  8. OFFSETTING TRADE (reversing trade): Closing out futures contract by taking the opposite of
an initial trading position.

* Open Interest, Zero-sum game, Total Gain (Long)=f3 – f1 10am, (Short)=f1 10am – f3



* CURRENCY OPTION: THE RIGHT TO BUY OR TO SELL THE CONTRACTED
CURRENCIES AT THE SPECIFIED PRICES AT THE EXPIRATION DATE.

HOW DOES IT WORK? (using the fwd example)

         - Type of an option? Call, How many contracts? 32

         - K=$1.75/BP, P0 = $0.02/BP

         - Exercise or Not? It depends. If S1=2?, If S1=1.6? Total Costs?

         - Which state is preferred? Why? A comparison with an insurance.

         - What if it is an A/R?

ASIDE: AMERICAN VS. EUROPEAN OPTIONS:

         EXERCISE (STRIKING) PRICE

         PHLX (PHILADELPHIA STOCK EXCHANGE)

         IN-THE-MONEY, OUT-OF-THE MONEY, AND AT-THE-MONEY

*WHO ARE PURCHASING CURRENCY OPTIONS? (PROS AND CONS OF THE
CURRENCY OPTIONS VIS-A-VIS FWD & FUTURES)

* READING FUTURES AND OPTIONS PRICES:

* SPECULATIVE OPPORTUNITIES

* 3 FUNCTIONS OF THE FOREIGN EXCH MARKETS:

 1. TRANSFER OF PURCHASING POWER, EXCH OF CURRENCIES
2. SPECULATIVE OPPORTUNITIES

3. HEDGING MECHANISM

-Example: HOW THE SPECULATION WORKS.

      S0 = $.60/A$,   f = $.64/A$,   E(S1) = $.62/A$

      CAPITAL = $20K, CALL OPTION'S EXERCISE PRICE, K=$.63/A$

      OPTION PM, C=$.01/A$

      1. SPECULATION IN SPOT MARKETS

      2. SPECULATION IN FWD MARKETS

      3. SPECULATION IN OPTIONS MARKETS
CH 8, 9, 10, EXCAHGE RATE RISK EXPOSURES AND MANAGEMENT

* Exchange Rate Risk Relevant?

* Types of Exposures

 1) Transaction – Contractual cashflows vary

  - “Net”



 2) Economic (Operational) – Need to know firm’s operation, market conditions, competition, etc

  - Economic exposure of domestic firm

  - Measuring Economic Exposure – difficult!

 3) Translation (Accounting) – arises when the MNC consolidates financial statements of all of its
operations (HQs, subsidiaries, and affiliates) – historical vs. current exchange rates

  - Does it matter?

  - Determinants of Translation Exposure

  - Accounting Methods,

    a. Current/non-current, b. Monetary/non-monetary, c. Temporal, d. Current rate

  - FASB 8 vs FASB 52,
* MANAGING TRANSACTION EXPOSURE

* A US firm has a Sf 25m receivable in two months. So = $.63, E(S1) = $.64, F=$.64, ius=5%,
isf=4%, option premium (cents per unit) = 0.15 for K=$.67 and 0.30 for K=$.68

(Hint: 5%=>.83%, 4%=>.67%, op pm=$.0015)

1. UH: $16m

2. FH: $16m, pp.336-341, RCH

3. MMH: Sf 24.83m, PV=$15.64m, FV=$15.77m

Note: CIRP and MMH & FH

4. Currency Option Hedge: 400 contracts, $75k option premium for K=$.68 and $37.5k for
K=$.67,

Guaranteed $ receipt = $16.75m vs $17m, with net (in FV) $16,712,188 vs $16,924,377.50

  - Option value determinants: So, volatility, time to maturity, interest rate, exercise price

5. Futures:

* Comparing Hedging Techniques and Examples

* MNC’s Hedging Policies – Buying car insurance? How about increased deductibles?

* Other Hedging Techniques

6. Risk Shifting and Pricing Decision – Price sales in home currency (e.g., $ invoicing)

7. Hedging via lead or lag – pay or collect early or late.

8. Exposure Netting – Portfolio approach, “Net” offsetting exposure in one currency with
exposures in the same or other currency. Lufthansa example. This includes Cross-Hedging and
Currency Diversification

9. Currency Risk Sharing based on a formula

10. Currency Swap and Parallel Loan
* Limitations of Hedging

1. Contingent Exposure (Potential) Exposure – FC denominated transaction is not certain and
contingent on a future event. Example: comparing alternative hedging techniques for GE
bidding on a hydroelectric project in Canada. If accepted, GE gets an A/R of CD$ 100m.

2. Overhedging – example

3. Limitation of Repeated Short-Term Exposure

* Hedging Long-Term Transaction Exposure

1. Long-Term Forward Contract

2. Currency Swap

3. Parallel Loan

                    * Examples of transaction exposure and management

1. Your brewery produces Lusty Lite, a very-low-calorie, almost tasteless beer that has not yet
developed a following. In mid-March you receive an order for 10,000 cartons from Munich,
Germany, for next fall's Oktoberfest, with payment of 384,000 euro due in mid-September. In
you opinion the euro will rise from its present rate of e 1.006/$ to e 1.005/$ by September. You
can borrow marks for six months at 6% per annum. What should you do? Discuss issues as
necessary.

2. Whitfield Corporation is completing a new factory building in Yorkshire, England, and must
make a final construction payment of £8,000,000 in six months. Foreign exchange and interest
rate quotations are as follows.

          Present spot rate                               $1.80/£

          Six-month forward rate                           1.79/£

          British six-month interest rate                  8.00% per annum

          U.S. six-month interest rate                    7.00% per annum

The financial manager's own analysis suggests that in six months the following spot rates can be
expected.

          Highest expected rate                $1.80/£

          Most likely rate                      $1.78/£
          Lowest expected rate                   $1.77/£

What alternatives are available for making payment, and what are the advantages or
disadvantages of each?

3. Ithaca Tool Company has received an order from a Malaysian manufacturing company for
machinery worth M$480,000. (M$ stands for Malaysian ringgits.) The export sale would be
denominated in Malaysian ringgits on a one-year open account basis.

The current spot rate is M$2.00/US$, and the forward ringgit sells at a discount of 10% per
annum. The finance staff of Ithaca Tool Company forecasts that the ringgit will drop 8% in
value over the next year. Ithaca Tool Company faces the following alternatives.

a. Wait one year to receive M$480,000 and then sell the ringgits received for dollars in the spot
market.

b. Sell the ringgit proceeds of the sale forward today.

c. Borrow ringgits from Public Bank Berhad in Kuala Lumpur at 15% per annum against the
expected future receipts of ringgits.

What do you recommend and why?

4. You have just purchased a deluxe Lamborghini sports car to be delivered to you in Italy three
months from today. The purchase price is 90,000 euro to be paid in cash at that time.

You have enough dollars in the bank in the United States to pay cash for the car. These dollars
are earning interest at 3% per annum, compounded monthly. Banco di Napoli offers 8% per
annum interest on three-month time deposits, no compounding.

You want to avoid all foreign exchange risk because foreign exchange markets have been
unusually volatile in recent months. The current spot rate is e 1.002/$ and the current three-
month forward rate is e 1.003/$.

How should you plan to pay for your Lamborghini?

5. Tay Enterprises of Los Angeles has just sold merchandise for 250,000 euro to a customer in
Germany, with payment due in euro three months from today. Tay Enterprises can borrow for
three months from a bank in Los Angeles at 5% per annum, or from a bank in Germany at 7.5%
per annum. Today's spot rate (direct basis) is $1.004/e. Three-month option contracts are
available with the following characteristics.

                    Contract size                                  125,000 euro

                    Strike price                                    $1.005/e
                      Option premium, per option                   $200

a. Assume that you in fact hedged the transaction by the use of option contracts. On the day the
option matures, three months from now, the spot exchange is $1.005/e. Would you exercise the
option at that time or sell euro in the spot market? Why, and what is the dollar advantage of one
choice over the other?

b. What would have been your dollar sales proceeds, three months hence, if you had hedged via
the money market?

c. Given today's interest rates, what should be the three-month forward exchange rate for euro?

d. Given this forward exchange rate, what would have been your dollar sales proceeds had you
hedged via the forward market?

e. Given the choice, would you prefer a forward hedge or a money market hedge? Why, and
what is the dollar advantage of one choice over the other?

6. Korean Airlines (KAL) has just signed a contract with Boeing to purchase two new jet aircraft
for a total of $60,000,000, with payment, due three months from today. KAL currently has
excess cash of 50,000,000,000 won in a Seoul bank, and it is from these funds that KAL plans to
make its next payment.

          Spot rate                                     1200 won/$

          Three-month forward rate                      1179 won/$

          Korean three-month interest rate               5% per annum

          U.S. three-month interest rate                4% per annum

These are the only rates available to KAL for either borrowing or investing.

A three-month call option in the over-the-counter (bank) market at a strike price of 1189
won/$ sells at a premium of 0.5% payable at the time the option is purchased.

KAL's foreign exchange advisor forecasts the spot rate in three months to be 1192 won/$.

How should KAL plan to make the second payment to McDonnell Douglas if KAL's goal is to
maximize the amount of won cash left in the bank at the end of three months? That is, how
much in won would be left under each possible alternative? Which alternative do you
recommend, and why?

     CH. 11,12,13 INTERNATIONAL FINANCIAL INSTITUTIONS AND MARKETS

* INTERNATIONAL BUSINESS AGENCIES
- IMF

- IBRD/IFC/IDA

- WTO

- BIS

- REGIONAL AGENCIES



        International Money and Capital Markets

·       What are required for business development?

·       Different types of financing based on the length of instrument maturity

·       Int’l Banking Services

    *Types of services

                 -      trade financing – L/C

                 -      currency exchange transactions

                 -      hedging transactions (A/R or A/P denominated in FC using derivatives)

                 -      consulting services on international business/finance

    * Access to international financial markets

    * Merchant banks – both commercial and investment banking (Glass-Steagall Act)

    * Universal banks/full service bank

·     Why a bank wants to establish multinational operations? 1) not subject to regulations of the
    country of the currency, 2) very competitive

·       Capital Adequacy Standards

         -      How much reserves (equity/retained earnings and supplemental capital) does the
             bank hold against risky assets. Larger reserves -> safer bank!

·       International Money Markets
       -       Eurocurrency – time deposit (CD) in a currency, outside of the country of the
            currency. E.g., Eurodollar: $ deposit in a bank outside of the US.

·     International Capital Markets

       - Eurocredit (Euronotes) – medium-term funds

Note: Eurobanks control interest rate risk using floating rate Eurocredit loans or Forward Rate
Agreement (FRA, an interbank contract allowing the Eurobank to hedge the interest rate risk in
mismatched (maturity) deposits and loans by the forward rate).

           - Eurobonds – long-term cf) foreign bonds: issued by a foreign investor

* International Stock Markets

* Valuation of Foreign Stocks

* How to invest internationally

* Exchange rate risk of foreign stocks



                     CH. 14 INTEREST RATE AND CURRENCY SWAPS

* INTEREST SWAPS: Interest payments based on a notional principal exchanged between two
counterparts periodically. A typical interest rate swap (plain vanilla) has fixed payment on one party
and variable payment based on an index rate (LIBOR) for the other party.

- EXAMPLE: Assuming the notional amount of $100m

Co. A is fuding a fixed-rate investment yielding 13.25% by a floating rate loan, Libor+.5%

Co. B is funding a loading-rate investment, Libor+.75% by a 11% fixed-rate loan.

       => Both may be interested in a swap deal that results in positive locked-in spreads. For
       examples, Co. A offers Libor for say 11.5% to B.

       A Swap Bank may engage in a swap deal

       * Risks in interest rate swaps – Basis, Credit

       * Pricing factors: prevailing current and expected future interest rates, availability of
       counterparties, your risk aversion, credit risk, etc.
       * Interest rate swaps can be used to reduce the costs of funding. See P.333 example. In
       this case, you need to identify the comparative advantages. Co. A has L+!% revenue
       which can be financed by 10% or L%, while Co. B has 13% project funded by 11.25% or
       L+.5%. QSD(quality spread differential)?

* CURRENCY SWAPS

Example: Co. A has $10m project financed by 5m BPs, while Co B has 5m BP project financed by
$10m. The returns on the both projects are 10% and the costs of funding are 7%. Set the swap rate
at say $2/BP, both companies expected to enjoy positive profits.

* Debt for Equity Swap pp. 276-278

MNC purchases LDC debt (e.g., $100m Mexican government debt) for $60m (40% discount from
the face value). The Central Bank of Mexico buys back the debt at say 80% of the face value. The
MNC has $80 worth of Mexican pesos and invested in Mexico.



            CH. 18, 19, 20, 21 OTHER ISSUES IN INTERNATIONAL FINANCE

								
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