Fall, 2004
Dick Sweeney
International Finance: 1
The Exchange Market and Management of Exchange-Rate Risk
323 Old North; (202) 687-3742, 687-3796
M,W, 1-2:30pm; if these times are inconvenient or conflict with other obligations, let’s make an appointment—
please do not hesitate to talk with me
Prerequisites: A Financial Management course, and a Statistics course—or permission of teacher
Religious Observances: If there are any conflicts, let me know right away and we’ll take care of them.
Objectives: The overriding goal is to make you competitive with top MBAs who are strong in international finance.
You should have complete control of basics such as covered interest arbitrage, and covered versus uncovered
interest parity. You should be practiced and confident in using risk models on international finance problems. You
should feel secure that you know when and how to use asset-pricing models versus portfolio models for foreignexchange problems.
Class time: Some meetings are technical, to help you get the mechanics down and to develop intuition about when
the mechanics are appropriate. In other meetings, we discuss cases or problems, to build problem-solving skills and
intuition.
Grades:
Case write-ups, problem sets and class participation:
Mid-term exam and pop quizzes:
Final exam:
33 1/3 %
33 1/3 %
33 1/3 %
Save in rare instances, cleared with me in advance, no case or problem can be turned in late. There are no make-ups.
For excused absences, notify me in advance; I'll ignore a missed mid-term or quiz. All examination and quiz
answers must be solely your own work; please do not give anyone help or ask for help from anyone other than me.
Exams are open-book, open-note; quizzes are not.
Cases: Each class member must be present for every case discussion, prepared to discuss the case questions (after
the Case Questions towards the end of the syllabus). Each person turns in a one-page write-up on each case, in class,
at the start of the meeting in which we discuss the case. Please do not ask anyone to turn in your work for you, and
do not turn in your work if you are not present during the class for the entire discussion. Please work on cases in
groups—but each person must do an independent write-up. Do not discuss the cases with people who have worked
on them in the past; this hurts development of your problem-solving skills and intuition; this is a serious breach of
academic faith, and I view it as the equivalent of cheating on an exam. Please follow the “Format for Case Writeup” (p. 8 below). Be sure to ask me for help if you have any questions.
Note: Check the course web page for class handouts. You can find the course web page by going to my
page under MSB faculty.
International Finance: 1. Fall, 2003. Page 2
International Finance: 1. The Exchange Market and Management of Exchange-Rate Risk
Short Meeting-by-Meeting Outline
Weds., Sept. 1
Introduction
Weds., Sept. 8
Mon., Sept. 13
The Foreign Exchange Market and Its Mechanics
The Foreign Exchange Market and Its Mechanics, cont. (Prob. 1 is due)
Weds., Sept. 15
Covered-interest arbitrage: SEBank (B) (case write-up is due).
Mon., Sept. 20
Weds., Sept. 22
Hedging foreign exchange exposure: e-Mother case (case write-up is due)
Hedging and Portfolio Analysis (case write-up is due)
Mon., Sept. 27
Mid-term Exam (Intro to use of APMs; short exam)
Weds., Sept. 29
Using APMs to analyze foreign-exchange decisions (Prob. 2 is due)
Mon., Oct. 4
Weds., Oct. 6
Baggins Co. case (first case write-up is due)
Baggins Co. case (second case write-up is due)
Weds., Oct. 13
Using Portfolio Analysis and APMs in other international problems: Chat Shipping and
Handling (A) (case write-up is due)
Using Portfolio Analysis and APMs in other international problems: Chat Shipping and
Handling (B) (case write-up is due; review session in class)
Thurs., Oct. 14
All readings are required. Please do all the starred "*" reading before the class meeting.
Notes in packet. Some of the Notes are overlapping. This is to give you a chance to look at some topics from
different viewpoints. If you understand the material from one note, you do not have to spend time on overlapping
notes. One chapter of ESM, below, is required.
Required: Financial Times.
Optional texts, on reserve; read them if they are useful to you:
Eiteman, D.E., A.I. Stonehill, and M.H. Moffett (ESM). Multinational Business Finance. 10th ed. Boston:
Addison-Wesley Publishing Co., 2004.
Chapter 4 of ESM is required reading for the second and third meetings. Ten copies are on reserve
at Lauinger Library; check with the reserve desk for electronic availability.
Moffett, M.H., A.I. Stonehill, and D.E. Eiteman. Fundamentals of Multinational Finance. Boston:
Addison-Wesley Publishing Co., 2004.
International Finance: 1. Fall, 2003. Page 3
International Finance: 1. The Exchange Market and Management of Exchange-Rate Risk
Detailed Meeting-by-Meeting Outline:
Weds., Sept. 1
Introduction
Topics: Goals and organization of course.
Reading: None. See packet for Comparison of Stocks and Exchange Rates—Figure and Table
Weds., Sept. 8
The Foreign Exchange Market and Its Mechanics
Topics: Organization, size and importance of the foreign exchange market; the mechanics of the foreign exchange
market. Value dates; American, European and direct, indirect quotes; bid-ask spreads;
Reading: *ESM Chp. 4 (don’t worry about memorizing things).
Mon., Sept. 13
The Foreign Exchange Market and Its Mechanics, cont. (Prob. 1 due)
Topics: Continuation of previous meeting; introduction to covered interest arbitrage.
Prob. 1 is due at the next meeting. Be prepared to discuss the problems in detail in class. All assigned problems are
at the end of this syllabus.
Reading: *“Covered Interest Arbitrage: The Basics” (plus tables), and “Covered Interest Arbitrage: An Example,”
in course packet; *review ESM, Chp. 4.
SEBank (B) case write-up is due at the next meeting. Please use the Case Write-Up format, which is after the Case
Questions towards the end of the syllabus.
Weds., Sept. 15
Covered interest arbitrage (in packet; SEBank (B) case write-up is due).
Topics: Covered interest arbitrage and its relationship to covered interest parity; mechanics, logic of transactions;
effects of bid-ask spreads. Introduction to hedging.
Read *“Notes on Covered Interest Parity” (in packet—this is a review and supplement to material that is in
“Covered Interest Arbitrage: The Basics” and “Covered Interest Arbitrage: An Example.”).
Mon., Sept. 20
e-Mother (A) case: Hedging foreign exchange exposure (in packet; case write-up due)
Topics: How do spot and forward exchange rates behave? Should you cover forward? or spot? take an open
position? When? How do you decide?
Weds., Sept. 22
e-Mother (B) case: Hedging and Portfolio Analysis (in packet; case write-up is due)
Topics: Mean-variance portfolio analysis. Applying it to foreign-direct investment decisions.
Reading: Review mean-variance analysis in any of your texts.
*Stern, S., tables from Fourteen Years of European Investments: 1914-1929.
International Finance: 1. Fall, 2003. Page 4
Problem 2 is due at the meeting on Sept. 24.
Mon., Sept. 27
Mid-term exam! (Intro to use of APMs. Short exam in class.)
Weds., Sept. 29
Using APMs to analyze foreign-exchange decisions
Topics: Systematic and non-systematic risk in FX markets; using beta and the SML to analyze decisions on
currency-denomination of deposits, and on whether to hedge or not.
Read *“Notes on Using the CAPM to Analyze the FX Market,” (in packet), *”Notes on Beta Risk and Uncovered
Interest Parity,” (in packet). *“A Review of Asset-Pricing Models and the CAPM,” (in packet), *Multi-Factor AssetPricing Models—An example,” (in packet). *”What portion of exchange-rate risk is diversifiable?” (in packet).
“Foreign-Exchange Risk and the Diversified Decision Maker, (A) – (C),” (in packet—this is a detailed review and
supplement to the readings and discussion, for use if you need it.).
Problem 2 is due at this meeting.
Mon., Oct. 4
Baggins Co. case (first case write-up is due)
Read: *”Mordor Saves on Transactions Costs by Not Hedging.” Look at “DEM and JPY Betas Vary Over Time …
(graph),” “DEM Net Appreciation … Market Models (table),” “U.S. Dollars per Euro…(two graphs),” (all in
packet).
Weds., Oct. 6
Baggins Co. case (second case write-up is due)
Weds., Oct. 13
Using Portfolio Analysis and APMs in other international problems: Chat Shipping
and Handling (A) (in packet; case write-up is due)
Topics: Applying mean-variance portfolio analysis to foreign-direct investment decisions; using scenario analysis.
Does international diversification pay? How much? How can you estimate the benefits? Pitfalls in estimating
benefits (see Stern tables).
Reading: Review mean-variance analysis in any of your texts.
*Stern, S., tables from Fourteen Years of European Investments: 1914-1929.
Thurs., Oct. 14
Using Portfolio Analysis and APMs in other international problems: Chat Shipping
and Handling (B) (in packet; case write-up is due; review session in class)
Topics: Choosing between mean-variance analysis and beta/SML analysis.
Reading: Review beta analysis in Notes used above.
International Finance: 1. Fall, 2003. Page 5
Case Questions
Be prepared to discuss all questions in class for the given case. Please answer the bold-faced question in your
write up; we will discuss some of the “Questions to think about” in class. Follow the “Format for Case write-up” (p.
8 below), including the one-page limitation. If you have any questions, please ask me for help.
SEBank (B) case:
If Ms. Juselius attempts to profit from covered interest arbitrage, what trades will she
make? If she gets the quoted rates, what are her profits? When does she actually get the
profits?
Question to think about: What can go wrong with an attempt to profit from covered interest arbitrage?
e-Mother (A) case:
If Mr. Patel decides to hedge, would you recommend a money market or forward hedge?
Why? Give numerical results.
Question to think about: If e-Mother uses a spot hedge, what will it do with the borrowed funds? or what rate will
they grow at? What do you think is the most reasonable rate to use?
e-Mother (B) case:
If Mr. Patel uses portfolio theory to decide on hedging, what is the effect of the correlation
coefficient on his decision?
Baggins Co. case: Do question 1 for the first write-up, and question 2for the second write-up.
1. Mordor do better on its actual hedges than it would have on average if it had hedged all
its transactions? What do you conclude about the ability of Mordor’s people to forecast
exchange rate movements? What is the implicit benchmark used in drawing this
conclusion?
2. What part of actual Euro depreciation was due to systematic risk? What part to nonsystematic, diversifiable risk? Mark these components in a SML diagram. Did Mordor’s
treasury people do better than would be expected given what happened to the Euro? Show
this in your SML diagram.
Chat Handling and Shipping (A) case:
What is the risk-return trade off for the company? Find numerical results, and also draw
an (approximate) efficient frontier for the company’s problem. Should the company go into
Europe, given that it is going to stay in the U.S.?
Chat Handling and Shipping (B) case:
International Finance: 1. Fall, 2003. Page 6
Using beta/SML analysis, does the Europe operation look good? How does this depend on
the debate about correlation with the market? Justify your views in quantitative terms.
Question to think about: Would the Chat family be wise to focus on portfolio theory in deciding on the Europe
operation?
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Format for Case Write-up
Name: ------- ------Case Title: XYZ Corp.
Issue: Should XYZ go ahead with its Ruritania plant?
Analysis: Table 1 shows expected cash flows...
[The write-up is all on one page; please type the write-up, single-spaced if you like, in Times Roman 10pt or larger,
with at least 1-inch margins all around. Use as many pages as you like for exhibits to support your analysis, but do
not carry on the discussion in the exhibits. The exhibits need not be typed. Work on the case in groups; your
write-up must be only your own work. Please do not ask anyone to turn in your case write-ups for
you, and do not turn in your write-ups unless you are in class for the entire discussion.]
International Finance: 1. Fall, 2003. Page 7
Problems
If you get stuck, call me at my office or drop by and we can talk over the solutions.
Problem 1—Foreign-Exchange Mechanics
[These problems let you validate that you have a handle on this key material.]
1. You call a dealer who quotes spot, one-month, three-months, and one-year forward. You ask for Japanese Yen (it
is understood it is against the USD unless you say otherwise) and hear
“111.43 to 51, 52 to 48, 150 to 144, 337 to 205.”
a. If you sell JPY 300,000,000, what do you receive?
b. How much does it cost you to buy JPY 400,000,000 forward three-months?
2.
spot
1-month
3-month
6-month
Mexican peso
9.3850-80
70-80
210-215
410-440
a. Express the above quotations on an outright basis.
b. For six-months pesos, express these quotations as a forward premium or discount, from the point of view of a
trader in New York, using the bid prices.
3.
spot
1-month
3-month
6-month
Mexican peso
Pound sterling
9.3850-80
1.6320-35
70-80
40-34
210-215
105-95
410-440
190-170
What is your best guess of the current cross spot rate for Mexican pesos/pounds sterling? Hint: triangular arbitrage.
Problem 2—Hedging a Payable
[This problem is a variation on the e-Mother case, with added difficulty. It lets you validate that you are
fully in charge of forward and spot hedges.]
Mr. Wilbur Chat, CFO of Wiskas, accepted delivery of a CHF2 million atomic metal press from a Swiss
firm, with payment due in three months. Reviewing Wiskas' receivables and payables over the next six months, Mr.
Chat found he had none that affected the exchange risk of the required payment. He decided to hedge, but was
uncertain how to hedge. He had the following bid-ask data from Wiskas' Bank:
Interest Rates--3-mths (deposit, borrowing rates)
Exchange Rates
USD
CHF
Spot
Forward--3mths
4.000-4.090
8.000-8.100
2.000/10
2.100/200
Fatigued by all of this excitement, Mr. Chat turns the whole issue over to you. He wants alternatives and
concrete recommendations.