finance technical assignment
iamnickok
PPT.zipIF15.ppt
Chapter 15
International Portfolio Investments
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
Discuss benefits of international investments and demonstrate the effect of correlations.
Define home bias and discuss why it occurs.
Graphically analyze international diversification benefits.
Analyze effects of currency risk in international investments.
15-*
A1. Why Invest Internationally?
- Can increase profits or returns:
- Growing economies
- Capital Starved, so returns bid up
- Inefficient Markets
- Currency Play
- Can Reduce Risk: low correlation between national markets produce diversification
15-*
A2. Correlation: A Key Driver
15-*
| Scenario | Probability | Asset X Home Country | Asset Y Foreign Country | ||
| Return | Deviation | Return | Deviation | ||
| I | 40% | 30% | 18.0% | 36% | 23.6% |
| II | 40% | -10% | -22.0% | 0% | -12.4% |
| III | 20% | 20% | 8.0% | -10% | -22.4% |
| Mean | 12.00% | 12.40% | |||
| Variance | 0.0336 | 0.0385 | |||
| Std. Dev. | 18.33% | 19.61% | |||
| Covariance | 0.0243 | ||||
| Correlation | 0.6765 |
A3. Example of Diversification
Consider the previous example concerning countries X and Y. An investor located in country X wishes to invest equally in the stocks of X and Y. Demonstrate the benefits of diversification for this investor. Assume that the risk-free rate of interest in country X is 5%.
15-*
B1. Barriers to Diversification
- Takes time for investors to learn how to diversify internationally
- Withholding taxes
- High transaction costs
- Government regulations restricting foreign ownership of assets
- Limits on currency transactions
- Cost of acquiring information
15-*
B2. Home Bias
- In principle investors should have exposure to assets in proportion to their value
- US assets are roughly 25% of world assets, yet US investors have more than 80% of their portfolio in US assets
- Internationally, there is considerable variation in home bias
- Europeans appear less biased and Asians appear more biased, compared to Americans
15-*
C. Graph of Diversification
15-*
Exhibit: International Portfolios Provide a Better Risk-Return Tradeoff (Sharpe Index)
Line 2
Portfolio Return Curve 2
Line 1
G Curve 1
E
F B A
D Optimal Domestic Portfolio
H
Risk-free Rate C Optimal International Portfolio (higher Sharpe Index)
{A,B,C,D} = purely domestic portfolios
{E,F,G,H} = international portfolios
D. Currency Risk
EXAMPLE: A US investor is considering an investment in Mexico. The asset has a local currency standard deviation (asset risk) of 25%. The standard deviation of MXPUSD is 8%. Assume that the correlation between the asset and MXPUSD is -0.3. Estimate total risk. Determine whether the investment is riskier for a US investor compared to a local (Mexican) investor.
15-*
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Portfolio Risk
{A,B,C,D} = purely domestic portfolios
{E,F,G,H} = international portfolios
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IF01.ppt
Chapter 1
Introduction
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objectives
Explain globalization and discuss Factors.
Discuss theories of trade. Distinguish.
Discuss how MNCs facilitate globalization and special risks faced by them.
Compare US and other governance models.
List international financial management issues.
1-*
A1. What is Globalization?
- Movement of Goods: worldwide integration of producers and consumers
- Movement of Services: cross-border flow of services (e.g., tourism, consulting)
- Movement of People: migration toward work
- Movement of Money: investments across borders
1-*
A2. Factors Influencing Globalization
- End of World War II: unprecedented era of peace helped the global economy
- Trade Agreements: WTO, NAFTA, etc.
- Dismantling of Socialist Systems: liberation of E. Europe
- Rise of Asia: China, India and other economic power
1-*
A3. Technology, Innovation & Globalization
- Telecommunications Revolution: allows low-cost contact and spurs business activity
- Internet: a post-1980 phenomenon, radically transforms ability of parties to conduct business across borders (e.g., outsourcing)
- Sea and Air Shipping: containerization and other innovations brought down cost
1-*
B1. Trade: Classical Theory
- Theory of comparative advantage (David Ricardo, 19th century)
- Labor productivity differs within country and across countries because of varying technology
- Nations have relative advantages in certain products (e.g., Portugal had advantage in wine and England had advantage in cloth)
- Countries benefit by shifting production and making products where they have an advantage and by trading with other countries (e.g., Portugal produces more wine and England produces more cloth)
1-*
B2. Trade: Neoclassical Theory
- Heckscher and Ohlin (HO) model:
- Focus on factor abundance, rather than technology, as explanation for productivity differences
- Countries with relatively more capital will focus on capital intensive industries (e.g., automobile, steel)
- Countries with relatively more labor will focus on labor intensive industries (e.g., textiles, agriculture)
1-*
B3. Other Theories of Trade
- Imperfect Markets: Factors of production (e.g., labor, capital) cannot easily move across borders, so countries specialize using what they have.
- Gravity: More trade occurs between countries of similar size and of close proximity
- Firm-level Product Cycle: Over time, to increase scale, firms export
- New Trade: Consumers seek variety and producers seek scale. This theory is unique is explaining why a country may simultaneously import and export the same product
1-*
B4. Location Theories
- Industry Agglomeration: Positive externalities such as knowledge spillover, labor market pooling and development of ancillaries help ‘agglomerate’ an industry in one location (e.g., computer industry in Silicon Valley)
- Porter’s Diamond: Explains why nations have advantage in certain products:
- Factor conditions
- Demand conditions
- Related and Supporting Industries
- Firm Strategy, Structure and Rivalry
1-*
C1. Why Firms Become MNCs?
- OLI model:
- Ownership Advantages: firm has specialized assets
- Location Advantages: input availability, low taxes, etc.
- Internalization Advantages: in-sourcing more advantageous than outsourcing
- Knowledge-Capital model:
- Knowledge capital can be transferred cross-border much easier than physical capital (foreign subsidiaries can be created easily)
- Skilled labor is important, usually abundant in the home country of MNC
1-*
C2. MNCs Facilitate Globalization
- MNCs are skilled in moving and selling goods in foreign markets (helps international trade)
- MNCs are skilled in making investments in foreign real assets (helps FDI)
- MNCs are skilled in business contracting (helps trade as well as FDI)
1-*
C3. Special Risks Faced by MNCs
- Currency Risk: affects transactions, assets and operations
- Economic Risk: macro-economic variables such as inflation are highly variable
- Political and Regulatory Risk: MNCs deal with foreign governments and regulatory bodies
- Variation in Business Processes: business is often conducted using different methods globally
1-*
C4. MNCs and the Agency Problem
- MNCs wish to maximize shareholder wealth
- Difficulties arise because:
- MNCs are large with dispersed operations (monitoring and control are difficult)
- MNCs produce and sell a large number of products (complexity provides opportunity for managers to deviate from overall goals)
- MNCs are typically highly de-centralzied (unit-level managers have more power, can be abused)
1-*
D1. US Governance Model
- Independent board of directors
- Incentive contracts for managers
- Accounting procedures are geared toward reasonably transparent reports for the benefit of external investors
- Vigilant markets
- Vigilant regulators
1-*
D2. Governance in Asia
- Family Control
- Boards dominated by insiders
- Mergers are infrequently used to discipline poor management
- Accounting reports not always transparent
- Minority shareholder rights not always respected
1-*
E. International Financial Management Issues
- Understanding the environment: global markets, especially currency related markets
- Managing currency risk: measure and manage risk, understand multiple methods of risk control
- International Project Analysis: understand various nuances in capital budgeting
- Global Financing: how to source capital globally and decrease the cost of capital
- Global Operations: methods of conducting global business and penetrating new markets
1-*
IF02.ppt
Chapter 02
International Financial Markets: Structure and Innovation
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objectives
Describe FX markets, structure and participants.
Use FX direct and indirect quotes, compute transaction costs and calculate cross rates.
Classify international banking transactions.
Describe Euro-markets (short- and long-term) and global equity markets.
2-*
A1. Foreign Exchange (FX): Overview
- Focus on spot market (current exchange of one currency for another) in this chapter
- Large market with daily volume greater than that of any other financial market
- 3 reasons for transactions:
- MNCs and other entities have business related needs to convert currency
- Banks and other intermediaries ‘service’ others by converting currencies
- Investment funds have portfolio related needs to convert currencies
2-*
A2. FX Markets: MNC Participation
- MNCs convert currencies to facilitate transactions with subsidiaries, affiliates, suppliers and customers
- 3 specific ways of participation:
- MNCs purchase inputs/components from foreign suppliers
- MNCs sell goods and services in foreign markets
- MNCs make cross-border investments in real assets
2-*
A3. FX: Banks & Other Participants
- Banks: most important players, make up the Interbank market
- Other financial institutions: mutual funds, hedge funds
- Governments: not the largest player, but very influential
- Individuals: tourism and investment needs met through currency transactions
2-*
A4. FX Markets: Size & Structure
- Overall size is USD 3 trillion a day of which USD 1 trillion is spot (rest ‘future’ contracts)
- Average transaction size is USD 4 million
- Major currencies are USD, EUR, JPY and GBP
- USD in 86% of all transactions
- Large banks serve as market-makers
- Markets are over-the-counter (OTC) electronic markets
- Settlement is electronically conducted. US systems include Fedwire and CHIPS
2-*
B1. FX: Direct vs. Indirect Quote
2-*
Direct Quote ‘USD 1.25 per EUR’ Or ‘EURUSD=1.25’
Indirect Quote ‘EUR 0.80 per USD’ Or ‘USDEUR=0.80’
EUR 1
USD 1.25
USD 1
EUR 0.80
EQUALS
EQUALS
B2. FX: Bid and Ask
- EURUSD is quoted at 1.5511-1.5514
- The bank is willing to purchase EUR by paying USD 1.5511
- The bank is willing to sell EUR by receiving USD 1.5514
2-*
B3. FX: Transaction Costs
EXAMPLE: A Brazilian firm wishes to purchase USD 400,000. It approaches Unibanco for a quote. Unibanco quotes USDBRL at 1.4015 – 1.4037. Also Unibanco imposes a commission of BRL 200 on each transaction.
Firm Pays =
2-*
B3. FX: Transaction Costs (cont.)
If there are no transaction costs, firm would pay =
Transaction Costs =
Transaction Costs % =
2-*
B4. FX: Cross Rates
EXAMPLE: The EUR is quoted directly and indirectly relative to USD at 1.5514 and 0.64458 respectively. The JPY is quoted directly and indirectly relative to the USD at 0.0100 and 100.00 respectively. Calculate the cross rate between EUR and JPY using one of the following two approaches.
Solution:
Value of EUR expressed in JPY = EURJPY
= Direct quote of EUR / Direct quote of JPY
= 1.5514 / 0.0100
= 155.14
2-*
C1. International Banking
2-*
|
Classification of Banking Positions |
||
|
|
Residents |
Non-Residents |
|
Domestic Currency |
A |
B |
|
Foreign Currency |
D |
C |
|
B+C = external or cross-border positions C+D = foreign currency positions (also known as Eurocurrency) B+C+D = international positions A+B+C+D = global positions Source: BIS, Guide to the International Banking Statistics, 2003 |
C2. Classifying deposits, Example
EXAMPLE: Consider the following transactions of a French bank. It accepts two deposits from a French citizen: EUR 5,000 and USD 10,000. It also accepts two deposits from a Japanese citizen: JPY 2,500,000 and EUR 8,000. Classify these deposits.
Solution:
External positions = JPY 2,500,000 + EUR 8,000
Foreign currency positions = USD 10,000 + JPY 2,500,000
International positions = USD 10,000 + JPY 2,500,000 + EUR 8,000
Global positions = USD 10,000 + JPY 2,500,000 + EUR 13,000
2-*
D1. Eurodollars & LIBOR
- Eurocurrency or foreign currency transactions in the USD are called Eurodollar transactions
- The key indicator for this market is the London Inter Bank Offer Rate (LIBOR), the rate offered by Eurobanks for loans to other institutions
- LIBOR rates are compiled by the British Banker’s Association, and disseminated at 11 AM Greenwich Mean Time, reflect rates at which banks are willing to lend to each other
2-*
D2. LIBOR Convention
MNC deposits $3 million for 60 days at a LIBOR rate of 5%. LIBOR uses simple interest ‘actual/360’ basis
2-*
D3. Eurocurrency Markets
- Eurodollar, Euroyen, Europound and other instruments make up the Eurocurrency markets (move toward renaming to foreign currency markets, because of confusion with EUR)
- Eurdollar origins:
- Regulation Q (investors searched abroad for better interest
- External holdings of USD (current account deficits)
- Innovation by Midland Bank in 1955, thwarting regulation and creating this market
2-*
D4. Eurocredits
- Medium-term markets
- Main instrument is Floating Rate Note (FRN)
- Coupon specified as ‘LIBOR + X’
- At any point in time, only the next coupon is known, others depend on future values of LIBOR
- Term Structure models or prices from futures markets may be used to infer future values of LIBOR
- Fixed rate instruments known as Euronotes
2-*
D5. Eurobonds
- Mismatch between country of issue and currency denomination (e.g., USD bonds issued outside of US)
- First Eurobond issued in 1963 by Autostrade
- Traditionally, Eurobonds were bearer bonds
- Main currencies: USD, EUR, JPY
- Median issue: USD 100 million
- Most are fixed rate instruments
- Development: Global bonds, issued simultaneously around the world, often USD 1 billion or greater
2-*
D6. Global Equity
- US equity markets are important part of global equity markets (1/3 of value approximately)
- NYSE and NASDAQ continue to innovate and lead trading practices
- Emerging markets are becoming more important
- Electronic trading is becoming more important
- Cross-border listing is increasing
2-*
Direct Quote
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EUR 1
USD 1.25
USD 1
EUR 0.80
EQUALS
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Classification of Banking Positions
Residents Non-Residents
Domestic Currency
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Foreign Currency
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B+C = external or cross-border positions
C+D = foreign currency positions (also known as Eurocurrency)
B+C+D = international positions
A+B+C+D = global positions
Source: BIS, Guide to the International Banking Statistics, 2003
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IF03.ppt
Chapter 03
Currency and Eurocurrency Derivatives
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objectives
Describe derivatives markets, structure and participants.
Describe FX forwards and futures; calculate prices.
Describe FX options; calculate payoff and profit; distinguish between calls and puts.
Price an FX option.
3-*
A1. What are Derivatives?
- Derivatives are financial contracts whose cash flows and value derives from some underlying financial asset or commodity or indicator. For example, stock options provided to managers.
- Underlying assets may be financial assets, commodities, currencies, etc.
- Counterparties are typically known as buyer (long) and seller (short).
- Forwards and Options are the most contract type
3-*
A2. Derivatives Markets
3-*
| Notional Value of Derivatives in 2007, USD Billions | |
| Exchange Traded Derivatives: | |
| Interest Rate Futures | 26,787 |
| Currency Futures | 159 |
| Equity Futures | 1,133 |
| Interest Rate Options | 44,308 |
| Currency Options | 133 |
| Equity Options | 8,103 |
| OTC: | |
| Currency Contracts | 60,091 |
| Interest Rate contracts | 346,937 |
| Equity contracts | 9,202 |
| Commodity contracts | 7,567 |
| Credit-default swaps | 42,580 |
| Source: BIS, 2007 Statistics |
B1. Currency Forwards
- The exchange of one currency for another at a future date using a pre-determined exchange rate
- At inception, the two parties—long and short—simply agree on the forward price.
- At maturity, the short delivers the contracted units of the base currency and in return the long makes payment using the terms currency.
- Certain currency forwards do not entail actual delivery of the foreign currency and are known as non-deliverable forwards (NDF).
3-*
B2. Forward Price and Forward Premium
- Price is calculated using the following equation:
- Premium (or discount) is calculated as follows:
3-*
B3. Forward Pricing Example
- S = 0.02174 (INRUSD)
- r = 5% (US interest rate)
- r* = 10% (Indian interest rate)
- t = 2 (years)
3-*
B4. Currency Futures
- A currency futures contract is an exchange traded version of the currency forward contract.
- Futures are standardized. For instance, the GBP futures traded in the Chicago Mercantile Exchange has very specific maturities (every 3 months) and size (62,500 currency units).
- Futures may be priced using the forward pricing equation since futures and forwards are very similar instruments.
3-*
B4. Currency Futures (cont.)
- Daily settlement of profits and losses in margin accounts eliminates counterparty risk
- The CME lists more than 20 futures contracts in various currencies, cross-currencies and currency indexes. This list includes the major currencies—JPY, GBP, EUR and CHF—as well as emerging markets currencies such as the Chinese Renminbi, South African Rand and the Russian Ruble (CNY, ZAR and RUB respectively).
3-*
C1. Currency Options
- Provides the right but not the obligation to purchase (or sell) the underlying or base currency at a future date at a pre-specified strike price denominated in the terms currency.
- Options may be calls (allowing purchase) or puts (allowing sale).
- Unlike forwards and futures, an option may only be acquired by paying a premium.
- Currency options are traded in the PHLX and CME.
3-*
C2. Call Option Payoff & Profit
3-*
| Call Option: Payoff & Profit to Long (Buyer) Call Parameters: C = 0.06, X =1.25 All Values in USD | |||||
| At Contract Inception | Cash Flows At Maturity | Overall Result | |||
| Currency Value at Maturity | Premium Paid | Exercise Price Paid | Value Received | Payoff | Profit |
| 1.16 | 0.06 | No Exercise | No Exercise | 0 | -0.06 |
| 1.19 | 0.06 | No Exercise | No Exercise | 0 | -0.06 |
| 1.22 | 0.06 | No Exercise | No Exercise | 0 | -0.06 |
| 1.25 | 0.06 | No Exercise | No Exercise | 0 | -0.06 |
| 1.28 | 0.06 | 1.25 | 1.28 | 0.03 | -0.03 |
| 1.31 | 0.06 | 1.25 | 1.31 | 0.06 | 0.00 |
| 1.34 | 0.06 | 1.25 | 1.34 | 0.09 | 0.03 |
| 1.37 | 0.06 | 1.25 | 1.37 | 0.12 | 0.06 |
| Note: Payoff & Profit to Short (Seller) is the exact opposite (that is, positive values are negative and negative values are positive) |
C3. Call Option Diagram
3-*
C4. Put Option Payoff & Profit
3-*
| Put Option: Payoff & Profit to Long (Buyer) Call Parameters: P = 0.03, X =1.25 All Values in USD | |||||
| At Contract Inception | Cash Flows At Maturity | Overall Result | |||
| Currency Value at Maturity | Premium Paid | Exercise Price Received | Value Given Up | Payoff | Profit |
| 1.16 | 0.03 | 1.25 | 1.16 | 0.09 | 0.06 |
| 1.19 | 0.03 | 1.25 | 1.19 | 0.06 | 0.03 |
| 1.22 | 0.03 | 1.25 | 1.22 | 0.03 | 0.00 |
| 1.25 | 0.03 | No Exercise | No Exercise | 0 | -0.03 |
| 1.28 | 0.03 | No Exercise | No Exercise | 0 | -0.03 |
| 1.31 | 0.03 | No Exercise | No Exercise | 0 | -0.03 |
| 1.34 | 0.03 | No Exercise | No Exercise | 0 | -0.03 |
| 1.37 | 0.03 | No Exercise | No Exercise | 0 | -0.03 |
| Note: Payoff & Profit to Short (Seller) is the exact opposite (that is, positive values are negative and negative values are positive) |
C5. Put Option Diagram
3-*
C6. Summary of Option Payoff & Profit
3-*
| Summary of Option Payoff & Profits | ||
| Call Option | Put Option | |
| Long (Buyer) | Long pays premium upfront Long exercises by buying currency Payoff = Profit = Long gains when currency rises | Long pays premium upfront Long exercises by selling currency Payoff = Profit = Long gains when currency falls |
| Short (Seller) | Short receives premium upfront Short responds to exercise by selling currency Payoff = Profit = Short gains when currency falls | Short receives premium upfront Short responds to exercise by buying currency Payoff = Profit = Short gains when currency rises |
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3-*
D2. Option Pricing Example
3-*
| USE PAST DATA TO CALCULATE σ | ||||
| Date | EURUSD | % change | ||
| 1/8/2008 | 1.4708 | n/a | ||
| 1/15/2008 | 1.4804 | 0.65% | ||
| 1/22/2008 | 1.4631 | -1.17% | OBTAIN OPTION PARAMETERS | |
| 1/29/2008 | 1.4775 | 0.99% | Option is 90-day option on EUR | |
| 2/5/2008 | 1.4648 | -0.86% | X = 1.55 | Strike Price |
| 2/12/2008 | 1.4584 | -0.44% | t = 90/365 | Maturity |
| 2/19/2008 | 1.4725 | 0.97% | ||
| 2/26/2008 | 1.4975 | 1.69% | + | |
| 3/4/2008 | 1.5216 | 1.61% | ||
| 3/11/2008 | 1.5344 | 0.84% | OBTAIN CURRENCY SPOT | |
| 3/18/2008 | 1.5731 | 2.52% | S = 1.5992 | Spot Currency |
| 3/25/2008 | 1.5423 | -1.96% | ||
| 4/1/2008 | 1.5615 | 1.25% | CONTINUOUSLY COMPOUNDED RATES | |
| 4/8/2008 | 1.5711 | 0.61% | r (USD) = 2.9% | |
| 4/15/2008 | 1.5790 | 0.51% | r*(EUR) = 3.8% | |
| 4/22/2008 | 1.5992 | 1.28% | ||
| Weekly σ | 1.20% | |||
| Annual σ | *SQRT(52) | 8.62% |
D2. Option Pricing Example (Cont.)
3-*
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IF04.ppt
Chapter 04
Currency Systems and Valuation
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objectives
Describe the history of currency systems: gold standard to EMU.
Describe the continuum of systems, fixed to floating.
Discuss general current and financial account factors affecting currency values.
Discuss why and how governments influence currency values.
4-*
A1. Overview of History
- Gold Standard (1970-1915)
- (The two World Wars)
- Bretton Woods (1944-1971)
- Smithsonian (1971-)
- The Euro (2000-)
4-*
A2. Gold Standard
- Not new, has existed for millennia
- Classical gold standard (1870-1915)
- Major nations (US, UK, France) backed their currencies using gold
- Emergence of monetary unions
- Period of economic growth
4-*
A3. How does the gold standard work?
- Quantity of gold (grams) defined per currency
- Ratio of gold quantities = exchange rate (mint parity)
- Central banks import and export gold to maintain currency values
- Gold points (bracketing the mint parity) defines trigger points for import or export
- Current account balances mitigated by gold flows (gold inflows in surplus countries, money supply rises, inflation rises, deters exports)
- War and resulting high inflation brought an end to this era
4-*
A4. Bretton Woods
- Followed World War II and had these objectives:
- Multilateral Cooperation
- Currency Convertibility
- Key Provisions:
- USD 35 = 1 ounce of gold
- Central banks held reserves of gold and currencies and pledged to maintain currency values
- International Monetary Fund (IMF) created
4-*
A5. Bretton Woods: The Success
- Currency convertibility was achieved, at least for major nations, by 1958
- Currency rates were stable and international trade blossomed
- Major nations also reduced capital controls
- Boom in FDI (birth of MNCs)
4-*
A6. Demise of Bretton Woods
- In 1960s, the USD became overvalued
- The US ran large current account deficits (imports greater than exports)
- Large amounts of USD were held by external parties in excess of gold reserves of the US
- Germany had the opposite problem, was an export machine, but upward pressure was placed on German mark, also inflation was a threat
- Germany experimented with floating the mark
- US closed the “gold window” and placed a 10% import tax
4-*
A7. Smithsonian Agreement
- Group of ten nations (largest contributors to IMF) produced agreement in December 1971
- Although hailed by President Nixon as a major agreement, Smithsonian was mostly a stop-gap agreement and perpetuated the fixed regime
- USD was devalued and certain other currencies (German mark) were valued higher
- But problems persisted (e.g., GBP crisis in 1972)
- By end of 1973, most major currencies were floating
4-*
A8. European Monetary Union
- European Commission (EC) and the European Monetary Union (EMU) resulted from Treaty of Rome (1957) and subsequent agreements. This was the informal creation of the European Union (EU).
- The “snake” currency system (each currency linked to another) was introduced in 1971. Strong sentiment to keep currencies aligned
4-*
A8. European Monetary Union (cont.)
- In 1979, the European Monetary System (EMS) as created along with the European Currency Unit (ECU) the precursor to the EUR.
- European Union (EU) and the European Central Bank (ECB) formally created by the Maastricht treaty of 1992.
- The EUR was created in 2000.
4-*
B1. IMF Classification of Currency Systems
- Currency Board: extremely rigid, foreign currency holdings (usually EUR or USD) are matched against money supply, fixed exchange rate rigorously upheld
- Conventional Fixed Peg: Narrow band of +-1% is used.
- Pegged with Horizontal Bands: Looser band of up to 2%.
4-*
B1. IMF Classification of Currency Systems (cont.)
- Crawling Peg: Currency values adjusted over time at fixed rate (it crawls along!)
- Managed Floating: frequent intervention
- Independent Floating: infrequent intervention
4-*
B2. Floating Currency Systems
- Requires investments in monetary and market infrastructure
- Country needs an open economy to act as a shock absorber
- Most industrialized nations adopt this system
- In 2006, 88 nations followed this system
- Countries can pursue independent macro policy
- MNCs need to be adept at managing risk in this setting
4-*
B3. Pegged Currency System
- Value pegged to a stable currency such as EUR or USD
- Offers relief to countries with track record of high inflation and monetary mismanagement
- Problem: need to match macro policies with the country of the peg
- Small countries, already economically tied to a large economy peg their currencies to the currency of the larger economy
- Relinquish monetary policy tools for managing the economy
4-*
C1. Currency Valuation
- Demand: MNCs and other entities require a foreign currency for trade, investment, travel or other purpose.
- Supply: This is the flip side of demand. When an entity demands a foreign currency, that entity supplies the domestic currency.
4-*
C1. Currency Valuation (cont.)
- Equilibrium: Based on demand and supply, the currency rate is determined.
- This is a very rough model. We study specific models later in this chapter and in chapter 5.
- In this chapter, we study current account and capital account variables that affect currency values
4-*
C2. Current Account Analysis
- Inflation: A higher rate of inflation in a country makes that country’s products less competitive and reduces demand and value for that country’s currency.
- National Income: Higher income means more imports, means a lowering of one’s currency
- Productivity: A country with higher productivity will face rising global demand for its goods and its currency will rise in value.
- Consumer Preferences: If consumers prefer foreign goods, the country’s currency loses value.
4-*
C3. Financial Account Analysis
- Interest Rate: A country with a high interest rate attracts investment flows. Its currency rises in value.
- Investors will focus on real and not nominal rates.
- Investors also forecast future currency values: this is a topic we discuss in chapter 5.
- Corporate Management and Governance: Investment will flow toward countries which provide a good setting for management and governance.
4-*
D. Government Intervention
- Governments buy and sell currencies to manipulate exchange rates
- Intervention is sterilized when money supply effects are neutralized (through purchases and sales of securities)
- Other than currency spot markets, governments may use the following markets:
- Forwards
- Foreign Exchange Swaps
- Options
- Governments may also use capital controls and currency controls
4-*
IF05.ppt
Chapter 05
Currency Parity Conditions
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objectives
Discuss parity conditions and how they relate to arbitrage.
Discuss and apply three kinds of currency arbitrage: locational, triangular and covered interest.
Describe and apply interest rate parity (IRP).
5-*
Learning Objectives (cont.)
Describe and apply purchasing power parity (PPP).
Describe the Fisher effect and its link to other parities.
Discuss and apply methods of deriving currency forecasts and methods of assessing forecasting accuracy.
5-*
A1. Overview of Parity Conditions
- Parities relate currency values to fundamental variables such as interest rates and inflation
- Two important parities are the Interest Rate Parity (currencies and interest rates) and the Purchasing Power Parity (currencies and inflation rates)
- Parities help managers forecast future currency values
- Parities arise because of money or products moving to locations offering greater value
5-*
A2. Overview of Arbitrage
- When financial assets (or currencies) are mispriced in markets, arbitragers exploit discrepancies by buying (at low prices) and selling (at high prices)
- Currency markets offer the following types of arbitrage opportunities:
- Locational: when currencies trade at different values at different locations
- Triangular: when the cross-rate of a currency pair is not in synch with the separate quotes for the two currencies
- Covered Interest: when a foreign money market offers an attractive interest rate premium that is not entirely offset by projected decline in the foreign currency
5-*
B1. Locational Arbitrage
5-*
NEW YORK EURUSD = 1.584
PARIS EURUSD = 1.589
BUY EUR USD 1,584,000 è EUR 1,000,000
SELL EUR EUR 1,000,000 è USD 1,589,000
ARBITRAGE PROFIT = USD 5,000
PRICE DISCREPANCY
B2. Triangular Arbitrage
5-*
1
B3. Covered Interest Arbitrage
5-*
Inputs: GBPUSD (spot) = S = 1.50 GBPUSD (1-year forward) = F = 1.46 USD interest rate = r = 4% GBP interest rate = r* = 8%
BORROW USD 1,500
REPAY USD 1,560
DEPOSIT GBP 1,000
OBTAIN GBP 1,080 CONVERT AT FORWARD RATE TO OBTAIN USD 1,576.80
Convert at spot: GBP 1,000
Pay Interest of 4%
Earn Interest of 8%
ARBITRAGE PROFIT = USD 16.80
B4. Covered Interest Arbitrage: Another Example (using equation approach)
- This example illustrates CIA where borrowing occurs in the high-interest currency. Assume S = 0.75, F = 0.70, r = 6%, r* = 10%. Calculate profit per unit of currency borrowed.
- Arbitrage occurs because the rate of currency depreciation (s = 6.7%) exceeds the interest differential (4%).
5-*
C1. Interest Rate Parity
- CIA will cease to be profitable in equilibrium because:
- Interest rates will change (e.g., a heavy demand for a funding currency will raise interest rates)
- Currency values (spot and forward) will change (e.g., heavy demand for a funding currency will increase the spot rate)
5-*
C2. IRP Application: Find the Forward Rate
The 180-day LIBOR rates for USD and JPY are 4% and 1% respectively (actual/360 convention). The spot rate is as follows: USDJPY = 110. Estimate the 180-day forward rate for JPY. Adjust the IRP equation for LIBOR.00
5-*
C3. Impediments to IRP
- When default risk varies, the interest levels in various countries may reflect not only the forward premium but also differential levels of default risk.
- Transactions costs for conducting covered interest arbitrage may be high enough to prevent arbitrage from occurring even when there are deviations from parity.
- Political risk or country risk would also cause deviations from IRP.
- Taxations and other market imperfections that hinder the free movement of capital across borders.
5-*
C4. Empirical Evidence on IRP
- Overall, IRP theory works quite well especially with major currencies.
- Tests use two approaches:
- Simulation Tests: The actual arbitrage strategy is simulated with available data to determine whether profits are available. Profits are typically calculated net of the costs of the following transactions: (a) selling a domestic security or borrowing money (b) purchase of spot foreign exchange (c) forward contract (d) buying a foreign security.
- Regression Tests: The dependent variable (Y variable) is the ratio of forward-to-spot (or equivalently the natural log of forward minus the natural log of spot). The independent variable (X variable) is the interest differential (specification differs depending on whether logs are used for the Y variable). IRP requires an intercept of one.
5-*
D1. Law of One Price
- The ability of goods to move freely across borders would mean that their prices in various locations should be similar.
- Imagine that 5 lbs of sugar sells for USD 3.00 in the US and GBP 1.50 in the UK. The law of one price relies on the currency rate to makes these prices equal. This implies that the spot rate GBPUSD = 2.00.
5-*
D2. Purchasing Power Parity
- The law of one price, when applied to national price indexes, is known as purchasing power parity theory (PPP).
- The relative version of PPP is a less restrictive and perhaps more useful version of the theory. While the absolute version of PPP requires equivalent prices, relative PPP only requires that price changes are harmonized with currency changes.
- Absolute PPP focuses on price levels, relative PPP focuses on price changes or inflation.
5-*
D3. PPP Equation
Ratio of Inflation Ratio of Expected Spot
Rate Factor to Spot
5-*
D4. PPP Example
- Starting values for CPI: US CPI = 300 and Canadian CPI = 250.
- Spot CADUSD = 1.10.
- A year later CPI levels are expected to rise to 309 (US) and 255 (Canada).
- What are inflation rates in the US and Canada? What is expected ending value of CADUSD? What is its change?
5-*
D4. PPP Example (CONT.)
5-*
D5. Impediments to PPP
- Taxes differ between countries, and can cause major deviations in prices between countries. For example, value-added taxes often lead to higher prices in Europe compared to the US.
- Transportation costs can be prohibitive and can discourage cross-border transactions. For example, durable goods like cars and washing machines can sometimes incur transportation costs of more than 5% of value.
- National consumption preferences can differ. Because even similar products are no longer substitutes in the minds of consumers, they may trade at different prices.
5-*
D6. Empirical Evidence on PPP
- Tests involve calculation of real exchange rates to see if they are constant.
- There are numerous difficulties constructing tests including differences in national CPI indexes, non-traded goods and sticky prices.
- Absolute PPP is rejected (e.g., Big Mac tests!)
- Relative PPP is somewhat supported. In the long-term currency values converge toward PPP. Deviations from PPP appear to decrease at a rate of about 15% a year.
5-*
E1. Fisher Effect: National
- Denoting the nominal rate, the real rate and the rate of inflation as r, rr and i respectively, the Fisher effect (FE) is given by:
5-*
E2. Fisher Effect: International
Ratio of Interest Ratio of Expected Spot
Rate Factor to Spot
5-*
S
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5-*
INFLATION DIFFERENTIAL
EXPECTED FUTURE SPOT
INTEREST DIFFERENTIAL
FORWARD
Fisher
Interest Rate Parity
Unbiased Forward
Purchasing Power Parity
F1. Currency Forecasting
- FX theories and parities are useful to MNC managers in deriving currency forecasts
- The simplest forecast is today’s spot.
- If a forward rate is available, it could be a better forecast than the spot rate. If unavailable, try to estimate the forward using parity conditions.
- Fundamental methods may also be used to forecast currencies.
5-*
F2. Forecasting using Parities
- A UK based MNC wishes to forecast the value of JPY in 7 years time. GBP and JPY denominated risk-free (government) debt instruments have yields of 6% and 3% respectively. If JPYGBP = 0.0075 now, what is the expected future spot?
5-*
F3. Assessing Forecast Accuracy: Methods
5-*
F4. Forecast Accuracy Example (Inputs)
5-*
| Pre-forecast spot | Post-forecast spot | Forecast A | Forecast B |
| 1.44 | 1.49 | 1.52 | 1.55 |
| 1.31 | 1.29 | 1.33 | 1.26 |
| 1.52 | 1.53 | 1.51 | 1.54 |
| 1.41 | 1.40 | 1.38 | 1.44 |
F5. Forecast Accuracy Example (Solution)
5-*
| A | B | ||||||||
| AFE | Success | AFE | Success | ||||||
| 1.44 | 1.49 | 1.52 | 0.03 | 0.0009 | Y | 1.55 | 0.06 | 0.0036 | Y |
| 1.31 | 1.29 | 1.33 | 0.04 | 0.0016 | N | 1.26 | 0.03 | 0.0009 | Y |
| 1.52 | 1.53 | 1.51 | 0.02 | 0.0004 | N | 1.54 | 0.01 | 0.0001 | Y |
| 1.41 | 1.40 | 1.38 | 0.02 | 0.0004 | Y | 1.44 | 0.04 | 0.0016 | N |
| MAFE | 0.028 | 0.035 | |||||||
| RMSE | 0.0287 | 0.0394 | |||||||
| SR | 50% | 75% |
NEW YORK
EURUSD = 1.584
PARIS
EURUSD = 1.589
BUY EUR
USD 1,584,000 è
EUR 1,000,000
SELL EUR
EUR 1,000,000 è
USD 1,589,000
ARBITRAGE PROFIT
=
USD 5,000
PRICE DISCREPANCY
EURUSD = 1.50
USDJPY = 100
EURJPY = 155
USD
Start: USD 15,000
Step 3: USD 15,500
(=1,550,000/100)
EUR
Step 1: EUR 10,000
(=15,000/1.5)
JPY
Step 2: JPY1,550,000
(=10,000*155)
Inputs:
GBPUSD (spot) = S = 1.50
GBPUSD (1-year forward) = F = 1.46
USD interest rate = r = 4%
GBP interest rate = r* = 8%
BORROW USD 1,500REPAY USD 1,560
DEPOSIT GBP 1,000
OBTAIN GBP 1,080
CONVERT AT
FORWARD RATE TO
OBTAIN USD 1,576.80
Pay Interest of 4%
Convert at spot: GBP 1,000
Earn Interest of 8%
ARBITRAGE PROFIT = USD 16.80
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IF06.ppt
Chapter 06
Currency Risk Exposure Measurement
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objectives
Define currency exposure, list categories.
Provide evidence on currency volatility and demonstrate how it is calculated.
Discuss transaction exposure. Apply methods including portfolio and VaR methods.
Discuss operating exposure and its measurement.
Discuss translation exposure.
6-*
A1. What is Exposure?
- Currency movements affects the operations and results of firms
- MNCs as well as purely domestic firms are affected in various ways
- The currency impact is known as exposure
- Firms need to measure, assess and manage exposure
- This chapter concerns the measurement of exposure
6-*
A2. Types of Exposure
- Transaction: effect of currency changes on foreign cash balances as well as near-term contractual flows (e.g., payables).
- Operating: effect of currency changes on the operating cash flows.
- Translation: effect of currency changes on net income and assets.
6-*
B1. Currency Variation
6-*
B2. Calculating Currency Sigma
6-*
| Calculation of Currency Standard Deviation | ||||||||
| GBP | SGD | |||||||
| GBPUSD | s | SGDUSD | s | |||||
| 1998 | 1.6335 | n/a | n/a | n/a | 0.5685 | n/a | n/a | n/a |
| 1999 | 1.6566 | 0.0141 | -0.0103 | 0.00011 | 0.5984 | 0.0527 | 0.0282 | 0.00080 |
| 2000 | 1.6370 | -0.0118 | -0.0363 | 0.00132 | 0.6048 | 0.0106 | -0.0139 | 0.00019 |
| 2001 | 1.4977 | -0.0851 | -0.1096 | 0.01200 | 0.5757 | -0.0481 | -0.0725 | 0.00526 |
| 2002 | 1.4426 | -0.0368 | -0.0612 | 0.00375 | 0.5411 | -0.0601 | -0.0845 | 0.00714 |
| 2003 | 1.6055 | 0.1129 | 0.0885 | 0.00783 | 0.5737 | 0.0602 | 0.0358 | 0.00128 |
| 2004 | 1.8245 | 0.1364 | 0.1120 | 0.01253 | 0.5888 | 0.0262 | 0.0017 | 0.00000 |
| 2005 | 1.8834 | 0.0323 | 0.0078 | 0.00006 | 0.6076 | 0.0320 | 0.0075 | 0.00006 |
| 2006 | 1.7404 | -0.0759 | -0.1004 | 0.01008 | 0.6053 | -0.0038 | -0.0282 | 0.00080 |
| 2007 | 1.9736 | 0.1340 | 0.1095 | 0.01200 | 0.6529 | 0.0787 | 0.0542 | 0.00294 |
| 0.0245 | 0.0165 | |||||||
| 0.00746 | 0.00231 | |||||||
| 8.64% | 4.80% |
2.unknown
5.unknown
B3. Sigmas for a Sample of Currencies
6-*
| Currency Standard Deviation: 2005-2007 | |||
| Weekly | Monthly | Annual | |
| Major Currencies: | |||
| EUR | 1.02% | 2.12% | 7.36% |
| JPY | 1.19% | 2.48% | 8.59% |
| GBP | 1.09% | 2.26% | 7.83% |
| CAD | 1.06% | 2.20% | 7.62% |
| CHF | 1.14% | 2.38% | 8.26% |
| Emerging Market Currencies: | |||
| BRL | 1.78% | 3.72% | 12.87% |
| CNY | 0.21% | 0.44% | 1.54% |
| INR | 0.70% | 1.47% | 5.08% |
| MXP | 0.89% | 1.86% | 6.43% |
| SGD | 0.53% | 1.11% | 3.84% |
| KRW | 0.81% | 1.69% | 5.87% |
| Source: Federal Reserve Bank of NY website. Calculations based on weekly returns using Tuesday values. To obtain annual from weekly multiply by square-root of 52. To obtain monthly from annual divide by square-root of 12. |
C1. Transaction Exposure
- Impact of currency changes on the value of liquid financial assets
- Impact of currency changes on the value of contractual cash flows
- All MNCs have transaction exposure because they have foreign affiliates and subisidiares
- Transaction exposure can also arise because of foreign suppliers and customers
6-*
C2. Transaction Exposure: Scenario Analysis
6-*
| Currency Exposure using Best and Worst Case Scenarios | |||||
| Currency positions | |||||
| JPY | -80,000,000 | ||||
| MXP | 10,000,000 | ||||
| Value in USD | |||||
| Best Scenario | Worst Scenario | ||||
| Currency Spot | USD value | Currency Spot | USD value | ||
| JPY | -80,000,000 | 1/120 | -666,667 | 1/90 | -888,889 |
| MXP | 10,000,000 | 1/6 | 1,666,667 | 1/8 | 1,250,000 |
| Total | 1,000,000 | 361,111 |
C3. Portfolio Analysis
- Treat currency positions like a portfolio
- Low correlations among currencies will reduce the risk of currency portfolios
Risk of Risk of Interaction Effect of
Asset 1 Asset 2 Asset 1 and Asset 2
6-*
C4. Portfolio Calculations
6-*
| Markowitz Model Calculations | ||||
| Currency Portfolio Composition and Current Value (maturity = 6 months) | ||||
| Currency | Amount | S | USD value | w |
| BRL | 150,000 | 0.6 | 90,000 | 47.37% |
| GBP | 50,000 | 2.0 | 100,000 | 52.63% |
| 190,000 | ||||
| Other information | ||||
| Sigma | Correlation | |||
| BRL | 13% | 0.2 | ||
| GBP | 8% | |||
| Portfolio Standard Deviation: | ||||
| 6-month Portfolio Standard Deviation: | ||||
C5. Netting
- Transaction exposures involve cash flows (receivables and payables) at various future time points
- Netting involves offsetting amounts wherever possible
- Netting can also be performed over time by using PV or FV calculations
- The objective of netting in this setting is to end up with fewer cash flows for transaction analysis
6-*
C6. Value at Risk
- What is the maximum likely losses in a situation? VaR answers this question
- The 5% VaR excludes the 5% of the lower tail (not very likely)
- To calculate VaR, one needs to understand all possible outcomes in a risky situation. This is accomplished using
- An estimate of Sigma (Delta Normal Approach)
- Simulation
6-*
C7. VaR: Delta Normal Approach
- Suppose you have the following data:
- The currency portfolio is worth USD 10,000
- The annual portfolio standard deviation is 12%.
- The firm is expecting to unwind the position in 3 months
- The firm estimates the portfolio to lose 2% of its value during the 3 months
6-*
D1. Operating Exposure
- Economic exposure is the currency-related exposure the firm faces in regard to all its cash flows, near-term and in the future
- A critical component of economic exposure is operating exposure: the effect of currencies on the risky operating cash flows of the firm
- Purely domestic firms may have no transaction exposure but it is possible for them to have operating exposure
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D2. Determinants of Operating Exposure
- Pricing Policy: Firms may be price followers (local firms set prices) or price takers
- Market Structure: Market may be competitive (many sellers) or concentrated
- Cost Structure: Competing firms may have costs in different currencies
- Overall: a mix of these conditions will determine how a currency change affects the revenues (units times price) of a firm
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D3. Estimating Operating Exposure
- Focus on revenues (and costs)
- How do currencies affect revenues and costs?
- Use regression analysis based on based data:
- Dependent variable: revenues or costs
- Independent variables: currency changes
- To properly estimate exposure, one needs to understand industry conditions (competition) as well as strategies of competitors
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E. Translation Exposure
- The impact of currency values on the accounting statements of the firm
- Focus is on how net income is affected
- Also called accounting exposure, because translation exposure depends on accounting procedures(standards)
- In the US, the Financial Accounting Standard No.52 (FAS-52) governs these procedures
- Revenues and expenses are translated using average exchange rates for the period. Assets and liabilities are translated using the exchange rate on the reporting date. (discussed in detail in chapter 14)
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IF07.ppt
Chapter 07
Currency Exposure Management
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
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Learning Objectives
- A. Discuss reasons for hedging.
- B. Discuss which type of firms hedge and what types of exposures are hedged.
- C. Discuss operational considerations concerning hedging.
- D. Implement a forward hedge, compare with unhedged.
- E. Implement a money market hedge.
- F. Implement an option hedge.
- G. Discuss operating decisions to mitigate transaction exposure.
- H. Discuss operating decisions to mitigate operating exposure.
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A1. Why Hedge? Strategic Reason
- Suppose a firm faces potential FX losses,
what are alternatives to hedging? None are good!
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| Alternative I | Alternative II | Alternative III | |
| Action | Issue stocks, bonds; raise private equity or debt | Combine with another firm (e.g., joint venture, merger) | Forgo R&D expense |
| Advantage | Invites external monitoring; ensures continued operations | Obtain expertise and financing from another entity | NONE |
| Dis-advantage | Because of financial problems financing may be costly | Must share benefits; relinquish partial control of firm | Miss product cycle and head toward long-term failure |
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A2. Why Hedge? Save Taxes
A firm expects taxable incomes of $10 million and $100 million over a period of two years.
Assume that the variation in incomes is because of currency exposure and that the firm can eliminate this risk substantially through hedging, producing incomes of $50 million and $60 million over this two-year period. Assume that the tax code indicates rates of 20% for incomes up to $50 million and 30% for incomes above $50 million. Calculate taxes in the two scenarios and identify the benefit of hedging.
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A2. Why Hedge? Save Taxes (cont.)
Solution:
Unhedged scenario tax calculations:
Year 1 taxes = 20% (10) = 2
Year 2 taxes = 20% (50) 30% (100-50) = 25
We make similar calculations for the hedged scenario and complete the table below.
Discussion: With hedging, total taxes are reduced from 27to 23. The benefit of hedging equals 4.
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| Year 1 | Year 2 | Total taxes | |||
| Scenario | Income | Taxes | Income | Taxes | |
| Unhedged | 10 | 2 | 100 | 25 | 27 |
| Hedged | 50 | 10 | 60 | 13 | 23 |
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A3. Why Hedge? Other Reasons
- Managerial Compensation: managers may desire stability (using hedging), but some who are given options may wish instability (unhedged)
- Managerial Risk Aversion: managers are ill-diversified, so wish hedging.
- Debtors: prefer stable cash flows (prefer hedging)
- Suppliers and Customers: prefer stable cash flows
- Market inefficiency: hedging may actually give extra value because derivatives may be mispriced relative to FX values (e.g., buy an FX cheaply)
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B1. Which Firms Hedge?
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| Hedging Activity by US Non-financial firms | |
| Category | Percent of Firms Hedging |
| Size: | |
| Large | 83% |
| Medium | 45% |
| Small | 12% |
| Type of Firm: | |
| Primary Products | 68% |
| Manufacturing | 48% |
| Services | 42% |
| Source: Bodnar, Hayt and Marston, 1998, 1998 Wharton Survey of Financial Risk Management by US non-financial firms, Financial Management 27.4, 70-91. |
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B2. Which Types of Exposure are Hedged?
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| What types of currency exposure are hedged? | |||||
| Exposure | Percent of firms responding in the following ranges for proportion of exposure hedged | ||||
| 0-25% | 26-50% | 51-75% | 76-100% | Average Proportion Hedged | |
| On Balance Sheet Commitments | 40% | 13% | 12% | 35% | 49% |
| Off Balance Sheet Commitments | 72% | 11% | 5% | 13% | 23% |
| Anticipated Transactions < 1 year | 42% | 22% | 9% | 27% | 42% |
| Anticipated Transactions > 1 year | 78% | 11% | 4% | 6% | 16% |
| Competitive Exposure | 90% | 6% | 2% | 3% | 7% |
| Translation | 84% | 6% | 3% | 8% | 12% |
| Repatriation | 50% | 14% | 5% | 31% | 40% |
| Source: Bodnar, Hayt and Marston, 1998 |
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C. Operational Issues in Hedging
- Partial vs. Full Hedging: firms rarely hedge 100% because of cost and precision concerns.
- Hedging Instruments:
- Matching: maturity and currency must ideally match
- Symmetry: forwards & futures provide symmetric hedges, options provide asymmetric hedges (clarified using examples later in chapter)
- Hedging Horizon: typically matches maturity of FX position, but sometimes firms decide to use a short-term hedge to solve a long-term problem mostly because of uncertainty.
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D1. Forward Hedge
EXAMPLE: A Brazilian exporter to Europe invoices goods in EUR and expects to receive EUR 4 million in 3-months. A 3-month forward contract is available at a EURBRL rate of 2.7513. Explain the hedging strategy and show its result.
Solution:
The exporter takes a short position in the forward contract with a notional value of EUR 4 million. At maturity, he delivers EUR 4 and receives:
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D2. Forward vs. Unhedged
An Indian garment exporter to the US is concerned about the weakening dollar and is considering a 6-month currency forward at a rate (USDINR) of 42. The firm internally forecasts USD values as follows: USDINR = 40 (probability = 50%) and USDINR = 45 (probability = 50%). Evaluate the hedging decision. Assume that the firm has receivables of USD 2 million.
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| Cash Flows (INR) | ||||
| Scenario | USDINR | Probability | Unhedged | Hedged |
| I | 40 | 50% | 80,000,000 | 84,000,000 |
| I | 45 | 50% | 90,000,000 | 84,000,000 |
| 85,000,000 | 84,000,000 | |||
| 5,000,000 | 0 |
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E1. Money Market Hedge
- Involves the pre-emptive conversion of currencies.
- FX Receivables: Borrow FX today, convert to home currency today, repay loan using receivables.
- FX Payables: Borrow home currency today, convert to FX today, lend and use FX to meet payables.
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E1. Money Market Hedge (cont.)
- In equilibrium (if interest rates are in harmony with spot and forward FX) money market hedge is equivalent to forward hedge.
- Quick method of determining results of money market hedge: use formula below making appropriate adjustments for time period :
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E2. Money Market Receivables Hedge Example
A US-firm has receivables of EUR 5 million in 9 months. The spot and forward (EURUSD) rates are 1.55 and 1.52 respectively. Assume that the firm can borrow as well as lend at the following Eurocurrency rates: 2% (USD) and 4% (EUR). Show details of the money market hedge.
EUR to be borrowed =
USD to be deposited =
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F1. Options Hedge
- Option hedges are asymmetric hedges. They protect against FX losses and at the same time preserve FX gains. You pay a premium for this benefit.
- FX receivables are hedged using put options (the FX is sold for the option strike price).
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F1. Options Hedge (cont.)
- FX payables are hedged using call options (the FX is bought at the option stock price).
- Unlike forward hedges, the resulting CF has some volatility (but option hedge sigma is lower than the sigma of the unhedged position, see example that follows)
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F2. Some Useful Equations for Option Hedge Calculations
Call Option Payables Hedge:
Put Option Receivables Hedge:
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F3. An Options Hedge CF Calculation
EXAMPLE: A US firm has EUR-payables that mature in 180-days. It hedges using a call option on EUR with a strike price of USD 1.50 and a premium of USD 0.04. Suppose the maturity value of EURUSD is 1.60. Assume that the USD-denominated LIBOR rate is 4% (actual/360 simple interest). Calculate the (net) cash flow to the payables hedge.
Solution:
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F4. Summarizing an Option Hedge
Consider again the previous example involving an option hedge by a US-firm. The call option is on EUR with a strike price of USD 1.50 and a premium of USD 0.04. The firm forecasts that the EURUSD is equally likely to be 1.45 or 1.60 at maturity. Assume payables of EUR 25,000. Assume that the USD-denominated LIBOR rate is 4% (actual/360 simple interest). Calculate the cash flow of the call option hedge in the two scenarios. What are expected value and standard deviation?
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F4. Summarizing an Option
Hedge (cont.)
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