Multinational Financial Management Test 2

________ is defined as the spread of a crisis in one country to its neighboring countries and other countries with similar characteristics. a. Contagion b. Political science c. Speculation d. Capital market liquidity

A

________, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. a. Filibusters b. Technical analysts c. Trappist monks d. Mappists

B

Corporate Cost of Debt

• The cost of debt consists of the risk‐free interest rate plus the credit risk premium: ▫ k Debt$ = k US$ + RPM $Rating • The credit risk premium is typically based on the borrower's credit rating. • The cost of debt changes with maturity. • The U.S. Treasury yield curve establishes the base rates at which all corporate credits are priced

Credit Risk

▫ a.k.a. Roll‐over Risk ▫ The possibility that the lender reclassifies a borrower's creditworthiness at the time of renewing a credit

elasticity of demand formula

% change in quantity demanded / % change in price

Cross-Rate Consistency in Forecasting

- International financial managers must often forecast their home currency exchange rates for the set of countries in which the firm operates - Checking cross-rate consistency—the reasonableness of the cross rates implicit in individual forecasts—acts as a reality check.

Options for Managing interest rate risk:

- Refinancing - Forward rate agreement - Interest rate future - Interest rate swap

Six sensitivities (option pricing)

1. The impact of changing forward rates 2. The impact of changing spot rates 3. The impact of time to maturity 4. The impact of changing volatility 5. The impact of changing interest differentials 6. The impact of alternative option strike prices

A country's currency that strengthened relative to another country's currency by more than that justified by the differential in inflation is said to be ________ in terms of PPP. A) overvalued B) over compensating C) undervalued D) under compensating

A

A currency board is: a. All of these b. a structure, rather than a mere commitment, to limiting the growth of the money supply in the economy. c. designed to eliminate the power of politicians to exercise judgment by relying on an automatic and unbendable rule. d. a recipe for conservative and prudent financial management.

A

An important thing to remember about foreign exchange rate determination is that parity conditions, asset approach, and balance of payments approaches are ________ theories rather than ________ theories a. complementary; competing b. complementary; contiguous c. competing; complementary d. competing; contemporary

A

Covered interest arbitrage moves the market ________ equilibrium because ________. A) toward; purchasing a currency on the spot market and selling in the forward market narrows the differential between the two B) toward; investors are now more willing to invest in risky securities C) away from; purchasing a currency on the spot market and selling in the forward market increases the differential between the two D) away from; demand for the stronger currency forces up interest rates on the weaker security

A

Examples of a business motivation for long-run exchange rate forecasts include all but which of the following? a. the desire to hedge a 90-day security b. a major capital investment in a foreign country c. All of these are examples of a business motivation for long-run exchange rate forecast. d. a portfolio manager considering investing in foreign securities

A

If the goal were to increase the value of a country's currency - to fight an depreciation of the domestic currency in exchange for foreign currency - the central bank would: a. buy its own currency in exchange for foreign currency. b. follow a expansive monetary policy. c. drive real rates of interest down. d. sell its own currency in exchange for foreign currency.

A

________ is the active buying and selling of the domestic currency against foreign currencies. a. Direct Intervention b. Federal Funding c. Foreign Direct Investment d. Indirect Intervention

A

Overshooting

A behavior in financial markets in which a major market adjustment in price changes"overshoots" or surpasses the likely value it will settle at after a longer adjustment period. A market movement akin to an "over‐reaction"

Foreign Currency Options

A contract giving the option purchaser(the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date)

Exchange Rate Pass-Through

A measure of the response of imported and exported product prices to changes in exchange rates

Disequilibrium: Exchange Rates In Emerging Markets

Although the three different schools of thought on exchange rate determination make understanding exchange rates seem straightforward, that it rarely the case. ▫ The large and liquid capital and currency markets follow many of the principles outlined so far relatively well in the medium to long term. ▫ The smaller and less liquid markets, however, frequently demonstrate behaviors that seemingly contradict the theory. ▫ The problem lies not in the theory but in the relevance of the assumptions underlying the theory

Exchange Rate Dynamics: Making Sense of Market Movements

Although the various theories surrounding exchange rate determination are clear and sound, it may appear on a day‐to‐day basis that the currency markets do not pay much attention to the theories

Forward Rate Agreement

An interbank‐traded contract to buy or sell interest rate payments on a notional principal. ▫ The buyer of an FRA obtains the right to lock in an interest rate for the desired term that begins at a future date with maturities of 1, 3, 6, 9, or 12 months. ▫ Contract specifies that the seller of the FRA will pay the buyer the increased interest expense on the notional principal if interest rates rise above the agreed rate, but the buyer will pay the seller the differential interest expense if interest rates fall below the agreed rate. ▫ Contracts are settled in cash

Out-of-the- Money (OTM)

An option that would not be profitable, excluding the cost of the premium, if exercised immediately

Asset Market Approach to Forecasting

Assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers: ▫ Illiquid capital markets ▫ Weak economic and social infrastructure ▫ Political instability ▫ Weak corporate governance laws and practices ▫ Susceptibility to contagion effects ▫ Widespread speculation

A ________ is an exchange rate quoted today for settlement at some time in the future. A) spot rate B) forward rate C) currency rate D) yield curve

B

Assume the implied PPP rate of exchange of Mexican Pesos per U.S. dollar is 8.50 according to the Big Mac Index. Further, assume the current exchange rate is Peso 10.80/$1. Thus, according to PPP and the Law of One Price, at the current exchange rate the peso is: A) overvalued. B) undervalued. C) correctly valued. D) There is not enough information to answer this question.

B

Exchange rate pass-through may be defined as: A) the bid/ask spread on currency exchange rate transactions. B) the degree to which the prices of imported and exported goods change as a result of exchange rate changes. C) the PPP of lesser-developed countries. D) the practice by Great Britain of maintaining the relative strength of the currencies of the Commonwealth countries under the current floating exchange rate regime.

B

If the current exchange rate is 113 Japanese yen per U.S. dollar, the price of a Big Mac hamburger in the United States is $3.41, and the price of a Big Mac hamburger in Japan is 280 yen, then other things equal, the Big Mac hamburger in Japan is: A) correctly priced. B) under priced. C) over priced. D) There is not enough information to determine if the price is appropriate or not.

B

If we set the real effective exchange rate index between the United Kingdom and the United States equal to 100 in 2005, and find that the U.S. dollar has changed to a value of 91.4, then from a competitive perspective the U.S. dollar is: A) overvalued. B) undervalued. C) equally valued. D) There is not enough information to answer this question.

B

Short-term foreign exchange forecasts are often motivated by such activities as ________ whereas long-term forecasts are more likely motivated by ________. a. long-term capital appreciation; desire to hedge a receivable b. the desire to hedge a payable; the desire for long-term investment c. the desire for long-term investment; d. the desire to hedge a payable long-term investment; long-term capital appreciation

B

The ________ approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets a. law of one price b. asset market c. balance of payments d. monetary

B

Which of the following is NOT a motivation for a government or central bank to manipulate domestic currency valuation? a. spur too slow economic growth b. All of these are motivations for the government or central bank to manipulate currency values. c. fight inflation d. slow too rapid economic growth

B

________ is the restriction of access to foreign currency by government. a.Indirect Intervention b. Capital Controls c. Direct Intervention d. Foreign Direct Investment

B

Assume a nominal interest rate on one-year U.S. Treasury Bills of 2.60% and a real rate of interest of 1.00%. Using the Fisher Effect Equation, what is the approximate expected rate of inflation in the U.S. over the next year? A) 2.10% B) 2.05% C) 1.60% D) 1.00%

C

If an identical product can be sold in two different markets, and no restrictions exist on the sale or transportation of product between markets, the product's price should be the same in both markets. This is known as: A) relative purchasing power parity. B) interest rate parity. C) the law of one price. D) equilibrium.

C

In its approximate form the Fisher effect may be written as ________. Where: i = the nominal rate of interest, r = the real rate of return and π = the expected rate of inflation. A) i = (r)(π) B) i = r + π + (r)(π) C) i = r + π D) i = r + 2π

C

Chapter 6 Slides 20 and 21

Chapter 6 Slides 20 and 21

Debt Cost (Plain-Vanilla Strategies)

Companies of lower credit quality use plain‐vanilla swaps to effectively going from paying floating to paying fixed

Debt Structures (Plain-Vanilla Strategies)

Companies with very high credit quality have better access to the fixed‐rate debt markets and often raise large amounts of debt in long maturities at fixed rates. They then use the plain‐vanilla swap market to alter certain amounts of their fixed‐rate debt into floating‐rate debt to achieve their desired objective. Swaps allow them to alter the fixed/floating debt composition of their capital structure

Interest Rate Risk

Competitive pressures have required tightening of management of interest rates on both the left and right sides of the firm's balance sheet

Major features that are standardized (for futures) are:

Contract size Method of stating exchange rates Maturity date Last trading day Collateral and maintenance margins Settlement Commissions Use of a clearinghouse as a counterparty

Assume the current U.S. dollar-British spot rate is 0.6993£/$. If the current nominal one-year interest rate in the U.S. is 5% and the comparable rate in Britain is 6%, what is the approximate forward exchange rate for 360 days? A) £1.42/$ B) £1.43/$ C) £0.6993/$ D) £0.7060/$

D

If the goal were to decrease the value of a country's currency - to fight an appreciation of the domestic currency in exchange for foreign currency - the central bank would: a. drive real rates of interest up. b. buy its own currency in exchange for foreign currency. c. follow a restrictive monetary policy. d. sell its own currency in exchange for foreign currency.

D

Other things equal, and assuming efficient markets, if a Honda Accord costs $24,682 in the U.S., then at an exchange rate of $1.57/£, the Honda Accord should cost ________ in Great Britain. A) £24,682 B) £38,751 C) £10,795 D) £15,721

D

The ________ approach argues that equilibrium exchange rates are achieved when the net inflow of foreign exchange arising from current account activities is equal to the net outflow of foreign exchange arising from financial account activities. a. asset market b. monetary c. law of one price d. balance of payments

D

The ________ provides a means to account for international cash flows in a standardized and systematic manner. a. International Fisher Effect b. parity conditions c. asset approach d. balance of payments

D

The asset market approach to forecasting assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations. These include all but which of the following choices? a. capital market liquidity b. political safety c. relative real interest rates d. All of these are considered by investors in their decision process

D

The current U.S. dollar-yen spot rate is 125¥/$. If the 90-day forward exchange rate is 127 ¥/$ then the yen is selling at a per annum ________ of ________. A) premium; 1.57% B) premium; 6.30% C) discount; 1.57% D) discount; 6.30%

D

The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as: A) absolute PPP. B) the law of one price. C) relative PPP. D) the international Fisher Effect.

D

With covered interest arbitrage: A) the market must be out of equilibrium. B) a "riskless" arbitrage opportunity exists. C) the arbitrageur trades in both the spot and future currency exchange markets. D) all of the above

D

________ states that differential rates of inflation between two countries tend to be offset over time by an equal but opposite change in the spot exchange rate. A) The Fisher Effect B) The International Fisher Effect C) Absolute Purchasing Power Parity D) Relative Purchasing Power Parity

D

________ states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. A) Absolute PPP B) Relative PPP C) The Law of One Price D) The Fisher Effect

D

Pass-Through Emerging Market Currencies

Emerging market countries have shifted from choosing a pegged exchange rate and independent monetary policy over the free flow of capital to policies allowing more capital flows at the expense of a fixed exchange rate This change in focus has now introduced exchange rate pass‐through as an issue in these same emerging markets

Complete Pass-Through

Example: 100% of the impact of a change in exchange rates on the dollar price of imported goods is passed on to the consumer. If an item costs €10,000 and the exchange rate is $1.00/€ then the price would be$10,000. If the exchange rate goes to $1.15/€ and the item still costs €10,000, the price would rise to $11,500

Short Positions

Example: If a speculator believes that theMexican peso will fall in value versus theU.S. dollar by June, she could sell a June futures contract, taking a short position. By selling a June contract, she locks in the selling 500,000 Mexican pesos at a set price. --- If the price of the peso falls by the maturity date as she expects, she has a contract to sell pesos at a price above their current price on the spot market, making a profit. ▫ Value at maturity (Short position) =−Notional principal × (Spot − Futures)

Long Positions

Example: If a speculator believes that theMexican peso will rise in value versus theU.S. dollar by June, she could buy a June futures contract, taking a long position. By buying a June contract, she locks in the right to buying 500,000 Mexican pesos at a set price. --- If the peso price rises by the maturity date, she has a profitable contract to buy pesos at a price below their current price on the spot market. ▫ Value at maturity (Long position) =Notional principal × (Spot − Futures)

Partial Pass-Through

Example: Less than 100% of the impact of a change in exchange rates on the dollar price of imported goods is passed on to the consumer. If an item costs €10,000 and the exchange rate is $1.00/€ then the price would be$10,000. If the exchange rate goes to $1.15/€ and the item still costs €10,000 but the price only rises to $10,500. Change in prices is dependent on price elasticity of demand

Foreign Currency derivatives, Swaps & Futures

Foreign currency derivatives and swaps can be used for two very distinct management objectives: ▫ Speculation: use of derivative instruments to take a position in the expectation of a profit. ▫ Hedging: use of derivative instruments to reduce the risks associated with the everyday management of corporate cash flow

Currency Intervention

Foreign currency intervention is the active management, manipulation, or intervention in the market's valuation of a country's currency

Exchange Rate Indices

Formed by weighting the bilateral exchange rates between the home country and its trading partners

Relative Purchasing Power Parity

If the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate

Japan 2010 (Currency Market Intervention Failure)

In September 2010, the Bank of Japan intervened in the foreign exchange markets in an attempt to slow the appreciating yen. Japan reportedly bought nearly 20 billion U.S. dollars in exchange. The intervention resulted in public outcry from Beijing to Washington to London over the "new era of currency intervention". The intervention was largely unsuccessful - the yen continued to appreciate throughout 2010

Real Effective Exchange Rate Index

Indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period

Forecasting: What to think?

It appears, from decades of theoretical and empirical studies, that exchange rates do adhere to fundamental principles and theories. Fundamentals do apply more strongly in the long term. In the short term, a variety of random events, institutional frictions, and technical factors can cause currency values to deviate significantly from their long‐term fundamental path

The Fisher Effect

Nominal interest rates in each country are equal to the required real rate of returnplus compensation for expected inflation: i = r + π + (r × π) i = r + π (Approximate form) --- i = nominal interest rate --- r = real interest rate --- π = expected inflation. ▫ Empirical tests (using ex‐post) national inflation rates have shown the Fisher effect usually exists for short‐maturity government securities

Forward Premium or Discount

Percentage difference between the spot and forward exchange rate, stated in annual percentage terms

Balance of Payment (Exchange Rate Determination)

Second most utilized theoretical approach in exchange rate determination. ▫ The balance of payment (BOP) approach argues that the equilibrium exchange rate is found when currency flows match up vis‐à‐vis current and financial account activities. ▫ This framework has wide appeal as BOP transaction data is readily available and widely reported. ▫ Critics may argue that this theory does not consider stocks of money or financial assets

Direct Intervention (Currency Market Intervention)

The active buying and selling of the domestic currency against foreign currencies

Indirect Intervention (Currency Market Intervention)

The alteration of economic or financial fundamentals thought to be drivers of capital flow into and out of specific currencies

Currency vs. Plain-Vanilla Swap Differences

The currency swap is different from the plain‐vanilla interest rate swap in two important ways: 1. The spot exchange rate in effect on the date of the agreement establishes what the notional principal is in the target currency. 2. The notional principal itself is part of the swap agreement

Interest Rate Parity

The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction cost

Repricing Risk

The possibility of changes in interest rates charged (earned) when a financial contract's rate isreset

Parity Conditions Approach (Exchange Rate Determination)

The purchasing power parity theory is the most widely accepted theory of all exchange rate determination theories. ▫ The theory of purchasing power parity (PPP) states that the ratio of domestic prices relative to foreign prices determines the long‐run equilibrium exchange rate. ▫ PPP is the oldest and most widely followed of the exchange rate theories. ▫ Most exchange rate determination theories have PPP elements embedded within their frameworks. ▫ PPP calculations and forecasts are, however, plagued with structural differences across countries and significant data challenges in estimation

Fisher Effect Example: ▫ The forecasted inflation rates for Japan and the United States are 1% and 5%, respectively—a 4%differential. ▫ The nominal interest rate in the U.S. dollar market (1‐year government security) is 8%—a differential of 4% over the Japanese nominal interest rate of 4%

The real rate is 3%: U.S. dollar markets: (r = i − π = 8% − 5% = 3%) Japanese yen markets: (r = I ‐ π = 4% − 1% = 3%)

The International Fisher Effect

The relationship between the percentage change in the spot exchange rate overtime and the differential between comparable interest rates in different national capital markets Investors must be rewarded or penalized to offset the expected change in exchange rates

Capital Controls (Currency Market Intervention)

The restriction of access to foreign currency by the government

Absolute Purchase Power Parity

The spot exchange rate is determined by the relative prices of similar baskets of goods.

Cross-Currency Swaps

The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in the desired currency The desired currency is often the currency in which the firm's future operating revenues will be generated, but they may find capital costs in another specific currency attractively priced to them

Interest Rate Risk Management: MedStat needs to borrow $10 million over 3 years

Three strategies: Strategy 1: Borrow $1 million for three years at a fixed interest rate. --- Least flexibility but eliminates credit risk and repricing risk. Strategy 2: Borrow $1 million for three years at a floating rate, LIBOR + 2% (LIBOR to be reset annually). --- Eliminates credit risk but is subject to repricing risk. Strategy 3: Borrow $1 million for one year at a fixed rate, then renew the credit annually. --- Most flexibility but subject to credit risk and repricing risk

Nominal Effective Exchange Rate Index

Uses actual exchange rates to create an index, on a weighted average basis, of the value of the subject currency over time

Foreign Currency Futures Contract

an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price

In-the-money (ITM)

an option that would be profitable, excluding the cost of the premium if exercised immediately

call option

an option to buy a foreign currency

put option

an option to sell a foreign currency

At-the-Money (ATM)

an option whose exercise price is the same as the spot price of the underlying currency

Swaps

contractual agreements to exchange or swap a series of cash flows - A swap serves to alter the firm's cash flow obligations, as in changing floating‐rate payments into fixed‐rate payments associated with an existing debt obligation

Contract specifications

established b y the exchange the futures are traded on

Currency Option Pricing Sensitivity

f currency options are to be used effectively, either for the purposes of speculation or risk management, the individual trader needs to know how option values (premiums) react to their various components

American Option

gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date

European option

gives the buyer the right to exercise the option only on its expiration date, not before

notional principal

the principal amount involved in a swap

Alternative Strike Prices and Option Premiums

• A firm purchasing an option in the over‐the‐counter market may choose its own strike rate. • Options with strike rates that are already in‐the‐money will have both intrinsic and time value elements. • Options with strike rates that are out‐of‐the‐money will have only a time value component

Other Factors in the 1997 Asian Crisis

• Although the causes of the crisis were a bit different in each country, all countries shared three common contributors: ▫ Corporate socialism ▫ Corporate governance cronyism ▫ Banking instability • In 2002, the United States enacted the Sarbanes‐Oxley Act, to address corporate board independence.• In 2010, the United States enacted the Wall Street Consumer Protection and Reform Act. ▫ a.k.a. ‐ Dodd‐Frank Act

Example: Call Option Buyer

• Buyer of an option only exercises his/her rights if the option is profitable. • In the case of a call option, as the spot price of the underlying currency moves up, the holder has the possibility of unlimited profit

Sovereign Debt

• Debt issued by governments• Historically considered debt of the highest quality. ▫ This stems from the ability of a government to tax its people and, if need be, print more money. ▫ Therefore, the government can service its own debt, when that debt is denominated in its own currency. • Sovereign Spreads measure the credit risk of the sovereign entity. The ability of sovereign borrowers to repay foreign currency‐denominated debt: k Foreign$ = k US$ + RPM $Foreign ▫ where: ▫ kForeign$ = the cost of foreign sovereign dollar debt ▫ kUS$ = the cost for the foreign government to raise U.S. dollar debt on global markets ▫ RPM $Foreign = the foreign sovereign risk-premium for a dollar borrower

Forward Rate as an Unbiased Predictor of the Future Spot Rate

• Forward exchange rates are thought of as unbiased predictors of future spot exchange rates. ▫ Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree.

Foreign Currency Futures vs. Forwards

• Futures are standardized in terms of size while forwards can be customized. • Futures have fixed maturities while forwards can have any maturity (both typically have maturities of one year or less). • Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks. • Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward. • Futures are rarely delivered upon (settled) while forwards are normally delivered upon(settled).

spot rate sensitivity (delta)

• If the current spot rate falls on the side of the option's strike price—which would induce the option holder to exercise the option upon expiration—the option also has an intrinsic value. • The sensitivity of the option premium to a small change in the spot exchange rate is called the delta. • Delta varies between +1 and 0 for a call option and −1 and 0 for a put option. • As an option moves further in‐the‐money, delta rises toward 1.0. As an option moves further out‐of‐the‐money, delta falls toward zero. • Rule of Thumb: The higher the delta (deltas of .7, or .8 and up are considered high) the greater the probability of the option expiring in‐the‐money.

Disequilibrium: Argentine Crisis of 2002

• In 1991, the Argentine peso was fixed to the U.S. dollar at a one‐to‐one exchange rate. • Argentina adopted a currency board to limit the growth of money in the economy. ▫ Under this currency board, the central bank could increase the money supply in the banking system only by increasing in its holdings of U.S. dollars. ▫ This strategy resulted in a restrictive monetary policy that slowed economic growth, which resulted in a recession that began in 1998. • By 2001, crisis conditions had revealed three very important underlying problems with Argentina's economy: 1. The Argentine peso was overvalued. 2. The currency board regime had eliminated monetary policy alternatives for macroeconomic policy. 3. The Argentine government budget deficit was out of control. • Devaluation ▫ In January 2002, in the first act of his presidency, President Eduardo Duhalde devalued the peso from 1.00 to1.40 Argentine peso per U.S. dollar. ▫ In February 2002, the Argentine government announced that the peso would be floated. ▫ The government would no longer attempt to fix or manage its value to any specific level, allowing the market tofind or set the exchange rate

Uncovered Interest Arbitrage

• Investors borrow in countries/currencies exhibiting relatively low interest rates and convert the funds into currencies that offer much higher interest rates. • The transaction is "uncovered," because the investor does not sell the higher yielding currency proceeds forward. Instead, they choose to remain uncovered(accepting the currency risk of exchanging the higher yield currency into the lower yielding currency later to cover the position)

Time to Maturity: Value and Deterioration (theta)

• Option values increase with the length of time to maturity. The expected change in the option premium from a small change in the time to expiration is termed theta. • Theta is calculated as the change in the option premium over the change in time. Theta is based not on a linear relationship with time, but rather the square root of time. • Option premiums deteriorate at an increasing rate as they approach expiration. • Rule of Thumb: A trader will normally find longer‐maturity options better values, giving the trader the ability to alter an option position without suffering significant time value deterioration

sensitivity to volatility (Lambda)

• Option volatility is the standard deviation of daily percentage changes in the underlying exchange rate. • The primary problem with volatility is that there is no single method for its calculation. Volatility is calculated in three ways: ▫ Historic ‐ where the volatility is drawn from a recent period of time. ▫ Forward‐looking ‐ where the historic volatility is altered to reflect expectations about the future period over which the option will exist. ▫ Implied ‐ where the volatility is backed out of the market price of the option. • Rule of Thumb: Traders who believe volatilities will fall significantly in the near‐term will sell (write) options now, hoping to buy them back for a profit immediately after volatilities fall causing option premiums to fall

Foreign Currency Derivatives Firm Uses.

• Permit firms to achieve payoffs that they would not be able to achieve without derivatives or could achieve only at greater cost. • Hedge risks that otherwise would not be possible to hedge. • Make underlying markets more efficient. • Reduce volatility of stock returns. • Minimize earnings volatility. • Reduce tax liabilities. • Motivate management (agency theory effect)

Forward rate sensitivity

• Standard foreign currency options are priced around the forward rate because the current spot rate and both the domestic and foreign interest rates (home currency and foreign currency rates) are included in the option premium calculation. • The forward rate is central to valuation. • The option‐pricing formula calculates a subjective probability distribution centered on the forward rate.

Example: Put Option Buyer

• The basic terms of this example are similar to but inverse those with the call. • The buyer of a put option wants to be able to sell the underlying currency at the exercise price when the market price of that currency drops (not rises as in the case of the call option). • If the spot price drops to $0.575/SF, the buyer of the put will deliver francs to the writer and receive $0.585/SF. • At any exchange rate above the strike price of 58.5, the buyer of the put would not exercise the option, and would lose only the $0.05/SF premium.• The buyer of a put (like the buyer of the call) can never lose more than the premium paid up front

Sensitivity to Changing Interest Rate Differentials (Rho and Phi)

• The expected change in the option premium from a small change in the domestic interest rate (home currency) is termed rho. • The expected change in the option premium from a small change in the foreign interest rate (foreign currency) is termed phi. • Rule of Thumb: A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises. This will allow the trader to purchase the option before its price increases

Example: Put Option Writer

• The option will be exercised it the spot price of francs drops below 58.5 cents per franc. • Below a price of 58.5 cents per franc, the writer will lose more than the premium received from writing the option (falling below break‐even). • If the spot price is above$0.585/SF, the option will not be exercised, and the option writer will pocket the entire premium

Counterparty Risk

• The potential exposure any individual firm bears that the other party(parties) in any financial contract will be unable to fulfill its obligations under the contract's specifications. • Concern over counterparty risk periodically rises, usually associated with large and well‐publicized derivative and swap defaults: ▫ AIG - American International Group▫ If a counterparty to a swap does not make the payment as agreed, the firm legally holding the debt is still responsible for debt service

Disequilibrium: Exchange Rates in the 1997 Asian Crisis

• The roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net importers. • The most visible roots of the crisis were the excess capital inflows into Thailand. • As the investment "bubble" expanded, some market participants questioned the ability of the economy to repay the rising amount of debt and the Thai bhat came under attack. • The Thai government repeatedly intervened in the foreign exchange markets directly (using up much of its foreign exchange reserves) and indirectly (by raising interest rates). • In July 1997, the Thai central bank finally allowed the baht to float. ▫ By November, the baht had fallen from 25 to 40 baht per dollar, a fall of about 38%

Option valuation

• The total value (premium) of an option is equal to the intrinsic value plus time value. • Intrinsic value is the financial gain if the option is exercised immediately. ▫ For a call option, intrinsic value is zero when the strike price is above the market price --- When the spot price rises above the strike price, the intrinsic value become positive. ▫ Put options behave in the opposite manner ▫ On the date of maturity, an option will have a value equal to its intrinsic value (zero time remaining means zero time value). • The time value of an option exists because the price of the underlying currency, the spot rate, can potentially move further into (or out of) the money between the present time and the option's expiration date

Example: Call Option Writer

• The writer gains what the buyer of an option loses. ▫ The maximum profit that the writer of the call option can make is limited to the premium. • If the writer wrote the option naked, that is without owning the currency, the writer would now have to buy the currency at the spot and take the loss delivering at the strike price.• The amount of such a loss is unlimited and increases as the underlying currency rises.▫ Even if the writer already owns the currency, the writer will experience an opportunity loss

MedStat Uses a Cross‐Currency Swap (Example)

▫ After raising $10 million in floating‐rate financing and subsequently swapping into fixed‐rate payments, MedStat decided that it would prefer to make its debt service payments in British pounds (GBP). ▫ In addition, MedStat had recently signed a sales contract with a British buyer who will pay in GBP to MedStat across the next 3‐year period. ▫ This would be a natural inflow of GBP for the coming three years, andMedStat wishes to match the currency of denomination of the cash flows through a cross‐currency swap

Interest Rate Futures

▫ Attractive due to: High liquidity of the interest rate futures markets. Simplicity in use . Standardizes interest rate exposure. ▫ The yield of a futures contract is calculated from the settlement price, which is theclosing price for that trading day. Each contract is for a 3‐month period (one quarter) and has a notional principal of$1 million, each basis point is actually worth $2,500 ▫ Used for: Hedging Speculation

Forward Rate

▫ Exchange rate quoted today for settlement at some future date ▫ Forward Exchange Agreement States the rate of exchange at which a foreign currency will be "bought forward" or "sold forward" at a specific date in the future

Motivations for Currency Market Intervention:

▫ Fight inflation (strong currency). ▫ Fight slow economic growth (weak currency)

MedStat's Floating-Rate Loans (Medstat):

▫ Floating‐rate loans are the single largest and most frequently observed corporate interest rate exposure. Whereas the LIBOR component is truly floating, the spread of 1.250% is actually a fixed component of the interest payment, which is known with certainty for the life of the loan MedStat will not know the actual interest cost of the loan until the loan has been completely repaid

Technical Analysts (chartists)

▫ Focus on price and volume data to determine past trends that are expected to continue into the future ▫ The single most important element of technical analysis is that future exchange rates are based on the current exchange rate ▫ Exchange rate movements can be subdivided into three periods: Day‐to‐day Short‐term (several days to several months) Long‐term The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be ▫ Time Series Techniques Infer no theory or causality but simply predict future values from the recent past

Option fundamentals:

▫ Holder --- The buyer of an option. ▫ Writer or Grantor --- The seller of an option. ▫ Price Elements: --- The exercise or strike price: the exchange rate at which the foreign currency can be purchased (call) or sold (put). --- The premium: the cost, price, value of the option. --- The underlying or actual spot rate in the market.

Law of One Price

▫ Identical products or services that can be sold in two different markets, and no restrictions exist on the sale or transportation of product between markets, the price should be the same in both markets ▫ If a product is sold in two markets in two different countries, that product's price may be stated in different currency terms, but the price of the product should still be the same

Exchange rate Indices: Real and Nominal

▫ Individual national currencies often need to be evaluated against other currency values to determine relative purchasing power ▫ The objective is to discover whether a nation's exchange rate is "overvalued" or"undervalued" in terms of PPP ▫ This problem is often dealt with through the calculation of exchange rate indices such as the nominal effective exchange rate index

Swap Structures

▫ Interest Rate Swap --- Plain‐vanilla Swap ▫ Currency Swap --- Cross‐currency Swap

Credit ratings and Cost of Funds

▫ Investment Grade ▫ Speculative Grade ▫ Credit Spreads

LIBOR (London Interbank Offered Rate)

▫ Most widely used and quoted reference rate ▫ 1‐month, 3‐month, and 6‐month LIBOR are the most significant maturities

Options on the Over‐the‐Counter Market

▫ Over‐the‐counter (OTC) options are most frequently written by banks for U.S. dollars againstBritish pounds sterling, Canadian dollars, Japanese yen, Swiss francs, or the euro. ▫ An advantage of OTC options is that they are tailored to the specific needs of the firm in terms of notional principal, strike price, and maturity. ▫ Some counterparty risk

Empirical Tests of Purchasing Power Parity

▫ PPP holds up well over the very long run but poorly for shorter time periods ▫ The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets

The pricing of any currency option combines six elements:

▫ Present spot rate ▫ Time to maturity ▫ Forward rate for matching maturity ▫ U.S. dollar interest rate ▫ Foreign currency interest rate ▫ Volatility (standard deviation of daily spot price movements)

interest rate risks of the nonfinancial firm include:

▫ Refinancing risk ▫ Reinvestment Risk

Options on organized exchanges

▫ Settled through a clearing house, which essentially eliminates counterparty risk. ▫ Options on organized exchanges are standardized

Turkey 2014 (Currency Market Intervention Failure)

▫ The Turkish economy suffered a widening current account deficit and rising inflation in late 2013. ▫ In the fourth quarter of 2013, the U.S. Federal Reserve announced that it would be slowing its bond purchases. ▫ With this, rates were anticipated to rise in the U.S., and capital began exiting Turkey. ▫ To defend its currency, the Turkish central bank needed to raise interest rates. ▫ But the president of Turkey wanted the central bank to lower interest rates, which he insisted would stimulate the Turkish economy. ▫ Instead, lower interest rates provided additional incentive for capital flight. ▫ Eventually, the Turkish central bank had little choice but to increase the Turkish one‐week bank repo rate from 4.5% to 10%.78

International Parity Conditions

▫ The economic theories that link exchange rates, price levels, and interest rates together ▫ International parity conditions form the core of the financial theory that is unique to international finance.

Monetary Approach (Exchange Rate Determination)

▫ The exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks. ▫ Focuses on changes in the supply and demand for money as the primary determinant of inflation. ▫ Changes in relative inflation rates are expected to alter exchange rates through a purchasing power parity effect

Covered Interest Rate Rule of Thumb

▫ The key to determining whether to start in dollars or the foreign currency is to compare the differences in interest rates to the forward premium on the foreign currency (the cost of cover). If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower interest yielding currency

Consider the example of MedStat unwinding a Currency Swap (EXAMPLE)

▫ The partners to a swap may wish to terminate the agreement before it matures. ▫ If, for example, after one year, MedStat Corporation's British sales contract is terminated, MedStatwill no longer need the swap as part of its hedging program. MedStat could terminate or unwind the swap with the swap dealer. ▫ Unwinding a currency swap requires the discounting of the remaining cash flows under the swap agreement at current interest rates, then converting the target currency back to the home currency of the firm

Covered Interest Arbitrage

▫ The spot and forward exchange markets are not always in equilibrium. ▫ When the market is not in equilibrium, the potential for arbitrage profit exists. ▫ The arbitrager who recognizes such an imbalance will invest in whichever currency offers the higher return on a covered basis.

Market-to-Market

▫ The value of the contract is revalued using the closing price for the day. ▫ The value of the contract is marked to market daily, and all changes in value are paid in cash daily

Asset Market Approach (Exchange Rate Determination)

▫ a.k.a. Relative Price of Bonds or Portfolio Balance Approach ▫ Supply and demand for various financial assets determine exchange rates. Shifts in the supply and demand for widely varied financial assets shift exchange rates. ▫ The forecasting inadequacies of fundamental theories have led to the growth and popularity of technical analysis, The belief that studying past price behavior provides insights into future price movements. The primary assumption is that any market‐driven price (i.e., exchange rates) follows trends