International Finance Midterm

Covered interest arbitrage

Capitalising on the difference in interest rates between two countries while covering your exchange rate risk with forward contracts. Between forward rate, spot rate and interest rate.

What is the definition of Purchasing Power Parity

Change in FX (over period) = Difference in inflation rates (over period)

Motives for FDI

Firm specific-Marketing skills Internalization-Need to control production Country specific-natural resources FDI can improve their profitability and increase stockholder wealth by increasing revenues and reducing costs

What is a capital account?

Foreign Direct Investment (FDI) and portfolio investment (including central bank flows) and other capital investments

Explain what is meant by the phrase "Global reserve Currency" and the benefits and disadvantages of becoming one.

Foreign currency held by central banks and other financial institutions which is used as a means to pay off international debt obligations or to influence their domestic exchange rate Benefits: Confidence from world markets, highly liquid currency Disadvantages: Reduced control of monetary policy, difficulties for domestic exporters

Hedging strategies for Translation Exposure

Purchasing foreign currency Using currency swaps, currency futures or a combo of the two These techniques fix value of foreign subs A/L

Benefits of FDI

Reduces overall risk for firms b/c more stock in different countries creates LESS volatility in portfolio Access to a larger market - increase profits Stronger currency in foreign country-EURO is expected to perform better than the $ Broader credit base

What is translation exposure?

Risk that a company's financial statements will be affected by exchange rate fluctuations Specific to subsidiaries - Earnings from subsidiaries translated into reporting currency on income statement can be impacted by changes in exchange rates

What is Transaction Exposure?

Risk that exchange rates will fluctuate after companies already enter into financial obligations

Indirect intervention

Try to influence the factors that affect interest rates •Inflation •Interest rates (lower rates to prevent inflows, raise rates to prevent outflows (stimulates the economy) •Government controls (currency exchange restrictions or capital controls) •Exchange rate expectations (warn of possible intervention)

Example of Triangular Arbitrage

• Ex: if GBP/USD and EUR/USD is known, GBP/EUR can be calculated; • If the calculated exchange value is different from the quoted value, triangular arbitrage is possible.

Monetary example of Triangular Arbitrage

e.g $/DKK = DKK 5.50 €/$ = $1.30 €/DKK = DKK 7.50 You have USD 1m One sells $1m for € 769,231 ($1m / 1.30), then sells € 769,231 for DKK 5,769,231 (€ 769,231 * 7.50), then sell DKK 5,769,231 for $1,048,951 (DKK 5,769,231 / 5.50), thus earning $48,951, or 4.9%. As it is a triangular relationship, one can start with either $, € , or DKK and achieve the same return.

Futures Hedging

2 options: Purchasing Currency Futures: ■ Buying firm entitled to receive specified amount in specified currency at later date ■ Firm may purchase a currency futures in the currency needed to make future payment Selling Currency Futures: ■ Entitled to sell a specified amount in specified currency at later date ■ To hedge; firm can sell futures contract for currency it will receive

How do you limit transaction exposure?

4 techniques: Futures Hedging ● Used by firms that desire to hedge transaction exposure Forward Hedge ● Used to lock in future exchange rate to buy/sell currency Money Market Hedge ● Taking a money market position to cover a future payables or receivables position Currency Option Hedge ● Used by firm to protect from adverse exchange rate movements, but allow the firm to benefit from favorable exchange rate movements Forward contracts are used to mitigate transaction exposure because it locks in the price at a future date negating fluctuations in exchange rates

Why did the Bretton Woods system eventually break down?

BW failed because the US had large, persistent budget deficits, higher inflation than desired countries, and showed little political desire to change policies

What is a current account?

A balance of trade in goods and services, factor income and transfers

What is a derivative financial contract?

A contract which derives its value from something else Price depends on performance of underlying investments

What is cross hedging?

A cross hedge is the act of hedging ones position by taking an offsetting position in another good with similar price movements ■ EX: Investor who holds a long or short position in an asset takes an opposite position in a separate good, in order to limit exposure related to the initial holding as long as the goods move in the same price direction

What is a non-deliverable forward contract with an example of how they are used?

An NDF represents an agreement regarding a position in a specified amount of a specified currency, exchange rate, and future settlement date

What is meant by the term currency arbitrage?

Arbitrage is risk-free profits from price discrepancies

Example of locational arbitrage

Between two banks. $/DKK spot (DKK per 1$) = Bid/Ask Nordea: 5.50/5.56 Jyske Bank: 5.55/5.57 Nykredit: 5.57/5.58 One buys $1m at Nordea for DKK 5,560,000 (DKK 5,560,000 / 5.56), then immediately sells $1m at Bank Nykredit and receives DKK 5,570,000 ($1m * 5.57), thus earning DKK 10,000, or 0.18%. Alternatively, one sells $1m at Bank Nykredit for DKK 5,570,000 ($1m * 5.57), then immediately sells DKK 5,570,000 at Bank Nordea and receives $1,001,799 (DKK 5,570,000 / 5.56), thus earning $1,799, or 0.18%.

Locational arbitrage

Buy currency where it's cheap, and selling it where price is higher

Triangular Arbitrage

Cross exchange rate: the value of a third currency can be calculated based on the value of two other cross rates • Ex: if GBP/USD and EUR/USD is known, GBP/EUR can be calculated; • If the calculated exchange value is different from the quoted value, triangular arbitrage is possible.

What is the major change introduced to the world's currency market by the Bretton Woods agreement?

Currencies were fixed to the US dollar which in turn was fixed to Gold The IMF was created to help temporarily fix BOP crisis of a member country

Currency option hedging

Currency calls Options: Provides the right to BUY a specific amount in a particular currency at the specified price within a given period of time Currency put options: Provides the right to SELL a specific amount in a particular currency at the specified price within a given period of time EX: An acquisition is contingent on that national governments approval, expected fluctuation in currency may cause the firm to lock in exchange rate, yet doesn't want obligation in the event acquisition isn't approved

Risk Associated with FDI

Currency fluctuations Liquidity Risk Political Risk,

What is the definition of Interest Rate Parity? (IRP)

Difference in interest rate between two countries = Difference between the foreign exchange rate and spot exchange rate Interest rates and exchange rates are in equilibrium Used to prevent covered interest arbitrage Currency forward differs from the spot rate by a sufficient amount to offset interest rate differential between any two countries

The Greek economy continues to suffer under pressure from it's international creditors. Explain the options typically open to national governments to stimulate the economy by influencing exchange rates, and the implications for Greece in this regard due to its membership of the Euro?

Direct intervention: Purchase own currency Indirect intervention: Increase interest rates to prevent outflow, decrease supply of funds (money supply) Implications: Since the Greek currency is pegged to the Euro the indirect options would have no effect on the currencys value, also the ECB makes decisions on interest rates

Describe the basic characteristics of a forward contract, a futures contract, a FOREX option and a FOREX Swap contract. What are the differences between a forward contract and a futures contract?

Forward: A contract between two parties to buy or sell an asset at an agreed upon price at some date in the future. Unlike futures, forward contracts can be specified to any commodity, amount and delivery date. Ex: Buyer: Purchasing goods with a delivery date in the future. Purchases a forward contract to minimise forex fluctuations between date of contract and delivery; Seller: Receiving funds on a delivery date in the future in a foreign currency. Locks in an exchange rate now through a forward contact to give certainty on income stream. Futures: Standardized version of a forward contract that is publicly traded on a futures exchange, and cleared daily; FOREX Options: Contract with an option, but not an obligation, to to sell or buy a currency at a specified point in the future (a "put" or "call" option). FOREX Swaps: A financial contract where a certain element (e.g. currency or interest rate) can be "swapped" at a future date if certain criteria are met (e.g. currency swapped from EUR to CHF, or interest rate swapped from floating to fixed).

What factors make Purchasing Power Parity much less valid in determining currency rates?

Government intervention, portfolio investment flows, lack of substitutes, Non-traded inputs (Rent, wages, overhead)

Hedging strategies for Economic exposure

Hedging with forward contracts-only used for a period of time EX: If the Euro is weak sell it forward for period in which it wants to hedge against adverse effects of the weak Euro. Gains from forward contract will be better the more the Euro weakens because the exchange rate is already locked in. Purchasing foreign supplies-Reduces costs EX:buy materials in Europe if the Euro is weak Financing with foreign funds-Reduce economic exposure by financing a portion of its business with loans in Euros - convert loan proceeds to pounds and use pounds to support its business, euro weakens the loan will need fewer pounds to cover for it Revising operations of other units

What is lagging?

If a US company expects that the dollar will soon APPRECIATE against the euro, it may attempt to delay the payment process until the dollar appreciates

What is leading?

If a US company expects that the dollar will soon DEPRECIATE against the euro, it may attempt to speed up the payment process before the dollar depreciates

Mitigation of FDI

Invest in FOREX futures and options Watch bid/ask spread Diversify political risk-invest in multiple countries

What are the 4 alternative hedging strategies?

Leading Lagging Cross-hedging Currency Diversification

LegoLand Exchange Rate risks

Legoland Florida opened in 2011. Explain the exchange rate risks inherent for the Danish group in this operation. Translation exposure: If Legoland Florida is treated as a subsidiary then the Danish group will experience this type of exposure. Legoland Florida earnings will be in USD but will need to be translated into DKK when it comes time to generate the financial statements (exposed to changes in this exchange rate) Transaction exposure: An agreement with a contractor to build the park in the U.S. would need to be negotiated in USD. Should the DKK fall relative to the USD, it will become more expensive to complete the job Economic exposure: Risk of a recession in the U.S., would make such a leisure activity more of a luxury and decrease the amount of business done; even with a more valuable DKK this would negatively affect the bottom line

You are looking to make a FOREX deal. Explain what is meant by the "Spot rate", and the difference between a "bid" rate and an "ask" rate.

Spot rate-rate determined by the bank Bid rate-Highest price a buyer will purchase at Ask rate-the price an owner is willing to sell at Margin between the two is the profit

What is Economic Exposure?

The risk that a company's future cash flows (foreign investments, and earnings) may be influenced due to fluctuating currency exchange rates Relatively difficult to hedge risk b/c it deals with unexpected FOREX rate changes Degree of economic exposure is directly linked to higher currency volatility EX: A US company with 50% revenues from overseas forecasts the dollar to depreciate over the year, instead the dollar appreciates and the overseas revenue is worth much less when converted back to dollars than expected EX 2: Earthquakes devalue assets in China

Monetary Policy

The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, a Central Bank's monetary policy affects how much households and companies want to borrow.

What are the three different types of forex risk?

Transaction, economic and translation exposure

Example of Covered Interest arbitrage

e.g. (you have USD 1m) Spot $/DKK = DKK 5.50 12 month Forward $/DKK = DKK 5.52 DKK 12 month interest rate = 4% US$ 12 month interest rate = 3% One sells $1m spot for DKK 5,500,000 ($1m * 5.50), then invests DKK 5,500,000 at 4% for 12 months (DKK 5,500,000 * (1 + 4%)), after which time one sells DKK 5,720,000 for $1,036,232 (DKK 5,720,000 / 5.52), thus earning $36,232, or 3.62%. Note that this return of 3.62% is greater than the 3% rate one would earn by investing in $. This indicates that arbitrage is possible and that Interest Rate Parity is absent. One can see this quite quickly by noting that the percentage difference between the Forward and Spot rate at a per annum rate is only 0.36% ((5.52-5.50) / 5.50) while the difference between interest rates is 1%.

What is a FOREX option contract? How are they used?

• Option contracts provide the right but not the obligation to purchase or sell the currency at specified prices; • They are typically used to hedge against foreign currency risks; • Call option: The option to purchase foreign currency at a specified price in the future for a fee. E.g. you expect the euro to appreciate against the pound. You hold pounds. If the rate used in the call contract exceeds the current rate plus the premium/fee for the contract then you make a profit. • Put option: The option to sell a currency at a specific price in the future for a fee. Same as above in reverse;

What factors limit IRP?

• Transactions costs • Political risks • Different tax laws

Direct intervention

•Directly exchange home currency for foreign currency •Dependent on the amount of central bank FX reserve holdings(ex. China) •High FX volume trading makes it harder for central banks to influence FX rates

What is currency diversification?

○ Diversify their business among numerous countries to limit the potential effect of any single currency's movements on the value of an MNC ○ Less exchange rate risk than if the portfolio exposure was in a single foreign currency. ○ Increases global exposure

Money Market Hedging

● Occurs when firm takes position in the money market to cover future payables or receivables.

Forward Hedging

● Used to lock in future exchange rate to buy/sell currency at large transaction values ● Commonly used by large companies for hedging risk linked with underlying transactions Considerations: ■ Forward Hedge vs. No Hedge on Payables: ● Forward contracts easy to use for hedging ● Sometimes used, but gains/losses may even themselves out ● Based on firm's degree of risk aversion ○ Greater degree; more likely to hedge positions ■ Forward Hedge vs. No Hedge on Receivables: ● Develop probability distribution on future spot rate ● Can be considered if if exchange rate movements can be avoided