TOPIC 7 INTERNATIONAL BOND AND EQUITY MARKETS
QUESTIONS AND SUGGESTED ANSWERS
QUESTIONS
1. Briefly define each of the following major types of international bond market
instruments, noting their distinguishing characteristics. Straight fixed-rate bonds;
Floating rate notes; Convertible bonds; Zero coupon bonds; Dual currency bonds.
Answer: The major types of international bond instruments and their distinguishing
characteristics are as follows:
Straight fixed-rate bond issues have a designated maturity date at which the principal of
the bond issue is promised to be repaid. During the life of the bond, fixed coupon
payments that are some percentage rate of the face value are paid as interest to the
bondholders. This is the major international bond type.
Floating-rate notes (FRNs) are bonds with their coupon payments indexed to some
reference rate that changes over time. Common reference rates are either three-month
or six-month U.S. dollar LIBOR. Coupon payments on FRNs are usually quarterly or
semi-annual.
A convertible bond issue allows the investor to exchange the bond for a pre-determined
number of equity shares of the issuer. The floor value of a convertible bond is the
maximum of its straight fixed-rate bond value and conversion value. Convertibles
usually sell at a premium above the larger of their straight debt value and their
conversion value. Equivalently, investors are usually willing to accept a lower yield
compared with comparable straight fixed coupon bond rate because conversion feature
is valuable. Bonds with equity warrants can be viewed as a straight fixed-rate bond with
the addition of a call option (more correctly, a warrant) feature. The warrant entitles the
bondholder to purchase a certain number of equity shares in the issuer at a pre-stated
price over a pre-determined period of time.
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. Another
form of zero coupon bonds are stripped bonds. Note that a fixed rate bond can be
considered a series of zero coupon bonds that results from stripping the coupons and
principal from a coupon bond. The result is a series of zero coupon bonds represented
by the individual coupon and principal payments.
A dual-currency bond is a straight fixed-rate bond which is issued in one currency and
pays coupon interest in that same currency. At maturity, the principal is repaid in a
second currency. The dual currency bond can be considered a “strip” of coupons in one
currency plus a zero coupon bond in another currency. From the investorʼs perspective,
a dual currency bond can also be considered as a portfolio of a straight fixed rate bond
in the coupon currency plus a long-term forward contract that is long the principal
currency and short the coupon currency.
2. You are an investment banker advising a European bank about a new international
bond offering it is considering. The proceeds are to be used to fund USD loans to bank
clients with rates linked to 3-month LIBOR. What type of bond instrument would you
recommend that the bank consider issuing? Why?
Answer: Since the bank desires to use the bond proceeds to finance floating rate loans,
the investment banker would likely recommend that the bank issue FRNs, which are a
variable rate instrument. Issuing this kind of instrument will ensure there is 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-month LIBOR. This
would eliminate any interest rate risk that the bank would face.
3. A five-year, 4 percent Euroyen bond sells at par (a Euroyen bond is the yen equivalent
of a Eurodollar bond). A comparable risk five year, 5.5 percent yen/dollar dual currency
bond pays $833.33 at maturity with coupons paid annually. It sells for \110,000 on a par
value of \100,000. What is the implied F(\/$) forward exchange rate for this
instrument?
Answer: The yield on the Euroyen bond pins down the yield on a straight fixed rate yen
bond. The dual currency bond is a portfolio of a yen straight fixed rate bond and a
forward to sell yen and buy USD. We need to solve for the forward rate such that when
we convert the USD principal into yen at that rate, the price equals the PV of yen cash
flows, discounted at 4%:
5,500
1.04
110,000
110,000
𝐹
24,485
𝐹
684.9
833.33
1.04
𝐹
124.9
4. What are some of the advantages and costs associated with a company cross-listing
its equity shares on more than one national exchange?
Answer: A company may cross-list its shares on foreign exchanges to broaden its
investor base and therefore to increase the demand for its stock and stock liquidity. An
increase in demand will generally increase the stock price, which is a primary goal of
managers, and also can improve its market liquidity. A broader investor base may also
mitigate the possibility of a hostile takeover. Additional, cross-listing a companyʼs
shares establishes name recognition and thus facilitates sourcing new equity capital in
these foreign capital markets and indicates that the company can meet the securities
regulations in the foreign market.
The costs are primarily the direct costs associated with listing on a new exchange (fees
paid to banks and exchanges, regulatory costs etc.) and also additional costs associated
with record keeping (i.e. maintaining an accurate registry of shareholders across
jurisdictions).
5. Why might it be easier for an investor desiring to diversify their portfolio
internationally to buy depository receipts rather than the actual shares of the company
on a foreign exchange?
Answer: A depository receipt can be purchased on the investorʼs domestic exchange. It
represents a package of the underlying foreign security that is automatically converted
into the investorʼs local currency and in a denomination that is typical for the investorʼs
marketplace. The investor can purchase a depository receipt directly from his or her
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.
6. On the Tokyo Stock Exchange, Honda Motor Company stock closed at \3,945 per
share on Thursday, April 11, 2013. Honda trades as an ADR on the NYSE. Each ADR
represents one underlying Honda share. On April 11, 2013, the \/$ spot exchange rate
was \99.8270/$1.00.
a. At this exchange rate, what is the no-arbitrage U.S. dollar price of one ADR?
b. Honda ADRs traded at $39.97. Why might there not be an arbitrage opportunity here,
even if the markets are open simultaneously?
Answer:
a. The no-arbitrage ADR U.S. dollar price is: \3,945 ÷ 99.8270 = $39.52.
b. Transaction costs may well make this potential arbitrage unprofitable. These costs
include brokerage fees and bid ask spreads paid in the ADR, the share and the currency.
Furthermore, if the markets did not trade simultaneously, then the slight difference in
prices could just reflect the fact that the Tokyo Stock Exchange closes several hours
before the NYSE. For example, if the days trading range for Honda ADR on the NYSE
was $39.45̶$40.15; the no-arbitrage price was inside this range.
7. If Honda ADRs were trading at $44 when the underlying shares were trading in Tokyo
at \3,945, what could you do to earn a riskless profit? Use the information in problem 1,
above, to help you, assume that you can convert shares to ADRs and vice versa and that
transaction costs are negligible.
Answer: As the solution to problem 1 shows, the no-arbitrage ADR U.S. dollar price is
$39.52. If Honda ADRs were trading at $44, a wise investor might buy X shares of Honda
for a USD cost of $39.52. They would then convert these shares into ADRs and sell
them on the NYSE for $44 per ADR, earning $44 - $39.52 = $4.48 per ADR.
MULTIPLE CHOICE QUESTIONS
1. Find the present value of a 3-year bond that pays an annual coupon, has a
coupon rate of 6%, a yield to maturity of 5%, and a par value of €1,000.
A. €1,018.81
B. €1,027.23
C. €1,099.96
D. none of the above
2. Straight fixed-rate bond issues have
A. a designated maturity date at which the principal of the bond issue is
promised to be repaid. During the life of the bond, fixed coupon payments,
which are a percentage of the face value, are paid as interest to the
bondholders.
B. a designated maturity date at which the principal of the bond issue is promised
to be repaid. During the life of the bond, coupon payments are determined by
the realizations of reference interest rates.
C. a fixed payment, which amortizes the debt, like a house payment or car
payment.
D. none of the above
3. True or false: floating rate notes behave differently in response to interest rate
risk than straight fixed-rate bonds.
A. True since FRNs experience only mild price changes between reset dates,
over which time the next period's coupon payment is fixed (assuming, of
course, that the reference rate corresponds to the market rate applicable
to the issuer).
B. False since all bonds experience an inverse price change when the market rate
of interest changes.
C. None of the above
4. The floor value of a convertible bond
A. is the "straight bond" value.
B. is the conversion value.
C. is the minimum of a and b.
D. is the maximum of a and b.
5. Bonds with equity warrants
A. are really the same as convertible bonds if the prestated price of exercising the
warrant is the par value of the bond.
B. can be viewed as straight debt with a call option (technically a warrant)
attached.
C. can only be exercised on coupon dates.
D. typically are convertible as well.
6. Find the price of a 30-year zero coupon bond with a €1,000 par value that has a
yield to maturity of i€ = 5 percent.
A. €231.38
B. €432.20
C. €4,321.94
D. none of the above
7. Zero-coupon bonds issued in 2006 are due in 2016. If they were originally sold at
55 percent of face value, the implied yield to maturity at issuance is
A. 1.062%.
B. 6.16%.
C. 8.31%.
D. cannot be determined without more information.
8. Find the value today of a 2-year dual currency bond with annual coupons (paid in
U.S. dollars at a 5 percent coupon rate) that pays £500 per $1,000 par value at
maturity. The cash flows of the bond are:
The dollar-based yield to maturity is i$ = 3%; the spot exchange rate is $1.80 =
£1.00; the pound-based yield to maturity is i£ = 4%.
A. $927.77
B. $941.30
C. $965.06
D. $880.65
9. Companies domiciled in countries with weak investor protection can reduce
agency costs between shareholders and management
A. by moving to a different county.
B. by listing their stocks in countries with strong investor protection.
C. by occasionally providing additional accounting information to investors.
D. having a press conference and promising to be nice to their investors.
10. "Yankee" stock offerings are
A. shares in foreign companies originally sold to U.S. investors.
B. dollar-denominated shares in foreign companies originally sold to U.S.
investors.
C. U.S. stocks held abroad.
D. none of the above
11. American Depository Receipt (ADRs) represent foreign stocks
A. denominated in U.S. dollars that trade on European stock exchanges.
B. denominated in U.S. dollars that trade on a U.S. stock exchange.
C. denominated in a foreign currency that trade on a U.S. stock exchange.
D. non-registered (bearer) securities.
12. On the Paris bourse, shares of Avionelle trade at €45. The spot exchange rate is
$1.40 = €1.00. What is the no-arbitrage U.S. dollar price of an Avionelle ADR?
Assume that transactions costs are negligible and the ADR represents one share
of Avionelle.
A. $63
B. $32.14
C. $45
D. $45.50
13. Calculate the dollar-based percentage return an American would have if he
bought a British stock at ₤50 per share and sold it one year later at ₤60. The spot
exchange rate one year ago was S($/₤) = 1.50 and the spot rate prevailing at the
end of the year was S($/₤) = 1.20
A. 36% gain
B. 20% gain
C. 4% loss
D. 9.6% gain
E. None of the above
14. Consider a stock market with 20 stocks. Eighteen stocks have market
capitalization of $1 billion each. The remaining two stocks have market
capitalizations of $2 billion and $3 billion respectively. The Concentration Ratio
is:
A. 0.059
B. 0.565%
C. 56.5%
D. 21.7%
E. None of the above
15. Consider a stock market with 20 stocks. Eighteen stocks have market
capitalization of $1 billion each. The remaining two stocks have market
capitalizations of $2 billion and $3 billion respectively. The HHI is:
A. 0.059
B. 0.565%
C. 56.5%
D. 21.7%
E. None of the above