FIN 480 Keypoints from PPT and Textbook Flashcards
chapter 1 From PPT
Managing the Multinational Corporation(MNC)
The objective of the manager: making the decision to maximize the stock price
MNCs whose parents fully own foreign subsidiaries
母公司完全拥有国外子公司
How Business Disciplines Are Used to Manage the
MNC
Common finance decisions include:
• Whether to discontinue operations in a particular country
• Whether to pursue new business in a particular country
• Whether to expand business in a particular country
• How to finance expansion in a particular country
是否中断某国家业务运营
是否在某国开展新业务
是否在某国扩张业务
如何为某国筹集扩张业务基金
finance decision also be influenced by marketing, management, accounting and information system
Agency Costs: Cost of ensuring that managers maximize shareholder wealth.
Agency Problems: The conflict of goals between managers and shareholders
Costs for several seasons: MNCs > purely domestic firm
Higher cost reason:
• Monitoring managers of distant subsidiaries in foreign countries is more difficult. 长距离管理支部难
• Foreign subsidiary managers raised in different cultures may not follow uniform goals. 不同地区文化经理难以跟随统一的目标
• Sheer size of larger MNCs can create large agency problems. 公司太大，代理问题也就大了
• Some non-U.S. managers tend to downplay the short-term effects of decisions. 非美国经理人倾向于淡化决策的短期影响。问题：为啥不是淡化了长期目标呢？
- Parent control of agency problems
- Parent should clearly communicate the goals for each subsidiary to ensure managers focus on maximizing the value of the subsidiary. 总公司与分公司沟通分公司本身价值最大化问题
• Corporate control of agency problems
• Entire management of the MNC must be focused on
maximizing shareholder wealth. 整个跨国公司必须保持股东的价值最大化基调
- Sarbanes-Oxley Act (SOX)
- Ensures a more transparent process for managers to report on the productivity and financial condition of their firm. 塞班斯法案在透明度上一波助攻
how SOX to improve report:
• How SOX Improved Corporate Governance of MNCs
• Establishing a centralized database of information 建立中央数据库
• Ensuring that all data are reported consistently among subsidiaries 确保数据在分公司间是一致的
• Implementing a system that automatically checks for unusual discrepancies relative to norms
• Speeding the process by which all departments and subsidiaries have access to all the data they need
• Making executives more accountable for financial statements
Management Structure of MNC
• Centralized (See Exhibit 1.1a)
• Allows managers of the parent to control foreign subsidiaries
and therefore reduce the power of subsidiary managers.
• Decentralized (See Exhibit 1.1b)
• Gives more control to subsidiary managers who are closer to
the subsidiary’s operation and environment.
• How the Internet Facilitates Management Control
• Makes it easier for parent to monitor the actions and performance of its foreign subsidiaries.
Why MNCs Pursue International Business
Theory of Comparative Advantage: Specialization
increases production efficiency.
Imperfect Markets Theory: Factors of production are
somewhat immobile, providing incentive to seek out
foreign opportunities.
Product Cycle Theory: As a firm matures, it recognizes
opportunities outside its domestic market. (Exhibit 1.2)
How Firms Engage in International Business
Establishment of New Foreign Subsidiaries
• Firms can penetrate markets by establishing new
operations in foreign countries.
• Requires a large investment.
• Acquiring new as opposed to buying existing allows
operations to be tailored exactly to the firms needs.
• May require smaller investment than buying existing firm.
Summary of Methods
• Any method of increasing international business that
requires a direct investment in foreign operations is
referred to as direct foreign investment (DFI).
• International trade and licensing usually not included.
• Foreign acquisition and establishment of new foreign
subsidiaries represent the largest portion of DFI.
International Trade
• Relatively conservative approach that can be used by
firms to:
• penetrate markets (by exporting).
• obtain supplies at a low cost (by importing).
• Minimal risk — no capital at risk
• How the Internet Facilitates International Trade?
• The internet facilitates international trade by allowing firms to advertise their products and accept orders on their websites
Licensing
• Obligates a firm to provide its technology (copyrights,
patents, trademarks, or trade names) in exchange for
fees or some other specified benefits.
- Allows firms to use their technology in foreign markets without a major investment and without transportation costs that result from exporting. 好处
- Major disadvantage: difficult to ensure quality control in foreign production process 坏处
Franchising
• Obligates firm to provide a specialized sales or service strategy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees. 与licensing不同，这里不包括技术
• Allows penetration into foreign markets without a major investment in foreign countries.
Joint Ventures
• A venture that is jointly owned and operated by two or more firms. A firm may enter the foreign market by engaging in a joint venture with firms that reside in those markets.
• Allows two firms to apply their respective cooperative
advantages in a given project.
Acquisitions of Existing Operations
• Acquisitions of firms in foreign countries allows firms to have full control over their foreign businesses and to
quickly obtain a large portion of foreign market share.
• Subject to the risk of large losses because of larger
investment. 坏处
• Liquidation may be difficult if the foreign subsidiary
performs poorly Establishment of New Foreign Subsidiaries 坏处
Valuation Model for an MNC
Domestic Model
• V represents present value of expected cash flows
• E(CF$,t) represents expected cash flows to be received at the end of period t,
• n represents the number of periods into the future in
which cash flows are received, and
• k represents the required rate of return by investors.
Multinational Modell
• CFj,t represents the amount of cash flow denominated
in a particular foreign currency j at the end of period t,
• Sj,t represents the exchange rate at which the foreign
currency (measured in dollars per unit of the foreign
currency) can be converted to dollars at the end of
period t.
chapter 2 international flow of funds
notes from PPT
Balance of Payments
Summary of transactions between domestic and foreign residents for a specific country over a specified period of time.
Components:
• Current Account: summary of flow of funds due to purchases of goods or services or the provision of
income on financial assets.
• Capital Account: summary of flow of funds resulting from the sale of assets between one specified country and all other countries over a specified period of time.
• Financial Account: refers to special types of
investment, including DFI and portfolio investment.
Current Account:
• Payments for Goods and Services
• Merchandise exports and imports represent tangible products that are transported between countries. Service exports and imports represent tourism and other services. The difference between total exports and imports is referred to as the balance of trade.
• Primary Income Payments
• Represents income (interest and dividend payments) received by investors on foreign investments in financial assets (securities).
• Secondary Income
• Represents aid, grants, and gifts from one country to another
Capital Account
• Originally included the financial account.
• Includes the value of financial assets transferred across country borders by people who move to a different country.
• Includes patents and trademarks.
• Relatively minor (in terms of dollar amounts) to financial account.
Financial Account
• Direct foreign investment
Investments in fixed assets in foreign countries.
• Portfolio investment
Transactions involving long term financial assets (such as stocks and bonds) between countries
• Other capital investment
Transactions involving short-term financial assets (such as money market securities) between countries.
Growth in International Trade:
Events That Increased Trade Volume
• Removal of the Berlin Wall: Led to reductions in trade
barriers in Eastern Europe.
• North American Free Trade Agreement (NAFTA): Allowed U.S. firms to penetrate product and labor markets that previously had not been accessible.
• General Agreement on Tariffs and Trade (GATT): Called for the reduction or elimination of trade restrictions on specified imported goods over a 10-year period across 117 countries.
• Single European Act of 1987: Improved access to
supplies from firms in other European countries.
• The European Union: Free movement of products,
services, and capital among member countries.
• Inception of Euro: Avoid exposure to exchange rate risk.
• Other Trade Agreements: The United States has
established trade agreements with many other countries.
Impact of Outsourcing on Trade:
Outsourcing: The process of subcontracting
to a third party in another country to provide supplies or services that were previously produced internally.
- Impact of outsourcing:
- Increased international trade activity because MNCs now purchase products or services from another country.
- Lower cost of operations and job creation in countries with low wages.
- Criticism of outsourcing:
- Outsourcing may reduce jobs in the United States.
Factors Affecting International Trade Flows:
Cost of Labor: Firms in countries where labor costs are low commonly have an advantage when competing globally, especially in labor intensive industries
Inflation: Higher prices decreases exports and increases imports. Thus Current account (which is essentially ExportsImports) decreases if inflation increases relative to trade partners.
National Income: Higher income increases imports and thus Current account decreases if national income increases relative to other countries.
Credit Conditions: Tend to tighten when economic conditions weaken, causing banks to be less willing to extend financing to MNCs
Impact of Government Policies on Trade
• Restrictions on Imports: Taxes (tariffs) on imported goods increase prices and limit consumption. Quotas limit the volume of imports.
• Subsidies for Exporters: Government subsidies help firms produce at a lower cost than their global competitors.
• Restrictions on Piracy: A government can affect international trade flows by its lack of restrictions on piracy.
• Environmental Restrictions: Environmental restrictions
impose higher costs on local firms, placing them at a global disadvantage compared to firms in other countries that are not subject to the same restrictions.
- Labor Laws: Countries with more restrictive laws will incur higher expenses for labor, other factors being equal.
- Business Laws: Firms in countries with more restrictive bribery laws may not be able to compete globally in some situations.
- Tax Breaks: Though not necessarily a subsidy, still a form of government financial support that might benefit many firms that export products.
- Country Trade Requirements: Requiring various forms or obtaining licenses before countries can export to the country (Bureaucracy) is a strong trade barrier.
• Government Ownership or Subsidies: Some
governments maintain ownership in firms that are major exporters.
- Country Security Laws: Governments may impose certain restrictions when national security is a concern, which can affect on trade.
- Policies to Punish Country Governments: Many expect countries to restrict imports from countries that:
- Fail to enforce environmental laws and child labor laws.
• Initiate war against another country or are unwilling to
participate in a war.
Exchange Rates: Current account decreases if currency
appreciates relative to other currencies.
• How exchange rates may correct a balance of trade deficit:
When a home currency is exchanged for a foreign currency to buy foreign goods, then the home currency faces downward pressure, leading to increased foreign demand for the country’s products.
• Why exchange rates may not correct a balance of trade deficit:
Exchange rates will not automatically correct any international trade balances when other forces are at work.
- Limitations of a Weak Home Currency Solution
- Competition: Foreign companies may lower their prices to remain competitive.
- Impact of other currencies: A country that has balance of trade deficit with many countries is not likely to solve all deficits simultaneously.
- Prearranged international trade transactions: International transactions cannot be adjusted immediately. The lag is estimated to be 18 months or longer, leading to a J-curve effect. (Exhibit 2.6)
- Intracompany trade: Many firms purchase products that are produced by their subsidiaries. These transactions are not necessarily affected by currency fluctuations.
• Exchange Rates and International Friction
• All governments cannot weaken their home currencies simultaneously.
• Actions by one government to weaken its currency
causes another country’s currency to strengthen.
• Government attempts to influence exchange rates can lead to international disputes.
Factors Affecting Direct Foreign Investment
• Changes in Restrictions
• New opportunities have arisen from the removal of
government barriers.
• Privatization
• DFI is stimulated by new business opportunities associated with privatization.
• Managers of privately owned businesses are motivated to ensure profitability, further stimulating DFI.
• Potential Economic Growth
• Countries with greater potential for economic growth are more likely to attract DFI.
• Tax Rates
• Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI.
• Exchange Rates
• Firms typically prefer to pursue DFI in countries where the local currency is expected to strengthen against their own.
Factors Affecting International Portfolio Investment
• Tax Rates on Interest or Dividends
• Investors normally prefer to invest in a country where taxes are relatively low.
• Interest Rates
• Money tends to flow to countries with high interest rates, as long as the local currencies are not expected to weaken.
• Exchange Rates
• Investors are attracted to a currency that is expected to strengthen.
• The United States relies heavily on foreign investment in:
• U.S. manufacturing plants, offices, and other buildings.
• Debt securities issued by U.S. firms.
• U.S. Treasury debt securities.
• Foreign investors are especially attracted to the U.S. financial markets when the interest rate in their home country is substantially lower than that in the United States.
• U.S. reliance on foreign funds: In general, access to
international funding has allowed more growth in the U.S. economy over time but has also made the U.S. more reliant on foreign investors.
Agencies that Facilitate International Flows:
International Monetary Fund
• Major Objectives
• promote cooperation among countries on international monetary issues,
• promote stability in exchange rates,
• provide temporary funds to member countries attempting to correct imbalances of international payments,
• promote free mobility of capital funds across countries,
• promote free trade. It is clear from these objectives that the IMF’s goals encourage increased internationalization of business.
• Its compensatory financing facility (CFF) attempts to reduce the impact of export instability on countries.
• Financing is measured in special drawing rights (SDRs)
World Bank — (International Bank for Reconstruction and Development)
• Major Objective — Make loans to countries to enhance economic development.
• Structural Adjustment Loans (SALs) are intended to
enhance a country’s long-term economic growth.
• Funds are distributed through cofinancing agreements:
• Official aid agencies
• Export credit agencies
• Commercial banks
World Trade Organization (WTO)
• Major Objective — Provide a forum for multilateral trade negotiations and to settle trade disputes related to the GATT accord.
• Member countries are given voting rights that are used to make judgments about trade disputes and other issues.
International Finance Corporation (IFC)
• Major Objective — promote private enterprise within
countries.
• Provides loans to corporations and purchases stock
• It traditionally has obtained financing from the World Bank but can borrow in the international financial markets.
• International Development Association (IDA)
• Major Objective — extend loans at low interest rates to poor nations that cannot qualify for loans from the World Bank.
Bank for International Settlements (BIS)
• Major Objectives — facilitate cooperation among countries with regard to international transactions.
• Provides assistance to countries experiencing a financial crisis.
• Sometimes referred to as the “central banks’ central
bank” or the “lender of last resort.”
OECD — Organization for Economic Cooperation and
Development
• Major Objective — Facilitate governance in governments and corporations of countries with market economics.
• It has 30 member countries and has relationships with
numerous countries.
• Promotes international country relationships that lead to globalization.
Regional Development Agencies
• Inter-American Development Bank: focusing on the
needs of Latin America
• Asian Development Bank: established to enhance social and economic development in Asia
• African Development Bank: focusing on development in African countries
• European Bank for Reconstruction and Development:
created in 1990 to help the Eastern European countries
adjust from communism to capitalism.
Chapter 3 notes from PPT
Foreign Exchange Market
Allows for the exchange of one currency for
another.
Exchange rate specifies the rate at which one
currency can be exchanged for another.
History of Foreign Exchange
• Gold Standard (1876 - 1913)
• Each currency was convertible into gold at a specified
rate. When World War I began in 1914, the gold
standard was suspended.
• Agreements on Fixed Exchange Rates
• Bretton Woods Agreement (1944 – 1971)
• Smithsonian Agreement 1971 – 1973 (US dollar value
was devalued)
• Floating Exchange Rate System (since 1973)
• Widely traded currencies were allowed to fluctuate in
accordance with market forces
Foreign Exchange Transactions
• The over-the-counter market is the telecommunications network where companies normally exchange one currency for another.
• Foreign exchange dealers serve as intermediaries in the foreign exchange market
• Spot Market: A foreign exchange transaction for immediate exchange is said to trade in the spot market. The exchange rate in the spot market is the spot rate.
• Spot Market Structure: Trading between banks occurs in the interbank market.
• Use of the dollar in spot markets: The U.S. Dollar is the
commonly accepted medium of exchange in the spot market. This is especially true in countries where the home currency is weak or subject to restrictions.
• Spot market time zones: Foreign exchange trading is
conducted only during normal business hours in a given
location. Thus, at any given time on a weekday, somewhere around the world a bank is open and ready to accommodate foreign exchange requests.
• Spot market liquidity: More buyers and sellers means more liquidity.
Foreign Exchange Quotations
• At any given point in time, a bank’s bid (buy) quote for a foreign currency will be less than its ask (sell) quote.
• Bid/Ask spread of banks: The bid/ask spread covers the bank’s cost of conducting foreign exchange transactions.
• Comparison of Bid/Ask spread among currencies
(Exhibit 3.1)
Bid/ask spread = (Ask rate - bid rate)/ask rate
• Factors That Affect the Spread
• Order costs: Costs of processing orders, including clearing costs and the costs of recording transactions.
• Inventory costs: Costs of maintaining an inventory of a particular currency.
• Competition: The more intense the competition, the smaller the spread quoted by intermediaries.
• Volume: Currencies that have a large trading volume are more liquid because there are numerous buyers and sellers at any
given time.
• Currency risk: Economic or political conditions that cause the demand for and supply of the currency to change abruptly.
Interpreting Foreign Exchange Quotations
• Direct versus indirect quotations at one point in time
• Direct Quotation represents the value of a foreign currency in dollars (number of dollars per currency).
• Example: $1.40 per Euro
• Indirect quotation represents the number of units of a
foreign currency per dollar.
• Example: €0.7143 per Dollar
• Indirect quotation = 1 / Direct quotation
• Direct versus indirect exchange rate over time
• When the euro is appreciating against the dollar (based on an upward movement of the direct exchange rate of the euro), the indirect exchange rate of the euro is declining.
• When the euro is depreciating (based on a downward
movement of the direct exchange rate) against the dollar, the indirect exchange rate is rising.
• Source of exchange rate quotations
• Updated currency quotations are provided for several
major currencies on Yahoo finance, Wall Street Journal,
etc
• Cross Exchange Rates
• Cross exchange rate is the amount of one foreign
currency per unit of another foreign currency
• Example
Value of peso = $0.11
Value of Canadian dollar = $0.70
Value of peso in C$ = Value of peso in $ /Value of C$ in $ = $0.11/ $0.70 = C$ 0.157
• Source of cross exchange rate quotations: Cross exchange rates are provided for several major currencies on Yahoo’s website (finance.yahoo.com/currency-converter).
- Currency Derivatives: A contract with a price that is partially derived from the value of the underlying currency that it represents.
- Forward Contracts: agreements between a foreign exchange dealer and an MNC that specifies the currencies to be exchanged, the exchange rate, and the date at which the transaction will occur.
- The forward rate is the exchange rate specified by the forward contract.
- The forward market is the over-the-counter market where forward contracts are traded.
• Currency futures contracts: similar to forward
contracts but sold on an exchange.
• Specifies a standard volume of a particular currency to be exchanged on a specific settlement date.
• The futures rate is the exchange rate at which one can
purchase or sell a specified currency on the specified
settlement date.
• The future spot rate is the spot rate that will exist at a
future point in time and is uncertain as of today.
- Currency Options Contracts
- Currency Call Option: provides the right to buy currency at a specified strike price within a specified period of time.
- Currency Put Option: provides the right to sell currency at specified strike price within a specified period of time.
Corporations or governments need short-term funds
denominated in a currency different from their home
currency.
The international money market has grown because
firms:
• May need to borrow funds to pay for imports
denominated in a foreign currency.
• May choose to borrow in a currency in which the
interest rate is lower.
• May choose to borrow in a currency that is expected to
depreciate against their home currency
Origins and Development
• European Money Market: Dollar deposits in banks in
Europe and other continents are called Eurodollars
• Asian Money Market: Centered in Hong Kong and
Singapore. Originated as a market involving mostly dollar denominated deposits, and was originally known as the Asian dollar market.
Money Market Interest Rates Among Currencies
• The money market interest rates in any particular country are dependent on the demand for short-term funds by borrowers, relative to the supply of available short-term funds that are provided by savers. (Exhibit 3.4)
• Money market rates vary due to differences in the
interaction of the total supply of short-term funds available (bank deposits) in a specific country versus the total demand for short-term funds by borrowers in that country.
Comparison of 2015 International Money Market Interest Rates
Market interest rate
Brazil > Australia > Germany > United Kindom > United states > Japan
Inflation also like that:
Brazil > Australia > Germany > United Kindom > United states > Japan
• Global Integration of Money Market Interest Rates
• Money market interest rates among countries tend to be highly correlated over time.
• When economic conditions weaken, the corporate
need for liquidity declines, and corporations reduce the
amount of short-term funds they wish to borrow.
• When economic conditions strengthen, there is an
increase in corporate expansion and corporations need
additional liquidity to support their expansion.
- Risk of International Money Market Securities
- International Money Market Securities are debt securities issued by MNCs and government agencies with a short-term maturity (1 year or less).
- Normally, these securities are perceived to be very safe from the risk of default.
- Even if the international money market securities are not exposed to credit risk, they are exposed to exchange rate risk when the currency denominating the securities differs from the home currency of the investors.
MNCs sometimes obtain medium-term funds through term-loans from local financial institutions or through the
issuance of notes (medium-term debt obligations) in their
local markets.
Loans of 1 year or longer extended by banks to MNCs or
government agencies in Europe are commonly called
Eurocredits or Eurocredit loans.
To avoid interest rate risk, banks commonly use floating
rate loans with rates tied to the London Interbank Offer
Rate (LIBOR).
• Sometimes a single bank is unwilling or unable to lend
the amount needed by an MNC or government agency.
• A syndicate of banks can be formed to underwrite the
loans and the lead bank is responsible for negotiating
the terms with the borrower.
Regulations in the Credit Market
• Single European Act
• Capital can flow freely throughout Europe.
• Banks can offer a wide variety of lending, leasing, and securities activities in the EU.
• Regulations regarding competition, mergers, and taxes are similar throughout the EU.
• A bank established in any one of the EU countries has the right to expand into any or all of the other EU countries.
• Basel Accord — Banks must maintain a high level of
capital as a percent of their assets. For this purpose,
banks’ assets are weighted by risk.
- Basel II Accord — Attempts to account for differences in collateral among banks. In addition, this accord encourages banks to improve their techniques for controlling operational risk, which could reduce failures in the banking system. Also plans to require banks to provide more information to existing and prospective shareholders about their exposure to different types of risk.
- Basel III Accord — Called for new methods of estimating risk-weighted assets that would increase the level of riskweighted assets, and therefore require banks to maintain higher levels of capital.
Impact of the Credit Crisis on the Credit Market
• The credit crisis of 2008 triggered by defaults in
subprime loans led to a halt in housing development,
which reduced income, spending, and jobs.
• Financial institutions became cautious with their funds
and were less willing to lend funds to MNCs.
International Bond Market Foreign bonds are issued by borrower foreign to the country where the bond is placed. Eurobonds • Features of Eurobonds • Bearer bonds • Annual coupon payments • Convertible or callable • Denominations of Eurobonds • Commonly denominated in a number of currencies • Secondary Market • Market makers are in many cases the same underwriters who sell the primary issues
Development of Other Bond Markets
• Bond markets have developed in Asia and South America.
• Bond market yields among countries tend to be highly
correlated over time.
• When economic conditions weaken, aggregate demand for funds declines with the decline in corporate expansion.
• When economic conditions strengthen, aggregate
demand for funds increases with the increase in corporate expansion.
• Interest Rate Risk — potential for the value of bonds to
decline in response to rising long-term interest rates.
• Exchange Rate Risk — represents the potential for the
value of bonds to decline (from the investor’s perspective) because the currency denominating the bond depreciates against the home currency.
• Liquidity Risk — represents the potential for the value of bonds to decline because there is not a consistently active market for the bonds.
• Credit Risk — represents the potential for default.
Impact of the Greek Crisis on Bonds
• Spring 2010: Greece experienced weak economic conditions and a large increase in the government budget deficit.
• Concern spread to other European countries such as Spain, Portugal, and Ireland that had large budget deficits.
• May 2010: Many European countries and the IMF agreed to provide Greece with new loans.
• Contagion Effects:
• Weakened some other European countries.
• Forced creditors to recognize that government debt is not always risk-free.
International Stock Markets
Issuance of Stock in Foreign Markets — Some U.S. firms
issue stock in foreign markets to enhance their global image.
• Impact of the Euro: resulted in more stock offerings in
Europe by U.S. and European based MNCs.
Issuance of Foreign Stock in the U.S.
• Yankee stock offerings — Non-U.S. corporations that
need large amounts of funds sometimes issue stock in
the United States
• American Depository Receipts (ADR) — Certificates
representing bundles of stock. ADR shares can be
traded just like shares of a stock.
Non-U.S. Firms Listing on U.S. Exchanges
• Non-U.S. firms have their shares listed on the New York
Stock Exchange or the Nasdaq market so that the shares
can easily be traded in the secondary market.
• Effect of Sarbanes-Oxley Act on Foreign Stock Listings — Many non-U.S. firms decided to place new issues of their stock in the United Kingdom instead of in the United States so that they would not have to comply with the law.
Investing in Foreign Stock Markets
• Many investors purchase stocks outside of the home
country.
• Recently, firms outside the U.S. have been issuing stock more frequently.
• Comparing the size of stock markets (Exhibit 3.5)
How Market Characteristics Vary among Countries
• Stock market participation and trading activity are higher in
countries where managers are encouraged to make
decisions that serve shareholder interests, and where
there is greater transparency.
• Factors that influence trading activity:
• Rights vary by country
• Legal protection of shareholders
• Government enforcement of securities laws
• Accounting laws
Impact of Governance on Stock Market Participation and Trading Activity
shareholder voting power, and strong shareholder Right———>managerial decision intended to Serve Shareholders ——-> Greater Investor participation and Trading Activity
strong securities law —> Greater invest Participation and Trading Activity
low level of corporate corruption and high level of financial disclosure ——> Greater Transparency of Corporate Financial Conditions
Corporate functions that require foreign exchange markets.
• Foreign trade with business clients.
• Direct foreign investment, or the acquisition of foreign real assets.
• Short-term investment or financing in foreign securities.
• Longer-term financing in the international bond or stock markets.
Foreign Cash Flow Chart of a Multinational Corporation
page 38
chapter 4
notes from PPT
Measuring Exchange Rate Movements
Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
Comparing foreign currency spot rates over two points in time, S and St-1
percent change in foreign currency value = (S - St-1)/St-1
A positive percent change indicates that the currency has appreciated. A negative percent change indicates that it has depreciated
Exchange Rate Equilibrium
The exchange rate represents the price of a currency, or the rate at which one currency can be exchanged for another.
Demand for a currency increases when the value of the currency decreases, leading to a downward sloping demand schedule. (See Exhibit 4.2)
Supply of a currency for sale increases when the value of the currency increases, leading to an upward sloping supply schedule. (See Exhibit 4.3)
Equilibrium equates the quantity of pounds demanded with the supply of pounds for sale. (See Exhibit 4.4)
change in the equilibrium exchange rate
Increase in demand schedule: Banks will increase the exchange to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.
Decrease in demand schedule: Banks will reduce the
exchange to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.
Increase in supply schedule: Banks will reduce the exchange to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.
Decrease in supply schedule: Banks will increase the
exchange to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.
what is the difference between Decrease in demand schedule and Increase in supply schedule
Factors That Influence Exchange Rates
The equilibrium exchange rate will change over time as
supply and demand schedules change
e = f(change of INF, change of INT, change of INC, change of GC, change of EXP)
e = percentage change in the spot rate
change of INF = change in the differential between U.S. inflation and the foreign country’s inflation
change of INT = change in the differential between U.S. interest rate and foreign country’s interest rate
change of INC = change in the differential between the U.S. income level and the foreign country’s income level and foreign country’s income level
change of GC = change in government controls
change of EXP = change in expectations of future exchange rates
Relative Inflation Rates:
Increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency.
In addition, the jump in US inflation should reduce the British desire for US goods and thereby reduce the supply of pounds for sale at any given exchange rate.
Both of these effects put an upward pressure on the value of pound as shown in Exhibit 4.5.
Relative Interest Rates: Increase in U.S. interest
rates leads to increase in demand for U.S. deposits
and a decrease in demand for foreign deposits,
leading to an increase in demand for dollars and an
increased exchange rate for the dollar.
Because US interest rates now look more attractive to British investors, the supply of pounds increase as they
establish more bank deposits in US因为美国储存利率更加诱人，所以UK将用更多的英镑去建立美国储存头寸
Real Interest Rates
Fisher Effect: real interest rate ~=norminal interest rate - inflation rate
Relative Income Levels: Increase in U.S. income
leads to an increase in U.S. demand for foreign
goods, an increased demand for foreign currency
relative to the dollar, and an increase in the exchange
rate for the foreign currency.
Government Controls via:
Imposing foreign exchange barriers
Imposing foreign trade barriers
Intervening in foreign exchange markets
Affecting macro variables such as inflation, interest
rates, and income levels
Expectations:
Impact of favorable expectations: If investors expect interest rates in one country to rise, they may invest in that country, leading to a rise in the demand for foreign currency and an increase in the exchange rate for foreign currency.
Impact of unfavorable expectations: Speculators can place downward pressure on a currency when they expect it to depreciate.
Impact of signals on currency speculation: Speculators may overreact to signals, causing currency to be temporarily overvalued or undervalued.
Interaction of Factors: Some factors place upward pressure while other factors place downward pressure.
Influence of Factors across Multiple Currency Markets:
common for European currencies to move in the same
direction against the dollar.
Influence of Liquidity on Exchange Rate adjustment: If a currency’s spot market is liquid then its exchange rate will not be highly sensitive to a single large purchase or sale.
Summary of How Factors Affect Exchange Rates
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Movements in Cross Exchange Rates
If currencies A and B move in same direction, there is no change in the cross exchange rate.
When currency A appreciates against the dollar by a greater (smaller) degree than currency B, then currency A appreciates (depreciates) against B.
When currency A appreciates (depreciates) against the dollar, while currency B is unchanged against the dollar, currency A appreciates (depreciates) against currency B by the same degree as it appreciates (depreciates) against the dollar.
Explaining Movements in Cross Exchange Rate.
Changes are affected in the same way as types of forces explained earlier for those that affect demand and supply conditions between two currencies
Institutional speculation based on expected appreciation:
When financial institutions believe that a currency is valued lower than it should be in the foreign exchange market, they may invest in that currency before it appreciates.
Institutional speculation based on expected depreciation:
If financial institutions believe that a currency is valued
higher than it should be in the foreign exchange market, they may borrow funds in that currency and convert it to their local currency now before the currency’s value declines to its proper level.
Speculation by individuals: Individuals can speculate in
foreign currencies.
Capitalizing on Expected Exchange Rate Movements
One of the most common strategies used by investors to speculate in the foreign exchange market is the “Carry Trade”. Specifically, the strategy involves borrowing a currency with a low interest rate and investing the funds in a currency with a high interest rate. Thus with carry trade, investors attempt to
capitalize on the differential in interest rates between two countries.
Impact of appreciation in the investment currency:
Increased trade volume can have a major influence on
exchange rate movements over a short period.
Risk of the Carry Trade: Exchange rates may move
opposite to what the investors expected.
chapter 5
notes from PPT
A currency derivative is a contract whose price is
derived from the value of an underlying currency.
Examples include forwards/futures contracts and
options contracts.
Derivatives are used by MNCs to:
• Speculate on future exchange rate movements
• Hedge exposure to exchange rate risk
A forward contract is an agreement between a
corporation and a financial institution:
• To exchange a specified amount of currency
• At a specified exchange rate called the forward rate
• On a specified date in the future
How MNCs Use Forward Contracts
• Hedge their imports by locking in the rate at which they
can obtain the currency.
Bank Quotations on Forward Rates
• Bid/Ask Spread is wider for less liquid currencies.
• May negotiate an offsetting trade if an MNC enters into
a forward sale and a forward purchase with the same
bank.
• Non-deliverable forward contracts (NDF) can be used
for emerging market currencies where no currency
delivery takes place at settlement; instead, one party
makes a payment to the other party.
Premium or Discount on the Forward Rate
(Exhibit 5.1)
F = S(1 + p)
where:
F is the forward rate
S is the spot rate
p is the forward premium, or the percentage by
which the forward rate exceeds the spot rate.
• Arbitrage — If the forward rate was the same as the
spot rate, arbitrage would be possible, as shown on the next slide
Forward rates typically differ from the spot rate for any given
currency because of the differential in interest rates between the
foreign country and the United States. If a currency’s spot and
forward rates were the same and if the foreign currency’s
interest rate was higher than the U.S. rate, then U.S.
speculators could achieve a higher return on the foreign savings
deposit than a U.S. savings deposit by following these steps: (1)
purchase the foreign currency at the spot rate, (2) invest the
funds at the attractive foreign interest rate, and (3)
simultaneously sell forward contracts in that foreign currency for
a future date when the savings deposit matures. These actions
would place upward pressure on the spot rate of the foreign
currency and downward pressure on the forward rate, causing
the forward rate to fall below the spot rate (exhibit a discount).
Movements in the Forward Rate over Time — The forward
premium is influenced by the interest rate differential between the two
countries and can change over time.
Offsetting a Forward Contract — An MNC can offset a forward
contract by negotiating with the original counterparty bank.
Using Forward Contracts for Swap Transactions — Involves a
spot transaction along with a corresponding forward contract that will
ultimately reverse the spot transaction.
Non-deliverable forward contracts (NDF) — Can be used for
emerging market currencies where no currency delivery takes place at
settlement; instead, one party makes a payment to the other party
Currency Futures Market
Similar to forward contracts in terms of obligation to
purchase or sell currency on a specific settlement date in
the future.
Contract Specifications: Differ from forward contracts
because futures have standard contract specifications:
• Standardized number of units per contract (See Exhibit 5.2)
• Offer greater liquidity than forward contracts
• Typically based on U.S. dollar, but may be offered on cross-rates
• Commonly traded on the Chicago Mercantile Exchange (CME)
Trading Currency Futures
• Firms or individuals can execute orders for currency
futures contracts by calling brokerage firms.
• Trading platforms for currency futures: Electronic
trading platforms facilitate the trading of currency futures.
These platforms serve as a broker, as they execute the
trades desired.
• Currency futures contracts are similar to forward contracts
in that they allow a customer to lock in the exchange rate
at which a specific currency is purchased or sold for a
specific date in the future.
Comparing Futures to Forward Contracts
• Currency futures contracts are similar to forward contracts in
that they allow a customer to lock in the exchange rate at
which a specific currency is purchased or sold for a specific
date in the future. (Exhibit 5.3)
• Pricing Currency Futures — The price of currency futures
will be similar to the forward rate
Credit Risk of Currency Futures Contracts — To minimize its
risk, the CME imposes margin requirements to cover
fluctuations in the value of a contract, meaning that the
participants must make a deposit with their respective
brokerage firms when they take a position.
How Firms Use Currency Futures
• Purchasing Futures to Hedge Payables — The
purchase of futures contracts locks in the price at which a
firm can purchase a currency.
• Selling Futures to Hedge Receivables — The sale of
futures contracts locks in the price at which a firm can sell
a currency.
• Closing Out a Futures Position
• Sellers (buyers) of currency futures can close out their positions
by buying (selling) identical futures contracts prior to settlement.
• Most currency futures contracts are closed out before the
settlement date.
Speculation with Currency Futures
• Currency futures contracts are sometimes purchased
by speculators attempting to capitalize on their
expectation of a currency’s future movement.
• Currency futures are often sold by speculators who
expect that the spot rate of a currency will be less than
the rate at which they would be obligated to sell it.
Speculation with Currency Futures (cont.)
• Efficiency of the currency futures market
• If the currency futures market is efficient, the futures
price should reflect all available information.
• Thus, the continual use of a particular strategy to take
positions in currency futures contracts should not lead to
abnormal profits.
• Research has found that the currency futures market may
be inefficient. However, the patterns are not necessarily
observable until after they occur, which means that it may
be difficult to consistently generate abnormal profits from
speculating in currency futures.
Currency options provide the right to purchase or sell
currencies at specified prices.
Options Exchanges
• 1982 — Exchanges in Amsterdam, Montreal, and
Philadelphia first allowed trading in standardized foreign
currency options.
• 2007 — CME and CBOT merged to form CME group.
• Exchanges are regulated by the SEC in the U.S.
Over-the-counter market — Where currency options are
offered by commercial banks and brokerage firms. Unlike
the currency options traded on an exchange, the over-thecounter market offers currency options that are tailored to
the specific needs of the firm.
Currency Call Options
• Grants the right to buy a specific currency at a
designated strike price or exercise price within a
specific period of time.
• If the spot rate rises above the strike price, the owner of
a call option can exercise the right to buy currency at
the strike price.
• The buyer of the option pays a premium.
• If the spot exchange rate is greater than the strike price,
the call option is in the money. If the spot rate is equal
to the strike price, the call option is at the money. If the
spot rate is lower than the strike price, the call option is
out of the money.
The premium on a call option is affected by three factors:
• Spot price relative to the strike price: The higher
the spot rate relative to the strike price, the higher the
call option price will be.
• Length of time before expiration: The longer the
time to expiration, the higher the option price will be.
• Potential variability of currency: The greater the
variability of the currency, the higher the probability
that the spot rate can rise above the strike price and
thus higher the price of the call option will be
How Firms Use Currency Call Options
• Using call options to hedge payables
• Using call options to hedge project bidding to lock in
the dollar cost of potential expenses
• Using call options to hedge target bidding of a
possible acquisition
Speculating with Currency Call Options
• Individuals may speculate in the currency options based
on their expectations of the future movements in a
particular currency.
• Speculators who expect that a foreign currency will
appreciate can purchase call options on that security.
• The net profit to a speculator is based on a comparison
of the selling price of the currency versus the exercise
price paid for the currency and the premium paid for the
call option.
Speculating with Currency Call Options (cont.)
• Break-even point from speculation
• Break even if the revenue from selling the currency equals
the payments made for the currency plus the option
premium.
• Speculation by MNCs.
• Some institutions may have a division that uses currency
options to speculate on future exchange rate movements.
• Most MNCs use currency derivatives for hedging and not
speculation.
• Grants the right to sell a currency at a specified strike price
or exercise price within a specified period of time.
• If the spot rate falls below the strike price, the owner of a put
option can exercise the right to sell currency at the strike
price.
• The buyer of the options pays a premium.
• If the spot exchange rate is lower than the strike price, the
put option is in the money. If the spot rate is equal to the
strike price, the put option is at the money. If the spot rate is
greater than the strike price, the put option is out of the
money.
Put option premiums are affected by three factors:
• Spot rate relative to the strike price: The lower
the spot rate relative to the strike price, the higher
the probability that the put option will be exercised.
• Length of time until expiration: The longer the
time to expiration, the greater the put option
premium.
• Variability of the currency: The greater the
variability, the greater the probability that the option
may be exercised and thus greater the option price
Hedging with Currency Put Options
• Corporations with open positions in foreign currencies can
use currency put options in some cases to cover these
positions.
• Some put options are deep out of the money, meaning that
the prevailing exchange rate is high above the exercise price.
These options are cheaper (have a lower premium), as they
are unlikely to be exercised because their exercise price is too
low.
• Other put options have an exercise price that is currently
above the prevailing exchange rate and are therefore more
likely to be exercised. Consequently, these options are more
expensive.
Speculating with Currency Put Options
• Individuals may speculate with currency put options based
on their expectations of the future movements in a particular
currency.
• Speculators can attempt to profit from selling currency put
options. The seller of such options is obligated to purchase
the specified currency at the strike price from the owner who
exercises the put option.
• The net profit to a speculator is based on the exercise price
at which the currency can be sold versus the purchase price
of the currency and the premium paid for the put option.
Speculating with Currency Put Options (cont.)
• Speculating with combined put and call options
• Straddle — Uses both a put option and a call option at
the same exercise price.
• Good when speculators expect strong movement in one
direction or the other.
• Efficiency of the currency options market
• Research has found that, when transaction costs are
controlled for, the currency options market is efficient.
• It is difficult to predict which strategy will generate
abnormal profits in future periods.
Contingency graph for the buyer of a call option
• Compares price paid for the option to the payoffs received under
various exchange rate scenarios. (Exhibit 5.6)
Contingency graph for the seller of a call option
• Compares premium received from selling the option to the payoffs
made to the options buyer under various exchange rate scenarios.
(Exhibit 5.6)
Contingency graph for the buyer of a put option
• Compares premium paid for put option to the payoffs received
under various exchange rate scenarios. (Exhibit 5.7)
Contingency graph for the seller of a put option
• Compares premium received for put option to the payoffs made
under various exchange rate scenarios.
European Currency Options
• European-style currency options must be exercised
on the expiration date if they are to be exercised at all.
• They do not offer as much flexibility; however, this is not
relevant to some situations.
• If European-style options are available for the same
expiration date as American-style options and can be
purchased for a slightly lower premium, some
corporations may prefer them for hedging.
Chapter 6
notes from PPT
Exchange Rate Systems
Exchange rate systems can be classified according to the degree of government control and fall into the following categories: • Fixed • Freely floating • Managed float • Pegged
Fixed Exchange Rate System
• Exchange rates are either held constant or allowed to
fluctuate only within very narrow boundaries.
• Central bank can reset a fixed exchange rate by
devaluing or reducing the value of the currency
against other currencies.
• Central bank can also revalue or increase the value of
its currency against other currencies
Fixed Exchange Rate System (cont.)
• Bretton Woods Agreement 1944 – 1971 — Each
currency was valued in terms of gold.
• Smithsonian Agreement 1971 – 1973 — called for a
devaluation of the U.S. dollar by about 8% against other
currencies.
• Advantages of fixed exchange rates
• Insulate country from risk of currency appreciation.
• Allow firms to engage in direct foreign investment without
currency risk.
• Disadvantages of fixed exchange rates
• Risk that government will alter value of currency.
• Country and MNC may be more vulnerable to economic
conditions in other countries
Freely Floating Exchange Rate System
• Exchange rates are determined by market forces without
government intervention.
• Advantages of a freely floating system:
• Country is more insulated from inflation of other countries.
• Country is more insulated from unemployment of other
countries.
• Does not require central bank to maintain exchange rates
within specified boundaries.
• Disadvantages of a freely floating exchange rate system:
• Can adversely affect a country that has high unemployment.
• Can adversely affect a country with high inflation
Managed Float Exchange Rate System
• Governments sometimes intervene to prevent their
currencies from moving too far in a certain direction.
• Countries with floating exchange rates: Currencies
of most large developed countries are allowed to float,
although they may be periodically managed by their
respective central banks. (Exhibit 6.1)
• Criticisms of the managed float system: Critics
suggest that managed float allows a government to
manipulate exchange rates to benefit its own country
at the expense of others.
Pegged Exchange Rate System
• Home currency value is pegged to one foreign currency
or to an index of currencies.
• Limitations of pegged exchange rate
• May attract foreign investment because exchange rate is
expected to remain stable.
• Weak economic or political conditions can cause firms
and investors to question whether the peg will be broken.
• Currency Boards Used to Peg Currency Values
• A system for pegging the value of the local currency to some
other specified currency. The board must maintain currency
reserves for all the currency that it has printed.
• Interest Rates of Pegged Currencies
• Interest rate will move in tandem with the interest rate of the
currency to which it is tied.
• Exchange Rate Risk of a Pegged Currency
• Exhibit 6.2 provides examples of countries that have pegged
the exchange rate of their currency to a specific currency.
Currencies are commonly pegged to the U.S. dollar or to the
euro.
Dollarization
• Replacement of a foreign currency with U.S. dollars.
• This process is a step beyond a currency board
because it forces the local currency to be replaced by
the U.S. dollar. Although dollarization and a currency
board both attempt to peg the local currency’s value,
the currency board does not replace the local currency
with dollars.
• Example: Ecuador started using U.S. dollar as its
currency in 2000 since its local currency (the sucre)
depreciated by 97% against U.S. dollar from 1990 to
2000.
Monetary Policy in the Eurozone
• European Central Bank — Based in Frankfurt and is responsible
for setting monetary policy for all participating European countries
• Objective is to control inflation in the participating countries and to
stabilize (within reasonable boundaries) the value of the euro with
respect to other major currencies.
Impact on Firms in the Eurozone — Prices of products are now
more comparable among European countries.
Impact on Financial Flows in the Eurozone — Bond investors who
reside in the eurozone can now invest in bonds issued by
governments and corporations in these countries without concern
about exchange rate risk, as long as the bonds are denominated in
euros.
Exposure of Countries within the Eurozone
• A single European monetary policy prevents any individual
European country from solving local economic problems
with its own unique monetary policy.
• Any given monetary policy used in the eurozone during a
particular period may enhance conditions in some
countries and adversely affect others.
Impact of Crises within the Eurozone — may affect the
economic conditions of the other participating countries
because they all rely on the same currency and same
monetary policy.
Impact of Crises within the Eurozone (cont.)
• Lessons from Eurozone crisis
• Financial problems of one bank can easily spread to other
banks.
• Banks in Eurozone frequently engage in loan
participations. If companies have trouble repaying, all
banks may be affected.
• News about concerns in one area of Eurozone can trigger
actions in other areas.
• Eurozone country governments must rely on fiscal policy
when they experience serious financial problems.
• Banks lend heavily to governments. Performance is related
to whether that government can repay its debts.
• ECB Role in Resolving Economic Crises
• In recent years the bank’s role has expanded to include
providing credit for eurozone countries that are
experiencing a financial crisis.
• The ECB imposes restrictions intended to help resolve
the country’s budget deficit problems over time.
Impact on a Country that Abandons the Euro
• Would allow a country to set its own exchange rate to encourage
purchasers of exports.
• Would possibly be expelled from the European Union, which would
almost certainly reduce its trade with other European Union
countries.
Impact of Abandoning the Euro on Eurozone Conditions
• Investors may fear other countries abandoning the euro and
reduce investments in the eurozone.
• Critics agree that the threat of abandonment creates more
problems than actual abandonment.
Reasons for Government Intervention
• Smoothing exchange rate movements
• If a central bank is concerned that its economy will be
affected by abrupt movements in its home currency’s value, it
may attempt to smooth the currency movements over time.
• Establishing implicit exchange rate boundaries
• Some central banks attempt to maintain their home currency
rates within some unofficial, or implicit, boundaries.
• Responding to temporary disturbances
• A central bank may intervene to insulate a currency’s value
from a temporary disturbance.
Direct Intervention (Exhibit 6.3) • To force the dollar to depreciate, the Fed can intervene directly by exchanging dollars that it holds as reserves for other foreign currencies in the foreign exchange market. • By “flooding the market with dollars” in this manner, the Fed puts downward pressure on the dollar. • If the Fed desires to strengthen the dollar, it can exchange foreign currencies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar.
• Reliance on reserves
• The potential effectiveness of a central bank’s direct
intervention is the amount of reserves it can use.
• Frequency of Intervention
• Number of direct interventions by Fed has declined from 97
different days in 1989 to no more than 20 days in a year
• Coordinated Intervention
• Intervention more likely to be effective when it is coordinated
by several central banks.
• Nonsterilized versus sterilized intervention (See Exhibit 6.4)
• When the Fed intervenes in the foreign exchange market
without adjusting for the change in the money supply, it is
engaging in a nonsterilized intervention.
• In a sterilized intervention, the Fed intervenes in the foreign
exchange market and simultaneously engages in offsetting
transactions in the Treasury securities markets.
• Speculating on direct intervention
• Some traders in the foreign exchange market attempt to
determine when Federal Reserve intervention is occurring
and the extent of the intervention in order to capitalize on the
anticipated results of the intervention effort.
Indirect Intervention
percentage change in the spot rate=
change in the differenti al between U.S.inflation and the foreign country’sinflation
change in the differenti al between the U.S.interest rate
and the foreign country’sinterest rate
change in the differenti al between the U.S.income level and the foreign country’sincome level
change in government controls
change in expectations of future exchange rates
• Government Control of Interest Rates by increasing or
reducing interest rates.
• Government Use of Foreign Exchange Controls such as
restrictions on the exchange of the currency.
• Intervention Warnings intended to warn speculators. The
announcements could discourage additional speculation and
might even encourage some speculators to unwind (liquidate)
their existing positions in the currency.
A weak home currency can stimulate foreign demand for
products. (See Exhibit 6.5)
A strong home currency can encourage consumers and
corporations of that country to buy goods from other
countries. (See Exhibit 6.6)
Chapter 7
notes from PPT
International Arbitrage Defined as capitalizing on a discrepancy in quoted prices by making a riskless profit. Arbitrage will cause prices to realign. Three forms of arbitrage: • Locational arbitrage • Triangular arbitrage • Covered interest arbitrage
Locational Arbitrage
• Defined as the process of buying a currency at the location where it is priced cheap and immediately selling it at another
location where it is priced higher. (See Exhibit 7.1)
• Gains from locational arbitrage are based on the amount
of money used and the size of the discrepancy. (See Exhibit 7.2)
• Realignment due to locational arbitrage drives prices to adjust in different locations so as to eliminate discrepancies
Triangular Arbitrage
• Defined as currency transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies. (See Exhibits 7.3, 7.4, & 7.5)
• Gains from triangular arbitrage: Currency transactions are conducted in the spot market to capitalize on the
discrepancy in the cross exchange rate between two
countries.
• Accounting for the Bid/Ask Spread: Transaction costs
(bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage.
• Realignment due to triangular arbitrage forces exchange rates back into equilibrium.
Covered Interest Arbitrage
• Steps involved in covered interest arbitrage
• Defined as the process of capitalizing on the
interest rate differential between two countries while
covering your exchange rate risk with a forward
contract.
• Consists of two parts:
• Interest arbitrage: the process of capitalizing on
the difference between interest rates between
two countries.
• Covered: hedging the position against exchange
rate risk.
You desire to capitalize on relatively high rates of interest in the United Kingdom and have funds available for 90 days. The interest rate is certain; only the future exchange rate at which you will exchange
pounds back to U.S. dollars is uncertain. You can use a forward sale of pounds to guarantee the rate at which you can exchange pounds for dollars at some future time.
You have $800,000 to invest.
• The current spot rate of the pound is $1.60.
• The 90-day forward rate of the pound is $1.60.
• The 90-day interest rate in the United States is 2 percent.
• The 90-day interest rate in the United Kingdom is 4 percent
Based on this information, you should proceed as follows:
1. On day 1, convert the $800,000 to £500,000 and deposit the £500,000 in a British bank.
2. On day 1, sell £520,000 90 days forward. By the time the deposit matures, you will have £520,000 (including interest).
3. In 90 days when the deposit matures, you can fulfill your forward contract obligation by converting your £520,000 into $832,000 (based on the forward contract rate of $1.60 per pound). In this example, the strategy results in a 4 percent return over the
three-month period, which is 2 percent above the return on a U.S. deposit. In addition, the return on this strategy is known on day 1, as
you know when you make the deposit exactly how many dollars you will get back from your 90-day investment
• As with the other forms of arbitrage, market forces
resulting from covered interest arbitrage will eventually
lead to market realignment. As many investors capitalize on covered interest arbitrage by executing step 2 in the example (selling British pounds forward), there is downward pressure on the 90-day forward rate.
• Once the forward rate has a discount from the spot rate that is about equal to the interest rate advantage, covered interest arbitrage will no longer be feasible. Because the interest rate advantage of the British interest rate over the U.S. interest rate is 2 percent in this example, the arbitrage will no longer be feasible once the forward rate of the pound exhibits a discount of about 2 percent.
Assume that, as a result of covered interest arbitrage, the 90-day forward rate of the pound declined to $1.5692 (which reflects a discount of about 2 percent from the pound’s spot rate of $1.60). Consider the
results from using $800,000 (as in the previous example) to engage in covered interest arbitrage after the forward rate has adjusted.
1. Convert $800,000 to pounds: $800,000 / $1.60 = £500,000
2. Calculate accumulated pounds over 90 days at 4 percent: £500,000 x 1.04 = £ 520,000
3. Reconvert pounds to dollars (at the forward rate of $1.5692) after 90 days: £520,000 x $1.5692 = $815,984
4. Determine the yield earned from covered interest arbitrage: ($815,984 - $800,000) / ($800,000) = 0.02 or 2%
As this example shows, the forward rate has declined to a level (by about 2 percent) that offsets the 2 percent interest rate advantage, such that future attempts to engage in covered interest arbitrage are no longer feasible.
• Realignment due to covered interest arbitrage causes
market realignment.
• Timing of realignment may require several transactions before realignment is completed.
• Realignment is focused on the forward rate
• the forward rate is likely to experience most if not all of the adjustment needed to achieve realignment.
• Covered interest arbitrage by Non-U.S. investors
• The concept of covered interest arbitrage applies to any two countries for which there is a spot rate and a forward rate between their currencies as well as risk-free interest rates quoted for both currencies
Comparison of Arbitrage Effects
• The threat of locational arbitrage ensures that quoted
exchange rates are similar across banks in different
locations.
• The threat of triangular arbitrage ensures that cross
exchange rates are properly set.
• The threat of covered interest arbitrage ensures that forward exchange rates are properly set. Any discrepancy will trigger arbitrage, which should eliminate the discrepancy.
• Thus, arbitrage tends to allow for a more orderly foreign exchange market.
• How arbitrage reduces transaction costs
• Locational arbitrage limits the differences in a spot
exchange rate quotation across locations, while covered interest arbitrage ensures that the forward rate is properly priced. Thus, an MNC’s managers should be able to avoid excessive transaction costs.
Interest Rate Parity
• When market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage is no longer feasible, the result is an equilibrium state know as interest rate parity.
• Thus in equilibrium, the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies.
Derivation of Interest Rate Parity p = (1 + ih)/(1+ij) - 1 p = forward premium ih = home interest rate if = foreign interest rate
Determining the Forward Premium
• Effect of the interest rate differential: The relationship
between the forward premium (or discount) and the interest rate differential according to IRP is simplified in an approximated form:
p = (F-S) /S 约等于 ih - if
p = forward premium(or discount)
F = forward rate in dollars
S = spot rate in dollars
ih = home interest rate
if = foreign interest rate
• Implications: If the forward premium is equal to the interest rate differential as just described, then covered interest arbitrage will not be feasible.
Graphic Analysis of Interest Rate Parity
• Points representing a discount: points A and B
• Points representing a premium: points C and D
• Points representing IRP: points A, B, C, D
• Points below the IRP line: points X and Y
• Investors can engage in covered interest arbitrage and earn a higher return by investing in foreign currency after considering foreign interest rate and forward premium or discount.
• Points above the IRP line: point Z
• U.S. investors would achieve a lower return on a foreign investment than on a domestic one.
How to Test Whether Interest Rate Parity Holds
• The location of the points provides an indication of
whether covered interest arbitrage is worthwhile.
• For points to the right of the IRP line, investors in the
home country should consider using covered interest
arbitrage, since a return higher than the home interest
rate (ih) is achievable.
• Of course, as investors and firms take advantage of such opportunities, the point will tend to move toward the IRP line.
• Covered interest arbitrage should continue until the
interest rate parity relationship holds.
Interpretation of Interest Rate Parity
• Interest rate parity does not imply that investors from
different countries will earn the same returns.
Does Interest Rate Parity Hold?
• Compare the forward rate (or discount) with interest rate quotations occurring at the same time. Due to limitations in access to data, it is difficult to obtain quotations that reflect the same point in time.
Considerations When Assessing Interest Rate Parity
• Transaction costs
• The actual point reflecting the interest rate differential and forward rate premium must be farther from the IRP line to make covered interest arbitrage worthwhile. (See Exhibit 7.10)
• Political risk
• A crisis in the foreign country could cause its government to restrict any exchange of the local currency for other currencies.
• Differential tax laws
• Covered interest arbitrage might be feasible when
considering before-tax returns but not necessarily when considering after-tax returns.
Variation in Forward Premiums
Forward Premiums across Maturities
• The annualized interest rate differential between two countries can vary among debt maturities, and so will the annualized forward premiums.(See Exhibit 7.11)
Changes in Forward Premiums over Time
• Exhibit 7.12 illustrates the relationship between interest rate differentials and the forward premium over time, when interest rate parity holds. The forward premium must adjust to existing interest
rate conditions if interest rate parity holds.
• Explaining changes in the forward rate
• The forward rate is indirectly affected by all the factors that can
affect the spot rate (S) over time, including inflation differentials,
interest rate differentials, etc. The change in the forward rate
can also be due to a change in the premium.
Chapter 8
Interpretations of Purchasing Power Parity
• Absolute Form of PPP: Without international barriers,
consumers shift their demand to wherever prices are
lower. Prices of the same basket of products in two
different countries should be equal when measured
in common currency.
• Relative Form of PPP: Due to market imperfections,
prices of the same basket of products in different
countries will not necessarily be the same, but the rate
of change in prices should be similar when measured in common currency
• Exchange rate adjustment is necessary for the relative purchasing power to be the same whether buying products locally or from another country.
• If the purchasing power is not equal, consumers will
shift purchases to wherever products are cheaper until
the purchasing power is equal.
Derivation of Purchasing Power Parity
Relationship between relative inflation rates (I) and the
exchange rate (e).
ef = (1+Ih)/(1+Ih) - 1
Using PPP to Estimate Exchange Rate Effects
• The relative form of PPP can be used to estimate how an exchange rate will change in response to differential inflation rates between countries.
• International trade is the mechanism by which the inflation differential affects the exchange rate according to this theory (Exhibit 8.1)
• Using a simplified PPP relationship:
ef may equal to Ih - If
• The percentage change in the exchange rate should be approximately equal to the difference in inflation rates between the two countries.
Exhibit 8.1 Summary of Purchasing Power Parity page 7
Graphic Analysis of Purchasing Power Parity
• Using PPP theory, we should be able to assess the
potential impact of inflation on exchange rates. The
points on Exhibit 8.2 suggest that given an inflation
differential between the home and the foreign country
of X percent, the foreign currency should adjust by X
percent due to that inflation differential.
• PPP Line — The diagonal line connecting all these
points together.
- Purchasing Power Disparity
- Any points off of the PPP line represent purchasing power disparity. If the exchange rate does not move as PPP theory suggests, there is a disparity in the purchasing power of the two countries.
- Point C in Exhibit 8.2 represents a situation where home inflation (Ih) exceeds foreign inflation (If ) by 4%. Yet, the foreign currency appreciated by only 1% in response to this inflation differential. Consequently, purchasing power disparity exists.
Testing the Purchasing Power Parity Theory
• Simple test of PPP
• Choose two countries (such as the United States and a foreign country) and compare the differential in their inflation rates to the percentage change in the foreign currency’s value during several time periods. This simple test of PPP is applied to four different currencies from a U.S. perspective in Exhibit
8.3.
• Statistical Test of PPP
• Apply regression analysis to historical exchange rates and inflation differentials.
• Results of Statistical Tests of PPP
• Deviations from PPP are not as pronounced for longer time periods, but they still exist. Thus, reliance on PPP to derive a forecast of the exchange rate is subject to significant error, even when applied to long-term forecasts
Testing the Purchasing Power Parity Theory
• Limitation of PPP Tests
• Results vary with the base period used. The base period chosen should reflect an equilibrium position since subsequent periods are evaluated in comparison to it. If a base period is used when the foreign currency was relatively weak for reasons other than high inflation, most subsequent periods could show higher appreciation of that currency than what would be predicted by PPP.
Why Purchasing Power Parity Does Not Hold
• Confounding effects
• A change in a country’s spot rate is driven by more than the inflation differential between two countries:
Since the exchange rate movement is not driven solely by ΔINF, the relationship between the inflation differential and exchange rate movement run as same as the PPP theory suggest
• No Substitutes for Traded Goods
• If substitute goods are not available domestically,
consumers may not stop buying imported goods.
International Fisher Effect (IFE)
Fisher effect
• Suggests that the nominal interest rate contain two
components:
• Expected inflation rate
• Real interest rate
• The real rate of interest represents the return on the
investment to savers after accounting for expected
inflation.
Using the IFE to Predict Exchange Rate Movements
• Apply the Fisher Effect to Derive Expected Inflation per Country
• The first step is to derive the expected inflation rates of the two countries based on the Fisher effect. The Fisher effect suggests that nominal interest rates of two countries differ because of the difference in expected inflation between the two countries.
• Rely on PPP to Estimate the Exchange Rate Movement
• The second step of the international Fisher effect is to apply the theory of PPP to determine how the exchange rate would change in response to those expected inflation rates of the two countries.
Implications of the International Fisher Effect
• The international Fisher effect (IFE) theory suggests that currencies with high interest rates will have high expected inflation (due to the Fisher effect) and the relatively high inflation
will cause the currencies to depreciate (due to the PPP effect).
• Implications of the IFE for Foreign Investors
• The implications are similar for foreign investors who attempt to
capitalize on relatively high U.S. interest rates. The foreign
investors will be adversely affected by the effects of a relatively
high U.S. inflation rate if they try to capitalize on the high U.S. interest rates.
• Implications of the IFE for Two Non-U.S. Currencies
• The IFE theory can be applied to any exchange rate, even exchange rates that involve two non-U.S. currencies.
International Fisher Effect (IFE)
Derivation of the International Fisher Effect
• Relationship between the interest rate (i) differential
between two countries and expected exchange rate (e)
ef = (1+ih)/(1+if) - 1
• Numerical example based on derivation of the IFE
Assume that the interest rate on a one-year insured home country bank deposit is 11%, and the interest rate on a 1-year insured foreign bank deposit is 12%. For the actual returns of these two investments
to be similar from the perspective of investors in the home country, the foreign currency would have to change over the investment horizon by
the following percentage:
page 22
Derivation of the International Fisher Effect (cont.)
• Simplified relationship
ef may equal to ih - if
• Point E in Exhibit 8.6 reflects a situation where the foreign interest rate exceeds the home interest rate by three percentage points. The foreign currency has depreciated by 3% to offset its interest rate advantage.
• Point F represents a home interest rate 2% above the
foreign interest rate. IFE theory suggests that the currency should appreciate by 2% to offset the interest rate disadvantage.
• Point F illustrates the IFE from a foreign investor’s
perspective. The home interest rate will appear attractive to the foreign investor. However, IFE theory suggests that the foreign currency will appreciate by 2%.
• Points on the IFE Line
• All the points along the IFE line reflect exchange rate
adjustments to offset the differential in interest rates. This means investors will end up achieving the same yield (adjusted for exchange rate fluctuations) whether they invest at home or in a foreign country.
• Points below the IFE Line
• Points below the IFE line generally reflect the higher returns from investing in foreign deposits.
• Points above the IFE Line
• Points above the IFE line generally reflect returns from foreign deposits that are lower than the returns possible domestically
What Can be Tested (Exhibit 8.6)
• If the actual points (one for each period) of interest rates and exchange rate changes were plotted over time on a graph, we could determine whether:
• the points are systematically below the IFE line (suggesting higher returns from foreign investing),
• above the line (suggesting lower returns from foreign
investing), or
• evenly scattered on both sides (suggesting a balance of higher returns from foreign investing in some periods and lower foreign returns in other periods).
• Statistical Test of the IFE
• Apply regression analysis to historical exchange rates and the nominal interest rate differential.
- The IFE theory relies on the Fisher effect and PPP
- Limitation of the Fisher Effect
- The difference between the nominal interest rate and actual inflation rate is not consistent. Thus, while the Fisher effect can effectively use nominal interest rates to estimate the market’s expected inflation over a particular period, the market may be wrong.
- Limitation of PPP
- Other country characteristics besides inflation (income levels, government controls) can affect exchange rate movements. Even if the expected inflation derived from the Fisher effect properly reflects the actual inflation rate over the period, relying solely on inflation to forecast the future exchange rate is subject to error.
IFE Theory versus Reality
• The IFE theory contradicts how a country with a high
interest rate can attract more capital flows and therefore cause the local currency’s value to strengthen (Ch. 4).
• IFE theory also contradicts how central banks may
purposely try to raise interest rates in order to attract
funds and strengthen the value of their local currencies
(Ch. 6).
• Whether the IFE holds in reality is dependent on the
countries involved and the period assessed.
• The IFE theory may be especially meaningful to situations in which the MNCs and large investors consider investing in countries where the prevailing interest rates are very high.
Although all three theories relate to the determination of exchange rates, they have different implications. (Exhibit 8.7)
• IRP focuses on why the forward rate differs from the spot rate and on the degree of difference that should exist. It relates to a specific point in time.
• PPP and IFE focus on how a currency’s spot rate will change over time.
• Whereas PPP suggests that the spot rate will change in accordance with inflation differentials, IFE suggests that it will change in accordance with interest rate differentials.
• PPP is related to IFE because expected inflation differentials influence the nominal interest rate differentials between two countries.
Notes from chapter 10
Relevance of Exchange Rate Risk
• Exchange rates are extremely volatile.
• Arguments have been made to suggest that under some
assumptions, the exchange rate exposure of MNCs
should not matter.
• For each argument as to why exchange rate risk might
be irrelevant for MNCs, there is an argument for why
exchange rate risk is relevant for MNCs
The Investor Hedge Argument: Exchange rate risk is
irrelevant because investors can hedge exchange rate risk on their own.
Currency Diversification Argument: If U.S.-based MNC
is well diversified across numerous currencies, its value will not be affected by exchange rate risk
Stakeholder Diversification Argument: If stakeholders
are well diversified, they will be somewhat insulated
against losses due to MNC exchange rate risk.
Response from MNCs
• Many MNCs attempt to stabilize their earnings with hedging strategies because they believe exchange rate risk is relevant.
Because we manufacture and sell products in a number of countries throughout the world, we are exposed to the impact on revenues and expenses of movements in currency exchange rates.
—Proctor & Gamble Co.
Increased volatility in foreign exchange rates … may have an adverse impact on our business results and financial condition.
—PepsiCo
- Forms of Exchange Rate Exposure
- Transaction exposure
- Economic exposure
- Translation exposure
Definition: Sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements.
Assessing transaction exposure:
Estimating net cash flows in each currency (See
Exhibits 10.2 & 10.3)
Exposure of an MNC’s portfolio
Measure potential impact of the currency exposure
与计算投资组合的标准差的方法是一样的
Exhibit 10.3 Consolidated Net Cash Flow Assessment of Miami Co. page 10
• Thus Miami Company will be favorably affected by appreciation of British pound, Canadian dollar and Mexican peso against the dollar over the next quarter.
• Conversely, it will be adversely affected by appreciation of the Swedish krona against the dollar over the next quarter.
Transaction Exposure
• Measurement of currency volatility
• The standard deviation statistic measures the degree of movement for each currency. In any given period, some currencies clearly fluctuate much more than others.
• Currency volatility over time
• The volatility of a currency may not remain consistent from one time period to another. An MNC can identify currencies whose values are most likely to be stable or highly volatile in the future.
• Measurement of currency correlations
• The correlations coefficients indicate the degree to which two currencies move in relation to each other.
• Applying currency correlations to net cash flows
• If an MNC has positive net cash flows in various
currencies that are highly correlated, it may be
exposed to exchange rate risk. However, many MNCs
have some negative net cash flow positions in some
currencies to complement their positive net cash flows
in other currencies.
• Currency correlations over time
• Because currency correlations change over time, an MNC cannot use previous correlations to predict
future correlations with perfect accuracy.
Transaction Exposure Based on Value at Risk (VaR)
• Measures the potential maximum 1-day loss on the
value of positions of an MNC that is exposed to
exchange rate movements.
• Factors that affect the maximum 1-day loss:
• Expected percentage change in the currency rate for the next day
• Confidence level used
• Standard deviation of the daily percentage changes in the currency
Maximum 1-day loss = E(et) - (1.65 x std[MXP])
• Applying VaR to Longer Time Horizons
• The standard deviation should be estimated over the time horizon in which the maximum loss is to be measured.
• Applying VaR to Transaction Exposure of a Portfolio
• Since MNCs are commonly exposed to more than one
currency, they may apply the VaR method to a currency
portfolio. When considering multiple currencies, software packages can be used to perform the computations.
- Estimating VaR with an Electronic Spreadsheet
- Obtain the series of exchange rates for all relevant dates for each currency of concern and list each currency in its own column.
- Compute the percentage changes per period (from one date to the next) for each exchange rate in a column.
- Estimate the standard deviation of the column of percentage changes for each exchange rate.
- In a separate column, compute the periodic percentage change in the portfolio value by applying weights to the individual currency returns.
- Use a compute statement to determine the standard deviation of the column of percentage changes in the portfolio value.
• Limitations of VaR
• If the distribution of exchange rate movements is not normal, the estimate of the maximum expected loss is subject to error.
• The VaR method assumes that the volatility (standard
deviation) of exchange rate movements is stable over time. If exchange rate movements are less volatile in the past than in the future, the estimated maximum expected loss derived from the VaR method will be underestimated.
Economic Exposure
Definition: The sensitivity of the firm’s cash flows to
exchange rate movements, sometimes referred to as
operating exposure. (Exhibit 10.5)
Exposure to local currency appreciation
• Appreciation in the firm’s local currency causes a reduction in both cash inflows and outflows. The impact on a firm’s net cash flows will depend on whether the inflow transactions are affected more or less than the outflow transactions.
Exposure to local currency depreciation
• Depreciation of the firm’s local currency causes an increase in both cash inflows and outflows.
Economic Exposure of Domestic Firms
• Even purely domestic firms are affected by economic exposure.
Measuring Economic Exposure
• Using sensitivity analysis (See Exhibits 10.6 & 10.7)
• Consider how sales and expense categories are
affected by various exchange rate scenarios.
• Use of regression analysis
PCFt = a0 + a1*et + ut
where,
PCFt = percentage change in inflation-adjusted cash flow measured in home currency
et = percentage change in direct exchange rate
ut = random error term
a0 = interpret
a1 = slope coefficient
a significant and positive a1 indicates that an increase in the currency’s value has a favourable effect on the firm’s cash flows
Translation Exposure
Definition: The exposure of the MNC’s consolidated
financial statements to exchange rate fluctuations.
Determinants of translation exposure:
• Proportion of business by foreign subsidiaries: The
greater the percentage of an MNC’s business conducted by its foreign subsidiaries, the larger the percentage of a given financial statement item that is susceptible to translation exposure.
• Locations of foreign subsidiaries: Location can also
influence the degree of translation exposure because the financial statement items of each subsidiary are typically measured by the respective subsidiary’s home currency.
• Accounting Methods: MNC translation exposure is
affected by accounting procedures, many of which are
based on Financial Accounting Standards Board
• The functional currency of an entity is the currency of the economic environment in which the entity operates.
• The current exchange rate of the reporting date is used to translate the assets and liabilities of a foreign entity from its functional currency into the reporting currency.
• Accounting Methods (cont.)
• The weighted average exchange rate over the relevant period is used to translate revenue, expenses, and gains and losses of a foreign entity from its functional currency into the reporting
currency.
• Translated income gains or losses due to changes in foreign currency values are not recognized in current net income but are reported as a second component of stockholder’s equity; an exception to this rule is a foreign entity located in a country with high inflation.
• Realized income gains or losses due to foreign currency transactions are recorded in current net income, although there are some exceptions.
Exposure of an MNC’s Stock Price to Translation Effects
• Because an MNC’s translation exposure affects its
consolidated earnings, it can affect the MNC’s valuation. (Exhibit 10.8)
• Signals that complement translation effects: Exchange
rate conditions that cause a translation effect can also signal changes in expected cash flows in future years. Such changes could also influence the stock price.
• Exposure of managerial compensation to translation
effects: Since an MNC’s stock may be subject to translation effects and since managerial compensation is often tied to the MNC’s stock price, it follows that managerial compensation is affected by translation effects.
chapter 11
Managing Transaction Exposure
Policies for Hedging Transaction Exposure
Hedging Most of the Exposure
• Hedging most of the transaction exposure allows MNCs to more accurately forecast future cash flows (in their home currency) so that they can make better decisions regarding the amount of financing they will need.
Selective Hedging
• MNC must identify its degree of transaction exposure.
• MNC must consider the various techniques to hedge the exposure so that it can decide which hedging technique is optimal and whether to hedge its transaction exposure.
Hedging Exposure to Payables An MNC may decide to hedge part or all of its known payables transactions using: • Forward or futures hedge • Money market hedge • Currency option hedge
Forward or Futures Hedge on Payables
• Allows an MNC to lock in a specific exchange rate at
which it can purchase a currency and hedge payables. A forward contract is negotiated between the firm and a financial institution. The contract will specify the:
• currency that the firm will pay.
• currency that the firm will receive.
• amount of currency to be received by the firm.
• rate at which the MNC will exchange currencies (called the forward rate).
• future date at which the exchange of currencies will occur.
Money Market Hedge on Payables
• Involves taking a money market position to cover a
future payables position.
• If a firm prefers to hedge payables without using its cash
balances, then it must
• Borrow funds in the home currency and
• Invest in the foreign currency.
• Money market hedge versus forward hedge
• Since the results of both hedges are known beforehand, the firm can implement the one that is more feasible.
Call Option Hedge on Payables
• A currency call option provides the right to buy a
specified amount of a particular currency at a specified
strike price or exercise price within a given period of
time.
• The currency call option does not obligate its owner to buy the currency at that price. The MNC has the
flexibility to let the option expire and obtain the currency at the existing spot rate when payables are due.
- Cost of call options based on contingency graph (Exhibit 11.1)
- Advantage: provides an effective hedge
- Disadvantage: premium must be paid
- Cost of call options based on currency forecasts (Exhibit 11.2)
- MNC can incorporate forecasts of the spot rate to more accurately estimate the cost of hedging with call options.
- Consideration of Alternative Call Options
- Several different types of call options may be available, with different exercise prices and premiums for a given currency and expiration date.
- Whatever call option is perceived to be most desirable for hedging a particular payables position would be analyzed, so that it could then be compared to the other hedging techniques.
Comparison of Techniques to Hedge Payables
• The cost of the forward hedge or money market hedge can be determined with certainty.
• The currency call option hedge has different outcomes depending on the future spot rate at the time payables are due.
Comparison of Techniques to Hedge Payables
• Optimal Technique for Hedging Payables (Exhibit 11.4)
• Select optimal hedging technique by:
• Considering whether futures or forwards are preferred.
• Considering desirability of money market hedge versus futures/forwards based on cost.
• Assessing the feasibility of a currency call option based on estimated cash outflows.
• Choose optimal hedge versus no hedge for payables.
• Even when an MNC knows what its future payables will be, it may decide not to hedge in some cases.
Evaluate the hedge decision by estimating the real cost of hedging versus the cost if not hedged.
Forward or futures hedge on receivables allows the
MNC to lock in the exchange rate at which it can sell a
specific currency.
Money market hedge on receivables involves
borrowing the currency that will be received and using
the receivables to pay off the loan.
Put option hedge on receivables provides the right to
sell a specified amount of a particular currency at a
specified strike price by a specified expiration date.
• Cost of Put Options Based on Contingency Graph (Exhibit 11.5)
• Advantage: provides an effective hedge
• Disadvantage: premium must be paid
• Cost of Put Options Based on Currency Forecasts (Exhibit 11.6)
• MNC can use currency forecasts to more accurately estimate the dollar cash inflows to be received when hedging with put options.
• Consideration of Alternative Put Options
• Several different types of put options may be available that feature different exercise prices and premiums for a given currency and expiration date.
Comparison of Techniques for Hedging Receivables
• Optimal Technique for Hedging Receivables: (Exhibit 11.8)
• Consider whether futures or forwards are preferred.
• Consider desirability of money market hedge versus
futures/forwards based on cost.
• Assess the feasibility of a currency put option based on estimated cash outflows.
• Optimal hedge versus no hedge on receivables
• An MNC may know what its future receivables will be yet still decide not to hedge. In that case, the MNC needs to determine the probability distribution of its revenue from receivables when not hedging
Evaluating the hedge decision by estimating the
real cost of hedging receivables versus the cost of
receivables if not hedged.
Limitations of Hedging
Limitation of Hedging an Uncertain Payment
• Some international transactions involve an uncertain
amount of foreign currency, leading to overhedging.
Limitation of Repeated Short-Term Hedging
• The continual short-term hedging of repeated
transactions may have limited effectiveness. (Exhibits
11.10 and 11.11)
• Long-term Hedging as a Solution
• Some banks offer forward contracts for up to 5 years or
10 years on some commonly traded currencies.
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Exhibit 11.10 Repeated Hedging of Foreign Payabl
Alternative Hedging Techniques
Leading and Lagging: Adjusting the timing of a
payment or disbursement to reflect expectations about
future currency movements.
Cross-Hedging: Hedging by using a currency that
serves as a proxy for the currency in which the MNC
is exposed.
Currency Diversification: Reducing exposure by
diversifying business among numerous countries.
