International Finance

Transcription

1 International Finance

2 Agenda Balance of payment Parity conditions in International Finance The foreign exchange market Futures and option markets Swaps and interest derivatives Measuring and managing translation and transaction exposure Measuring and managing economic exposure

3 Agenda Balance of payment Parity conditions in International Finance The foreign exchange market Futures and option markets Swaps and interest derivatives Measuring and managing translation and transaction exposure Measuring and managing economic exposure

4 Balance of payments Balance of payments = record of transactions of the residents of a country with the rest of the word Balance of payments is made of a good and services components and an assets one CURRENT ACOUNT (goods and services) BALANCE OF PAYMENTS CAPITAL ACOUNT (assets) Private transactions Official Reserve Transactions

5 Balance of payments (1) (2) (3) (4) (5) Current account Export Import Balance (500) (500) (500) (500) (500) Capital account Private transactions Capital inflow Capital outflow Balance Official Reserve Foreign reserves sold Foreign reserves bought Balance (200) Situation 1: current account deficit is financed by private residents selling assts or borrowing abroad allowing capital inflow Situation 2: current account deficit is financed by Government selling foreign reserves. Situation 3: balance of payments is financed by both privates and central bank Situation 4: balance of payment surplus Situation 5: balance of payment deficit Balance of payments (200)

6 Monetary policy: target and tools Targets To increase real pro-capita income Y=PQ Inflation stabilization π Exchange rate stabilization To increase real capital Target linked to financial system Tools: Monetary base (internal and external) with permanent and temporary effects credit control Interest rate levels

7 Key indicators of Country Risk and Economic health: A large government deficit relative to GDP A high rate of monetary expansion (especially if combined with fixed exchange rate) Substantial government expenditures yielding low rate of return Price controls, interest rate ceilings, trade restrictions, rigid labor law, and other Gov. imposed barriers High tax rate that destroy incentive to work, save and invest Vast state-owned firms High standard of living gained through public-sector spending and regulations associated with low level of political system stability Corruption Inefficient legal system

8 Parity conditions in International Finance..

9 Relationships UFR Expected % change of spot rate of foreign currency -3% IFE Forward premium or discount on foreign currency -3% IRP PPP Interest rate differential +3% Expected inflation rate differential +3% FE UFR = unbiased predictors of future spot rates PPP = purchasing power parity IFE = International Fisher Effect FE = Fischer Effect IRP = Interest rate paritu

10 Purchasing Power Parity Expected % change of spot rate of foreign currency -3% Forward premium or discount on foreign currency -3% PPP Interest rate differential +3% Expected inflation rate differential +3% UFR = unbiased predictors of future spot rates PPP = purchasing power parity IFE = International Fisher Effect FE = Fischer Effect IRP = Interest rate paritu

11 Purchasing Power Parity e t = e 0 x (1+i h ) t /(1+i f ) t ; e t is the PPP rate. For example: US inflation rate 5%; Switz. inflation rate 3% Spot rate = SFr 1 = $ 0,75 e t = e 0 x (1+i h /1+i f ) t = 0,75 x (1,05/1,03) 3 e 3 = 0,7945; it s the best prediction for the Franc spot rate in 3 years PPP is also expressed as follow: (e t e 0 ) /e 0 = i h i f => exchange rate change should equal the inflation differential. PPP says that currencies with high rates of inflation should devaluate relative to currencies with lower rates of inflation

12 Real exchange rate Changes in nominal exchange rate may be of little significance in determining true effects of currency changes on firs and nations. Rather focus on real purchasing power of one currency relative to another Real exchange rate is nominal exchange rate adjusted for relative purchasing power of each currency since some based period. Real exchange rate at time t e t relative to base period (specified as time 0) is defined as e t =e t P f /P h

13 example CPI USA from 82,4 to 152,4 CPI Japan from 92,1 to 119,2 Y/1$ from Y226,63/$ to Y93,96/$ In nominal terms Yen has appreciated of 58,54% = (226,63-93,96)/226,63; In real terms Yen has appreciated more Y/$ PPP rate = 226,63 x (119,2/92,1) / (152,4 /82,4) = Y160,51/$ PPP was supposed to be 160,51 instead of 93,96 e t = 93,76 x (119,2/92,1) / (152,4 /82,4) = Y65,6109/$ (226,63 65,6109) / 226,63 = 71% => Yen appreciation in real terms

14 The Fisher effect Expected % change of spot rate of foreign currency -3% Forward premium or discount on foreign currency -3% Interest rate differential +3% Expected inflation rate differential +3% FE UFR = unbiased predictors of future spot rates PPP = purchasing power parity IFE = International Fisher Effect FE = Fischer Effect IRP = Interest rate paritu

15 The Fisher effect 1 + Nominal rate = (1+Real rate) (1 + expected inflation rate) 1+r = (1+a)(1+i) r= a + i + ai Which might be approximated as follow r = a + i r h r f = i h i f =>interest rate differential will approximately equal the anticipated inflation differential (1+r h ) /(1+ r f ) = (1+i h ) /(1+i f )

16 The international fisher effect Expected % change of spot rate of foreign currency -3% IFE Forward premium or discount on foreign currency -3% Interest rate differential +3% Expected inflation rate differential +3% UFR = unbiased predictors of future spot rates PPP = purchasing power parity IFE = International Fisher Effect FE = Fischer Effect IRP = Interest rate paritu

17 The international fisher effect (1+r h ) t / (1+r f ) t = e t /e 0 => (1+r h ) t = (1+r f ) t x e t /e 0 The expected return from investing at home (1+r h ) t should equal the expected home currency return from investing abroad (1+r f ) t x e t /e 0 r h r f = (e t e 0 )/e 0 Currencies with low interest rates are expected to appreciate relative to currencies with high interest rates e t = e 0 X (1+r h ) t / (1+r f ) t

18 International fisher effect: example r f = 4%; r h = 13% e 0 = $0,63/1SFr 0,63 x 1,13/1,04 = 0,6845 exchange rate expected in 1 year

19 Interest rate parity Expected % change of spot rate of foreign currency -3% Forward premium or discount on foreign currency -3% IRP Interest rate differential +3% Expected inflation rate differential +3% UFR = unbiased predictors of future spot rates PPP = purchasing power parity IFE = International Fisher Effect FE = Fischer Effect IRP = Interest rate paritu

20 Interest rate parity The currency of the country with a lower interest rate should be at forward premium in terms of the currency of the country with the higher rate. The return on a hedged (or covered) foreign investment will just equal the domestic interest rate on investments of identical risk

21 Interest rate parity New York Finish $ Start $ Simultaneously with euro Investment Sell the 1.148,066,50 at a rate of 1,12556/$ for delivery in 90 Days, and recive $ In 90 days Alternative Investment: Invest $ In New York for 90 days At 2% and receive $ in 90 days 1. convert $ to euros at 1,13110/$ for Frankfurt 90 days 1.148,066,50 2. Invest at 1,5% For 90 days, yielding 1.148,066,50 in 90 days Frankfurt today

22 Interest rate parity US interest rate 7% GB interest rate 12% Spot rate $ 1,75/ Forward rate $ 1,65/ One year New York Today Finish 7. Net profit equals $ Repay the $ loan plus interest Of $ out of the $ 1.075, Collect the And deliver it in return For $ Start 1. Borrow $1 million at an interest rate o 7%, owing $ at year end 2. Convert the $1 million to Pounds at $1.75/ for ,57 3. Invest the ,57 in London at 12%, generating by year end. London one year London today 4. Simultaneously, sell the in principal plus interest forward at a rate of $1,68/ for delivery in one Year, yielding $ at year end.

23 Adjustment process Transactions associated with covered interest arbitrage will effect prices in both the money and foreign market. As are bought spot and sold forward, boosting the spot rate and lowering the forward rate, the forward discount will tend to be widen. Simultaneously, as money flows from New York, interest rates will tend to increase and the inflow of funds to London will depress interest rates there. Funds will continue to flow from New York to London until 1+r NY < (1+r Lond. )f 1 /e 0 => 1,07 < (1,12) 1,68/1,75 = 1,0752 Funds will flow from London to New York if 1+r NY > (1+r Lond. )f 1 /e 0

24 Interest rate parity Interest rate parity holds when there are no covered interest arbitrage opportunity No arbitrage condition can be stated as follow: (1+r h )/(1+r f )= f 1 /e 0 r h r f = (f 1 e 0 )/e 0 High interest rates on a currency are offset by forward discounts; low interest rates on a currency are offset by forward premium

25 Unbiased nature of the forward rate (UFR) UFR Expected % change of spot rate of foreign currency -3% Forward premium or discount on foreign currency -3% Interest rate differential +3% Expected inflation rate differential +3% UFR = unbiased predictors of future spot rates PPP = purchasing power parity IFE = International Fisher Effect FE = Fischer Effect IRP = Interest rate paritu

26 Unbiased nature of the forward rate (UFR) The forward rate should reflect the expected future spot rate on the date of settlement of the forward contract: f t = e t e t is the expected future exchange rate at time t and f t is the forward rate settlement at time t (f 1 e 0 )/e 0 = (e 1 e 0 )/e 0

27 The foreign exchange market

28 The foreign exchange market Spot market: currencies are traded for immediate delivery (within 2 business days) Forward market: contracts are made to buy or sell currencies for future delivery Direct quotation: HC price for a given quantity of FC $0,009251/1SFr Indirect quotation: FC price for a given quantity of HC Y108,10/$1

29 Forward Vs. Spot rates A foreign currency is said to be a forward discount if the forward rate expressed in $ is below the spot rate, whereas a forward premium exists if the forward rate is above the spot rate Forward premium or discount = Forward rate Spot rate x Spot rate Forward contract Number of days

30 Market participants Brokers: specialists in matching net supplier and demander banks within interbank market Arbitragers: seek to earn risk-free profits by taking advantage of interest rates among currencies Traders: use forwards contracts to eliminate or cover risk of losses on export or import orders that are denominated in foreign currencies Hedger: (mostly multinational firms), engage in forwards contracts to protect home currency value of various foreign-currency denominated assets and liabilities on their balance sheets that are not to be realized over the life of the contracts.

31 Bid-ask prices Bid (buy) price: price at which banks are willing to buy Ask (sell) price: price at which banks are willing to sell $1, / => $1,4419 bid price and $ 1,4429 ask price The bid-ask spread is based on breadth and depth of the market for that currency as well as on the currency s volatility. The lower the spread, the most currencies are traded. Spot currency spreads are lower than forward spreads. Percent spread = (ask pr bid pr.)/ask pr. X 100

32 Cross rates Y 135,62/$ Japan W 763,89/$ Korean (Japanese Yen/$) / (Korean won/$)= Y/W 135,6/763,89 = Y 0,17754

33 Currency arbitrage Finish $ ,05 PROFIT = 1.239,05 New York Start $ Resell the pounds Sterling in New York At 1 = $ 1,5422 for $ ,05 1. Sell $ In Frankfurt at 1 = $0,9251 for ,22 London ,76 2. Sell euros in London At 1 = 1,6650 For ,76 Frankfurt today ,22 Rates for specific currency tend to be the same everywhere, with only minimal deviations due to transaction costs

34 The forward contract: example 1 A forward contract between a bank and a customer calls for delivery, at a fixed future date, a specified amount of one foreign currency against domestic currency. Suppose a US firm buys textiles from England with payment of 1 million due in 90 days. The importer is short pounds. Spot price $1,72/1. During 90 days pound might rise (depreciation) against dollar. The importer might guard against this exchange risk by negotiating a 90-days forward contract at a price of, say, 1 = $1,72. doing so, the importer offset the short position in pound by going long in the forward market. A forward contract receipt of 1 million allows a zero net exposed position. Importer s T-Account Forward contract receipt Account payable Forward contract payment $

35 Profit and loss Situation 1: dollar apreciation Spot rate 1,72 $/1 Exchange rate at 90 days 1,68 $/1 Cash Flow with forward Cash Flow w ithout forward Forward Loss/gain $ $ $ Forwaed payment 1,72 ( ) ( ) (40.000) Forwaed recepit Payment to supplyer ( ) Situation 2: dollar depreciation Spot rate 1,72 $/1 Exchange rate at 90 days 1,77 $/1 Cash Flow with forward Cash Flow w ithout forward Forward Loss/gain $ $ $ Forwaed payment 1,72 ( ) ( ) Forwaed recepit Payment to supplyer ( )

36 Long position in forward contract Payment cost Forward contract loss Forward contract gain Forward rate.< 1,72 1,72.>1,72 Dollar value of pound in 90 days

37 The forward market: example 2 Suppose an American exporter sells products to an European customer payment 1 million at 90 days (long in euro) the spot rate is $1,15/. He s worry about $ depreciation/ appreciation, he might hedge by negotiating a 90-days forward contract at a price of, say, 1 = $1,15. doing so, the exporter offset the long position in euro by going short in the forward market. A forward contract payment of 1 million allows a zero net exposed position Exporter s T-Account Account Receivable Forward contract recepit $ Forward contract payment

38 Profit & Loss Situation 1: $ depreciation Spot rate 1,15 $/1 Exchange rate at 90 days 1,2 $/1 Cash Flow with forward Cash Flow w ithout forward Forward Loss/gain $ $ $ Forwaed payment 1, Forwaed recepit Receivable from customer Situation 2: $ apreciation Spot rate 1,15 $/1 Exchange rate at 90 days 1,1 $/1 Cash Flow with forward Cash Flow w ithout forward Forward Loss/gain $ $ $ Forwaed payment 1, Forwaed recepit (39.526) Receivable from customer

39 Short position in forward contract Payment cost Forward contract gain Forward contract loss Forward rate.< 1,15 1,15.>1,15 Dollar value of pound in 90 days

40 .. If forecasts are to be used to decide whether or not to hedge with forward contracts the relative predictive abilities of forecasting services can be evaluated by using the following decision rule: If f 1 > e 1 sell forward If f 1 < e 1 buy forward Exchange rate $/1 Cash flow Forward Expected exchange rate at time 1 $ 1,20 1,00 Buy/receve the asset ( ) Sell forward ( ) Prof it Cash flow Forward Expected exchange rate at time 1 $ 0,90 1,00 Sell/pay the asset ( ) Buy Forward ( ) Prof it

41 Futures and option markets

42 Futures Vs. forward Future Forward Regulation Frequency of delivery Size of contracts Delivery date Settlement Quotes Transaction costs Margins In regulated markets Less than 1% standardized On only few specified dates a year Daily by the Exchange Clearing House (marking to market) American terms ($ per one foreign currency unit) Brokerage fees required OTC 90% Individually tailored On any date On the date agreed on between the bank and the customer Generally in European terms (units of L.C. per $) Based on bid-ask spread Not required Credit risk Clearing house become the opposite side (reducing credit risk) Risk is borne by each party (higher risk)

43 Long Vs short position Profit Loss Long position Settlement price > contract price Settlement price < contract price Short position Settlement price < contract price Settlement price > contract price

44 Long position future contract operation: Long position future contract at $0,75/1Sfr 0,75 Amount Sfr Margins: Initial requirement Maintenance Day Description Settlements Exch. Variation Profit/Loss Deposit Margin Cash flow Tuesday deposit performace bond ,00 (1.485,00) Tuesday 0,755 0, , ,00 625,00 Wednesday 0,743 (0,0120) (1.500,00) 610,00 (1.500,00) Wednesday deposit performace bond ,00 (875,00) Thursday 0,74 (0,003) (375,00) 1.110,00 (375,00) 1.110,00 0,00 Thursday 1.110,00 0,00 commission 1.110,00 0,00 performance bond (2.360) (1.250,00) 2.360,00 (1.250,00) 0,00 (1.250,00)

45 Short position future contract operation: short position future contract at $0,009433/Y 0, Amount Y Margins: Initial requirement Maintenance Day Description Settlements Exch. Variation Profit/Loss Deposit Margin Cash flow Monday deposit performace bond ,00 (4.950,00) Monday 0, (0,000109) (1.362,50) 3.587,50 (1.362,50) Tuesday 0, (0,000039) (487,50) 3.100,00 (487,50) Tuesday deposit performace bond 487, ,50 (487,50) Wednesday 0, , , , ,00 Thursday 0, , , ,50 75,00 Friday 0, (0,000025) (312,50) 5.925,00 (312,50) commission (27,00) 5.898,00 (27,00) performance bond (5.438) 460, ,50 460,50 0,00 460,50

46 Call/Put Option A call (put) option is the right to buy (sell) the underlying asset at a given exercise (strike) price during an agreed upon period of time

47 Long Call option Exercise price Limited loss Potentially unlimited profit Buying a call option I buy the right to purchase a given amount of currency at a given date for a given exchange rate called exercise price. In the example Exercise the option = x 0,94 = Call premium Out of the money 0,92 0,94 0,96 at the money Break Even price 0,98 in the money You re gambling prices go up Contract size Exercize price 0,94 Option premium: $ per euro 0,02 Expiration date 60 days spot price of euro at expiration 0,90 0,92 0,94 0,96 0,98 1,00 Inflows spot sale of euros Outflows Call premium (1.250) (1.250) (1.250) (1.250) (1.250) (1.250) Exercise of option (58.750) (58.750) (58.750) Prof it (1.250) (1.250) (1.250)

48 Short Call option Selling a call option I sell the right to buy a given amount of currency at a given date for a given exchange rate. Limited profit Exercise price In the example Exercise the option = x 0,94 = You re gambling prices go down Break Even price Potentially unlimited loss Contract size Exercize price 0,94 Option premium: $ per euro 0,02 Expiration date 60 days spot price of euro at expiration 0,90 0,92 0,94 0,96 0,98 1,00 Out of the money 0,92 0,94 0,96 0,98 at the money in the money Inflows Call premium Exercise of option Outflows spot purchase of euros (60.000) (61.250) (62.500) Profit (1.250) (2.500)

49 Long Put option Potential profit Break Even price Out of the money 0,92 0,94 0,96 at the money Exercise price Limited loss 0,98 in the money put premium Buying a put option I buy the right to sell a given amount of currency at a given date for a given exchange rate called exercise price. In the example Exercise the option = x 0,94 = You re gambling prices go down Contract size Exercize price 0,94 Option premium: $ per euro 0,02 Expiration date 60 days spot price of euro at expiration 0,88 0,90 0,92 0,94 0,96 0,98 Inflows Exercise of option Outflow s Put premium (1.250) (1.250) (1.250) (1.250) (1.250) (1.250) spot purchase of euros (55.000) (56.250) (57.500) (58.750) Profit (1.250) (1.250) (1.250)

50 Short Put option Break Even price Limited profit Selling a put option I sell the right to sell a given amount of currency at a given date for a given exchange rate called exercise price. In the example exercise the option = x 0,94 = You re gambling prices go up Potential loss Exercise price Contract size Exercize price 0,94 Option premium: $ per euro 0,02 Expiration date 60 days spot price of euro at expiration 0,88 0,90 0,92 0,94 0,96 0,98 1,00 0,90 Out of the money 0,92 0,94 0,96 0,98 at the money in the money Inflows Put premium spot sale of euros Outflows Exercise of option (58.750) (58.750) (58.750) Profit (2.500) (1.250)

51 Pricing Pricing forward => F = S(1+r) Put call parity: S = spot PRICE; E = exercise price; C = long call price; P = long put price S + P = C + E/(1+r) C = S E/(1+r) + P C = S E + E -E/(1+r) + P INTRINSIC VALUE TIME VALUE INSURANCE PREMIUM

52 Pricing Investment S E E Bond E/(1+r) Call Option C E Put Option P E S + P = C + E/(1+r)

53 Put Call Parity

54 Agenda Balance of payment Parity conditions in International Finance The foreign exchange market Futures and option markets Swaps and interest derivatives

55 The classic swap transaction Counterparties A and B both require $100 million for 5 years; A is rated BBB would borrow at fixed rate B is rated AAA would borrow at floating rate Borrower A B Difference Fixed-Rate available 8,5% 7,0% 1,5% Floating-Rate available 6M LIBOR + 0,5 6M LIBOR 0,5% opportunity: There is an anomaly between the two markets since one judges that the differences in credit quality between AAArated firm and BBB-rated firm is worth 150 basis points and the other determinates that the difference is only 50 basis points. The two parties might take advantage of the 100 basis points spread differential

56 Interest rate swaps It is an agreement between two parties to exchange interest payments for a specific maturity on an agreed upon notional amount Notional => theoretical principal underlying the swap; it is a reference amount against which the interest is calculated. In a coupon swap one party pays a fixed rate calculated at the time of trade as a spread to a particular treasury bond, and another side pays a floating rate that resets periodically through the life of the deal against a designed index In a basis swap, two parties exchange floating interests payments based on different references rates.

57 Interest rate swap structure 7,35% 7,25% Counterparty A LIBOR Big-Bank LIBOR Counterparty B LIBOR + 05% Net Profit % 7,35% - 7,25% + Libor Floating rate - LIBOR lenders Eurobond 0,10%% Net Cost ,35% + Libor + 0,5% -LIBOR ,85% Net Cost LIBOR + 7% -7,25% LIBOR 0,25%

58 Currency swaps It is an exchange of debt-service obligations denominated in one currency for the service on an agreed upon principal amount of debt denominated in another currency By swapping their future cash-flows obligations, the counterparties are able to replace cash flows denominated in one currency with cash flows in a more desired currency

59 Currency swap structure Company A which has borrowed Japanese Yen at a fixed interest rate, can transform its yen debt into a fully hedged dollar liability by exchanging cash flows with counterparty B. the two loans have parallel interest and principal repayment schedule Currency swap contain the right of offset, which gives each party the right to offset any nonpayment of principal or interest with a comparable nonpayment Because a currency swap is not a loan, it does not appear as a liability on the parties balance sheets Counterparty A Dollars Yen Yen Yen Yen Yen Yen Dollars Counterparty B Dollars Dollars Dollars Dollars t

60 Fixed for fixed /$ currency swap US company is looking to hedge some of its euro exposure by borrowing in euros. At the same time EU company is seeking $ to finance additional investment in the US market. Both want the equivalent of $200 million in fixedrate financing for 10 years ( 1,1/$ = 220). US company can issue $-denominated debt at a coupon rat of 7,5% or -denominated rate of 8,25%. Equivalent rates for the EU company are 7,7% and 8,1% respectively

61 Fixed for fixed currency swap structure Fixed-rate US dollar debt Fixed-rate euro debt $ 15 million Years 1-10 $ 200 million Time 0 $ 200 million Year 10 Year 10 $ 200 million $ 15 million Years 1-10 $ 200 million 220 million Time million Year 10 17,82 million Years 1-10 Us Company Cost of borrowing Euros ,1% Time million 17,82 million Years 1-10 Year million EU Company Cost of borrowing U.S. Dollars ,5%

62 Dual currency bond swap It is the case when one has the issue s proceeds and interest payments stated in foreign currency and the principal repayment stated in domestic currency. Example: FNMA issued on October 1, year 8% coupon debentures in the amount o Yen 50 billion (Y /$1). In return Fannie Mae agreed to pay interest averaging about $21 million annually and to redeem these bonds at the end of 10 years at a cost of $240,4 million The net effect for FNMA was an all-in dollar cost of 10,67% annually regardless of what happened to the yen/dollar exchange rate

63 Cash flow associated with Yen Dual Currency Swap Payment on dual Currency Debenture Dollar Payment under Swap Yen/Dollar exchange Discount factor Discouted $ cash flow Payment date year October 1, Issues expenses $ ,3777 underwriters expenses -$ October 1, $ October 1, $ ,6326 1, October 1, $ ,1571 1, October 1, $ ,5037 1, October 1, $ ,4656 1, October 1, $ ,0030 1, October 1, $ ,0003 1, October 1, $ ,0490 2, October 1, $ ,8574 2, October 1, $ ,0265 2, October 1, $ ,0253 2, October 1, $ ,9867 2, annually cost 10,6704%

64 Interest rate forwards and futures: forward forward A forward forward is a contract that fixes an interest rate today on a future loan or deposit. The contract specifies the interest rate, the principal amount the start and ending dates of the future interest rate period.

65 forward forward example Example: a company wishes to lock in six-month rate on $1 million eurodollar deposit to be placed in three months. It can buy a forward forward or it can create its own. Suppose the company can borrow and lend at LIBOR. Than the company can simultaneously borrow the present value of $1 million for 3 month and lend that same amount of money for 9 months. LIBOR3 is 6,7%; than the company might borrow $ /(1+0,0674) = $ 983,526 today and end the same amount for 9 months. If LIBOR9 is 6,95% at the end of 9 months the company will receive $ 983,526 x (1+0,0695 x 9/12) = $ months months The only net cash flows are the cash outlay of $1 million in 3 months and the receipt of $ These Transactions are equivalent to investing $1 million in 3 months and receiving back $ months later

66 Interest rate forwards and futures: Forward Rate Agreement FRA A FRA is a cash-settled, over-the-counter forward contract that allow a company to fix an interest rate to be applied to a specified interest period on a notional principal amount Interest payment = notional principal x LIBOR (forward rate) x (days/360) 1 + LIBOR x (days/360)

67 Forward Rate Agreement FRA Example Suppose a company needs to borrow $50 million in two months for a six month period. To lock in the interest rate the company buys a 2x3 FRA on LIBOR at 6,5% from a Bank for a notional of $50 million. This means that the bank has entered into a twomonths forward contract on six-month LIBOR. Two months from now if LIBOR6 exceed 6,5% the Bank will pay the company the difference in interest rate expense, if LIBOR6 is less than 6,5% the company will pay the bank the difference. Assuming that in 2 months LIBOR6 is 7,2% the bank will pay the difference: $ 50million x [(0,072-0,065)(180/360)]/[1+0,072(180/360)] = $170,730

68 Measuring and managing translation and transaction exposure

69 Translation exposure Changes in income statement items and the book value of balance sheet assets and liabilities caused by an exchange rate. The resulting exchange gains and losses are determined by accounting rules and are paper only The measurement of accounting exposure is retrospective in nature as it is based on activities that occurred in the past Impacts: balance sheets (BS) assets and liabilities and income statement (IS) items that already exist

70 Operating exposure Changes in the amount of future operating cash flows caused by an exchange rate change. The resulting exchange gains or losses are determined by changes in the firm s future competitive position and are real The measurement of operating exposure is prospective in nature as it is based on future activities Impacts: revenues and cost associated with future sales

71 Transaction exposure Changes in the value of outstanding foreign currency-denominated contracts The resulting exchange gains and losses are determined by the nature of contracts already entered into and are real The measurement of transaction exposure mixes the retrospective and prospective because it is based on activities that occurred in the past but will be settled in the future. Contracts already in the BS are part of accounting exposure, whereas contracts not yet on the BS are part of operating exposure

72 Alternative currency translation methods Current/non-current method Monetary/non-monetary method Temporal method Current rate method which is the simplest one since all the BS and IS items are translated at the current rate

73 Current/non-current method the underlying theatrical basis is maturity; all the foreign subsidiary s current assets and liabilities are translated into HC at the current exchange rate. Each non-current asset and liability is translated at its historical exchange rate Hence a foreign subsidiary with positive local currency working capital will give rise to a translation loss (gain) from a devaluation (revaluation) and vice versa if working capital is negative IS is translated at the average exchange rate of the period, except for revenues and items related to non-current assets and liabilities which are translated at the same rates as the corresponding balance sheet items (it is possible to see different revenues and expenses items with similar maturities being translated at different rates)

74 Monetary-non monetary method It differentiates between monetary assets and liabilities and non-monetary, or physical assets and liabilities Monetary items are translated into current rate Non-monetary items are translated at historical rate IS items are translated at the average exchange rate during the period, except for revenues and expense items related to non-monetary assets and liabilities. Depreciation expenses and cost of goods sold are translated at the same rate as the corresponding BS items. As a result, the cost of goods sold may be translated at a different rate from that used to translate sales.

75 Temporal method It appears to be a modified version of monetary/non-monetary method. The only difference is that in this case inventory is normally translated at historical rate, but it can be translated at the current rate if inventory is shown at market values IS items are normally translated at an average rate for the reporting period. However depreciation and amortization related to BS items carried at past prices are translated at historical rates.

76 Example Local Currency US prior to exchange rate change LC 4 = $1 After devaluation of local currency (LC 5 = $1) Temporal Monetary/n onmonetary Current/noncurrent Current rates Current Assets Cash, receivables 2.600,00 650,00 520,00 520,00 520,00 520,00 inventory (at market) 3.600,00 900,00 900,00 720,00 720,00 720,00 Prepaid exenses 200,00 50,00 50,00 50,00 40,00 40, , , , , , ,00 Fixed assets (less accumulated depreciations): 3.600,00 900,00 900,00 900,00 900,00 720,00 goodwill 1.000,00 250,00 250,00 250,00 250,00 200, , , , , ,00 920,00 Total assets , , , , , ,00 current liabilities 3.400,00 850,00 680,00 680,00 680,00 680,00 L-T- debt 3.000,00 750,00 600,00 600,00 750,00 600,00 Deferred income taxes 500,00 125,00 100,00 100,00 125,00 100, , , , , , ,00 Capital stock 1.500,00 375,00 375,00 375,00 375,00 375,00 retained earnings 2.600,00 650,00 865,00 685,00 500,00 445, , , , ,00 875,00 820,00 liabilities + equity , , , , , ,00 translation gain (losses) 0,00 215,00 35,00 (150,00) (205,00)

77 The net exposure The translation gain or losses for each method show up the change in the equity account The net LC translation exposure = exposed assets minus exposed liabilities LC (that equals the equity value) multiplied by $0,05 ($0,25 $0,20) change in the exchange rate = $ Another way is $ x (0,05/0,25) = $

78 Designing a hedging strategy 1. Determinate the types of exposure to be monitored 2. Formulate corporate objectives and give guidance in resolving potential conflicts in objectives 3. Ensure that these corporate objectives are consistent with maximizing shareholder value and can e implemented 4. Clearly specify who is responsible for which exposures and detail the criteria by which each manager is to be judged 5. Make explicit any constraints on the use of exposuremanagement techniques, such as limitations on entering into forward contracts 6. Identify the channels by which exchange rate considerations are incorporated into operating decisions that will affect the firms exchange risk posture 7. Develop a system for monitoring and evaluating exchange risk management activities

79 Basic hedging techniques: depreciation scenario Sell local currency forward Buy 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 account payable Speed up dividend and fee remittances to the parent and other subsidiaries Speed up payment of inter-subsidiary accounts payables Delay collection of inter-subsidiary accounts receivable Invoice exports in foreign currency and imports in local currency

80 Basic hedging techniques: appreciation scenario Buy local currency forward Buy 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 account payable delay dividend and fee remittances to the parent and other subsidiaries Delay payment of inter-subsidiary accounts payables Speed up collection of inter-subsidiary accounts receivable Invoice exports in local currency and imports in foreign currency

81 Centralization Pros: through lack of knowledge or incentive, individual subsidiaries may undertake heading actions that increase, rather than reduce overall corporate exposure in a given currency. Centralization of exchange risk management should reduce the amount of hedging to achieve a given level of safety Centralization management might take into account tax planning strategies

82 Managing exposure 1. Adjusting fund flows 2. Forward market hedge 3. Money-market hedge 4. Risk shifting 5. Exposure netting 6. Cross hedging 7. Foreign currency option 8. Currency collar

83 Fund adjustment Basically it means to increase hard currencies (HC) assets and soft currencies liabilities and to decrease soft currencies (SC) assets and hard currencies liabilities direct fund adjustment method: Pricing exports in hard currency securities pricing imports in local currency Investing in HC securities Replacing HC borrowing with LC loans Indirect fund adjustment method: Adjusting transfer prices on the sale of goods between affiliates Speeding up the payment of dividends, fess, royalties Speeding the payment of inter-subsidiary accounts payable Delaying the collection of inter-subsidiary accounts receivable

84 Forward market hedge If you re long a currency, hedge by selling forward if the currency is at forward premium (f 1 > e 0 ); if the currency is at forward discount (f 1 < e 0 ) do not hedge If you re short a currency, hedge by buying forward if the currency is selling at a forward discount (f 1 < e 0 ); if the currency is at a forward premium (f 1 > e 0 ) do not hedge

85 Money-market hedge It is an alternative to forward market hedge It involve simultaneous borrowing and lending activities in two different countries to lock in the domestic currency value of a future foreign currency cash flow

86 Forward and money-market hedge: example On Jan. 1, GE is awarded a contract to supply to Lufthansa On Dec. 31 GE will receive payment of 10 million The most direct way for GE is to sell 10 million forward contract for delivery in one year. Spot price $1,00/ ; 1 year forward rate $0,0957/ Alternatively it can use a monetary-market hedge, which would involve borrowing 10 million for one year, converting into $, investing the proceed in security maturing on Dec. 31. suppose Euro and US interest rates are 15% and 10% respectively

87 Forward and money-market hedge: example FORWARD HEDGE; Dec. 31; GE T-Account (million) ACCAUNT RECEIVABLE FORWARD CONTRACT RECEPIT 10,00 9,57 FORWARCD CONTRACT PAYMENT 10,00 Using Money-Market hedge: 1) borrow (10/1,15) million = 8,70 million for 1 year at 15% 2) Convert the 8,70 up-front into dollar getting $ 8,70 3) Invest the $ 8,7 for 1 year at 10% getting (8,7 x 1,1) = $ 9,57 on Dec ) Use the proceeds of euro receivable to repay 8,7 x 1,15 = 10,00 to repay the loan MONEY MARKET HEDGE; Dec. 31: GE T-Account (million) ACCAUNT RECEIVABLE INVESTING RETURN 10,00 $ 9,57 LOAN REPEYMENT (including interest) 10,00 (including interest)

88 Comparing hedging alternatives when there are transaction costs Suppose you want to hedge C$40 million payable due in 90 days Spot rate $0, /C$ Forward rate (90 days) $0, /C$ Canadian $ 90-day interest rate 4,71%- 4,64% (annualized) US $ 90-day interest rate 5,5%-5,35%

89 Comparing hedging alternatives when there are transaction costs Forward market solution: Cash in Cash out In 90 days C$40 million * 0,7341 = $ C$ $ payment to supplyer C$ Money market solution: M = C*(1+i*t) => C = M / (1+i*t) => (1+i*t) = 1, = (1+4,64%*90/360) PV of what I have to pay in C$ ,68 = /1,0116 tranlsated in $ at spot rate (ask) ,68 = *0,7311 equivalent to the amount I have to borrow in $ at 5,5% in 90 days In 90 days I'll have to give back ,12 = *(1+5,5%*90/360) Cash in Cash out today Borrow $ buy C$ at 0,7311 C$ $ Invest C$ In 90 days investment return (principal + interest) C$ loan payback (principal + interest) $ payment to supplyer C$ With money market solution we ll save $ ( )

90 Pricing and risk shifting Invoicing in domestic currency allow shifting the risk to the customer but this can work with not-informed customer; (alternatively) pricing on forward rate. In the precedent example, in order to be sure to get $10 million, GE should have priced at 10 million/0,957 = 10,45 million Adopting price adjustment clauses setting a neutral zone representing the currency range in which risk is not shared

91 Exposure netting It involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in a way such that losses (gains) on the first exposed position will be offset by gains (losses) on the second currency exposure A firm can offset a long position in a currency with a short position in the same currency If the exchange rate movements of two currencies are positively correlated, than the firm can offset a long position in one currency and a short position in the other If the currency movements are negatively correlated, than short (or long) positions can be used to offset each other In exposure netting you ve to take into account different maturities of assets and liabilities

92 Cross-hedging Hedging with future is very similar to hedging with forward contracts. However the exact future contract required might be unavailable. Future contracts on another currency that is correlated with the one of interest might be used. The resulting regression coefficient tells us the sign and approximate the size of the futures/forward position we should take in the related currency

93 Foreign currency option In the precedent example G can buy for $ the right to sell to Citigroup 10 million on Dec. 31 at a price of $0,957/. Instated of a straight put option, GE could use a futures put option. This would entail GE buying a put option on a December futures contract with the option expiring in April. If the put were in-the-money on April 1, GE would exercise it and receive a short position in a euro futures contract plus a cash amount equal to the strike price minus the Dec. futures price as of April 1.

94 Currency collars A currency collar is a combination of option contracts allowing to create a range so that the holder of the collar can exercise the contract if at the expiring date the currency is settled within this range. Beyond the range protection is assured

95 Option Vs. forward contracts The ideal use of forward contracts is when the exposure has a straight riskreward profile; forward contract gains or losses are exactly by the losses or gains on the underlying transaction If the transaction exposure is uncertain (the volume or the foreign currency prices of the items being bought or sold are unknown), currency option are preferred