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Financial management Financial management Document Transcript

  • TITLE: PRINCIPLES OF INTERNATIONAL FINANCE PART I1.0 INTRODUCTION TO INTERNATIONAL FINANCIAL MANAGEMENTWhat is International Financial Management?This is concerned with financial management in an international setting.Financial management in general terms is mainly concerned with how to optimally makevarious corporate financial decisions, such as those pertaining to:-• Investment;• Capital structures;• Dividend policy; and• Working capital management.All the above decisions are with the view to achieving a set of given corporateobjectives.We need international financial management because we are now turning in a highlyglobalize and integrated world. Continued liberalization of international trade is certainto further internationalize consumption patterns around the world. Like consumption,production of goods and services has become highly globalize. To a large extent, thishas happened as a result of multinational corporations (MNCs) …. Efforts to sourceinputs and locate production anywhere in the world where costs are lower and profitsare higher.Recently, financial markets have also become highly integrated. This developmentallows investors to diversify their portfolios internationally. In the words of a wall streetjournal article, “Over the past decade, its investors have framed buckets of money intooverseas markets, in the form of mutual funds. At the same time, Japanese investorsare investing heavily in U.S and other foreign financial markets an effort to recycleenormous trade surpluses.In addition, many major corporations of the world, such as IBM, Sony, etc, have theshares cross-listed on foreign stock exchange, thereby rendering their sharesinternationally tradable and gaining access to foreign capital as well.Undoubtedly, we are now living in a world where all the major economic functions.Consumption, production and investment are highly globalised. It is thus essential for 1
  • financial managers to fully understand vital international dimensions of financialmanagement.Dimensions about International FinanceThis deals with: “How is international finance different from domestic finance”.There are three major dimensions set for international finance a part from domesticfinance. They are:-1. Foreign exchange and political risk.2. Market imperfection.3. Expanded opportunity set.These major dimensions of international finance largely stem from the fact thatsovereign nations have the right and power to issue currencies, formulate their owneconomic policies, impose taxes and regulate movement of people, goods and capitalacross their borders.1. Foreign Exchange and Political RiskWhen firms and individuals are engaged in cross border transactions, they arepotentially exposed to “foreign exchange risk” that they would not normally encounterin purely domestic transactions.Currently, the exchange rates among such major currencies fluctuate continuously in anunpredictable manner. This has been the case since the early 1970s when fixedexchange rates were abandoned, exchange rate utility has exploded since 1973 and willhave a persuasive influence in all major economic functions, that is, consumption,production and investment.On the other hand, one of the major risks that face firms and individuals an internationalsetting is “political risk”; and this ranges from unexpected changes in tax rules tooutright expropriation of assets held by foreigners. Political risk arises from the fact thata sovereign country can change the “rules of the game” and the affected parties maynot have effective recourse.For example, in 1992, the Enron Development Corporation, a subsidiary of a Huston-based energy-based company, signed a contract to build India’s longest power plant.After Euron had spent nearly $300 million, the project was cancelled in 1995 bynationalist politicians in the Maharashtra State, who argued India did not need thepower plant. This episode illustrates the difficulty of enforcing contracts with foreigncommittees. 2
  • 2. Market ImperfectionsAlthough the world economy is much more integrated today than was the case 20 yearsago, a variety of barriers still hamper free movement of people, goods, services, andcapital across national boundaries. These barriers include legal restrictions, excessivetransaction and transportation costs, and discriminatory taxation. The world markets arethus highly imperfect. Market imperfections, which of present various functions andimpediments preventing markets from functioning perfectly, play an important role inmotivating MNCs to locate production overseas. For example, Honda, a Japaneseautomobile company, decided to establish production facilities in Ohio, Munich tocircumvent trade barriers i.e. MNCs are always referred to be a gift of marketimperfections.Imperfections in the world financial market tend to restrict the extent to which investorscan diversify their portfolio. For example, Nestle Company, a Swiss MNC, used to issuetwo different classes of common stock, bearer shares and registered shares andforeigners were allowed to hold only bearer shares. Bearer shares used to trade forabout twice the price of registered shares, which were exclusively presented for Swissresidents. This kind of price disparity is a uniquely international phenomenon that isattributable to market imperfections.3. Expanded Opportunity SetWhen firms venture into the arena of global markets, they can benefit from “anExpanded Opportunity Set”. Firms can locate production in any country or region ofthe world to maximize their performance and raise funds in any capital market wherethe cost of capital is lowest. In addition, firms can gain from greater economies of scalewhen their tangible and intangible assets are deployed on a global basis.Individual investors can also benefit greatly if they invest internationally rather thandomestically. If you diversify internationally, the resulting international portfolio mayhave a lower risk or higher return (or both) than a purely domestic portfolio.This can happen mainly because stock returns tend to carry much less across countriesthan within a given country. Once you are aware of overseas investment opportunitiesand are willing to diversify internationally, you face a much expanded opportunity setand you can benefit from it.Goals for International Financial ManagementInternational Financial Management is designed to provide today’s financial managerswith an understanding of the fundamental concepts and tools necessary to be effectiveglobal managers. International financial management is geared to the realization of thegoal of “shareholder wealth maximization”, which means that the firm makes all 3
  • business decisions and investment with an eye towards making the owners of the firm –the shareholders better off financially, or more wealthy, than they were before.GLOBALISATION OF THE WORLD ECONOMY: RECENT TRENDS(i) Key Trends of the World EconomyThe emergence of globalised financial markets. The 1990s saw the rapid integration ofinternational capital and financial markets. The impetus for globalized financial marketsinitially came from the government of major countries that began to deregulate theforeign exchange and capital markets.For example, in 1980, Japan deregulated its foreign exchange market; 1986, the BigBang occurred when the London Stock Exchange eliminated brokerage commissions,etc.Deregulated financial markets and heightened competition in financial services provideda national environment for financial innovation that resulted in the introduction of variousinstruments; e.g. currency futures and options, multi currency frauds, internationalmutual funds, country funds and foreign stock index futures and options.Communications played an active role in integrating the world financial market listingtheir shares across boarders, and this allow investors to buy and sell foreign shares asif they were domestic shares, facilitating international investments.Lastly, advances in computer and telecommunication technology contributed to theemergence of global financial markets. These technological advancements, especiallyinternet based information technologies gave the investors around the world immediateaccess to the most recent news and information affecting their investments sharplyreducing information costs. Also computerized order processing and settlementprocedures have reduced the cost of international transactions. As a result of thesetechnological developments and the liberalization of financial markets, cross boarderfinancial transactions have exploded in recent years.(ii) Advent of the EuroThis has caused a massive change in the history of the financial world system. Thecommon monetary policy for the euro zone is now formulated by the European CentralBank (ECB) that is located in Frankfurt.ECB is legally mandated to achieve price stability for the euro zone. Considering thesheer size of the euro zone in terms of population, economic output and world tradeshare and the prospect of monetary stability in Europe, the euro has a strong potential 4
  • in becoming another global currency rivaling the US dollar for dominance ininternational trade and finance. The creation of the euro area will eventually butinevitably lead to competition with the dollar area both from the stand point ofexcellence in monetary policy, and in the enlistment of other currencies. Thus the worldfaces a prospect of bifrolen international monetary system.Since its inception, the euro has already brought about revolutionary changes inEuropean finance. For example, by redenominating corporate and government bondsand stocks from 12 different currencies into the common currency, the euro haspredicated the emergence of contaminated capital markets in Europe that arecomparable to the US market in depth and liquidity. Countries from all over the worldcan benefit as they can raise capital more easily on favourable terms in Europe.In addition, the recent surge in Europe M&A activities, cross boarder alliances amongfinancial exchanges, and lessening dependence on banking sector for capital rainingare all manifestation of the profound efforts of the euro.(iii) Trade liberalization and Economic LitigationInternational trade, which has been the traditional link between national economiescontinued to expand. Currently, international trade is becoming further liberalized atboth the regional and the global levels.At the global level, the GATT, which is a multilateral agreement among membercountries has played a key role in dismantling barriers to international trade. GATTsince its formation has been successful in gradually eliminating and reducing tariffs,subsidies, quotas and other barriers to trade.On the regional level, formal arrangement among countries have been instituted topromote integration. All these have helped to ease the movement of goods and servicesacross the globe and among countries.(iv) PrivatizationThrough this, a country divest itself of the ownership and operation of a businessventure by turning it over to the free market system. The major benefit is that the sale ofstate owned businesses brings to the national treasury local currency foreign reserves.The sale proceeds are often used to pay down sovereign debts that has weighedheavily on the economy.Multinational CorporationsIn addition to international trade, foreign direct investment by MNCs is a majorpredominating force in globalization of the world economy. 5
  • A MNC is a business firm incorporated in one country that has a production and salesoperations in several countries. It involves a firm obtaining raw materials from onenational market and financial capital from another, producing goods with labour andcapital equipment in a third country and selling the finished product in yet other nationalmarkets.MNCs obtain financing from major money centres around the world in many differentcurrencies to finance their operations.Global operations force the treasurer’s office to establish international bankingrelationships, place short-term funds in several currency denominations, and effectivelymanage foreign exchange risk.MNCs may gain from their global preserve in a variety of ways:(a) MNCs can benefit from the economy of scale by: • Spreading R & D expenditures and advertising costs over their global sales. • Pooling global purchasing power over suppliers. • Utilizing their technological and managerial know how globally with minimum additional costs, etc.(b) MNC can use their global preserve to take advantage of under prices, labour services available in certain developing countries, and gain access to special R & D capabilities residing in advanced foreign countries. MNCs can indeed leverage their global presence to boost their profit margins and create shareholder value.2.0 INTERNATIONAL MONETARY SYSTEMIntroductionThis defines the overall financial environment in which multinational corporationsoperate. The international monetary system can be defined as the institutionalframework within which international payments are made, movements of capital areaccommodated, and exchange rates among currencies are determined.It is a complex whole of agreements, rules, institutions, mechanizations, and policiesregarding exchange rates, international payments, and the flow of capital.Evolution of the International Monetary SystemThe international monetary system went through several distinct stages of evolution asfollows:1. Bimetallism, Begue 1875.2. Classical Gold Standard: 1875-1914. 6
  • 3. Inter war period 1915-1944.4. BreHon Woods System: 1945-1972.5. Flexible exchange rate regime: since 1973.1. Bimetallism: Before 1875Prior to the 1870s, many countries had “bimetallism”, that is, a double standard in thatfree coverage was maintained for both gold and silver. For example, in Great Britain,bimetallism was maintained until 1816 when Parliament passed a law maintaining freecoverage of sliver.While in the USA, bimetallism was adopted by the Coverage Act of 1792 and remaineda legal standard until 1873, when congress dropped the silver dollar from the list ofcoins to be invited.However, the international monetary system before 1870s can be characterized as“bimetallism” in the sense that both gold and silver were used as international meansof payment and that the exchange rates among currencies were determined by eithergold or silver contents. For example, Ground 1870, the exchange rate between theBritish pound, which was fully on a gold standard, and the French firm, which wasofficially in a bimetallic standard, was determined by the gold content of the twocurrencies.On the other hand, the exchange rate between the pound and the mark was determinedby their exchange rates against the franc.Countries that were on the bimetallic standard often experienced the well knownphenomenon referred to as “Gresham’s Law”. Since the exchange ratio between thetwo metals was fixed officially, only the abundant metal was used as money, drivingmore scarce metal out of circulation. This is what is termed as “Gresham’s Law”,according to which “bad” (abundant) money drives out “good” (scarce) money.2. Classical Gold Standard: 1875-1914Gold has been widely praised as a store for health and a means of exchange.Christopher Columbus once said “Gold constitutes treasure and he who preserves ithas all he needs in this world”.The first full fledged “gold standard”, however, was not established until 1801 in GreatBritain, when notes from the Bank of England were made fully redeemable for gold.France was effectively on the gold standard beginning in the 1850s and finally adoptedthe standard in 1878; while the USA adopted the gold standard in 1879, Russia andJapan in 1897. 7
  • However, the majority of countries got off gold in 1914 when world war I broke out.Among the classical gold, standard system, London became the centre of internationalfinancial system, reflecting Britain’s advanced economy and its pre-eminent position ininternational trade.In international gold standard can be said to exist when, in most major countries:(i) gold alone is assured of unrestricted coinage;(ii) there is two way convertibility between gold and national currencies at a stable ratio; and(iii) gold may be freely exported or imported. In order to support unrestricted convertibility into gold, bank notes need to be backed by a gold reserve of a minimum stated ratio. In addition, the domestic money stock shall rise and full as gold flows in and out of the country.Under the gold standard, the exchange rate between two currencies were determinedby their gold content. For example, suppose that the pound is pegged to gold at sixpounds per ounce, whereas one ounce of gold is worth 12 francs. The exchange ratebetween the pound and the franc would then be two francs per pound. To the extentthat the pound and the franc remain pegged to gold at given prices, the exchange ratebetween the two currencies will remain stable.Highly stable exchange rates under the classical gold standard, provided anenvironment that was conducive to international trade and investment.Under the gold standard, misalignment of the exchange rate was automaticallyconverted by cross border flows of gold. Likewise, international imbalances of paymentwas also converted automatically. This adjustment mechanism is referred to as the“price-spew-flow mechanism”. Gold standard is still viewed to-date as an ultimatehedge against price inflation. Gold has a national scarcity and no one can increase itsquantity at will. Likewise gold is used as the sole international means of payment, thenthe countries’ balance of payments will be regulated automatically via the movements ofgold.The Gold Standard, however, has few short comings:-(i) The supply of newly minted gold is so restricted that the growth of world trade and investment can be seriously hampered for the lack of sufficient monetary reserves. The world economy can fare deflationary pressures.(ii) Whenever the government finds it politically necessary to pursue national objectives that are inconsistent with maintaining the gold standard, it can abandon the gold standard. In other words, the international gold standard per se 8
  • has no mechanism to compel each major country to abide by the rules of the game. And there were the reasons for the collapse of the system.3. The Inter war Period: 1915-1944World war I ended the classical gold standard in August 1914, as major countries suchas major countries such as Great Britain, France, Germany and Russia suspendedredemption of bank notes in gold and imposed embargoes on gold exports.After the war, many countries suffered buffer inflation. Freed from war time pegging,exchange rates among currencies were fluctuating in the early 1920s. During thisperiod, countries widely used “predatory” depreciations of their currencies are a meansof gaining advantages in the world export market.As major countries began to recover from the war and stabilize their economies, theyattempted to restrict the gold standard; and the USA spearheaded this effort. With onlymild inflation, the USA was able to lift restrictions on gold exports and return to a goldstandard in 1919. In Britain, the Chancellor of the Exchequer, played a key role inrestricting the gold stand in 1925. Other countries in Europe also restored the goldstandard by 1928.During this period, most major countries gave priority to the “sterilization of gold” byhatching inflows and outflows of gold respectively with reductions and increases indomestic money and credit. For example, the Federal Reserve of the USA, kept somegold outside the credit base by circulating it as gold certificates. The Bank of Englandalso kept the amount of available domestic credit stable by neutralizing the efforts ofgold flows. In short, countries lacked the political will to abide by the “rules of thegame” and so the automatic adjustment mechanism of the gold standard was unable towork.The Great Depression and the accompanying financial crisis also contributed to thecollapse of the gold standard. During this period, many banks, especially in Austria,Germany, and the USA, suffered sharp declines in their portfolio values, touching offruins on the banks. Against this backdrop, Britain experienced a massive outflow ofgold, which resulted from chronic balance of payment diffracts and lack of confidence inthe pound sterling; their gold reserves continued to fall to the point where it wasimpossible to maintain the gold system. In the end the British Government suspendedgold payment and let the funds float. Other countries also followed suit to abandon thegold standard. 9
  • In summary, the inter war period was characterized by economic nationalism, halfhearted attempts and failures to restore the gold standard, economic and politicalinstabilities, bank failures and panicky flights of capital across boarders.4. Brettons Woods System: 1945-1972In July 1994, representatives of 44 nations gathered at BreHon Wooods, NewHansphire, to discuss and design the postwar international monetary system.These representatives crafted and signed the Articles of Agreement of the InternationalMonetary Fund (IMF) that constituted the core of the BreHon Woods System.This agreement was then ratified to launch the IMF in 1945; that embodied an explicitset of rules about the conduct of international monetary policies and responsible forenforcing them.Delegates also created a sister institution, the International Bank for Reconstruction andDevelopment (IBRD), commonly known as the World Bank, that was chiefly responsiblefor financing individual development projects.In designing the BreHon Woods system, representatives were coached with how toprevent the reassurance of economic nationalism with destructive “beggar-thy-neighbor” policies and how to adhere the lack of then rules of the game plaguing theinter war years.The delegates desired exchange rate stability without restoring an international goldstandard. They proposed a currency pool to which member countries would makecontributions and from which they might borrow to fide themselves over during short-term balance of payment deficits.Under this system, each country established a “far value” in relation to the US dollar,which was pegged to gold at $35 per ounce. Each country was responsible formaintaining its exchange rate within -1 or +1 percent of the adopted per value by buyingor selling foreign exchange as necessary.However, a member country with a “fundamental disequilibrium” may be allowed tomake a change in the per value of its currency. Under this system, the US dollar wasthe only currency that was fully convertible to gold; other currencies were not directlyconvertible to gold.Countries held US dollar, as well as gold, for use as an international means of payment.Because of this arrangements, the BreHon Woods system was described as dollar-based “gold exchange standard”. A country on the gold-exchange standard holdsmost of its reserves in the form of currency of a country that is really on the goldstandard. 10
  • Advantages of the system are that:-(i) It economizes on gold because countries can use not only gold but also foreign exchange as international means of payment; that always offsets the deflationary effects of limited addition to the world’s monetary gold stock;(ii) Individual countries can earn interest on their foreign exchange holdings, whereas gold holdings yield no returns;(iii) Countries can save transaction costs associated with transporting gold across countries under the gold exchange system.However, in the 1970s, this system also collapsed creating a phenomenon known asthe “Triffin Paradox”. This means that under the gold exchange system, the reserve-currency country should run balance of payments deficits to supply reserves but if suchdeficits are large and persistent, they can lead to a crisis of confidence in the reservecurrency itself.The IMF then created an artificial international reserve called the SAR in 1970. TheSAR which is a basket currency comprising major individual currencies, was allotted tothe embers of the IMF, who could then use it for transactions among themselves or withthe IMF. In addition to gold and foreign exchanges, countries could use the SAR tomake international payments.(e) The Flexible Exchange Rate Regime: 1973 to PresentThis followed the demise of the BreHon Woods system, and the key elements are asfollows:(i) Flexible exchange rates were declared acceptable to the IMF members, and central banks were allowed to intervene in the exchange markets to iron out unwarranted volatilities;(ii) Gold was officially abandoned (i.e. demonetized) as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold with the proceeds to be used to help poor nations;(iii) Non-oil exporting countries and less developed countries were given greater access to IMF funds.The IMF cautioned to provide assistance to countries facing balance-of-payments andexchange rate difficulties; on the condition that these countries follow the IMF macroeconomic policy presentation. This conditionality, which often involves deflationarymacro economic policies and the elimination of various subsidy programs providedresentment among the people of developing countries receiving the IMFs balance-of-payments loans. 11
  • As can be expected, exchange rates have become substantially more volatile than theywere under the BreHon Woods System. The value of the dollar has been on as of itspeak. In lieu of this, as the dollar continued its decline, the governments of the majorindustrial counties began to worry that the dollar may fall too far.To address the problem of exchange rate volatility and other related issues, the G.7economic summit meeting was convened in Paris in 1987. The meeting produced the“Louvre Accord; according to which:• G.7 countries would cooperate to achieve greater exchange rate stability;• The G.7 countries agreed to move closely consult and coordinate their macro economic policies.The Louvre Accord marked the inception of the ‘managed flat system’ under which theG.7 countries would jointly intervene in the exchange market to correct over orundervaluation of currencies. Since this accord, exchange rates became relatively morestable for a while.(f) The current Exchange Rate ArrangementAlthough the most traded currencies of the world such as the dollar, yen, pound are theeuro may be fluctuating against each other, a significant number of the world’scurrencies are pegged to single currencies, particularly the US dollar and the euro, orbaskets of currencies such as the SAR.The IMF currently classifies exchange rate arrangements into eight special regimes.(i) Exchange arrangements with no separate legal tenderThe currency of another country circulates as the sole legal tender or the countrybelongs to monetary or currency union in which the same legal tender is shared by themembers of the union e.g. the Euro Zone.(ii) Currency board arrangementsA monetary regime based on an explicit legislative commitment to exchange domesticcurrency for a specified foreign currency at a fixed exchange rate, combined withrestrictions in the issuing authority to ensure the fulfillment of its obligations. Forexample, Hongkong fixed to the US Dollar.(iii) Other conventional fixed peg managementThe country pegs its currency(formally or defacto) at a fixed rate to a major currency ora basket of currencies where the exchange rate fluctuates within a narrow margin ofless than 1%, plus or minus, a round a central rate. For example, China, Malaysia andSaudi Arabia. 12
  • (iv) Pegged exchange rates within horizontal banksThe value of the currency is maintained within the margins of fluctuations around aformal or defacto fixed peg that are wider than at least 1%, plus or minus, around acentral rate. For example, Denmark, Egypt and Hungary.(v) Crawling pegThe currency is adjusted periodically in small amounts at a fixed, pre-announced rate orin response to changes in selective quantitative indicators e.g. Bolivia and Costa Rica.(vi) Exchange rates within Crawling banksThe currency is maintained within certain fluctuation margins around a central rate thatis adjusted periodically at a fixed pre-annoused rate or in response to changes inselective quantitative indicators. For example, Israel, Romania and Venezuela.(vii) Managed floating with no preannounced path for the exchange rateThe monetary authority influences the movement of the exchange rate through activeintervention in the foreign exchange market without specifying or pre-committing to apreannounced path for the exchange rate. For example, Algeria, Singapore andThailand.(viii) Independent floatingThe exchange rate is market determined with any foreign exchange intervention aimedat moderating the rate of change and preventing undue fluctuations in the exchangerate than at establishing a level for it. For example, Australia, Brazil, Canada, Korea,Mexico, the UK, Japan, Switzerland, and the USA.THE EUROPEAN MONETARY SYSTEMSAccording to the Savithsanian Agreement, which was signed in December, 1971, theband of exchange rate movement was expanded from the original plus or minus 1% toplus or minus 2.25%.BALANCE OF PAYMENTSThis provides detailed information concerning the demand and supply of a country’scurrency. For example, if the USA imports more than it exports, then this means that thesupply of dollars is likely to exceed the demand in the foreign exchange market, ceterisbaribus. 13
  • One would infer that the US dollar would be under pressure to depreciate against othercurrencies. On the other hand, if the USA exports more than it exports, then the dollarwould be likely to appreciate.Secondly, a country’s balance of payments data may signal its potential as a businesspartner for the rest of the world. If a country is grappling with a major balance ofpayment difficulties, it may be able to expand imports from outside world. Instead, thecountry may be tempted to impose resources to restrict imports and discourage capitaloutflows in order to improve the balance of payments situation.On the other hand, a country experiencing a significant balance of payment surpluswould be more likely to expand imports, offering marketing opportunities for foreignenterprises, and less likely to impose foreign exchange restrictions.Thirdly, balance of payments data can be used to evaluate the performance of thecountry in international economic competition. For example, if a country is experiencingtrade deficit year after year. This trade data may then signal that the country’s domesticindustries lack international competitiveness.Balance of Payments AccountingThe balance of payments can be formally defined as “the statistical record of acountry’s international transactions over a certain period of time presented in theform of double entry book-keeping”. For example, if international transactionsinclude imports and exports of goods and services and cross-boarder investments inbusinesses, bank accounts, bonds, stocks and real estates. Since the balance ofpayment is recorded over a certain period of time i.e. a quarter or a year, it has thesame time dimension as national income accounting.Generally speaking, any transaction that results in a receipt from foreigners will berecorded as a credit, with a positive sign, in the country’s balance of payments, whereasany transaction that gives rise to a payment to foreigners will be recorded as a debitwith a negative sign. Credit entries in the Government balance of payments results fromforeign sales of the Government goods and services, goodwill, financial claims, and realassets.Debit entries on the other hand, arise from Government purchases of foreign goods andservices, goodwill, financial claims, and real assets.Further, credit entries gives rise to the demand for the country’s currency, whereas debitentries gives rise to the supply of the country’s currencies. Note that the demand(supply) for the country’s currency is associated with the supply (demands) of foreignexchange. 14
  • Since the balance of payments is presented as a system of double entry bookkeeping,every credit in the account is balanced by matching debt and vice versa.Example I: Suppose that Boeing Corporation exported a Boeing 747 aircraft to JapanAirlines for $50 million, and that Japan Airlines pays from its dollar account kept withChase Mashattan Bank in New York City. Then the receipt of $50 million by Boeing willbe recorded as a credit (+), which will be matched by a debit (-) of the same amountrepresenting a reduction of the US bank’s liabilities.Example II: Suppose that Boeing imports jet engines produced by Rolls-Royce for $30million, and that Boeing makes payment by transferring the funds to a New York bankaccount kept by Rolls-Royce. In this case, payment by Boeing will be recorded as adebit (-) whereas the deposit of the funds by Rolls-Royce will be recorded as a credit(+).As shown by the preceding examples, every credit in the balance of payments ismatched by a debit somewhere to conform to the principle of double-entry bookkeeping.Not only international trade, that is, exports and imports, but also cross boarderinvestments are recorded in the balance of payments.Example III: Suppose that Ford acquires Jaguar a British car manufacturer, for $750million and that Jaguar deposits the money in Barclays Bank in London, which in turnuses the sum to purchase US treasury notes. In this case, the payment of $750 millionby Ford will be recorded as a debit (-), whereas Barclay’s purchase of the US treasurynotes will be recorded as a credit (+).The above samples, therefore, can be summarized as follows:Transactions Credit DebitBoeing’s export +$50 millionWithdrawal from US Bank -$50 millionBoeing’s import -$30 millionDeposits at US bank +30 millionFord’s acquisition of Jaguar -$750 millionBarclay’s purchase of US securitiesBalance of Payments AccountsSince the balance of payments records all types of international transactions, a countryconsummates over a certain period of time, it contains a wide variety of accounts.However, a country’s international transactions can be grouped into the following threemain types:-(i) The current account.(ii) The capital account. 15
  • (iii) The official reserve account.(i) The Current AccountThis includes the export and imports of goods and services. It is defined as exportsminus imports plus unilateral transfer that is (1) + (2) + (3) in the exhibit below, wasnegative -$444.69 billion. The US thus had a balance of payments deficit on the currentaccount in 2000. The current account deficit implies that the USA used more outputthan it produced. Since a country must finance its current account deficit either byborrowing from foreigners or drawing down on its previously accumulative foreignwealth, a current account deficit represents a reduction in the country’s net foreignwealth.On the other hand, a country with a current account surplus acquires 104 fromforeigners, there by increasing its net foreign wealth.The current account is divided into four categories:-• Merchandise trade.• Services.• Factor income.• Unilateral transfers.A summary of the US Balance of Payments for 2000 (in $ billion) Credits DebitsCurrent Account1. Exports 1,418.64 1.1 Merchandise 774.86 1.2 Services 290.88 1.3 Factor income 352.902 Imports -1809.18 1.1 Merchandise -1204.42 1.2 Services -217.07 1.3 Factor income -367.683. Unilateral transfer 10.24 -64.39 Balance on current account -444.69 (1)+(2)+(3)Capital Account4. Direct investment 287.68 -152.445. Portfolio investment 474.59 -124.94 5.1 Equity Securities 193.85 -99.74 5.2 Debt Securities 280.74 -25.706. Other investments 262.64 -303.27 Balance on capital account 444.26 (4)+(5)+(6) 16
  • 7. Statistical discrepancies 0.73 Overall balance 0.30 Official Reserve Account -30The current account balance, especially trade balance, tends to be sensitive toexchange rate charges when a country’s currency depreciates against the currencies ofmajor trading partners, the country’s exports and to rise and imports fall, improving thetrade balance.The effect of currency depreciation on a country’s trade balance can be morecomplicated than the case described above. Indeed, following a depreciation, the tradebalance may at first deteriorate for a while. Eventually, however, the trade balance willtend to improve over time. This particular reaction pattern of the trade balance to adepreciation is referred to as J – Curve effect.A depreciation will begin to improve the trade balance immediately if imports andexports are responsive to the exchange rate changes. On the other hand, if imports andexports are inelastic, the trade balance will worsen following a depreciation. Following adepreciation of the domestic currency and the resultant rise in import prices, domesticresidents may still continue to purchase imports because it is difficult to change theirconsumption habits in a short period of time. Even if domestic residents are willing toswitch to less expensive domestic substitutes for foreign imports, it may take time fordomestic producers to supply import substitutes. Likewise, foreigners demand fordomestic products, which become less expensive with a depreciation of the domesticcurrency, can be inelastic essentially for the same reasons. In the long run, however,both imports and exports tend to be responsive to exchange rate changes, exertingpositive influences in the trade balance.(ii) The Capital Account 17
  • The capital account balance measures the effectiveness between the Government’ssales of assets to foreigners and the Government’s purchase of foreign assets.Government sales or exports of assets are recorded as credits, as they result in capitalinflow. On the other hand, the country’s purchases (imports) of foreign assets arerecorded as debits, as they lead to capital outflow.Unlike trades in goods and services, trade in financial assets affect future payments andreceipt of factor income.As the previous exhibit shows, the US had a capital account surplus of $444.26 billion in2000, implying that the capital inflow to the USA far extended capital outflow.Clearly, the current account deficit was almost entirely offset by the capital accountsurplus. A country’s current account deficit must be paid for either by borrowing fromforeigners or selling off post foreign investments.In the absence of the government’s reserve transactions, the current account balancemust equal to the capital account balance but with the opposite sign. When nothing isexcluded, a country’s balance of payments must balance.The capital account can be divided into three categories:• Direct investment;• Portfolio investments; and• Other investments.Direct investment occurs when the investor acquires a measure of control of the foreignbusiness. In the US balance of payments, acquisition of 10% or more of the votingshares of a business is considered giving a measure of control to the investor.Portfolio investments mostly represents sale and purchases of foreign financial assetssuch as stock and bonds that do not involve a transfer of control international portfolioinvestments have booked due to the relaxation of capital controls and regulations inmany countries, and partly due to investors’ desires to diversify risks globally. Portfolioinvestments comprises equity securities and debt securities that include corporateshares, bonds and notes respectively, and money market instruments and financialderivatives like options.Other investments include transactions in currency bank deposits, trade credits, etc.these investments are quite sensitive to both changes in relative interest rates betweencountries and the anticipated change in exchange rate.(iii) Statistical Discrepancy 18
  • Imperfections arising out of recording, where certain invisible services are likely notgoing to be captured and always escape detention, e.g. cross boarder financialtransactions conducted electronically as well as consulting.(iv) Official Reserve AccountWhen a country must make payment to foreigners because of a balance of paymentsdeposit, the central bank of the country should either run down its official reserveassets, such as gold, foreign exchanges and SARs, or borrow a new from foreigncentral banks.On the other hand, if a country has a balance of payments surplus its central bank willeither retire some of its foreign debts or acquire additional reserve assets fromforeigners.The official reserve account includes transactions undertaken by authorities to financethe overall balance and intervene in foreign exchange markets.International reserve assets comprise:-• Gold.• Foreign exchange.• Special drawing rights (SARs).• Reserve positions in the IMF.The Balance of Payments IdentityWhen the balance of payments accounts are recorded correctly, the combined balanceof the current account, the capital account, and the reserve account must be zero, thatis,BCA + BKA + BRA = 0Where; BCA = balance on the current account. BKA = balance on the capital account. BRA = balance on the reserve account.Hence, the balance on the reserve account, BRA represent the change in the officialreserves. BOP indicates that a country can run a balance of payments surplus ordeficits by increasing or decreasing its official reserves. Under the fixed exchange rateregime, countries maintain official reserves that allow them to have a balance ofpayments disequilibrium, that is, BCA + BKA is non zero, without adjusting theexchange rate. Under this exchange rate playing, the combined balance on the currentand capital accounts will be equal in size, but opposite in sign, to the change in theofficial reserves.BCA + BKA = -BRA 19
  • For example, if a country runs a deficit on the overall balance that is, BCA + BKA isnegative, the Central Bank of the country can supply foreign exchange out of its reserveholdings. But if the deficit persists, the central bank will eventually run out of its reserve,and the country may be forced to devalue its currency.Under the pure flexible exchange rate regime, the Central Bank will not intervene in theforeign exchange market. In fact, Central Banks do not need to maintain officialreserves than this regime, the overall balance this must necessarily balance, that is,BCA = -BKA. In other words, a current account surplus or deficit or surplus and vice-versa.In a duty float, the exchange rate system under which the central bank discreetly buyand sale foreign exchange.Functions and Structure of the Forex MarketThe structure of the foreign exchange market is an outgrowth of one of the primaryfunctions of commercial banker to assist clients in the conduct of internationalcommerce. For example, a corporate client desiring to import merchandize from abroadwould need a source for foreign exchange if the import was invoiced and received in theimporter’s home currency. Assisting in foreign exchange transactions of this type is oneof the services that commercial banks provide for their clients, and one of the servicesthat bank customers expect from their bank.The spot and forward foreign exchange market is an “over-the-counter (OTC) market”;that is, trading does not take place in a central place of the market where buyers andsellers congregate; Rather, the foreign exchange market is a world wide linkage of bankcurrency traders, non dealers, and FX bookers who assist in trades connected to oneanother via a network of telephones telex machines, computer terminals, andautomated dealing systems.The communications systems of the foreign exchange market is highly modern,including industry, governments, the military and national security and intelligenceoperations.Twenty-for-how-a-day among trading follows the sum around the globe. And threemajor market segments are Australia, Europe and North America. Most trading normsoperate over a 9 to 12 hour working days although some banks have experimented withoperating three eight-hour shift in order to trade around the clock.The FX Market ParticipantsThe market for foreign exchange can be viewed as a two tier market. One tier is the“wholesale” or “retail or client market”. FX market participants can be categorized intofive groups:- 20
  • • International banks;• Bank customers;• Non-bank dealers; and• Central banks.International banks provide the core of the FX market and actively “make a market” inforeign exchange, that is, they stand willing to buy or sell foreign currency for their ownaccount. These international banks service their retail clients, the bank customers, inconducting foreign commerce or making international investments in financial assetsthat require foreign exchange. Bank customers include, MNCs, money managers, andprivate speculators.Non-bank dealers are large non-bank financial institutions such as investment banks,while size and frequency of trades make it cost effective to establish their own dealingnorms to trade directly in the interbank market for their foreign exchange needs.Part of the interbank trading among international banks involve adjusting the inventorypositions they hold in various foreign currencies. However, most interbank trades arespeculative or arbitrage transactions, where market participants attempt to correctlyjudge the future direction of price movement in one currency versus another or attemptto profit from temporary price discrepancies in currencies between competing dealers.Market psychology is a key ingredient in currency today and a dealer can often inferanother’s trading intention from the currency position being accumulated.FX brokers match dealer orders to buy and sell currencies for a fee, but do not take aposition themselves. Brokers have knowledge of the quotes of many dealers in themarket. Consequently, interbank traders will use a broker primarily to disseminate asquickly as possible a currency quote to many other dealers. However, in recent years,since the introduction and increased usage of electronic dealing systems, the use ofbrokers has declined because the computerized systems duplicate many of the sameservices at much lower fees.Central banks of particular countries always intervene in the foreign exchange market inan attempt to influence the price of its currency against that of major trading partner, ora security that it “fixes” or “pegs” its currency against. Intervention is the process ofusing foreign currency reserves to buy one’s own curry in order to decrease its supplyand thus increase its value in the foreign exchange market, or alternatively, sellingone’s own currency for foreign currency in order to increase its supply and lower itsprice. However, intervention that successfully increases the value of one’s currencyagainst a trading partner may reduce exports and increase imports, thus alleviatingpersistent trade deficits of the trading partner likewise central bank intervention incurrency markets lose bank reserves attempting to accomplish their goals.Correspondent Banking Relationships 21
  • The interbank market is a network of correspondent banking relationships, with largecommercial banks maintaining demand deposit accounts with one another calledcorrespondent banking accounts. The correspondents bank accounts network allows forthe efficient functioning of the foreign exchange market.The Society for World wide Interbank Financial Telecommunications (SWIFT) allowsinternational commercial banks to communicate instructions to one another. SWIFT is aprivate non-profit message transfer system, headquarters in Brussels, withintercontinental switching centres in the Netherlands and Virginia.The Clearing House Ltd (ECHO), the first global clearing house for settling interbankFOREX transactions, allows multilateral netting system that on each settlement datenetted a client’s payments and receipts in each currency, regardless of whether they aredue to or from multiple counter parties. Multilateral netting eliminates the risk andinefficiency of individual settlement.The Spot MarketThis involves almost the immediate purchase or sale of foreign exchange. Typicallycash settlement is made two business days (excluding holidays of either the buyer orthe seller) after the transactions of trades between the US dollar and non-NorthAmerican currency for example.(a) Spot Rate QuotationsSpot rate currency quotations can be stated in direct or indirect terms. Direct quotationsis the price of one unit of the foreign currency priced in US dollars. Indirect quotations isthe price of the US dollar in the foreign currency.It is common practice among currency trades world wide to both price and tradecurrencies against the US dollar.Most currencies in the interbank market are quoted in “European terms”, i.e. the USdollar is priced in terms of the foreign currency (an indirect quote from the US,perspective). By convention, it is standard practice to price certain currencies in terms ofthe US dollar or in what is referred to as “American terms”. (a direct quote from the USperspective).In general, S(j/k) refers to the price of one unit of currency K in terms of currency j. itshould thus be intuitive that the American and European term quotes are reciprocals ofone another; i.e.S($/£) = 1/S(£/$)1.5272 = 1/.6548 22
  • andS(£/$) = 1/S($/£).6548 = 1/1.5272(b) The Bid-Ash SpreadInterbank FX traders buy currency for inventory at the “bid price” and sell from theinventory at the higher “offer” or “ask price”.The recognition of the bid-ask spread implies:S($/£a) = 1/$(£/$b)(c) Spot FX TradingMost currencies quotations are carried out to four decimal places in both American andEuropean terms. However, for some currencies e.g. the Japanese yen, SlovalcianKoruna, South Korean wou), quotations in European terms are carried out only to two orthree decimal places, but in American terms the quotations may be carried out to asmany as eight decimals.The establishment of the bid-ask spread always facilitate acquiring or disposing ofinventions. For example, a trader believing the pound will soon appreciate substantiallyagainst the dollar will desire to acquire a larger inventory of British pounds. The retailbid-ask spread is wider than the interbank spread; i.e. lower bid and higher ask pricesapply to the smaller sums traded at the retail level. This is necessary to cover the fixedcosts of a transaction that exists regardless of which tier the trade is made in.Interbank trading rooms are typically organized with individual traders dealing in aparticular currency. The dealing rooms of large banks are set up with traders dealingagainst the US dollars in all the major currencies: the Japanese yen, euro, Canadiandollar, Swiss Franc and British pound plus the local currency if it is not one of themajors.Individual banks may also specialize by making a market in regional currencies or in thecurrencies of less developed countries, again all versus the US dollar. Additionally,banks will normally have a cross rate desk where trades between two currencies notinvolving the US dollar are handled. In smaller European Banks accustomed to moreregional tradings, dealers will frequently quote and trade versus the euro.(d) Cross-Exchange Rate QuotationsCross-exchange rate is an exchange rate between a currency pair where neithercurrency as the US dollar. The cross-exchange rate can be calculated from the US 23
  • dollar exchange rates for the two currencies, using either European or American termquotation. For example, є/£ cross rate can be calculated from American term quotationsas follows:-S(ŧ/£) = S($/£)/S($/ŧ)(e) Triangular ArbitrageCertain banks specialize in making direct market between non-dollar currencies, pricingat a narrower bid-ask spread than the cross rate spread. If their direct quotes are notconsistent with cross-exchange rates, a triangular arbitrage profit is possible. Triangulararbitrage is the process of trading out of the US dollar into a second currency thentrading it for a third currency, which is in turn traded for US dollars.The purpose is to earn an arbitrage profit via trading from the second to the thirdcurrency when the direct exchange rate between the two is not in alignment with thecross-exchange rate.The Forward MarketThis involves contracting today for the future purchase or sale of foreign exchange. Theforward price may be the same as the spot price, but usually it is higher (at a premiumor lower (at a discount) then spot price. Forward exchange rates are quoted on mostmajor currencies for a variety of maturities. Bank quotes for maturities of 1, 3, 6, 9 & 12months are readily available. Maturities extending beyond one yen are being morefrequent and for good bank customers a maturity extending out to 5, and even as longas 10 years is possible.(a) Forward Rate QuotationsForward quotes are either direct or indirect, one being the reciprocal of the other. Forexample, European term forward quotations are the reciprocals of the American termquotes. One can buy (take a long position) or sell (take a short position) foreignexchange forward. Bank customers can contract with their international bank to buy orsell a specific sum of FX for delivering on a certain date. Likewise, interbank traders canestablish a long or short position by dealing with a trader from a competing bank.Forward contracts can also be used for speculative purpose. If one uses the forwardcontract, he has “locked in” the forward price for forward purchase or sale of foreignexchange.(b) Forward Cross Exchange RatesThese quotations are calculated in an analogous manner to spot cross rates. In generalterms, 24
  • FN(j/k) = FN($/k)/FN($/j)orFN(j/k) = FN(j/$)/FN(k/$)andFN(k/j) = FN($/j)/FN($/k)orFN(k/j) = FN(k/$)/FN(j/$)(c) Swap TransactionsForward traders can be classified as outright or swap transactions. In conducting theirtrading, bank dealers do take speculative position in the currencies they trade but moreoften traders offset the currency exposure inherent in the trade.Swap transactions provide a means for the bank to mitigate the currency exposure in aforward trade.A swap transaction as the simultaneous sale or purchase of spot foreign exchangeagainst a forward purchase or sale of approximately an equal amount of the foreigncurrency. Because interbank forward transactions are most frequently made as part of aswap transaction, bank dealers in conversation among themselves use a shorthandnotation to quote bid and ask forward prices in terms of forward points that are eitheradded or subtracted from the spot bid and ask quotations.(d) Forward PremiumsThe forward premium or discount is useful for comparing against the interest ratedifferentials between two countries.The forward premium or discount can be expressed in American or European terms, itwill be at a discount (premium) in European terms. The formula for calculating theforward premium or discount in American terms for currency j is:ƒNjv$ = FN($/j) – S($/j)/S($/j) x 360 daysFor example, ƒ3v$ = .008471 - .008433 x 360 = 0.176 .008433 92 25
  • We see that the three months forward premium is 0.176 or 1.76 percent. In other words,we see that the Japanese yen is trading versus the US dollar is trading versus the yenat a 1.75 percent discounts for delivery in 92 days.INTERNATIONAL PARITY RELATIONSHIPS AND FORECASTING FOREIGNEXCHANGE RATESThese are the manifestations of the lieu of one price that must hold in arbitrageequilibriums. An understanding of these parity relationships provides insights into:1. how foreign exchange rates are determined;2. how to forecast foreign exchange rates.Arbitrage can be defined as the act of simultaneously buying and selling the same orequivalent assets or commodities for the purpose of making certain guaranteed profits.As long as there are profitable arbitrage opportunities, the market cannot be inequilibrium when no profitable opportunities exist. Such well known parity relationshipsas interest rate parity and purchasing power parity, in fact, present arbitrage equilibriumconditions.Interest Rate ParityIRP is an arbitrage condition that must hold when international financial markets are inequilibrium.IRP is a manifestation of the law of one price (LOP) applied to international moneymarket instruments.IRP can as well be derived by constructing an arbitrage portfolio, which involves:-(a) not net investment, as well as(b) no risk, and then requiring that such a portfolio should not generate any net cash flow in equilibrium.Consider an arbitrage portfolio consisting of three separate positions:-1. Borrowing $S in the US, which is just enough to buy £1 at the prevailing spot exchange rate (S);2. Lending £1 in the UK at the UK interest rate.3. Selling the maturity value of UK investment forward.Exhibit below summarizes the present and future (maturity date) cash flows, CFO andCFI, from investing in the arbitrage portfolio. Transactions CF0 CF1 26
  • 1. Borrow in the US $S -S(1+i$)2. Lead in the UK -$S S1(1+i£)3. Sell the £ receivable forward 0 (1+i£)(F-S1) Nit cash flow 0 (1+i£)F, (1+i$)STwo things are worth noting in the above exhibit.(i) the net cash flow at the time of investment is zero, which implies that eh arbitrage portfolio is indeed fully self financing; it does not cost any money to hold this portfolio;(ii) the net cash flow on the maturity date is known with certainty because non of the variables involved in the net cash flow, that is, S, F, 2$ and 2£ is uncertain. Since no one should be able to make certain profits by holding this arbitrage portfolio. Market equilibrium requires that the net cash flow on the maturity date be zero for this portfolio: (1+i£)F-(1+i$)S = 0The IRP relationship is often approximated as follows:-(i$-i£) = (F-S)/SAs can be seen from this equation, IRP provides a linkage between interest rates in twodifferent countries. Specifically, the interest rate will be higher in the US than in the UKwhen the dollar is at a forward discount i.e. F75. This implies that, the dollar is expectedto depreciate against the pound. If so, the US interest rate to compensate for theexpected depreciation of the dollar. Otherwise, nobody would hold dollar denominatedsecurities.On the other hand, the US interest rate will be lower than the UK interest rate when thedollar is at a forward premium, that is, FLS.Equation above also indicates that the forward exchange rate will deviate from the spotrate as long as the interest rates of the two countries are not the same.When IRP holds, you will be indifferent between investing your money in the US andinvesting in the UK with forward hedging. However, if IRP is violated, you will major oneto another. When IRP does not hold, the situation also gives rise to “covered interest”arbitrage opportunities, as illustrated in the example below:Example 2: Suppose that the annual interest rate is 5 percent in the USA and 8 percentin the UK and that the spot exchange rate is $1.50/£ and the forward exchange rate,with one year maturity is $1.48/£. In terms of our notation, i$ = 5%, i£ = 8%, S = $1.50and F = $1.48. 27
  • Assume that the arbitrager can borrow up to $1,000,000 on £666,667, which isequivalent to $1,000,000 at the current spot exchange rate. Let me first check if IRP isholding under current market conditions. Subtracting the given data we find,(F/S)(1+i£) = (1.48/1.50)(1.08) = 1.0656which is not exactly equal to (1+2$) = 1.05. Specifically, we find that the current marketcondition is characterized by:(1+i$)<(F/S)(1+i£)Clearly, IRP is not holding, implying that arbitrage opportunity exists since the interestrate is lower in the US, an arbitrage transaction should involve borrowing in the USAand lending in the UK.The arbitrager can carry out the following transactions:-1. In the USA, borrow $1,000,000. Repayment in one year will be $1,050,000 = $1,000,000 x 1.05.2. Buy £666,667 spot using $1,000,000.3. Invest £666,667 in the UK. The maturity value will be £720,000 = £666,667 x 1.08.4. Sell £720,000 forward in exchange for $1,065,600 = (£720,000)($1.48/£).Hence, in one year when everything matures, the arbitrager will receive the full maturityvalue of his UK investment, that is, £720,000. The arbitrager then will deliver this poundamount to the counterparty if the forward contract and receive $1,065,600 in return. Outof this dollar amount, the maturity value of the dollar loan, $1,050,000 will be paid. Thearbitrager still has $15,000 ($1,065,600-$1,050,000) left in his account, which is hisarbitrage profit.In making this certain profit, the arbitrager neither invested any money out of his pocketnor bore any risk. He indeed carried out “lowered interest arbitrage”, which meansthat he borrowed at one interest rate and simultaneously lent at another interest rate,with exchange risk fully covered via forward hedging.The exhibit below provides a summary of C/A transactions Transaction CF0 CF11. Borrow $1,000,000 $1,000,000 -$1,050,0002. Buy spot -$1,000,000 £666,6673. Land £666,667 -£666,667 £720,000 28
  • 4. Sell 720,000 forward -£720,000 $1,065,000 Net cash flow 0 $15,000This arbitrage opportunity will last only for a short while. As soon as deviations from IRPare detected, informed traders will immediately carry out C/A transactions. As a result ofthese arbitrage activities IRP will be resolved quite quickly.Interest Rate Parity and Exchange Rate DeterminationBeing an arbitrage equilibrium condition involving the (spot) exchange rate, IRP has animmediate implication for exchange rate determination.S = {1+i£/1+i$}FThis indicates that given the forward exchange rate, the spot exchange rate depends onrelative interest rates. All else equal, an increase in US interest rate will lead to a higherforeign exchange value of the dollar. This is so because a higher US interest rate willattract capital to the US, increasing the demand for dollar. In contrast, a decrease in theUS interest rate will lower the foreign exchange value of the dollar.In addition to relative interest rates, the forward exchange rate is an important factor inspot exchange rate determination. Under certain conditions the forward exchange ratecan be viewed as the expected future spot exchange rate conditional on all relevantinformation being available now, that is,F = E(St+1/1t)Where st+1 is the future spot rate when the forward contract matures, and 1t denotesthe set of information currently achievable. Two things are important to note:-(i) Expectations plays a key role in exchange rate determination; the expected future exchange rate is shown to be a major determinant of the current exchange rate; when people expect the exchange rate to go up in the future, it goes up now. People’s expectations thus become self-fulfilling.(ii) The exchange rate behavior will be driven by news events. People from their expectation based on the set of information (1t) they possess. As they receive news continuously, they are going to update their expectations continuously. As a result, the exchange rate will tend to exhibit a dynamic and volatile short-term behavior, responding to various news events, which are unpredictable, making forecasting future exchange rate an arduous task.Reasons for deviation from IRP are:-(a) Transaction costs. 29
  • (b) Capital controls imposed by governments, etc.Purchasing Power ParityWhen the law of one price is applied internationally to a standard basket of commoditiesobtain the theory of “Purchasing Power Parity” (PPP). This theory states that theexchange rate between currencies of two countries equal to the ratio of the countries’price levels.Formally, PPP states that the exchange rate between the dollar and the pound shouldbe:S=P$/PtWhere S is the dollar price of one pound. PPP implies that if the standard commoditybasket costs $225 in the US, and £150 in the UK, then the exchange rate should be$1.50 per pound: $1.50/£ = $225/£150.If the price of the commodity basket is higher in the US, say $300, then PPP indicatesthat the exchange rate should be higher, i.e. $2000/£. PPP1 is written as follows: P$ = S x P£This equation states that the dollar price of the commodity basket in the USA, P$ mustbe the same as the dollar price of the basket in the UK, that is, P£ multiplied by S. inother words, PPP requires that the price of the standard commodity basket be the sameacross countries when measured in a common currency. PPP is a way of defining theequilibrium exchange rate.PPP has important implications for international trade. If PPP holds and thus thedifferential inflation rates between countries are exactly offset by exchange ratechanges, countries’ competitive positions in world export market will not besystematically affected by exchange rate changes. However, if there are deviations fromPPP1 charges in nominal exchange rate cause changes in the “real exchange rates”,affecting the international competitive positions of countries. This in turn, would affectcountries’ trade balances.The real exchange rate, q, which measures deviation from PPP1 can be defined asfollows:-Q = 1+ /(1+e)(1+ ) 30
  • If PPP holds, i.e. (1+e) = (1+ )/(+ the real exchange rate will be unity, q=1. WhenPPP is violated, however, the real exchange rate will deviate from unity.Suppose for example, the annual inflation rate is 5 percent in the US and 3.5 percent inthe UK, and the dollar depreciated against the pound by 4.5 percent. Then the realexchange rate is .97.Q = (1.05)/(1.045)(1.035) = .97In the above example, the dollar depreciated by more than warranted by PPP1strengthening the competitiveness of US industries in the world market. If the dollardepreciates by less than the inflation rate differential, the real exchange rate will begreater than unity, weakening the competitiveness of US industries. To summarize:-q=1 : competitiveness of the domestic country unaltered.q<1 : competitiveness of the domestic country improves.q>1 : competitiveness of the domestic country deteriorates.Fisher EffectsThis holds that an increase (decrease) in the expected inflation rate in a country willcause a proportionate increase (decrease) in the interest rate in the country.Formally the Fisher effect can be written for the US as follows:-i$=p$+E( ≅ +E(Where p$ denotes the equilibrium expected “real” interest rates in the US.The fisher effect implies that expected inflation rate is the difference between thenominal and real interest rates in each country, that is,E( = (i$-p$)/(1+p$) ≅ i$-p$E( =(i£-p£)/(1+p£) ≅ i£-p£The International Fisher Effect (IFE) suggests that the nominal interest rate differentialreflects the expected change in exchange rate. For example, if the interest rate is 5 31
  • percent per year in the USA and 7 percent in the UK, the dollar is expected toappreciate against the British pound by about 2 percent per year.Lastly, when the International Fisher Effect is combined with IRP, that is,(F-S)/S=(i$-i£)/(1+i£), we obtain:(F-S)/S=E(e),which is referred to as Forward Expectation Parity (PEP), which states that any forwardpremium a discount is equal to the expected change in the exchange rate.When investors are risk neutral, forward party will hold as long as the foreign exchangemarket is informationally efficient. Otherwise, it need not hold even if the market isefficient.Forecasting Exchange RatesSince the advent of the flexible exchange rate system in 1973, exchange rates havebecome increasingly more volatile and erratic. At the same time, the scope of businessactivities has become highly international. Consequently, many business decisions arenow made based on forecasts, implicit or explicit, of future exchange rates.Forecasting exchange rate as accurately as possible is a matter of vital importance forcurrency traders who are actively engaged in speculating, hedging, and arbitrage in theforeign exchange markets.It is also a vital concern for MNCs that are formulating international sourcing,production, financing and marketing strategies. The quality of these corporate decisionswill critically depend on the accuracy of exchange rate forecasts.Some corporations generate their own forecasts while others subscribe to outsideservices for a fee. Forecasters use the following approaches:-(i) Efficient market approach(ii) Fundamental approach(iii) Technical approach(i) Efficient Market ApproachFinancial markets are said to be efficient if the current asset prices reflect fully all theavailable and relevant information.Suppose that foreign exchange markets are efficient. This means that the currentexchange rate has already reflected all relevant information, such as money supplies,inflation rates, trade balances and output growth. The exchange rate will then changeonly when the market receives new information. Since news by definition isunpredictable, the exchange rate will change randomly over time. In a word, incremental 32
  • changes in the exchange rate will be independent of the past history of the exchangerate.If the exchange rate indeed follows a random walk, the future exchange rate isexpected to be the same as the current exchange rate, that is,St = E(St+1)In a sense the “random walk hypothesis” suggests that today’s exchange rate is thebest predictor of tomorrow’s exchange rate.Hence, predicting the exchange rates using the efficient market approach has toadvantages:-(a) since the efficient market approach is based on market determined process, it is costless to generate forecasts. Both the current spot and forward exchange rates are public information. As such, everyone has free access to it.(b) Given the efficiency of foreign exchange markets, it is difficult to out perform the market-based forecasts unless the forecaster has access to private information that is not yet reflected in the current exchange rate.(ii) Fundamental ApproachThis approach uses various models e.g. the monetary approach to exchange ratedetermination suggests that the exchange rate is determined by three independent(explanatory) variables:-• relative money supplies;• relative velocity of monies;• relative national outputs.Money approach is computed as below:- 1 (m-m*)+β2)v-v*)+β3(y*-y)+ųWhere;S = National logarithm of the spot exchange rate.m-m* = National logarithm of domestic/foreign money supply.v-v* = National logarithm of drastic/foreign velocity of money.y*-y = National logarithm of foreign/domestic output.ų = Random term error with mean zero. 33
  • = Model parameters.Generating forecasts using the fundamental approach involves three steps:1. Estimation of the structural model to determine the numerical values of the parameters such as and βs.2. Estimation of future values of the independent variables like (m-m*)(v-v*), and (y*-y).3. Substituting the estimated values of the independent variables into the estimated structural model to generate the exchange rate forecasts.(iii) Technical ApproachThis approach first analyses the past behavior of exchange rates for the purpose ofidentifying “patterns” and their projects then into the future to generate forecasts.This approach is based on the premise that history repeats itself. It sometimesconsiders various transactions data like trading volume, outstanding interests, and bid-ask spreads to aid them analyses.Many technical analysts or chartists compute moving averages as a way of separatingshort and long term trends from the vicissitudes of daily exchange rates.Many traders depend on technical analysis for their trading strategies. If a trader knowsthat other traders use technical analysis, it can be rational for the trader to use technicalanalysis, the predictions based on it can become self-fulfilling to some extent, at least inthe short run.Performance of ForecastersBecause predicting exchange rates is difficult, many firms and investors subscribe toprofessional forecasting services for a fee.In evaluating performance, forecasters compute the following ratio especially for banks: R = MSF(B)/MSF(S)Where; MSE(B) = mean square forecast error of a bank; MSE(S) = mean square forecast error of the spot change rate. 34
  • If a bank provides more accurate forecasts rather than the spot exchange rate, that is,MSE(B)<MSE(S), the ratio R will be less than unity, i.e. R<1.PART TWO: WORLD FINANCIIAL MARKET AND INSTITUTIONS6.0 INTERNATIONAL BANKING AND MONEY MARKETInternational banks can be categorized by the types of services they provide thatdistinguish them from domestic banks.International banks facilitate the imports and exports of their clients by arranging tradefinancing. They also serve their clients by arranging for foreign exchange necessary toconduct cross border transactions and make foreign investments.In conducting foreign exchange transactions, banks often assist their clients in hedgingexchange rate risks in foreign currency receivables and payables through forward andoptions contacts.Some international banks have the facilities to trade foreign exchange, they generallyalso trade foreign exchange presents for their own account.Large international banks borrow and lend in Euro currency market. Likewise, they arefrequently members of international loan syndicates, participating with other banks tolend large sums to MNCs needing project financing and the foreign governmentsneeding funds for economic development.Depending on the regulations of the country in which it operates and its organizationaltype, an international bank may participate in the underwriting of Eurobonds and foreignbonds. International banks frequently provide consulting services and advice to their clients, inareas of foreign exchange hedging strategies, interest rate and currency swapfinancing, and international cash management services. Banks that do provide amajority of these services are commonly known as “Universal Banks” or “Full ServiceBanks”.Reasons for International BankingRugman and Kamath (1987) provides a more formal list as follows:-1. Low Marginal Costs – Management and marketing knowledge development at home can be used abroad with low marginal costs.2. Knowledge Advantage – The foreign bank subsidiary can draw on the parent bank’s knowledge of personal contacts and credit investigations for use in that foreign market. 35
  • 3. Home Nation Information Services – Local firms in a foreign market may be able to obtain more complete information on trade and financial market in the multinational bank’s home nation than is otherwise obtainable from foreign domestic banks.4. Prestige – Very large multinational banks have perceived prestige, liquidity, and deposit safety that can be used to attract clients abroad.5. Regulation advantage – Multinational banks are often not subject to the same regulations as domestic banks. There may be reduced need to publish adequate financial information, lack of required deposit insurance and reserve requirement on foreign currency deposit, and the absence of territorial restrictions (i.e. US banks may not be restricted to the state of origin).6. Wholesale defensive strategy – Banks follow their multinational customers abroad to prevent the erosion of their clientele to foreign banks seeking to service the multinational’s foreign subsidiaries.7. Retail defensive strategy – Multinational banks prevent erosion by foreign banks of the traveler’s check, tourists, and foreign business market.8. Transaction costs – By maintaining foreign branches and foreign currency balances, banks may reduce transaction costs and foreign exchange risks on currency conversion if government controls can be circumvented.9. Growth – Growth prospects in a home nation may be limited by a market largely saturated with the services offered by domestic banks.10. Risk Reduction – Greater stability of earnings is possible with international diversification. Offsetting business and monetary policy cycles across nations reduces the country specific risk of any one nation.Types of International Banking OfficesThe services and operations of international banks are a function of the regulatoryenvironment in which the bank operates and the type of banking facility established.1. Correspondent BankA correspondent bank relationship is established when two banks maintain acorrespondent bank account with one another. For example, a large New York bank willhave a correspondent bank account in a London Bank, and the London Bank willmaintain one with the New York Bank. 36
  • The correspondent banking relationship system enables a bank’s MNC client to conductbusiness world wide through his local bank or its contacts. The banking services centeraround foreign exchange conversions that arise through the international transactionsthe MNC makes; also include assistance with trade financing such as honoring letters ofcredit and attempting drafts drawn on the correspondent banks. Likewise, a MNCneeding foreign local financing for one of its subsidiaries may rely on its local bank toprovide it with a letter of introduction to the correspondent bank in the foreign country.This banking relationship is advantageous because a bank can service its MNC clientsat a very low cost and without the need of having bank personal physically located inmany countries.2. Representative OfficeA representative office is a finance service facility staffed by parent bank personnel thatis designed to assist MNC clients of the parent bank in dealings with the bank’scorrespondent. It is a way for the parent bank to provide its MNC clients with a level ofservice greater than that provided through merely a correspondent relationship.The parent bank may open a representative office in a country in which it has manyMNCs. Clients or at least an important client. This office also assists MNC clients withinformation about local business practices, economic information, and credit evaluationof the MNCs foreign customers.3. Foreign BranchesThis operates like a local bank, but legally it is a part of the parent bank. As such abranch bank is subject to both the banking regulations of its home country and thecountry in which it operates.The reasons why a parent bank might establish a branch bank are:-(a) the bank organization to provide a much fuller range of service for its MNC customers through a branch office then it can through a representative office. Thus, a branch bank system allows customers much faster check clearing than does a correspondent bank system because the debit and credit procedure is handled internationally within one organization.(b) to compete on a local level with the banks of the host country in terms of their cost structure in making loans;For instance, the most important piece of legislation affecting the operation of foreignbanks in the USA is the International Banking Act of 1978 which specifies that foreign 37
  • branch bank operating in the USA must comply with USA banking regulation just likeUS banks.4. Subsidiary and Affiliate BanksA subsidiary bank is a locally incorporate bank that is either wholly owned or owned inmajor part by a foreign parent.An affiliate bank is one that is only partially owned but not controlled by its foreignparent. Both subsidiary and affiliate banks operate under the banking laws of thecountry in which they are incorporated.5. Edge Act BanksThese are federally characterized subsidiaries of US banks that are physically located inthe US and are allowed to engage in a full range of international banking activities.The Federal Reserve Regulation K, allows Edge Act banks to accept foreign deposits,extend trade credit, finance foreign projects abroad, trade foreign currencies, andengage in investment banking activities with the US citizens involving foreign securities.An Edge Act bank is typically located in a state different from that of its parent in orderto get around the prohibition on interstate branch banking.6. Offshore Banking CentersAn offshore banking center is a country whose banking system is organized to persistexternal accounts beyond the normal economic activity of the country. The IMFrecognizes the Bahamas, Bahavain, the Layman Island, Hongkong, the NetherlandsAntilles, Panama and Singapore as major offshore banking centers.These banks operate as branches or subsidiaries of the parent bank. The attractivefeature for offshore banks are critically total freedom from the host countrygovernmental banking regulations e.g. low reserve requirements, and no depositinsurance, low taxes, favourable time zone that facilitates international bankingtransactions and a strict banking secrecy laws.The primary activities of offshore banks are to seek deposits and grant loans incurrencies other than the currency of the host government.7. International Banking Facilities 38
  • An IBF is a separate set of asset and liability accounts that are segregated on theparent bank’s books; it is not a unique physical or legal entity. IBFs are not subject todomestic reserve requirements on deposits. IBF seeks deposits from non US citizensand can make loans only to foreigners. IBFs were established largely as a result of thesuccess of offshore banking and were able to capture a large part of the two dollarbusiness that was previously handled offshore.Capital Adequacy StandardsA concern of bank regulators world wide and of bank depositors is the safety of bankdeposits. Bank capital adequacy refers to the amount of equity capital and othersecurities a bank holds as reserves against risky assets to reduce the probability of abank failure.The Basle Accord was established to adopt this issue, which amongst other thingscalled for a minimum bank capital adequacy ratio of 8 percent of risk-weighted assetsfor banks that engage in cross-boarder transactions. This accord widens bank capitalinto two categories:-(i) Tier I core capital, which consists of shareholder equity and retained earnings; and(ii) Tier II supplemental capital, which consist of internationally recognized non- equity items such as preferred stock and subordinated bonds. This capital is allowed to count for no more than 50 percent of total bank capital, or as more than 4 percent of risk-weighted assets.In determining risk-weighted assets, four categories of risky assets are weighteddifferently. More risky assets receive a higher weight. Government obligations areweighted at zero percent, short term interbank assets are weighted at 20 percent,residential mortgages at 50 percent, and other assets at 100 percent.Due to some shortcomings of the 1988 accord, amendment was made in 1996 whichrequires commercial banks engaging in significant trading activity to set aside additionalcapital to cover the market risks inherent in their trading accounts. It allowssophisticated banks to use internally developed portfolio models to assess adequatecapital requirements, i.e., instead of using a “rules based” approach to determiningadequate bank capital, a “risk focused” approach that relies on modern portfolio maybe used. The bank’s portfolio is the monetary value of its own and off balance sheettrading account positions.Value at risk (VAR) technique is used and is a loss that will be exceeded with aspecified probability over a specified time horizon. 39
  • The amendment requires VAR to be calculated clearly according to the criterion thatthese will only be 1 percent chance that the maximum loss over a 10 day time periodwill exceed the bank’s capital. VAR = Portfolio Value X daily standard Deviation of Return X Confidence Interval Factor X Horizon.The confidence interval factor is the appropriate Z-Value from the standard normaldensity functions associated with the maximum level of loss that is tolerable.For example, the 1 percent VAR for a portfolio of $400 million with a daily portfoliostandard deviation of .75 percent for a 10 day planning horizon is $22.07 million = $400million X 0.0075 x 2.326 X √10 where 2.326 is the Z value associated with a one-tail 99percent confidence level. That there is only a 1 percent chance that the loss during a 10day period will exceed $22.07 million.Hence, in this example, the bank would be required to maintain an equivalent amount ofcapital as an explicit cushion against it price risk exposure.Therefore, the Basle II provides a capital adequacy framework incorporating threemutually reinforcing pillars that allow banks and supervisors to evaluate the risks thatbanks face. The three pillars are:-• minimum capital requirements;• a supervisory review process; and• effective use of market discipline.With respect to the first pillar, a bank’s minimum 8 percent capital ratio is calculated onthe sum of the bank’s credit, market and operational risks that include such matters ascomputer failure, poor documentation and fraud.The second pillar is designed to ensure that each bank has a sound internal process inplace to properly assess the adequacy of its capital based on a thorough evaluation ofits risks and encourage supervisory intervention at the national level with the authority torequire capital in excess of the minimum.Lastly, the third pillar seeks to enhance bank disclosures standards to holster the rolethat market participants have in encouraging banks to hold adequate capital.International Money Market(a) Euro Currency MarketThe core of the international money market is the Euro currency market. A Eurocurrency is a time deposit of money in an international bank located in a countrydifferent from the country that issued the currency. For example, Euro dollars aredeposits of US dollars in banks located outside the USA, Euro Sterling are deposits of 40
  • British pound sterling in banks outside of the UK, and Euro yen are deposits ofJapanese yen in banks outside the Japan.The Euro currency market is an external banking system that runs parallel to thedomestic banking system of the country that issued the currency. Both banking systemsseek deposits and make loans to customers from the deposited funds. Euro dollardeposits are not subject to arbitrary regulations such as reserve requirements or depositinsurance; hence, the cost of operations is less.The Euro currency market operates at the interbank and wholesale level. The majorityof Euro currency transactions are interbank transactions, representing sums of$1,000,000 or more Eurobanks with surplus funds and no retail customers to lend to willlend to Eurobanks that have borrowers but need loanable funds.The rate charged by banks with excess funds is referred to as the “interbank offeredrate”; they will accept interbank deposits at the “interbank bid rate”. The spread isgenerally 1/8 of 1 percent for most major Euro currencies.LIBOR refers to the reference rate in London for Euro currency deposits. There isLIBOR for Euro dollars, Euro Canadian dollars, Euro yen and even euros. Likewise inother financial centres, other reference rates are used e.g. SIBOR (Sing aproneInterbank Offer Rate), and BRIBOR (the Brussells at which interbank deposits of theeuro are offered by one prime bank to another in the euro zone.In the wholesale money market, Eurobanks accept Euro currency fixed time depositsand issue Negotiable Certificates of Deposits (NCDs). These are preferable ways forEurobanks to raise loanable funds as the deposits tend to be a lengthier period and theacquiring rate is often slightly less than the interbank rate. Rates on Eurocurrencydeposits are quoted for maturities ranging from one day to several years; however,more standard maturities are for 1, 2, 3, 6, 9 and 12 months.(b) Euro CreditsThese are short-to medium-term loans of Euro currency extended by eurobanks tocorporations, sovereign governments, non prime banks, or international organizations.The loans are denominated in currencies other than the home currency of theEurobank. Eurobanks always bond together to form a bank lending syndicate to sharerisks because of the large size of the loan.However, the credit risks in these loans is greater than on loans to other banks in theinterbank market. Thus, the interest rate on Euro credits must compensate the bank, orbanking syndicate for the added credit risk. Therefore, a Euro credit may be viewed as aseries of shorter term loans, where at the end of each time period (generally three to sixmonths), the loan is rolled over and the base lending rate is repriced to current LIBORover the next interval of the loan. 41
  • Example: Rollover pricing of Euro credit Telforex International can borrow $3,000,000at LIBOR plus a lending margin of .75 percent per annum on a three months rolloverbasis from Barclays in London. Suppose that three months LIBOR is currently 517/32percent. Further, suppose that over the second three months interval LIBOR fall to 51/8percent. How much will Telforex pay in interest to Barclays over the six months periodfor the Euro dollar loan.Solution: $3,000,000 x (0.0553125 + 0.0075)/4 + $3,000,000 x (.05125 + .0075)/4 =$47,109.38+$44,062.50 = $91,171.88.(c) Forward Rate AgreementA major risk Eurobanks face in accepting Euro deposits and in extending Euro Credits isinterest rate risk resulting from a mismatch in the maturities of the deposits and credits.For instance if deposit maturities are longer than credit maturities, and interest rates fall,the credit rates will be adjusted downwards while the bank is still paying a higher rateon deposits. Conversely, if deposit maturities are shorter than credit maturities andinterest rates risk deposit rates will be adjusted upwards while the bank is still receivinga lower rate on credits. Therefore, only when deposits and credit maturities are perfectlymatched will the rollover feature of Euro credits allow the bank to earn the deposit loanrate spread.A Forward Rate Agreement (FRA) is an interbank contract that allows the Eurobank tohedge the interest rate risk in mismatched deposits and credits. An FRA involves twoparties, a buyer and a seller where:(i) the buyer agrees to pay the seller the increased interest cost on a notional amount if the interest rates fall below an agreements rate, or(ii) the seller agrees to pay the buyer the increased interest cost if interest rates increased above the agreement rate.FRAs are structured to capture the maturity mismatched in standard length Eurodeposits and credits. For example, the FRA might be on a six months interest rate for asix months period beginning three months from today and ending nine months fromtoday; this would be a “three against nine” FRA.The following time line depicts this FRA example. 42
  • The payment account under an FRA is calculated as the absolute value of:Notional Amount x (SR-AR)xdays/360 1+(SRxdays/360)Where SR denotes the settlement rate, AR denotes the agreement rate, and daysdenotes the length of the FRA period.FRAs can also be used for speculative purposes. If one believes rates will be less thenthe AR, the sale of an FRA is the suitable position. In contrasts, the purchase of an FRAis the suitable position if one believes rates will be greater than the AR.(d) Euro notesThese are short term notes underwritten by a group of international investment orcommercial banks called a “facility”. A client borrower makes an agreement with afacility to issue Euro notes in its own name for a period of time, generally 3 to 10 years.Euro notes are sold at a discount from face value and payback the full face value atmaturity. Euro notes typically have maturities of from three to six months. Borrowersfind Euro notes attractive because the interest expense is usually slightly less – typicallyLIBOR plus 1/8 percent in comparison to syndicated Eurobank loans. The banks findthem attractive to issue because they earn a small fee from the underwriting or supplythe funds and earn the interest return.(e) Euro Commercial PapersLike domestic commercial paper, is an unsecured short-term promissory note issued bya corporation or a bank and placed directly with the investment public through a dealer.Like Euro notes, Euro Commercial paper is sold at a discount from face value maturitiestypically range from one to six months.The vast majority of Euro Commercial paper is US dollar denominated and therefore,the secondary market is more active than for US paper. Likewise, Euro Commercialpaper issuers tend to be of much lower quality than their US counterpart, consequently,yields tend to be higher. 43
  • International Debt CrisisCertain principles define social banking behavior and these are:-(a) Avoid an undue concentration of loans to single activities, individuals or groups;(b) Expand cautiously into unfamiliar activities;(c) Know your counterparty;(d) Control mismatches between assets;(e) and beware that your collateral is not vulnerable to the same stocks that weaken the borrower – remain as relevant today as in earlier times.Nevertheless, violation of the first of these principles by some of the largest internationalbanks in the world was responsible for the “international debt crisis”, which wascaused by lending to the sovereign governments of some less developed countries(LDCs).This risk was uncertain by international banks to lend to LDC sovereign governmentsbecause they held vast sums of money in Euro dollar deposits that needed to be quicklyplaced to start producing interest income. Banks were simply too eager and not carefulenough in analyzing the risks they were undertaking in lending to unfamiliar borrowers.Additionally, many US banks claim that there was official “arm twisting” from wastingform to assist the economic development of third world countries. Nevertheless, had thebankers and Washington policy makers been better versed in economic history,perhaps the LDC debt crisis might have been avoided, or at least mitigated.Debt for Equity SwapsIn the midst of the LDC debt crisis, a secondary market developed for LDC debt atprices discounted significantly from farc value. The LDC debt was purchased for use in“debt-for-equity swaps”. As part of debt rescheduling agreements among the banklending syndicates and the debtor nations, creditor banks would sell their loans for USdollars at discounts from face value to MNCs desiring to make equity investments insubsidiaries or local firms in the LDCs.In LDC Central Bank would buy the bank debt from a MNC at a smaller discount thanthe MNC paid, but in local currency. The MNC would use the local currency to makepre-approved investment in the LDC that was economically or socially beneficial to theLDC and its populace.For instance, during the midst of the LDC debt crisis, Latin American debt was going atan average discount of approximately 70 percent.Who benefits from a debt-for-equity SwapAll parties. 44
  • 1. The creditor bank benefits from getting an unproductive loan off its books and at least a portion of the financial repaid.2. The market maker benefits from earnings the bid as spread on the discounted loan amount.3. The LDC benefits by:- (a) being able to pay off a hard currency loan generally at a discount from face value on which it cannot meet the debt service with its own local currency; (b) non reproductive investment made in the country, which was designed to foster economic growth.4. The equity investor benefits from the purchase of LDC local currency needed to make the investment at a discount from the current exchange rate.LDC only allowed swaps when the benefits of the new equity investment was expectedto be greater than the harm caused to the economy by increased inflation. Acceptabletypes of investments have been in:(a) Export oriented industries such as automobile that were being held in hardcurrency;(b) High technology industries that will lead to larger exports, improve the technological base of the country and develop the skills of its people;(c) Tourist industry such as resort hotels, that will increase tourism and visitors bringing hard currency;(d) Low income housing developments that will improve the standard of living of some of the populace.The solution: Brandy BondsBrandy solution was to offer creditor banks one of three alternatives:-(a) Convert their loans to marketable bonds with a face value equal to 65 percent of the original loan accounts;(b) Convert the loans into collateralized bonds with a reduced interest rate of 6.5 percent;(c) Lend additional funds to allow the debtor nations to get on their feet. 45
  • Hence, the second alternative called for extending the debt maturities by 25 to 30 yearsand the purchase by the debtor nation of zero coupon US. Treasury bonds with acorresponding maturity to govern the bonds and make them marketable. These bondshave come to be called “Brandy Bonds”, after the founder – Nicholas F. Brandy, USTreasury Secretary of the first Bush Administration.INTERNATIONAL BOND MARKETThe international bond market encompasses two basic market segments:• Foreign bonds; and• Euro bonds.(i) A foreign bond i.e. issue is one offered by a foreign borrower to the investor in a national capital market and denominated in that nation’s currency. For example, a German MNC issuing dollar denominated bonds to US investors.(ii) Eurobond i.e. issue is one denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency. For example, a Dutch borrower issuing dollar denominated bonds to investors in UK Switzerland and the Netherlands.Hence, the markets for foreign bonds and Eurobonds operate in parallel with domesticnational bond markets and all three market groups compete with one another.Eurobonds are known by the currency in which they are denominated. For example;• US dollar Eurobonds;• Yen Eurobonds;• Swiss Eurobonds; or• Euro yen bonds;• Euro dollar bonds;• Euro SF bonds.Foreign bonds frequently have names that designate the country in which they areissued e.g.• Yankee bonds are dollar denominated foreign bonds originally sold to US investors;• Samurai bonds are yen-denominated foreign bonds sold in Japan;• Bull dogs are pound sterling denominated foreign bonds sold in the UK.Types of Eurobondsi) Bearer bonks, i.e. with its possession, it is evidence of ownership. The issuer does not keep any records indicating who is the current owner of a bond.ii) Registered bonds, i.e. with this, the owner’s name is on the bond and it is also recorded by the issuer, or else the owner’s name is assigned to a bond serial 46
  • number recorded by the issuer when a registered bond is sold, a new bond certificate is issued with the new owners to the bond serial number.For instance, US security regulations require YanKee bonds and US corporate bonds tobe sold to US citizens to be registered. Bearer bonds are attractive to investorsdesigning privacy and anonymity, to enable tax evasion. Consequently, investors willgenerally accept a lower yield on bearer bonds than on registered bonds of comparableterms, making them a less costly source of funds for the issuer to service. Hence,foreign bonds must meet the security regulations of the country in which they areissued. This means that publicly traded YanKee bonds must meet the same regulationas US domestic bonds. For instance, the US Securities Act of 1933 requires fulldisclosure of relevant information relating to a security issue. Security sold in the US topublic investors must be registered with the SEC, and a prospectus disclosing detailedfinancial information about the issuer must be provided and make available toprospective investor. Likewise, foreign bonds and Eurobonds may or may not besubjected to withholding taxes.Global BondsThis is a very large issue of international bond offering by a single borrower that issimultaneously sold in North America, Europe and Asia.Global bonds follow the registration requirements of domestic bonds, but hence the feestructure of Eurobonds. Global bond offerings enlarge the borrower’s opportunities forfinancing at reduced costs. Purchasers, mainly institutional investors to date, desire theincreased liquidity of the issues and have been willing to accept lower yields.Types of InvestmentsThe international bond market has been much more attractive and innovative than thedomestic bond market in the types of instruments offered to investors. They are asfollows:-1. Straight fixed rate bondThese issues have a designated maturity date at which the principal of the bond issue ispromised to be repaid. During the type of the bond, fixed coupon payments, which are apercentage of the face value, are paid as interest to the bond holders. Coupon interestson Eurobonds are paid annually for the reason that they are bearer bonds, and anormal coupon redemption is more convenient for the bondholders and less costly forthe bond issuer because the bondholders are scattered geographically.2. Euro-Medium Term NotesThese are typically fixed-rate notes issued by a corporation with maturities ranging froma year to about 10 years. Euro MTNs have a fixed maturity and pay coupon interest on 47
  • periodic dates. This issue is partially sold on a continuous basis through an issuancefacility that allows the borrower to obtain funds only as needed on a flexible basis.Hence, two MTNs have become popular means of raising medium-term funds and arevery attractive to issuers.3. Floating Rate NotesThese are typically medium-term bonds with coupon payments indexed to somereference rate. Coupon reference rates are either three months or six months. US dollarLIBOR. Coupon payments on FRNs are usually quarterly or semi annual and in accordwith the reference rates.FRNs make attractive investments for investors with a strong need to preserve theprincipal value of the investment should they need to liquidate the investment prior tothe maturity of the bonds.4. Equity – Related BrandsThere are two types of this:-(a) Convertible bonds; and(b) Bonds with equity warrants.In convertible bond issue allows the investor to exchange the bond for a pre-determinednumber of equity shares of the issuer. The “floor value” of a convertible bond is itsstraight fixed rate bond value. Convertibles usually sell at a premium above the larger oftheir straight debt value and their conversion value. Additionally, investors are usuallywilling to accept a lower coupon rate of interest than the comparable straight fixedcoupon bond rate because they find the conversion feature attractive.Bonds with equity warrants can be viewed as straight fixed rate bonds with the additionof a call option (or warrant) feature. The warrant entitles the bondholder to purchase acertain number of equity shares in the issuer at a pre-stated price over a predeterminedperiod of time.5. Zero Coupon BrandsThese are sold at a discount from face value and do not pay any coupon interest overtheir life. At maturity, the investor receives the full face value. Alternatively, some zerocoupon bonds originally sell for face value and at maturity the investor receives anamount in excess of face value to compensate the investor for the use of money. 48
  • Zero coupon bonds have been denominated primarily in the US dollar and Swiss Franc.Japanese investors are particularly attracted to zero coupon bonds because their taxlaws treat the difference between face value and the discounted purchase price of thebond as a tax face capital gain, whereas coupon interest is taxable.More generally, zero coupon bonds are attractive to investors who desire to avoid thereinvestment risk of coupon receipts at possibly lower interest rates.Another form of zero coupon bonds are “stripped bonds”, that results from strippingthe coupons and principal from a coupon bond. The result is a series of zero couponbonds represented by the individual coupon and principal payments. The strippedbonds are actually receipts representing a portion of the treasury security held in trust.6. Dual Currency BondsThis is a straight fixed rate bond issued in one currency, say, Swiss Franc, that payscoupon interest in that same currency. At maturity, the principal is repaid in anothercurrency, e.g. US dollars. Coupon interest is frequently at a higher rate than comparablestraight-fixed rate bonds. The amount of dollar principal repayment at maturity is set atinception; frequently, the amount allows for some appreciation in the exchange rate ofthe stronger currency.From the investor’s perspective, a dual currency bond includes a long-term forwardcontract. If the dollar appreciates over the life of the bonds, the principal repayment willbe worth more than a return of principal in Swiss Franc. Japanese firms have beenlarge issuers of dual currency bonds, and pay coupon interest in yen with the principalreimbursement in US dollars. Yen/dollar dual currency bonds could be an attractivefinancing methods for Japanese MNCs desiring to establish or expand US subsidiaries.The yen proceeds can be converted to dollars to finance the capital investments in theUS, and during the early years the coupon payments can be made by the parent firm inyen. At maturity, the dollar principal repayment can be made from dollar profits earnedby the subsidiary.International Bond Market Credit RatingFitch IBCA, Moody’s Investor Service, are Standard and Poors (S&P) have providedcredit ratings on domestic and international bonds. These three credit ratingorganization classify bond issues into categories based upon the credit worthiness ofthe borrower. The ratings are based on an analysis of current information regarding thelikelihood of default and the specifics of the debt obligation. The ratings only reflectcredit worthiness of the borrower. The ratings are based on an analysis of currentinformation regarding the likelihood of default and the specifics of the debt obligation.The ratings only reflect credit worthiness and not exchange rate uncertainty.Moody’s rates bonds into nine categories from Aaa, Aa, A, Baa, Ba down to C. Ratingsof Aaa to Baa are known as investment grade ratings. These issues are judged not to 49
  • have any speculative elements; interest payments and principal safety appear adequateat present. Within each of the nine categories, Moody’s has numeric modifiers, 1, 2, or3, to place an issue respectively at the upper, middle, or lower end of the category.Standard and Poor’s rates bonds into 11 categories from AAA, AA, A, BBB, BB downto D and C1. Category D is reserved for bond issues that are presently in default, andthe payment of interest and or the repayment of principal is in arrears.Category C1 is reserved for income bonds on which no income is being paid. Ratingsfor categories AA to CCC may be modified with a plus (+) or minus (-) to reflect therelative standing of an issue to others in the category. Fitch uses ratings symbols anddefinitions similar to S & P.In assessing or rating a sovereign government, S&P’s analysis centres around anexamination of the degree of political risk and economic risk. An assessing political risk,S&P examines the stability of the political system, the social environment, andinternational relations with other countries.Factors examined in assessing economic risk include the sovereign’s external financialposition, balance of payments flexibility, economic structure and growth management ofthe economy and economic prospects.Eurobond Market Structure and PracticesThey are arranged into:-1. Primary MarketHere, a borrower desiring to raise funds by issuing Eurobonds to the investing public willcontact an investment banker and as it to serve as “lead manager” of an underwritingsyndicate that will bring the bonds to the market. The “underwriting syndicate” is agroup of investment banks, merchant banks and the merchant banking arms ofcommercial banks that specialize in some phase of a public issuance. The leadmanager will sometimes write to co-manager to form a “managing group” to helpnegotiate terms with the borrower, ascertain market conditions and manage theissuance.The managing group along with other banks, will serve as underwriters for the issue, i.e.they will commit their own capital to buy the issue from the borrower at a discount fromthe issue price. Most of the underwriters, along with other banks, will be part of “sellinggroup” that sells the bonds to the investing public. The various members of theunderwriting syndicate receive a portion of the spread, depending on the number andtype of functions they perform. Hence, the total elapsed time from the decision date ofthe borrower to issue Eurobonds until the net proceeds from the sale are received istypically five to six weeks. 50
  • 2. Secondary MarketThis is an over the counter market for Eurobonds with principal trading in bonds. Thesecondary market comprises market makers and brokers connected by an array oftelecommunication equipment. Market makers stand ready to buy or sell for their ownaccount by quoting two-way “bid” and “ask” prices. Market makers trade directly withone another, through a broker, or with retail customers. The bid-ask spread representstheir only profit; no other commission charged.Eurobond market makers and dealers are members of the International SecuritiesMarket Association (ISMA), a self-regulatory body based in Zurich. Market makers alsoserve as lead managers in an underwriting. Brokers on the other hand, accept to buy orsell orders from market makers and then attempt to find a matching party for the otherside of the trade; they also trade for their own account; also charge a small commissionfor their services to the market maker that engage them.Clearing ProceduresEurobond transactions in the secondary market require a system for transferringownership and payment from one party to another. Two major clearing systems,Euroclear and clearstream international, have been established to handle mostEurobond trades. Euroclear clearance system is operated by Euroclear Bank.Each clearing system has a group of depository banks that typically store bondcertificates. Members of either system hold cash and bond accounts.The functions of the clearing system are:-1. Financing up to 90% of the inventory that a Eurobond market maker has deposited within the system;2. assist in the distribution of a new bond issue, taking physical possession of the newly printed bond certificates in the depository, collect subscription payments from the purchasers, and record ownership of the bonds;3. Distributing coupon payments. The borrower pays to the clearing system the coupon interest due on the portion of the issue held in the depository, which in turn credits the appropriate accounts to the bond’s owners cash account.International Bond Market IndexesThere are several international bond market indexes. Some of the best known are:-• J.P Morgan and Company Domestic Government Bond Indices;• Global Government Bond Indices. 51
  • J.P. Morgan publishers a government bond index for 18 individual countries: Australia,Canada, Belgium, Denmark, France, Germany, Italy, Japan, the Netherlands, Spain,Sweden, the UK, USA, New Zealand, Ireland, Finland, Portugal and South Africa. Eachbond index includes only government bonds in five major categories:-• 1-3 years;• 3-5 years;• 5-7 years;• 7-10 years;• 10-plus years.The Global Government Bond Index is a value-weighted representation of the 18government bond indexes. These indexes are widely referenced and used frequentlyas benchmarks of international bond market performance.The Wall Street Journal also publishes daily values of yields to maturity for Japanese,German, British and Canadian Governments Bonds of various terms to maturity. Thesedata allows for comparing the term structures of interest rates from these majorindustrial countries with one another and with the term structure of US treasury bondsthat can be found elsewhere in the WSJ. Another source of international bond data isthe coupon rates, prices and yields to maturity found in the daily “BenchmarkGovernment Bonds” table in the financial times.INTERNATIONAL EQUITY MARKETSInvestment in foreign equity markets became common practice in the 1980s asinvestors became aware of the benefits of international portfolio diversification.However, during the 1980s, cross-border equity investment was largely confined to theequity markets of developed countries. Only in the 1990s did world investors start toinvest sizable amounts in the equity market, as the economic growth and prospects ofthe developing countries improved.Measures of LiquidityA liquid stock market is one in which investors can buy and sell stocks quickly at closeto the current quoted prices. A measure of liquidity for a stock market is the turnoverratio; that is, the ratio of stock market transactions over a period of time divided by thesize, or market capitalization, of the stock market. Generally, the higher the turnoverratio, the more liquid the secondary stock market, indicating ease in trading.Measures of Market ConcentrationIn order to construct a diversified portfolio, there must be opportunities for makingforeign investment. The more concentrated a national equity is in a far stock issues, theless opportunity a global investor has to include shares from that country in an 52
  • internationally diversified portfolio. The smaller the concentration percentage, the lessconcentrated a market is in a few stock issues.Market Structure, Trading Practices, and CostsThe secondary equity markets of the works serve two major purposes:(i) They provide marketability and share valuation. Investors or traders who buy shares from the issuing firm in the primary market may not want to hold them indefinitely. The secondary market allows share owners to reduce their holdings of unwanted shares and purchases to acquire the stock. Firms house have difficult time attracting buyers in the primary market without the marketability provided through secondary market.(ii) Competitive trading between buyers and sellers in the secondary market establishes a fair market price for existing issues.In conducting a trade in secondary market, public buyers and sellers are presented byan agent known as a broker. The order submitted to the broker may be a market orderor a limit order.A market order is executed at the best price available when the order is received in themarket, i.e. the market price. A limit order is an order away from the market price that isheld in a “limit order book” until it can be executed at the desired price.Generally a secondary market is structured as a dealer or agency market. In a dealermarket, the broker takes the trade throughout the dealer who participates in trades as aprincipal by buying and selling the security for his own account. Public traders do nottrade directly with one another in a dealer market.While in an agency market, the broker takes the client’s order through the agent, whomatches it with another public order. The agent can be viewed as a “broker’s broker”.Other names for the agent are “official broker and central broker”.The Over-The-Counter (OTC) market is a dealer market, which is a computer-linkedsystem that shows the bid (buy) and ask (sell) prices of all dealers in a security; e.g. theNASDAQ.The exchange markets can be agency or auction market. Each stock traded on theexchange is represented by a specialist, who makes a market by holding an inventory ofthe security. Each specialist has a designated station (desk) on the exchange tradingfloor where trades in his stock are conducted.Floor brokers bring the flow of public market orders for a security to the specialist’s deskfor execution. Serving as a dealer, the specialist is obligated to post did and ask prices 53
  • for the stock he represents and to stand willing to buy or sell for his own account atthese prices.Through an auction process, the “crowd” of floor brokers may arrive at a morefavourable market price for their clients between the specialist’s bid and ask prices andthus transact among themselves. The specialist also holds the limit order book. Inexecuting these orders, the specialist serves as an agent. Both OTC and exchangemarkets can be “continuous market” where market and limit orders can be executed atany time during business hours.In recent years, most stock markets have become automated for at least some of theissues traded on them, e.g. the Computer Assisted Trading System (CATS). Inautomated trading system electronically stores and displays public orders on acontinuous basis, and allows public traders to cross orders with one another to executea trade without the assistance of exchange personnel.Other markets are termed, a “Call Market”, where an agent of the exchangeaccumulates over a period of time, a batch of orders that are periodically executed bywritten or verbal auction throughout the trading day. Its drawback is that traders are notcertain about the price at which their orders will transact because bid and askquotations are not available prior to the call.Another non-continuous exchange trading system is “crowd trading”. In a trading ring,an agent of the exchange periodically calls out the name of the issuer. At this point,traders announce their bid and ask prices for the issue, and seek computers to a trade.Between counterparts a deal may be struck and a trade executed. In this market,several bilateral trades may take place at different prices.In summary, continuous trading systems are desirable for actively traded issues,whereas call markets and crowd trading offer advantages for thinly traded issuesbecause they mitigate the possibility of sparse order flow over short time periods.International Equity Market BenchmarksAs a benchmark of activity or performance of a given national equity market, an index ofthe stock traded on the secondary exchange (or exchanges) of a country is used.Several national equity indexes are available for use by investors.Examples of these indexes are:-(i) S & P publishes its emerging stock market fastbook, which provides a variety of statistical data on both emerging and developed country stock markets. 54
  • (ii) Morgan Stanley Capital International (MSCI) are excellent source of national stock market performance. It presents return and market capitalization data for 24 national stock market indexes from developed countries.(iii) The Don Jones Company (DJ) provides stock market index values for a number of countries; and their value and percentage changes are found daily in the Wall Street Journal. The data are presented in local currency terms and for comparative purposes in US dollars.(iv) The Wall Street Journal also reports values and percentages changes in local currency. Values of the major stock market indexes of the national exchanges or markets from various countries in the world, many of these indexes are prepared by the stock markets themselves or well-known investment advisory terms.World Equity Benchmark SharesRecently Barclays Global investors introduced World Equity Benchmark Shares(WEBS) as vehicles to facilitate investment in country funds. WEBS are country specificbaskets of stocks designed to replicate the MSCI country indexes of 20 countries andthree regions. They trade as shares on the American Stock Exchange.WEBS are a low cost, convenient way for investors to hold diversified investments inseveral different countries.Trading for International EquitiesDuring the 1980s, world capital markets began a trend toward greater global integrationdue to the following factors.(i) investors began to realize the benefits of international portfolio diversification;(ii) major capital markets became more liberalized through the elimination of fixed trading commission, the reduction in governments regulations, and measures taken by EU to integrate their markets.(iii) New computer and communication technology facilitated efficient and fair securities tradings through order routing and execution, information dissemination, clearance and settlement.(iv) MNCs realized the benefits of sourcing new capital internationally.Types of trading1. Cross-Listing of Shares 55
  • This refers to a firm having its equity shares listed on one or more foreign exchanges, inaddition to the home stock exchange. With increased globalization of world equitymarkets, the amount of cross listing has exploded in recent years.The reasons for cross listing are:-(a) It provides a means for expanding the investor base for a firm’s stock, thus increasing the demand for the stock, which likely increases the market price.(b) It brings the firm’s name before more investor and consumer groups.(c) It establishes name recognition of the company in a new capital market, thus paving the way for the firm to source new equity or debt capital from local investors as demands dictate.(d) it may mitigate the possibility of a hostile takeover of the firm through the broader investor base heated for the firm’s shares. Cross listing of a firm’s stock obligates the firm to adhere to the securities regulations of its home country as well as the regulation of the countries in which it is cross listed.2. YanKee Stock Offerings i.e. US investors have bought and sold a large amount of foreign stock. Many foreign companies, have listed their stocks on US equity market for future yenkee stock offerings that is, the direct sale of new equity capital to US public investors. Factors driving this have been:- (a) Push for privatization by many Latin American and Eastern European government owned companies. (b) The rapid growth in the economies of the developed countries. (c) The expected large demand for new capital by Mexican companies due to formation of the NAFTA3. The European Stock Market This has formed several combinations and trading arrangements e.g. the Euronext. They have also formed the NASDAQ Europe with the desires to create the world’s tracking global securities market. It offers low cost cross border trading similar to trading on NASDAQ in the United States. It expects to offer trading in both Europen and US stocks.4. American Depository Receipts 56
  • This is a receipt representing a number of foreign shares that remain on depositwith the US depository’s custodian in the issuer’s home market.The bank serves as the transfer agent for ADRs, which are traded on the listedexchanges in the USA or in OTC market.Similarly, Global Depository Receipts allow foreign firms to trade principally onthe London and Luxembourg stock exchanges, and Singapore DepositoryReceipts trade on the Singapore Stock Exchange.ADRs offer the US investor many advantages over trading directly in theunderlying stock on the foreign exchange. Non-US investors can also invest inADRs, and frequently do so rather than invest in the underlying stock because ofinvestment advantages that include:-(a) ADRs are denominated in dollars, trade on a US stock exchange, and can be purchased through the investor’s regular broker.(b) Dividends received on the underlying shares are collected and converted to dollars by the custodian and paid to the ADR investor;(c) ADR trades clear in three business days as do US equities, whereas settlement practices for the underlying stock vary in foreign countries.(d) ADR price quotes are in US dollars.(e) ADRs are registered securities that provide for the protection of ownership rights, whereas most underlying stocks are bearer securities.(f) In ADR investment can be sold by trading the depository receipt to another investor in the US stock market, or the underlying stock can be sold in the local stock market. In this case, the ADR is delivered for cancellation to the bank depository, which delivers the underlying shares to the buyer.(g) ADRs frequently represent a multiple of the underlying shares, rather than a one-for-one correspondence, to allow the ADR to trade in a price range customary for US investors. A single ADR may represent more or less than one underlying share, depending on the per share value.Types of ADRs are: 57
  • (a) Sponsored ADRs are created by a bank at the request of the foreign company that issued the underlying security. And they are the ones that are listed on the US stock markets. All new ADRs must be sponsored. (b) Unsponsored ADRs were usually created at the request of US investment banking firm without direct involvement by the foreign issuing firm.5. Globally Registered Share These are the one traded globally. The shares are fully tangible – a GRS purchased on one exchange can be sold on another. They trade in both US dollars and euros. Its advantage is that all shareholders have equal status and direct voting rights. Its main disadvantage appears to be the greater expense in establishing the global registrar and clearing facility. GRs have meet with limited success; many companies that considered them opted instead for ADRs.Factors Affecting International Equity Returns1. Macro economic factors – like exchange rate charges, interest rate differentiation, the level of domestic interest rate, and charges in domestic inflation expectations.2. Exchange Rates i.e. the exchange rate charges in a given country reinforces the stock market movements in that country as well as in the other countries.3. Industrial Structure – plays significant part of the correlation structure of international equity index returns in terms of traded goods and non traded goods, etc.FUTURES AND OPTIONS ON FOREIGN EXCHANGEFutures and options contracts can be very risky investments, when used for speculativepurposes. Nevertheless, they are also important risk management tools.Future ContractsBoth forward and futures contracts are classified as “derivative or contingent claimsecurities” because their values are derived from or contingent upon the value of theunderlying security.A futures contract has the following features. 58
  • • It is traded competitively on an organized exchange;• It has a standardized amount of the underlying asset;• It is daily settlement, or marking to the market, done by the futures clearing house through the participants’ margin account.• It has standardized delivery date;• Its delivery of the underlying asset is seldom made. Usually a reversing trade is transacted to exit the market;• Lastly, it has a Bid-ask spread plus broker’s commission.A forward contract on the other hand has the following features;• It is traded by bank dealers via a network of telephones, telex machines, and computerized dealing systems;• It is tailor made to the needs of the participants;• Its participants buy or sell the contractual amount of the underlying assets from the bank at maturity at the forward (contractual) price;• Its tailor-made delivery date meets the needs of the investor;• Deliver of the underlying asset is commonly made;• Lastly, its bid-ask plus indirect bank charges are made via compensating balance requirements.Hence, the major difference between a forward contract and a futures contract is theway the underlying asset is priced for future purchase or sale.The two types of market participants that are necessary for derivation market to operateinclude:-• Speculators; and• Hedgers.A speculator attempts to profit from a change in the future price. To do this, thespeculator will take a long or short position in a futures contract depending upon hisexpectations of future price movement.A hedger, on the other hand, wants to avoid price variation by locking in a purchaseprice of the underlying asset through a long position in the futures contract or a salesprice through a short position. In effect, the hedger passes off the risk of price variationto the speculator, who is better able, or at least more willing, to bear this risk.Hence, both forward and future markets for foreign exchange are very liquid “reversingtrade” can be made in either market that will close out, or neutralize, a position. In theforward market, the investor holds offsetting position after a reversing trade; in thefutures market the investor actually exits the market place. 59
  • The “commission” that buyers and sellers pay to transact in the futures market is asingle amount paid up front that covers the round-trip transactions of initiating andclosing out the positions.In futures markets, a clearing house serves as the third party to all transactions, i.e. thebuyer of a futures contract effectively buys from the clearing house and the seller sellsto the clearing house. This feature facilitates active secondary market trading becausethe buyer and seller do not have to evaluate one another’s creditworthiness.The clearing house is made up of clearing members to clear a customer’s trade. In theevent of default of one side of a futures trade, the clearing member stands in for thedefaulting party, and then seeks restitution from that party.Frequently, a futures exchange may have a daily price limit on the futures price, i.e. alimit as to how much the settlement price can increase or decrease from the previousday’s settlements price. When the price limit is hit, trading will halt as a new market –clearing equilibrium price cannot be obtained.Currency Futures MarketThese are the markets when future contracts are traded. For each delivery month foreach currency, we see the opening price quotation, the high and the low quotes for thetrading day, and the settlement price. For each contract, the open interest is alsopresented. This is the total number of short or long contracts outstanding for theparticular delivery month.Note that the open interest is greatest for each currency in the nearby contract. Ingeneral, open interest (loosely an indication of demand) typically decreases with theterm to maturity of most future contracts. Even though marketing-to-market is animportant economic difference between the operation of futures markets and theforward market, it has little effect on the pricing of futures contracts as opposed to theway forward contracts are priced. It is also worth noting that both the forward andfutures contracts together display a chronological depreciating pattern. Hence, bothmarkets are useful for “price discovery” or obtaining the market’s forecast of the spotexchange rate at different future dates.The equation below is used to define futures:Fi($/i)=So($/i) (1+r$)T (1+ri)TEurodollar Interest Rate Future ContractsFuture contracts are traded on many different underlying assets, especially theEurodollar interest rates futures traded on the different exchanges. 60
  • The Eurodollar contract has become the most widely used futures contract for hedgingespecially the short-term US dollar interest rate risk. It is also used by Eurobanks as analternative, to the Forward Rate Agreement (FRA) for hedging interest rate risk due tomaturity mismatch between Eurodollar deposits and rollover Eurocredits.Other Eurocurrency futures contracts that are traded are the Euroyen, EuroSwiss, andthe EURIBOR contract, which began trading after the introduction of the euro. Forinstance, the CME Eurodollar futures contract is written on a hypothetical $1,000,000ninety day deposits of Eurodollars. The contracts trades in the March, June, Septemberand December circle. The hypothetical delivery date is the third Wednesday of thedelivery month. The last day of trading is two business days prior to the delivery date.The contract is a cash settlement contract, i.e. the delivery of a $1,000,000 Eurodollardeposit is not actually made or received. Instead, final settlement is made throughrealizing profits or losses on the margin account on the delivery date based on the finalsettlement price on the last day of trading.Options ContractsAn option is a contract giving the owner the right, but not the obligation to buy or sell agiven quantity of an asset at a specified price at sometime in the future. An option is aderivative, or contingent claim, security. Its value is derived from its definablerelationship with the underlying asset, i.e foreign currency or some claim on it.In options terminology, the buyer of an option is frequently referred to as the long andthe seller of an option is referred to as the writer of the option, or the short.Because the option owner does not have to exercise the option if it is to hisdisadvantages, the option has a price, or premium. There are two types of options:• American option – that can be exercised at any time during the contract and allows the owner to do everything he can do with a European option and more.• European option – can be exercised only at maturity or expiration date of the contract.Currency option contracts can be over the counter options written by internationalbanks, investment banks and brokerage houses. Over-the-counter options are tailormade according to the specification of the buyer in terms of maturity length, exerciseprice, and the amount of the underlying currency. Generally, these contracts are writtenfor large amounts, at least $1,000,000 of the currency saving as the underlying assets.Frequently, they are written for US dollars, with euro, pound, yen, Swiss Franc andCanadian dollar serving as the underlying currency, though options are also availableon less actively traded currencies. Over-the-counter options are typically Europeanstyle.The volume of OTC currency options trading is much larger than that of organizedexchange option trading. 61
  • Options on currency futures behave very similarly to options on the physical currencysince the futures price converges to the spot price as the futures contract nearsmaturity. Exercise of a futures option results in a long futures position for the call buyeror the put writer and a short futures position for the put buyer or call writer. If the futuresposition is not offset prior to the futures expiration date, receipt or delivery of theunderlying currency will, respectively, result or be required.For call options the time T expiration value can be stated per unit of foreign currency as:CaT = CcT = (Max)ST-E,0)Where CaT denotes the value of the American call at expiration, CcT is the value of theEuropean call at expiration, E is the exercise price per unit of foreign currency, ST is theexpiration date sport price, and Max is the abbreviation denoting the maximum of thearguments within the brackets.A call (put) option with ST>E(E>ST) expires “in the money” and it will be exercised. If ST= E the option expires “at-the-money”. If ST<E(E<ST) the call (put) option expires “out-of-the-money” and it will not be exercised.Likewise, at expiration a European put or American put will have the same valuealgebraically, the expiration value can be stated as;PaT = PeT = Max [E-STO)Where P denotes the value of the put at expiration.Binomial Option Pricing ModelThis provides an exact pricing formula for a American call or put. This model relies onthe risk-neutral probabilities of the underlying asset increasing and decreasing in value.The risk-neutral probability of the SF appreciating is calculated as:q = (FT-So.d)/So(U-d)where FT is the forward (or futures) price that spans the option period. Because theAmerican call option can be exercised at any time, including time O, the binomial calloption premium is determined by;Co = Max[qCuT+(1-q)CdT]/(1+r$).So-E] 62
  • European Option Pricing FormulaThis can be calculated using the formulaCe = Ste-riTN(d1)-Ee-riTN(dq)andPe+Ee-r$TN(-d2)-Ste-riTN(-dt)FOREIGN EXCHANGE EXPOSURE AND MANAGEMENTTHE MANAGEMENT OF ECONOMIC EXPOSUREIntroductionAs business becomes increasingly global, more and more firms find it necessary to paycareful attention to foreign exchange exposure and to design and implementappropriate hedging strategies. For example, suppose the US dollar substantiallydepreciates against the Japanese yen, this change in exchange rate can havesignificant economic consequences for both the US and Japanese firms. It canadversely affect the competitive position of Japanese car makers in the highlycompetitive US market by forcing them to raise dollar prices of their cars by more thantheir US competitors do. The same change in exchange rate, however, will tend tostrengthen the competitive position of import competing US car makers.On the other hand, should the dollar appreciate against the yen, it would bolster thecompetitive position of Japanese car makers at the expense of US makers. Hence,charges in exchange rates can affect not only firms that are directly engaged ininternational trade, but also purely domestic firms, for instance, if it competes againstimports of similar products. Likewise, change in exchange rates may affect not only theoperating cash flows of a firm by altering its competitive position but also home currencyvalues of the firm’s asset and liabilities. For example, if a US firm that has borrowedSwiss Franc since the dollar amount needed to pay off the franc debt depends on thedollar/franc exchange rate, the US firm can gain or lose as the Swiss franc depreciatesor appreciates against the dollar.Exchange rate changes can systematically affect the value of the firm by influencing itsoperating cash flows as well as the domestic currency values of its assets and liabilities.Types of Exposures1. Economic Exposure.2. Transaction Exposure.3. Translation Exposure. 63
  • 1. Economic ExposureThis can be defined as the extent to which the value of the firm would be affected byunanticipated changes in exchange rates. Any anticipated changes in exchange rateswould have been already discounted and reflected in the firm’s value. Changes inexchange rates can have a profound effect on the firm’s competitive position in theworld market and thus on its cash flows and market value.2. Transaction ExposureThis can be defined as the sensitivity of “realized” domestic currency values of thefirm’s contractual cash flows “denominated” in foreign currencies to unexpectedexchange rate changes. Since settlements of these contractual cash flows affect thefirm’s domestic currency cash flows, transaction exposure is sometimes regarded as ashort-term economic exposure. This exposure arises from fixed-price contracting in aworld where exchange rates are changing randomly.3. Translation ExposureThis refers to the potential that the firm’s consolidated financial statements can beaffected by changes in exchange rates. Consolidation involves translation ofsubsidiaries’ financial statements from local currencies to the home currency.For instance, a US MNC that has subsidiaries in the UK and Japan. Each subsidiary willproduce financial statements in local currency. To consolidate financial statementsworld wide, the firm must translate the subsidiaries’ financial statements in localcurrencies into the US dollar, the home currency.How to Measure Economic ExposureExposure to currency risk can be properly measured by the sensitivities of:-(i) the future home currency values of the firm’s assets and liabilities;(ii) the firm’s operating cash flows to random changes in exchange rates. 64
  • This illustrated in the exhibit below:Channels of Economic ExposureAssets include the tangible assets (property, plant and equipment, inventory) as well asfinancial assets.Exposure can be measured by the coefficient (b) in regressing the dollar value (P) ofthe British asset on the dollar/pound exchange rate (S).P=a+bxS+eWhere a is the regression constant and e is the random error term with mean zero, thatis, E(e) = 0; P = SP*, where P* is the local currency (pound) price of the asset. It isobvious from the above equation that the regression coefficient b measures thesensitivity of the dollar value of the asset (P) to the exchange rate (S). If the regressioncoefficient is zero, that is, b=0, the dollar value of the asset is independent of exchangerate movements implying no exposure.On the basis of the above analysis, one can say that “exposure” is the regressioncoefficient. Statistically, the exposure coefficient, b, is defined as follows:-b = Cov (P1S) Var (S)Where Cov(P1S) is the covariance between the dollar value of the asset and theexchange rate, and Var(S) is the variance of the exchange rate.Operating ExposureWhile many managers understand the effects of random exchange rate changes on thedollar value of their firm’s assets and liabilities denominated in foreign currencies, they 65
  • do not fully understand the effect of volatile exchange rates on operating cash flows. Asthe economy becomes increasingly globalised, more firms are subject to internationalcompetition. Fluctuating exchange rate can seriously alter the relative competitivepositions of such firms in domestic and foreign markets, affecting their operating cashflows.The exposure of operating cash flows depends on the effect of random exchange rate.Changes on the firm’s competitive position, which is not readily measurable. It isimportant for the firm to properly manage operating exposure as well as asset exposure.In many cases, operating exposure may account for a larger portion of the firm’s totalexposure than contractual exposure.Formally, operating exposure can be defined as the “extent to which the firm’soperating cash flows would be affected by random change in exchange rates”.Determinants of Operating ExposureUnlike contractual i.e. transaction exposure which can readily be determined from thefirm’s accounting statements, operating exposure cannot be determined in the samemanner. A firm’s operating exposure is determined by:-(i) the structure of the markets in which the firm sources its inputs such as labour and materials, and sells its products; and(ii) the firm’s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.Generally speaking, a firm is subject high degrees of operating exposure when either itscosts or its price is sensitive to exchange rate changes. On the other hand, when boththe cost and the price are sensitive or insensitive to exchange rate changes, the firmhas no major operating exposure.Given the market structure, however, the extent to which a firm is subject to operatingexposure depends on the firm’s ability to stabilize cash flows in the face of exchangerate changes. For instance, even if Ford faces competition from local car makers inMexico, it can reduce exposure by starting to source Mexican parts and materials,which would be cheaper in dollar terms after the dollar appreciation. Ford can ever startto produce cars in Mexico by hiring local workers and sourcing local imports, therebymaking peso costs relatively insensitive to changes in the dollar/peso exchange rate.In other words, the firm’s flexibility regarding production locations, sourcing, andfinancial hedging strategy is an important determinant of its operating exposure toexchange risk.However, changes in nominal exchange rates may not always affect the firm’scompetitive position when a change in exchange rate is exactly offset by the inflationdifferential. 66
  • When facing exchange rate change, a firm may choose one of the following pricingstrategies:-(a) pass the cost stock fully to its selling price (complete-pass-through);(b) fully absorb the stock to keep its selling price unaltered (no-pass-through);(c) do some combination of the two strategies described above (partial-pass- through).It is worth noting that partial pass-through is common but varies a great deal acrossindustries. Import prices would be affected relatively little by exchange rate changes inindustries with low product differentiation and thus high demand elasticities. In contrast,in industries with a high degree of product differentiation and thus low demandelasticity, import prices will tend to change more as the exchange rates change.Managing Operating ExposuresAs the economy becomes increasingly globalised, many firms are engaged ininternational activities such as exports, cross border sourcing, joint ventures with foreignpartners, and establishing production and sales affiliates abroad.The cash flows of such firms can be quite sensitive to exchange rate charges. Theobjective of managing operating exposure is to stabilize cash flows in the face offluctuating exchange rates.Managing operating exposure is thus not a short-term tactical issue. The firm can usethe following strategies for managing operating exposure.1. Selecting low cost production sites;2. Flexible sourcing policy;3. Diversification of the market;4. Product differentiation and R&D efforts;5. Financial hedging.1. Selecting Low Cost Production Sites When the domestic currency is strong or expected to become strong, eroding the competitive position of the firm, it can choose to donate production facilities in a foreign country where costs are low due to either the undervalued currency or underpriced factors of production. For example, Japanese car makers have increasingly been shifting production to US manufacturing facilities in order to mitigate the negative effect of the strong yen on US sales. Also, the firm can choose to establish and maintain production facilities in multiple countries to deal with the effect of exchange rate changes. For example, Nissan, which has 67
  • manufacturing facilities in the US and Mexico as well as in Japan provide it with a great deal of flexibility regarding where to produce, given the prevailing exchange rates. Maintaining multiple manufacturing sites, however, may prevent the firm from taking advantage of economies of scale, raising its costs of production.2. Flexible Sourcing Policy i.e. by substantially lessening the effect of exchange rate changes by sourcing from where import costs are low. In the 1980s when the dollar was very strong against most major currencies, US MNCs often purchase materials and components from low cost foreign suppliers in order to keep themselves from being priced out of the market. Likewise, facing the strong yen in recent years, many Japanese firms are adopting the same practices, by depending heavily on parts and intermediate products from such low cost countries as Thailand, Malaysia and China. Firms can also hire low cost guest workers from foreign countries instead of high cost domestic workers in order to be competitive. For example, Japan Airlines is known to heavily hire foreign crews to stay competitive in international routes in face of a strong yen.3. Diversification of the market i.e. for the firm’s products as much as possible. As long as exchange rates do not always move in the same direction, the firm can stabilize its operating cash flows by diversifying its export market. The firm can also reduce currency exposure by diversifying across different business lines. However, the firm should not get into new lines of business solely to diversify exchange risk because conglomerate expansion can bring about inefficiency and losses. Expansion into a new business should be justified on its won right.4. K & D Efforts and Product Differentiation Investment in R & D activities can allow the firm to maintain and strengthen its competitive position in the face of adverse exchange rate movements. Successful R & D efforts allow the firm to cut costs and enhance productivity. In addition, R & D efforts can lead to the introduction of new and unique products for which competitors offer no close substitutes. Since the demand for unique products tend to be highly inelastic i.e. price insensitive, the firm would be less exposed to exchange risk. At the same time, the firm can strive to create a perception among customers that its product is indeed different from those offered by competitors. Once the firm’s product acquires a unique identity its demand is less likely to be price sensitive. 68
  • 5. Financial Hedging This can be used to stabilize the firm’s cash flows. For example, the firm can lend or borrow foreign currencies on a long-term basis or the firm can use currency forward or options contracts and roll them over if necessary. Financial contract can at best provide an appropriate hedge against the firm’s opening exposure, and can provide the firm with a flexible and economical way of dealing with exchange exposure.Procedure for Financial Hedging1. Exchange forecasting i.e. involves reviewing the likelihood of adverse exchange movement. Staff of treasury estimates possible ranges for strength or weaknesses of for instance the dollar over a five year planning horizon.2. Assessing strategic plan impact.3. Deciding whether to hedge i.e. with the objective of maximizing long-term cash flows and on the potential effect of exchange rate movements on the firm’s ability to meet its strategic objectives.4. Selecting the hedging instruments such as forward currency contracts, foreign currency borrowing and currency options.5. Constructing a Hedging Program either on: • Hedge for a multi-year period using long-dated options contracts, rather than hedge year-by-year, to protect the firm’s strategic cash flows; • Not use far-out of money options to save costs; • Hedge only on a partial basis, with the remainder self-insured.Hence for most cost effective program, the firm may decide to develop a computerbased model that simulates the effectiveness of various hedging strategies.MANAGEMENT OF TRANSACTIN EXPOSUREIntroductionThe firm is subject to transaction exposure when it faces contractual cash flows that arefixed in foreign currencies. For example, suppose that a US firm sold its product to aGerman client on three-month credit terms and in invoiced є1million. When the US firmreceives є1million in three months, it will have to convert, unless it hedges the eurosinto dollars at the spot exchange rate prevailing on the maturity date, which cannot beknown in advance. As a result, the dollar receipt from this foreign sale becomesuncertain; should the euro appreciate or depreciate against the dollar, the dollar receipt 69
  • will be higher (lower). This situation implies that if the firm does nothing about theexposure, it is effectively speculating on the future course of the exchange rate.This example suggests that whenever the firm has foreign currency denominatedreceivables or payables, it is subject to transaction exposure and their settlements arelikely to affect the firm’s cash flow position.Ways of Heading Transaction exposures.1. Financial Contracts: • Forward market hedge; • Money market hedge; • Option market hedge; • Swap market hedge.2. Operational Technologies • Choice of the invoice currency; • Lead/lag strategy; • Exposure netting.1. Forward Market HedgeThe most direct and popular way of hedging transaction exposure is by currencyforward contracts. The firm may sell (buy) it foreign currency receivables (payables)forward to eliminate its exchange risk exposure.The gain will be positive as long as the forward exchange rate is greater than the spotrate on the maturity date, that is, F75T, and the gain will be negative (i.e. a loss willresult) if the opposite holds.To help the firm decide, it is useful to consider the following three alternative scenarios: _(i) ST≅F(ii) ST<F _(iii) ST>F _Where ST denotes the firm’s expected spot exchange rate for the maturity date. _Under the first scenario, where the firm’s expected future spot exchange rate, ST, isabout the same as the forward rate, F, the expected gains or losses are approximatelyzero. But forward hedging eliminated exchange exposure. In other words, the firm can 70
  • eliminate foreign exchange exposure without sacrificing any expected dollar proceedsfrom the foreign sale.Under the second scenario, where the firm’s expected future spot exchange rate is lessthan the forward rate, the firm expects a positive gain from hedging. Since the firmexpects to increase the dollar proceeds while eliminating exchange exposure, it wouldbe even more inclined to hedge under this scenario than under the first scenario. Thisscenario implies that the firm’s management dissents from the market’s consensusforecast of the future spot exchange rates as reflected in the forward rate.Under the third scenario, on the other hand, where the firm’s expected future spotexchange rate is more than the forward rate, the firm can eliminate exchange exposurevia the forward contract only at the cost of reduced exported dollar proceeds from theforeign sale. Thus the firm would be less inclined to hedge under this scenario, otherthings being equal. Whether the firm actually hedges or not depends on the degree ofrisk aversions; the more risk aversion the firm is, the more likely it is to hedge.From the view of a hedging firm, the reduction in the expected dollar proceeds can beviewed implicitly as an “insurance premium” paid for avoiding the hazard of exchangerisk. Hence, the firm uses a currency futures contract rather than a forward contract, tohedge.2. Money Market HedgeTransaction exposure can also be hedged by lending and borrowing in the domesticand foreign money markets. Generally, the firm may borrow (lend) in foreign currency tohedge its foreign currency receivable (payables), thereby matching its assets andliabilities in the same currency. For example, Boeing can eliminate the exchangeexposure arising from the British sale by first borrowing in pounds, then converting theloan proceeds into dollars, which then can be invested at the dollar interest rate. On thematurity date of the loan, Boeing is going to use the pound receivable to pay off thepound loan. Hence, the first step in money market hedging is to determine the amountof pounds to borrow. Since the maturity value of borrowing should be the same as thepound receivable, the amount to borrow can be computed as the discounted presentvalue of the pound receivable.3. Options Market HedgeHere, there are multiple exercise exchange rates (prices) for the options contract.Choice of the exercise price for the options contract ultimately depends on the extent towhich the firm is willing to bear exchange risk. For instance, if the firm’s objective is onlyto avoid very unfavourable exchange rate charges, that is, a major depreciation of e.g.the pound, then it should consider buying an out-of-money put option with a lowexercise price, varying option cost. 71
  • 4. Cross-Hedging Minor Currency ExposureIf a firm has receivables or payables in major currencies, it can easily use forward,money market or options contracts to manage its exchange risk exposure. In contrast, ifthe firm has positions in minor currencies such as the Korean won, it may be either verycostly or impossible to use financial contracts in these currencies. This is becausefinancial markets of developing countries are relatively under developed and oftenhighly regulated.Facing this situation, the firm may consider using “cross-hedging” technique tomanage its minor currency exposure. Cross hedging involves hedging a position in oneasset by taking a position in another asset. Likewise, commodity futures contract maybe used effectively to cross-hedge some minor currency exposures. For example, thefirm can sell (buy) oil futures if it has peso receivable (payable). In the same vein,soybean and coffee futures contracts may be used to cross hedge a Brazilian realexposure. However, the effectiveness of this cross-hedging technique would depend onthe strength and stability of the relationship between the exchange rate and thecommodity futures prices.5. Hedging Contingent ExposureIn addition to providing a flexible hedge against exchange exposure, option contractscan also provide an effective hedge against what is called “contingent exposure”, whichrefers to a situation in which the firm may or may not be subject to exchange exposure.6. Hedging Recurrent Exposure with Swap ContractsFirms often have to deal with a sequence of accounts payable or receivable in terms ofa foreign currency. Such recurrent cash flows in a foreign currency can best be hedgedusing a currency swap contract, which is an agreement to exchange one currency foranother at a predetermined exchange rate, that is, the swap rate, on a sequence offuture dates. Swaps are very flexible in terms of amount and maturity; the maturity canrange from a few months to 20 years.7. Hedging through Invoice CurrencyHere, the firm can shift, share or diversify exchange risk by appropriately choosing thecurrency of invoice. For example, if Boeing invoices $15 million rather than £100 millionfor the sale of the aircraft, then it does not face exchange exposure any more.The firm can diversify exchange exposure by using currency baskets units such as theSDR as the invoice currency. Often MNCs and sovereign entities are known to floatbonds denominated either in SDRs or in the ECU prior to the introduction of the euro.These currency baskets are used to reduce exchange exposure. 72
  • Currency basket units can be a useful hedging tool especially for long-term exposure forwhich no forward or option contracts are readily available.8. Hedging via Lead and LagThis refers to leading and lagging foreign currency receipts and payments to “lead”means to pay or collect early, whereas to “lag” means to pay or collect late. The firmwould like to lead soft currency receivables and lag have currency receivables to avoidthe loss from depreciation of the soft currency and benefit from the appreciation of thehard currency. In the same reason, the firm will attempt to lead the hard currencypayables and lag soft currency payables. The lead-lag strategy can be employed moreeffectively to deal with intra-firm payables and receivables, such as material costs,rents, royalties, interests and dividends among subsidiaries of the same MNC. Sincemanagement of various subsidiaries of the same firm are presumably working for thegood of the entire firm, the lead/lag strategy can be applied more aggressively.9. Exposure NettingIf the firm wishes to use this strategy aggressively, it helps to centralize the firm’sexchange exposure management function in one location. MNCs are using a “reinvoicecentre”, a financial subsidiary as mechanism for centralizing exposure managementfunctions. All the invoices arising from intra-firm transactions are sent to the reinvoicecentre, where exposure is netted. Once the resident exposure is determined, thenforeign exchange experts at the centre determine optimal hedging methods andimplement them.Reasons for a firm to Hedge1. Information asymmetry: Management knows about the firm’s exposure position much better than stockholders. Thus, the management of the firm, not its stockholders, should manage exchange exposure.2. Differential transaction Costs: The firm is in a position to acquire a low-cost hedges; transaction costs for individual stockholder can be substantial. Also the firm has hedging tools like the reinvoice centers that are not available to stockholders.3. Default costs: If default costs are significant, corporate hedging would be justified because it will reduce the probability of default. Perception of a reduced default risk, in turn can lead to a better credit rating and lower financing costs.4. Progressive Corporate Taxes: Under this, stable before tax earnings can lead to lower corporate taxes than volatile earnings with the same average value. This happens because under progressive tax rates, the firm pays more taxes in high earning periods than it saves in low earning periods. 73
  • DERIVATIVE PRODUCTSIntroductionDerivatives have become a very important part of the financial landscape over the pastyears and in many cases have been at the centre of some high risk strategies. Whilederivatives can be used as hedging strategies, it seems they only bring public attentionwhen they are used for speculative purposes or “blow up” because of too muchleverage or misuse.Derivative products entails the following:-1. Options2. Entries1. OPTIONS1.1 What is an option?The word option has many different meanings, but most of them include the ability orright to choose a certain alternative. One definition provided by Webster is “the right,acquired for a consideration, to buy or sell something at a fixed price within aspecified period of time”.The person acquiring the option pays an agreed upon sum to the person providing theoption. For example, someone may want to buy your house for its sales price of$100,000. The buyer does not have the money but will give you $7000 in cash if yougive him the right to buy the house at $100,000 for the next 60 days. If you accept, youhave given the buyer an option and have given the buyer an option and have agreednot to sell the house to any one else for the next 60 days. If the buyer raises $100,000within the 60 days limit, he may buy the house, giving you the $100,000. Perhaps, hegets the $100,000 but also finds another house he like better for $95,000. He will notbuy your house but you have a $7000 option premium and must now find some oneelse to buy your house. By selling the option, you tied up the sale of your house for 60days, and if the option is not exercised, you have for gone an opportunity to sell thehouse to some one else.As the world of investments, an option is a type of contract between two people wherein one person grants the other person the right to buy a specific asset at a specific pricewithin a specific time period. Alternatively, the contract may grant the other person theright to sell a specific asset at a specific price within a specific time period. The personwho has received the right and thus has a decision to make is known as “the optionbuyer” because he or she must pay for this right. The person who has sold the rightand thus must respond to the buyer’s decision is known as “the option writer”. 74
  • Options have become popular type of investment because the potential return fromtaking positions in options are much larger than those associated with long and shortpositions in the underlying assets. However, the biggest difference is that the amount ofleverage associated with options is greater than what can be achieved by taking aposition in the underlying assets. As a result, the risks associated with positions inoptions are also larger than those associated with long and short positions in theunderlying asset.1.2 Types of option contractsThe two most basic types of option contracts are known as “calls and puts”. Suchcontracts are traded on many exchanges around the world and many are createdprivately (i.e. off exchange “or” over the counter”. Privately created calls and putstypically involve financial institutions or investment banking firms and their clients.(a) Call options This is the most prominent type of option contract. It gives the buyer the right to buy (“call away”) a specific number of shares of a specific company from the option writer at a specific purchase price at any time up to and including a specific data. The contract specifies four items. (i) The company whose shares can be bought; (ii) The number of shares that can be bought; (iii) The purchase price for those shares known as the exercise (or the strike price); (iv) The date when the right to buy expires known as the “expiration date”.(b) Put options This gives the buyer the right to sell (“to put away’) a specific number of shares of a specific company to the option writer at a specific selling price at any time up to and including a specific dates. The contract specifies four items that are analogous to those in call options: (i) The company whole shares can be sold; (ii) The number of shares that can be sold; (iii) The selling price for those shares, known as the exercise price (or strike price); (iv) The date when the right to sell expires, known as the expiration date.1.3 Option MarketsBefore the days of option trading on exchanges, puts and calls were traded over-the-counter by the put and call Dealers Association. These dealers would buy and sell puts 75
  • and calls for their own accounts for stocks traded on the NYSE and then try to find aninvestor, hedger, or speculator to take the other side of the option. For example, if youowned 1000 shares of Ford and you wanted to write a call option giving the buyer theright to buy 1000 shares of Ford at $70 per share for six months, the dealer might buythe calls and look for some one who would be willing to buy them from him.Dealers had to have content with the buyers and sellers, and the financial stability of theoption writer had to be endorsed (guaranteed) by a brokerage house.The option writer either had to keep the shares on deposits with the brokerage firm orput up a cash margin. Options in the same stock could exist in the market at variousstrike prices (prices at which the option could be exercised) and scattered expirationdates. This meant that when an option buyer wanted to exercise or terminate thecontract before expiration, he or she would have to deal directly with the option writer.This, in reality does not make for an efficient, liquid market. Unlisted options alsoreduced the striking price of a call by any dividends paid during the option period, whichdid not benefit the writer of the call.Hence, options are purchased and traded either on an organized exchange such asPhiladelphia Stock Exchange or in the Over-The-Counter (OTC) market. Exchangetraded options or listed options are standardized contracts with predetermined exerciseprices, standard maturities (one, three, six, nine and twelve months), and fixedmaturities (March, June, September and December). Options are traded in standardcontracts; cross-rate options are also available for the DM/7/£/DM, and £/y. by takingthe US dollar out of the equation, cross-rate option allows one to hedge directly thecurrency risk that arises when dealing with non-dollar currencies.OTC options are contracts whose specifications are generally negotiated as to theamount, exercise price and rights, underlying instruments, and expiration.OTC currencyoptions are traded by commercial and investment banks in virtually all finance centres.The OTC option markets consist of the two sectors:-(a) Retail market composed of non-bank customers who purchase from banks what amounts to customize insurance against adverse exchange rate movements; and(a) Wholesale market among commercial banks, investment banks, and specialized trading firms; this market may include interbank OTC trading or trading on the organized exchanges. The interbank market in currency options is analogous to the interbank markets is spot and forward exchange. Banks use the wholesale market to hedge or the “reinsure” the risks undertaken in trading with customers and to take speculative positions in options.Most retail customers for OTC options are either corporations active in internationaltrade or financial institutions with multi-currency asset portfolio. These customers couldpurchase foreign exchange puts or calls on organized exchanges, but they generally 76
  • turn to the backs for options in order to find precisely the terms that match their needs.Contracts are generally tailored with regard to amount, strike price, expiration date, andcurrency.One can now also buy a put or call option on “stock indexes” in addition to individualstock. There are several reasons the listed option markets are so desirable comparedwith the previous method of over the counter trading for options. The use of three cyclesspread out the expiration dates for the options so that not all contracts came due on thesame day.In an attempt to satisfy demand for longer-term options, “long-term equity anticipationsecurities” (LEAPS) were added and provided options with up to two years orexpiration. LEAPS have the same characteristics as the short-term options, but becauseof their length, they have higher prices.Lastly, option trading has the standardized “exercise price” (strikes price). This is theprice the contract specifies for a buy or sell for all stocks over $25 per share, the strikingprice normally changes by $5 intervals and for stocks selling under $25 per share, thestrike price usually changes by $2.5 a share. As the underlying stocks change prices inthe market, options with new striking prices are added. This standardization ofexpiration date and strike prices creates more certainty when buying and selling optionsin a changing market and allows more efficient trading strategies because of bettercoordination between stock prices, strike prices and expiration dates. Dividends nolonger affect the option contract as they did in the unlisted market. Transactions occurat arm’s length between the buyer and seller without any direct match making neededon the part of the broker. The ultimate month of these changes in the option market is ahighly liquid, efficient market where speculators, hedgers and arbitrageurs all operatetogether.1.4 Options clearing corporationThis is a well capitalized financial institution that guarantees contract performance toboth parties. As soon as the trade is communicated, the Clearing House interposesitself between the buyer and seller. At this point, the original buyer and seller haveobligations to the clearing house and no obligations to each other.Investors who want to trade puts and calls need to have an approved account with amember brokerage firm; on opening an account, they receive a prospective from theoptions clearing corporation detailing all aspects of option trading.In the calculation of clearing margins, the exchange clearing house calculates thenumber of contracts on trading on either a gross or a net basis. Basis is the differencebetween the current spot price on an asset and corresponding futures prices. The grosssimilarly adds the total of all long positions entered into by clients to the total all shortpositions entered into by clients to the total of all short positions entered into by clients.The net basis allows these to be offset against each others. 77
  • The whole purpose of the margining system is to reduce the possibility of marketparticipants sustaining losses because of defaults.1.5 Basic Option StrategiesOption strategies can be very aggressive and risky, or they can be quite conservativeand used as a means of reducing risk. Options buyers and writers both attempt to takeadvantage of the option premiums. In theory, many option strategies can be created,but in practice, the market must be liquid enough to execute these strategies. Much ofthe option activity has been absorbed by options of the standard poor’s 100 and 500stock indexes where large institutional investors can transact portfolio strategies on themarket rather than on individual stocks.A reduction of individual option reduces the ability to create workable strategies forspecific companies. For example, the lack of a liquid market can keep institutionalinvestors from executing hedging strategies involving several hundred thousand shares.Even with these limitations in mind, the average investor can find many opportunities foroption strategies.Uses of calls and puts to achieve different investment goals(a) Buying Call Options (i) The Leverage Strategy Leverage is a very common reason for buying call options when the market is expected to rise during the exercise period. The call option is priced much lower than common stock and the leverage is denied from a small percentage change in the price of call options. An investor striving for maximum leverage generally buys options that are out of the money or slightly in the money. Buying high-priced option for $10 and $15 that are well in the money limits the potential for leverage. You have to invest almost as much in the options as you would in the stock. (ii) Call options instead of stock. i.e. many people do not like to risk large amount of money and view call options as way of controlling 100 shares of stock without a large dollar commitments. This strategy works to the investor’s advantage because in the end the loss is less for owning the call option than it would be for owning 100 shares of stock outright. 78
  • (iii) Protecting a Short Position Calls are often used to cover a short sale against the risk of rising stock prices. This is called hedging from position. By purchasing a call, the short seller guarantees a loss of no more than a fixed amount while at the same time reducing any potential profit by the total premium paid for the call. Writing a call to protect a short sale is equivalent to buying an insurance policy that you hope would not need. (iv) Guaranteed Price The important point for this strategy is that the investor wants to own this stock eventually but does not want to miss out on a good buying opportunity (based on expectations). A call option can be utilized. The investor could be anticipating a cash inflow in the future when he/she plans to exercise the call option with a tax refund, a book royalty check, or even the annual bonus.(b) Writing Options Writers of call options take the opposite side of the market from buyers. The writer is similar to a short seller in that he or she expects the stock to decline or stay the same. For short sellers to profit, prices must decline but because writers of call options receive a premium, they can make a profit if prices stay the same or even rise less than the speculative premium. Option writers can write “covered options”, meaning they own the underlying common stock, or they can write “naked options”, meaning they do not own the underlying stock. Writing covered call option is often considered a hedge position because if the stock price declines, the writers loss on the stock is partially offset by the option premium. A potential writer of a covered call must decide if he is willing to sell the underlying stock if it closes above the strike price. If not, the writer must repurchase the call option before the option is exercised by the owner. Another critical decision for a call writer is the choice of months. The shortest expiration dates usually provide the highest daily speculative premium. In most cases, the call writer chooses the short-term option and as they expire, writes another short-term option.(c) Buying put options The owner (buyer) of a put may sell 100 shares of stock to the put writer at the strike price. The strategy behind a put is similar to selling short or writing a call except losses are limited to the total investment (premium), and no more risk exposure is possible if the stock rises. Buying a put in anticipation of a price decline is one method of speculating on market price changes. The same factors 79
  • influencing call premiums also apply to put premiums except that expectations for the direction for the market are the opposite. Puts can also help an investor offset a potential decline in the price of common stock that you continue to hold for tax purposes. You can hold the put along with your stock and keep buying new puts if necessary until you are ready to sell your stock.1.6 Using Options in Combinations (a) Spreads. This refers to the combinations of options and consists of buying one option (going long) and writing an option (going short) on the same underlying stock. (b) Straddles This is a combination of a put and call on the same stock with the same strike price and expiration date. It is used to play wide fluctuations in stock prices and is usually applied to individual stocks with high betas and a history of large, short-term fluctuations in price. The speculator using a straddle may be unsure of the direction of the price movement but may be able to make a large enough profit on one side of the straddle to cover the cost of both options even if one option expires worthless. Hence, some who engage in spreads or straddles might attempt to close out one position before the other. This expands the profit potential but also increases the risk.1.7 Other Options Consideration (a) Tax laws relating to options are constantly changing, and some items, such as capital gains have been revised several times in the last few years. The recognition of the year in which a gain or loss is declared can still be affected by option strategies in combination with stock positions. The best advice is to check the tax consequences of any option strategy with your accountant or stock broker. (b) Commissions vary among brokerage houses and are not easy to pinpoint for option transactions since quantity discounts exists and selling can significantly alter your returns and even create losses. For example, commission on acquiring common stock through options are higher than the transaction costs of options, and this is a motivating force in closing out option transaction before expiration. Overall, commissions on option tend to be more significant than commissions on commodities or other highly leveraged investments. 80
  • 1.8 Valuation of Options Here we look at the factors that determine the price of an option and their proceeds to look at the Black-Scholes option pricing formula. (a) Principles of Option Pricing A fundamental principle underlying the pricing of an option is that the greater the probability of an option being exercised, the higher will be its price other things being equal. The other key factor that will be crucial is the expected profit if the options were to be exercised. There are five crucial factors that determine the likelihood of the call option being exercised and which therefore influence the price to be paid for the call option; (i) The current price of the share – The higher the current price of the stock the more likely the share is to be exercised for any given strike price, and consequently the higher the rice of a call option. (ii) The strike price – the higher the strike price of a call option the less likely it is that it will be exercised, and hence the lower its price. (iii) The time left to expiration. The lower the time left to expiration then the higher the chance of the option being exercised, and hence the higher its price. (iv) The volatility – the more volatile an option is the more likely that its price at the time of expiration will exceed the strike price, and hence the higher the price of the option. (v) The risk free rate of interest. The purchaser of a call option is paying the issuer cash for an option that can be exercised to buy an underlying security at a future date. The option holder is thus benefitting from the fact that the difference between the option premium and actually buying the underlying security can be invested at a risk free rate of interest until the option expires. A rise in the risk free rate of interest make it more attractive to buy the option rather than the underlying security. For this reason, other things being equal, a call option needs to be priced more highly when interest rates are higher than when interest rates are low. The higher the risk-free rate of interest the higher a call option price. 81
  • Nonetheless, changes in the risk-free rate of interest are usually only a marginal factor in the pricing of options.(b) Intrinsic Value and Time Value An option premium is made up of two components, the “intrinsic value” and the “time value”. The intrinsic value is the gain that would be realized if an option was exercised immediately. For a call option this is simply the strike price less the cash price of the underlying asset; while for a put option it is the strike price less the cash price. Intrinsic value for a call option = cash price - strike price Intrinsic value for a put option = strike price – cash price If an intrinsic value for an option exists, then the option is said to be “in- the-money”. A call option will be in the money if the strike price is below the cash price. If its strike price is above the cash price, the call option will have zero intrinsic value and it is said to be “out-of-the-money”, If the strike price is equal to the spot price it is “at-the-money” with zero intrinsic value. Call Put In-the-money Cash price above Cash price below strike price strike price At-the-money Cash price equals Cash price equals strike price strike price Out-of-the-money Cash price below Cash price above strike price strike price Therefore, the intrinsic value reflects the price that would be received if the option were “locked in” today at the current market price. Hence, the intrinsic value of an option is either positive or zero. The “time value” of an option is the option premium less the intrinsic value. The time value reflects the fact that an option may have more ultimate values than its intrinsic value. Time value = option premium – intrinsic value 82
  • An option buyer, even if the option is not of the money, will still have some hope that at sometime prior to expiration changes in the spot price will move the option into the money or further increase its value if it is already in the money. This prospect given an option a value greater than its intrinsic value.(c) The Black-Scholes Option pricing formula This formula applies to European option. It is based upon a number of simplifying assumptions:- (i) The underlying asset being analysed pays no dividends or interests during its life time. (ii) The option is a European option, i.e. it cannot be exercised prior to maturity. (iii) The risk free rate of interest is fixed during the life of the option. (iv) The financial markets are perfectly efficient with zero transaction costs. No bid-ask spread and no taxes. (v) The price of the underlying asset is log normally distributed, with a constant mean and standard deviation. (vi) It is possible to short-sell the underlying asset and utilize the proceeds obtained without restrictions. (vi) The price of the underlying asset moves in a continuous fashion.The basic idea underlying the derivative of the Black-Scholes option pricingmodel is that a long position in the underlying stock is neutralized by a shortposition in options (appropriately priced), such that the stockholder with such acombined position will only have a return equal to the risk-free rate of interest.When the stock price rises, the premium on an option rises (implying a loss for ashort position) so as to offset any gains from the rise in the price of the stock.Hence, the Black-Scholes formula is saying that the current value of a call is thepresent value of the expected cash price less the expected value of the strikeprice and is calculated by the formula.d1 = In(S/x)+(r+δ2/2)T δ√Tandd2 = d1 = δ√T 83
  • where S is the current spot price; x is the exercise price; δ2 is the variance of the price of the underlying asset on an annual basis, δ is the standard deviation of the price of the underlying on an annual basis, r is the risk free rate of interest and T is the time to expiry as a fraction of years (one quarter = 0.75, 6 months = 0.5, etc). Example Let us assume that the current spot price of a share is 100 pence and an investor buys a call option to purchase the share at 90 pence. The risk free rate of interest is 6 percent and the relevant measure of historical volatility is 30 percent. The option has 90 days to expiry. Hence: S = 100p X = 90p r = 0.06 T = 90/365 = 0.75 (approx.) δ2 = 0.49 so that δ = 0.7 We first calculate the value of d1: d1 = In(S/x)+(r+δ2/2)T δ√T that is, d1 = In(100/90+(0.06+0.72/2)0.25 = 0.52 0.7√0.25 From the cumulative normal distribution table supplied at the end, we find: N(d1) = N(0.52) = 0.69852. FUTURES Introduction A financial futures contract is an agreement between two counterparties to exchange a specified amount of a financial security (bond, bill, currency or stocks) at a fixed future date at a pre-determined price. The contract specifies the amounts of security to be traded, the exchange on which the contract is traded, the delivery date and the process for delivery of the security and funds. Future contracts have proved very popular for both commodities and financial assets. God, oil, cotton and coffee are among the most popular commodity contracts. London International Financial Futures Exchange (LIFFE) also currently trades numerous financial futures contracts, among the most popular of which are short and long term interest rates contracts, currency contracts and stock index contracts. 84
  • Like other financial instruments, futures and forward contracts can be used for managing risks and assuming speculative positions. The growth of futures exchanges Reasons for the rapid growth of futures markets are:- (i) The markets offer a low cost means of managing risk exposure. Many futures markets are more liquid than the spot market in the underlying assets. For example, there are an enormous amount of outstanding UK government bond issuer but only one UK hound futures contract, the high degree of liquidity in the bond futures contracts keeps transaction costs in trading in bonds down. (ii) Future markets enable traders to take speculative positions on price movements for a low initial cash payments (known as the initial margin). (iii) Future contracts enable traders to take short positions, i.e, to sell something they own with considerable ease. This means that taking positions on price falls is made as easy as taking positions on price rises. For example, if a speculator feels the stock market will fall below the futures price of 4000 he can sell a future contract on the stock market index, if the index subsequently falls to say 3800 he will receive a cash profit based on the difference of 200 index points. Without the futures market only participants who currently own a portfolio of stocks that make up the index or who are able to borrow stock will be in a position to take advantage of expected price falls. (iv) Unlike forward contracts where there is a degree of counterparty risk, all futures contracts are guaranteed by the exchange on which they are traded.Composition between Futures and Forward ContractsThese contracts are basically very similar financial instruments, they are bothagreements to make an exchange of underlying assets between two parties at anagreed price sometime in the future.One party agrees to sell the underlying asset (go short) and the other party agree topurchase the asset (go long). 85
  • However, despite their similarities, their differences are the following:-1. A future contract is a standardized national agreement between two counterparties to exchange a specified amount of an asset at a fixed future date for a predetermined price. While, with a forward contract the amount to be exchanged is negotiated between two parties, for example, the two parties can agree to buy/sell say $2020500 forward.2. Future contracts are traded on an exchange, while forward contracts are over the counter instruments with the exchange being made directly between two parties.3. Future contracts are guaranteed by the exchange whereas forward contracts are not. The fact that a futures contract is guaranteed removes the counterparty risk inherent in forward contracts. With a forward contract each party needs to carefully consider if the losing party will be capable of seeing through their commitment which may involve quite substantial losses. This credit risk tends to limit the forward market to only very high grade financial and commercial institutions.4. Future contracts have greater liquidity then forward contracts. Because of their standardized nature, a future contract can easily be sold to another party at any time up until maturity at the prevailing futures price with the trader taking a profit or loss. Hence, since forward obligations cannot be transferred to a third party they are relatively illiquid assets. The only way for a trader to et out of a forward contract is to take out a new offsetting position.Types of futures contracts1. Short-term interest rate futures.2. Long-term bond futures.3. Currency futures.4. Stock index futures.1. Short term Interest Rate FuturesAn interest rate future is a commitment to borrow or lend a predetermined sum ofmoney at a specified date at a predetermined rate of interest. Short term Eurofuturescontracts are quoted on an index basis.When we trade in interest rate futures, we do not take actual title or possession of thecommodity unless we fail to reverse our initial position. The contract merely representsa bet or hedge on the direction of future interest rates and bond prices.Interest rate futures have opened up opportunities for hedging that can only becompared with the development of the agricultural commodities market. Many dealersprefer “cross-hedging” by using one form of security to hedge another form of security. 86
  • Likewise, others prefer “partial hedges” to complete hedges. They are willing to takeaway part of the risk but not all of it. Others prefer no hedge at all because it licks intheir position while a hedge ensures them against a loss, it precludes the possibility ofan abnormal gain.Hence, in a risk-averse financial market environment, most financial managers can gainby hedging their position.Another aspect of interest future is the interest rate swaps, which its basic premise isthat one party is able to trade one type of risk exposure to another party, and bothparties are able to rebalance their portfolios with less risk. For example, Bank A may beobligated to pay a fixed rate on a $100,000 CD for the next five years. The bank isfearful that rates may go down and that it will be receiving on loans. Under thesecircumstances, bank A may try to find “a counterparty” who has the opposite type ofproblem i.e. company B, borrowing from a finance company at a variable rate and isfearful that rates will go up. Under this, bank A will agree to pay company B a variablerate on a hypothetical $100,000 of principal referred to as notational principal. In return,company B will agree to pay bank A a fixed rate on the same hypothetic principal. Bothsides have used this swap agreement to eliminate their risk.In sum, the interest rate swap agreement are not, initially, as structured as the futuresand options contracts (contract months, strike prices, etc). the counterparties can startout with a blank piece of paper and put together any kind of deal they desire. Majorfinancial institutions often serve as facilitators or dealers in bringing parties together fora transaction.2. Long term Bond FuturesGovernment bond futures contracts are among the most popular financial futurecontracts. A bond futures contract is a commitment to buy or sell a long termgovernment bond at a predetermined price at some future date. The precise bond to bedelivered is chosen by the seller from a range of deliverable bonds set out in the futurescontract. Bonds futures contracts are not settled via a cash payment, rather they aresettled by delivery of one of a range of government bonds specified in the contract. Thereason for having a deliverable bond is to eliminate the possibility of price manipulationwhich could occur if a speculator cornered the market in a particular bond issue. Thebond that would actually be delivered is what is known as the cheapest to deliver bond.Like most other futures contract, the vast majority of government bond contracts areclosed out prior to maturity so actual delivery does not usually take place.An important issue is that since a range of bonds are deliverable in fulfillment of thecontract, it is vital that due allowance is made for the fact that a bond with a highcoupon will be worth more than a bond with a low coupon. This is the rational underlyingthe fact that each bond contract has a notional coupon, that is treated as if it has agiven coupon and each bond is multiplied by a factor price. Essentially, the price factorconverts the price of the bond that is offered for delivery, so that it is valued on delivery 87
  • as if it were a bond that had the notional coupon. The price factor formula for eachbond futures contract is set by the exchange in the form of an explicit formula that isused in all circumstances.3. Currency FuturesA currency futures contract is an agreement between two parties to buy/sell specifiedamount of a currency at a predetermined price at a given date in the future. Theappropriate futures price is given by the formula.F = S X [1+(rusX(T-t)/360] [1+(ruk X (T-t)/360]Where; F is the futures price in dollars per pound; S is the spot exchange rate in dollarsper pound; rus is the interest rate of the US; ruk is the interest rate of the UK; T is thenumber of days of duration of the contract (e.g. 30, 60, 90 days); t is the number ofdays into the contract; and T-t is the number of days remaining to delivery of thecontract. For example, the six month US interest rate is 5% and the UK interest rate is8%. The spot dollar starting rate is $1.50/£1. What is the price of a six month (180 days)standing futures contract which is 100 days into the contract?F = $1.50 X [1+(0.05X(180-100)/360] [1+(0.08X(180-100)/360]= $1.50 X [1.011111] 1.017777= $1.49024. Stock Index FuturesThis is the most popular type of futures contracts; and is a notional commitment buy orsell a given amount of stock on a specified date in the future at a predetermined price.The amount of stock is a weighted basket of shares, and the best known stock futuresindices include the standard and poor 500 in the US, the Nikkei 225 in Japan, theFinancial Times Stock Exchange 100 (FTSE 100), the DAX in Germany, the CAC40 inFrance and Hang Seng Index in Hong Kong.Stock indexes futures are settled on a cash basis after due allowance for any variationsin margin payments that have been made. Stock index futures can be used to eitherhedge five purposes. Because they are composed of a basket of well known sharesthey are attractive as a means of hedging for pension funds, investment trust and otherinstitutional investors that hold a wide variety of shares. 88
  • The appropriate arbitrage model for the pricing of the future index is:FSIt.T = CS1t+(CSIt+(CSItx(rt1T-dt.T) x T-t ] 360Where; FSIt.T is the stock index futures price at time t with a settlement date T; CSI isthe price of anomalized cost of finance for the period between t and T; and dt1T is theexpected average dividend yield on the stocks that make up the cash index during theholding period. For example, on November, 1996, the FTSE index is 3927. Theborrowing Bill rate is 6%. The expected animalized dividend yield is 4% based on thehistorical dividend yield, and the carrying period (T-t) is 137 days.FSItT = CSIt [CSItx(r1T-dt1T) x T-t ] 360 = 3927 + [3927x(0.06-0.04)x137 ] 360 = 3956.47Hence, financial futures contracts are example of derivative instruments, i.e. the price ofthe contract is partly derived from the price of the underlying asset in the cash or sportmarket.THE INTERNATIONAL SWAP MARKETIntroductionToday’s financial swaps markets owe their origin to the exchange rate instability thatfollowed the demise of the Bretton Words System and to the controls on internationalcapital movements that most countries maintained in those days.Swaps are at the centre of the global financial revolutions and have had a major macro-economic impact forging the linkage between the Euro and domestic markets, flatteringthe cash yield curves and reducing central bank monopoly influences on markets.When you are offered a swap deal, always remember the saying “Beware of honeyoffered on a Sharp Knife”, and as well “he who knows does not speak, he whospeaks does not know”.The Concept of SwapsThe essence of a swap contract is the binding of two counterparties to exchange twodifferent payment streams over time, the payment being tied, at least in part, tosubsequent and uncertain market price developments. 89
  • In most swaps so far, the prices covered have been exchange rates or interest rates butthey increasingly reach out to equity indices and physical commodities. All such priceshave risk characteristics in common, in quality if not in degree. And for all, the allure ofswaps may be expected cost savings, yield enhancement, or hedging or speculativeopportunity.Financial swaps revolutionary, especially for portfolio management. A swap coupledwith an existing asset or liability can radically modify effective risk and return.Individually and together with futures, options and other financial derivatives, they allowyield curve and currency risks, and liquidity and geographic market considerations, all tobe managed separately and also in dependently of underlying cash market stocks.Growth of the Swap MarketLike most other new “products” in international finance, “swap” transactions are notexecuted in a physical market. Participants in the swap market are many and varied intheir location character and motives in exciting swaps. The sum total of the activity ofparticipants in the swap market have taken on the character of a classical financialmarket connected to, and integrating the underlying money, capital and foreignexchange market.The initial deals of swaps were characterized by three critical features.1. Barter – two counterparties with exactly offsetting exposures were introduced by a third party. If the credit risk were unequal, the third party if a bank might interpose itself or arrange for a bank to do so for a small fee;2. Arbitrage driven – the swap was driven by an arbitrage which gave some profit to all three parties. Generally, this was a credit arbitrage or market access arbitrage.3. Liability driven – almost all swaps were driven by the need to manage a debt issue on both sides.The major dramatic change has been the emergence of the large banks as aggressivemarket makers in dollar interest rate swaps. Major US banks are in the business oftaking credit risk and interest rate risk. They, therefore, do not need counterparties to dodollar swaps. The net result is that spreads have collapsed and volume has exploded.This means that institutional investors get a better return on their investments andinternational borrowers pay lower financing costs. This in turn results in morecompetitively priced goods for consumers and in enhanced returns pensioners.Swaps, therefore, have an effect on almost all of us yet they remain an arcanederivative risk management tool, sometimes suspected of providing the internationalbanking systems with tools required to bring about destruction. 90
  • Although firmly established, there remains a wide divergence among current andpotential users as to how exactly a given swap structure works, what risks are entailedwhen entering into swap transactions and precisely what “the swap market” is and etc.The Basic Swap StructuresThe underlying swap transactions seen in the market today are four basic structures asfollows:-• the interest rate swap;• the fixed rate currency swap;• the currency coupon swap;• the basis rate swap.(i) The Interest Rate SwapThe basic structure of an interest rate swap consists of the exchange between twocounterparties of fixed rate interest for floating rate interest in the same currencycalculated by reference to a mutually agreed national principal amount. This principalamount, which would normally equate to the underlying assets and liabilities being“swapped” by the counterparties, is applicable solely for the calculation of the interestto be exchanged under the swap.Through this straightforward swap structure, the counterparties are able to convert anunderlying fixed rate/liability into a floating rate asset/liability and vice versa.The majority of interest rate swap transactions are driven by the cost savings to beobtained by each of the counterparties. These cost savings, which are often substantial,result from differentials in the credit standing of the counterparties and other structuralconsiderations.In general, investors in fixed rate instruments are more sensitive to credit quality thanfloating rate bank lenders. Therefore, a greater premium is demanded of issuers oflesser credit quality in the fixed rate debt markets than in the floating rate bank lendingmarket. The counterparties to an interest rate swap may, therefore, obtain an arbitrageadvantage by accessing the market in which they have the greatest relative costadvantage and then entering into an interest rate swap to convert the cost of the fundsso raised from a fixed rate to a floating rate basis or vice versa.This ability to transfer a fixed rate cost advantage to floating rate liabilities has led tomany high quality credits issuing fixed rate Eurobonds purely to swap and obtain, inmany cases, sub-LIBOR funding. The use of this structure in a fixed rate Eurobondissue enables the issuer to obtain substantial funding at prints below LIBOR. 91
  • This most attractive of rate is made possible by:(a) the careful timing of the Eurobond issues to ensure its success at the finest of rates;(b) the use of exact hedging and a deferred swap accruals dated to ensure that best possible swaps terms for the issuer.The counterparty to the swap may be a combination of banks and corporate clients. Thebanks may want to hedge their fixed rate income into a floating rate return that fullymatched their floating rate liabilities in order to alleviate interest rate exposure. Whilethe corporate clients may want to hedge their floating rate binding into fixed rateliabilities for size and maturity unavailable in the direct fixed rate debt market.Acting as a principal, the intermediary may be able to provide both the banks and itscorporate clients with swap terms to meet their exact requirements and thensubsequently lock the Eurobond issuer into an opposite swap when the Eurobondmarket was most receptive to the issue.In addition, interest rate swaps also provide an excellent mechanism for entities toeffectively access markets which are otherwise closed to then name familiarity onexcessive use. The ability to obtain the benefits of markets without the need to complywith the prospectus disclosures, credit ratings lend other formal requirement providesan additional benefit especially for private companies.The interest rate swap market also provides money with the perfect mechanism formanaging interest rate costs and exposure whilst leaving the underlying source of fundsunaffected. For example, the cost of fixed rate funding may be reduced in a declininginterest rate environment through the use of the interest rate swap technique whilstleaving the underlying funding in place.Classification of Interest Swap Market ActivitiesThey are broadly classified into two types:-(i) the primary market;(ii) the secondary market.The primary market can be further subdivided into two sub-sectors i.e. by source of rawmaterials for an interest rate swap bank/financial market funding/hedging instruments(CDS, financial futures, etc) and the securities markets, in particular the Eurobondmarket which have centres in New York and Tokyo and London. The participants,principally banks, include a number of brokers who have extended their normal moneymarket dealing activities with banks to include interest swap activities success as abroker or principal in this segment of the primary market is dependent not only on closeintegration of an institution’s treasury and swap operations but also on distribution and 92
  • in particular, the ability to move positions quickly due to price volatility and risks inherentto the market. Inventory (hooked but not closed position) also quickly becomes state inthe short-term market because most transactions are done on a spot (immediatesettlement) basis; holding a position for any period of time may, therefore, mean one’sinventory may not move irrespective of price.The growth of the secondary market in the short-term swaps has decreased the risk ofposition taking in the short-term primary market. This development is associated withthe use of financial futures market to create the “other side” of an interest swaps. Theadvent of the swap market has also meant that the Eurodollar bond market now nevercloses due to interest rate levels; issuers who would not come to market because ofhigh interest rates now do so to the extent that a swap is available.Pricing in this segment of the market is exclusively related to the US. Treasury rates forcomparable maturities on a “Spread” Versus Treasuries bans and is marked by therelative stability of these spreads by comparison to the short-term markets.Given the size of the most Eurobond issues and the over supply of entities able andwilling to approach the Eurobond market to swap into floating rate funds, most majorhouses in the swap market now enter into swap agreement with an issuer without acounterparty (fixed-rate payer) on the other side. This “warehousing” activity isnormally hedged in the US Treasury or financial futures market, leaving the warehousemanager with a “spread” risk, or the difference between the spread at which he bookedthe swap with the issuer and where he manages to fund over a course of time amatched counterparty.The relative stability of spread and a positively slopped yield curve for funding thehedge at a positive carry have allowed the market to function reasonably well on thisbasis with only occasional periods of severe over supply in any particular maturity. Themajor houses tend to spread their inventory across the yield curve to reduce risk and toensure ready availability of a given maturity for particular clients’ requirement.INTERNATIONAL PORTFOLIO INVESTMENTIn recent years, portfolio investments by individuals and institutional investors ininternational stocks, bonds, and other financial securities have grown at a phenomenalpace, surpassing in dollar volumes foreign direct investments by corporations.The rapid increase in international portfolio investments in recent years reflect theglobalization of financial markets. The impetus for globalized financial markets initiallycame from the governments of major countries that began to deregulate foreignexchange and capital markets in the late 1970s. For example, the UK dismantled theinvestment dollar premium system in 1979, while Japan liberalized its foreign exchangemarket in 1980, allowing its residents to freely invest in foreign securities.Even developing countries like Brazil, India and Mexico took measures to allowforeigners to invest in their capital markets by offering country funds or directly listinglocal stocks on international stock exchanges. 93
  • Besides, recent advances in telecommunications and computer technology havecontributed to the globalization of investments by facilitating cross border transactionsand rapid dissemination of information across national borders.International Correlation Structure and Risk DiversificationIt is evident that security prices in different countries don’t move together very much andthis suggests that investors may be able to achieve a given return on their investmentsat a reduced risk when they diversify their portfolio holding internationally for the samereason they diversify domestically to reduce risks as much as possible.This goes together with the saying’’ Don’t put all your eggs in one basket’’, most peopleare averse to risk and would like to diversify it away..Investors can reduce portfolio riskby holding securities that are less than perfectly correlated. Infact , the less correlatedthe securities in the portfolio, the lower the portfolio risk.International diversification has a special dimension regarding portfolio riskdiversification. Security returns are much less correlated across countries than within acountry due to political, economic, institutional and even psychological factors affectingsecurities returns across countries, hence resulting in low correlations amonginternational securities. For instance, political turmoil in China may very well influencereturns on most stocks in Hong Kong, but it may have little or no impact on stock returnsin Finland, which may be affected by political turmoil in Russia due to geographicalproximity and economic ties between the two countries.In addition, business cycles are often asynchronous among countries, furthercontributing to low international correlations, which implies that investors should be ableto reduce portfolio risk more if they diversify internationally rather than domestically.International correlation structure therefore strongly suggests that internationaldiversification can sharply reduce risks. As the portfolio holds more and more stocks,the risks of the portfolio steadily declines, and eventually converges to the systematic ornondiversifiable risk. Systematic risk refers to the risk that remains even after investorsfully diversify their portfolio holding.However, it must be noted that international stock markets tend to move more closelytogether when the market volatility is higher. As observed during the October 1987crash of markets, most developed markets declined together. Considering that investorsneed risk diversification most precisely when markets are turbulent, this finding castssome doubts on the benefits of international diversification. One may say that unlessinvestors liquidate their portfolio holdings during the turbulent period, they can stillbenefit from international risk diversification.Optimal International Portfolio SelectionRational investors would select portfolios by considering returns as well as risks.Investors may be willing to assume additional risk if they are sufficiently compensatedby a higher expected return. 94
  • Investors need to examine the risk return characteristics of major stock markets andthen evaluate the potential gains from holding optimal international portfolios and theirrelated correlations.The investors also need to measure the mean and the standard deviations of monthlyreturns and the world beta measure for each market. The world beta measure thesensitivity of a national market to world market movements. National markets havehighly individualized risk-return characteristics and their mean return per month needsto be measured to know the stock markets sensitivities to world market movements.The basic technique always used is The Sharpe Performance measure( SHP) whichprovides a ‘’ risk-adjusted’’ performance measure, that represents the excess return(above and beyond the risk free interest rate) per standard deviation risk. For instance,in the USA, the Sharpe performance measure is computed by using the monthly U.STreasury bill rate as a proxy for the risk-free interest rate..Using the historical performance data, we can then solve for the composition of theoptimal international portfolio from the perspective of for instance U.S dollar basedinvestors and see hoe they allocate the shares of portfolio according to the variousmarkets.Similarly, we can also solve for the composition of the optimal international portfoliofrom the perspective of each of the national investors. Since the risk returncharacteristics of international stock markets vary depending on the numeraire currencyused to measure returns, the composition of the optimal international portfolio will alsovary across national investors using different numeraire currencies.Having obtained the optimal international portfolios, we can now evaluate the gains fromholding these portfolios over purely domestic portfolio. We can measure the gains fromholding international portfolios in two different ways: • The increase in the Sharpe performance measure and ; • The increase in the portfolio return at the domestic equivalent risk levelHence, the increase in the Sharpe performance portfolio measure is given by thedifference in the Sharpe ratio between the optimal international portfolio( OIP) and thedomestic portfolio( DP)Effects of Changes in the Exchange RateThe success of foreign investment rests on the performance of both the foreign securitymarket and the foreign currency. Exchange rate changes affect the risk of foreigninvestments through three possible channels: • Its own volatility • Its covariance with the local market returns 95
  • • The contribution of the cross product termExchange rate changes are found to covary positively with local bond market returns.Empirical evidence regarding bond markets suggests that it is essential to controlexchange risk to enhance the efficiency of international bond portfolios.Hence, the risk of investing in foreign stock markets is, to a lesser degree, attributableto exchange rate uncertainty. The exchange rate covaries negatively with local stockmarkets returns, partially offsetting the effect of exchange rate volatility. In summary,while exchange rates are somewhat less volatile than stock market returns, they willcontribute substantially to the risk of foreign stock investments.International Bond InvestmentThe preponderance of exchange risk in foreign bond investment suggests that investorsmay be able to increase their gains from international bond diversification if they canproperly control the exchange risk, by using currency forward contracts. The advent ofthe euro is most likely to alter the risk characteristics of the affected markets especiallythe EU countries since all the euro zone bonds will be denominated and transacted inthe common currency, rendering the nationality of bonds a much less significant factor.This implies that the non euro currency bonds like British bonds would play anenhanced role in international diversification strategies as they would retain their uniquerisk characteristics.International Mutual FundsCurrently U.S investors can achieve international diversification at home simply byinvesting in U.S based international mutual funds. By investing in international mutualfunds, investors can: • Save any extra transaction or information costs they have to incur when they attempt to invest directly in foreign markets • Circumvent many legal and institutional barriers to direct portfolio investments in foreign markets • Potentially benefit from the expertise of professional fund managersThese advantages of international mutual funds should be particularly appealing tosmall individual investors who would like to diversify internationally but have neither thenecessary expertise nor direct access to foreign markets.In addition to international mutual funds, investors may achieve international portfoliodiversification at home by investing in country funds; American depositoryreceipts(ADRs); or world equity benchmark shares ( WEBS), without having to investdirectly in foreign stock markets. 96
  • Country funds invests exclusively in stocks of a single country, and using this, investorscan speculate in a single foreign market with minimum costs; construct their ownpersonal international portfolios using country funds as building blocks and diversifyinto emerging markets that are otherwise practically inaccessible.Most of country funds available , however, have a close ended status and issues agiven number of shares that trade on the stock exchange of the host country as if thefunds were an individual stock by itself. Shares of these funds cannot be redeemed atthe underlying net asset value set at the home market of the fund.Likewise US investors can achieve international diversification at home using ADRs aswell as country funds. ADRs represent receipts for foreign shares held in the USdepository banks foreign branches or custodians and these funds are traded on USexchanges like domestic American securities. Consequently, US investors can savetransactional costs and also benefit from speedy and dependable disclosures,settlements and other custody services.Lastly,WEBS are exchange traded open ended country funds that are designed toclosely track foreign stock markets indices. There aree 20 WEBS tracking the MorganStanley Capital Investment indexes for developed and developing countries of America,Europe and South East Asia. Using exchange traded funds like WEBS and spiders,investors can trade a whole stock market index as if it were a single stock. Being openend funds, WEBS trade at fair prices that are very close to their net asset values. Inaddition to single country index funds, investors can achieve global diversificationinstantaneously just by holding shares of the S&P Global 100 Index Fund that is alsotrading on the AMEX with other WEBS.Hence WEBS indeed track the underlying MSCI country indexes very closely. For thoseinvestors who desire international equity exposure, WEBS may well serve as a majoralternative to such traditional tools as international mutual funds, ADRs and close endedcountry funds.In summary, investors can benefit a great deal from international diversification due toongoing integration of international financial markets and the active innovationsintroducing new financial products such as country funds and international mutualfunds.FINANCIAL MANAGEMENT OF THE MULTINATIONAL FIRM 97
  • FOREIGN DIRECT INVESTMENTS AND CROSS BORDERACQUISITIONS.Firms become multinational when they undertake foreign direct investment (FDI), whichoften involves the establishment of new production facilities in foreign countries.FDI may also involve mergers with and acquisitions of existing foreign businesses.Whether FDI involves a green field investment, like building brand new productionfacilities or cross border mergers and acquisitions it affords the MultinationalCorporation (MNC) a measure of control. FDI thus represents an internal organizationalexpansion by MNCs.FDI by MNC now plays a vital role in linking national economies and defining the natureof the emerging global economy. By undertaking FDI on a global basis, MNCs haveestablished their presence world wide and become familiar household names. TheseMNC deploy their formidable resources, tangible and intangible, irrespective of theirnational boundaries to persue and bolster their competitive positions.Once MNC acquires a production facility in a foreign country, its operations will besubject to the rules of the game set by the host government. Political risk ranges fromunexpected restrictions on the repartriation of foreign earnings to outright confiscation offoreign owned assets. Hence, it is essential to the new welfare of MNC to effectivelymanage political risk.Why Do Firms Invest Overseas?Unlike the theory of international trade, or theory of international portfolio investments,we do not have a well developed , comprehensive theory of FDI. But several theoriescan explain certain aspects of the FDI phenomenon. Many of the existing theories, suchas Kindleberger( 1969) and Hymer ( 1976), emphasize various market imperfections,that is, imperfections in product, factor and capital markets, as the key motivating forcesdriving FDI.In what follows, some of the key factors that are important in firm’s decisions to investoverseas are:• Trade barriers;• Imperfect labor markets;• Intangible assets;• Vertical integration;• Product life cycle;• Shareholder diversification servicesCross Border Mergers and Acquisitions 98
  • In recent years, a growing portion of FDI has taken the form of cross border mergersand acquisitions. The rapid increase in cross border M&A deals can be attributed to theongoing liberalization of capital markets and the integration of the world economy.Firms may be motivated to engage in cross border M&A deals to bolster theircompetitive positions in the world market by acquiring special assets from other firms orusing their own assets on a larger scale.As a mode of entry of FDI, cross border M&A offer two key advantages over green fieldinvestments: speed and access to proprietary assets.According to United Nations:-----M&A are popular mode of investments for firms wishing to protect, consolidate andadvance their global competitive positions, by selling off divisions that fall outside thescope of their core competence and acquiring strategic assets that enhance theircompetitiveness. For those firms, ownership assets acquired from another firm, such astechnical competence, established brand names, and existing supplier networks anddistribution systems, can be put to immediate use towards better serving globalcustomers, enhancing profits, expanding market share and increasing corporatecompetitiveness by employing international production networks more efficiently-----Cross border acquisitions of businesses are a politically sensitive issue, as mostcountries prefer to retain local controls of domestic firms. As a result, although countriesmay welcome green field investments, as they are viewed as representing newinvestments and employment opportunities, foreign firms bid to acquire domestic firmsare often resisted and sometimes even resented. Whether or not cross borderacquisitions produce synergistic gains and how such gains are divided betweenacquiring and target firms are thus important issues from the perspective of shareholderwelfare and public policy.If cross border acquisitions generate synergistic gains and both the acquiring andtarget shareholders gain wealth at the sametime, one can argue that cross borderacquisitions are mutually beneficial and thus should not be thwarted from both nationaland global perspective. In other words, firms may decide to acquire foreign firms to takeadvantage of mispriced factors of production and to cope with trade barriers.Political Risk and Foreign Direct InvestmentsIn assessing the investment opportunities in a foreign country, it is important for aparent to take into consideration the risks arising from the fact that investments arelocated in foreign country. A sovereign country can take actions that may adverselyaffect the interest of MNCs. Political risks can be classified into two groups:• Macro risk, where all foreign operations are affected by adverse political development in the host country; 99
  • • Micro risk, where only selected areas of foreign business operations or particular foreign firms are affected.Depending on the manner in which firms are affected, political risks can be classifiedinto three types:Transfer risk, which arises from the uncertainty about the cross border flows of capital,payments, know how etcOperational risk, which is associated with uncertainty about host country’s policiesaffecting the local operations of MNCs;Control risk, which arises from uncertainty about the host country policy regardingownership and control of operations.Political risk is not easy to measure. However, experts of political risk analysis evaluate,often subjectively, a set of key factors such as:• The host country’s political and government system;• Track records of political parties and their relative strength;• Integration into the world system;• The host country’s ethnic and religious stability;• Regional security;• Key economic indicators.Hence MNCs may use in house experts to do the analysis, but may as well utilize theservices of outside experts who provide professional assessments of political risks indifferent countries.How to Manage Political Risk1) MNC can take a conservative approach to foreign investment projects when faced with political risks. It can explicitly incorporate political risk into the capital budgeting process and adjust the project’s NPV accordingly, by either reducing expected cash flows or by increasing the cost of capital. The MNC may undertake foreign projects only when the adjusted NPV is positive. Likewise, political risk associated with a single country may be diversifiable to some extent in that MNCs can use geographic diversification of foreign investments as a means of reducing political risks.2) Once a MNC decides to undertake a foreign project, it can take various measures to minimize its exposures to political risk. For example, a MNC can form a joint venture with a local company; consider a consortium of international companies to undertake the foreign project; or the MNC can use local debt to finance the foreign project, where it has an option to repudiate its debt if the host governments take actions to hurt its interests. 100
  • 3) MNC may purchase insurance against the harzard of political risk, and are especially useful for small firms that are less equipped to deal with political risk of their own.4) Many countries have concluded bilateral or multilateral investment protection agreements, effectively eliminating most political risks. As a result a MNC invests in a country that signed the investment agreements with the MNC home country it need not be overly concerned with political risk.5) It is important for MNC to hire people are familiar with local operating environments, strengthen local support for the company, and enhance physical security measures. These are meant to curb the political risk of corruption, bribery and extortion by government officials or bureaucrats.To deal with this kind of situation, it is important for companies with local operatingenvironment, strengthen local support for the company and enhance physical securitymeasures.QUESTIONS1. Explain Vermon’s product life cycle theory of FDI. What are the strengths and weaknesses of the theory?2. Explain the Internationalization Theory of FDI. What are the strengths and weaknesses of the theory.3. Define Country Risk. How is it different from political risk?4. Discuss the different ways political events in a host country may affect local operation of a MNC?INTERNATIONAL CAPITAL STRUCTURE AND THE COST OF CAPITALRecently, many major firms throughout the world have begun to internationalize theircapital structure by raising funds from foreign as well as domestic sources. As a result,these corporations are becoming multinational not only in scope of their businessactivities but also in their capital structure. The trend reflects not only a conscious efforton the parts of firms to lower the cost of capital by international sourcing of funds butalso the ongoing liberalization and deregulation of international financial markets thatmake them accessible to many firms. 101
  • If international financial markets were completely integrated, it would not matter whetherfirms raised capital from domestic or foreign sources because the cost of capital wouldbe equalized across countries. If on the other hand, these markets are less than fullyintegrated, firms may be able to create value for their shareholders by issuing securitiesin foreign as well as domestic markets.Cross listing of a firm’s shares on foreign stock exchange is one way a firm operating insegmented capital markets can lessen the negative effects of segmentation and alsointernationalise the firm’s capital structure. By interactionalising its corporate ownershipstructure, a firm can generally increase its share price and lower its cost of capital.Cost of CapitalThis is the minimum rate of return on investment project must operate in order to pay itsfinancing costs. If the return on an investment project is equal to the cost of capital,undertaking the project will leave the firm’s value unaffected. When a firm identifies andundertakes an investment project that generates a return exceeding its cost of capital,the firm’s value will increase. It is thus important for a value maximizing firms to try tolower its cost of capital.When a firm has both debt and equity in its capital structure, its financing cost can berepresented by the weighted average cost of capital. It can be computed by weightingthe after tax borrowing cost of the firm and the cost of equity capital, using the capitalstructure ratio as the weight. Specifically K = (1- λ)Ki +λ(j – č)iWhere;K = Weighted average cost of capita;Kj = Cost of equity capital for a leveraged firm;I = Before tax cost of debt capital (i.e. borrowing);Č = Marginal corporate income tax ratio; andΛ = Debt-to-total market value ratio.In general, both Ki and I increase as the proportion of debt in the firm’s capital structureincreases. At the optimal combination of debt and equity financing, however, theweighted average cost of capital (K) will be the lowest. Firms may have an incentive touse debt financing to take advantage of the tax deductibility of interest payments. Inmost countries, interest payments are tax deductible, unlike dividend payments.The debt financing, however, should be balanced against possible bankruptcy, costsassociated with higher debt. A trade off between the tax advantage of debt and potentialbankruptcy costs in this a major factor in determining the optimal capital structure.Choice of the optimal structure is important, since a firm that desires to maximizeshareholder wealth will finance new capital expenditures up to the point where themarginal return on the last unit of new invested capital equals the weighted marginal 102
  • cost of the last unit of new financing to be raised. Consequently, for a firm confrontedwith a fixed schedule of possible investments, any policy that lowers the firm’s cost ofcapital will increase the profitable capital expenditures the firm take on and increase thewealth of the firm’s shareholders. Internationalizing the firm’s cost of capital is one suchpolicy.Hence, the value maximizing firm would undertake an investment project as long as theinternal rate of return (IRR) on the project exceeds the firm’s cost of capital.Cross Border Listing of StockFirms can potentially benefit from cross border listing. As a result, cross border listing ofstocks have become quite popular among major corporations.Generally speaking, a company can benefit from cross border list of its shares in thefollowing ways:-• The company can expand its potential investor base, which will lend to a higher stock price and a lower cost of capital;• Cross listing creates a secondary market on the company’s shares, which facilitates raising new capital in foreign markets;• Cross listing can enhance the liquidity of the company’s stock;• Cross listing enhances the visibility of the company’s name and its products in foreign market places;• Cross listed shares may be used as the “acquisition currency” for taking over foreign companies;• Cross listing may improve the company’s corporate governance and transparency.Despite these potential benefits, not every company seeks overseas listings because ofthe costs:• It can be costly to meet the disclosure and listing requirements imposed by the foreign exchange and regulatory authorities;• Once a company’s stock is traded overseas markets there can be volatility skill over from those markets;• Once a company’s stock is make available to foreigners, they might acquire a controlling interest and challenge the domestic control of the company.According to surveys, disclosure requirements appear to be the most significant barrierto overseas listing. For example, adaptation to US accounting rules, which is requiredby the US SEC is found to be the most onerous barrier facing foreign companies thatconsider NYSE listing.Karosy (1996) reports, among other things that:• The share price reacts favourably to cross border listing;• The total post listing trading volume increases on average, and for many issues, home-market trading volume also increases; 103
  • • Liquidity of trading in shares improves overall;• The stock’s exposure to domestic market risk is significantly reduced and is associated with only small income in global market risk;• Cross border listing resulted in net reduction in the cost of equity capital of 114 basis point on average.Stringent disclosure requirements are the greatest impendicament to cross borderlisting. Considering these findings, cross border listing of stocks seem to have been onaverage, positive NPV projects. To maximize the benefits from partial integration ofcapital markets, a country should choose to internationally cross-list those assets thatare most highly correlated with the domestic market portfolio. Many firms have indeedexperienced a reduction in the cost of capital when their stocks were listed on foreignmarkets.The Effect of Foreign Equity Ownership RestrictionsWhile companies have incentives to internalize their ownership structure to lower thecost of capital and increase their market values, they may be concerned, at thesametime, with possible loss of corporate control to foreigners. Consequently,governments in both developed and developing countries often impose restrictions onthe maximum percentage ownership of local firms by foreigners.In countries like India, Mexico and Thailand, foreigners are allowed to purchase nomore than 49% of the outstanding shares of local firms. These countries want to makesure that foreigners do not acquire majority states in local companies.The Financial Structure of SubsidiariesOne of the problems faced by financial managers of MNCs is how to determine thefinancial structure of foreign subsidiaries. According to research and Sharpio (1984),there are three different approaches to determining the subsidiary’s financial structure:a) Conform to the parent company norms;b) Conform to the local norms of the country where the subsidiary operates;c) Vary judiciously to capitalize on opportunities to lower taxes, reduce financing costs and risks, and take advantage of various market imperfections.Which approach to take depends largely on whether and to what extent the parentcompany is responsible for the subsidiary’s financial obligations. When the parent isfully responsible for the subsidiary’s obligations, the independent structure of thesubsidiary is irrelevant.When the parent is legally and morally responsible for the subsidiary’s debts, potentialcreditors will examine the parents’ overall financial conditions not the subsidiary’s. 104
  • When, however, the parent company is willing to let its subsidiary department or theparent’s guarantee of its subsidiary’s financial obligations becomes difficult to enforceacross national borders, the subsidiary’s financial structure becomes relevant. In thiscase, potential creditors will examine the subsidiary’s financial conditions closely toaccess default risks. As a result, the subsidiary should choose its own finance structureto reduce default risks and thus financing costs. In reality, the parent company cannotlet its subsidiary to default on its debt without expecting its world wide operations to behampered in one way or another. Default by a subsidiary can deplete the parent’sreputational capital, possibly increase its own cost of capital, and certainly make itdifficult to undertake future projects in the country where default occurred.Therefore, an immediate implication of the parent’s legal and moral obligation to honourits subsidiary’s debt is that the parent should monitor its subsidiary’s financial conditionsclosely and make sure that the firm’s overall financial conditions are not adverselyaffected by the subsidiary’s financial structure. The subsidiary’s financial structureshould be chosen so that the parent’s overall cost of capital can be minimized.INTERNATIONAL CAPITAL BUDGETINGIntroductionWe have taken the view that the fundamental goal of the financial manager isshareholder wealth maximization which is created when the firm makes an investmentthat will return more in a present value sense. The most important decision that confrontthe financial manager are which capital projects to select. By their very nature, capitalprojects denote investment in capital assets that make up the production capacity of thefirm. These investments which are typically expensive relative to the firm’s overall value,will determine how efficiently the firm will produce the product it intends to sell, and thuswill also determine how profitable the firm will be.In total, these decisions determine the competitive position of the firm in the productmarket place and the firm’s long run survival. Consequently, a valid framework foranalysis is important. The generally accepted methodology in modern finance is to usethe NPV discounted cash flow model. The NPV of a capital project is the present valueof all cash flows including those at the end of the project’s life, minus the present valuesof cash out flows. The NPV rule is to accept a project if NPV ≥0 and to reject if NPV < 0.In capital budgeting, our concern is only with the change in the firm’s total cash flowsthat are attributable to the capital expenditure. The basic net present value (NPV)capital budgeting equation can be stated as: T CF TVC - CoNPV = ∑ (1+K)t + (1+K)t t-1where; 105
  • CFt = expected after-tax cash flow for year t;TVt = expected after-tax terminal value including recapture of working capital;Co = Initial investment at inception;K = Weighted average cost of capital;T = Economic life of the capital project in years.Capital Budgeting from the Parent Firm’s PerspectiveDonald Lessard (1985) developed an APV model that is suitable for a MNC to use inanalyzing a foreign capital expenditure. The model recognizes that the cash flows willbe denominated in a foreign currency and will have to be converted into the currency ofthe parent. Additionally Lessard’s model incorporates special cash flows that arefrequently encountered in foreign project analysis. Using the basic structure of the APVmodel, Lessard’s model can be stated as: T T TAPV = ∑ StDCFt(1-T) + ∑ STDt + ∑ STLt + STTVT - SoCo + SoRFo + SoCLo t=1 (I+Kud)t (I-t Kud)t T St L Pt - ∑ (I + id)t t=1Key points to the equation:(i) the cash flows are assumed to be denominated in the foreign currency and converted to the currency of the parent at the expected sport exchange rate, st, applicable for year t. The marginal corporate tax rate r, is he larger of the parent’s or the foreign subsidiaries because the model essences that the tax authority in the parent’s home country will give foreign tax credits for foreign taxes paid up to the amount of the tax liability in the home country. Thus, if the parent’s tax rate is the larger of the two, additional taxes are due in the home country, which equate the difference between the domestic tax liability and the foreign credit tax.(ii) OCFt represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm cash flows earned in the foreign country that are blocked by the host government from being repatriated do not provide any benefit to the stockholders of the parent firm and are not relevant to 106
  • the analysis. Likewise, cash flows that are repatriated circumventing restrictions are not included here.(iii) It is important to include only incremental revenues and operating costs in calculating the OCFt.(iv) The term SOFFo represents the value of accumulated restricted funds (of amount Ro) in the foreign land from existing operations that are faced up by the proposed projects. These funds become available only because of the proposed project and therefore available to offset a position of the initial capital outlays. Examples are funds “whose use is restricted by exchange controls” or funds on which additional taxes would be due in the parent company if they are remitted. RFo equals the difference between the face value of these funds and their present value used in the next best alternative. T(v) The term SoCho = ∑ StLPc denotes the present value in the currency of the t=1 (I+id)t parent firm of the benefit of below-market rate borrowing in foreign currency. In certain cases, a concessionary loan (of amount cho) at below market rate of interest may be available to the parent firm if the proposed capital expenditure is made in foreign land.The host country offers this financing in its foreign currency as a means of attractingeconomic development and investment that will create employment for its citizens. Thebenefit to the MNC is the difference between the face value of the concessionary loanconverted into the home currency and the present value of the similarly convertedconcessional loan payment (LPt) discounted at the MNC’s normal domestic borrowingrate (id). The loan payments will yield a present value less than the face amount of theconcessionary loan when they are discounted at the higher normal rate. This differencerepresents a subsidy the host country is willing to extend to the MNC if the investment ismade.The interest tax shield term ScTli in the APV model recognizes the tax shields ofborrowing capacity created by the project regardless of how the project is financed.Risk Adjustment in the Capital Budgeting AnalysisSome projects may be more or less risky than average, however. The risk adjusteddiscount method is the standard way to handle this situation. This approach requiresadjusting the discount rate upwards of downwards for increases or decreasesrespectively, in the systematic risk of the project relative to the firm as a whole. In theAPV model, only the cash flows discounted at Kud incorporate systematic risk; thus onlyKud needs to be adjusted when project risk differs from that of the firm as a whole. 107
  • The second way to adjust for risk is the “certainty equivalent method”. This approachextracts the risk premium from the expected cash flows to convert them into equivalentriskless cash flows, which are then discounted at the risk free rate of interest. This isaccompanied by multiplying the risky cash flows by a certainty equivalent factor that isunity or less. The more risky the cash flow, the smaller is the certainty equivalent factor.In general, cash flows tend to be more risky the further into the future they are expectedto be received.Sensitivity AnalysisUnder this, the different scenarios are examined by using different exchange rateestimates, inflation rate estimates and cost and pricing estimates in the calculation ofthe APV. In essence, the sensitivity analysis allows the finance manager a means toanalyse the business risk, economic exposure, exchange rate uncertainty, and politicalrisk inherent in the investment.Sensitivity analysis puts financial managers in a position to more fully understand theimplication of planned capital expenditures. It forces them to consider in advanceactions that can be taken should an investment not develop as anticipated.Real OptionThe firm is confronted with many possible real options over the life of a capital asset.For example, the firm may have a timing option about when to make the investment, itmay have a growth option to increase the scale of the investment, it may have asuspension option to temporarily cease production; and it may have an abandonmentoption to quit the investment early. All these situations can be evaluated as real options.The firm, therefore, is confronted with many possible real options over the life of acapital asset. In international capital expenditures, the MNC is faced with the politicaluncertainties of doing business in a foreign host country. For example, stable politicalenvironment for foreign investment may turn unfavourable if a different political partywins power by election or worse by political coup.These and other political uncertainties make real options analysis ideal for use inevaluating international capital expenditures. Real options, however, should be thoughtof as an extension of discounted cash flow analysis not as a replacement of it.Questions1. Why is capital budgeting important to the firm?2. What is the intuition behind the NPV Capital Budgeting framework?3. What is the nature of “concessionary loan” and how is it handled in the NPV model? 108
  • 4. Discuss the difference between performing the capital budgeting analysis from the parent firm’s perspective as apposed to the project’s perspective?5. Define the concept of a real option. Discuss some of the various real options a firm can be confronted with when investing in real projects.MULTINATIONAL CASH MANAGEMENTIntroductionThis deals with the efficient management of cash within a MNC; and are concerned withthe size of cash balances, their currency denominations, and where these cashbalances are located among the MNCs affiliates. Efficient management of cashtechniques can reduce the investments in cash balances and foreign exchangetransactions expenses, and it can provide for maximum return from the investment ofexcess cash. Additionally, efficient cash management technique results in borrowing atthe lowest rate when a temporary cash shortage exists.Management of International Cash BalancesCash management refers to the investment the firm has in transaction balances tocover scheduled outflows of funds during a cash budgeting period and the funds thefirm has tied up in precautionary cash balances. Precautionary cash balances arenecessary in case the firm has underestimated the amount needed to covertransactions.Good cash management also encompass investing excess funds at the most favourablerate and borrowing at the lowest rate when there is a temporary cash shortage.Multinational operations require the firm to decide on whether the cash managementfunction should be centralized at corporate headquarters or elsewhere or decentralizedand handled locally by each affiliate.The foundation of any cash management system is its cash budget. The cash budget isa plan detailing the time and size of expected cash receipts and disbursements.There are two ways for the management of cash by MNCs:1. Netting system i.e. this shows the amount that each affiliate is to pay and receive from the other. Under a bilateral netting system, each pair of affiliates determines the net amount due between them, and only the net amount is transferred. Also rather than stop at bilateral netting, the MNC can establish a multilateral netting system. Under this system, each affiliate nets all its inter affiliate receipts against all its disbursements. It then transfers or receives the balance respectively, if it is 109
  • a net payer or receiver. Thus, under a multilateral netting system, the net funds to be received by the affiliate will equal the net disbursements to be made by the affiliates will equal the net disbursements to be made by the affiliates.2. Centralised Cash Depository A multilateral netting system requires a certain degree of administrative structure. At the minimum, there must be a netting center manager who has an overview of the interaffiliate cash flows from the cash budget. The Netting Center Manager determines the amount of the net payments and which affiliates are to make or receive them. A netting center does not imply that the MNC has a Central Cash Manager. Indeed, the multilateral netting system suggests that each affiliate has a local cash manager who is responsible for investing excess cash and borrowing when there is a temporary cash shortage. Under a centralized cash management system, unless otherwise instructed, all interaffiliate payments will flow through the central cash depository derive mainly from the business transactions the affiliate have with external parties. With a centralized cash depository, excess cash is remitted to the central cash pool. Accordingly, the Central Cash Management arranges to cover shortages of cash. The Central Cash Management has a global view of the MNC’s overall cash position and needs. Consequently, there is a less chance of misallocated funds; that is, there is less of a chance for funds being denominated in the wrong currency. Because of this global perspective, the Central Cash Manager will know the best borrowing and investing rates. A centralized system facilitates “fund mobilization”, where system wide cash excesses are invested at the most advantageous rates and cash shortages are covered by borrowing at the most favourable rates. Without a centralized cash depository, one affiliate might end up borrowing locally at unfavourable rate, while another is investing temporary surplus funds locally at a disadvantageous rate.Transfer Pricing and Related CostsWithin a large business firm with multiple diversions, goods and services are frequentlytransferred from one division to another. The process brings into question the “transferprice” that should be assigned, for bookkeeping purposes, to the goods and services asthey are transferred between divisions.The higher the transfer price, the larger will be the gross profits of the transferringdivision relative to the receiving division within MNC, the decision is furthercompounded by exchange restrictions on the part of the host country where thereceiving affiliate is located, a difference in income tax rates between the two countries,and import duties and quotas imposed by the host country. 110
  • Transfer pricing strategies may be beneficial when the host country restricts the amountof foreign exchange that can be used for importing specific goods. In this event, a lowertransfer price allows a greater quantity of the good to be imported under a quotarestriction. This may be a more important consideration than income tax savings, if theimported item is a necessary component needed by an assembly or manufacturingaffiliate to continue or expand production.Transfer prices also have an effect on how divisions of a MNC are perceived locally. Ahigh mark up policy leaves little net income to show on the affiliate’s books. If the parentfirm expects the affiliate to be able to borrow short-term funds locally in the event of acash shortage, the affiliate may have difficulty doing so with unimpressive financialstatements.On the other hand, a low mark up policy makes it appear at leas superficial as ifaffiliates, rather than the parent firm are contributing to a larger position to consolidatedearnings. To the extent that financial markets are inefficient, or securities analysts donot understand the transfer pricing strategy being used, the market value of the MNCmay be lower than is justified.Hence, transfer pricing strategies have an effect on international capital expenditureanalysis. A very low (high) mark up policy makes the APV of a subsidiary’s capitalexpenditure appear more or less attractive. Consequently, in order to obtain ameaningful analysis, arm’s length pricing should be used in the APV analysis toalternative after tax operating income, regardless of the actual transfer price employed.Blocked FundsA country may find itself short of foreign currency reserves, and thus impose exchangerestrictions on its own currency limiting its conversion into other currencies so as not tofurther reduce scare foreign currency reserves. When a country enforces exchangecontrols, the remittance of profits from a subsidiary firm to its parent is blocked.A lengthy blockage is detrimental to a MNC. Without the ability to repatriate profits froma subsidiary, the MNC firm might as well not even have the investment as returns arenot being paid to the stockholders of the MNC. Prior to making a capital investment in aforeign subsidiary, the parent firm should investigate the potential future funds blockage.Unexpected funds blockage after an investment has been made, however, is a politicalrisk with which the MNC must contend. Thus, the MNC must be familiar with methodsfor moving funds so as to benefit its stockholders. And the methods include transferpricing strategies, unbundling services, paralled and back-to-back loans, ledding andlagging payment, export creation and direct negotiation.EXPORTS AND IMPORTSIntroduction 111
  • Foreign trade is obviously important for a country. In modern firms, it is virtuallyimpossible for a country to produce domestically everything its citizens need or demand.Even if it could, it is unlikely that it could produce all items more efficiently thanproducers in other countries. Without international trade, scarce resources are not put totheir best use.International trade is more difficult and risky, however, than domestic trade. In foreigntrade, the exporter may not be familiar with the buyer, and thus not know if the importeris a good credit risk. Additionally, political instability makes it risky to ship merchandizeabroad to certain parts of the world. From the importer’s perspective, it is risky to makeadvance payment for goods that may never be shipped by the exporters.Foreign Trade TransactionsOver the years, an elaborate process has evolved for handling foreign conversetransactions. The key documents used in effecting foreign trade transactions are:• A letter of credit (L/C) which is a guarantee from the importer’s bank that it will act on behalf of the importer and pay the exporter for the merchandise if all relevant documents specified in the L/C are presented according to the terms of the L/C. in essence, the importer’s bank is substituting its credit worthiness for that unknown importer.• A time draft i.e. is a written order instructing the importer or his agent, thus importer’s bank, to pay the amount specified on its face on a certain date, that is, the end of the credit period in a foreign trade transaction.• A bill of lading (B/L) i.e. is a document issued by the common carrier specifying that it has received the goods for shipment; it can serve as title to the goods. The exporter’s bank presents the shipping documents and the time draft to the importer’s bank.• After taking title to the goods in the bill of lading, the importer’s bank accepts the time draft, creating at this point a “banker’s acceptance” (B/A), a negotiable money market instrument for which a secondary market exists. The importer’s bank charges an acceptance commission, which is deducted at the time of final settlement. The acceptance commission is based on the term to maturity of the time draft and the credit worthiness of the importer.Example: Cost Analysis of a Banker’s AcceptanceSuppose the face amount of the promissory note is $1,000,000 and the importer’s bankcharges an acceptance commission of 1.5 percent since the note is for 60 days , theexporter will receive $997,500 = $1,000,000 x {1-{0.15x60/360)) if he decides to holdthe B/A until maturity. Thus, the acceptance commission is $2,500. 112
  • If 60 day B/A rates are 5.25 percent and the exporter discounts the B/A with theimporter’s bank, he will receive $988,750 = $1,000,000 x {1-({.0525+.0150)x60/360}.Thus, the importer’s bank receives a discount rate of 6.75 percent = 5.25+1.50 percenton investment. At maturity, the importer’s bank will receive $1,000,000 from theimporter. The bond equivalent yield it receives on its investment (which is figured on theactual number of days in a year instead of a 360 day banker’s) year is 6.92 percent, or .0692 = ($1,000,000/$988,750-1) x 365/60.The exporter pays the acceptance commission regardless of whether he or shediscounts the B/A or holds it to maturity, hence, it is not marginal to a decision todiscount the B/A. The bond equivalent rate exporter receives from discounting the B/Ais 5.38 percent, or .0538 = $997,000/$988,750-1)x365/60. If the exporter’s opportunitycosts of capital is greater than 5.38 percent compounded bi-monthly (an effectiveannual rate of 5.5 percent) discounting makes sense; if not, the exporter should hold theB/A to maturity.ForfeitingThis is a type of medium-term trade financing used to finance the sale of capital goods.It involves the sale of promissory notes signed by the importer in favour of the exporter.The forfeit, usually a bank buys the notes at a discount from face value from theexporter. In this way, the exporter receives payment for the export and does not have tocarry the financing. The forfeit does not have recourse against the exporter in the eventof default by the importer. The promissory notes are typically structured to extend out ina series over a period of from three to seven years, with a note in the series maturingevery six months. Forfeit transactions are typically denominated in Swiss Francs, eurosand US dollars.Government Assistance in ExportingSuccess in international trade is fundamentally important for a country. Success inexporting implies that there is demand for a country’s products, that its labour force isbenefitting from employment, and that some resources are used for technologicaladvancement. To be successful in international trade, requires a country’s exportsoriented form to be good marketers, that is, to be competitive in terms of productofferings, promotion, price, delivery capability and service provided to importers. Equallyimportant, however, is for firms to be competitive in terms of extending credits toimporters. Because of the benefits that accrue from exporting the governments of mostdeveloping countries offer competitive assistance to domestic exports in the firm ofsubsidized credit that can be extended to importers. Also, credit insurance programsthat guarantee financing extended by private financial institutions are common.Other important institutions associated with export-import assistance are:• Eximbanks – that facilitate and finance exports, in situations where private financial institutions are unable or unwilling to because; 113
  • o the loan maturity is too long; o the amount of the loan is too large; o the loan risk is too great; o the importing firm has difficulty obtaining hard currency for payment.Through their working capital guarantee programs, Eximbanks facilitate the expansionof a country’s exports by encouraging commercial lenders to make working capital loansto exporters. Also, these banks guarantee the loans made by private financialinstitutions to foreign importers. Interest charged on these loans is normally at a floatingrate. Exim Banks also protect exporters against losses should a foreign buyer or otherforeign debtor default for political or commercial reasons. Insurance policies may coverboth comprehensive commercial and political credit risk or only specific political risk.Counter TradeThis is an umbrella term used to describe many different types of transactions, each, inwhich the seller provides a buyer with goods or services and promises in return topurchase goods or services from the buyer (Hennort, 1990). countertrades may or maynot involve the use of money. If the money is not exchanged, the trade is a type ofbarter. Regardless, countertrade results in a two-way flow of commodities.There are six forms of countertrade:• Barter;• Clearing arrangements;• Switch tradings;• Buy bank;• Counterpurchase; and• Offset.The first three do not involve the sue of money, whereas the latter three do. Positivereasons for countertrade include enhanced economic development, increasedemployment, technology transfer, market expansion, increased profitability, lessquarterly servicing of supply, reduction of surplus goods from inventory, and thedevelopment of marketing expertise.Those against countertrade transactions claim that such transactions tamper with thefundamental operations of free markets, and therefore resources are used inefficiently.Opponents claim that transaction costs are increased, that multilateral trade is restrictedthrough fostering bilateral trade agreements, and that, in general, transactions that donot make use of money represent a step backwards in economic development.Hence, whether countertrade transactions are good or bad for the global economy, itappears certain that they will increase in the near future as world trade increases.Questions 114
  • 1. Discuss some of the reasons why international trade is more difficult and risky from the exporters perspective than is domestic trade.2. What three basic documents are necessary to conduct a typical foreign countertrade?3. What is a forfeiting transaction?4. What is the purpose of Export-Import Banks?6. Briefly discuss the various types of countertrade.INTERNATIONAL TAX ENVIRONMENTIntroductionTax regulation is a complex topic at the domestic level and much more complex at theinternational level.The Objectives of TaxationThe two basic objectives of taxation have to be discussed to keep frame our thinkingabout the international tax environments, tax neutrality and tax equity. Tax neutrality hasits foundations in the principles of economic efficiency and equity. It is determined bythree criteria. Capital-export neutrality is the criterion that an ideal tax should beeffective in raising revenue for the government and not have any negative effects on theeconomic decision making process of the tax payer. That is, a good tax is one that isefficient in raising tax revenue for the government and does not prevent economicresources from being allocated to their most appropriate use no matter where in theworld the highest rate of return can be earned. Obviously, capital-export neutrality isbased on world wide economic efficiency.A second neutrality criterion is “national neutrality”, that is, taxable income is taxed inthe same manner by the tax payer’s national tax authority regardless of where in theworld it is earned. In theory, national tax neutrality is a commendable objective, as it isbased on the principle of equality. For example, in USA, foreign source income is taxedat the same rate as US earned income and a foreign tax credit is given against taxespaid to a foreign government. However, the foreign tax credit is limited to the amount oftax that would be due on that income if it were earned in the USA. Thus, if the tax ratepaid on foreign source income is greater than the U1 tax rate, part of the credit may gounused.The third neutrality criterion is “capital import-neutrality”. This criterion implies that thetax burden a host country imposes on the foreign subsidiary of a MNC should be the 115
  • same regardless of which country the MNC is incorporated and the same as that placedon domestic firms.Implementing capital-import neutrality means that if the US tax rate were greater thanthe tax rate of a foreign country in which a US MNC earned foreign income, additionaltax on that income above the amount paid to the foreign tax authority would not be duein the USA.The concept of capital-import neutrality is based on the concept of equality, and itsimplementation provides a level competitive playing field for all participants in a singlemarket place, at least with taxation. Implementing capital-import neutrality means that asovereign government follows the taxation policies of foreign tax authorities on theforeign source income of its resident MNCs and that domestic tax payers end up payinga larger portion of the total tax burden.In addition, the underlying principle of tax equity is that all similarly situated tax payersshould participate in the cost of operating the government according to the same rules.Operationally, this means that regardless of the country in which an affiliate of a MNCearns taxable income, the same tax rate and tax due date apply.Types of Taxation1. Income tax2. Withholding tax3. Value Added TaxNational Tax EnvironmentThe international tax environment confronting a MNC or an international investor is afunction of tax jurisdiction established by the individual countries in which the MNC doesbusiness or in which the investor owns financial assets. There are two fundamentaltypes of tax jurisdiction: the world wide and the territorial. Unless some mechanismswere established to prevent it, double taxation would result if all nations were to followboth methods simultaneously.(a) World wide Taxation i.e. is to tax national residents of the country or their world wide income no matter in which country is earned. The national tax authority according to this method is declaring its tax jurisdiction over people and businesses. A MNC firm with many foreign affiliates would be taxed in its home country on its income earned at home and abroad if the host country of the foreign affiliates of a MNC also tax the income earned within their territorial borders, the possibility of double taxation exists, unless a mechanism is established to prevent it.(b) Territorial Taxation or source method of declaring a tax jurisdiction is to tax all income earned within the country by any tax payer, domestic or foreign. Hence, 116
  • regardless of the nationality of a tax payer, if the income is earned within the territorial boundary of a country, it is taxed by that country. Consequently, local firms and affiliates of foreign MNCs are taxed on the income earned in the source country. If the parent country of the foreign affiliates also levies a tax on world wide income, the possibility of double taxation exists, unless a mechanism is established to prevent it.Approaches to Finding Double Taxation1. Foreign tax credit i.e. is for a nation not to tax foreign source income of its national residents. In general, foreign tax credits are either direct or indirect. A direct foreign tax credit is computed for direct taxes paid on active foreign source income of foreign branch of a MNC or on the indirect withholding taxes withheld from passive income distributed by the foreign subsidiary to the parent.2. Tax havens i.e. a country is one that has a low corporate income tax rate and low withholding tax rates on passive income. Tax havens are useful locations for a MNC to establish a wholly owned “paper” foreign subsidiary that in turn would own the operating foreign subsidiaries of the MNC. Hence, when the tax rates in the host countries of the operating affiliates were lower than the tax rate in the parent company, dividends would be routed through the tax haven affiliate for use by the MNC at the taxes due on them in the parent company could continue to be deferred until a dividend was declared by the tax haven subsidiary.Questions1. Discuss the twin objectives of taxation.2. Compare and contrast the three types of taxation that governments levy within their tax jurisdiction.3. What methods do taxing authorities use to eliminate or mitigate the evil of double taxation?CORPORATE GOVERNANCE AROUND THE WORLDIntroductionThe space of corporate scandals and failures including Errow, World Com and Globalcrossing in the United States, Daewoo Group (a major chaebol) in Korea, and HIH (a 117
  • major insurance group) in Australia, has raised serious questions about the way publiccorporations are governed around the world.When self interested managers take control of the company, they sometimes engage inactions that are profoundly detrimental to the interests of shareholders and otherstakeholders. For example, such managers may give themselves excessive salariesand indulgent prerequisites, squander resources for corporate empire building, divertthe company’s cash and assets for private benefits, engage in cronyism, and stealbusiness opportunities from the company.When managerial self dealings are excessive and left unchecked, they can haveserious negative effects on corporate values and the proper functions of capitalmarkets. In fact, there is a growing consensus around the world that it is vitallyimportant to strengthen corporate governance to protect the rights of shareholders, curbmanagerial excesses, and restore confidence in capital markets.Corporate governance, therefore, can be defined as the economic, legal andinstitutional framework in which corporate control and cash flow rights are distributedamong shareholders, managers and other stakeholders of the company. Otherstakeholders may include workers, creditors, banks, institutional investors, and evengovernment. Corporate governance structures varies a great deal across countries,reflecting divergent cultural, economic, political and legal environments.Governance of Public Corporations, Key issuesThe public corporation, which is jointly owned by a multitude of shareholders protectedwith limited liability, is a major organizational innovation of vast economicconsequences. The genius of public corporations stems from their capacity to allowefficient sharing or spreading of risk among many investors, who can buy and sell theirownership shares on liquid stock exchange and let professional managers run thecompany on behalf of shareholders. This efficient risk-sharing mechanism enablespublic corporations to raise large amounts of capital at relatively low costs andundertake many investment projects that individual entrepreneurs or private investorsmight eschew because of the costs and or risks. Public corporations have played apivotal role in spreading economic growth and capitation world wide. However, thesecapitations have many key weaknesses i.e. the conflict of interest between managersand shareholders. The separation of the company’s ownership and control, prevalent inthe USA and the UK, where corporate ownership is highly diffusely gives rise topossible conflict between shareholders and managers. In principle, shareholders electthe board of directors for the company, which in turn hires managers to run thecompany for the interest of shareholders. Managers are thus supposed to be the agentsworking for their principals, that is, shareholders, who are the real owners of thecompany. In a public company with diffused ownership, the board of directors isentrusted with the vital task of monitoring the management and safeguarding theinterests of shareholders. 118
  • In reality, however, management friendly insiders often dominate the board of directorswith relatively few outside directors who can independently monitor the management.Further more, with diffused ownership, few shareholders have strong incentive to incurthe costs of monitoring management themselves when the benefits from suchmonitoring accrue to all shareholders alike. The benefits are shared, but not the costs.When company ownership is highly diffused, this “file rider” problem discouragesshareholder activism. As a result, the interests of managers and shareholders are oftenallowed to diverge. With an ineffective and unmotivated board of directors, shareholdersare basically left without effective recourse to control managerial self dealings.Shareholders in different countries may indeed face divergent corporate governancesystems. However, the central problem in corporate governance remains the sameeverywhere; “how best to protect outside investors from expropriation by the controllinginsiders so that the former can receive fair returns on their investments”. In order todeal with this problem has enormous practical implications for shareholder welfare,corporate allocation of resources. Corporate financing and valuation, development ofcapital markets, and economic growth. For more details, refer to the website:www.oeed.or/daf/corporate-affairs/governance.Corporate Governance ReformIn the wake of the Asian financial crisis of 1997-98 and the spectacular failure of severalmajor companies, scandal weary investors around the world are demanding corporategovernance reform. The failure of these companies hurt shareholders as well as otherstakeholders, including workers, customers, and suppliers. Many employees whoinvested heavily in company stock for their retirement were dealt severe financial blows.It is not first the companies’ internal governance mechanism that failed; auditors,regulators, banks and institutional investors also worked in their respective roles. Failureto reform corporate governance will damage investor confidence, shut the developmentof capital markets, raise the cost of capital, distort capital allocation, and even shakeconfidence in capitation itself.Hence, to reform these anomalies, the following were taken:1. Reformers had to understand the political dynamics surrounding governance issues and seek help from the media, public opinion, and NGOs.2. The Government hand to pass laws like the Sarbanese-Oxley Act in 2002 to address accounting issues, audit matters and executive responsibility.3. Set in place a Code of Best Practice in Corporate Governance. For example, the Cadbury Code of Best Practice. 119
  • All these laws changed the landscape of corporate governance, where the job securityof chief executives has become more sensitive to the company’s performance,strengthening managerial accountability and weakening its entrenchments.Questions1. The majority of major corporations are franchised as public corporations. Discuss the key strengths and weaknesses of the “public corporations”. When do you think the public corporation as an organization form is unsuitable?2. The public corporation is owned by a multitude of shareholders but now by professional managers. Managers can take self interested actions at the expense of shareholders. Discuss the conditions under which the so called agency problem arises.3. Many companies grant stock or stock options to managers. Discuss the benefits and possible costs of using this kind of incentive compensation scheme. 120