Weeks 7-8

Question 1

Comparison of Techniques
to Hedge Payables

Answer 1

Optimal Technique for Hedging Payables
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 comparing the real cost of
hedging versus the cost if not hedged.

Question 2

Hedging Transaction Exposure
FC Payables

Answer 2

• Forward Contract
  – Buy FC Forward
• Futures
  – Take a long position on FC futures
  – Gain / Loss on Futures offsets ∆Spot
• Money Market
  – Borrow Domestic & Invest Internationally
• Call Options
  – Right to Purchase

Question 3

Hedging Transaction Exposure
FC Receivables

Answer 3

• Forward Contract
  – Sell FC Forward
• Futures
  – Take a short position on FC futures
  – Gain / Loss on Futures offsets ∆Spot
• Money Market
  – Borrow Internationally & Invest Domestically
• Put Options
  – Right to Sell

Question 4

Comparison of Techniques
for Hedging Receivables

Answer 4

Optimal Technique for Hedging Receivables:
* Consider whether futures or forwards are preferred.
* Consider desirability of money market hedge versus
futures/forwards based on receipts.
* Assess the feasibility of a currency put option based
on estimated cash inflows.
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

Question 5

Forward Hedge

Answer 5

Allows an MNC to lock in a specific exchange rate at
which it can purchase a currency and hedge payables or
receivables. 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.

Question 6

Forward Contract Variants

Answer 6

* Non-Deliverable Forwards (NDF)
Like a forward contract, represents an agreement
regarding a position in a specified currency, a specified
exchange rate, and a specified future settlement date,
but does not result in delivery of currencies. Instead, a
payment is made by one party in the agreement to the
other party based on the exchange rate at the future date.
[Madura p.700]
* Break Forwards
Forward with an optional exit

Question 7

Synthetic Hedge

Answer 7

The Problem:
– What if a forward contract was unavailable?
– Firms can create their own forward contract
using borrowing and lending in the money
market.
– We may desire a combination of currencies that
is currently unavailable or expensively priced.
* In our coming example we should acknowledge that
in reality both the AUD and the CHF are highly liquid
currencies.

Question 9

Money Market Hedge on Payables

Answer 9

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
To hedge a receivable:
– Borrow funds in the overseas market

Question 10

How to construct a hedge
using futures (1)

Answer 10

1. Am I long or short in the physical market?
2. If long in underlying, short in future.
   If short in underlying, long in future.
   To complete the hedge:
3. Close the futures position
   * a profit/loss is made
4. Transact in the physical market
   * profit/loss offset by loss/profit in the future

Question 11

what is basis risk?

Answer 11

Basis risk refers to the risk that arises when the price of a hedging instrument (such as a futures or forward contract) does not move in perfect correlation with the price of the underlying asset being hedged. This difference between the spot price of the asset and the price of the derivative (futures or forward) is called the “basis,” and any fluctuation in this relationship creates basis risk.

Basis risk arises if:
1. Hedger uncertain as to exact date asset will be bought or
sold.
2. Hedge may require the futures contract to be closed out
well before its expiration date

Question 12

Hedging with Options (Concepts)

Answer 12

• Call option
  – The right to buy at a fixed price
  – Long position
• Put option
  – The right to sell at a fixed price
  – Short position
• Choice of option is dependent upon the type of transaction exposure.
  – Long transaction exposure
   Short hedge
   Buy put options
  – Short transaction exposure
   Long hedge
   Buy call options

Question 13

Hedging with Options (Result)

Answer 13

Assuming delivery:
* Future FC payment
– Short Transaction Exposure
– Buy Call option
* Future FC receipt
– Long Transaction Exposure
– Buy Put options
assuming cash settlement:
- as value FC increases -> cost decrease, value of option increase (gain)
- as value FC decrease -> receipts decrease, value of option increase (gain)

Question 14

why use options

Answer 14

Currency options have not been designed as a substitute for forward markets but as a new, distinct financial vehicle that offers significant opportunities and advantages to those seeking either protection or profit from exchange rates.

• Asymmetric payoff
  – Option holder will only exercise options that are ‘in the
  money’
  – Able to limit risk while still maintaining exposure to
  favourable exchange rate movements

Question 15

what is financial engineering

Answer 15

• The upfront cost of hedging with options can be substantial.
• Companies who do not wish to incur this cost while
  remaining hedged may of course use futures or forward
  contracts.
• However, it is possible that companies may wish to retain
  some of the positive characteristics associated with option
  contracts yet may not wish to incur the full cost of hedging
  in this manner.
• To reduce the cost of hedging, various option strategies can
  be taken which alter the payoff structure of the hedge
  while reducing the upfront cost to the company.

Question 16

zero-premium options

Answer 16

Zero-premium options (also known as zero-cost options or costless collars) are a type of options strategy in which an investor or company sets up two offsetting options (usually a call and a put) in such a way that the premiums of the options cancel each other out. This results in no upfront cost (zero premium) to the investor for establishing the hedge.

–Cylinder Options
–Range Forwards
–Participating Forwards

Question 17

Synthetic Forwards (Options)

Answer 17

Previously we created a synthetic forward using a money market hedge.
– We can also create a synthetic forward using a combination of option
contracts.
This is done by combining call and put options with the same strike price.

• Premium & Chosen Strike Price
  – Note that there will be NO initial cost if the chosen
  strike price (X) is equal to the current market forward
  rate (F).
  – We would expect this to hold as there is no difference
  in payoffs between the synthetic forward using options
  and the actual market forward contract available,
  which has no initial cost.
• Alternatively:
  – We can choose a settlement price different from that of the Forward
  Rate (F).
• Should the strike price vary from the market forward contract, then
  this strategy will have an expected payoff of F-X.
  – Thus, we would expect to pay (or receive) the present value of F-X to
  pursue this strategy. This will occur at t0, as the difference between the
  premium of the call and put options.

Question 18

Path Dependent Options

Answer 18

Options where the payoff is dependent upon the
path of the underlying asset over all or part of
its life.
* Barrier Options
* Average Rate Options
* Average Strike Options

Question 19

Barrier Options

Answer 19

• Example: Knock-out option is like a standard option
  but becomes worthless should the FX rate cross a
  pre-defined barrier.
• Once the FX price moves beyond a ‘barrier’ the option
  expires.
  Thus, the writer of the option only demands compensation for
  the risk that they face up to a certain point, making these
  types cheaper than standard options.
• Alternatives: Down and Out, Up and Out, Down and In, Up and In

Question 20

Average Rate Option (Asian Option)
Average Strike Option

Answer 20

Average Rate Option (Asian Option)
* Where the final spot rate applied is the average of
the spot rate over the life of the option.
Less expensive than standard options.
Useful for hedging a cash flow stream evenly spread
over a period.
Average Strike Option
* Final strike applied is the average spot rate.

Question 21

Compound Options

Answer 21

An option on an option.
* Very little outlay. Premium is to maintain
the right to either pay or receive the second
premium
* Two different maturity dates
* Useful for hedging against potential distant
and highly contingent exposures.

Question 22

Options on Futures

Answer 22

An option on a Futures Contract
* Two different maturity dates
* Call option on Futures
* If exercised, you receive a Long position in a
Futures contract plus cash
* Put option on Futures
* If exercised, you receive a Short position in a
Futures contract plus cash

Question 23

Implicit Options

Answer 23

• Firms may create ‘implicit’ options through
  transactions involving foreign currencies
• Examples of how you create implicit options:
  – Fixing a price list in multiple currencies
• Hedge - Buy a FC put option
  – Bidding on a project with FC revenue and HC costs
• Hedge - Buy a FC put option
  – Takeover bid on a foreign firm
• Hedge - Buy a FC call option
• When your firm has given an implicit option in a foreign currency,
  hedge the risk by buying the same kind of currency option

Question 24

Pure vs. Selective Hedging

Answer 24

• Pure Hedging
  – Removal of risk
  – No regard to expectations
  – Derivatives assumed to be fairly priced
• Selective Hedging
  – A person who hedges only when he or she believes
  that prices are likely to move against him or her
  – Currency expectations are considered

Question 25

Pure Hedging

Answer 25

Forward : Fixed and inviolable
Option : A right but not an obligation
Foreign currency outflow
– Quantity known : Buy FC Forward, Long Futures
– Quantity unknown : Buy FC Call Options, Buy Compound Options
on Calls, Buy Call Options on Futures
– Date unknown : Long Futures, Call Options (Exchange),
Contracts for Difference.
Foreign currency inflow
– quantity known : Sell FC Forward, Short Futures
– quantity unknown : Buy FC Put Options, Buy Compound Options
on Puts, Buy Put Options on Futures
– Date unknown : Short Futures, Put Options (Exchange),
Contracts for Difference.

Question 26

Selective Hedging

Answer 26

• Selective hedging is a form of speculating
• Employing the use of company forecasts in the
  selection of hedging policies
  – Direction
  – Volatility
• Direction
  – View on the direction only, then use Futures,
  Forwards, Spot or Options
• Volatility
  – View on volatility only, then use Options

Question 27

Limitations of Hedging

Answer 27

• Limitation of hedging an uncertain payment
  – over-hedging / under-hedging
• Limitation of hedging an uncertain date
• Long-term hedging
  – availability
  – expectations incorporated in an efficient market
• Repeated short-term hedging
  – rolling the hedge forward
• Unavailable hedge asset
  – cross hedging

Question 28

Global Financing Motivations

Answer 28

Theoretical Arguments
A firm is potentially able to lower its cost of capital through
Global Financing by:
* Improving liquidity for its securities
– increasing the supply of capital, both old and new
* Reduction in agency cost (Stulz, 1996)
* Inclusion in market indices
* Overcoming market segmentation

In addition, a firm can benefit from Global Financing by:
* The ability to use those shares in firm acquisitions
* Marketing
* Local employee profit sharing arrangements

Question 29

Market Segmentation

Answer 29

• Pricing of securities by domestic standards
  A market can be efficient yet still segmented by
  international standards
• Causes: Imperfections (Direct or Indirect Barriers)
  – Government constraints, investor perceptions and
  specific country risks.
• Examples: Regulatory barriers, risk of insider trading and
  political risk.
• Overcoming market segmentation
  Evidence - Mixed

Question 30

External Sources of Equity

Answer 30

• Domestic Equity Offering
  – MNCs can engage in a domestic equity offering in their
  home country in which the funds are denominated in their
  local currency.
• Global Equity Offering
  – Some MNCs pursue a global equity offering in which they
  simultaneously access equity from multiple countries.
• Public or Private Placement of Equity
  – Public issues: Listed on domestic or foreign exchanges
  – Private issues: Offer a private placement of equity to
  financial institutions in their home country or in the foreign
  country where they are expanding.

Question 31

Issuance of Foreign Stock in the U.S.

Answer 31

• 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.
• Effect of Sarbanes-Oxley (2002) 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.

Question 32

International Money Market

Answer 32

Corporations or governments need short-term funds
denominated in a currency different from their home
currency.
Money Market
A money market facilitates the process by which surplus
units can transfer funds to deficit units.
**European Money Market: **Dollar deposits in banks in
Europe and other continents are called Eurodollars or
Eurocurrency. Origins of the European money market can
be traced to the Eurocurrency market that developed
during the 1960s and 1970s.
Asian Money Market: Centred in Hong Kong and Singapore.
Originated as a market involving mostly dollar-
denominated deposits and was originally known as the
Asian dollar market.

Question 33

Eurocurrencies

Answer 33

“Euro”
Outside of the country which issues the currency of
denomination
Eurodollar
“dollar deposits in banks in Europe (and on other
continents)” Madura p.699
Eurocurrency
A time deposit in a bank account located outside the banking
regulations of the country which issues the currency.
Eurobank
Commercial bank that participates as a financial
intermediary in the Eurocurrency market.

Question 34

Eurocurrency Creation

Answer 34

Eurocurrencies are not bought and sold.
Eurocurrencies are created through a series
of transactions beginning in the home
country.
Example:
A firm has a deposit with a U.S. bank.
Ownership of the deposit is transferred to a UK bank.
The UK Bank has a deposit with the U.S. bank, and a
liability to the firm, both is USD.

Question 35

Global Equity Offerings:
Euro-Equity Issues

Answer 35

“Euro”
Outside of the country which issues the currency of
denomination
Euro-Equity
* Where a company issues underwritten equity across
foreign equity markets
– Can be simultaneous with a domestic issue
* A market created by financial institutions
* Began with the privatisation of British Telecom (1984)

Question 36

International Debt Financing

Answer 36

Debt Financing
– Concept: Standardised Floating Interest Rates
– Concept: Intermediation vs. Disintermediation
– Considerations in the Choice of the Type of Debt
International Debt Financing (Sources)
– Eurocurrency Loans
– Euronotes (NIF’s, ECP & EMTN’s)
– International Bonds
* Foreign Bonds
* Eurobonds
– Floating Rate Notes
* Zero Coupon Bonds

Question 37

Standardised Floating
Interest Rates

Answer 37

• Standardised floating interest rates are used
  extensively in pricing Eurodebt facilities.
• Examples
  – SOFR (Secured Overnight Financing Rate)
  – US Prime Rate
  – ESTR (Euro Short Term Rate)
  – SORA (Singapore Overnight Rate Average)
  – BBSW (Bank Bill Swap Rate / Australia)
  – LIBOR : Discontinued (Used by Shapiro)

Question 38

Financial Intermediation
vs. Disintermediation

Answer 38

• Financial Intermediation
  – The process of raising debt finance through
  an intermediary
• Disintermediation
  – The process of raising debt directly from the
  market, by issuing securities to debtholders
  – Reduces the cost to borrowers
  – Increases flexibility

Question 39

Considerations in the Choice
of the Type of Debt

Answer 39

The MNC’s cost of debt affects its required rate of return when it assesses
proposed projects. Features of debt such as currency of denomination, maturity,
and whether the rate is fixed or floating can affect the cost of debt, and therefore
affect the feasibility of projects that are supported with the debt. (Madura)
* Minimise the after-tax cost of debt
* Currency matching
– Matching the cash flows from Assets and Liabilities in similar denominated
currencies
– Managing changing exposures as debts are repaid
* Maturity matching
– Matching the durations of Assets and Liabilities
– Controlling exposure to movements in interest rates
* Fixed versus floating
* Forward hedging
* Parallel loans
* Ability to Swap

Question 40

Currency Matching

Answer 40

• If subsidiaries of MNCs desire to match the currency they
  borrow with the currency they use to invoice products, their
  cost of debt is dependent on the local interest rate of their
  host country.
• A subsidiary in a host country where interest rates are high
  might consider borrowing in a different currency to avoid the
  high cost of local debt.

Question 41

Countries with High Interest Rates

Answer 41

• Subsidiaries based in developing countries may be subject to
  relatively high interest rates.
• The matching strategy would force MNC subsidiaries in
  developing countries to incur a high cost of debt.
• The parent of a U.S.-based MNC may consider providing a
  loan in dollars to finance the subsidiary so the subsidiary can
  avoid the high cost of local debt. However, this will force the
  subsidiary to convert some of its funds to dollars to repay the
  loan.

Question 42

Debt Maturity Decision

Answer 42

A MNC must decide on the
maturity for its debt.
Assessment of Yield Curve
* The shape of the yield
curve can vary among
countries. An upward
sloping yield curve may
indicate that investors
require compensation for
illiquidity associated with
long-term debt.

Financing Costs of Loans with Different Maturities
* Must decide whether to obtain a loan with a maturity that
perfectly fits its needs or one with a shorter maturity if it has
a more favourable interest rate and then source additional
financing when this loan matures.

Question 43

Fixed versus Floating Rate Debt Decision

Answer 43

MNCs that wish to use a long-term maturity but wish to avoid the
prevailing fixed rate may consider floating rate bonds (tied to a
reference rate).
Financing Costs of Fixed versus Floating Rate Loans
* If an MNC considers financing with floating-rate loans it can
first forecast the rate for each year, and that would determine
the expected interest rate it would pay per year, allowing it to
derive forecasted interest payments for all years of the loan.

Question 44

Managing Economic Exposure
(Through Policy)

Answer 44

* Change the firm’s operating policies
– Leads and Lags
* Interfirm vs. Intrafirm
– Reinvoicing Centers
– Netting
* Change the firm’s financing policies.
– Natural Hedging (matching)
– Forward Contracts + Debt
– Diversifying Currencies
– Parallel Loans
– Currency Swaps

Question 45

Using Parallel Loans to Execute the Matching Strategy

Answer 45

• If an MNC is not able to borrow a currency that matches its
  invoice currency, it might consider financing with a parallel (or
  back-to-back) loan so that it can match its invoice currency.
• In a parallel (or back-to-back) loan, two parties provide
  simultaneous loans with an agreement to repay at a specified
  point in the future.
• Particularly attractive if the MNC is conducting a project in a foreign country, will receive the cash flows in the foreign currency, and is worried that the foreign currency will depreciate substantially.

Question 46

Swaps

Answer 46

• Definition:
  – …a swap – whether an interest rate swap or a currency swap –
  can simply be described as the transformation of one stream of
  future cash flows into another stream of future cash flows with
  different features.
• Swaps allow two parties to transform the nature of their
  liabilities/assets
  – interest rate swap: agreement to swap interest payments
  whereby interest payments based on a fixed interest rate are
  exchanged for interest payments based on a floating interest
  rate.
  – currency swap: agreement to exchange one currency for
  another at a specified exchange rate and date. Madura p.704
  (includes principal)
  – a combination of the above
• A financial intermediary is usually involved

Question 47

Interest Rate Swaps: Purpose

Answer 47

• to hedge interest rate risk
• to take a position in interest rate
  markets
• to reduce the cost of debt if
  imperfections exist
• allows construction of longer
  horizon hedges.

Question 48

Hedging Interest Payments
with Interest Rate Swaps

Answer 48

• If MNCs are concerned that interest rates will rise,
  they may complement their floating rate debt with
  interest rate swaps to hedge the risk of rising interest
  rates.
• Financial institutions such as commercial and
  investment banks and insurance companies often act
  as dealers in interest rate swaps.
• In a plain vanilla interest rate swap, one
  participating firm makes fixed rate payments
  periodically in exchange for floating rate payments.
  – The payments are based on a notional value.

Question 49

Financial Intermediaries

Answer 49

There is a cost of time and resources associated
with searching for a suitable swap candidate and
negotiating the swap terms.
Each swap participant also faces the risk that the
counter participant could default on payments.
Financial Intermediaries
➢ ensure legal compliance
➢ act as swap warehouses
➢ reduce information asymmetry of the parties
➢ bear credit risk
➢ share in the potential gains
* we will extend the previous example in which the maximum
possible benefit (100 b.p.) is achieved

Question 50

Currency Swaps / FX Swaps

Answer 50

Currency Swap: agreement to exchange one currency for another at a
specified exchange rate and date. Madura p.698
Bank of International Settlements
* Currency Swap:
– Contract which commits two counterparties to exchange streams
of interest payments in different currencies for an agreed period
of time and to exchange principal amounts in different
currencies at a pre-agreed exchange rate at maturity.
* FX Swap:
– Transaction which involves the actual exchange of currencies
(principal amount only) on a specific date at a rate agreed at
the time of conclusion of the contract and a reverse exchange of
the same two currencies at a date further in the future and at a
(generally different) rate agreed at the time of the contract.

Question 51

Using Currency
Swaps to Execute
the Matching
Strategy

Answer 51

• An MNC faces
  exchange rate risk
  when it is not able to
  exchange in the
  same currency as its
  invoice currency.
• A currency swap
  specifies the
  exchange of
  currencies at
  periodic intervals
  and may allow the
  MNC to have cash
  outflows in the same
  currency in which it
  receives most or all
  of its revenue

Question 52

Why do Swaps Work?

Answer 52

• Comparative advantage
  – Ricardo’s explanation of international trade
  – a convincing argument for swaps?
• Market segmentation
• Mispricing of risk
  – if risk is mispriced, what are the
  consequences?
• Low-cost flexibility

Question 53

The Benefits of Swaps

Answer 53

We have seen how swaps work
– swaps can help corporations vary their
cost and structure of debt
– swaps can hedge interest rate risk
– swaps can hedge foreign exchange risk
SWAPS offer corporations a longer time horizon
for their hedging than do exchange traded
products and many OTC products.

Question 54

Sources of Debt

Answer 54

Domestic Debt Sources
– Loans from Financial Institutions
* An MNC’s parent commonly borrows funds from financial institutions.
* Syndicated loans (Commonly used in Australia)
– Credit
– Overdraft
– Commercial Paper
– Medium-Term Notes
– Bond Market
* MNCs commonly engage in a domestic bond offering in their home
country in which the funds are denominated in their local currency.
International Sources of Debt
– Eurocurrency Loans
– Euronotes
– International Bonds
* MNCs can engage in a global bond offering, in which they
simultaneously sell bonds denominated in the currencies of multiple
countries.

Question 55

International Sources of Debt
-Eurocurrency Loans-

Answer 55

Loans sourced in the Eurocurrency markets.
* Syndicated Loan (chapter 3)
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.
* Lower Interest Rate Spreads
– Wholesale market
– High credit ratings
– Lower costs
– Lower requirements

Question 56

International Sources of Debt
-Euronotes-

Answer 56

• Euronote Market
  – Short to medium term debt sourced in
  Eurocurrency markets
• Major Classes
  – Underwritten
• Short term promissory notes
• Underwritten by an arranger bank
  – Non-Underwritten
• Euro Commercial Paper
• Euro Medium Term Notes

Question 57

International Bond Market

Answer 57

Market Participants
– Countries, MNC’s, large domestic corporations, and international
institutions.
* Foreign bonds
– Bonds sold in the country of denomination with a foreign issuer
– e.g. USD bonds sold and underwritten in the U.S. by an
Australian firm
– Registered:
* Owner’s name is on the bond
– Alternatively, a record of serial numbers is kept
* Updated as bonds are traded
* Eurobonds
– Bonds sold in countries outside of the country of denomination

Question 58

Eurobonds

Answer 58

Types
* Straight fixed issue / floating rate note / convertible bonds
Common features
* Large denomination & long duration
* Bearer form
* Possession is evidence of ownership
* No ownership records are kept
* Call provisions
– The borrower has the option of retiring the bonds prior
to maturity
* Sinking Funds
– A fixed amount of bonds is retired each year after a
period of time
– Supports the market price by reducing bondholder risk
as not all the debt will fall due at once

Question 59

Advantages of Eurobonds

Answer 59

Fixed rate
* Useful for hedging known cash flows
Relatively inexpensive, fast and flexible to issue
* Lack of regulations and disclosure requirements
(self regulated market)
* Tax advantages (bearer form)
Swap driven
* Raise one currency in one market to swap for an
alternative interest rate structure or currency
– Choose a currency where you have high
demand, to achieve a saving by swapping for
the curren