Weeks 7-8 Flashcards

Question

Pure vs. Selective Hedging

Answer 1

* 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

Answer 2

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.

Answer 3

* 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

Answer 4

* 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

Answer 5

**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

Answer 6

* 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

Answer 7

* 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.

Answer 8

* 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.

Answer 9

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.

Answer 10

**“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.

Answer 11

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.

Answer 12

“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)

Answer 13

**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

Answer 14

* 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)

Answer 15

* 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

Answer 16

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

Answer 17

* 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.

Answer 18

* 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.

Answer 19

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.

Answer 20

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.

Answer 21

*** 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

Answer 22

* 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.

Answer 23

* 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

Answer 24

* 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.

Answer 25

* 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.

Answer 26

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

Answer 27

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.

Answer 28

* 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

Answer 29

* 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

Answer 30

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.

Answer 31

**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.

Answer 32

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

Answer 33

* 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

Answer 34

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

Answer 35

**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

Answer 36

**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