1-0 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objectives: Understand why it is important to study international finance.

1-0 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objectives: Understand why it is important to study international finance. Distinguish international finance from domestic finance. 1 Chapter One Globalization & the Multinational Firm

1-1 What’s Special about “International” Finance? Goals for International Financial Management Globalization of the World Economy Multinational Corporations Organization of the Text Summary Chapter One Outline

1-2 What’s Special about “International” Finance? Foreign Exchange Risk Political Risk Market Imperfections Expanded Opportunity Set

1-3 What’s Special about “International” Finance? Foreign Exchange Risk The risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. Suppose $1 = ¥100 and you buy 10 shares of Toyota for ¥100,000 (i.e. $100 per share = ¥10,000 per share). One year later the investment is worth ten percent more in yen: ¥110,000 But, if the yen has depreciated to $1 = ¥120, your investment has actually lost money in dollar terms.

1-4 What’s Special about “International” Finance? Political Risk Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways.

1-5 Market Imperfections Legal restrictions on movement of goods, people, and money Transactions costs Shipping costs Tax arbitrage What’s Special about “International” Finance?

1-6 The Example of Nestlé’s Market Imperfection Nestlé used to issue two different classes of common stock bearer shares and registered shares. Foreigners were only allowed to buy bearer shares. Swiss citizens could buy registered shares. The bearer stock was more expensive. On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares.

1-7 Nestlé’s Foreign Ownership Restrictions 12,000 10,000 8,000 6,000 4,000 2,000 0 11203191824 Source: Financial Times, November 26, 1988 p.1. Adapted with permission. SF Bearer share Registered share

1-8 The Example of Nestlé’s Market Imperfection Following this, the price spread between the two types of shares narrowed dramatically. This implies that there was a major transfer of wealth from foreign shareholders to Swiss shareholders. Foreigners holding Nestlé bearer shares were exposed to political risk in a country that is widely viewed as a haven from such risk. The Nestlé episode illustrates both the importance of considering market imperfections and the peril of political risk.

1-9 Expanded Opportunity Set It doesn’t make sense to play in only one corner of the sandbox. True for corporations as well as individual investors. What’s Special about “International” Finance?

1-10 The focus of the text is to equip the reader with the “intellectual toolbox” of an effective global manager—but what goal should this effective global manager be working toward? Maximization of shareholder wealth? or Other Goals? Goals for International Financial Management

1-11 Maximize Shareholder Wealth Long accepted as a goal in the Anglo-Saxon countries, but complications arise. Who are and where are the shareholders? In what currency should we maximize their wealth?

1-12 Other Goals In other countries shareholders are viewed as merely one among many “stakeholders” of the firm including: Employees Suppliers Customers In Japan, managers have typically sought to maximize the value of the keiretsu—a family of firms to which the individual firms belongs.

1-13 Other Goals As shown by a series of recent corporate scandals at companies like Enron, WorldCom, and Global Crossing, managers may pursue their own private interests at the expense of shareholders when they are not closely monitored. These calamities have painfully reinforced the importance of corporate governance i.e. the financial and legal framework for regulating the relationship between a firm’s management and its shareholders.

1-14 Other Goals These types of issues can be much more serious in many other parts of the world, especially emerging and transitional economies, such as Indonesia, Korea, and Russia, where legal protection of shareholders is weak or virtually non-existing. No matter what the other goals, they cannot be achieved in the long term if the maximization of shareholder wealth is not given due consideration.

1-15 Globalization of the World Economy: Recent Trends Emergence of Globalized Financial Markets Advent of the Euro Trade Liberalization and Economic Integration Privatization

1-16 Deregulation of Financial Markets coupled with Advances in Technology have greatly reduced information and transactions costs, which has led to: Financial Innovations, such as Currency futures and options Multi-currency bonds Cross-border stock listings International mutual funds Emergence of Globalized Financial Markets

1-17 Advent of the Euro A momentous event in the history of world financial systems. Currently more than 300 million Europeans in 12 countries are using the common currency on a daily basis. By 2004, up to 10 more countries may join the European Union and adopt the euro. The “transaction domain” of the euro may become larger than the U.S. dollar’s in the near future.

1-18 Advent of the Euro For more information on the euro, visit the European Central Bank's Web site at www.ecb.int.www.ecb.int

1-19 Value of the Euro in U.S. Dollars January 1999 to March 2003

1-20 Economic Integration Over the past 50 years, international trade increased about twice as fast as world GDP. There has been a sea change in the attitudes of many of the world’s governments who have abandoned mercantilist views and embraced free trade as the surest route to prosperity for their citizenry.

1-21 Liberalization of Protectionist Legislation The General Agreement on Tariffs and Trade (GATT) a multilateral agreement among member countries has reduced many barriers to trade. The World Trade Organization has the power to enforce the rules of international trade.

1-22 NAFTA The North American Free Trade Agreement (NAFTA) calls for phasing out impediments to trade between Canada, Mexico and the United States over a 15-year period. For Mexico, the ratio of export to GDP has increased dramatically from 2.2% in 1973 to 28.7% in 2001. The increased trade will result in increased numbers of jobs and a higher standard of living for all member nations.

1-23 Privatization The selling off state-run enterprises to investors is also known as “Denationalization”. Often seen in socialist economies in transition to market economies. By most estimates this increases the efficiency of the enterprise. Often spurs a tremendous increase in cross-border investment.

1-24 Multinational Corporations A firm that has incorporated on one country and has production and sales operations in other countries. There are about 60,000 MNCs in the world. Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labor and capital equipment in a third country and sell their output in various other national markets.

1-25 Top 10 MNCs 1General ElectricUnited States 2ExxonMobile CorporationUnited States 3Royal Dutch/Shell GroupNetherlands/ UK 4General MotorsUnited States 5Ford Motor CompanyUnited States 6Toyota Motor CorporationJapan 7DaimlerChrysler AGGermany 8TotalFina SAFrance 9IBMUnited States 10BPUnited Kingdom

1-26 The Organization of the Text Macroeconomic Environment World Financial Markets and Institutions Foreign Exchange Exposure and Management Part I Chapters 1-5 Part II Chapters 6-11 Part III Chapters 12-14 Financial Management of the MNC Part IV Chapters 15-21

1-27 End Chapter One

1-28 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter serves to introduce the student to the institutional framework within which: International payments are made. The movement of capital is accommodated. Exchange rates are determined. 2 Chapter Two The International Monetary System

1-29 Evolution of the International Monetary System Current Exchange Rate Arrangements European Monetary System Euro and the European Monetary Union The Mexican Peso Crisis The Asian Currency Crisis Fixed versus Flexible Exchange Rate Regimes Chapter Two Outline

1-30 Evolution of the International Monetary System Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973- Present

1-31 Bimetallism: Before 1875 A “double standard” in the sense that both gold and silver were used as money. Some countries were on the gold standard, some on the silver standard, some on both. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. Gresham’s Law implied that it would be the least valuable metal that would tend to circulate.

1-32 Classical Gold Standard: 1875-1914 During this period in most major countries: Gold alone was assured of unrestricted coinage There was two-way convertibility between gold and national currencies at a stable ratio. Gold could be freely exported or imported. The exchange rate between two country’s currencies would be determined by their relative gold contents.

1-33 For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: Classical Gold Standard: 1875-1914 $30 = £6 $5 = £1

1-34 Classical Gold Standard: 1875-1914 Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

1-35 Price-Specie-Flow Mechanism Suppose Great Britain exported more to France than France imported from Great Britain. This cannot persist under a gold standard. Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

1-36 Classical Gold Standard: 1875-1914 There are shortcomings: The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. Even if the world returned to a gold standard, any national government could abandon the standard.

1-37 Interwar Period: 1915-1944 Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”. The result for international trade and investment was profoundly detrimental.

1-38 Bretton Woods System: 1945-1972 Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank.

1-39 Bretton Woods System: 1945-1972 Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. The Bretton Woods system was a dollar-based gold exchange standard.

1-40 Bretton Woods System: 1945-1972 German mark British pound French franc U.S. dollar Gold Pegged at $35/oz. Par Value

1-41 The Flexible Exchange Rate Regime: 1973-Present. Flexible exchange rates were declared acceptable to the IMF members. Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities. Gold was abandoned as an international reserve asset. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

1-42 Current Exchange Rate Arrangements Free Float The largest number of countries, about 48, allow market forces to determine their currency’s value. Managed Float About 25 countries combine government intervention with market forces to set exchange rates. Pegged to another currency Such as the U.S. dollar or euro (through franc or mark). No national currency Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

1-43 European Monetary System Eleven European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives: To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis-à-vis non- European currencies. To pave the way for the European Monetary Union.

1-44 What Is the Euro? The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

1-45 EURO CONVERSION RATES 1 Euro is Equal to: 40.3399 BEFBelgian franc 1.95583 DEMGerman mark 166.386 ESPSpanish peseta 6.55957 FRFFrench franc.787564 IEPIrish punt 1936.27 ITLItalian lira 40.3399 LUFLuxembourg franc 2.20371 NLGDutch gilder 13.7603 ATSAustrian schilling 200.482 PTEPortuguese escudo 5.94573 FIMFinnish markka

1-46 What is the official sign of the euro? The sign for the new single currency looks like an “E” with two clearly marked, horizontal parallel lines across it. € It was inspired by the Greek letter epsilon, in reference to the cradle of European civilization and to the first letter of the word 'Europe'.

1-47 What are the different denominations of the euro notes and coins ? There are be 7 euro notes and 8 euro coins. The notes are: €500, €200, €100, €50, €20, €10, and €5. The coins will be: 2 euro, 1 euro, 50 euro cent, 20 euro cent, 10, euro cent, 5 euro cent, 2 euro cent, and 1 euro cent. The euro itself is divided into 100 cents, just like the U.S. dollar.

1-48 How did the euro affect contracts denominated in national currency? All insurance and other legal contracts continued in force with the substitution of amounts denominated in national currencies with their equivalents in euro.

1-49 Value of the Euro in U.S. Dollars January 1999 to March 2003

1-50 The Long-Term Impact of the Euro If the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a “United States of Europe” feasible. It is likely that the U.S. dollar will lose its place as the dominant world currency. The euro and the U.S. dollar will be the two major currencies.

1-51 The Mexican Peso Crisis On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency trader’s expectations about the future value of the peso. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent.

1-52 The Mexican Peso Crisis The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. Two lessons emerge: It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. An influx of foreign capital can lead to an overvaluation in the first place.

1-53 The Asian Currency Crisis The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession.

1-54 Currency Crisis Explanations In theory, a currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies. In the long run. In the short run, currency trader’s expectations play a much more important role. In today’s environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to “get to the exits first”. Thus, fears of depreciation become self-fulfilling prophecies.

1-55 Fixed versus Flexible Exchange Rate Regimes Arguments in favor of flexible exchange rates: Easier external adjustments. National policy autonomy. Arguments against flexible exchange rates: Exchange rate uncertainty may hamper international trade. No safeguards to prevent crises.

1-56 Fixed versus Flexible Exchange Rate Regimes Suppose the exchange rate is $1.40/£ today. In the next slide, we see that demand for British pounds far exceed supply at this exchange rate. The U.S. experiences trade deficits.

1-57 Fixed versus Flexible Exchange Rate Regimes SD Q of £ Dollar price per £ (exchange rate) $1.40 Trade deficit Demand (D) Supply (S)

1-58 Flexible Exchange Rate Regimes Under a flexible exchange rate regime, the dollar will simply depreciate to $1.60/£, the price at which supply equals demand and the trade deficit disappears.

1-59 Fixed versus Flexible Exchange Rate Regimes Supply (S) Demand (D) Demand (D*) D = S Dollar depreciates (flexible regime) Q of £ Dollar price per £ (exchange rate) $1.60 $1.40

1-60 Fixed versus Flexible Exchange Rate Regimes Instead, suppose the exchange rate is “fixed” at $1.40/£, and thus the imbalance between supply and demand cannot be eliminated by a price change. The government would have to shift the demand curve from D to D* In this example this corresponds to contractionary monetary and fiscal policies.

1-61 Fixed versus Flexible Exchange Rate Regimes Supply (S) Demand (D) Demand (D*) D* = S Contractionary policies (fixed regime) Q of £ Dollar price per £ (exchange rate) $1.40

1-62 End Chapter Two

1-63 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter serves to introduce the student to the balance of payments. How it is constructed and how balance of payments data may be interpreted. 3 Chapter Three The Balance of Payments

1-64 Chapter Three Outline Balance of Payments Accounting Balance of Payments Accounts The Current Account The Capital Account Statistical Discrepancy Official Reserves Account The Balance of Payments Identity Balance of Payments Trends in Major Countries

1-65 Balance of Payments Accounting The Balance of Payments is the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping. N.B. when we say “a country’s balance of payments” we are referring to the transactions of its citizens and government.

1-66 Balance of Payments Example Suppose that Maplewood Bicycle in Maplewood, Missouri, USA imports $100,000 worth of bicycle frames from Mercian Bicycles in Darby England. There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewood’s bank account. This will lead to a rise in the supply of dollars and the demand for British pounds.

1-67 The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations. They are composed of the following: The Current Account The Capital Account The Official Reserves Account Statistical Discrepancy Balance of Payments Accounts

1-68 The Current Account Includes all imports and exports of goods and services. Includes unilateral transfers of foreign aid. If the debits exceed the credits, then a country is running a trade deficit. If the credits exceed the debits, then a country is running a trade surplus.

1-69 The Capital Account The capital account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets. The U.S. enjoys about a $444,000,000,000 capital account surplus—absent of U.S. borrowing from foreigners, this “finances” our trade deficit. The capital account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

1-70 Statistical Discrepancy There’s going to be some omissions and misrecorded transactions—so we use a “plug” figure to get things to balance. Exhibit 3.1 shows a discrepancy of $0.73 billion in 2000.

1-71 The Official Reserves Account Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF.

1-72 The Balance of Payments Identity BCA + BKA + BRA = 0 where BCA = balance on current account BKA = balance on capital account BRA = balance on the reserves account Under a pure flexible exchange rate regime, BCA + BKA = 0

1-73 U.S. Balance of Payments Data CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73

1-74 U.S. Balance of Payments Data In 2000, the U.S. imported more than it exported, thus running a current account deficit of $444.69 billion. CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73

1-75 U.S. Balance of Payments Data During the same year, the U.S. attracted net investment of $444.26 billion—clearly the rest of the world found the U.S. to be a good place to invest. CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73

1-76 U.S. Balance of Payments Data Under a pure flexible exchange rate regime, these numbers would balance each other out. CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73

1-77 U.S. Balance of Payments Data In the real world, there is a statistical discrepancy. CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73

1-78 U.S. Balance of Payments Data Including that, the balance of payments identity should hold: BCA + BKA = – BRA ($444.69) + $444.26 + $0.73 = $0.30= –($0.30) CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73

1-79 Balance of Payments and the Exchange Rate Q P Exchange rate $ CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 S D

1-80 Balance of Payments and the Exchange Rate Q P As U.S. citizens import, they are supply dollars to the FOREX market. CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 Exchange rate $ S D

1-81 Balance of Payments and the Exchange Rate Q P As U.S. citizens export, others demand dollars at the FOREX market. CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 Exchange rate $ S D

1-82 Balance of Payments and the Exchange Rate Q PS D As the U.S. government sells dollars, the supply of dollars increases. S1S1 CreditsDebits Current Account 1Exports$1,418.64 2Imports ($1,809.18) 3Unilateral Transfers$10.24($64.39) Balance on Current Account ($444.69) Capital Account 4Direct Investment$287.68($152.44) 5Portfolio Investment$474.39($124.94) 6Other Investments$262.64($303.27) Balance on Capital Account $444.26 7Statistical Discrepancies Overall Balance $0.30 Official Reserve Account ($0.30) 0.73 Exchange rate $

1-83 Balance of Payments Trends Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account. During the same period, Japan has experienced the opposite.

1-84 Balances on the Current (BCA) and Capital (BKA) Accounts of the United States Source: IMF International Financial Statistics Yearbook, 2000

1-85 Balances on the Current (BCA) and Capital (BKA) Accounts of United Kingdom Source: IMF International Financial Statistics Yearbook, 2000

1-86 Balances on the Current (BCA) and Capital (BKA) Accounts of Japan Source: IMF International Financial Statistics Yearbook, 2000

1-87 Balances on the Current (BCA) and Capital (BKA) Accounts of Germany Source: IMF International Financial Statistics Yearbook, 2000

1-88 Balances on the Current (BCA) and Capital (BKA) Accounts of China Source: IMF International Financial Statistics Yearbook, 2000

1-89 Balance of Payments Trends Germany traditionally had current account surpluses. Since 1991 Germany has been experiencing current account deficits. This is largely due to German reunification and the resultant need to absorb more output domestically to rebuild the former East Germany. What matters is the nature and causes of the disequilibrium.

1-90 Balances on the Current (BCA) and Capital (BKA) Accounts of Five Major Countries Source: IMF International Financial Statistics Yearbook, 2000

1-91 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objectives: This chapter serves to introduce the student to the institutional framework within which exchange rates are determined. This chapter lays the foundation for much of the discussion throughout the remainder of the text, thus it deserves your careful attention. 4 Chapter Four The Market for Foreign Exchange

1-92 Chapter Outline Function and Structure of the FOREX Market The Spot Market The Forward Market

1-93 Chapter Outline Function and Structure of the FOREX Market FX Market Participants Correspondent Banking Relationships The Spot Market The Forward Market

1-94 Chapter Outline Function and Structure of the FOREX Market The Spot Market Spot Rate Quotations The Bid-Ask Spread Spot FX Trading Cross Exchange Rate Quotations Triangular Arbitrage Spot Foreign Exchange Market Microstructure The Forward Market

1-95 Chapter Outline Function and Structure of the FOREX Market The Spot Market The Forward Market Forward Rate Quotations Long and Short Forward Positions Forward Cross-Exchange Rates Swap Transactions Forward Premium

1-96 The Function and Structure of the FOREX Market FOREX Market Participants Correspondent Banking Relationships

1-97 FOREX Market Participants The FOREX market is a two-tiered market: Interbank Market (Wholesale)  About 700 banks worldwide stand ready to make a market in Foreign exchange.  Nonbank dealers account for about 20% of the market.  There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. Client Market (Retail) Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.

1-98 Correspondent Banking Relationships Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.

1-99 The Spot Market Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

1-100 Spot Rate Quotations Direct quotation the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny” Indirect Quotation the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar” See the insert card from your textbook.

1-101 Spot Rate Quotations The direct quote for British pound is: £1 = $1.5627 Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso)0.33090.32923.02213.0377 Australia (Dollar)0.59060.59341.69321.6852 Brazil (Real)0.29390.28793.40253.4734 Britain (Pound)1.56271.5660.63990.6386 1 Month Forward1.55961.56290.64120.6398 3 Months Forward1.55351.55680.64370.6423 6 Months Forward1.54451.54770.64750.6461 Canada (Dollar)0.66920.67511.49431.4813 1 Month Forward0.66810.67411.49681.4835 3 Months Forward0.66580.67171.5021.4888 6 Months Forward0.6620.66781.51061.4975

1-102 Spot Rate Quotations The indirect quote for British pound is: £.6399 = $1 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry

1-103 Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote: 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry

1-104 The Bid-Ask Spread The bid price is the price a dealer is willing to pay you for something. The ask price is the amount the dealer wants you to pay for the thing. The bid-ask spread is the difference between the bid and ask prices.

1-105 Spot FX trading In the interbank market, the standard size trade is about U.S. $10 million. A bank trading room is a noisy, active place. The stakes are high. The “long term” is about 10 minutes.

1-106 Cross Rates Suppose that S($/€) =.50 i.e. $1 = 2 € and that S(¥/€) = 50 i.e. €1 = ¥50 What must the $/¥ cross rate be?

1-107 Triangular Arbitrage $ £ ¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

1-108 Triangular Arbitrage $ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 The implied S(¥/£) cross rate is S(¥/£) = 80 Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. So, how can we make money? Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars. ¥ £

1-109 Triangular Arbitrage $ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $. ¥ £ 1 2 3 $

1-110 Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $ 106,250- $100,000 = $6,250

1-111 Spot Foreign Exchange Microstructure Market Microstructure refers to the mechanics of how a marketplace operates. Bid-Ask spreads in the spot FX market: increase with FX exchange rate volatility and decrease with dealer competition. Private information is an important determinant of spot exchange rates.

1-112 The Forward Market Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium

1-113 The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

1-114 Forward Rate Quotations The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term swaps are available.

1-115 Forward Rate Quotations Consider the example from above: for Japanese yen, the spot rate is $1.5627 = £1.00 While the 180-day forward rate is $1.5445 = £1.00 What’s up with that?

1-116 Spot Rate Quotations Clearly the market participants expect that the pound will be worth less in dollars in six months. 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry

1-117 Long and Short Forward Positions If you have agreed to sell anything (spot or forward), you are “short”. If you have agreed to buy anything (forward or spot), you are “long”. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long.

1-118 Payoff Profiles 0 S 180 ($/¥) F 180 ($/¥) =.009524 Short positionloss profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain. If you agree to sell anything in the future at a set price and the spot price later rises then you lose.

1-119 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) profit Whether the payoff profile slopes up or down depends upon whether you use the direct or indirect quote: F 180 (¥/$) = 105 or F 180 ($/¥) =.009524. short position

1-120 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F 180 (¥/$) = 105 profit short position

1-121 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) 120 If, in 180 days, S 180 (¥/$) = 120, the short will make a profit by buying ¥ at S 180 (¥/$) = 120 and delivering ¥ at F 180 (¥/$) = 105. 15¥ profit short position

1-122 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 Long position-F 180 (¥/$) F 180 (¥/$) short position profit Since this is a zero-sum game, the long position payoff is the opposite of the short.

1-123 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 Long position -F 180 (¥/$) profit The long in this forward contract agreed to BUY ¥ in 180 days at F 180 (¥/$) = 105 If, in 180 days, S 180 (¥/$) = 120, the long will lose by having to buy ¥ at S 180 (¥/$) = 120 and delivering ¥ at F 180 (¥/$) = 105. 120 –15¥

1-124 Forward Cross Exchange Rates It’s just an “delayed” example of the spot cross rate discussed above. In generic terms

1-125 SWAPS A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.

1-126 Forward Premium It’s just the interest rate differential implied by forward premium or discount. For example, suppose the € is appreciating from S($/€) =.5235 to F 180 ($/€) =.5307 The forward premium is given by:

1-127 End Chapter Four

1-128 End Chapter Three

1-129 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter examines several key international parity relationships, such as interest rate parity and purchasing power parity. 5 Chapter Five International Parity Relationships & Forecasting Exchange Rates

1-130 Chapter Outline Interest Rate Parity Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates

1-131 Chapter Outline Interest Rate Parity Covered Interest Arbitrage IRP and Exchange Rate Determination Reasons for Deviations from IRP Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates

1-132 Chapter Outline Interest Rate Parity Purchasing Power Parity PPP Deviations and the Real Exchange Rate Evidence on Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates

1-133 Chapter Outline Interest Rate Parity Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates

1-134 Chapter Outline Interest Rate Parity Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates Efficient Market Approach Fundamental Approach Technical Approach Performance of the Forecasters

1-135 Interest Rate Parity Interest Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity

1-136 Interest Rate Parity Defined IRP is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds.

1-137 Interest Rate Parity Defined Suppose you have $100,000 to invest for one year. You can either 1. invest in the U.S. at i $. Future value = $100,000(1 + i $ ) or 2. trade your dollars for yen at the spot rate, invest in Japan at i ¥ and hedge your exchange rate risk by selling the future value of the Japanese investment forward. The future value = $100,000(F/S)(1 + i ¥ ) Since both of these investments have the same risk, they must have the same future value—otherwise an arbitrage would exist, therefore (F/S)(1 + i ¥ ) = (1 + i $ )

1-138 Interest Rate Parity $100,000$100,000(1 + i $ ) $100,000(F/S)(1 + i £ ) 1.Trade $100,000 for £ at S 2.Invest £100,000 at i £ S 3.One year later, trade £ for $ at F

1-139 Interest Rate Parity Defined Formally, (F/S)(1 + i ¥ ) = (1 + i $ ) or if you prefer, IRP is sometimes approximated as 1 + i ¥ 1 + i $ = S F i $ – i ¥ = S F – S

1-140 Interest Rate Parity Carefully Defined Depending upon how you quote the exchange rate ($ per ¥ or ¥ per $) we have: 1 + i $ 1 + i ¥ S ¥/$ F ¥/$ = 1 + i $ 1 + i ¥ S $/¥ F $/¥ = or

1-141 IRP and Covered Interest Arbitrage If IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rateS($/£)=$1.25/£ 360-day forward rateF 360 ($/£)=$1.20/£ U.S. discount ratei$i$ =7.10% British discount rate i £ =11.56%

1-142 IRP and Covered Interest Arbitrage A trader with $1,000 to invest could invest in the U.S., in one year his investment will be worth $1,071 = $1,000  (1+ i $ ) = $1,000  (1.071) Alternatively, this trader could exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at i £ = 11.56% for one year to achieve £892.48. Translate £892.48 back into dollars at F 360 ($/£) = $1.20/£, the £892.48 will be exactly $1,071.

1-143 Interest Rate Parity $1,000$1,071 1.Trade $100,000 for £800 2.Invest £800 at 11.56% = i £ 3.One year later, trade £892.48 for $ at F 360 ($/£) = $1.20/£

1-144 Interest Rate Parity & Exchange Rate Determination According to IRP only one 360-day forward rate, F 360 ($/£), can exist. It must be the case that F 360 ($/£) = $1.20/£ Why? If F 360 ($/£)  $1.20/£, an astute trader could make money with one of the following strategies:

1-145 Arbitrage Strategy I If F 360 ($/£) > $1.20/£ i. Borrow $1,000 at t = 0 at i $ = 7.1%. ii. Exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at 11.56% (i £ ) for one year to achieve £892.48 iii. Translate £892.48 back into dollars, if F 360 ($/£) > $1.20/£, £892.48 will be more than enough to repay your dollar obligation of $1,071.

1-146 Arbitrage Strategy II If F 360 ($/£) < $1.20/£ i. Borrow £800 at t = 0 at i £ = 11.56%. ii. Exchange £800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071. iii. Translate $1,071 back into pounds, if F 360 ($/£) < $1.20/£, $1,071 will be more than enough to repay your £ obligation of £892.48.

1-147 You are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100M is due in one year. IRP and Hedging Currency Risk IRP implies that there are two ways that you fix the cash outflow to a certain U.S. dollar amount: a)Put yourself in a position that delivers £100M in one year—a long forward contract on the pound. You will pay (£100M)(1.2/£) = $120M b)Form a forward market hedge as shown below. Spot exchange rateS($/£)=$1.25/£ 360-day forward rateF 360 ($/£)=$1.20/£ U.S. discount ratei$i$ =7.10% British discount rate i £ =11.56%

1-148 IRP and a Forward Market Hedge To form a forward market hedge: Borrow $112.05 million in the U.S. (in one year you will owe $120 million). Translate $112.05 million into pounds at the spot rate S($/£) = $1.25/£ to receive £89.64 million. Invest £89.64 million in the UK at i £ = 11.56% for one year. In one year your investment will have grown to £100 million—exactly enough to pay your supplier.

1-149 Forward Market Hedge Where do the numbers come from? We owe our supplier £100 million in one year—so we know that we need to have an investment with a future value of £100 million. Since i £ = 11.56% we need to invest £89.64 million at the start of the year. How many dollars will it take to acquire £89.64 million at the start of the year if S($/£) = $1.25/£?

1-150 Reasons for Deviations from IRP Transactions Costs The interest rate available to an arbitrageur for borrowing, i b,may exceed the rate he can lend at, i l. There may be bid-ask spreads to overcome, F b /S a < F/S Thus (F b /S a )(1 + i ¥ l )  (1 + i ¥ b )  0 Capital Controls Governments sometimes restrict import and export of money through taxes or outright bans.

1-151 Purchasing Power Parity Purchasing Power Parity and Exchange Rate Determination PPP Deviations and the Real Exchange Rate Evidence on PPP

1-152 Purchasing Power Parity and Exchange Rate Determination The exchange rate between two currencies should equal the ratio of the countries’ price levels: S($/£) = P£P£ P$P$ P£P£ P$P$ £150 $300 == $2/£ For example, if an ounce of gold costs $300 in the U.S. and £150 in the U.K., then the price of one pound in terms of dollars should be:

1-153 Purchasing Power Parity and Exchange Rate Determination Relative PPP states that the rate of change in the exchange rate is equal to the differences in the rates of inflation: e = (1 +  £ ) (  $ –  £ ) ≈  $ –  £ If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 2.78% or around 3%.

1-154 PPP Deviations and the Real Exchange Rate The real exchange rate is q = (1 + e)(1+  £ ) (1 +  $ ) If PPP holds, (1 + e) = (1 +  £ ) (1 +  $ ) then q = 1. If q < 1 competitiveness of domestic country improves with currency depreciations. If q > 1 competitiveness of domestic country deteriorates with currency depreciations.

1-155 Evidence on PPP PPP probably doesn’t hold precisely in the real world for a variety of reasons. Haircuts cost 10 times as much in the developed world as in the developing world. Film, on the other hand, is a highly standardized commodity that is actively traded across borders. Shipping costs, as well as tariffs and quotas can lead to deviations from PPP. PPP-determined exchange rates still provide a valuable benchmark.

1-156 The Fisher Effects An increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country. For the U.S., the Fisher effect is written as: 1 + i $ = (1+  $ )(1 + E[  $ ]) = 1 +  $ + E[  $ ] +  $ E[  $ ] i $ =  $ + E(  $ ) +  $ E[  $ ] ≈  $ + E[  $ ] Where  $ is the equilibrium expected “real” U.S. interest rate E[  $ ] is the expected rate of U.S. inflation i $ is the equilibrium expected nominal U.S. interest rate

1-157 Expected Inflation The Fisher effect implies that the expected inflation rate is approximated as the difference between the nominal and real interest rates in each country, i.e. E[  $ ] = (1 +  $ ) (i$ – $)(i$ – $) ≈ i $ –  $ i $ =  $ + (1 +  $ )E[  $ ] ≈  $ + E[  $ ]

1-158 International Fisher Effect If the Fisher effect holds in the U.S. i $ = (1+  $ )(1 + E[  $ ]) ≈  $ + E[  $ ] and the Fisher effect holds in Japan, i ¥ = (1+  ¥ )(1 + E[  ¥ ]) ≈  ¥ + E[  ¥ ] and if the real rates are the same in each country (i.e.  $ =  ¥ ), then we get the International Fisher Effect E(e) = (1 + i ¥ ) (i$ – i¥)(i$ – i¥) ≈ i $ – i ¥

1-159 International Fisher Effect If the International Fisher Effect holds, then forward parity holds. E(e) = (1 + i ¥ ) (i$ – i¥)(i$ – i¥) and if IRP also holds = (1 + i ¥ ) (i$ – i¥)(i$ – i¥) S F – SF – S S F – SF – S E(e) =

1-160 Approximate Equilibrium Exchange Rate Relationships E(  $ –  £ ) ≈ IRP ≈ PPP ≈ FE≈ FRPPP ≈ IFE≈ FEP S F – SF – S E(e)E(e) (i$ – i¥)(i$ – i¥)

1-161 The Exact Fisher Effects An increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country. For the U.S., the Fisher effect is written as: 1 + i $ = (1 +  $ ) × E(1 +  $ ) Where  $ is the equilibrium expected “real” U.S. interest rate E(  $ ) is the expected rate of U.S. inflation i $ is the equilibrium expected nominal U.S. interest rate

1-162 International Fisher Effect If the Fisher effect holds in the U.S. 1 + i $ = (1 +  $ ) × E(1 +  $ ) and the Fisher effect holds in Japan, 1 + i ¥ = (1 +  ¥ ) × E(1 +  ¥ ) and if the real rates are the same in each country  $ =  ¥ then we get the International Fisher Effect: E(1 +  ¥ ) E(1 +  $ ) 1 + i $ 1 + i ¥ =

1-163 International Fisher Effect If the International Fisher Effect holds, then forward rate PPP holds: E(1 +  ¥ ) E(1 +  $ ) 1 + i $ 1 + i ¥ = and if IRP also holds 1 + i $ 1 + i ¥ S ¥/$ F ¥/$ = E(1 +  ¥ ) E(1 +  $ ) = S ¥/$ F ¥/$

1-164 PPP FRPPP FE FEP IFE Exact Equilibrium Exchange Rate Relationships IRP E(1 +  ¥ ) E(1 +  $ ) 1 + i $ 1 + i ¥

1-165 Forecasting Exchange Rates Efficient Markets Approach Fundamental Approach Technical Approach Performance of the Forecasters

1-166 Efficient Markets Approach Financial Markets are efficient if prices reflect all available and relevant information. If this is so, exchange rates will only change when new information arrives, thus: S t = E[S t+1 ] and F t = E[S t+1 | I t ] Predicting exchange rates using the efficient markets approach is affordable and is hard to beat.

1-167 Fundamental Approach Involves econometrics to develop models that use a variety of explanatory variables. This involves three steps: step 1: Estimate the structural model. step 2: Estimate future parameter values. step 3: Use the model to develop forecasts. The downside is that fundamental models do not work any better than the forward rate model or the random walk model.

1-168 Technical Approach Technical analysis looks for patterns in the past behavior of exchange rates. Clearly it is based upon the premise that history repeats itself. Thus it is at odds with the EMH

1-169 Performance of the Forecasters Forecasting is difficult, especially with regard to the future. As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate. The founder of Forbes Magazine once said: “You can make more money selling financial advice than following it.”

1-170 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter serves to begin our discussion of world financial markets and institutions. 6 Chapter Six International Banking and Money Market

1-171 Chapter Six Outline International Banking Services The World’s Largest Banks

1-172 Chapter Six Outline International Banking Services Reasons for International Banking

1-173 Chapter Six Outline International Banking Services Reasons for International Banking Types of International Banking Offices Correspondent Bank Representative Offices Foreign Branches Subsidiary and Affiliate Banks Edge Act Banks Offshore Banking centers International Banking Facilities

1-174 Chapter Six Outline International Banking Services Reasons for International Banking Types of International Banking Offices Capital Adequacy Standards

1-175 Chapter Six Outline International Banking Services Reasons for International Banking Types of International Banking Offices Capital Adequacy Standards International Money Market Eurocurrency Markets Eurocredits Forward Rate Agreements Euronotes Euro-Medium-Term Notes Eurocommercial Paper

1-176 Chapter Six Outline International Banking Services Reasons for International Banking Types of International Banking Offices Capital Adequacy Standards International Money Market International Debt Crisis History Debt-for-Equity Swaps The Solution: Brady Bonds

1-177 Chapter Six Outline International Banking Services Reasons for International Banking Types of International Banking Offices Capital Adequacy Standards International Money Market International Debt Crisis Japanese Banking Crisis

1-178 Chapter Six Outline International Banking Services Reasons for International Banking Types of International Banking Offices Capital Adequacy Standards International Money Market International Debt Crisis Japanese Banking Crisis The Asian Crisis

1-179 International Banking Services International Banks do everything domestic banks do and: Arrange trade financing. Arrange foreign exchange. Offer hedging services for foreign currency receivables and payables through forward and option contracts. Offer investment banking services (where allowed).

1-180 The World’s 10 Largest Banks CitigroupU.S. Mizuho Bank/ Mizuho Corp BankJapan HSBC HoldingsU.K. Bank of AmericaFrance JP Morgan ChaseU.S. Deutsche BankGermany Royal Bank of Scotland GroupU.K. Sumitomo Mitsui Banking GroupJapan HypoVereinsbankGermany UFJ Bank Ltd.Japan

1-181 Reasons for International Banking Low Marginal Costs Managerial and marketing knowledge developed at home can be used abroad with low marginal costs.

1-182 Reasons for International Banking Low Marginal Costs Knowledge Advantage The foreign bank subsidiary can draw on the parent bank’s knowledge of personal contacts and credit investigations for use in that foreign market.

1-183 Reasons for International Banking Low Marginal Costs Knowledge Advantage Home Nation Information Services Local firms in a foreign market may be able to obtain more complete information on trade and financial markets in the multinational bank’s home nation than is obtainable from foreign domestic banks.

1-184 Reasons for International Banking Low Marginal Costs Knowledge Advantage Home Nation Information Services Prestige Very large multinational banks have high perceived prestige, which can be attractive to new clients.

1-185 Reasons for International Banking Low Marginal Costs Knowledge Advantage Home Nation Information Services Prestige Regulatory Advantage Multinational banks are often not subject to the same regulations as domestic banks.

1-186 Reasons for International Banking Low Marginal Costs Knowledge Advantage Home Nation Information Services Prestige Regulatory Advantage Wholesale Defensive Strategy Banks follow their multinational customers abroad to avoid losing their business at home and abroad.

1-187 Reasons for International Banking Low Marginal Costs Knowledge Advantage Home Nation Information Services Prestige Regulatory Advantage Wholesale Defensive Strategy Retail Defensive Strategy Multinational banks also compete for retail services such as travelers checks, tourist and foreign business market.

1-188 Reasons for International Banking Knowledge Advantage Home Nation Information Services Prestige Regulatory Advantage Wholesale Defensive Strategy Retail Defensive Strategy Transactions Costs Multinational banks may be able to circumvent government currency controls.

1-189 Reasons for International Banking Home Nation Information Services Prestige Regulatory Advantage Wholesale Defensive Strategy Retail Defensive Strategy Transactions Costs Growth Foreign markets may offer opportunities to growth not found domestically

1-190 Reasons for International Banking Prestige Regulatory Advantage Wholesale Defensive Strategy Retail Defensive Strategy Transactions Costs Growth Risk Reduction Greater stability of earnings due to diversification

1-191 Types of International Banking Offices Correspondent Bank Representative Offices Foreign Branches Subsidiary and Affiliate Banks Edge Act Banks Offshore Banking Centers International Banking Facilities

1-192 Correspondent Bank A correspondent banking relationship exists when two banks maintain deposits with each other. Correspondent banking allows a bank’s MNC client to conduct business worldwide through his local bank or its correspondents.

1-193 Representative Offices A representative office is a small service facility staffed by parent bank personnel that is designed to assist MNC clients of the parent bank in dealings with the bank’s correspondents. Representative offices also assist with information about local business customs, and credit evaluation of the MNC’s local customers.

1-194 Foreign Branches A foreign branch bank operates like a local bank, but is legally part of the the parent. Subject to both the banking regulations of home country and foreign country. Can provide a much fuller range of services than a representative office. Branch Banks are the most popular way for U.S. banks to expand overseas.

1-195 Subsidiary and Affiliate Banks A subsidiary bank is a locally incorporated bank wholly or partly owned by a foreign parent. An affiliate bank is one that is partly owned but not controlled by the parent. U.S. parent banks like foreign subsidiaries because they allow U.S. banks to underwrite securities.

1-196 Edge Act Banks Edge Act banks are federally chartered subsidiaries of U.S. banks that are physically located in the U.S. that are allowed to engage in a full range of international banking activities. The Edge Act was a 1919 amendment to Section 25 of the 1914 Federal Reserve Act.

1-197 Offshore Banking Centers An offshore banking center is a country whose banking system is organized to permit external accounts beyond the normal scope of local economic activity. The host country usually grants complete freedom from host-country governmental banking regulations.

1-198 Offshore Banking Centers The IMF recognizes the Bahamas Bahrain the Cayman Islands Hong Kong the Netherlands Antilles Panama Singapore as major offshore banking centers

1-199 “Shell” Branches Shell branches need to be nothing more than a post office box. The actual business is done by the parent bank at the parent bank. The purpose was to allow U.S. banks to compete internationally without the expense of setting up operations “for real”.

1-200 International Banking Facilities An international banking facility is a separate set of accounts that are segregated on the parents books. An international banking facility is not a unique physical or legal identity. Any U.S. bank can have one. International banking facilities have captured a lot of the Eurodollar business that was previously handled offshore.

1-201 Capital Adequacy Standards Bank capital adequacy refers to the amount of equity capital and other securities a bank holds as reserves. There are various standards and international agreements regarding how much bank capital is “enough” to ensure the safety and soundness of the banking system.

1-202 Capital Adequacy Standards While traditional bank capital standards may be enough to protect depositors from traditional credit risk, they may not be sufficient protection from derivative risk. For example, Barings Bank, which collapsed in 1995 from derivative losses, looked good on paper relative to capital adequacy standards.

1-203 International Money Market Eurocurrency is a time deposit in an international bank located in a country different than the country that issued the currency. For example, Eurodollars are U.S. dollar-denominated time deposits in banks located abroad. Euroyen are yen-denominated time deposits in banks located outside of Japan. The foreign bank doesn’t have to be located in Europe.

1-204 Eurocurrency Market Most Eurocurrency transactions are interbank transactions in the amount of $1,000,000 and up. Common reference rates include LIBOR the London Interbank Offered Rate PIBOR the Paris Interbank Offered Rate SIBOR the Singapore Interbank Offered Rate A new reference rate for the new euro currency EURIBOR the rate at which interbank time deposits of € are offered by one prime bank to another.

1-205 Eurocredits Eurocredits are short- to medium-term loans of Eurocurrency. The loans are denominated in currencies other than the home currency of the Eurobank. Often the loans are too large for one bank to underwrite; a number of banks form a syndicate to share the risk of the loan. Eurocredits feature an adjustable rate. On Eurocredits originating in London the base rate is LIBOR.

1-206 Forward Rate Agreements An interbank contract that involves two parties, a buyer and a seller. The buyer agrees to pay the seller the increased interest cost on a notational amount if interest rates fall below an agreed rate. The seller agrees to pay the buyer the increased interest cost if interest rates increase above the agreed rate.

1-207 Forward Rate Agreements: Uses Forward Rate Agreements can be used to: Hedge assets that a bank currently owns against interest rate risk. Speculate on the future course of interest rates.

1-208 Euronotes Euronotes are short-term notes underwritten by a group of international investment banks or international commercial banks. They are sold at a discount from face value and pay back the full face value at maturity. Maturity is typically three to six months.

1-209 Euro-Medium-Term Notes Typically fixed rate notes issued by a corporation. Maturities range from less than a year to about ten years. Euro-MTNs is partially sold on a continuous basis –this allows the borrower to raise funds as they are needed.

1-210 Eurocommercial Paper Unsecured short-term promissory notes issued by corporations and banks. Placed directly with the public through a dealer. Maturities typically range from one month to six months. Eurocommercial paper, while typically U.S. dollar denominated, is often of lower quality than U.S. commercial paper—as a result yields are higher.

1-211 International Debt Crisis Some of the largest banks in the world were endangered when loans to sovereign governments of some less-developed countries. At the height of the crisis, third world countries owed $1.2 trillion.

1-212 International Debt Crisis Like a great many calamities, it is easy to see in retrospect that: It’s a bad idea to put too many eggs in one basket, especially if: You don’t know much about that basket.

1-213 Debt-for-Equity Swaps As part of debt rescheduling agreements among the bank lending syndicates and the debtor nations, creditor banks would sell their loans for U.S. dollars at discounts from face value to MNCs desiring to make equity investment in subsidiaries or local firms in the LDCs. A LDC central bank would buy the bank debt from a MNC at a smaller discount than the MNC paid, but in local currency. The MNC would use the local currency to make pre- approved new investment in the LDC that was economically or socially beneficial to the LDC.

1-214 Debt-for-Equity Swap Illustration International Bank Equity Investor or MNC LDC Central Bank LDC firm or MNC subsidiary $60m Sell $100m LDC debt at 60% of face Redeem LDC debt at 80% of face in local currency $80m in local currency

1-215 Japanese Banking Crisis The history of the Japanese banking crisis is a result of a complex combination of events and the structure of the Japanese financial system. Japanese commercial banks have historically served as the financing arm and center of a collaborative group know as keiretsu. Keiretsu members have cross-holdings of an another’s equity and ties of trade and credit.

1-216 Japanese Banking Crisis The collapse of the Japanese stock market set in motion a downward spiral for the entire Japanese economy and in particular Japanese banks. This put in jeopardy massive amounts of bank loans to corporations. It is unlikely that the Japanese banking crisis will be rectified anytime soon. The Japanese financial system does not have a legal infrastructure that allows for restructuring of bad bank loans. Japanese bank managers have little incentive to change because of the Keiretsu structure.

1-217 The Asian Crisis This crisis followed a period of economic expansion in the region financed by record private capital inflows. Bankers from the G-10 countries actively sought to finance the growth opportunities in Asia by providing businesses with a full range of products and services. This led to domestic price bubbles in East Asia, particularly in real estate.

1-218 The Asian Crisis Additionally, the close interrelationships common among commercial firms and financial institutions in Asia resulted in poor investment decision making. The Asian crisis is only the latest example of banks making a multitude of poor loans—spurred on no doubt by competition from other banks to make loans in the “hot” region. It is doubtful if the international debt crisis or the Asian crisis has taught banks a lasting lesson.

1-219 End Chapter Six

1-220 End Chapter Five

1-221 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter continues discussion of international capital markets with a discussion of the structure of the international bond market. 7 Chapter Seven International Bond Market

1-222 Chapter Outline The World’s Bond Markets: A Statistical Perspective Foreign Bonds and Eurobonds Types of Instruments Currency Distribution, Nationality, Type of Issuer International Bond Market Credit Ratings Eurobond Market Structure & Practices International Bond Market Indices

1-223 The World’s Bond Markets A statistical Perspective: The total market value of the world’s bond markets are about 50% larger than the world’s equity markets. Most issues are denominated in U.S. dollars, Japanese Yen are second, followed by Deutchmarks in a distant third.

1-224 A Statistical Perspective:

1-225 Amounts of Domestic and International Bonds Outstanding (As of Year-End 2001 in U.S. $Billions) CurrencyDomesticPercentInternationalPercentTotalPercent U.S. dollar$15,377.050.4%$3,465.650.7%$18,842.650.5% Euro$5,226.117.1%$2,170.231.7%$7,396.319.8% Pound$920.83.0%$505.37.4%$1,426.13.8% Yen$5,846.819.2%$409.16.0%$6,255.916.8% Other$3,118.210.2%$288.94.2%$3,407.19.1% Total$30,488.9100.0%$6,839.1100.0%$37,328.0100.0%

1-226 Amounts of Domestic and International Bonds Outstanding (As of Year-End 2001 in U.S. $Billions)

1-227 (As of Year-End 2001 in U.S. $Billions)

1-228 Foreign Bonds and Eurobonds Bearer Bonds and Registered Bonds National Security Registrations Withholding Taxes Recent Regulatory Changes Global Bonds

1-229 Bearer Bonds and Registered Bonds Bearer Bonds are bonds with no registered owner. As such they offer anonymity but they also offer the same risk of loss as currency. Registered Bonds: the owners name is registered with the issuer. U.S. security laws require Yankee bonds sold to U.S. citizens to be registered.

1-230 National Security Registrations Yankee bonds must meet the requirements of the SEC, just like U.S. domestic bonds. Many borrowers find this level of regulation burdensome and prefer to raise U.S. dollars in the Eurobond market. Eurobonds sold in the primary market in the United States may not be sold to U.S. citizens. Of course, a U.S. citizen could buy a Eurobond on the secondary market.

1-231 Withholding Taxes Prior to 1984, the United States required a 30 percent withholding tax on interest paid to nonresidents who held U.S. government or U.S. corporate bonds. The repeal of this tax led to a substantial shift in the relative yields on U.S. government and Eurodollar bonds. This lends credence to the notion that market participants react to tax code changes.

1-232 Recent Regulatory Changes Shelf Registration (SEC Rule 415) Allows the issuer to preregister a securities issue, and then offer the securities when the financing is actually needed. SEC Rule 144A Allows qualified institutional investors to trade private placements. These issues do not have to meet the strict information disclosure requirements of publicly traded issues.

1-233 Global Bonds A global bond is a very large international bond offering by a single borrower that is simultaneously sold in North America, Europe and Asia. Mostly institutional investors are the purchasers so far. SEC Rule 415 and 144A have likely facilitated global bond offerings, and more can be expected in the future.

1-234 Types of Instruments Straight Fixed Rate Debt Floating-Rate Notes Equity-Related Bonds Zero Coupon Bonds Dual-Currency Bonds Composite Currency Bonds

1-235 Straight Fixed Rate Debt These are “plain vanilla” bonds with a specified coupon rate and maturity and no options attached. Since most Eurobonds are bearer bonds, coupon dates tend to be annual rather than semi-annual. The vast majority of new international bond offerings are straight fixed-rate issues.

1-236 Floating-Rate Notes Just like an adjustable rate mortgage. Common reference rates are 3-month and 6-month U.S. dollar LIBOR Since FRN reset every 6 or 12 months, the premium or discount is usually quite small…as long as there is no change in the default risk.

1-237 Equity-Related Bonds Convertibles Convertible bonds allow the holder to surrender his bond in exchange for a specified number of shares in the firm of the issuer. Bonds with equity warrants These bonds allow the holder to keep his bond but still buy a specified number of shares in the firm of the issuer at a specified price.

1-238 Zero Coupon Bonds Zeros are sold at a large discount from face value because there is no cash flow until maturity. In the U.S., investors in zeros owe taxes on the “imputed income” represented by the increase in present value each year, while in Japan, the gain is a tax-free capital gain. Pricing is very straightforward:

1-239 Dual-Currency Bonds A straight fixed-rate bond, with interest paid in one currency, and principal in another currency. Japanese firms have been big issuers with coupons in yen and principal in dollars. Good option for a MNC financing a foreign subsidiary.

1-240 Composite Currency Bonds Denominated in a currency basket, like the SDRs or ECUs instead of a single currency. Often called currency cocktail bonds. Typically straight fixed rate debt.

1-241 Instrument Straight Fixed-Rate Floating Rate Note Convertible BondAnnualFixedCurrency of issue or conversion to equity shares. Straight fixed rate with equity warrants AnnualFixedCurrency of issue plus conversion to equity shares. ZerononezeroCurrency of issue Dual Currency BondAnnualFixedDual currency Frequency of Payment Annual Size of Coupon Payoff at Maturity Characteristics of International Bond Market Instruments Currency of issueFixed Every 3 or 6 monthsVariableCurrency of issue

1-242 Currency Distribution of International Bond Offerings Currency2001 U.S. dollar51% Euro32 Yen6 Pound Sterling7 Swiss franc2 Other2 Total100

1-243 Distribution of International Bond Offerings by Nationality Nationality2001 (U.S. $b) Australia99.8 Canada208.3 France366.7 Germany889.4 Italy259.3 Japan245.6 Sweden293.9 United Kingdom571.5 United States2,170.3 Total6,839.1

1-244 Distribution of International Bond Offerings by Type of Issuer Type of Issuer2001 (U.S. $ Billion) Governments1,416.5 Public enterprises1,416.5 Corporate issuers1,014.6 International organizations377.7 Total831.6

1-245 International Bond Market Credit Ratings Fitch IBCA, Moody’s and Standard & Poor’s sell credit rating analysis. Focus on default risk, not exchange rate risk. Assessing sovereign debt focuses on political risk and economic risk.

1-246 Eurobond Market Structure Primary Market Very similar to U.S. underwriting. Secondary Market OTC market centered in London.  Comprised of market makers as well as brokers.  Market makers and brokers are members of the International Securities Market Association (ISMA). Clearing Procedures Euroclear and Cedel handle most Eurobond trades.

1-247 International Bond Market Indices There are several international bond market indices. J.P. Morgan and Company Domestic Bond Indices International Government bond index for 18 countries. Widely referenced and often used as a benchmark. Appears daily in The Wall Street Journal

1-248 End Chapter Seven

1-249 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter discusses both the primary and secondary equity markets throughout the world. 8 Chapter Eight International Equity Markets

1-250 Chapter Outline A Statistical Perspective Market Structure, Trading Practices, and Costs International Equity Market Benchmarks World Equity Market Benchmark Shares Trading in International Equities Factors Affecting International Equity Returns

1-251 Chapter Outline A Statistical Perspective Market Capitalization of Developed Countries Market Capitalization of Developing Countries Measures of Liquidity Measures of Market Concentration Market Structure, Trading Practices, and Costs International Equity Market Benchmarks World Equity Market Benchmark Shares Trading in International Equities Factors Affecting International Equity Returns

1-255 Chapter Outline A Statistical Perspective Market Structure, Trading Practices, and Costs International Equity Market Benchmarks World Equity Market Benchmark Shares Trading in International Equities Magnitude of International Equity Trading Cross-Listing of Shares Yankee Stock Offerings The European Stock Market American Depository Receipts Factors Affecting International Equity Returns

1-257 A Statistical Perspective Market Capitalization of Developed Countries Market Capitalization of Developing Countries Measures of Liquidity Measures of Market Concentration

1-258 Market Capitalization of Developed Countries Almost 92% of the total market capitalization of the world’s equity markets is accounted for by the market capitalization of the developed world.

1-259 The other 10% is accounted for by the market capitalization of developing countries in “emerging markets”. Latin America Asia Eastern Europe Mideast/Africa Recently the growth rates in these emerging markets have been strong, but with more volatility than we have here at home. Market Capitalization of Developing Countries

1-260 Measures of Liquidity The equity markets of the developed world tend to be much more liquid than emerging markets. Liquidity refers to how quickly an asset can be sold without a major price concession. So, while investments in emerging markets may be profitable, the focus should be on the long term.

1-261 Measures of Market Concentration Emerging Markets tend to be much more concentrated than our markets. Concentrated in relatively few companies. That is, a few issues account for a much larger percentage of the overall market capitalization in emerging markets than in the equity markets of the developed world.

1-262 Market Structure, Trading Practices, and Costs Primary Markets Shares offered for sale directly from the issuing company. Secondary Markets Provide market participants with marketability and share valuation.

1-263 Market Structure, Trading Practices, and Costs Market Order An order to your broker to buy or sell share immediately at the market price. Limit Order An order to your broker to buy or sell at the at a price you want, when and if he can. If immediate execution is more important than the price, use a market order.

1-264 Market Structure, Trading Practices, and Costs Dealer Market The stock is sold by dealers, who stand ready to buy and sell the security for their own account. In the U.S., the OTC market is a dealer market. Auction Market Organized exchanges have specialists who match buy and sell orders. Buy and sell orders may get matched without the specialist buying and selling as a dealer. Automated Exchanges Computers match buy and sell orders.

1-265 International Equity Market Benchmarks North America Europe Asia/Pacific Rim

1-266 North American Equity Market Benchmarks

1-267 European Equity Market Benchmarks

1-268 Asia/ Pacific Rim Equity Market Benchmarks

1-269 World Equity Benchmark Shares World Equity Benchmark Shares (WEBS) Country-specific baskets of stocks designed to replicate the country indexes of 14 countries. WEBS are subject to U.S. SEC and IRS diversification requirements. Low cost, convenient way for investors to hold diversified investments in several different countries.

1-270 Trading in International Equities Magnitude of International Equity Trading Cross-Listing of Shares Yankee Stock Offerings The European Stock Market American Depository Receipts

1-271 Magnitude of International Equity Trading During the 1980s world capital markets began a trend toward greater global integration. Diversification, reduced regulation, improvements in computer and communications technology, increased demand from MNCs for global issuance.

1-272 Cross-Listing of Shares Cross-Listing refers to a firm having its equity shares listed on one or more foreign exchanges. The number of firms doing this has exploded in recent years.

1-273 Advantages of Cross-Listing It expands the investor base for a firm. Establishes name recognition for the firm in new capital markets, paving the way for new issues. May offer marketing advantages. May mitigate possibility of hostile takeovers.

1-274 Yankee Stock Offerings The direct sale of new equity capital to U.S. public investors by foreign firms. Privatization in South America and Eastern Europe Equity sales by Mexican firms trying to cash in on NAFTA

1-275 The European Stock Market There is not as yet a single European stock market that comprises all national markets. NASDAQ Europe hopes to become a pan- European stock market that operates independently of any national European exchange. All trading is denominated in the euro. It expects to offer trading in both European and U.S. stocks. www.NasdaqEurope.com

1-276 American Depository Receipts Foreign stocks often trade on U.S. exchanges as ADRs. It is a receipt that represents the number of foreign shares that are deposited at a U.S. bank. The bank serves as a transfer agent for the ADRs

1-277 American Depository Receipts There are many advantages to trading ADRs as opposed to direct investment in the company’s shares: ADRs are denominated in U.S. dollars, trade on U.S. exchanges and can be bought through any broker. Dividends are paid in U.S. dollars. Most underlying stocks are bearer securities, the ADRs are registered.

1-278 Global Registered Shares DaimlerChrysler AG is a German firm, whose stock trades as a GRS. GRS are one share traded globally, unlike ADRs, which are receipts for banks deposits of home- market shares and traded on foreign markets. They trade in both dollars and euros. All shareholders have equal status and voting rights.

1-279 Macroeconomic Factors Exchange Rates Industrial Structure Factors Affecting International Equity Returns

1-280 The data do not support the notion that equity returns are strongly influenced by macro factors. That is correspondent with findings for U.S. equity markets. Macroeconomic Factors Affecting International Equity Returns

1-281 Exchange Rates Exchange rate movements in a given country appear to reinforce the stock market movements within that country. One should be careful not to confuse correlation with causality.

1-282 Industrial Structure Studies examining the influence of industrial structure on foreign equity returns are inconclusive.

1-283 End Chapter Eight

1-284 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter discusses exchange-traded currency futures contracts, options contracts, and options on currency futures. 9 Chapter Nine Futures and Options on Foreign Exchange

1-285 Chapter Outline Futures Contracts: Preliminaries Currency Futures Markets Basic Currency Futures Relationships Eurodollar Interest Rate Futures Contracts Options Contracts: Preliminaries Currency Options Markets Currency Futures Options

1-286 Chapter Outline (continued) Basic Option Pricing Relationships at Expiry American Option Pricing Relationships European Option Pricing Relationships Binomial Option Pricing Model European Option Pricing Model Empirical Tests of Currency Option Models

1-287 Futures Contracts: Preliminaries A futures contract is like a forward contract: It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today. A futures contract is different from a forward contract: Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.

1-288 Futures Contracts: Preliminaries Standardizing Features: Contract Size Delivery Month Daily resettlement Initial Margin (about 4% of contract value, cash or T-bills held in a street name at your brokers).

1-289 Daily Resettlement: An Example Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically you think that the dollar will appreciate). Currently $1 = ¥140. The 3-month forward price is $1=¥150.

1-290 Daily Resettlement: An Example Currently $1 = ¥140 and it appears that the dollar is strengthening. If you enter into a 3-month futures contract to sell ¥ at the rate of $1 = ¥150 you will make money if the yen depreciates. The contract size is ¥12,500,000 Your initial margin is 4% of the contract value:

1-291 Daily Resettlement: An Example If tomorrow, the futures rate closes at $1 = ¥149, then your position’s value drops. Your original agreement was to sell ¥12,500,000 and receive $83,333.33 But now ¥12,500,000 is worth $83,892.62 You have lost $559.28 overnight.

1-292 Daily Resettlement: An Example The $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05 This is short of the $3,355.70 required for a new position. Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds or your position will be closed out. This is usually done with a reversing trade.

1-293 Currency Futures Markets The Chicago Mercantile Exchange (CME) is by far the largest. Others include: The Philadelphia Board of Trade (PBOT) The MidAmerica commodities Exchange The Tokyo International Financial Futures Exchange The London International Financial Futures Exchange

1-294 The Chicago Mercantile Exchange Expiry cycle: March, June, September, December. Delivery date 3rd Wednesday of delivery month. Last trading day is the second business day preceding the delivery day. CME hours 7:20 a.m. to 2:00 p.m. CST.

1-295 CME After Hours Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST. Singapore International Monetary Exchange (SIMEX) offer interchangeable contracts. There’s other markets, but none are close to CME and SIMEX trading volume.

1-296 Basic Currency Futures Relationships Open Interest refers to the number of contracts outstanding for a particular delivery month. Open interest is a good proxy for demand for a contract. Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

1-297 Reading a Futures Quote Expiry month Opening price Highest price that day Lowest price that day Closing price Daily Change Highest and lowest prices over the lifetime of the contract. Number of open contracts

1-298 Eurodollar Interest Rate Futures Contracts Widely used futures contract for hedging short- term U.S. dollar interest rate risk. The underlying asset is a hypothetical $1,000,000 90-day Eurodollar deposit—the contract is cash settled. Traded on the CME and the Singapore International Monetary Exchange. The contract trades in the March, June, September and December cycle.

1-299 Reading Eurodollar Futures Quotes EURODOLLAR (CME)—$1 million; pts of 100% OpenHighLowSettleChgYield Settle Change Open Interest July 94.69 94.68 -.01 5.32 +.0147,417 Eurodollar futures prices are stated as an index number of three-month LIBOR calculated as F = 100 – LIBOR. The closing price for the July contract is 94.68 thus the implied yield is 5.32 percent = 100 – 98.68 The change was.01 percent of $1 million representing $100 on an annual basis. Since it is a 3-month contract one basis point corresponds to a $25 price change.

1-300 Options Contracts: Preliminaries An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today. Calls vs. Puts Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. Put options gives the holder the right, but not the obligation, to sell a given quantity of some asset at some time in the future, at prices agreed upon today.

1-301 Options Contracts: Preliminaries European vs. American options European options can only be exercised on the expiration date. American options can be exercised at any time up to and including the expiration date. Since this option to exercise early generally has value, American options are usually worth more than European options, other things equal.

1-302 Options Contracts: Preliminaries In-the-money The exercise price is less than the spot price of the underlying asset. At-the-money The exercise price is equal to the spot price of the underlying asset. Out-of-the-money The exercise price is more than the spot price of the underlying asset.

1-303 Options Contracts: Preliminaries Intrinsic Value The difference between the exercise price of the option and the spot price of the underlying asset. Speculative Value The difference between the option premium and the intrinsic value of the option. Option Premium = Intrinsic Value Speculative Value +

1-304 Currency Options Markets PHLX HKFE 20-hour trading day. OTC volume is much bigger than exchange volume. Trading is in seven major currencies plus the euro against the U.S. dollar.

1-305 PHLX Currency Option Specifications CurrencyContract Size Australian dollarAD50,000 British pound£31,250 Canadian dollarCD50,000 Euro€62,500 Japanese yen¥6,250,000 Swiss francSF62,500

1-306 Currency Futures Options Are an option on a currency futures contract. Exercise of a currency futures option results in a long futures position for the holder of a call or the writer of a put. Exercise of a currency futures option results in a short futures position for the seller of a call or the buyer of a put. If the futures position is not offset prior to its expiration, foreign currency will change hands.

1-307 Basic Option Pricing Relationships at Expiry At expiry, an American call option is worth the same as a European option with the same characteristics. If the call is in-the-money, it is worth S T – E. If the call is out-of-the-money, it is worthless. C aT = C eT = Max[S T - E, 0]

1-308 Basic Option Pricing Relationships at Expiry At expiry, an American put option is worth the same as a European option with the same characteristics. If the put is in-the-money, it is worth E - S T. If the put is out-of-the-money, it is worthless. P aT = P eT = Max[E - S T, 0]

1-309 Basic Option Profit Profiles E STST Profit loss –c0–c0 E + c 0 Long 1 call If the call is in-the- money, it is worth S T – E. If the call is out-of- the-money, it is worthless and the buyer of the call loses his entire investment of c 0.

1-310 Basic Option Profit Profiles E STST Profit loss c0c0 E + c 0 short 1 call If the call is in-the- money, the writer loses S T – E. If the call is out-of- the-money, the writer keeps the option premium.

1-311 Basic Option Profit Profiles E STST Profit loss – p 0 E – p 0 long 1 put E – p 0 If the put is in- the-money, it is worth E –S T. The maximum gain is E – p 0 If the put is out- of-the-money, it is worthless and the buyer of the put loses his entire investment of p 0.

1-312 Basic Option Profit Profiles E STST Profit loss p 0 E – p 0 long 1 put – E + p 0 If the put is in- the-money, it is worth E –S T. The maximum loss is – E + p 0 If the put is out- of-the-money, it is worthless and the seller of the put keeps the option premium of p 0.

1-313 Example $1.50 STST Profit loss –$0.25 $1.75 Long 1 call on 1 pound Consider a call option on £31,250. The option premium is $0.25 per pound The exercise price is $1.50 per pound.

1-314 Example $1.50 STST Profit loss –$7,812.50 $1.75 Long 1 call on £31,250 Consider a call option on £31,250. The option premium is $0.25 per pound The exercise price is $1.50 per pound.

1-315 Example $1.50 STST Profit loss $42,187.50 $1.35 Long 1 put on £31,250 Consider a put option on £31,250. The option premium is $0.15 per pound The exercise price is $1.50 per pound. What is the maximum gain on this put option? At what exchange rate do you break even? –$4,687.50 $42,187.50 = £31,250×($1.50 – $0.15)/£ $4,687.50 = £31,250×($0.15)/£

1-316 American Option Pricing Relationships With an American option, you can do everything that you can do with a European option—this option to exercise early has value. C aT > C eT = Max[S T - E, 0] P aT > P eT = Max[E - S T, 0]

1-317 Market Value, Time Value and Intrinsic Value for an American Call E STST Profit loss Long 1 call The red line shows the payoff at maturity, not profit, of a call option. Note that even an out- of-the-money option has value—time value. Intrinsic value Time value Market Value In-the-moneyOut-of-the-money

1-318 European Option Pricing Relationships Consider two investments 1 Buy a European call option on the British pound futures contract. The cash flow today is – C e 2 Replicate the upside payoff of the call by 1 Borrowing the present value of the exercise price of the call in the U.S. at i $ The cash flow today is E /(1 + i $ ) 2 Lending the present value of S T at i £ The cash flow is – S T /(1 + i £ )

1-319 European Option Pricing Relationships When the option is in-the-money both strategies have the same payoff. When the option is out-of-the-money it has a higher payoff than the borrowing and lending strategy. Thus:

1-320 European Option Pricing Relationships Using a similar portfolio to replicate the upside potential of a put, we can show that:

1-321 Binomial Option Pricing Model Imagine a simple world where the dollar-euro exchange rate is S 0 ($/€) = $1 today and in the next year, S 1 ($/€) is either $1.1 or $.90. $1 $.90 $1.10 S 1 ($/€) S 0 ($/€)

1-322 Binomial Option Pricing Model A call option on the euro with exercise price S 0 ($/€) = $1 will have the following payoffs. $.90 $1.10 S 1 ($/€) S 0 ($/€)C 1 ($/€) $.10 $0 $1

1-323 Binomial Option Pricing Model We can replicate the payoffs of the call option. With a levered position in the euro. $.90 $1.10 S 1 ($/€) S 0 ($/€) $1 C 1 ($/€) $.10 $0

1-324 Binomial Option Pricing Model Borrow the present value of $.90 today and buy €1. Your net payoff in one period is either $.2 or $0. $.90 $1.10 S 1 ($/€) S 0 ($/€) $1 debt –$.90 portfolio $.20 $.00 C 1 ($/€) $.10 $0

1-325 Binomial Option Pricing Model The portfolio has twice the option’s payoff so the portfolio is worth twice the call option value. $.90 $1.10 S 0 ($/€) $1 debt –$.90 portfolio $.20 $.00 C 1 ($/€) $.10 $0 S 1 ($/€)

1-326 Binomial Option Pricing Model The portfolio value today is today’s value of one euro less the present value of a $.90 debt: $.90 $1.10 S 0 ($/€) $1 debt –$.90 portfolio $.20 $.00 C 1 ($/€) $.10 $0 S 1 ($/€)

1-327 Binomial Option Pricing Model We can value the option as half of the value of the portfolio: $.90 $1.10 S 0 ($/€) $1 debt –$.90 portfolio $.20 $.00 C 1 ($/€) $.10 $0 S 1 ($/€)

1-328 Binomial Option Pricing Model The most important lesson from the binomial option pricing model is: the replicating portfolio intuition. the replicating portfolio intuition. Many derivative securities can be valued by valuing portfolios of primitive securities when those portfolios have the same payoffs as the derivative securities.

1-329 European Option Pricing Formula We can use the replicating portfolio intuition developed in the binomial option pricing formula to generate a faster-to-use model that addresses a much more realistic world.

1-330 European Option Pricing Formula The model is Where C 0 = the value of a European option at time t = 0 r $ = the interest rate available in the U.S. r £ = the interest rate available in the foreign country—in this case the U.K.

1-331 European Option Pricing Formula Find the value of a six-month call option on the British pound with an exercise price of $1.50 = £1 The current value of a pound is $1.60 The interest rate available in the U.S. is r $ = 5%. The interest rate in the U.K. is r £ = 7%. The option maturity is 6 months (half of a year). The volatility of the $/£ exchange rate is 30% p.a. Before we start, note that the intrinsic value of the option is $.10—our answer must be at least that.

1-332 European Option Pricing Formula Let’s try our hand at using the model. If you have a calculator handy, follow along. Then, calculate d 1 and d 2 First calculate

1-333 European Option Pricing Formula N(d 1 ) = N(0.106066) =.5422 N(d 2 ) = N(-0.1768) = 0.4298

1-334 Option Value Determinants Call Put 1.Exchange rate+ – 2.Exercise price– + 3.Interest rate in U.S.+ – 4.Interest rate in other country+ – 5.Variability in exchange rate+ + 6.Expiration date+ + The value of a call option C 0 must fall within max (S 0 – E, 0) < C 0 < S 0. The precise position will depend on the above factors.

1-335 Empirical Tests The European option pricing model works fairly well in pricing American currency options. It works best for out-of-the-money and at-the-money options. When options are in-the-money, the European option pricing model tends to underprice American options.

1-336 End Chapter Nine

1-337 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk. 10 Chapter Ten Currency & Interest Rate Swaps

1-338 Chapter Outline Types of Swaps Size of the Swap Market The Swap Bank Interest Rate Swaps Currency Swaps

1-339 Chapter Outline (continued) Swap Market Quotations Variations of Basic Currency and Interest Rate Swaps Risks of Interest Rate and Currency Swaps Swap Market Efficiency Concluding Points About Swaps

1-340 Definitions In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. There are two types of interest rate swaps: Single currency interest rate swap  “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps. Cross-Currency interest rate swap  This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.

1-341 Size of the Swap Market In 2001 the notational principal of: Interest rate swaps was $58,897,000,000. Currency swaps was $3,942,000,000 The most popular currencies are: U.S. dollar Japanese yen Euro Swiss franc British pound sterling

1-342 The Swap Bank A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer. As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

1-343 An Example of an Interest Rate Swap Consider this example of a “plain vanilla” interest rate swap. Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. It would make more sense to for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.

1-344 An Example of an Interest Rate Swap Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. Alternatively, firm B can raise the money by issuing 5- year floating-rate notes at LIBOR + ½ percent. Firm B would prefer to borrow at a fixed rate.

1-345 An Example of an Interest Rate Swap The borrowing opportunities of the two firms are:

1-346 An Example of an Interest Rate Swap The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years Swap Bank LIBOR – 1/8% 10 3/8% Bank A

1-347 An Example of an Interest Rate Swap Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap. 10% ½% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Swap Bank LIBOR – 1/8% 10 3/8% Bank A

1-348 An Example of an Interest Rate Swap Company B The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank 10 ½% LIBOR – ¼%

1-349 An Example of an Interest Rate Swap They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating. LIBOR + ½% Here’s what’s in it for B: ½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Swap Bank Company B 10 ½% LIBOR – ¼%

1-350 An Example of an Interest Rate Swap The swap bank makes money too. ¼% of $10 million = $25,000 per year for 5 years. LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 ¼ Swap Bank Company B 10 ½% LIBOR – ¼% LIBOR – 1/8% 10 3/8% Bank A

1-351 An Example of an Interest Rate Swap Swap Bank Company B 10 ½% LIBOR – ¼% LIBOR – 1/8% 10 3/8% Bank A B saves ½% A saves ½% The swap bank makes ¼%

1-352 An Example of a Currency Swap Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds. This will give them exchange rate risk: financing a sterling project with dollars. They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.

1-353 An Example of a Currency Swap If they can find a British MNC with a mirror- image financing need they may both benefit from a swap. If the spot exchange rate is S 0 ($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

1-354 An Example of a Currency Swap Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational. Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.

1-355 $9.4% An Example of a Currency Swap Firm B $8% £12% Swap Bank Firm A £11% $8% £12%

1-356 An Example of a Currency Swap $8% £12% Firm B Swap Bank Firm A £11% $8% $9.4% £12% A’s net position is to borrow at £11% A saves £.6%

1-357 An Example of a Currency Swap $8% £12% Firm B Swap Bank Firm A £11% $8% $9.4% £12% B’s net position is to borrow at $9.4% B saves $.6%

1-358 An Example of a Currency Swap $8% £12% Firm B The swap bank makes money too: At S 0 ($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years. The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap). 1.4% of $16 million financed with 1% of £10 million per year for 5 years. Swap Bank Firm A £11% $8% $9.4% £12%

1-359 The QSD The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank. There is no reason to presume that the gains will be shared equally. In the above example, company B is less credit- worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

1-360 A is the more credit-worthy of the two firms. Comparative Advantage as the Basis for Swaps A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds. A pays 2% less to borrow in dollars than B A pays.4% less to borrow in pounds than B:

1-361 B has a comparative advantage in borrowing in £. Comparative Advantage as the Basis for Swaps B pays 2% more to borrow in dollars than A B pays only.4% more to borrow in pounds than A:

1-362 A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds. If they borrow according to their comparative advantage and then swap, there will be gains for both parties. Comparative Advantage as the Basis for Swaps

1-363 Swap Market Quotations Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs They also make a market in “plain vanilla” swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread. For example, 6.60 — 6.85 means the swap bank will pay fixed-rate DM payments at 6.60% against receiving dollar LIBOR or it will receive fixed-rate DM payments at 6.85% against receiving dollar LIBOR.

1-364 Variations of Basic Currency and Interest Rate Swaps Currency Swaps fixed for fixed fixed for floating floating for floating amortizing Interest Rate Swaps zero-for floating floating for floating For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.

1-365 Risks of Interest Rate and Currency Swaps Interest Rate Risk Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position. Basis Risk If the floating rates of the two counterparties are not pegged to the same index. Exchange rate Risk In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

1-366 Risks of Interest Rate and Currency Swaps (continued) Credit Risk This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap. Mismatch Risk It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time. Sovereign Risk The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

1-367 Pricing a Swap A swap is a derivative security so it can be priced in terms of the underlying assets: How to: Plain vanilla fixed for floating swap gets valued just like a bond. Currency swap gets valued just like a nest of currency futures.

1-368 Swap Market Efficiency Swaps offer market completeness and that has accounted for their existence and growth. Swaps assist in tailoring financing to the type desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.

1-369 Concluding Remarks The growth of the swap market has been astounding. Swaps are off-the-books transactions. Swaps have become an important source of revenue and risk for banks

1-370 End Chapter Ten

1-371 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objectives: Why investors diversify their portfolios internationally. How much investors can gain from international diversification. The effects of fluctuating exchange rates on international portfolio investments. Whether and how much investors can benefit from investing in U.S. based international mutual funds. The reasons for “home bias” in portfolio holdings. 11 Chapter Eleven International Portfolio Investments

1-372 Chapter Outline International Correlation Structure and Risk Diversification Optimal International Portfolio Selection Effects of Changes in the Exchange Rate International Bond Investment International Mutual Funds: A Performance Evaluation

1-373 Chapter Outline (continued) International Diversification through Country Funds International Diversification with ADRs International Diversification with WEBS Why Home Bias in Portfolio Holdings?

1-374 International Correlation Structure and Risk Diversification Security returns are much less correlated across countries than within a country. This is so because economic, political, institutional, and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities. Business cycles are often high asynchronous across countries.

1-375 International Correlation Structure Stock MarketAUFRGMJPNLSWUKUS Australia (AU).586 France (FR).286.576 Germany (GM).183.312.653 Japan (JP).152.238.300.416 Netherlands (NP).241.344.509.282.624 Switzerland (SW).358.368.475.281.517.664 United Kingdom (UK).315.378.299.209.393.431.698 United States (US).304.225.170.137.271.272.279.439 Relatively low international correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than domestically.

1-376 Domestic vs. International Diversification 0.44 0.27 0.12 Portfolio Risk (%) Number of Stocks 11020304050 Swiss stocks U.S. stocks International stocks When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio. A fully diversified international portfolio is only 12 percent as risky as holding a single security.

1-377 Optimal International Portfolio Selection The correlation of the U.S. stock market with the returns on the stock markets in other nations varies. The correlation of the U.S. stock market with the Canadian stock market is 70%. The correlation of the U.S. stock market with the Japanese stock market is 24%. A U.S. investor would get more diversification from investments in Japan than Canada.

1-378 Summary Statistics for Monthly Returns 1980-2001 ($U.S.) Stock Market Correlation Coefficient Mean (%) SD (%)  CNFRGMJPUK Canada (CN).885.780.99 France (FR)0.46 1.196.291.00 Germany (GM) 0.420.69 1.096.260.91 Japan (JP)0.330.410.33 0.916.991.20 United Kingdom 0.57 0.500.42 1.235.550.98 United States0.740.500.450.310.581.264.430.86.88% monthly return = 10.56% per year

1-379 Stock Market Correlation Coefficient Mean (%) SD (%)  CNFRGMJPUK Canada (CN).885.780.99 France (FR)0.46 1.196.291.00 Germany (GM) 0.420.69 1.096.260.91 Japan (JP)0.330.410.33 0.916.991.20 United Kingdom 0.57 0.500.42 1.235.550.98 United States0.740.500.450.310.581.264.430.86 Summary Statistics for Monthly Returns 1980-2001 ($U.S.)  measures the sensitivity of the market to the world market. Clearly the Japanese market is more sensitive to the world market than is the U.S.

1-380 The Optimal International Portfolio US CN GM UK JP FR 4.2% 1.53 OIP Efficient set RfRf

1-381 Composition of the OIP for a U.S. Investor (Holding Period: 1980—2000 Hong Kong market1.61% Italian market1.14% Netherlands market29.96% Swedish market26.45% U.S. market40.84% Total100.00%

1-382 1.42% 1.26% Gains from International Diversification For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 20% higher, suggesting that an equivalent- risk OIP would have 1.68% more return than a domestic portfolio. OIPODP Mean Return 1.42%1.26% Standard Deviation 4.51%4.43% risk return OIP ODP 4.43% 4.51%

1-383 Effects of Changes in the Exchange Rate The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the U.S. dollar and the foreign currency.

1-384 Effects of Changes in the Exchange Rate The realized dollar return for a U.S. resident investing in a foreign market is given by R i$ = (1 + R i )(1 + e i ) – 1 = R i + e i + R i e i Where R i is the local currency return in the i th market e i is the rate of change in the exchange rate between the local currency and the dollar

1-385 Effects of Changes in the Exchange Rate For example, if a U.S. resident just sold shares in a British firm that had a 15% return (in pounds) during a period when the pound depreciated 5%, his dollar return is 9.25%: R i$ = (1 +.15)(1 –0.05) – 1 = 0.925 =.15 + -.05 +.15×(-.05) =0.925

1-386 Effects of Changes in the Exchange Rate The risk for a U.S. resident investing in a foreign market will depend not only on the risk in the foreign market but also on the risk in the exchange rate between the U.S. dollar and the foreign currency. Var(R i$ ) = Var(R i ) + Var(e i ) + 2Cov(R i,e i ) +  Var The  Var term represents the contribution of the cross-product term, R i e i, to the risk of foreign investment.

1-387 Effects of Changes in the Exchange Rate Var(R i$ ) = Var(R i ) + Var(e i ) + 2Cov(R i,e i ) +  Var This equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three channels: 1. Its own volatility, Var(e i ). 2. Its covariance with the local market returns Cov(R i,e i ). 3. The contribution of the cross-product term,  Var.

1-388 International Bond Investment There is substantial exchange rate risk in foreign bond investment. This suggests that investors may be able to increase their gains is they can control this risk, for example with currency forward contracts or swaps. The advent of the euro is likely to alter the risk- return characteristics of the euro-zone bond markets enhancing the importance of non-euro currency bonds.

1-389 International Mutual Funds: A Performance Evaluation A U.S. investor can easily achieve international diversification by investing in a U.S.-based international mutual fund. The advantages include 1. Savings on transaction and information costs. 2. Circumvention of legal and institutional barriers to direct portfolio investments abroad. 3. Professional management and record keeping.

1-390 International Mutual Funds: A Performance Evaluation As can be seen below, a sample of U.S. based international mutual funds has outperformed the S&P 500 during the period 1977-1986, with a higher standard deviation.  US Mean Annual Return Standard Deviation  US R2R2 U.S. Based International Mutual Funds 18.96%5.78%0.690.39 S&P 50014.04%4.25%1.00 U.S. MNC Index 16.08%4.38.98.90

1-391 International Mutual Funds: A Performance Evaluation U.S. stock market movements account for less than 40% of the fluctuations of international mutual funds, but over 90% of the movements in U.S. MNC shares. This means that the shares of U.S. MNCs behave like those of domestic firms, without providing effective international diversification. Mean Annual Return Standard Deviation  US R2R2 U.S. Based International Mutual Funds 18.96%5.78%0.690.39 S&P 50014.04%4.25%1.00 U.S. MNC Index16.08%4.38.98.90

1-392 International Diversification through Country Funds Recently, country funds have emerged as one of the most popular means of international investment. A country fund invests exclusively in the stocks of a single county. This allows investors to: 1. Speculate in a single foreign market with minimum cost. 2. Construct their own personal international portfolios. 3. Diversify into emerging markets that are otherwise practically inaccessible.

1-393 American Depository Receipts Foreign stocks often trade on U.S. exchanges as ADRs. It is a receipt that represents the number of foreign shares that are deposited at a U.S. bank. The bank serves as a transfer agent for the ADRs

1-394 American Depository Receipts There are many advantages to trading ADRs as opposed to direct investment in the company’s shares: ADRs are denominated in U.S. dollars, trade on U.S. exchanges and can be bought through any broker. Dividends are paid in U.S. dollars. Most underlying stocks are bearer securities, the ADRs are registered.

1-395 International Diversification with ADRs Adding ADRs to domestic portfolios has a substantial risk reduction benefit.

1-396 World Equity Benchmark Shares World Equity Benchmark Shares (WEBS) Country-specific baskets of stocks designed to replicate the country indexes of 14 countries. WEBS are subject to U.S. SEC and IRS diversification requirements. Low cost, convenient way for investors to hold diversified investments in several different countries.

1-397 International Diversification with WEBS Recent research suggests that WEBs are an excellent tool for international risk diversification. For investors who desire international exposure, WEBs may well serve as a major alternative to such traditional tools as international mutual funds, ADRs, and closed-end country funds

1-398 Why Home Bias in Portfolio Holdings? Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.

1-399 The Home Bias in Equity Portfolios CountryShare in World Market Value Proportion of Domestic Equities in Portfolio France2.6%64.4% Germany3.2%75.4% Italy1.9%91.0% Japan43.7%86.7% Spain1.1%94.2% Sweden0.8%100.0% United Kingdom10.3%78.5% United States36.4%98.0% Total 100.0%

1-400 Why Home Bias in Portfolio Holdings? Three explanations come to mind: 1. Domestic equities may provide a superior inflation hedge. 2. Home bias may reflect institutional and legal restrictions on foreign investment. 3. Extra taxes and transactions/information costs for foreign securities may give rise to home bias.

1-401 End Chapter Eleven

1-402 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter provides a way to measure economic exposure, discusses its determinants, and presents methods for managing and hedging economic exposure. 12 Chapter Twelve Management of Economic Exposure

1-403 Chapter Outline Three Types of Exposure How to Measure Economic Exposure Operating Exposure: Definition An Illustration of Operating Exposure Determinants of Operating Exposure Managing Operating Exposure

1-404 Economic Exposure Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely domestic firms. Consider a U.S. bicycle manufacturer who sources and sells only in the U.S. Since the firm’s product competes against imported bicycles it is subject to foreign exchange exposure.

1-405 Economic Exposure Exchange risk as applied to the firm’s competitive position. Transaction Exposure Exchange rate risk as applied to the firm’s home currency cash flows. The subject of Chapter 13. Translation Exposure Exchange rate risk as applied to the firm’s consolidated financial statements. The subject of Chapter 14 Three Types of Exposure

1-406 Economic Exposure Exchange rate risk as applied to the firm’s competitive position. Any anticipated changes in the exchange rates would have been already discounted and reflected in the firm’s value. Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates.

1-407 Transaction Exposure This is the subject of Chapter 13. Defined as the sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Transaction exposure arises from fixed-price contracting in a world of constantly changing exchange rates.

1-408 Translation Exposure The subject of Chapter 14. Exchange rate risk as applied to the firm’s consolidated financial statements. Consolidation involves translation of subsidiaries’ financial statements from local currencies to home currency. Involves many controversial issues.

1-409 How to Measure Economic Exposure Economic exposure is the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates. There exist statistical measurements of sensitivity. Sensitivity of the future home currency values of the firm’s assets and liabilities to random changes in exchange rates. Sensitivity of the firm’s operating cash flows to random changes in exchange rates.

1-410 Operating exposure Channels of Economic Exposure Firm Value Home currency value of assets and liabilities Future operating cash flows Exchange rate fluctuations Asset exposure

1-411 How to Measure Economic Exposure If a U.S. MNC were to run a regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form: P = a + b×S + e Where a is the regression constant e is the random error term with mean zero. The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S.

1-412 How to Measure Economic Exposure The exposure coefficient, b, is defined as follows: Where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate. Cov(P,S) Var(S) b =

1-413 How to Measure Economic Exposure The exposure coefficient shows that there are two sources of economic exposure: Cov(P,S) Var(S) b = 1.the variance of the exchange rate and 2.the covariance between the dollar value of the asset and exchange rate

1-414 Example Suppose a U.S. firm has an asset in Britain whose local currency price is random. For simplicity, suppose there are only three states of the world and each state is equally likely to occur. The future local currency price of this British asset (P*) as well as the future exchange rate (S) will be determined, depending on the realized state of the world.

1-415 Example (continued) StateProbabilityP*SS×P* Case 1 11/3£980$1.40/£$1,372 21/3£1,000$1.50/£$1,500 31/3£1,070$1.60/£$1,712 Case 2 11/3£1,000$1.40/£$1,400 21/3£933$1.50/£$1,400 31/3£875$1.60/£$1,400 Case 3 11/3£1,000$1.40/£$1,400 21/3£1,000$1.50/£$1,500 31/3£1,000$1.60/£$1,600

1-416 Example (continued) In case one, the local currency price of the asset and the exchange rate are positively correlated. This gives rise to substantial exchange rate risk. StateProbabilityP*SS×P* Case 1 11/3£980$1.40/£$1,372 21/3£1,000$1.50/£$1,500 31/3£1,070$1.60/£$1,712

1-417 Example (continued) In case two, the local currency price of the asset and the exchange rate are negatively correlated. This ameliorates the exchange rate risk substantially. (Completely in this example.) StateProbabilityP*SS×P* Case 2 11/3£1,000$1.40/£$1,400 21/3£933$1.50/£$1,400 31/3£875$1.60/£$1,400

1-418 Example (continued) In case three, the local currency price of the asset is fixed at £1,000 This “contractual” exposure can be completely hedged. StateProbabilityP*SS×P* Case 3 11/3£1,000$1.40/£$1,400 21/3£1,000$1.50/£$1,500 31/3£1,000$1.60/£$1,600

1-419 Operating Exposure: Definition The effect of random changes in exchange rates on the firm’s competitive position, which is not readily measurable. A good definition of operating exposure is the extent to which the firm’s operating cash flows are affected by the exchange rate.

1-420 An Illustration of Operating Exposure Recently, there was an enormous shortage in the shipping market from Asia, due to the Asian currency crisis. This affected not only the shipping companies, which enjoyed “boom times”. But also retailers, who experienced increased costs and delays.

1-421 An Illustration of Operating Exposure Note that the exposure for the retailers has two components: The Competitive Effect  Difficulties and increased costs of shipping. The Conversion Effect  Lower dollar prices of imports due to foreign currency exchange rate depreciation.

1-422 Determinants of Operating Exposure Recall that operating exposure cannot be readily determined from the firm’s accounting statements as can transaction exposure. The firm’s operating exposure is determined by: The firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes. The market structure of inputs and products: how competitive or how monopolistic the markets facing the firm are.

1-423 Managing Operating Exposure Selecting Low Cost Production Sites Flexible Sourcing Policy Diversification of the Market R&D and Product Differentiation Financial Hedging

1-424 Selecting Low Cost Production Sites A firm may wish to diversify the location of their production sites to mitigate the effect of exchange rate movements. e.g. Honda built North American factories in response to a strong yen, but later found itself importing more cars from Japan due to a weak yen.

1-425 Flexible Sourcing Policy Sourcing does not apply only to components, but also to “guest workers”. e.g. Japan Air Lines hired foreign crews to remain competitive in international routes in the face of a strong yen, but later contemplated a reverse strategy in the face of a weak yen and rising domestic unemployment.

1-426 Diversification of the Market Selling in multiple markets to take advantage of economies of scale and diversification of exchange rate risk.

1-427 R&D and Product Differentiation Successful R&D that allows for cost cutting enhanced productivity product differentiation. Successful product differentiation gives the firm less elastic demand—which may translate into less exchange rate risk.

1-428 Financial Hedging The goal is to stabilize the firm’s cash flows in the near term. Financial Hedging is distinct from operational hedging. Financial Hedging involves use of derivative securities such as currency swaps, futures, forwards, currency options, among others.

1-429 End Chapter Twelve

1-430 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objective: This chapter discusses various methods available for the management of transaction exposure facing multinational firms. 13 Chapter Thirteen Management of Transaction Exposure

1-431 Chapter Outline Forward Market Hedge Money Market Hedge Options Market Hedge Cross-Hedging Minor Currency Exposure Hedging Contingent Exposure Hedging Recurrent Exposure with Swap Contracts

1-432 Chapter Outline (continued) Hedging Through Invoice Currency Hedging via Lead and Lag Exposure Netting Should the Firm Hedge? What Risk Management Products do Firms Use?

1-433 Forward Market Hedge If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract. If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract.

1-434 You are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100M is due in one year. Question: How can you fix the cash outflow in dollars? Forward Market Hedge: an Example Answer: One way is to put yourself in a position that delivers £100M in one year—a long forward contract on the pound.

1-435 Forward Market Hedge $1.50/£ Value of £1 in $ in one year Suppose the forward exchange rate is $1.50/£. If he does not hedge the £100m payable, in one year his gain (loss) on the unhedged position is shown in green. $0 $1.20/£ $1.80/£ –$30 m $30 m Unhedged payable The importer will be better off if the pound depreciates: he still buys £100 m but at an exchange rate of only $1.20/£ he saves $30 million relative to $1.50/£ But he will be worse off if the pound appreciates.

1-436 Forward Market Hedge $1.50/£ Value of £1 in $ in one year $1.80/£ If he agrees to buy £100m in one year at $1.50/£ his gain (loss) on the forward are shown in blue. $0 $30 m $1.20/£ –$30 m Long forward If you agree to buy £100 million at a price of $1.50 per pound, you will lose $30 million if the price of a pound is only $1.20. If you agree to buy £100 million at a price of $1.50 per pound, you will make $30 million if the price of a pound reaches $1.80.

1-437 Forward Market Hedge $1.50/£ Value of £1 in $ in one year $1.80/£ The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position. $0 $30 m $1.20/£ –$30 m Long forward Unhedged payable Hedged payable

1-438 Money Market Hedge This is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it. It’s more efficient to buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable.

1-439 Money Market Hedge The importer of British woolens can hedge his £100 million payable with a money market hedge: 1. Borrow $112.05 million in the U.S. 2. Translate $112.05 million into pounds at the spot rate S($/£) = $1.25/£ 3. Invest £89.64 million in the UK at i £ = 11.56% for one year. In one year the investment will have grown to £100 million. Spot exchange rateS($/£)=$1.25/£ 360-day forward rateF 360 ($/£)=$1.20/£ U.S. discount ratei$i$ =7.10% British discount rate i £ =11.56%

1-440 Money Market Hedge Where do the numbers come from? We owe our supplier £100 million in one year—so we know that we need to have an investment with a future value of £100 million. Since i £ = 11.56% we need to invest £89.64 million at the start of the year: How many dollars will it take to acquire £89.64 million at the start of the year if the spot rate S($/£) = $1.25/£? £89.64 = £100 1.1156 £89.64 × $1.25 £1.00 $112.05 =

1-441 Money Market Hedge If we borrow $112.05 today one year later we will owe $120 in one year: $120 = $112.05×(1.071) With this money market hedge, we have redenominated our £100 payable into a $120 payable.

1-442 Money Market Hedge: Step One Suppose you want to hedge a payable in the amount of £y with a maturity of T: i. Borrow $x at t = 0 on a loan at a rate of i $ per year. $x = S($/£)× £y (1+ i £ ) T 0T $x$x$x(1 + i $ ) T Repay the loan in T years

1-443 Money Market Hedge: Step Two at the prevailing spot rate. £y (1+ i £ ) T ii. Exchange the borrowed $x for Invest at i £ for the maturity of the payable. £y (1+ i £ ) T At maturity, you will owe a $x(1 + i $ ) T. Your British investments will have grown to £y. This amount will service your payable and you will have no exposure to the pound.

1-444 Money Market Hedge 1. Calculate the present value of £y at i £ £y (1+ i £ ) T 2. Borrow the U.S. dollar value of receivable at the spot rate. $x = S($/£)× £y (1+ i £ ) T 3. Exchange for £y (1+ i £ ) T 4. Invest at i £ for T years. £y (1+ i £ ) T 5. At maturity your pound sterling investment pays your receivable. 6. Repay your dollar-denominated loan with $x(1 + i $ ) T.

1-445 Options Market Hedge Options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable buy calls on the currency. If the currency appreciates, your call option lets you buy the currency at the exercise price of the call. To hedge a foreign currency receivable buy puts on the currency. If the currency depreciates, your put option lets you sell the currency for the exercise price.

1-446 Options Market Hedge $1.50/£ Value of £1 in $ in one year Suppose the forward exchange rate is $1.50/£. If an importer who owes £100m does not hedge the payable, in one year his gain (loss) on the unhedged position is shown in green. $0 $1.20/£ $1.80/£ –$30 m $30 m Unhedged payable The importer will be better off if the pound depreciates: he still buys £100 m but at an exchange rate of only $1.20/£ he saves $30 million relative to $1.50/£ But he will be worse off if the pound appreciates.

1-447 Options Markets Hedge Profit loss –$5 m $1.55 /£ Long call on £100m Suppose our importer buys a call option on £100m with an exercise price of $1.50 per pound. He pays $.05 per pound for the call. $1.50/£ Value of £1 in $ in one year

1-448 Value of £1 in $ in one year Options Markets Hedge Profit loss –$5 m $1.45 /£ Long call on £100m The payoff of the portfolio of a call and a payable is shown in red. He can still profit from decreases in the exchange rate below $1.45/£ but has a hedge against unfavorable increases in the exchange rate. $1.50/£ Unhedged payable $1.20/£ $25 m

1-449 –$30 m $1.80/£ Value of £1 in $ in one year Options Markets Hedge Profit loss –$5 m $1.45 /£ Long call on £100m If the exchange rate increases to $1.80/£ the importer makes $25 m on the call but loses $30 m on the payable for a maximum loss of $5 million. This can be thought of as an insurance premium. $1.50/£ Unhedged payable $25 m

1-450 Cross-Hedging Minor Currency Exposure The major currencies are the: U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a minor currency, like the Polish zloty. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies.

1-451 Cross-Hedging Minor Currency Exposure Cross-Hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging depends upon how well the assets are correlated. An example would be a U.S. importer with liabilities in Czech koruna hedging with long or short forward contracts on the euro. If the koruna is expensive when the euro is expensive, or even if the koruna is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way.

1-452 Hedging Contingent Exposure If only certain contingencies give rise to exposure, then options can be effective insurance. For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options.

1-453 Hedging Recurrent Exposure with Swaps Recall that swap contracts can be viewed as a portfolio of forward contracts. Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. It is also the case that swaps are available in longer-terms than futures and forwards.

1-454 Hedging through Invoice Currency The firm can shift, share, or diversify: shift exchange rate risk  by invoicing foreign sales in home currency share exchange rate risk  by pro-rating the currency of the invoice between foreign and home currencies diversify exchange rate risk  by using a market basket index

1-455 Hedging via Lead and Lag If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.

1-456 Exposure Netting A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.

1-457 Exposure Netting Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging.

1-458 Exposure Netting: an Example Consider a U.S. MNC with three subsidiaries and the following foreign exchange transactions: $10 $35 $40$30 $20 $25 $60 $40 $10 $30 $20 $30

1-459 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $10 $35 $40$30 $20 $25 $60 $40 $10 $30 $20 $30

1-460 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $10 $35 $40$30 $25 $60 $40 $10 $20 $30

1-461 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $10 $35 $40$30 $25 $60 $40 $10 $20 $30

1-462 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $10 $35 $10 $25 $60 $40 $10 $20 $30

1-463 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $10 $35 $10 $25 $60 $40 $10 $20 $30

1-464 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $10 $35 $10 $25 $60 $40 $10

1-465 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $10 $35 $10 $25 $60 $40 $10

1-466 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $25 $10 $25 $60 $40 $10

1-467 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $25 $10 $25 $60 $40 $10

1-468 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $25 $10 $25 $20 $10

1-471 Exposure Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $25 $10 $15 $20 $10

1-478 Exposure Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $10 $15 $30 $10

1-481 Exposure Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $10 $15 $30

1-482 Exposure Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $10 $15 $30

1-483 Exposure Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $15 $40

1-484 Exposure Netting: an Example Clearly, multilateral netting can simplify things greatly. $15 $40

1-485 Exposure Netting: an Example Compare this: $10 $35 $40$30 $20 $25 $60 $40 $10 $30 $20 $30

1-486 Exposure Netting: an Example With this: $15 $40

1-487 Should the Firm Hedge? Not everyone agrees that a firm should hedge: Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.

1-488 Should the Firm Hedge? In the presence of market imperfections, the firm should hedge. Information Asymmetry  The managers may have better information than the shareholders. Differential Transactions Costs  The firm may be able to hedge at better prices than the shareholders. Default Costs  Hedging may reduce the firms cost of capital if it reduces the probability of default.

1-489 Should the Firm Hedge? Taxes can be a large market imperfection. Corporations that face progressive tax rates may find that they pay less in taxes if they can manage earnings by hedging than if they have “boom and bust” cycles in their earnings stream.

1-490 What Risk Management Products do Firms Use? Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts. The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management.

1-491 End Chapter Thirteen

1-0 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objectives: Understand why it is important to study international finance.

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1-0 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objectives: Understand why it is important to study international finance.

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Presentation on theme: "1-0 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objectives: Understand why it is important to study international finance."— Presentation transcript:

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