UNIVERSITY OF LETHBRIDGE
Faculty of Management
Management 3460 - Institutions and Practices in International Finance
Instructions: Each question is worth 6 marks to a maximum of 100 marks total. The assignment is
worth 10% of your final grade. Due at 4:30pm November 20th 2003. Assignments can be dropped
off in the assignment box next to E566. Include a cover page with course number, instructor’s
name, date, and your name and ID number.
1. Explain using, supply and demand, the market for loanable funds.
Q* Q** Loanable funds
Money markets determine the price of loanable funds—the interest rate and the equilibrium
quantity bought and sold. More money (funds or bonds) is offered the higher the interest rate
(price). Less money is demanded the higher the interest rate, and vice versa. An increase in the
money supply for example lowers the interest rate c.p.(shown above). An increase in demand with
S1 will push up the interest rate. [Other examples can also be used]
2. Explain what capital adequacy means, describe the BIS Basle Accord and the reasons for
requiring sufficient capital.
Bank capital adequacy refers to the amount of equity capital and other securities a bank holds as
reserves. There are various standards and international agreements regarding how much bank
capital is “enough” to ensure the safety and soundness of the banking system. Traditional bank
capital standards may be enough to protect depositors from traditional credit risk, they may not be
sufficient protection from derivative risk.
3. A bank has a $1,000,000 portfolio of investments and bank credits. The daily standard
deviation of return on this portfolio is .575 percent. The Basle Accord capital adequacy
standards require the bank to maintain capital equal to its VAR, calculated over a 10-day
holding period at a maximum 1 percent loss level. What is the capital charge for the bank?
Value-at-Risk (VAR) = Portfolio Value X Daily Standard Deviation of return X Confidence
Interval factor X SQRT(time horizon)
$1,000,000 X .00575 X 2.326 X 3.1622 = $42,292.84
4. What is the International Monetary Fund’s mandate? What are the criticisms leveled at the
IMF from client countries?
The IMF promotes international monetary cooperation; facilitates the expansion and balanced
growth of international trade; promotes exchange stability; assists in the establishment of a
multilateral system of payments; and makes its resources available (under adequate safeguards) to
members experiencing balance of payments difficulties. More generally, the IMF is responsible
for ensuring the stability of the international monetary and financial system—the system of
international payments and exchange rates among national currencies.
It has been criticized by clients for requiring unsuitable monetary and fiscal policies that
restrict a country’s ability to climb out of debt or fiscal difficulties.
5. The Fisher effect suggests that nominal interest rates differ between countries because of
differences in the respective rates of inflation. According to the Fisher effect and your
examination of the one-year Eurocurrency interest rates presented in the table below, rank the
currencies from the eight countries from highest to lowest in terms of the size of the inflation
premium embedded in the nominal interest rates.
Short Term 7 days notice One month Three months Six months One Year
British sterling, Danish krone, Euro, Canadian dollar, U.S. dollar, Swiss franc, Singapore dollar,
and Japanese yen.
6. A bank sells a “three against six” $5,000,000 FRA for a three-month period beginning three
months from today and ending six months from today. The purpose of the FRA is to cover the
interest rate risk caused by the maturity mismatch from having made a three-month Eurodollar
loan and having accepted a six-month Eurodollar deposit. There are 91 days in the three-month
FRA period. The agreement rate with the buyer is 5.25 percent.
A) Assume that three months from today the settlement rate is 4.875 percent. Determine
how much the FRA is worth and who pays whom?
Since the settlement rate is less than the agreement rate, the buyer pays the seller the absolute
value of the FRA. The absolute value of the FRA is:
Note Amount X (SR-AR) X days/360
1+ (SR X days/360)
$5,000,000 x [(.04875-.0525) x 91/360]/[1 + (.04875 x 92/360)]
= $5,000,000 x [-.00095/(1.012323)]
B) Assume the settlement rate is 6.125 percent. What is the answer for this rate?
Seller pays the buyer the absolute value of the FRA.
$5,000,000 x [(.06125-.0525) x 91/360]/[1 + (.06125 x 92/360)]
= $5,000,000 x [.002212/(1.015483)]
7. Briefly discuss the cause of the international bank crisis involving less-developed countries.
What solutions to the problem were devised? Explain.
The international debt crisis began on August 20, 1982 when Mexico asked more than 100 U.S.
and foreign banks to forgive its $68 billion in loans. Soon Brazil, Argentina and more than 20
other developing countries announced similar problems in making the debt service on their bank
loans. At the height of the crisis, Third World countries owed $1.2 trillion!
The international debt crisis had oil as its source. In the early 1970’s, the Organization of
Petroleum Exporting Countries (OPEC) became the dominant supplier of oil worldwide.
Throughout this time period, OPEC raised oil prices dramatically and amassed a tremendous
supply of U.S. dollars, which was the currency generally demanded as payment from the oil
OPEC deposited billions in Eurodollar deposits; by 1976 the deposits amounted to nearly
$100 billion. Eurobanks were faced with a huge problem of lending these funds in order to
generate interest income to pay the interest on the deposits. Third World countries were only too
eager to assist the equally eager Eurobankers in accepting Eurodollar loans that could be used for
economic development and for payment of oil imports. The high oil prices were accompanied by
high interest rates, high inflation, and high unemployment during the 1979-1981 period. Soon,
thereafter, oil prices collapsed and the crisis was on.
Today, most debtor nations and creditor banks would agree that the international debt
crisis is effectively over. U.S. Treasury Secretary Nicholas F. Brady of the Bush Administration is
largely credited with designing a strategy in the spring of 1989 to resolve the problem. Three
important factors were necessary to move from the debt management stage, employed over the
years 1982-1988 to keep the crisis in check, to debt resolution. First, banks had to realize that the
face value of the debt would never be repaid on schedule. Second, it was necessary to extend the
debt maturities and to use market instruments to collateralize the debt. Third, the LDCs needed to
open their markets to private investment if economic development was to occur. Debt-for-equity
swaps helped pave the way for an increase in private investment in the LDCs. However, monetary
and fiscal reforms in the developing countries and the recent privatization trend of state owned
industry were also important factors.
Treasury Secretary Brady’s solution was to offer creditor banks one of three alternatives:
(1) convert their loans to marketable bonds with a face value equal to 65 percent of the original
loan amount; (2) convert the loans into collateralized bonds with a reduced interest rate of 6.5
percent; or, (3) lend additional funds to allow the debtor nations to get on their feet. The second
alternative called for an extension the debt maturities by 25 to 30 years and the purchase by the
debtor nation of zero-coupon U.S. Treasury bonds with a corresponding maturity to guarantee the
bonds and make them marketable. These bonds have come to be called Brady bonds.
8. What factors do Standard & Poor analyze when determining the credit rating it assigns a
In rating a sovereign government, S&P’s analysis centers around an examination of the degree of
political risk and economic risk. In assessing political risk, S & P examines the stability of the
political system, the social environment, and international relations with other the countries.
Factors examined in assessing economic risk include the sovereign’s external financial position,
balance of payments flexibility, economic structure and growth, management of the economy, and
economic prospects. The rating assigned a sovereign is particularly important because it usually
represents the ceiling for ratings S&P will assign an obligation of an entity domiciled within that
9. You are an investment banker advising a Eurobank about a new international bond offering it
is considering. The proceeds are to be used to fund Eurodollar loans to bank clients. What
type of bond instrument would you recommend the bank issue? Why?
Since the Eurobank desires to use the bond proceeds to finance Eurodollar loans, which are
floating-rate loans, the investment banker should recommend that the bank issue FRNs, which are
a variable rate instrument. Thus there will a correspondence between the interest rate the bank
pays for funds and the interest rate it receives from its loans. For example, if the bank frequently
makes term loans indexed to 3-month LIBOR, it might want to issue FRNs, also, indexed to 3-
10. Explain the difference between bearer bonds and registered bonds. What are the advantages of
each to the buyer? To the seller?
Bearer bonds do not have to meet the strict registration requirements and provide anonymity to the
owner and thus allow a means for evading taxes on the interest received. Because of this feature,
investors are generally willing to accept a lower yield on Eurodollar bonds in comparison to
registered bonds of comparable terms, where ownership is recorded. For borrowers the lower
yield means a lower cost of debt service. For sellers they are easier to market.
11. The discussion of zero-coupon bonds in the text gave an example of two zero-coupon bonds
issued by Commerzbank. The DM300,000,000 issue due in 1995 sold at 50 percent of face
value, and the DM300,000,000 due in 2000 sold at 33 1/3 percent of face value; both were
issued in 1985. Calculate the implied yield to maturity of each of these two zero-coupon bond
Zero coupon bonds are sold at a discount from face value and do not pay any coupon interest over
their life. At maturity the investor receives the full face value.
The bonds due in 1995 sold at 50% percent of face value. Since they were issued in 1985,
they had a ten year maturity. Assuming a DM1,000 par value, their yield-to-maturity is:
(DM1,000/DM500)1/10 - 1 = .07177 or 7.177% per annum.
The bonds due in year 2000 sold at 33 1/3%. They have a 15 year maturity. Their yield-
to-maturity is: (DM1,000/DM333.33)1/15 - 1 =.07599 or 7.599% per annum.
12. A bond is issued with a 5 year maturity with annual coupons paying C$10,000 to the bearer.
The par value of the bond is C$200,000. The expected market interest rates are 5%, 5.25%,
5.5%, 5.75%, & 6% in year 1,2, 3, 4, & 5 respectively..
A) Calculate the present value (price) of this bond today.
B) If expected inflation rates were 2%, 2%, 1.5%, 2%, & 2.5% in year 1, 2, 3, 4, & 5
respectively, what will the present value of the bond be? Explain.
Year 1 2 3 4 5
Annual Payment 10,000 10,000 10,000 10,000 210,000
Discount rate 1.05 1.0525 1.055 1.0575 1.06
PVi 9,523.81 9,027.26 8,516.14 7,996.11 156,924.22
Inflation rates would not change this PV (price) as both Annual payments and the interest
rate would be changed by the same rate and would cancel out.
13. Explain the workings of primary market and secondary markets for equity securities. How can
liquidity of equities be measured? Why is liquidity important? How can market concentration
be measured? Why is concentration important?
Primary markets are for issuing new shares (stock) and are usually offered through a brokerage
firm. Secondary markets trade existing shares in corporations listed on the stock exchange—for
example the TSX in Canada. The concentration ratio of a country’s stock market is frequently
calculated to show the market value of the ten largest stocks traded as a fraction of the total market
capitalization of all equities traded. The higher the concentration ratio, the less deep is the market.
That is, most value is concentrated in only a few companies. While this does not necessarily
imply that the largest stocks in the emerging market are not good investments, it does, however,
suggest that there are few opportunities for investment in that country and that proper
diversification within the country may be difficult. In terms of liquidity, an investor would be
wise to examine the market turnover ratio of the country’s stock market. High market turnover
suggests that the market is liquid, or that there are opportunities for purchasing or selling the stock
quickly at close to the current market price. The bid ask spread is also an indicator of liquidity
being higher the less liquid a stock is. This is important because liquidity means you can get in or
out of a stock position quickly without spending more than you intended on purchase or receiving
less than you expected on sale.
14. Why might it be easier for an investor desiring to diversify his portfolio internationally to buy
depository receipts (DRs) rather than the actual shares of the company? Compare exchange
traded funds (ETFS) to DRs as a form of international portfolio diversification.
A depository receipt can be purchased on the investor’s domestic exchange. It represents a
package of the underlying foreign security that is priced in the investor’s local currency and in a
trading range that is typical for the investor’s marketplace. The investor can purchase a depository
receipt directly from his domestic broker, rather than having to deal with an overseas broker and
the necessity of obtaining foreign funds to make the foreign stock purchase. Additionally,
dividends are received in the local currency rather than in foreign funds that would need to be
converted into the local currency. ETFs have all of the same advantages and also offer a
diversified foreign portfolio where DRs are based single company shares.
15. Explain the factors affecting international equity returns.
There are three likely factors affecting returns: macroeconomic factors, the exchange rate, and
industrial structure (microeconomic environment)
Macroeconomic factors include monetary and fiscal policy; monetary policy affects the
interest rate, the exchange rate, and the balance of payments. Evidence cited in the textbook
suggests the relationships to equity returns are weak.
Exchange rate changes initially seem to be a factor, however the relationship is also weak
Industrial structure is the highest correlated to equity returns in some research but the textbook
authors and others find small relationship correlation.
16. Fiat stock closed on the Milan bourse at EUR11.17 per share. On the same day the $/EUR spot
exchange rate was $0.9764/EUR1.00. Fiat also trades as an ADR on the NYSE, with one
underlying Fiat share equal to one ADR.
A) At this exchange rate, what is the no-arbitrage U.S. dollar price of one ADR?
B) If Fiat ADRs were trading at $15 when the underlying shares were trading in Milan at
EUR11.17, what could you do to earn a trading profit? Use the information above
and assume that transaction costs are negligible.
A) The no-arbitrage ADR U.S. dollar price is: EUR11.17 x $0.9764 = $10.91.
B) Using the solution to A) the no-arbitrage ADR U.S. dollar price is $10.91. If Fiat ADRs
were trading at $15, a wise investor would sell short the relatively overvalued ADRs.
Since the ADRs are a derivative security, one would expect the ADRs to fall in price from
$15 to $10.91. Assuming this happens, the short position could be liquidated for a profit of
$15 - $10.91 = $4.09 per ADR.
17. Explain why the returns on equities are less correlated across countries than within a country.
While national security markets have become more integrated in recent years, there is still a
tremendous amount of segmentation that brings about the benefit to be derived from international
diversification of financial assets. Monetary and fiscal policies differ among countries because of
different economic circumstances. The economic policies of a country directly affect the
securities traded in the country, and they will behave differently than securities traded in another
country with other economic policies being implemented. Hence, it is not surprising that domestic
factors are found to be more important than international factors in affecting security returns.
Similarly, industrial activity within a country is also affected by the economic policies of the
country; thus firms in the same industry group, but from different countries, will not necessarily
behave the same in all countries, nor should we expect the securities issued by these firms to
18. What is the ‘world beta’ of a security? How is it calculated? Explain the concept of the Sharpe
performance measure. How is it calculated?
The world beta measures the sensitivity of returns to a security to returns to the world market
portfolio. It is a measure of the systematic risk of the security in a global setting. Statistically, the
world beta can be defined as: Cov(Ri, RM)/Var(RM), where Ri and RM are returns to the I-th
security and the world market portfolio, respectively.
The Sharpe performance measure (SHP) is a risk-adjusted performance measure. It is
defined as the mean excess return to a portfolio above the risk-free rate divided by the portfolio’s
standard deviation. SHP = (Ri – Rf)/σi
19. Explain how exchange rate changes affect the risk of a foreign investment?
It is useful to refer to Equations 11.4 and 11.5 of the text. Exchange rate fluctuations mostly
contribute to the risk of foreign investment through its own volatility as well as its covariance with
the local market returns. The covariance tends to be positive in most of the cases, implying that
exchange rate changes tend to add to exchange risk, rather than offset it. Exchange risk is found to
be much more significant in bond investments than in stock investments.
Exchange rate changes need not always increase the risk of foreign investment. When the
covariance between exchange rate changes and the local market returns is sufficiently negative to
offset the positive variance of exchange rate changes, exchange rate volatility can actually reduce
the risk of foreign investment.
20. An international equity portfolio manager recognizes that optimal country allocation strategy combined
with an optimal currency strategy should produce optimal portfolio performance. To develop a strategy
she produced the table below, which provides expected return data for the three countries and three
currencies in which she may invest. The table contains the information she needs to make market
strategy (country allocation) decisions and currency strategy (currency allocation) decisions.
Expected Returns for a U.S.-Based Investor
Country Local Currency Exchange Rate Local Currency
Equity Returns Returns Eurodeposit Returns
Japan 7.0% 1.0% 5.0%
United Kingdom 10.5 -3.0 11.0
United States 8.4 0.0 7.5
A) Prepare a ranking of the three countries in terms of expected equity-market return premiums.
Show your calculations.
B) Prepare a ranking of the three countries in terms of expected currency return premiums from
the perspective of a U.S. investor. Show your calculations.
C) Explain one advantage a portfolio manager obtains, in formulating a global investment
strategy, by calculating both expected market premiums and expected currency premiums.
A) United Kingdom = first; United States = second; Japan = third.
B) Japan = first; United States = second; United Kingdom = third.
C) Computing expected currency premium helps the portfolio manager to decide whether to hedge