International Finance

What are some alternate goals of corporations? Other than shareholder wealth maximisation

Stakeholders - shareholders are viewed as stakeholders along with employees, suppliers and customers Principle Agent Conflict - managers may pursue their own private interests at the expense of shareholders when they are not closely monitored (corporate governance can help avoid this) Business Culture - legal protection of shareholders is weak or virtually non-existing

How can you Speculate with combined put and call options?

Straddle - uses both a put option and a call option at the same exercise price Good for when speculators expect strong movement in one direction or the other

How do firms use currency call options?

Using call options to hedge p ayables Using call options to hedge project bidding to lock in the dollar cost of potential expenses Using call options to hedge target bidding of a possible acquisition

Which hedging strategies do you know the cost of and which is uncertain?

We know the cost of a forward hedge and money market hedge with certainty With an option hedge we don't know the exact cost but we do know the maximum cost Without a hedge the cost is completely uncertain

What is a forward contract?

agreements between a foreign exchange dealer and MNC that specifies the currencies to be exchanged, the exchange rate, and the date at which the transaction will occur A forward contract is an agreement between a corporation and a financial institution: To exchange a specified amount of currency At a specified exchange rate called the forward rate On a specified date in the future

What is a currency call option?

provides the right to buy currency at a specified strike price within a specified period of time

What is a currency put option?

provides the right to sell currency at specified strike price within a specified period of time

What are the 3 scenarios of IFE?

relatively high local interest -> relatively high inflation -> increased imports and decreased exports -> local currency depreciates relatively low local interest -> relatively low inflation -> decreased imports and increased exports -> local currency appreciates relatively similar interest rates -> relatively similar inflation rates -> no impact on imports or exports -> local currency value is unchanged

What is a currency futures contract?

similar to forward contracts but sold on an exchange -Specifies a standard volume of a particular currency to be exchanged on a specific settlement date -The futures rate is the exchange rate at which one can purchase or sell a specified currency on the specified settlement date -The future spot rate is the spot rate that will exist at a future point in time and is uncertain as of today

What is a cross exchange rate?

the amount of one foreign currency per unit of another foreign currency

What is a forward rate?

the exchange rate specified by the forward contract

What is corporate governance?

the financial and legal framework for regulating the relationship between a firm's management and its shareholders

What is the forward market?

the over-the-counter market where forward contracts are traded

What is a non-deliverable forward contract (NDF)?

Can be used for emerging market currencies where no currency delivery takes place at settlement; instead one party makes a payment to the other party

What is covered interest arbitrage?

Capitalising on the interest rate differential between two countries while covering your exchange rate risk with a forward contract Consists of two parts: 1) Interest arbitrage: the process of capitalising on the difference between interest rates between two countries 2) Covered: hedging the position against interest rate risk. Steps for arbitrage: 1) borrow in US 2) lend in UK 3) buy the UKP at the spot rate 4) sell the UKP at the forward rate

What is the Asian Money Market and how did it originate?

Centred in Hong Kong and Singapore. Originated as a market involving mostly dollar-denominated deposits, and was originally known as the Asian dollar market

Why does PPP not hold?

Confounding effects: A change in a country's spot rate is driven by more than the inflation differential between two countries No Substitutes for Traded Goods: If substitute goods are not available domestically, consumers may not stop buying imported goods

What is the international money market?

Corporations or governments need short-term funds denominated in a currency different from their home currency.

What is the European money market and how did it develop?

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

What is the relative form of PPP?

Due to market imperfections, prices of the same basket of products in different countries will not necessarily be the same. However, the rate of change in prices should be similar when measured in common currency

What are some major developments in the globalisation of the world economy?

Emergence of Globalized Financial Markets Emergence of the Euro as a Global Currency Europe's Sovereign Debt Crisis of 2010 Trade Liberalization and Economic Integration Privatization Global Financial Crisis of 2008-2009

European currency options can be exercised ____; American currency options can be exercised ____. POSSIBLE ANSWERS: any time up to the expiration date OR only on the expiration date

European currency options can be exercised only on the expiration date; American currency options can be exercised any time up to the expiration date.

How would you evaluate the hedge decision for exposure to receivables?

Evaluating the hedge decision by estimating the real cost of hedging receivables versus the cost of receivables if not hedged

What is the rational behind Relative PPP Theory?

Exchange rate adjustment is necessary for the relative purchasing power to be the same whether buying products locally or from another country. If the purchasing power is not equal, consumers will shift purchases to wherever products are cheaper until the purchasing power is equal.

What are the differences between a forward hedge and currency call option hedge?

The cost of the forward hedge or money market hedge can be determined with certainty The currency call option hedge has different outcomes depending on the future spot rate at the time payables are due

How does forward rate change with time?

The forward premium is influenced by the interest rate differential between the two countries and can change over time

What are 4 of the main differences that arise from "international" finance? Briefly describe these differences

Foreign exchange risk - risk due to unanticipated exchange rate movements Political risk - risk due to unexpected law changes Market imperfections - legal restrictions, transaction costs, shipping costs, tax arbitrage Expanded Opportunity Set - firms have more opportunity on a global basis

How do MNC's hedge transactions?

Forward / futures hedge Money market hedge Currency option hedge

What should be the goal for international finance management? Why is this sometimes not the case?

The maximisation of shareholder wealth should be the goal of the manager. This is long accepted in developing countries but is sometimes complicated by who/where the shareholders are and what currency wealth should be maximised in

Explain the money market interest rates among currencies

The money market interest rates in any particular country are dependent on the demand for short-term funds by borrowers, relative to the supply of available short-term funds that are provided by savers Money market rates vary due to differences in the interaction of the total supply of short-term funds available (bank deposits) in a specific country versus the total demand for short-term funds by borrowers in that country

What is the maximum loss to the owner of a currency put option?

The premium paid for the option contract

How would you purchase Futures to Hedge Payables?

The purchase of futures contracts locks in the price at which a firm can purchase a currency.

How could you hedge exposure to receivables?

Forward or futures hedge on receivables allows the MNC to lock in the exchange rate at which it can sell a specific currency Money market hedge on receivables involves borrowing the currency that will be received and using the receivables to pay off the loan Put option hedge on receivables provides the right to sell a specified amount of a particular currency at a specified strike price by a specified expiration date

What are the implications of IFE?

International Fisher effect (IFE) theory suggests that currencies with high interest rates will have high expected inflation (due to the Fisher effect). Relatively high inflation will cause the currencies to depreciate (due to the PPP effect).

What is the risk of international money market securities?

International Money Market Securities are debt securities issued by MNCs and government agencies with a short-term maturity (1 year or less) Normally, these securities are perceived to be very safe from the risk of default Even if the international money market securities are not exposed to credit risk, they are exposed to exchange rate risk when the currency denominating the securities differs from the home currency of the investors

What is NAFTA? How has it benefited?

North American Free Trade Agreement (NAFTA) called for phasing out impediments to trade between Canada, Mexico, and the United States over a 15-year period beginning in 1994. For Mexico, the ratio of export to GDP has increased dramatically from 2.2% in 1973 to 31.7% in 2011. The increased trade has resulted in increased numbers of jobs and a higher standard of living for all member nations.

What are the 3 possible scenarios of PPP?

Relatively high local inflation -> Increased imports -> Exports decrease -> local currency depreciates Relatively low local inflation -> Decreased imports -> Exports increase -> local currency appreciates Local and foreign inflation are similar -> no impact on imports or exports -> currency value isn't affected

What is the real rate of interest?

Represents the return on the investment to savers after accounting for expected inflation

How does the efficiency of the currency options market affect speculating?

Research has found that, when transaction costs are controlled for, the currency options market is efficient It is difficult to predict which strategy will generate abnormal profits in future periods

What are the limits on PPP testing?

Results vary with the base period used. Base period chosen should reflect an equilibrium position since subsequent periods are evaluated in comparison to it. If a base period is used when the foreign currency was relatively weak for reasons other than high inflation, most subsequent periods could show higher appreciation of that currency than what would be predicted by PPP.

What are the risks associated with international bonds?

*Interest Rate Risk - potential for the value of bonds to decline in response to rising long-term interest rates. *Exchange Rate Risk - represents the potential for the value of bonds to decline (from the investor's perspective) because the currency denominating the bond depreciates against the home currency. *Liquidity Risk - represents the potential for the value of bonds to decline because there is not a consistently active market for the bonds. *Credit Risk - represents the potential for default. *International Integration of Credit Risk - represents the higher credit risk in one country is transmitted to another country

What are the implications of IFE for foreign investors?

- Implications are similar for foreign investors who attempt to capitalise on relatively high Australian interest rates. - Foreign investors will be adversely affected by the effects of a relatively high Australian inflation rate if they try to capitalise on the high Australian interest rates.

What is the process for finding the optimal technique of hedging receivables?

-Consider whether futures or forwards are preferred -Consider desirability of money market hedge versus futures/forwards based on cost -Assess the feasibility of a currency put option based on estimated cash outflows -Optimal hedge versus no hedge on receivables -An MNC may know what its future receivables will be yet still decide not to hedge. In that case, the MNC needs to determine the probability distribution of its revenue from receivables when not hedging

The owners of a business are the A) taxpayers. B) workers. C) suppliers. D) shareholders.

ANSWER: D A shareholder is anyone who owns shares in a company. Shares represent equity, or ownership in a company. Therefore shareholders are owners of the company.

What is closing out a futures position?

A US based MNC anticipates that it will need A$ in the future to pay for supplies -> purchase futures contract -> the firm later realizes it won't need the supplies -> need to offset purchase contract and sell the A$ futures contract

What is a currency derivative?

A contract with a price that is partially derived from the value of the underlying currency that it represents

What is a call option hedge on payables?

A currency call option provides the right to buy a specified amount of a particular currency at a specified strike price or exercise price within a given period of time The currency call option does not obligate its owner to buy the currency at that price. The MNC has the flexibility to let the option expire and obtain the currency at the existing spot rate when payables are due

9. A forward contract hedge is very similar to a futures contract hedge, except that ____ contracts are commonly used for ____ transactions. a. forward; small b. futures; large c. forward; large d. none of the above

A forward contract hedge is very similar to a futures contract hedge, except that FORWARD contracts are commonly used for LARGE transactions

What is a Multinational Corporation?

A multinational corporation (MNC) is a firm that has been incorporated in one country and has production and sales operations in other countries. There are about 60,000 MNCs in the world. Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labor and capital equipment in a third country, and sell their output in various other national markets.

Currency futures contracts sold on an exchange: A. contain a commitment to the owner, and are standardized. B. contain a commitment to the owner, and can be tailored to the desire of the owner. C. contain a right but not a commitment to the owner, and can be tailored to the desire of the owner. D. contain a right but not a commitment to the owner, and are standardized.

ANSWER A Currency futures contracts are standardised, they are not as easily tailored to the company's particular needs.

An MNC's short-term financing decisions are satisfied in the ____ market, while its medium debt financing decisions are satisfied in the ____ market. a. international money; international credit b. international money; international bond c. international credit; international money d. international bond; international credit e. international money; international stock

ANSWER: A

In general, common law countries such as the U.S., Canada, and the United Kingdom allow for more legal protection than French civil law countries such as France or Italy. a. True b. False

ANSWER: A

The international money market primarily concentrates on: a. short-term lending (one year or less). b. medium-term lending. c. long-term lending. d. placing bonds with investors.

ANSWER: A

A firm with concentrated ownership A) may give rise to conflicts of interest between dominant shareholders and small outside shareholders. B) may enjoy more accounting transparency than firms with diffuse ownership structures. C) is a partnership, never a corporation. D) none of the options

ANSWER: A Concentrated ownership occurs when a small number of parties own a large proportion of a company's shares. Since shareholders are the owners of a company, they have discretion in how the company should be run. If ownership is concentrated among a select few, this may cause conflict with other smaller shareholders with less power; whereas a company with equally dispersed ownership may experience a more democratic or equitable negotiation between shareholders on how the company should be run.

Research indicates that deviations from purchasing power parity (PPP) are reduced over the long run. a. True b. False

ANSWER: A Exchange rate movements can fluctuate substantially in the short term, but tend to follow a long term general path that can be somewhat predicted by PPP.

LIBOR is: a. the interest rate commonly charged for loans between banks. b. the average inflation rate in European countries. c. the maximum loan rate ceiling on loans in the international money market. d. the maximum deposit rate ceiling on deposits in the international money market e. the maximum interest rate offered on bonds that are issued in London.

ANSWER: A The London Inter-Bank Offer Rate represents the interest rate at which banks offer to lend funds to one another.

Because there are a variety of factors in addition to inflation that affect exchange rates, this will: a. reduce the probability that PPP shall hold. b. increase the probability that PPP shall hold. c. increase the probability the IFE will hold. d. B and C

ANSWER: A The countless number of factors affecting exchange rates, as well as unexpected random events reduce the probability that PPP or any other theory will consistently hold true.

What is the breakeven point from speculation with currency call options?

Break even if the revenue from selling the currency equals the payments made for the currency plus the option premium

Suppose you start with $100 and buy stock for £50 when the exchange rate is £1 = $2. One year later, the stock rises to £60. You are happy with your 20 percent return on the stock, but when you sell the stock and exchange your £60 for dollars, you only get $45 since the pound has fallen to £1 = $0.75. This loss of value is an example of A) exchange rate risk. B) political risk. C) market imperfections. D) weakness in the dollar.

ANSWER: A This is an example of exchange rate risk because the loss of value is due to the change in exchange rates.

Suppose your firm invests $100,000 in a project in Italy. At the time the exchange rate is $1.25 = €1.00. One year later the exchange rate is the same, but the Italian government has expropriated your firm's assets paying only €80,000 in compensation. This is an example of A) exchange rate risk. B) political risk. C) market imperfections. D) none of the options, since $100,000 = €80,000 × $1.25/€1.00.

ANSWER: B Expropriation of any kind is a political risk.

The goal of shareholder wealth maximization A) is not appropriate for non-U.S. business firms. B) means that all business decisions and investments that a firm makes are done for the purpose of making the owners of the firm better off financially. C) is a sub-objective the firm should attempt to achieve after the objective of customer satisfaction is met. D) is in conflict with the privatization process taking place in third-world countries

ANSWER: B The primary goal of any public company is to create value for its shareholders.

If the interest rate is higher in Australia than in the United Kingdom, and if the forward rate of the British pound (in Australian dollars) is the same as the pound's spot rate, then: a. Australian investors could possibly benefit from covered interest arbitrage. b. British investors could possibly benefit from covered interest arbitrage. c. neither Australian nor British investors could benefit from covered interest arbitrage. d. A and B

ANSWER: B F-S=0 and ih-if>0 => there is a possibility for covered interest rate arbitrage When the interest rate is higher in Australia than in the United Kingdom, the foreign (British) investors can gain profit (premium) by investing in the domestic market. foreign investors can get a better return in the Australian market because the interest rate is higher

A forward contract can be used to lock in the ____ of a specified currency for a future point in time. a. purchase price b. sale price c. A or B d. none of the above

ANSWER: C A forward contract specifies a contract that is settled presently but for which the transaction takes place in the future. One can arrange to buy or sell currencies at a future date through forward contracts.

Futures contracts are typically ____; forward contracts are typically ____. a. sold on an exchange; sold on an exchange b. offered by commercial banks; sold on an exchange c. sold on an exchange; offered by commercial banks d. offered by commercial banks; offered by commercial banks

ANSWER: C Futures are highly standardized and are thus sold on exchanges, whereas forward contracts can be privately negotiated between the parties.

Which of the following is not true regarding covered interest arbitrage? a. Covered interest arbitrage tends to force a relationship between the interest rates of two countries and their forward exchange rate premium or discount. b. Covered interest arbitrage involves investing in a foreign country and covering against exchange rate risk. c. Covered interest arbitrage opportunities only exist when the foreign interest rate is higher than the interest rate in the home country. d. If covered interest arbitrage is possible, you can guarantee a return on your funds that exceeds the returns you could achieve domestically. e. All of the above are true regarding covered interest arbitrage.

ANSWER: C It does not matter which country has the higher interest rate; covered interest arbitrage can occur whenever interest rate parity does not hold. This can be but it is not the only time - it doesn't matter which country has the higher interest rate - arbitrage can occur where the IRP does not hold

According to the international Fisher effect, if Bangladesh has a much higher nominal rate than other countries, its inflation rate will likely be ____ than other countries, and its currency will ____. a. lower; strengthen b. lower; weaken c. higher; weaken d. higher; strengthen

ANSWER: C Nominal interest rate = real interest rate + inflation rate. Therefore, a very high nominal interest rate implies a high inflation rate. The IFE predicts that a country with a higher interest rate will experience a devaluation in its currency relative to another country with a lower interest rate.

Under purchasing power parity, the future spot exchange rate is a function of the initial spot rate in equilibrium and: a. the income differential. b. the forward discount or premium. c. the inflation differential. d. none of the above

ANSWER: C Relative PPP claims that exchange rate movements should exactly offset any inflation differential between two countries.

The ultimate guardians of shareholder interest in a corporation are the A) rank and file workers. B) senior management. C) boards of directors. D) all of the options

ANSWER: C The board of directors are the highest level of management of a corporation; they often appoint the CEO and set out the overall direction of the company. However, since shareholders are the owners, the board of directors are supposed to represent the interest of the shareholders. Shares come with voting rights, and shareholders can elect the members of the board.

Assume that the international Fisher effect (IFE) holds between Australia and the U.K. The Australian inflation is expected to be 5%, while British inflation is expected to be 3%. The interest rates offered on pounds are 7% and Australian interest rates are 7%. What does this say about real interest rates expected by British investors? a. real interest rates expected by British investors are equal to the interest rates expected by Australian investors. b. real interest rates expected by British investors are 2 percentage points lower than the real interest rates expected by Australian investors. c. real interest rates expected by British investors are 2 percentage points above the real interest rates expected by Australian investors. d. IFE doesn't hold in this case because the Australian inflation is higher than the British inflation, but the interest rates offered in both countries are equal.

ANSWER: C The nominal interest rate roughly = expected inflation + real interest rate. UK real interest rate = 7% - 3% = 4% AU real interest rate = 7% - 5% = 2%

Prior to World War I ending, the dominant global currency was the A) German mark. B) French franc. C) Japanese yen. D) British pound.

ANSWER: D

Since the end of World War I, the dominant global currency has been the A) British pound. B) Japanese yen. C) Euro. D) U.S. dollar.

ANSWER: D

Suppose Mexico is a major export market for your U.S.-based company and the Mexican peso appreciates drastically against the U.S. dollar. This means A) your company's products can be priced out of the Mexican market, as the peso price of American imports will rise following the peso's fall. B) your firm will be able to charge more in dollar terms while keeping peso prices stable. C) your domestic competitors will enjoy a period of facing lessened price competition from Mexican imports. D) your firm will be able to charge more in dollar terms while keeping peso prices stable and your domestic competitors will enjoy a period of facing lessened price competition from Mexican imports.

ANSWER: D Domestic US companies will face lower competition from Mexican imports because importers need to buy the foreign currency to import foreign goods; if the Peso appreciates against the dollar, this means it becomes more expensive to import goods from Mexico into the US. If you export goods to Mexico, with an appreciation of the Peso, this means you can keep the Peso price of your exports stable, but you will receive more in US dollars (because 1 Peso now buys more US dollars).

Which of the following is not true with respect to spot market liquidity? a. The more willing buyers and sellers there are, the more liquid a market is. b. The spot markets for heavily traded currencies such as the Japanese yen are very liquid. c. A currency's liquidity affects the ease with which an MNC can obtain or sell that currency. d. If a currency is illiquid, an MNC is typically able to quickly purchase that currency at a reasonable exchange rate.

ANSWER: D If a currency is illiquid, this means that it is not traded very often (relative to other currencies) and therefore MNC's may struggle to buy it quickly at a reasonable price.

If Lazer Co. desired to lock in the maximum it would have to pay for its net payables in euros but wanted to be able to capitalize if the euro depreciates substantially against the Australian dollar by the time payment is to be made, the most appropriate hedge would be: a. a money market hedge. b. purchasing euro put options. c. a forward purchase of euros. d. purchasing euro call options. e. selling euro call options.

ANSWER: D Lazer Co. has euro put options, which can be hedged by purchasing euro call options. They already have put options "locked in the max" they should get call options "take advantage of depreciation"

Although the world economy is much more integrated today than was the case 10 or 20 years ago, a variety of barriers still hamper free movements of people, goods, services, and capital across national boundaries. These barriers include A) legal restrictions. B) excessive transportation costs. C) information asymmetry. D) all of the options

ANSWER: D Legal restrictions may inhibit a company from selling certain products or quantities to certain countries. Excessive transportations costs may inhibit profitability from exporting or importing goods. Information asymmetry occurs when one party/country has more or superior information than another party/country; this concept can interfere with the trading of assets between countries.

The massive privatization that is currently taking place in developing and formerly socialist countries A) will eventually enhance the standard of living to these countries' citizens. B) depends on private investment. C) increases the opportunity set facing these countries' citizens. D) all of the options

ANSWER: D Private companies that compete in a free market are typically more efficient, and therefore more profitable, than if they were government-owned. Private companies depend on investments from other private companies and/or citizens of the country. The profitability of these private companies increases their shareholders' (citizens') wealth, which will eventually enhance the living standards and opportunity sets of the country's citizens.

If Salerno Inc. desired to lock in a minimum rate at which it could sell its net receivables in Japanese yen but wanted to be able to capitalize if the yen appreciates substantially against the dollar by the time payment arrives, the most appropriate hedge would be: a. a money market hedge. b. a forward sale of yen. c. purchasing yen call options. d. purchasing yen put options. e. selling yen put options.

ANSWER: D Salerno Inc. has yen call options, which can be hedged by purchasing yen put options. Already can buy at low price (call option), want to capitalize on price rise (put option)

According to interest rate parity (IRP): a. the forward rate differs from the spot rate by a sufficient amount to offset the inflation differential between two currencies. b. the future spot rate differs from the current spot rate by a sufficient amount to offset the interest rate differential between two currencies. c. the future spot rate differs from the current spot rate by a sufficient amount to offset the inflation differential between two currencies. d. the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies.

ANSWER: D The percentage forward premium approximately equals the difference in interest rates between two countries.

The greater the variability of a currency, the ____ will be the premium of a call option on this currency, and the ____ will be the premium of a put option on this currency, other things equal.

ANSWER: the greater the premium of a call option and the greater the premium of a put option Since there is increased uncertainty caused by the volatility of the currency, those selling call and put options will want to ensure they are more protected from this risk

What are the advantages and disadvantages to call options in terms of hedging exposure to payables?

Advantage: provides an effective hedge Disadvantage: premium must be paid

What do points on the IFE line represent?

All the points along the IFE line reflect exchange rate adjustments to offset the differential in interest rates. This means investors will end up achieving the same yield (adjusted for exchange rate fluctuations) whether they invest at home or in a foreign country.

What are Forward or Futures Hedges on Payables?

Allows an MNC to lock in a specific exchange rate at which it can purchase a currency and hedge payables A forward contract is negotiated between the firm and a financial institution. The contract will specify the: currency that the firm will pay currency that the firm will receive amount of currency to be received by the firm rate at which the MNC will exchange currencies (called the forward rate) future date at which the exchange of currencies will occur

What is the difference between and American style option and a European style option?

American - can be executed at any time before the maturity date European - can only be executed at the maturity date

How can you offset a forward contract?

An MNC can offset a forward contract by negotiating with the original counterparty bank

What is purchasing power disparity? What does it look like on a graph?

Any points off of the PPP line represent purchasing power disparity. If the exchange rate does not move as PPP theory suggests, there is a disparity in the purchasing power of the two countries. Consequently, purchasing power disparity exists

How can we predict exchange rate movements using IFE? What are the two steps?

Apply the Fisher Effect to Derive Expected Inflation per Country: - The first step is to derive the expected inflation rates of the two countries based on the Fisher effect. - The Fisher effect suggests that nominal interest rates of two countries differ because of the difference in expected inflation between the two countries. Rely on PPP to Estimate the Exchange Rate Movement: -The second step of the international Fisher effect is to apply the theory of PPP to determine how the exchange rate would change in response to those expected inflation rates of the two countries.

The most direct and popular way of hedging transaction exposure is by a. exchange-traded futures options. b. currency forward contracts. c. foreign currency warrants. d. borrowing and lending in the domestic and foreign money markets.

B - currency forward contracts

A put option on British pounds has a strike (exercise) price of A$1.48. The present exchange rate is A$1.55. This put option can be referred to as: a. in the money. b. out of the money. c. at the money. d. at a discount.

B - out of the money

Why has the international money market grown?

Because firms: -May need to borrow funds to pay for imports denominated in a foreign currency -May choose to borrow in a currency in which the interest rate is lower -May choose to borrow in a currency that is expected to depreciate against their home currency.

What would you do to hedge your receivables with a money market hedge?

Borrow AUD, convert to USD, invest USD, use recievables to pay off AUD loan in 1 year

What would you do to hedge your payables with a money market hedge?

Borrow USD, convert to AUD, invest in AUD then repay your USD loan in one year

How can we hedge with currency put options?

Corporations with open positions in foreign currencies can use currency put options in some cases to cover these positions Some put options are deep out of the money, meaning that the prevailing exchange rate is high above the exercise price. These options are cheaper (have a lower premium), as they are unlikely to be exercised because their exercise price is too low Other put options have an exercise price that is currently above the prevailing exchange rate and are therefore more likely to be exercised. Consequently, these options are more expensive

What are the costs of put options when hedging recievables?

Cost of Put Options Based on Contingency Graph -provides an effective hedge -premium must be paid Cost of Put Options Based on Currency Forecasts MNC can use currency forecasts to more accurately estimate the dollar cash inflows to be received when hedging with put options

How does the system realign after covered interest arbitrage? What less obvious cost must someone using covered interest arbitrage consider?

Covered Interest Arbitrage: Realignment is focused on the forward rate. The forward rate is likely to experience most if not all of the adjustment needed to achieve realignment Accounting for spreads: Investor must account for the effects of the spread between the bid and ask quotes and of the spread between deposit and loan rates

What is the difference between a currency call option and a futures contract?

Currency call option is similar to the purchase of a futures contract but there is no obligation to exercise the currency option - the buyer pays a premium to get this option

How would you compare futures to forward contracts?

Currency futures contracts are similar to forward contracts in that they allow a customer to lock in the exchange rate at which a specific currency is purchased or sold for a specific date in the future Pricing Currency Futures: The price of currency futures will be similar to the forward rate

How would you speculate using currency futures?

Currency futures contracts are sometimes purchased by speculators attempting to capitalise on their expectation of a currency's future movement Currency futures are often sold by speculators who expect that the spot rate of a currency will be less than the rate at which they would be obligated to sell it

What are the currency options markets?

Currency options provide the right to purchase or sell currencies at specified prices Options Exchanges trading in standardised foreign currency options. - 1982 - exchanges in Amsterdam, Montreal and Philadelphia first allowed trading in standardised foreign currency options. - 2007 - CME and CBOT merged to form CME group - Exchanges are regulated by the SEC in the US Over-the-counter market Where currency options are offered by commercial banks and brokerage firms Unlike the currency options traded on an exchange, the over-the-counter market offers currency options that are tailored to the specific needs of the firm

What is international arbitrage?

Defined as capitalising on a discrepancy in quoted prices by making a riskless profit Arbitrage will cause prices to realign

What is triangular arbitrage?

Defined as currency transactions in the spot market to capitalise on discrepancies in the cross exchange rates between two currencies Gains from triangular arbitrage: Currency transactions are conducted in the spot market to capitalise on the discrepancy in the cross exchange rate between two countries Accounting for the Bid/Ask Spread: Transaction costs (bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage Realignment due to triangular arbitrage forces exchange rates back into equilibrium

What is locational arbitrage?

Defined as the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher Gains from locational arbitrage are based on the amount of money used and the size of the discrepancy Realignment due to locational arbitrage drives prices to adjust in different locations so as to eliminate discrepancies

What are main contributers to the globalisation of financial markets ?

Deregulation of Financial Markets coupled with Advances in Technology have greatly reduced information and transaction costs, which has led to: Financial Innovations, such as Currency futures and options, Multi-currency bonds, Cross-border stock listings, International mutual funds, Exchange-Traded Funds (ETFs)

Which of these are political risk? A) expropriation of assets. B) adverse change in tax rules. C) the opposition party being elected. D) both the expropriation of assets and adverse changes in tax rules are correct.

Expropriation occurs when a government confiscates a private company or asset(s) to use for the benefit of the public. E.g. A country may expropriate private oil companies to benefit the nation as a whole. This poses a risk to investors in the firm being expropriated because it typically deprives the investor of all ownership or substantially harms their return on investment. Adverse changes in tax laws will likely harm companies in that country. These are political risks because they are actions taken by a government that can hurt a company's profitability as well as its investors.

What is the forward premium?

F=S(1+p) F is the forward rate S is the spot rate p is the forward premium, or the percentage by which the forward rate exceeds the spot rate

The international Fisher effect (IFE) suggests that the currencies with relatively high interest rates will appreciate because those high rates will attract investment and increase the demand for that currency a. True b. False

FALSE Lower interest rate is better for foreign investors If there is high interest rates the currency will depreciate The IFE predicts that currencies with higher interest rates tend to depreciate and currencies with low interest rates tend to appreciate. This is based on the assumption that countries with lower interest rates will likely also face low inflation, which increases purchasing power / real value of the currency, which will subsequently attract demand and therefore appreciation in the currency.

What are the features of the Eurobond market? What is a denomination?

Features: Bearer bonds Annual coupon payments Convertible or callable Denomination: commonly denominated in a number of currencies

What is an Expanded Opportunity Set caused by international trade?

Firms can gain from greater economies of scale when their tangible and intangible assets are deployed on a global basis. True for corporations as well as individual investors.

How are currency futures traded?

Firms or individuals can execute orders for currency futures contracts by calling brokerage firms Trading platforms for currency futures: Electronic trading platforms facilitate the trading of currency futures. These platforms serve as a broker, as they execute the trades desired

What is the International Fisher Effect (IFE)?

Fisher effect suggests that the nominal interest rate contains two components - Expected inflation rate and real interest rate.

How has protectionist legislation been liberated?

General Agreement on Tariffs and Trade (GATT) is a multilateral agreement among member countries that has reduced many barriers to trade. World Trade Organization has the power to enforce the rules of international trade. On January 1, 2005, the era of quotas on imported textiles ended. This is an event of historic proportions.

How would a MNC use forward contracts?

Hedge their imports by locking in the rate at which they can obtain the currency

How do MNC's reduce their transaction exposure risk (exchange rates)?

Hedging most of the transaction exposure allows MNCs to more accurately forecast future cash flows (in their home currency) so that they can make better decisions.

What are the limitations of IFE?

IFE Theory depends on both the Fisher effect and PPP Limitation of the Fisher Effect: *The difference between the nominal interest rate and actual inflation rate is not consistent. *Thus, while the Fisher effect can effectively use nominal interest rates to estimate the market's expected inflation over a particular period, the market may be wrong. Limitation of PPP: *Other country characteristics besides inflation (income levels, government controls) can affect exchange rate movements. *Even if the expected inflation derived from the Fisher effect properly reflects the actual inflation rate over the period, relying solely on inflation to forecast the future exchange rate is subject to error.

What are the implications of IFE for non-Australian currencies?

IFE theory can be applied to any exchange rate, even exchange rates that involve two non-Australian currencies.

What is the difference between IFE theory and reality?

IFE theory contradicts how a country with a high interest rate can attract more capital flows and therefore cause the local currency's value to strengthen. IFE theory also contradicts how central banks may purposely try to raise interest rates in order to attract funds and strengthen the value of their local currencies. Whether the IFE holds in reality is dependent on the countries involved and the period assessed. IFE theory may be especially meaningful to situations in which the MNCs and large investors consider investing in countries where the prevailing interest rates are very high.

Can we test the international fisher effect?

If the actual points (one for each period) of interest rates and exchange rate changes were plotted over time on a graph, we could determine whether: -the points are systematically below the IFE line (suggesting higher returns from foreign investing), -above the line (suggesting lower returns from foreign investing), or -evenly scattered on both sides (suggesting a balance of higher returns from foreign investing in some periods and lower foreign returns in other periods). Statistical Test of the IFE Apply regression analysis to historical exchange rates and the nominal interest rate differential.

How does an efficient currency futures market prevent speculation?

If the currency futures market is efficient, the futures price should reflect all available information Thus, the continual use of a particular strategy to take positions in currency futures contracts should not lead to abnormal profits Research has found that the currency futures market may be inefficient However, the patterns are not necessarily observable until after they occur, which means that it may be difficult to consistently generate abnormal profits from speculating in currency futures

When would arbitrage be possible with forward contracts?

If the forward rate was the same as the spot rate, arbitrage would be possible

Why would/wouldn't a firm hedge long term?

If they hedge long term they can get larger savings if exchange rates skyrocket If the exchange rate isn't massively high however, they will be paying a large premium for no reason

How can we speculate with currency call options?

Individuals may speculate in the currency options based on their expectations of the future movements in a particular currency Speculators who expect that a foreign currency will appreciate can purchase call options on that security The net profit to a speculator is based on a comparison of the selling price of the currency versus the exercise price paid for the currency and the premium paid for the call option

How can we speculate with currency put options?

Individuals may speculate with currency put options based on their expectations of the future movements in a particular currency Speculators can attempt to profit from selling currency put options. The seller of such options is obligated to purchase the specified currency at the strike price from the owner who exercises the put option The net profit to a speculator is based on the exercise price at which the currency can be sold versus the purchase price of the currency and the premium paid for the put option

How can you use a forward contract for a swap transaction?

Involves a spot transaction along with a corresponding forward contract that will ultimately reverse the spot transaction

What is a money market hedging on payables?

Involves taking a money market position to cover a future payables position If a firm prefers to hedge payables without using its cash balances, then it must: Borrow funds in the home currency and Invest in the foreign currency

What happens to the spread of a longer term contract?

It increases because the risk will increase with time

What is the spread for an emerging market country like?

It is higher for countries with emerging markets because there are less forward contracts traded less frequently

What are market imperfections caused by international trade?

Legal restrictions on the movement of goods, people, and money Transactions costs Shipping costs Tax arbitrage

What are the limitations to hedging?

Limitation of Hedging an Uncertain Payment: Some international transactions involve an uncertain amount of foreign currency, leading to over-hedging. Limitation of Repeated Short-Term Hedging: The continual short-term hedging of repeated transactions may have limited effectiveness. Long-term Hedging as a Solution - Some banks offer forward contracts for up to 5 years or 10 years on some commonly traded currencies

What are the 3 types of arbitrage?

Locational arbitrage Triangular arbitrage Covered interest arbitrage.

How can a MNC estimate the cost of hedging with call options?

MNC can incorporate forecasts of the spot rate to more accurately estimate the cost of hedging with call options

What is selective hedging?

MNC must identify its degree of transaction exposure. MNC must consider the various techniques to hedge the exposure so that it can decide which hedging technique is optimal and whether to hedge its transaction exposure.

What is the international credit market?

MNCs sometimes obtain medium-term funds through term loans from local financial institutions or through the issuance of notes (medium-term debt obligations) in their local markets Loans of 1 year or longer extended by banks to MNCs or government agencies in Europe are commonly called eurocredits or eurocredit loans To avoid interest rate risk, banks commonly use floating rate loans with rates tied to the London Interbank Offer Rate (LIBOR)

How would a forward contract not be delivered?

May negotiate an offsetting trade if an MNC enters into a forward sale and a forward purchase with the same bank Non-deliverable forward contracts (NDF) can be used for emerging market currencies where no currency delivery takes place at settlement, instead one party makes a payment to the other party

How are money market interest rates globally integrated?

Money market interest rates among countries tend to be highly correlated over time. -When economic conditions weaken, the corporate need for liquidity declines, and corporations reduce the amount of short-term funds they wish to borrow. -When economic conditions strengthen, there is an increase in corporate expansion, and corporations need additional liquidity to support their expansion.

How has trade liberalisation and economic integration changed? Why might this have happened?

Over the past 50 years, international trade increased about twice as fast as world GDP. There has been a change in the attitudes of many of the world's governments, who have abandoned mercantilist views and embraced free trade as the surest route to prosperity for their citizenry. The principal argument for international trade is based on the theory of comparative advantage.

How do you hedge transaction exposure with a money market hedge?

Payables: Borrow local currency and convert to the currency denominating payables. Invest these funds until they are needed to cover the payables Receivables: Borrow the currency denominating receivables and convert to the local currency. Invest these funds then pay off the loan with cash inflows from the receivables

How do you hedge transaction exposure with a forward hedge?

Payables: Negotiate a forward contract to purchase the amount of foreign currency needed to cover the payables Receivables: Negotiate a forward contract to sell the amount of foreign currency that will be received as a result of the receivables

How do you hedge transaction exposure with a currency options hedge?

Payables: Purchase a currency call option representing the currency and amount related to the payables Receivables: Purchase a currency put option representing the currency and amount related to the receivables

How do you hedge transaction exposure with a futures hedge?

Payables: Purchase currency futures contract representing the currency and amount related to the payables Receivables: Sell a currency futures contract representing the currency and amount related to the receivables

What do points above the IFE line represent?

Points above the IFE line generally reflect returns from foreign deposits that are lower than the returns possible domestically.

What do points below the IFE line represent?

Points below the IFE line generally reflect the higher returns from investing in foreign deposits.

What would you do to hedge your payables with a forward hedge?

Purchase AUD forward

What would you do to hedge your payables with a call option hedge?

Purchase the call options with the premium, the exercise the call option if it is in the money

What would you do to hedge your receivables with a put option hedge?

Purchase the put options for the premium price then exercise if its in the money

How do firms use currency futures?

Purchasing Futures to Hedge Payables Selling Futures to Hedge Receivables Closing Out a Futures Position

How does the market realign after covered interest arbitrage?

Realignment due to covered interest arbitrage causes market realignment. Timing of realignment may require several transactions before realignment is completed Steps for realignment: 1. interest rate rises in US 2. interest rate falls in UK 3. UKP will appreciate in spot market 4. UKP will depreciate in forward market

What is the best technique for hedging payables?

Select optimal hedging technique by: -Consider whether futures or forwards are preferred -Consider desirability of money market hedge versus futures/forwards based on cost -Assess the feasibility of a currency call option based on estimated cash outflows -Choose optimal hedge versus no hedge for payables (Even when an MNC knows what its future payables will be, it may decide not to hedge in some cases) - Evaluate the hedge decision by estimating the real cost of hedging versus the cost if not hedged

What would you do to hedge your receivables with a forward hedge?

Sell AUD 1 year forward

How would you close out a futures position?

Sellers (buyers) of currency futures can close out their positions by buying (selling) identical futures contracts prior to settlement Most currency futures contracts are closed out before the settlement date

What different types of call options are available? How would a MNC decide which type of call option to use for hedging payables?

Several different types of call options may be available, with different exercise prices and premiums for a given currency and expiration date Whatever call option is perceived to be most desirable for hedging a particular payables position would be analysed, so that it could then be compared to the other hedging techniques

What is the currency futures market?

Similar to forward contracts in terms of obligation to purchase or sell currency on a specific settlement date in the future Contract Specifications: Differ from forward contracts because futures have standard contract specifications: -Standardised number of units per contract -Offer greater liquidity than forward contracts -Typically based on US dollar, but may be offered on cross-rates -Commonly traded on the Chicago Mercantile Exchange (CME)

What are the 2 tests of PPP theory? What are the results of these?

Simple test of PPP- Choose two countries (such as the United States and a foreign country) and compare the differential in their inflation rates to the percentage change in the foreign currency's value during several time periods Statistical Test of PPP -Apply regression analysis to historical exchange rates and inflation differentials Results of Statistical Tests of PPP - Deviations from PPP are not as pronounced for longer time periods, but they still exist. Thus, reliance on PPP to derive a forecast of the exchange rate is subject to significant error, even when applied to long-term forecasts

A call option on Singapore dollar has a strike (exercise) price of A$.88. The present exchange rate is A$.95. This call option can be referred to as: A. in the money. B. out of the money. C. at the money. D. at a discount.

Since strike < exchange rate the call option will be in the money we can buy the currency cheaper than the market allows

A put option on Singapore dollar has a strike (exercise) price of A$.88. The present exchange rate is A$.95. This put option can be referred to as: A. in the money. B. out of the money. C. at the money. D. at a discount.

Since strike < exchange rate the call option will be out of the money we want to sell at a higher price than the market but we can't here

A put option on Singapore dollar has a strike (exercise) price of A$.95. The present exchange rate is A$.88. This put option can be referred to as: A. in the money. B. out of the money. C. at the money. D. at a discount.

Since strike > exchange rate the call option will be in the money we want to sell at a higher price than the market and we can with our strike price

A call option on Singapore dollar has a strike (exercise) price of A$.95. The present exchange rate is A$.88. This call option can be referred to as: A. in the money. B. out of the money. C. at the money. D. at a discount.

Since strike > exchange rate the call option will be out of the money we can't buy the currency cheaper than the market allows

How would a firm decide between a money market hedge vs forward hedge?

Since the results of both hedges are known beforehand, the firm can implement the one that is more feasible

How do MNC's speculate with currency call options?

Some institutions may have a division that uses currency options to speculate on future exchange rate movements Most MNCs use currency derivatives for hedging and not speculation

What is political risk?

Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways

What affects currency call option premiums?

Spot price relative to the strike price (S - X): The higher the spot rate relative to the strike price, the higher the option price will be Length of time before expiration (T): The longer the time to expiration, the higher the option price will be Potential variability of currency (σ): The greater the variability of the currency, the higher the probability that the spot rate can rise above the strike price

What factors affect put option premiums?

Spot rate relative to the strike price (S-X): The lower the spot rate relative to the strike price, the higher the probability that the option will be exercised Length of time until expiration (T): The longer the time to expiration, the greater the put option premium Variability of the currency (σ): The greater the variability, the greater the probability that the option may be exercised

How can we use PPP to estimate Exchange Rate Effects?

The relative form of PPP can be used to estimate how an exchange rate will change in response to differential inflation rates between countries. International trade is the mechanism by which the inflation differential affects the exchange rate according to this theory. Simplified PPP relationship e_f=I_h-I_f The percentage change in the exchange rate should be approximately equal to the difference in inflation rates between the two countries

How would you Sell Futures to Hedge Receivables?

The sale of futures contracts locks in the price at which a firm can sell a currency.

What is foreign exchange risk?

This is risk that foreign currency profits may evaporate in local currency terms due to unanticipated unfavorable exchange rate movements.

What is the uncovered interest rate parity?

This is the international Fisher effect Doesn't tend to hold in real life This is an approximated covered interest rate parity

What does PPP look like graphically? How do we analyse this?

This should look like y=x Using PPP theory, we should be able to assess the potential impact of inflation on exchange rates. The points on the graph suggest that given an inflation differential between the home and the foreign country of X per cent, the foreign currency should adjust by X per cent due to that inflation differential. PPP Line: The diagonal line connecting all these points together.

How is credit risk managed in currency futures contracts?

To minimise its risk, the CME imposes margin requirements to cover fluctuations in the value of a contract, meaning that the participants must make a deposit with their respective brokerage firms when they take a position

8. Sometimes the overall performance of an MNC may already be insulated by offsetting effects between subsidiaries and it may not be necessary to hedge the position of each individual subsidiary. a. True b. False

True

T/F Since the results of both a money market hedge and a forward hedge are known beforehand, an MNC can implement the one that is more feasible.

True

How do you know if the US dollar is depreciating/appreciating based on the indirect exchange rate?

When the US dollar is depreciating (based on a downward movement of the direct exchange rate) against the Australian dollar, the indirect exchange of the US dollar rate is rising When the US dollar is appreciating against the Australian dollar (based on an upward movement of the direct exchange rate of the US dollar), the indirect exchange rate of the US dollar is declining

What is the absolute form of PPP?

Without international barriers, consumers shift their demand to wherever prices are lower. Prices of the same basket of products in two different countries should be equal when measured in common currency

What is arbitrage equilibrium with respect to covered interest arbitrage?

You can invest domestically at the Australian interest rate or invest in a foreign country at foreign interest rate and hedge the exchange rate risk 1. Exchange AUD for USD at the spot rate 2. Invest USD at US interest rate 3. Sell USD investment forward These investments will be equal at the arbitrage equilibrium

What are foreign bonds?

are issued by borrower foreign to the country where the bond is placed

Compare forward and futures in terms of: clearing operation

forward - handling contingent on individual banks and brokers, no separate clearinghouse function futures - handled by exchange clearinghouse, daily settlements to the marketplace

Compare forward and futures in terms of: liquidation

forward - most settled by actual delivery, some by offset but at a cost futures - most by offset, very few by delivery

Compare forward and futures in terms of: regulation

forward - self-regulating futures - Commodity Futures Trading Commission and National Futures Association

Compare forward and futures in terms of: transaction costs

forward - set by the spread between the banks buy and sell prices futures - negotiated brokerage fees

Compare forward and futures in terms of: delivery date

forward - tailored to individuals futures - standardised

Compare forward and futures in terms of: size

forward - tailored to individuals futures - standardised

Compare forward and futures in terms of: marketplace

forward - telecommunications network futures - central exchange floor with worldwide communications

Compare forward and futures in terms of: participants

forward -banks, brokers, MNCs, public speculation not encouraged futures - banks, brokers, MNCs, qualified public speculation encouraged

Compare forward and futures in terms of: security deposits

forward -none, compensating bank balances or lines of credit required futures - small security deposit required

How do different exchange rates affect a currency put option?

when exchange rate < strike price the call option is in the money when exchange rate = strike price the call option is at the money when exchange rate > strike price the call option is out of the money

What will a change in exchange rate do in a call option?

when exchange rate > strike price the call option is in the money when exchange rate = strike price the call option is at the money when exchange rate < strike price the call option is out of the money