e
International Financial
Financial
International
Management
Management
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Prof.Anuj Verma
Verma
11
Introduction:
Introduction:
International
International Financial
Financial
Management
Management
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OVERVIEW:
OVERVIEW:
I.I.
II.
II.
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The Rise
Rise of
of the
the Multinational
Multinational
The
Corporation
Corporation
The
The Internationalization
Internationalization of
of
Business
Business and
and Finance
Finance
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I.
The MNC:
I. The
MNC: Definition
Definition
aa company
company with
with production
production and
and
distribution
distribution facilities
facilities in
in more
more than
than
one
one country.
country.
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A. Forces
A.
Forces Changing
Changing Global
Global Markets
Markets
Massive
Massive deregulation
deregulation
Privatizations
Privatizations of
of state-owned
state-owned industries
industries
Revolution
Revolution in
in information
information technology
technology
Wave
Wave of
of M&A
M&A
Emergence
Emergence of
of free
free market
market policies
policies
Rise
Rise of
of Big
Big Emerging
Emerging Markets
Markets (BEMs)
(BEMs)
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B.
B. Prime
Prime Transmitter
Transmitter of
of Competitive
Competitive
Forces
Forces in
in the
the Global
Global Economy:
Economy:
The MNC
The
MNC emphases
emphases group
group performance
performance such
such
as
as
Global
Global coordinated
coordinated allocation
allocation of
of resources
resources
Market
Market —– entry
entry strategy
strategy
Ownership
Ownership of
of foreign
foreign operations
operations
Production,
Production, marketing
marketing and
and financial
financial activities
activities
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C.
THE MNC
C. EVOLUTION
EVOLUTION OF
OF THE
MNC
Reasons
Reasons to
to Go
Go Global:
Global:
1.
1. More
More raw
raw materials
materials
2.
2. New
New markets
markets
3.
3. Minimize
Minimize costs
costs of
of
production
production
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RAW
RAW MATERIAL
MATERIAL SEEKERS
SEEKERS
exploit
exploit markets
markets in
in other
other countries
countries
historically
historically first
first to
to appear
appear
modern-day
modern-day counterparts
counterparts
British Petroleum
Petroleum
British
Exxon
Exxon
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MARKET
MARKET SEEKERS
SEEKERS
produce
produce and
and sell
sell in
in foreign
foreign markets
markets
heavy
heavy foreign
foreign direct
direct investors
investors
representative
representative firms:
firms:
IBM
IBM
MacDonald’s
MacDonald’s
Nestle
Nestle
Levi
Levi Strauss
Strauss
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COST
COST MINIMIZERS
MINIMIZERS
seek
seek lower-cost
lower-cost production
production abroad
abroad
motive:
motive: to
to remain
remain cost
cost competitive
competitive
Texas
Texas Instruments
Instruments
Intel
Intel
Seagate
Seagate Technology
Technology
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10
D.
THE MNC:
D. THE
MNC: AA BEHAVIORAL
BEHAVIORAL
VIEW
VIEW
1. State
State of
of mind:
mind:
1.
committed to
to producing,
producing,
committed
undertaking
undertaking investment
investment
and
and marketing,
marketing, and
and
financing globally.
globally.
financing
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11
E.
THE GLOBAL
E. THE
GLOBAL MANAGER
MANAGER
1.
1. Understands
Understands political
political and
and
economic
economic differences;
differences;
2.
2. Searches
Searches for
for most
most costcosteffective
effective suppliers;
suppliers;
3.
3. Evaluates
Evaluates changes
changes on
on value
value
of
of the
the firm.
firm.
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12
The
Internationalization of
Business
The Internationalization
of Business
and
Finance
and Finance
I. Globalization
Globalization
I.
A.
Political
A.
Political and
and Labor
Labor Union
Union
Concerns
Concerns
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13
B. Consequences
Consequences of
of Global
Global
B.
Competition
Competition
Acceleration of
Acceleration
of the
the global
global economy
economy
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14
Four Facets
Facets to
to Understand
Understand the
the Concept
Concept of
of International
International
Four
Financial Management
Management in
in India:
India:
Financial
Foreign Exchange
Exchange
Foreign
Foreign exchange
exchange is
is an
an additional
additional risk
risk that
that aa finance manager is
is
Foreign
required to
to cater
cater to
to in
in an
an international
international setting.
setting. Foreign
Foreign exchange
exchange
required
risk refers
refers to
to the
the risk
risk related
related to
to fluctuating
fluctuating prices
prices of
of currency
currency
risk
that
that has
has the
the potential
potential to
to convert
convert aa profitable
profitable deal
deal into
into aa losslossmaking one.
one.
making
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15
Political
Political Risks
Risks
Political
Political risks
risks may
may include
include any
any change
change in
in the
the business
business economic
economic
environment
environment of
of the
the country.
country. These
These changes
changes can
can include
include Taxation
Taxation
Rules,
Rules, Contract
Contract Act,
Act, or
or any
any unforeseen
unforeseen government
government action.
action. It
It
pertains
pertains to
to the
the government
government of
of aa country
country that
that can
can change
change the
the
rules
rules of
of the
the game
game anytime,
anytime, in
in an
an unexpected
unexpected manner.
manner.
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16
Market
Market Imperfection
Imperfection
Due
Due to
to market and product integration,, the
the world
world economy
economy
faces
faces aa lot
lot of
of differences
differences across
across the
the countries
countries in
in terms
terms of
of
transportation
transportation cost,
cost, different
different taxation
taxation systems,
systems, etc.
etc. Imperfect
Imperfect
markets
markets force
force the
the finance
finance manager
manager to
to strive
strive for
for the
the best
best
opportunities
opportunities across
across international
international borders.
borders.
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17
Enhanced Opportunity
Opportunity Set
Set
Enhanced
By
By taking
taking the
the business
business across
across national
national borders,
borders,
expands its
its chances
chances of
of reaping
reaping fruits
fruits of
of aa different
different
aa business expands
taste. Not
Not only
only does
does it
it enhance
enhance the
the opportunity
opportunity for
for more
more
taste.
business
business but
but also
also diversifies
diversifies the
the overall
overall risk
risk of
of business
business to
to
various nations.
nations.
various
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18
THE
DETERMINATION
THE DETERMINATION
OF
OF EXCHANGE
EXCHANGE RATES
RATES
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A Brief
Brief History
History of
of the
the International
International
A
Monetary
Monetary System:
System:
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20
|
A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
I. THE USE OF GOLD
A. Desirable properties
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B.
In short run:
C.
In long run:
High production costs limit
changes.
Commodity money insures
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21
II.
The Classical Gold Standard
(1821-1914)
A.
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Major global currencies on gold
standard.
1.
Nations fix the exchange rate
in terms of a specific amount
of gold.
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22
III.
The Gold Exchange Standard
(1925-1931)
A.
Only U.S. and Britain allowed
to hold gold reserves.
Others could hold both gold, dollars
or pound reserves.
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23
The Bretton Woods System (1946-1971)
1.
URS
ol OUl again
valued at $1 - 1/35 oz. of
gold.
All currencies linked to that
a fixed rate system.
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price in
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24
B.
Exchange rates allowed to fluctuate
by 1% above or below initially set
rates.
Collapse, 1971
iW
= [0IS Sos
a.
U.S. high inflation rate
b.
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U.S.$ depreciated sharply.
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25
Post-Bretton Woods System (1971-Present)
A.
Smithsonian Agreement,
1971:
US$ devalued to 1/38 oz. of gold.
By 1973: World on a freely floating
exchange rate system.
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26
Currencies devalued in 1931
- led to trade wars.
Bretton Woods
Conference
- called in order to avoid
future protectionist and
destructive economic policies
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27
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
I. SETTING
SETTING THE
EQUILIBRIUM
I.
THE EQUILIBRIUM
A. Exchange
A.
Exchange Rates
Rates
market-clearing
market-clearing prices
prices that
that
equilibrate
equilibrate the
the quantities
quantities
supplied
Supplied and
and demanded
demanded of
of
foreign currency.
currency.
foreign
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28
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
B.
Americans Purchase
B. How
How Americans
Purchase
German
German Goods
Goods
1.
1. Foreign
Foreign Currency
Currency Demand
Demand
-derived
-derived from
from the
the demand
demand for
for
foreign
foreign country’s
country’s goods,
goods,
services,
services, and
and financial
financial
assets.
assets.
e.g.
The demand
e.g. The
demand for
for German
German
goods
Americans
goods by
by Americans
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29
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
2.
2. Foreign
Foreign Currency
Currency Supply:
Supply:
a.
a. derived
derived from
from the
the foreign
foreign
country’s
country’s demand
demand for
for
local
local goods.
goods.
b.
They must
b. They
must convert
convert their
their
currency
currency to
to purchase.
purchase.
e.g.
e.g. German
German demand
demand for
for US
US goods
goods
means
means Germans
Germans convert
convert €€ to
to US
US
in order
order to
to buy
buy. .
$¢ in
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30
MN
Dollar Price of one € (1€ =
$e)
= $e)
S
w
cz
w
=
©
e€oo
Co
©
&
2
a
D
D
Sum
S
o
a
Q
Qoo
Quantity
Quantity of
of €€
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Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
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31
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
3.
3. Equilibrium
Equilibrium Exchange
Exchange Rate:
Rate:
occurs
occurs when
when the
the quantity
quantity
supplied
Supplied equals
equals the
the quantity
quantity
demanded
demanded of
of a
a foreign
foreign
currency
currency at
at a
a specific
specific local
local
price.
price.
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32
|
Y
Jb
:
* *
|| Ne
~
-
P
a
y
|
|
|
|
Impact
Impact of
of Relative
Relative Inflation
Inflation Rate
Rate
x
s
~
~
s
s
s
s
s
s
s
S
s
s
s
s
L ¢
sy
S
&
e1
eo
¢
¢
S
S
.
¢
y
: eos
s
s
¢
¢
¢
¢
¢
¢
7
:
¢
¢
—
¢
L
S
¢
:
¢
¢
¢
:
7
¢
S
@
°
Dollar Price
Price of
of one
one €€ (€1
(€1 =
Dollar
$e)
= $e)
sy
D
Q
Qoo
Quantity
Quantity of
of €€
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33
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
C.
C. How
How Exchange
Exchange Rates
Rates Change
Change
1.
1. Increased
Increased demand
demand
as
as more
more foreign
foreign goods
goods are
are
demanded,
demanded, the
the price
price of
of the
the
foreign
foreign currency
currency in
in local
local
currency
currency increases
increases and
and vice
vice
versa.
versa.
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34
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
2.
2. Home
Home Currency
Currency Depreciation
Depreciation
a.
d.
b.
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Foreign
Foreign currency
currency becomes
becomes
more
more valuable
valuable than
than the
the home
home
currency.
currency.
The
The foreign
foreign currency’s
currency’s
value
value has
has appreciated
appreciated against
against
the
the home
home currency.
currency.
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Prof.Anuj
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35
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
3.
3. Calculating
Calculating a
a Depreciation:
Depreciation:
Currency
Currency Depreciation
Depreciation
=
e0 − e1
=
e
aa1
where
where ee,0 =
= old
old currency
currency value
value
ee,1 =
= new
new currency
currency value
value
Note:
Note: Resulting
Resulting sign
sign is
Is always
always negative
negative
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36
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
Currency
Appreciation
Currency Appreciation
e
e
0
1 −
€,
—
€g
=
e
Eo0
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37
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
EXAMPLE: dm
dm Appreciation
EXAMPLE:
Appreciation
If the
the dollar
dollar value
value of
of the
the dm
dm goes
goes from
from
If
$0.64
$0.64 (e
(e,)0) to
to $0.68
$0.68 (e
(e,),
then the
the dm
dm
1), then
has
has appreciated
appreciated by
by
e1 − e0
=
e0
=
= (.68
(.68 -- .64)/
.64)/ .64
.64
=
= 6.25%
6.25%
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38
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
EXAMPLE:
EXAMPLE: US$
US$ Depreciation
Depreciation
We
We use
use the
the first
first formula,
formula,
(e
(€)0 -- e
€,)/
e,1
1)/ e
substituting
substituting
(.64
(,64 -- .68)/
.68)/ .68
.68 =
= -- 5.88%
5.88%
which
which is
is the
the value
value of
of the
the US$
US$
depreciation.
depreciation.
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39
Equilibrium
Equilibrium Exchange
Exchange Rates
Rates
D.
AFFECTING
D. FACTORS
FACTORS AFFECTING
EXCHANGE
EXCHANGE RATES:
RATES:
1.
Inflation
1.
Inflation rates
rates
2.
Interest
2.
Interest rates
rates
3.
GDP
3.
GDP growth
growth rates
rates
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40
ILLUSTRATION
Calculating the Amount of Yen Depreciation Against
the Dollar
During 1995, the yen went from $0.0125 to $0.0095238. By how much did the yen depreciate against the dollar?
By how much has the dollar apptecated
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Prof.Anuj Verma
Verma
against the yen?
41
4]
Sw
a
ILLUSTRATION
| ae
oe
Calculating Yugoslav Dinar Devaluation
April 1, 1998, was an ill-fated date in Yugoslavia. On that day, the government. devalued
the Yugoslav dinar, setting its new rate at 10.92 dinar to the dollar, from 6.0 dinar previously. By how much has the dinar devalued against the dollar?
By how much has the dollar appreciated against the dinar?
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42
ILLUSTRATION Calculating Dollar Appreciation Against the Thai Baht
On July 2, 1997, the Thai baht fell 17% against the U.S. dollar. By how much has the dol-
lar appreciated against the baht?
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43
PARITY
PARITY CONDITIONS
CONDITIONS
AND
AND
CURRENCY
CURRENCY
FORECASTING
FORECASTING
44
OVERVIEW
OVERVIEW
I.
I.
ARBITRAGE
ARBITRAGE AND
AND THE
THE LAW
LAW OF
OF
ONE
ONE PRICE
PRICE
II.
PURCHASING
IT.
PURCHASING POWER
POWER PARITY
PARITY
III.
ITI. THE
THE FISHER
FISHER EFFECT
EFFECT
IV.
INV. THE
THE INTERNATIONAL
INTERNATIONAL FISHER
FISHER EFFECT
EFFECT
V. INTEREST
V.
INTEREST RATE
RATE PARITY
PARITY THEORY
THEORY
VI. THE
VI.
THE RELATIONSHIP
RELATIONSHIP BETWEEN
BETWEEN
THE FORWARD
AND FUTURE
THE
FORWARD AND
FUTURE
SPOT
SPOT RATE
RATE
VII. CURRENCY
VII.
CURRENCY FORECASTING
FORECASTING
45
45
ARBITRAGE AND
AND THE
LAW OF
ARBITRAGE
THE LAW
OF ONE
ONE
PRICE
PRICE
I.
I.
THE LAW
LAW OF
OF ONE
ONE PRICE
PRICE
THE
A.
Law states:
states:
A. Law
Identical
Identical goods
goods sell
sell for
for the
the
same
Same price
price worldwide.
worldwide.
46
46
ARBITRAGE AND
AND THE
LAW OF
ARBITRAGE
THE LAW
OF ONE
ONE
PRICE
PRICE
B.
B.
Theoretical
basis:
Theoretical basis:
If
If the
the price
price after
after exchange-rate
exchange-rate
adjustment
adjustment were
were not
not equal,
equal,
arbitrage
arbitrage in
in the
the goods
goods worldwide
worldwide
ensures
ensures eventually
eventually it
it will.
will.
47
47
ARBITRAGE
THE LAW
OF ONE
ONE
ARBITRAGE AND
AND THE
LAW OF
PRICE
PRICE
Five
Five Parity
Parity Conditions
Conditions Result
Result
From
These Arbitrage
Arbitrage Activities
Activities
From These
WNP
1.
2.
3.
4.
5.
“ie
C.
C,
Purchasing
Purchasing Power
Power Parity
Parity (PPP)
(PPP)
The
The Fisher
Fisher Effect
Effect (FE)
rE)
The
The International
International Fisher
Fisher Effect
Effect
(IFE)
(IFE)
Interest
Interest Rate
Rate Parity
Parity (IRP)
(IRP)
Unbiased
Unbiased Forward
Forward Rate
Rate (UFR)
(UFR)
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48
ARBITRAGE
ARBITRAGE AND
AND THE
THE LAW
LAW OF
OF ONE
ONE
PRICE
PRICE
D.
D. Five
Five Parity
Parity Conditions
Conditions Linked
Linked
by
by
1.
1.
The adjustment
The
adjustment of
of various
various
rates
rates and
and prices
prices to
to inflation.
inflation.
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49
ARBITRAGE
ARBITRAGE AND
AND THE
THE LAW
LAW OF
OF ONE
ONE
PRICE
PRICE
2.
The notion
2. The
notion that
that money
money
should
should have
have no
no effect
effect on
on
real
real variables
variables (since
(since they
they
have
have been
been adjusted
adjusted for
for
price
price changes).
changes).
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50
ARBITRAGE
ARBITRAGE AND
AND THE
THE LAW
LAW OF
OF ONE
ONE
PRICE
PRICE
E.
E.
Inflation
Inflation and
and home
home currency
currency
depreciation:
depreciation:
1.
jointly determined
1.
jointly
determined by
by the
the
growth
growth of
of domestic
domestic
money
supply;
money
supply;
2.
Relative
2.
Relative to
to the
the growth
growth of
of
domestic
domestic money
money demand.
demand.
51
51
ARBITRAGE
ARBITRAGE AND
AND THE
THE LAW
LAW OF
OF ONE
ONE
PRICE
PRICE
F.
F. THE
THE LAW
LAW OF
OF ONE
ONE PRICE
PRICE
-- enforced
enforced by
by international
international
arbitrage.
arbitrage.
52
52
PURCHASING
PURCHASING POWER
POWER PARITY
PARITY
I.THE
THEORY OF
I. THE THEORY
OF PURCHASING
PURCHASING
POWER PARITY:
PARITY:
POWER
states
States that
that spot
spot exchange
exchange rates
rates
between
between currencies
currencies will
will change
change to
to
the
the differential
differential in
in inflation
inflation rates
rates
between
between countries.
countries.
53
53
PURCHASING
PURCHASING POWER
POWER PARITY
PARITY
II.
ABSOLUTE PURCHASING
Il. ABSOLUTE
PURCHASING
POWER
POWER PARITY
PARITY
A.
Price levels
levels adjusted
adjusted for
for
A. Price
exchange
exchange rates
rates should
should be
be
equal
equal between
between countries
countries
54
54
PURCHASING
PURCHASING POWER
POWER PARITY
PARITY
II.
ABSOLUTE PURCHASING
Il. ABSOLUTE
PURCHASING
POWER
POWER PARITY
PARITY
B.
B. One
One unit
unit of
of currency
currency has
has
same
Same purchasing
purchasing power
power
globally.
globally.
55
55
PURCHASING
PURCHASING POWER
POWER PARITY
PARITY
III.
III. RELATIVE
RELATIVE PURCHASING
PURCHASING
POWER
POWER PARITY
PARITY
A. states
A.
states that
that the
the exchange
exchange
rate
rate of
of one
one currency
currency against
against
another
another will
will adjust
adjust to
to reflect
reflect
changes
changes in
in the
the price
price levels
levels
of
of the
the two
two countries.
countries.
56
56
PURCHASING
PURCHASING POWER
POWER PARITY
PARITY
1.
1.
In
In mathematical
mathematical terms:
terms:
where
where
e
|t
e
Ho0
(
1 + ih )
a+z,y
t
=
+ i
Z, )
y
(G1 +
t
f
ee,t
ee,0
ii,h
ii;f
tt
=
=
=
=
=
=
=
=
=
=
future
future spot
spot rate
rate
spot
spot rate
rate
home
home inflation
inflation
foreign
foreign inflation
inflation
the
the time
time period
period
57
57
PURCHASING
PURCHASING POWER
POWER PARITY
PARITY
2.
2.
If
If purchasing
purchasing power
power parity
parity is
is
expected
expected to
to hold,
hold, then
then the
the best
best
prediction
prediction for
for the
the one-period
one-period
spot
spot rate
rate should
should be
be
et
_
=
(G-+z,
1 + ih y)
t
t
e0
<< ~~ <0
(G+,
)
1 + i yy
f
58
58
(1 + ih )
t
et > e0
(1 + i )
t
Exports
Exports
f
(1 + ih )
t
et = e0
(1 + i )
t
Equilibrium
Equilibrium
f
(1 + ih )
t
et < e0
(1 + i )
t
Imports
Imports
f
59
59
5
4
Percentage change
change in
in Home
Home currency
currency
Percentage
3
value of
of Foreign
Foreign currency
currency
value
A
2
1
pop
5
-5
-4
4
-3
3
-2
2
!
nnnneee
B
B
|
-1
1
-1
2E
-2
Parity
Parity Line
Line
vee ey Geo
2
35
Imports
Imports
|
|
4
5
FS
Inflation differential,
differential, Home
Home country
country
Inflation
relative
relative to
to Foreign
Foreign country
country (%)
(%)
34
-3
Aut
-4
5 -5
Purchasing Power
Power Parity
Parity
Purchasing
PURCHASING
PURCHASING POWER
POWER PARITY
PARITY
3.
A more simplified
3. Amore
simplified but
but less
less precise
precise
relationship
relationship is
is
et
= ih − i f
e0
that
that is,
is, the
the percentage
percentage change
change should
should be
be
approximately
approximately equal
equal to
to the
the inflation
inflation rate
rate
differential.
differential.
61
61
THE
THE FISHER
FISHER EFFECT
EFFECT (FE)
(FE)
I. THE FISHER
FISHER EFFECT
EFFECT
I.THE
states
states that
that nominal
nominal interest
interest rates
rates
(r) are
are a
a function
function of
of the
the real
real
(r)
interest rate
rate (a)
(a) and
and aa premium
premium (i)
(i)
interest
for inflation
inflation expectations.
expectations.
for
R=atiti
R
= a + i
62
62
THE
FISHER EFFECT
EFFECT
THE FISHER
B.
B. Real
Real Rates
Rates of
of Interest
Interest
1.
1. Should
Should tend
tend toward
toward equality
equality
everywhere
everywhere through
through arbitrage.
arbitrage.
2.
2. With
With no
no government
government
interference
interference nominal
nominal rates
rates vary
vary
by
by inflation
inflation differential
differential or
or
iI,h - ilef
rTyh -- rIef =
—
63
63
5
4
Interest differential
differential in
in favor
favor of
of
Interest
home
home country
country ((%% ))
Parity
Parity Line
Line
32
2
1
-5
-4
-3
-2
-1
1
-1
C
22
33
44
55
Inflation
Inflation Differential
Differential ,, home
home country
country
relative
relative to
to foreign
foreign country(%)
country(%)
-2
Arbitrage
D
outflow from
home country
Li
ie
-3
-4
-5
The Fisher
Fisher Effect
Effect
The
rTh -> rUpf =
~ ityh -7 ilef Equlibrium
Equilibrium
rtT,h -- rVp
f >
> |,ih -— i1¢f
Inflow
Inflow of
of funds
funds from
from foreign
foreign country
country to
to home
home country
country
rTrh -- reS
f < iye
h - idyf Outflow
Outflow of
of funds
funds from
from home
home country
country to
to foreign
foreign country
country
65
65
INTEREST RATE
RATE PARITY
PARITY THEORY
INTEREST
THEORY
I.
I. INTRODUCTION
INTRODUCTION
A. The
Theory states:
A.
The Theory
states:
the
the forward
forward rate
rate (F)
(F) differs
differs
from
from the
the spot
spot rate
rate (S)
(S) at
at
equilibrium
equilibrium by
by an
an amount
amount
equal
equal to
to the
the interest
interest
differential
differential (r
(r,h -- rr.)f) between
between
two
two countries.
countries.
66
66
INTEREST
RATE PARITY
PARITY
NTEREST RATE
THEORY
THEORY
2.
2,
The forward
The
forward premium
premium or
or
discount
discount equals
equals the
the interest
interest
rate
rate differential.
differential.
(F
- S)/S =
(F-S)/S
= (r
(tyh -- rfs)f)
where
where
rr,h =
= the
the home
home rate
rate
rr;f =
= the
the foreign
foreign rate
rate
67
67
INTEREST
INTEREST RATE
RATE PARITY
PARITY
THEORY
THEORY
3.
3.
In
In equilibrium,
equilibrium, returns
returns on
on
currencies
currencies will
will be
be the
the same
same
i.i. e.
e. No
No profit
profit will
will be
be realized
realized
and
and interest
interest parity
parity exists
exists
which
which can
can be
be written
written
(1
rh) =
(1 +
+n)
= EFF
(1
rf)
S
(1 +
+ Fr)
S
68
68
INTEREST
INTEREST RATE
RATE PARITY
PARITY
THEORY
THEORY
B.
B.
Covered
Arbitrage
Covered Interest
Interest Arbitrage
1.
1. Conditions
Conditions required:
required:
interest
interest rate
rate differential
differential does
does
not
not equal
equal the
the forward
forward
premium
premium or
or discount.
discount.
2.
2. Funds
Funds will
will move
move to
to a
a country
country
with
with a
a more
more attractive
attractive rate.
rate.
69
69
5
4
Interest differential
differential in
in
Interest
favor of
of home
home country
country
favor
((%
%) )
Arbitrage
inflow to home
D
country
3
2
a
1
|
|
-5
-4
-3
-2
11
-1
-1
-2
-3
Parity
Parity Line
Line
-4
!
f
!
|
22
Arbitrage
Arbitrage
C
C outflow
outflow
'
from home
home
from
country
|
country
|
33
|
44
|
55
Forward
Forward Premium(+)
Premium(+) or
or
Discount(-)
Discount(-) on
on Foreign
Foreign
Currency
Currency
Points
C &
& DD shows
Points C
shows
covered
covered interest
interest arbitrage
arbitrage
-5
Interest
Interest Rate
Rate Parity
Parity
Point C
C :: Funds
Funds will
will flow
flow from
from Home
Home Country
Country to
to Foreign
Foreign Country
Country
Point
(1
+ r f ) f1
(+ry)f,
<
1I++r,r h
<
eCo0
Point
Point D
D :: Funds
Funds will
will flow
flow from
from Foreign
Foreign Country
Country to
to
Home Country
Country
Home
(1
+ r f ) f1
(l+r,)f,
>
1l++r,r h >
eCo0
Interest
Interest Rate
Rate Parity
Parity holds
holds when
when there
there is
1s no
no Covered
Covered
Interest Arbitrage
Arbitrage
Interest
1I+ry,
+rh
ff,1
=
1l+r,
+rf
eCo0
INTEREST
INTEREST RATE
RATE PARITY
PARITY
THEORY
THEORY
3.
3.
Market
Market pressures
pressures develop:
develop:
a.
As one currency
a. | Asone
currency is
is more
more demanded
demanded spot
spot
and
and sold
sold forward.
forward.
b.
b.
Inflow
Inflow of
of fund
fund depresses
depresses interest
interest rates.
rates.
c.
C.
Parity
Parity eventually
eventually reached.
reached.
72
72
INTEREST
INTEREST RATE
RATE PARITY
PARITY
THEORY
THEORY
C.
C.
Summary:
Summary:
Interest
Interest Rate
Rate Parity
Parity states:
states:
1.
Higher
1.
Higher interest
interest rates
rates on
on a
a
currency
currency offset
offset by
by
forward
discounts.
forward
discounts.
2.
2.
Lower
Lower interest
interest rates
rates are
are
offset
offset by
by forward
forward premiums.
premiums.
73
73
To illustrate this con-
dition, suppose an investor with $1,000,000 to invest for 90 days is trying
to decide between investing in U.S. dollars at 8% per annum (2% for 90 days)
or in euros at 6% per annum (1.5% for 90 days). The current spot rate i
€1.13110/5, and the 90-day forward rate is €1.12556/S. Exhibit 4.14 shows that
ical,
ident
be
will
rn
retu
ed
hedg
his
e,
choic
ency
curr
s
stor
inve
the
of
ss
rdle
reva
00
00,0
$1,0
yield
will
cays
90
for
rs
dolla
in
sted
inve
00
00,0
$1,0
Specifically,
a
on
s
euro
In
t
inves
to
ses
choo
stor
inve
the
if
,
vely
mati
Alte
00,
1.02 = $1,020,0
hedged basis, he will
74
74
| Convert the $1,000,000 to euros at the spot rate of €1.13110/$. This
yields €1,131,100 available for investment.
2. Invest the principal of €1,131,100 at 1.5% for 90 days. At the end of 90 |
|
days, the investor will have € 1 148,066.50.
3, Simultaneously with the other transactions, sell the €1,148,066.50 in
principal plus interest forward at a rate of €1.12556/$ for delivery in 90 days.
This transaction will yield €1,148,066.50/1.12556 = $1,020,000 in 90 days.
If the covered interest differential between two money markets is nonzero,
there is an arbitrage incentive to move money from one market to the other. This
movement of money to take advantage of a covered interest differential is known
as covered interest arbitrage.
75
75
AN
OF
EXAMPLE
INTEREST
RATE
PARITY
New York
Finish
$1,020,000
Start
$1,000,000
1. Convert $1,000,000
to euros at €1.13110/$ |
3. Simultaneously with euro investment,
sell the € 1,148,066.50 forward at a
rate of € 1.12556/$ for delivery in
for.€ 1,131,100.
90 days, and receive $1,020,000
in 90 days.
€1,148,066.50
Frankfurt: 90 days
4
€ 1,131,100
:
2 Invest €
1.131.100 at 1.5% for
Frankfurt: today
90 days, yielding € 1,148,066.50
in 90 days.
76
76
THE
RELATIONSHIP BETWEEN
BETWEEN THE
THE RELATIONSHIP
THE
FORWARD AND
AND THE
FUTURE SPOT
RATE
FORWARD
THE FUTURE
SPOT RATE
I. THE UNBIASED
UNBIASED FORWARD
FORWARD RATE
RATE
I.THE
A. States
A.
States that
that if
if the
the forward
forward rate
rate
is
is unbiased,
unbiased, then
then it
it should
should
reflect
reflect the
the expected
expected future
future
spot
spot rate.
rate.
B.
B. Stated
Stated as
as
ft = e t
77
77
5
4
Expected Change
Change in
in Home
Home
Expected
3,
Currency
Currency Value
Value of
of Foreign
Foreign
2
Currency
Currency (%)
(%)
Parity Line
1
-5
-4
-3
-2
-1
1
-1
-2
A
2
3
4
5
Forward Premium(+)
Premium(+) or
or
Forward
Discount(-) on
on Foreign
Foreign
Discount(-)
Currency
Currency
-3
Lin. e eee
B
ee eee
eee
fe
-4
-5
Relation
Relation Between
Between the
the Forward
Forward Rate
Rate and
and the
the Future
Future Spot
Spot Rate
Rate
CURRENCY
FORECASTING
CURRENCY FORECASTING
I.
I. FORECASTING
FORECASTING MODELS
MODELS
A. Created
A.
Created to
to forecast
forecast exchange
exchange rates
rates in
in
addition
addition to
to parity
parity conditions.
conditions.
B.
B. Two
Two types
types of
of forecast:
forecast:
1.
Market-based
1.
Market-based
2.
Model-based
2.
Model-based
79
79
CURRENCY
FORECASTING
CURRENCY FORECASTING
MARKET-BASED FORECASTS:
FORECASTS:
MARKET-BASED
derived
derived from
from market
market indicators.
indicators.
A. The
A.
The current
current forward
forward rate
rate contains
contains implicit
implicit
information
information about
about exchange
exchange rate
rate changes
changes
for one
one year.
year.
for
B.
B. Interest
Interest rate
rate differentials
differentials may
may be
be
used
used to
to predict
predict exchange
exchange rates
rates
beyond
beyond one
one year.
year.
80
80
CURRENCY
FORECASTING
CURRENCY FORECASTING
MODEL-BASED
MODEL-BASED FORECASTS:
FORECASTS:
include
include fundamental
fundamental and
and technical
technical
analysis.
analysis.
A. Fundamental
A.
Fundamental relies
relies on
on key
key
macroeconomic
macroeconomic variables
variables and
and
policies
policies which
which most
most like
like affect
affect
exchange
exchange rates.
rates.
B.
B. Technical
Technical relies
relies on
on use
use of
of
1.
1. Historical
Historical volume
volume and
and price
price data
data
2.
2. Charting
Charting and
and trend
trend analysis
analysis
81
81
Between 1980 and 1995, the ¥/5 exchange rate moved from ¥226,63/$ to ¥93,96 Da
his same 15-year period, the consumer prie index (CPI) in Japan rose from 91.0 to i
andthe US. Cl toe fom 82.4 to 1524
_
a. IE PPP had held over this period, what would the ¥/$ exchange rate have been in 19
82
82
a
1. From base price levels of 100 in 2000, German
and U.S. price levels in 2001 stood at 102 and
106, respectively.
a. If the 2000 $:DM exchange rate was $0.54,
what should-the exchange rate be in 2001?
83
83
2. Two countries, the United States and England,
produce only one good, wheat. Suppose the price
of wheat is $3.25 in the United States and is
£1.35 in England.
a. According to the law of one price, what should
the $:£ spot exchange rate be?
b. Suppose the price of wheat over the next year
is expected to rise to $3.50 in the United
_ States and to £1.60 in England. What should
the one-year $:£ forward rate be?
84
84
|i
r
,
i
*
i
we
‘
*
or
t
=
.
os
.
LL
|
|
geen
ae SR,
Ace
5. In July, the one-year interest rate is 12% on
British pounds and 9% on U.S. dollars.
|
a. If the current exchange rate is $1.63:£1, what is
the expected future exchange rate in one year?
b. Suppose a change in expectations regarding
_
future U.S. inflation causes the expected future
spot rate to decline to $1.52:£1. What should
happen to the U.S. interest rate?
85
85
|
a a
|
“NEP
|
|
Ne.
6. Suppose that in Japan the interest rate is 8% and
inflation is expected to be 3%. Meanwhile, the
expected inflation rate in France is 12%, and the
English interest rate is 14%. To the nearest whole
‘number, what is the best estimate of the one-year
forward exchange premium (discount) at which
the pound will be selling relative to the French
franc?
86
86
P| UL | | gee
OT
ae TT OR Re
10. Assume that the interest rate is 16% on pounds
sterling and 7% on euros. At the same time,
inflation is running at an annual rate of 3% in
Germany and 9% in England.
a. If the euro is selling at a one-year forward
premium of 10% against the pound, is there
an arbitrage
opportunity?
Explain.
b. What is the real interest rate in Germany? In —
England?
c. Suppose that during the year the exchange rate
changes from €1.8:£1 to €1.77:£1. What are
the real costs to a German company of
borrowing pounds? Contrast this cost to its
real cost of borrowing euros.
d. What are the real costs to a British firm of
borrowing euros? Contrast this cost to its real
cost of borrowing pounds.
87
87
88
88
we
12.
Suppose
>
|
the spot rates for the euro, pound
sterling, and
Swiss
franc are $0.92,
$1.13,
and
$0.38, respectively. The associated 90-day interest
rates (annualized) are 8%,
16%, and 4%; the US.
90-day rate (annualized) is 12%. What is the
90-day forward rate on an ACU (ACU 1 = €1 +
£1 + SFr 1) if interest parity holds?
89
89
PPR a
werZ
b
~
|
ly
13. Suppose that three-month interest rates
(annualized) in Japan and the United States are
7% and 9%, respectively. If the spot rate is
¥142:$1 and the 90-day forward rate is ¥139:$1,
a. Where would you invest?
b. Where would you borrow’
c. What arbitrage opportunity do these figures
present?
d. Assuming no transaction costs, what would be
your arbitrage profit per dollar or dollarequivalent borrowed?
90
90
-
\
Xe;
14.
an
eS
-_
rr EL
|
Here are some prices in the international money
markets:
Spot rate
= $0.95:€
Forward rate (one year) = $0.97:€
Interest rate (DM)
Interest rate ($)
= 7% per year
= 9% per year
a. Assuming no transaction costs or taxes exist,
do covered arbitrage profits exist in this
situation? Describe the flows.
b. Suppose now that transaction costs in the
foreign exchange market equal 0.25% per
transaction. Do unexploited covered arbitrage
profit opportunities still exist?
91
91
THE FOREIGN
THE
FOREIGN
EXCHANGE
EXCHANGE MARKET
MARKET
92
OVERVIEW
OVERVIEW
I.
I.
II.
IT.
INTRODUCTION
INTRODUCTION
ORGANIZATION
ORGANIZATION OF
OF THE
THE
FOREIGN
FOREIGN EXCHANGE
EXCHANGE
MARKET
MARKET
III.
ITT. THE
THE SPOT
SPOT MARKET
MARKET
IV.
IV. THE
THE FORWARD
FORWARD MARKET
MARKET
93
93
INTRODUCTION
INTRODUCTION
I.
I.
INTRODUCTION
INTRODUCTION
A.
The
A.
The Currency
Currency Market:
Market:
where
where money
money denominated
denominated
in
in one
one currency
currency is
is bought
bought
and
and sold
sold with
with money
money
denominated
denominated in
in another
another
currency.
currency.
94
94
INTRODUCTION
INTRODUCTION
B.
B.
International Trade
and Capital
Capital
International
Trade and
Transactions:
Transactions:
facilitated
facilitated with
with the
the ability
ability
to
to transfer
transfer purchasing
purchasing power
power
between
between countries
countries
95
95
INTRODUCTION
INTRODUCTION
C.Location
C.Location
1.
OTC-type:
1.
OTC-type: no
no specific
specific
location
location
2.
Most
2.
Most trades
trades by
by phone,
phone,
telex,
telex, or
or SWIFT
SWIFT
SWIFT:
SWIFT: Society
Society for
for Worldwide
Worldwide Interbank
Interbank Financial
Financial
Telecommunications
Telecommunications
96
96
Customer
Customer
buys $$ with
buys
with €€
}
Local bank
Local
bank
{
i
Stockbroker
Stockbroker
==>
banks
Major banks
wee Major
Foreign
Foreign
IMM,LIFFE,PSE
IMM,LIFFE,PSE
ssss
—ctj
t
interbank
market
marke
bank
inter
”™”™=
r
broke
exchange broker
exchange
Local
bank
Local bank
Stockbroker
Stockbroker
t
Customer
Customer
buys €€ with
buys
with $$
STRUCTURE OF FOREIGN EXCHANGE MARKETS
ORGANIZATION
FOREIGN
ORGANIZATION OF
OF THE
THE FOREIGN
EXCHANGE
EXCHANGE MARKET
MARKET
II. .
PARTICIPANTS
PARTICIPANTS IN
IN THE
THE FOREIGN
FOREIGN
EXCHANGE
EXCHANGE MARKET
MARKET
A. Participants
A.
Participants at
at 2
2 Levels
Levels
1.
Wholesale
1.
Wholesale Level
Level (95%)
(95%)
-- major
major banks
banks
2.
Retail
2.
Retail Level
Level
-- business
business customers
customers
98
98
ORGANIZATION
FOREIGN
ORGANIZATION OF
OF THE
THE FOREIGN
EXCHANGE MARKET
MARKET
EXCHANGE
B.
B.
Two
Types of
Two Types
of Currency
Currency Markets
Markets
1.
1. Spot
Spot Market:
Market:
-- immediate
immediate transaction
transaction
-- recorded
recorded by
by 2nd
2nd business
business day
day
99
99
ORGANIZATION
FOREIGN
ORGANIZATION OF
OF THE
THE FOREIGN
EXCHANGE MARKET
MARKET
EXCHANGE
2.
2.
Forward
Forward Market:
Market:
-- transactions
transactions take
take place
place at
ataa
specified
specified future
future date
date
100
100
ORGANIZATION
FOREIGN
ORGANIZATION OF
OF THE
THE FOREIGN
EXCHANGE MARKET
MARKET
EXCHANGE
C.
C. Participants
Participants by
by Market
Market
1.
1. Spot
Spot Market
Market
a.
a. commercial
commercial banks
banks
b.
b. brokers
brokers
c.
Cc. customers
customers of
of commercial
commercial
and
and central
central banks
banks
101
101
ORGANIZATION
FOREIGN
ORGANIZATION OF
OF THE
THE FOREIGN
EXCHANGE MARKET
MARKET
EXCHANGE
2.
2. Forward
Forward
a.
a.
b.
b.
c.
Cc.
Market
Market
arbitrageurs
arbitrageurs
hedgers
hedgers
speculators
speculators
102
102
ORGANIZATION
FOREIGN
ORGANIZATION OF
OF THE
THE FOREIGN
EXCHANGE MARKET
MARKET
EXCHANGE
II.
Il. CLEARING
CLEARING SYSTEMS
SYSTEMS
A. Clearing
A.
Clearing House
House Interbank
Interbank
Payments
Payments System
System
(CHIPS)
(CHIPS)
-- used
used in
in U.S.
U.S. for
for electronic
electronic
fund
fund transfers.
transfers.
103
103
THE
THE SPOT
SPOT MARKET
MARKET
I.
I.
SPOT
SPOT QUOTATIONS
QUOTATIONS
A. Sources
A.
Sources
1.
All
1.
All major
major newspapers
newspapers
2.
Major
2.
Major currencies
currencies have
have
four
four different
different quotes:
quotes:
a.
a
b.
b.
c.
C.
d.
d.
spot
Spot price
price
30-day
30-day
90-day
90-day
180-day
180-day
104
104
THE
MARKET
THE SPOT
SPOT MARKET
B.
B.
Method
Method of
of Quotation
Quotation
1.
1, For
For interbank
interbank dollar
dollar
trades:
trades:
a.
American terms
a.
American
terms
b.
b.
example:
example: $.5838/dm
$.5838/dm
European
European terms
terms
example:
example: Peso1.713/$
Pesol.713/$
105
105
THE
MARKET
THE SPOT
SPOT MARKET
C.
C.
Transactions Costs
Transactions
Costs
1.
1,
Bid-Ask
Bid-Ask Spread
Spread
used
used to
to calculate
calculate the
the fee
fee
charged by
by the
the bank
bank
charged
•
Bid
Bid =
= the
the price
price at
at which
which
the
the bank
bank is
is willing
willing to
to buy
buy
Ask =
Ask
= the
the price
price it
it will
will sell
sell
the
the currency
currency
•
106
106
THE
MARKET
THE SPOT
SPOT MARKET
4.
4.
Percent
Percent Spread
Spread Formula
Formula (PS):
(PS):
Ask − Bid
PS =
x100
Ask
107
107
THE
MARKET
THE SPOT
SPOT MARKET
D.
D.
Cross
Cross Rates
Rates
1.
1.
The exchange
The
exchange rate
rate
between
between 2
2 non
non -- US$
US$
currencies.
currencies.
108
108
THE
MARKET
THE SPOT
SPOT MARKET
2.
2,
Calculating
Calculating Cross
Cross Rates
Rates
When
When you
you want
want to
to know
know
what
what the
the dm/ff
dm/ff cross
cross rate
rate
is,
you know
is, and
and You
know dm2/US$
dm2/US$ and
and
ff.55/US$
ff.55/US$
then
then dm/ff
dm/ff =
= dm2/US$
dm2/US$ ÷
+ ff.55/US$
ff.55/US$
=
= dm3.636/
dm3.636/ ff
ff
109
109
THE
MARKET
THE SPOT
SPOT MARKET
E.
Currency
Arbitrage
E.
Currency Arbitrage
1.
1. If
If cross
cross rates
rates differ
differ from
from
one
one financial
financial center
center to
to
another,
another, and
and profit
profit
opportunities
opportunities exist.
exist.
110
110
THE
MARKET
THE SPOT
SPOT MARKET
2.
2.
Buy
Buy cheap
cheap in
in one
one int’l
int'l market,
market,
sell
sell at
at a
a higher
higher price
price in
in
another
another
3.
3.
Role
Available Information
Role of
of Available
Information
111
111
THE
MARKET
THE SPOT
SPOT MARKET
F.
F.
Settlement
Value Date:
Settlement Date
Date Value
Date:
1.
1. Date
Date monies
monies are
are due
due
2.
2. 2nd
2nd Working
Working day
day after
after date
date of
of
original
Original transaction.
transaction.
112
112
THE
MARKET
THE SPOT
SPOT MARKET
1.)
1.) Demand
Demand for
for higher
higher risk
risk
premium
premium
2.)
2.) Bankers
Bankers widen
widen bid-ask
bid-ask
spread
spread
113
113
MECHANICS OF
MECHANICS
OF SPOT
SPOT
TRANSACTIONS
TRANSACTIONS
SPOT
TRANSACTIONS: An
An Example
SPOT TRANSACTIONS:
Example
Step
Step 1.
1.
Currency
Currency transaction:
transaction:
verbal
verbal agreement,
agreement, U.S.
U.S. importer
importer specifies:
specifies:
a.
Account to
a. Account
to debit
debit (his
(his acct)
acct)
b.
b. Account
Account to
to credit
credit (exporter)
(exporter)
114
114
MECHANICS
MECHANICS OF
OF SPOT
SPOT
TRANSACTIONS
TRANSACTIONS
Step
Step 2.
2.
Bank
Bank sends
sends importer
importer
contract
contract note
note including:
including:
-- amount
amount of
of foreign
foreign
currency
currency
-- agreed
agreed exchange
exchange rate
rate
-- confirmation
confirmation of
of Step
Step 1.
1.
115
115
MECHANICS
MECHANICS OF
OF SPOT
SPOT
TRANSACTIONS
TRANSACTIONS
Step
Settlement
Step 3.
3.
Settlement
Correspondent
Correspondent bank
bank in
in Hong
Hong
Kong
Kong transfers
transfers HK$
HK$ from
from
nostro
nostro account
account to
to exporter’s.
exporter’s.
Value Date.
Value
Date.
U.S.
U.S. bank
bank debits
debits importer’s
importer’s
account.
account.
116
116
THE
FORWARD MARKET
MARKET
THE FORWARD
I.
I. INTRODUCTION
INTRODUCTION
A. Definition
A.
Definition of
of a
a Forward
Forward
Contract
Contract
an
an agreement
agreement between
between a
a bank
bank and
and a
a
customer
customer to
to deliver
deliver a
a specified
specified amount
amount of
of
currency
currency against
against another
another currency
currency at
at a
a
specified
specified future
future date
date and
and at
at a
a fixed
fixed
exchange
exchange rate.
rate.
117
117
THE
FORWARD MARKET
MARKET
THE FORWARD
2.
2. Purpose
Purpose of
of a
a Forward:
Forward:
Hedging
Hedging
the
the act
act of
of reducing
reducing exchange
exchange
rate
rate risk.
risk.
118
118
THE
FORWARD MARKET
MARKET
THE FORWARD
CALCULATING
THE FORWARD
CALCULATING THE
FORWARD
PREMIUM
PREMIUM OR
OR DISCOUNT
DISCOUNT
=
F-S xx 1212 xx 100
100
= F-S
S
nn
S
where
where
FF=_= the
the forward
forward rate
rate of
of exchange
exchange
S
S =
= the
the spot
spot rate
rate of
of exchange
exchange
nn== the
the number
number of
of months
months in
in the
the
forward
forward contract
contract
119
119
Es
ji -
|
a
»
Ree | |
ee
| ad
a
|
Suppose the pound sterling is bid at $1.5422 in New York and the euro is
ollered -at-$0.9251 in Frankfurt. At the same time, London banks are ollering
pounds sterling at €1.6650. An astute trader would sell dollars for euros in
Frankturt, use the euros to acquire pounds sterling in London, and sell the pounds
in New York.
.
Specially, if the trader begins in New York with $1 million, he could acquire
€ 1,080,964.22 for $1,000,000 in Frankfurt, sell these euros for £649 227.76. in
London, and resell the pounds in New York for $1,001.239.05, Thus, a few min-
utes’ work would yield a profit of $1,239.05, In effect, by arbitraging through
the euro, the trader would be able to acquire sterling at $1.5403 in London
(90.9251 X 1.6650) and sell it at $1.5422 in New York, This sequence of transactions, known as triangular currency arbitrage, is depicted in Exhibit 7.6
120
120
ae
TRIANGULAR
CURRENCY
ARBITRAGE
4. Net profit equals $1,239.05
New York
Finish
$1,001 ,239.05
Start
$1,000,000
2. Sell $1,000,000
in Frankfurt at €1 =
$0.9251 for
€ 1,080,964.22
oe
Multiplied by
$1.5422/2 fo
Divided by
$0.9251/€
3. Resell the pounds
sterling in New York
at £1 = $1.5422 for
$1,001,239.05
£649 ,227.76
London
"
Divided by
€ 1.6650/£
;
2. Sell these euros
in London at £1 = € 1.6650
for £649,227.76
€ 1,080,964.22
Frankfurt
121
1. The $/€ exchange rate is € 1 = $0.95, and the
€ /SFr exchange rate is SFr 1 = € 0.71. What is
the SFr/$ exchange rate?
2, Suppose the direct quote for sterling in New York
is 1.1110-5.
a. How much would £500,000 cost in New York?
b. What is the direct quote for dollars in London?
122
122
or ee
~
SE
6. Suppose Dow Chemical receives quotes of
$0.009369—71 for the yen and $0.03675-—6 for
the Taiwan dollar (NT$).
a. How many US. dollars will Dow Chemical
receive from the sale of ¥50 million?
b. What is the U.S. dollar cost to Dow Chemical
of buying ¥1 billion?
c. How many NT$ will Dow Chemical receive for
U.S:$500,0002
,
d. How many yen will Dow Chemical receive for
NT$200 million?
e. What is the yen cost to Dow Chemical of
buying NT$80 million?
123
123
7. Suppose the euro is quoted at 0.6064—80 in
London and the pound sterling is quoted at
— -1,6244-59 in Frankturt.
a. Is there a profitable arbitrage situation?
Describe it.
b. Compute the percentage bid-ask spreads on
the pound and euro.
124
124
—
te
ion
bo
a |
|
10. On checking the Telerate screen, you see the
following exchange rate and interest rate quotes:
Currency
90-Day
Interest Rates
(annualized)
Dollar
4.99% -~5.03%
Swiss franc
3.14%-—3.19%
Spot Rates
90-Day
Forward
Rates
$0.711-—22
$0.726—32
a. Can you find an arbitrage opportunity?
b. What steps must you take to capitalize on it?
c. What is the profit per $1,000,000 arbitraged?
125
125
CURRENCY
CURRENCY FUTURES
FUTURES
AND OPTIONS
AND
OPTIONS MARKETS
MARKETS
126
CHAPTER
CHAPTER OVERVIEW
OVERVIEW
I.
FUTURES
I.
FUTURES CONTRACTS
CONTRACTS
II.
IT, CURRENCY
CURRENCY OPTIONS
OPTIONS
127
PARTI.I.
PART
FUTURES CONTRACTS
FUTURES
CONTRACTS
I.CURRENCY
IT. CURRENCY FUTURES
FUTURES
A. Background
A.
Background
1.
1. 1972:
1972: Chicago
Chicago Mercantile
Mercantile
Exchange
Exchange
opens
opens International
International Monetary
Monetary
Market.
Market. (IMM)
(IMM)
128
128
FUTURES CONTRACTS
FUTURES
CONTRACTS
2.
2. IMM
IMM provides
provides
a.
d. an
an outlet
outlet for
for hedging
hedging currency
currency
risk
risk with
w ith futures
futures contracts.
contracts.
b.. Definition
Definition of
of futures
futures contracts:
contracts:
contracts
written requiring
requiring
contrac tS written
•e a
a standard
standard quantity
quantity of
of an
an available
available currency
currency
•e at
ataa fixed
fixed exchange
exchange rate
rate
•e at
ataa set
set delivery
delivery date.
date.
129
129
FUTURES CONTRACTS
FUTURES
CONTRACTS
c.
c.
Available Futures
Available
Futures Currencies:
Currencies:
1.)
1.) British
British pound
pound — 5.)
5.) Euro
Euro
2.)
2.)
3.)
3.)
4.)
4.)
Canadian
Canadian dollar
dollar 6.)
6.) Japanese
Japanese yen
yen
Deutsche
Deutsche mark
mark 7.)
7.) Australian
Australian dollar
dollar
Swiss
Swiss franc
franc
130
130
FUTURES CONTRACTS
FUTURES
CONTRACTS
d.
d. Standard
Standard Contract
Contract Sizes:
Sizes:
contract
contract sizes
sizes differ
differ for
for each
each of
of
the
the 7
7 available
available currencies.
currencies.
Examples:
Examples:
Euro
Euro =
= 125,000
125,000
British
British Pound
Pound =
= 62,500
62,500
131
131
FUTURES CONTRACTS
FUTURES
CONTRACTS
e.
e.
f.
Transaction
Transaction costs:
costs:
payment
payment of
of commission
commission to
to a
a
trader
trader
Leverage
Leverage is
is high
high
1.)
1.) Initial
Initial margin
margin required
required is
is
relatively
relatively low
low (e.g.
(e.g. less
less than
than
.02%
.02% of
of sterling
sterling contract
contract
value).
value).
132
132
FUTURES CONTRACTS
FUTURES
CONTRACTS
g.
g.
Maximum
Maximum price
price movements
movements
1.)
1.) Contracts
Contracts set
set to
to aa daily
daily
price
price limit
limit restricting
restricting
maximum
M aximum daily
daily price
price
movements.
M ovements.
133
133
FUTURES CONTRACTS
FUTURES
CONTRACTS
2.) If
If limit
limit is
is reached,
reached, a
a margin
margin
2.)
call
call may
may be
be necessary
necessary to
to
maintain a
a minimum
minimum margin.
margin.
maintain
134
134
FUTURES CONTRACTS
FUTURES
CONTRACTS
h.
h.
Global
Global futures
futures exchanges
exchanges that
that
are
are competitors
competitors to
to the
the IMM:
IMM:
1.)
1.)
Deutsche
Termin Bourse
Deutsche Termin
Bourse
2.)
2.)
L.I.F.F.E.London International
International
L.I.F.F.E.London
Financial
Financial Futures
Futures Exchange
Exchange
3.)
3.)
C.B.O.T.
Trade
C.B.0.T. Chicago
Chicago Board
Board of
of Trade
135
135
FUTURES CONTRACTS
FUTURES
CONTRACTS
4.)
4.)
S.I.M.E.X.Singapore International
International
S.I.M.E.X.Singapore
Monetary
Monetary Exchange
Exchange
5.)
5.)
H.K.F.E.
H.K.F.E. Hong
Hong Kong
Kong Futures
Futures Exchange
Exchange
136
136
FUTURES CONTRACTS
FUTURES
CONTRACTS
B.
B. Forward
Forward vs.
vs. Futures
Futures Contracts
Contracts
Basic
Basic differences:
differences:
1.
1. Trading
Trading Locations
Locations
U1
2.. Regulation
Regulation
3.. Frequency
Frequency of
of
delivery
delivery
4.. Size
Size of
of contract
contract
5.. Delivery
Delivery dates
dates
6.
6. Settlement
Settlement
Date
Date
7.
7. Quotes
Quotes
8.
Transaction
8. Transaction
costs
costs
9.
9. Margins
Margins
10.
10. Credit
Credit risk
risk
137
FUTURES CONTRACTS
FUTURES
CONTRACTS
Advantag
Advantages
es of
of futures:
futures:
1.) Smaller
1.)
Smaller
contract
contract size
size
2.) Easy
2.)
Easy liquidation
liquidation
organized
Well- organized
3.)
3.) Wellstable
and stable
and
market.
market.
Disadvantages of
of futures:
futures:
Disadvantages
1.) Limited
Limited to
to 77
1.)
currencies
currencies
2.) Limited
Limited dates
dates
2.)
delivery
ofof delivery
3.)
contract
Rigid contract
3.) Rigid
sizes.
SIZES.
138
138
| | we
Ah ||
Y
Hedging
Hedging a
a Future
Future Payment
Payment With
With a
a Forward
Forward Contract
Contract
1,750,000
1,750,000
Unhedged
Unhedged Cost
Cost of
of££ 11 Million
Million Payment
Payment
Forward
Forward Contract
Contract Gain
Gain
1,740,000
1,740,000
oO RMS
oS
P
a
y
m
e
n
t
1,730,000
1,730,000
C
o
s
t
1,690,000
1,690,000
1,720,000
1,720,000
1,710,000
1,710,000
Forward
Forward
—
Contract
Contract Loss
Loss
1,700,000
1,700,000
1,680,000
1,680,000
1,670,000
1,670,000
Forward
Forward Rate
Rate
1,660,000
1,660,000
1,650,000
1,650,000
1.65
1.72 1.73
1.65 1.66
1.66 1.67
1.67 1.68
1.68 1.69
1.69 1.70
1.70 1.71
1.711.72
1.73 1.74
1.74 1.75
1.75 1.76
1.76
Dollar Value
Value of
of Pound
Pound in
in 90
90 Days
Days
Dollar
PARTIIII
PART
CURRENCY
CURRENCY OPTIONS
OPTIONS
I.
I. OPTIONS
OPTIONS
A. Currency
A.
Currency options
options
1.
offer
1,
offer another
another method
method to
to
hedge
hedge exchange
exchange rate
rate risk.
risk.
2.
2.
3.
3.
first
first offered
offered on
on Philadelphia
Philadelphia
Exchange
Exchange (PHLX).
(PHLX).
fastest
fastest growing
growing segment
segment of
of
the
the hedge
hedge markets.
markets.
140
140
CURRENCY
CURRENCY OPTIONS
OPTIONS
4.
4. Definition:
Definition:
aa contract
contract from
from a
a writer
writer (( the
the seller)
seller) that
that
gives
gives the
the right
right not
not the
the obligation
obligation to
to the
the
holder
holder (the
(the buyer)
buyer) to
to buy
buy or
or sell
sell a
a standard
standard
amount
amount of
of an
an available
available currency
currency at
at a
a fixed
fixed
exchange
exchange rate
rate for
for a
a fixed
fixed time
time period.
period.
141
141
CURRENCY
CURRENCY OPTIONS
OPTIONS
5.
Types
5.
Types of
of Currency
Currency Options:
Options:
a.
American
a. American
exercise
exercise date
date may
may occur
occur any
any
time
time up
up to
to the
the expiration
expiration date.
date.
b.
b. European
European
exercise
exercise date
date occurs
occurs only
only at
at the
the
expiration
expiration date.
date.
142
142
CURRENCY
CURRENCY OPTIONS
OPTIONS
7.
7. Exercise
Exercise Price
Price
a.
Sometimes
d.
Sometimes known
known as
as the
the
strike
Strike price.
price.
b.
b. the
the exchange
exchange rate
rate at
at
which
which the
the option
option holder
holder
can
can buy
buy or
or sell
sell the
the
contracted
contracted currency.
currency.
143
143
CURRENCY
CURRENCY OPTIONS
OPTIONS
8.
8.
Status
Status of
of an
an option
option
a.
In-the-money
a.
In-the-money
Call:
Call:
Put:
Put:
Spot
Spot >
> strike
strike
Spot <
< strike
strike
Spot
b.
b.
Out-of-the-money
Out-of-the-money
c.
c.
At-the-money
At-the-money
Call:
Call:
Put:
Put:
Spot
Spot <
< strike
strike
Spot
Spot >
> strike
strike
Spot
Spot =
= the
the strike
strike
144
144
CURRENCY
CURRENCY OPTIONS
OPTIONS
9.
The premium:
9. The
premium: the
the price
price of
of an
an
option
option that
that the
the writer
writer charges
charges
the
the buyer.
buyer.
145
145
CURRENCY
CURRENCY OPTIONS
OPTIONS
B.
When
B.
When to
to Use
Use Currency
Currency Options
Options
1.
1. For
For the
the firm
firm hedging
hedging foreign
foreign
exchange
exchange risk
risk
a.
a. With
With sizable
sizable unrealized
unrealized gains.
gains.
b.
b. With
With foreign
foreign currency
currency flows
flows
forthcoming.
forthcoming.
146
146
CURRENCY
CURRENCY OPTIONS
OPTIONS
2.
2. For
For speculators
speculators
-- profit
profit from
from favorable
favorable
exchange
exchange rate
rate changes.
changes.
147
147
CURRENCY
CURRENCY OPTIONS
OPTIONS
c.
c.
Using
Using Forward
Forward or
or Futures
Futures
Contracts:
Contracts:
Forward
Forward and
and futures
futures contracts
contracts
are
are more
more suitable
suitable for
for hedging
hedging a
a
known
known amount
amount of
of foreign
foreign
currency
currency flow.
flow.
148
148
)
~—
ContractreSize| : DM
Contract
DM 62,500
62 500
en:
aa
| EP |
:
New.
Exercise
per DM
Exercise Price
Price :: $0.64
$0.64 per
DM
Option
per DM
Option Premium
Premium :: $$ 0.02
0.02 per
DM
($1,250 per
contract)
($1,250
per contract)
Potentially
P
p 2500
2500 |
Potent ally
R 18975/
Unlimited
Unlimited
R 1875
Expiration
O
Expiration Date
Date :: 60
60 days
days
Profit
Profit
O
7 1250
1250
Exercise Price
Price
Exercise
F
I 625
625 |.
I
|
|
4
T
$0.64
$0.66
$0.70
T
$0,$0.60 $0.$0.62
$0.64
$0.66 $0.68
$0.68
$0.70
—
-625 NO
Spot Price
Price of
of DM
DM at
at Expiration
Expiration
Spot
-625
L 1250
imited Loss
Loss
L
Limited
-1250
O
O
Break Even
Even
Break
Call
S
S§ -1875
-1875 |
Call
Price
Price
S
Premium
Premium
S
Profit from
from Buying
Buying aa Call
Call Option
Option for
for various
various Spot
Spot prices
prices at
at
Profit
Expiration
Expiration
|e
ul
em
te
Contract Size
: DM 62,500
Sebch.
Si ‘é,.
! 50
Exercise
per DM
Exercise Price
Price :: $0.64
$0.64 per
DM
Option
per DM
Option Premium
Premium :: $0.02
$0.02 per
DM (( $1,250
$1,250
per contract
per
contract ))
p 2500
2500 |
P
R
R 1875
1875} Potential
pus
Expiration
Expiration Date
Date :: 60
60 days
days
——Exercise
Price
Exercise Price
O
Profit
up
to
O 1250
1250 | Profira
$38,750
F
387
F
Spot
Spot Price
Price of
of DM
DM at
at Expiration
Expiration
625
II
|
|
|
T
$0.58
$0.60
$0.62
$0.64
$0.66
$0.68
T
$0.58
$0.60
$0.6
$0.
0:68
-625
LL “625
Breakeven
YSLimited Loss
Breakeven
-1250}° Price
Price
O
O -1250
-1875
Put Premium
Premi
Put
S
S -1875
S
S
Profit from
from Buying
Buying aa Put
Put Option
Option for
for Various
Various Spot
Spot Prices
Prices at
at
Profit
Expiration
Expiration
|e
IP
rr
4
"
|
P
*
—
ge=.
>.
:
ger
te TT Se
Se
|
3. Suppose that DEC buys a Swiss franc futures con' tract (contract size is SFr 125,000) at a price of
$0.83. If the spot rate for the Swiss franc at the
date of settlement is SFr 1 = $0.8250, what is
DECs gain or loss on this contract?
>.
Citigroup sells a call option on euros (contract size
is © 500,000) at a premium of $0.04 per euro. If
the exercise price is $0.71 and the spot price of
the mark at date of expiration is $0.73, what is
Citigroup's profit (loss) on the call option?
151
151
mere
|
ae
Re is a
Se
Apex Corporation must pay its Japanese supplier
¥125 million in three months. It is thinking of
buying 20 yen call options (contract size is. ¥6.25
million) at a strike price of $0.00800 in order to
protect against the risk of a rising yen. The premium is 0.015 cents per yen. Alternatively, Apex
could buy 10 three-month yen futures contracts
(contract size is ¥12.5 million). at a price of
$0.007940/¥. The current spot rate is ¥1 =
$0.007823. Apex’s treasurer believes that the most
likely value for the yen in 90 days is $0.007900,
but the yen could go as high as $0.008400 or as
low as $0.007500.
152
152
ae
a. Diagram Apex’ soins. and losses on the call
option position and the futures position within
its range of expected prices (see Exhibit 8.4).
Ignore transaction costs and margins.
b. Calculate what Apex would gain or lose on the
option and futures positions if the yen settled at
its most likely value.
c. What is Apex’s break-even future spot-price on
the option contract? on the futures contract?
d. Calculate and diagram the corresponding profit
and loss and break-even positions on the
futures and options contracts for the sellers of
these contracts.
153
MEASURING &
~MEASURING
& MANAGING
MANAGING
we? TRANSLATION
TRANSLATION &
&
TRANSACTION
TRANSACTION EXPOSURE
EXPOSURE
154
CHAPTER
CHAPTER OVERVIEW
OVERVIEW
I.I.
ALTERNATIVE
ALTERNATIVE MEASURES
MEASURES OF
OF
FOREIGN EXCHANGE
EXCHANGE EXPOSURE
EXPOSURE
FOREIGN
Tl. ALTERNATIVE
CURRENCY
II.
ALTERNATIVE CURRENCY
TRANSLATION METHODS
TRANSLATION
METHODS
TTT. TRANSACTION
EXPOSURE
III.
TRANSACTION EXPOSURE
155
155
CHAPTER
(con’t)
CHAPTER OVERVIEW
OVERVIEW
(con't)
IV.
IV. DESIGNING
DESIGNING AA HEDGING
HEDGING STRATEGY
STRATEGY
V.
V.
MANAGING
MANAGING TRANSLATION
TRANSLATION EXPOSURE
EXPOSURE
VI.
VI.
MANAGING
MANAGING TRANSACTION
TRANSACTION EXPOSURE
EXPOSURE
156
156
PART I. ALTERNATIVE
ALTERNATIVE MEASURES
MEASURES OF
PARTI.
OF
FOREIGN EXCHANGE
EXCHANGE EXPOSURE
EXPOSURE
FOREIGN
I.
ALTERNATIVE MEASURES
I. ALTERNATIVE
MEASURES OF
OF FOREIGN
FOREIGN
EXCHANGE
EXCHANGE EXPOSURE
EXPOSURE
A. Three
Three Types
Types of
A.
of Exposure
Exposure
1.
Accounting Exposure:
1. | Accounting
Exposure:
when
when reporting
reporting and
and
consolidating
consolidating financial
financial
statements
statements requires
requires
conversion
conversion from
from foreign
foreign to
to
local
local currency.
currency.
157
157
ALTERNATIVE MEASURES
MEASURES OF
FOREIGN
ALTERNATIVE
OF FOREIGN
EXCHANGE EXPOSURE
EXPOSURE
EXCHANGE
2. Transaction
I[ransaction Exposure:
Exposure:
2.
occurs
occurs from
from changes
changes in
in the
the value
value
of
of foreign
foreign currency
currency contracts
contracts as
as
aa result
result of
of exchange
exchange rate
rate
changes.
changes.
158
158
ALTERNATIVE MEASURES
MEASURES OF
FOREIGN
ALTERNATIVE
OF FOREIGN
EXCHANGE EXPOSURE
EXPOSURE
EXCHANGE
3.
3. Operating
Operating Exposure
Exposure
arises
arises because
because exchange
exchange rate
rate
changes
changes may
may alter
alter the
the value
value of
of
future
future revenues
revenues and
and costs.
costs.
159
159
ALTERNATIVE MEASURES
MEASURES OF
FOREIGN
ALTERNATIVE
OF FOREIGN
EXCHANGE EXPOSURE
EXPOSURE
EXCHANGE
Economic
Economic Exposure
Exposure
=
Transaction +
= Transaction
+ Operating
Operating Exposures
Exposures
160
160
PART IT,
II. ALTERNATIVE
ALTERNATIVE CURRENCY
PART
CURRENCY
TRANSLATION
METHODS
TRANSLATION METHODS
I. FOUR
FOUR METHODS
METHODS OF
OF TRANSLATION
I.
TRANSLATION
A. Current/Noncurrent
A.
Current/Noncurrent Method
Method
1.
Current
1.
Current accounts
accounts use
use
current
current exchange
exchange rate
rate for
for
conversion.
conversion.
2.
Income
2.
Income statement
statement accounts
accounts
use
use average
average exchange
exchange rate
rate
for
for the
the period.
period.
161
161
ALTERNATIVE
ALTERNATIVE CURRENCY
CURRENCY
TRANSLATION
METHODS
TRANSLATION METHODS
B.
B. Monetary/Nonmonetary
Monetary/Nonmonetary Method
Method
1.
Monetary
1.
Monetary accounts
accounts use
use
current
current rate
rate
2.
Pertains
2.
Pertains to
to
-- cash
cash
-- accounts
accounts receivable
receivable
-- accounts
accounts payable
payable
-- long
long term
term debt
debt
162
162
ALTERNATIVE CURRENCY
ALTERNATIVE
CURRENCY
TRANSLATION
METHODS
TRANSLATION METHODS
3.
3. | Nonmonetary
Nonmonetary accounts
accounts
-- use
use historical
historical rates
rates
-- Pertains
Pertains to
to
inventory
inventory
fixed
fixed assets
assets
long
long term
term investments
investments
4.
Income
4,
Income statement
statement accounts
accounts
-- use
use average
average exchange
exchange rate
rate
for the
the period.
period.
for
163
163
ALTERNATIVE CURRENCY
ALTERNATIVE
CURRENCY
TRANSLATION
METHODS
TRANSLATION METHODS
C.
C. Temporal
Temporal Method
Method
1.
Similar to
to monetary/nonmonetary
monetary/nonmonetary
1.
Similar
method.
method.
2.
Uses
2.
Uses current
current method
method for
for inventory.
inventory.
164
164
ALTERNATIVE
ALTERNATIVE CURRENCY
CURRENCY
TRANSLATION
METHODS
TRANSLATION METHODS
D.
D.
Current
Current Rate
Rate Method
Method
all
all statements
statements use
use current
current
exchange
exchange rate
rate for
for conversions.
conversions.
165
165
FINANCIAL STATEMENT
(U.S. $ THOUSANDS)
IMPACT
OF TRANSLATION
ALTERNATIVES
.
After Devaluation of
Local Currency (LC 5 = $1)
Local
Currency
U.S. Dollars
Current
Prior to
Rates
Exchange
for All
Rate Change
Monetary/
Current/ Assets and
(LC 4 = $1) Nonmonetary Temporal Noncurrent Liabilities
Assets
Current assets
Cash, marketable
securities,
'
>
and receivables
Inventory (at market)
Prepaid expenses,
Total current assets
LC 2,600
3,600
200
6,400
$ 650
900
50
1,600
$ 520
900
50
1,470
$ 520
720
50
1,290
3,600
1,000
LC 11,000
900
250
$2,750
900
250.
$2,620
900
250
$2,440
.
$ 520
720
40
1,280
$ 520
720
40
1,280
900
250
$2,430
720
200
$2,200
166
166
80
150
680
600
80
600
680
750
680
600
1,559
1380
375
445
51725
1 380
it1 380
5
650
315
bho
15
685
375
00
a
Ts
Ww
ww
$2750 =
$2,620
$2440
$2,430
32,200
_
$215
$35
$ (150)
§ (205)
167
167
PART III,
III. TRANSACTION
EXPOSURE
PART
TRANSACTION EXPOSURE
I.
I. WHEN
WHEN DOES
DOES IT
IT OCCUR?
OCCUR?
A. From
A.
From the
the time
time of
of agreement
agreement to
to time
time of
of
payment.
payment.
B.
B. Arises
Arises from
from possibility
possibility of
of exchange
exchange rate
rate
gains
gains and
and losses
losses from
from the
the transaction.
transaction.
168
168
TRANSACTION
EXPOSURE
TRANSACTION EXPOSURE
II.
TI. MEASUREMENT
MEASUREMENT
A. Currency
A.
Currency by
by currency
currency
B.
B. Equals
Equals the
the difference
difference between
between
1.
The
1.
The contractually-fixed
contractually-fixed invoice
invoice
amount
amount in
in a
a specific
specific currency
currency
2.
The
2.
The final
final payment
payment amount
amount
denominated
denominated in
in current
current exchange
exchange
rate
rate for
for the
the specific
specific currency.
currency.
169
169
PART IV.
IV. DESIGNING
DESIGNING AA HEDGING
HEDGING
PART
STRATEGY
STRATEGY
III.
III. DESIGNING
DESIGNING AA HEDGING
HEDGING STRATEGY
STRATEGY
A.
Strategies
A.
Strategies
a
a function
function of
of management’s
management's
objectives
objectives
B.
B. | Hedging’s
Hedging’s basic
basic objective:
objective:
reduce/eliminate
reduce/eliminate volatility
volatility of
of
earnings
earnings as
as a
a result
result of
of exchange
exchange
rate
rate changes.
changes.
170
170
BASIC
HEDGING
TECHNIQU
Depreciation
Sell local currency forward
Buy a local currency put option
Reduce levels of local currency cash and
marketable securities
Tighten
credit (reduce local currency
receivables)
Delay collection of hard currency receivables
Increase imports of hard currency goods
Borrow locally
Delay payment of accounts payable
Speed up dividend and fee remittances to
parent and other subsidiaries
Speed up payment of intersubsidiary
accounts payable
Delay collection of intersubsidiary accounts
receivable
Invoice exports in foreign currency and
imports in local.~currency
ES
Appreciation
Buy local currency forward
Buy a local currency call option
Increase levels of local currency cash
and marketable securities
Relax local currency credit terms
Speed up collection of soft currency
receivables
Reduce imports of soft currency goods
Reduce local borrowing
Speed up payment of accounts payable
Delay dividend and fee remittances to
parent and other subsidiaries
Delay payment of intersubsidiary
accounts payable
Speed up collection of intersubsidiary
accounts receivable
Invoice exports in local currency and
imports in foreign currency
171
171
COST
OF
THE
BASIC
HEDGING
TECHNIQUES
Depreciation
Costs
Sell local currency forward
Transaction. costs; difference between
forward and future spot rates
Buy a local currency put option
Reduce levels of local currency cash
marketable securities
Put option premium
Operational problems;
and
opportunity
cost (loss of higher interest rates on LC
securities)
Tighten credit (reduce local currency
receivables)
Delay collection of hard currency
receivables
Increase imports of hard currency goods
Borrow locally
Delay payment
of accounts
payable
Speed up dividend and fee remittances
to parent and other subsidiaries
Speed up payment of intersubsidiary
accounts payable
Delay collection of intersubsidiary
accounts receivable
Invoice exports in foreign currency and
imports in local currency
Lost sales and profits
Cost of financing additional receivables
Financing and holding costs
Higher interest rates
Harm to credit reputation
Borrowing cost if funds not available or
loss of higher interest rates if LC
securities must be sold
Opportunity cost of money
Opportunity cost of money
Lost export sales or lower price;
premium
price
for imports
172
172
DESIGNING AA HEDGING
HEDGING
DESIGNING
STRATEGY
STRATEGY
C.
C. Hedging
Hedging exchange
exchange rate
rate risk
risk
1.
Costs
1.
Costs money
money
2.
Should
2.
Should be
be evaluated
evaluated as
as any
any other
other
purchase
purchase of
of insurance.
insurance.
3.
Taking
3.
Taking advantage
advantage of
of tax
tax
asymmetries
asymmetries lowers
lowers hedging
hedging
costs.
costs.
173
173
PART V.
MANAGING TRANSLATION
PART
V. MANAGING
TRANSLATION
EXPOSURE
EXPOSURE
I.
TRANSLATION EXPOSURE
I. MANAGING
MANAGING TRANSLATION
EXPOSURE
A. 3
Available Methods
A.
3 Available
Methods
1.
Adjusting
1.
Adjusting fund
fund flows
flows
altering
altering either
either the
the amounts
amounts or
or
the
the currencies
currencies of
of the
the planned
planned
cash
cash flows
flows of
of the
the parent
parent or
or its
its
subsidiaries
subsidiaries to
to reduce
reduce the
the
firm’s
firm’s local
local currency
currency accounting
accounting
exposure.
exposure.
174
174
MANAGING TRANSLATION
MANAGING
TRANSLATION
EXPOSURE
EXPOSURE
2.2.
Forward
Forward contracts
contracts
reducing
reducing a a firm’s
firm’s translation
translation
exposure
exposure by
by creating
creating an
an
offsetting
offsetting asset
asset or
or liability
liability in
in the
the
foreign currency.
currency.
foreign
175
175
MANAGING TRANSLATION
MANAGING
TRANSLATION
EXPOSURE
EXPOSURE
3.
3.
Exposure
Exposure netting
netting
a.
a. offsetting
Offsetting exposures
exposures in
in one
one
currency
currency with
with exposures
exposures in
in the
the
same
Same or
or another
another currency
currency
b.
b. gains
gains and
and losses
losses on
on the
the two
two
currency
currency positions
positions will
will offset
offset
each
each other.
other.
176
176
MANAGING TRANSLATION
MANAGING
TRANSLATION
EXPOSURE
EXPOSURE
B.
B. Basic
Basic hedging
hedging strategy
strategy for
for reducing
reducing
translation
translation exposure:
exposure:
1.
increasing
1.
increasing hard-currency(likely
hard-currency(likely
to
to appreciate)
appreciate) assets
assets
2.
decreasing
2.
decreasing soft-currency(likely
soft-currency(likely
to
to depreciate)
depreciate) assets
assets
3.
decreasing
3.
decreasing hard-currency
hard-currency
liabilities
liabilities
177
177
MANAGING TRANSLATION
MANAGING
TRANSLATION
EXPOSURE
EXPOSURE
4.
4.
increasing
increasing soft-currency
soft-currency
liabilities
liabilities
i.e.
reduce
i.e.
reduce the
the level
level of
of cash,
cash, tighten
tighten credit
credit
terms
terms to
to decrease
decrease accounts
accounts receivable,
receivable, increase
increase
LC
LC borrowing,
borrowing, delay
delay accounts
accounts payable,
payable, and
and
sell
sell the
the weak
weak currency
currency forward.
forward.
178
178
Case
Case: :
On
On January
January 1,
1, GE
GE is
is awarded
awarded aa contract
contract to
to supply
supply
turbine
blades to
turbine blades
to Lufthansa,
Lufthansa, the
the German
German airlines.
airlines. On
On
December
payment of
December 31,
31, GE
GE will
will receive
receive payment
of €€ 10
10
million
blades.
million for
for these
these blades.
Spot
Spot rate
rate :: $1/€1
$1/€1
11 year
year forward
forward rate
rate :: $0.957/€1
$0.957/€1
Euro
Euro Interest
Interest rates
rates :: 15%
15%
U.S.
U.S. Interest
Interest rates
rates :: 10%
10%
179
179
PART VI.
MANAGING TRANSACTION
PART
VI. MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
era
nmmMonwyS
I.
I. METHODS
METHODS OF
OF HEDGING
HEDGING
A. Forward
Forward market
market hedge
hedge
B. Money
Money market
market hedge
hedge
C. Risk
Risk shifting
shifting
D. Pricing
Pricing decision
decision
E. Exposure
Exposure netting
netting
F. Currency
Currency risk
risk sharing
sharing
G. Currency
Currency collars
collars
H. Cross-hedging
Cross-hedging
I.. Foreign
Foreign currency
currency options
options
180
180
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
Central
Central idea:
idea: Hedging
Hedging
Hedging
Hedging a
a particular
particular currency
currency exposure
exposure
means
means establishing
establishing an
an offsetting
offsetting
currency
currency position
position
Whatever
Whatever is
is lost
lost or
or gained
gained on
on the
the original
original
currency
currency exposure
exposure is
is exactly
exactly offset
offset by
by a
a
corresponding
corresponding foreign
foreign exchange
exchange gain
gain or
or
loss
loss on
on the
the currency
currency hedge
hedge
181
181
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
Managing
Managing transaction
transaction exposure:
exposure:
AA transaction
transaction exposure
exposure arises
arises whenever
whenever a
a
company
company is
is committed
committed to
to a
a foreign
foreign
currency-denominated
Currency-denominated transaction.
transaction.
Protective measures
measures include
include using:
using:
Protective
forward
forward contracts,
contrac ts, price
price adjustment
adjustment
clauses,
clauses, currency
currency options,
options, and
and HC
HC
invoicing.
invoicing.
182
182
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
A.FORWARD MARKET
A.FORWARD
MARKET HEDGE
HEDGE
1.
1. consists
consists of
of offsetting
offsetting
a.
a. a
a receivable
receivable or
or payable
payable in
in a a
foreign
foreign currency
currency
b.b. using
using a
a forward
forward contract:
contract:
- to
to sell
sell or
or buy
buy that
that currency
currency
-- at
ataa set
set delivery
delivery date
date
-- which
which coincides
coincides with
with
receipt
receipt of
of the
the foreign
foreign
currency.
currency.
183
183
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
2.
True Cost
2. True
Cost of
of Hedging:
Hedging:
a.
The
a.
The opportunity
opportunity cost
cost depends
depends upon
upon
future
future spot
spot rate
rate at
at settlement
settlement
b.
Shown
b.
Shown as
as
where
where
ff,
1 -- e&e1
eEo0
ff,1 =
= forward
forward rate
rate
e€)0 =
= spot
spot rate
rate
ee,+1 =
= future
future spot
spot rate
rate
184
184
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
B.
B. MONEY
MONEY MARKET
MARKET HEDGE
HEDGE
1.
Definition:
1,
Definition:
simultaneous
simultaneous borrowing
borrowing and
and
lending
lending activities
activities in
in two
two different
different
currencies
currencies to
to lock
lock in
in the
the dollar
dollar
value
value of
of a
a future
future foreign
foreign currency
currency
cash
cash flow
flow
185
185
PespsiCo would like to hedge its C$40 million payable to Alcan, a Canadian aluminum producer, which is due in 90 days, Suppose it faces the following exchange and interest rates,
Spot rate
Forward rate (90 days):
Canadian dollar 90-day interest rate (annualized):
U.S. dollar 90-day interest rate (annualized)
$0.7307-12ICS
$0,7320-41/C$
4114.64
5.50%-5.35%
Which hedging alternative would you recommend? The first interest rate is the bot
rowing rate and the second one is the lending rate.
186
186
—
Tel,
The hedged cost of the payable using the forward market is
U.S.$29,364,000 (0.7341 X 40,000,000), remembering that PepsiCo must’ buy forward
Canadian dollars at the ask rate. Alternatively, PepsiCo could use a money-market hedge.
This hedge would entail the following steps:
1, Borrow U.S. dollars at 5.50% annualized for 90 days (the borrowing rate). The
actual interest rate for 90 days will be 1.375% (5.50% X 90/360).
2. Convert the U.S. dollars into Canadian dollars at $0.7312 (the ask rate).
3, Invest the Canadian dollars for 90 days at 4.64% annualized for 90 days (the
lending rate) and use the loan proceeds to pay Alcan. The actual interest rate for 90 days
will be 1.16% (4.64% X 90/360).
187
187
Since PepsiCo needs C$40 million in 90 days and will earn interest equal to1.16%,it must
invest the present value of this sum or C$39,54] 1 321 (40,000,000/1,0116), This sum is
equivalent to U.S.$28,912,614 convertedat the spot askrate (39,541,321 X 0.7312). Ata
9()-day borrowing rate of 1.375%, PepsiCo must pay back principal plus interest in 90 days
of U.S.$29,310,162 (28,912,614 X 1.01375). Thus, the hedged cost of the payable using
the money-market hedge is $29,310,162.
Comparing the two hedged costs, we see that by using the money-market hedge
instead of the forward market hedge, PepsiCo will save $53,838 (29,364,000 - 29,310,162).
(ther things being equal, therefore, this is the recommended hedge for PepsiCo.
188
188
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
C.
C. RISK
RISK SHIFTING
SHIFTING
1. home
home currency
currency invoicing
invoicing
1.
2.
2. zero
zero sum
sum game
game
3.
3. common
common in
in global
global business
business
4. firm
firm will
will invoice
invoice exports
exports in
in strong
strong
4.
currency,
currency, import
import in
in weak
weak currency
currency
5.
5. Drawback:
Drawback:
it
it is
is not
not possible
possible with
with informed
informed
customers
customers or
or suppliers.
suppliers.
189
189
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
D.
D. PRICING
PRICING DECISIONS
DECISIONS
1.
1. general
general rules:
rules: on
on credit
credit sales
sales connect
connect
foreign
foreign price
price to
to home
home price
price using
using
forward
forward rate,
rate, but
but not
not spot
spot rate.
rate.
2.
2. if
if the
the dollar
dollar price
price is
is high/low
high/low enough
enough
the
the exporter/importer
exporter/importer should
should follow
follow
through
through with
with the
the sale.
sale.
190
190
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
E.
E. EXPOSURE
EXPOSURE NETTING
NETTING
1. Protection
Protection can
can be
be gained
gained by
by selecting
selecting
1.
currencies
currencies that
that minimize
minimize exposure
exposure
2. Netting:
Netting:
2.
MNC chooses
chooses currencies
currencies that
that are
are not
not
MNC
perfectly
perfectly positively
positively correlated.
correlated.
3.
3. Exposure
Exposure in
in one
one currency
currency can
can be
be
offset
offset by
by the
the exposure
exposure in
in another.
another.
19]
191
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
F.
F. CURRENCY
CURRENCY RISK
RISK SHARING
SHARING
1.
Developing
1.
Developing a
a customized
customized hedge
hedge
contract
contract
2.
The
2.
The contract
contract typically
typically takes
takes the
the
form
Adjustment
form of
of a
a Price
Price Adjustment
Clause,
Clause, whereby
whereby a
a base
base price
price is
is
adjusted
adjusted to
to reflect
reflect certain
certain
exchange
exchange rate
rate changes.
changes.
192
192
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
F.
F. CURRENCY
CURRENCY RISK
RISK SHARING
SHARING (con’t)
(con't)
3.
Parties
3.
Parties would
would share
share the
the
currency
currency risk
risk beyond
beyond a
a neutral
neutral
zone
zone of
of exchange
exchange rate
rate
changes.
changes.
4.
The
4.
The neutral
neutral zone
zone represents
represents the
the
currency
Currency range
range in
in which
which risk
risk is
is
not
shared.
not
shared.
193
193
Neutral Zone
Neutral
Zone :: $0.98-1.02/€
$0.98-1.02/E Base
Base rate:
rate: $1/€
$1/€
Price
€10m at
Price €10m
at base
base rate
rate of
of $1/€
$1/€ =
= $10m
$10m
Lufthansa’s
€9.8m to
€10.2m
Lufthansa’s cost
cost within
within the
the neutral
neutral zone
zone €9.8m
to €10.2m
€€ depreciates
depreciates from
from $1
$1 to
to $.90
$.90
Exchange
Exchange rate
rate in
in settling
settling $.96/€
$.96/€ ($1-.08/2)
($1-.08/2)
New Price
€10m*.96 =
New
Price €10m*.96
= $9.6m
$9.6m
Lufthansa’s
€10.67m
Lufthansa’s cost
cost (9.6m/.90)
(9.6m/.90) =
= €10.67m
€€ appreciates
appreciates from
from $1
$1 to
to $1.10
$1.10
Exchange
Exchange rate
rate in
in settling
settling $1.04/€
$1.04/€ ($1+.08/2)
($1+.08/2)
New price
€10m*1.04 =
New
price €10m*1.04
= $10.4m
$10.4m
Lufthansa’s
€9.45m
Lufthansa’s cost
cost (10.4m/1.10)
(10.4m/1.10) =
= €9.45m
194
194
CURRENCY
RISK
SHARING:
GE
AND
LUFTHANSA
13)--
GE's revenue from sale to Lufthansa ($ millions)
12
=
Value of
receivable with
1 1
ae
Risk-sharing
contract
Use of forward
contract
Ft
tf
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SISSSSRSHRRS-HBSSRSrMTFlSS
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ocroicogcecgjoosd
io
&
Exchange
rr
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OO Tr
rate ($ per euro)
Kr
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ll
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195
195
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
G.
G. CURRENCY
CURRENCY COLLARS
COLLARS
1.
Contract
1.
Contract bought
bought to
to protect
protect against
against
currency
Currency moves
moves outside
outside the
the neutral
neutral
zone.
zone.
2.
Firm
2.
Firm would
would convert
convert its
its foreign
foreign
currency
Currency denominated
denominated receivable
receivable
at
at the
the zone
zone forward
forward rate.
rate.
196
196
GE's revenue from sale to Lufthansa ($ millions)
11
10.5
Receivable hedged with
a range forward
10;
Le
|
J
0.900
0.925
0.950
!
9
1.000
|
1.025
Exchange rate ($ per euro)
0.975
|
i
|
1.050
1.075
1.100
(c) Payoff profile of GE's receivable hedged with a range forward
197
197
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
H.
H. CROSS-HEDGING
CROSS-HEDGING
1.
1.
2.
2.
3.
3.
Often
Often forward
forward contracts
contracts not
not available
available
in
in a
a certain
certain currency.
currency.
Solution:
Solution: a
a cross-hedge
cross-hedge
-- aa forward
forward contract
contract in
in a
a related
related
currency.
currency.
Correlation
Correlation between
between 2
2 currencies
currencies is
is
critical
critical to
to success
success of
of this
this hedge.
hedge. 198
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
I.
I, Foreign
Foreign Currency
Currency Options
Options
When
When transaction
transaction is
is uncertain,
uncertain, currency
currency
options
options are
are a
a good
good hedging
hedging tool
tool in
in
situations
situations in
in which
which the
the quantity
quantity of
of foreign
foreign
exchange
exchange to
to be
be received
received or
or paid
paid out
out is
is
uncertain.
uncertain.
199
199
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
I.
I. Foreign
Foreign currency
currency options
options
1.
1.
AA call
call option
option
is
is valuable
valuable when
when a
a firm
firm has
has offered
offered to
to
buy
buy a
a foreign
foreign asset
asset at
at a
a fixed
fixed foreign
foreign
currency
currency price
price but
but is
is uncertain
uncertain
whether its
its bid
bid will
will be
be accepted.
accepted.
whether
200
200
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
2.
2. The
The firm
firm can
can lock
lock in
in a
a maximum
maximum dollar
dollar
price
price for
for its
its tender
tender offer,
offer, while
while
limiting
limiting its
its downside
downside risk
risk to
to the
the call
call
premium
premium in
in the
the event
event its
its bid
bid is
is rejected.
rejected.
201
201
MANAGING TRANSACTION
MANAGING
TRANSACTION
EXPOSURE
EXPOSURE
3.
3. AA put
put option
option
allows
allows the
the company
company to
to insure
insure its
its
profit
profit margin
margin against
against adverse
adverse
movements
movements in
in the
the foreign
foreign currency
currency
while
while guaranteeing
guaranteeing fixed
fixed prices
prices to
to
foreign customer.
customer.
foreign
202
202
=
bh
:
a
iP
|
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a
A
‘
fee
.
|
Se
(4) walt Disney expects to receive a Mex$16 million
theatrical fee from Mexico in 90 days. The
current spot rate is $0.1321/Mex$, and the
90-day forward rate is $0.1242/Mex$.
a. What is Disney’ peso transaction exposure
associated with this tee?
b. If the spot rate expected in 90 days is
$0.1305, what is the expected U.S. dollar
value of the fee?
c. What is the hedged dollar value of the fee?
d. What factors will influence the hedging
decision?
203
203
mere
Re is L
ia
S:
Wooper
Ingza
U.S:
a
|
|| ae
EP
has just invested
£500,000 in a note that will come due in 90 days
and is yielding 9.5% annualized. The current spot
valuevof the pound is $1.5612; and the 90- -day
forward rate is $1.5467.
4. What is the hedged dollar valine ‘of this note at
maturity?
4.
What is the annualized dollar yield on the
hedged note?
Sf Cooper. anticipates that the value of the pound
in 90 days will be $1.5550. Should it hedge?
Why or why not? |
d. Suppose that Cooper has a cwasabie of
£980,000 coming due in 180 days. Should this
affect its decision of whether to hedge its
sterling note? How and why?
204
LUT
| | aa
a, |
/9.
| |
American Airlines is trying to decide how to go
about hedging ©70 million in ticket sales
receivable in 180 days. Suppose it faces the
following exchange and interest rates.
Spot rate:
$0.6433—42/€
Forward rate (180 days):
$0.6578—99/€
Euro 180-day interest rate.
(annualized):
|
4.01% —3.97%
U.S. dollar 180-day interest
rate (annualized):
8.01%—7.98%
205
205
Pe
3
ji -
PS
—
\
I
7k
a
F “te
7
>.
|
Ce
|
<i
| | fle | MEP
Nee.
a. What is the hedged value of American’ ticket
sales using a forward market hedge?
b. What is the hedged value of Americans ticket
sales using a money-market hedge? Assume the
first interest rate is the rate at which money
can be borrowed and the second one the rate _
at which it canbe lent.
3
c. Which hedge is less expensive?
206
206
Oe tf
Rete | |
7.
Me.
4
lt
||
UL ae”
Fed
SIP
Ne
Magnetronics, Inc., a U.S. company, owes its
Taiwanese supplier NT$205 million in three
months. The company wishes to hedge its NTS
payable. The current spot rate is NT$1.=
U.S.$0.03987,
and
the
three-month
forward
rate
is NT$1 = U.S.$0.04051. Magnetronics can also
borrow or lend U.S. dollars at an annualized
interest rate of 12% and Taiwanese dollars at an
annualized interest rate of 8%.
a. What is the U.S. dollar accounting entry for
this payable?
a
b. What is the minimum U.S. dollar cost that
Magnetronics can lock in tor this payable?
¢)
Describe the procedure it would use to get this
price.
:
At what forward rate would interest rate parity
hold given the interest rates?
207
ZU/
}
ye
mp
i>,
eo
kee|
| lth
Nut
|
2. Rolls-Royce, the British jet engine manufacturer,
sells engines to U.S. airlines and buys parts from
U.S. companies. Suppose it has accounts
receivable of $1.5 billion and accounts payable of
$740 million. It also has borrowed $600 million.
The current spot rate is $1.5128/£.
a. What ‘is Rolls-Royce’s dollar transaction
exposure in dollar terms? in pound terms?
b. Suppose the pound appreciates to $1.7642/£.
What is Rolls-Royce’s gain or loss, in
_pound terms, on its dollar transaction exposure:
208
208