Chapter ThreeBalance of PaymentsCopyright © 2021 by the McGr

Chapter Three
Balance of Payments
Copyright © 2021 by the McGraw-Hill Companies, Inc. All
rights reserved.
1
Overview
Balance of Payments Accounting
Balance of Payments Accounts
The Current Account
The Capital Account
The Financial Account
Statistical Discrepancy
Official Reserves Account
The Balance of Payments Identity
Balance of Payments Trends in Major Countries
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Balance of Payments Accounting

Balance of payments is the statistical record of a country’s
international transactions over a certain period of time
presented in the form of double-entry bookkeeping
Important to study for a few reasons:
Provides detailed information concerning the demand and
supply of a country’s currency
May signal its potential as a business partner for the rest of the
world
Used to evaluate the performance of the country in international
economic competition
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Examples of international transactions include import and
export of goods and services and cross-border investments in
businesses, bank accounts, bonds, stocks, and real estate.
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Balance of Payments Accounting (Continued)
Any transaction that results in a receipt from foreigners will be
recorded as a credit, with a positive sign, in the U.S. balance of
payments
E.g., foreign sales of U.S. goods and services, goodwill,
financial claims, and real assets
Any transaction that gives rise to a payment to foreigners will
be recorded as a debit, with a negative sign, on the U.S. balance
of payments
E.g., U.S. purchases of foreign goods and services, goodwill,
financial claims, and real assets

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4
Balance of Payments Accounts
International transactions can be grouped into the following
four main types:
Current account includes the export and import of goods and
services
Capital account consists of capital transfers and the cross-
border acquisition and disposal of nonproduced nonfinancial
assets
Financial account (excluding official reserves) includes all
purchases and sales of financial assets, such as stocks, bonds,
bank accounts, etc.
Official reserve account covers all purchases and sales of
international reserve assets
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Summary of the U.S. Balance of Payments for 2018 ($b)

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The Current Account
Divided into four finer categories:
Goods trade represents exports and imports of tangible goods
(e.g., oil, wheat, clothes, automobiles, computers, etc.)
Services include payments and receipts for legal, consulting,
financial, and engineering services, royalties for patents and
intellectual properties, shipping fees, and tourist expenditures
Primary income consists largely of payments and receipts of
interest, dividends, and other income on foreign investments
that were previously made
Secondary income involves “unrequited” payments
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The Current Account (Continued)
Current account balance, especially the trade balance, tends to
be sensitive to exchange rate changes
Currency depreciation or devaluation can improve (worsen) the
trade balance if imports and exports are responsive (inelastic)
J-curve effect refers to the initial deterioration and eventual
improvement of trade balance following the depreciation of a
country’s currency
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The Financial Account
Measures the difference between U.S. sales of assets to
foreigners and U.S. purchases of foreign assets
Can be divided into three categories:
Foreign direct investment (FDI) occurs when the investor
acquires a measure of control of the foreign business
Portfolio investment mostly represents sales and purchases of
foreign financial assets, such as stocks and bonds, that do not
involve a transfer of control
Other investment includes transactions in currency, bank
deposits, trade credits, etc.
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Statistical Discrepancy
Exhibit 3.1 shows a statistical discrepancy of -$40.5 billion
in 2018
Recordings of payments/receipts arising from international
transactions are done at different times and places, possibly
using different methods
Financial transactions may be mainly responsible for
discrepancy
Overall balance is the cumulative balance of payments including
the current account, capital account, financial account, and the
statistical discrepancies

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Exhibit 3.1 is shown on Slide 6.
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The Official Reserves Account
Official reserve account includes transactions undertaken by the
authorities to finance the overall balance and intervene in
foreign exchange markets
Post-1945, international reserve assets comprise:
Gold
Foreign exchanges
Special drawing rights (SDRs)
Reserve positions in the IMF
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The Balance of Payments Identity (BOPI)
BCA + BKA + BFA + BRA = 0
where
BCA = balance on current account
BKA = balance on capital account
BFA = balance on financial account
BRA = balance on the reserves account

Under fixed exchange regime, countries maintain official
reserves that allow them to have BOP disequilibrium
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BOP Trends in Major Countries
U.S. has experienced continuous deficits on the current
accounts since 1982 and continuous surpluses on the financial
account; with the sole exception of 1991
Magnitude of U.S. current account deficits is far greater than
any that other countries ever experienced during the 36-year
sample period
Japan has had an unbroken string of current account surpluses
(and financial account deficits) since 1982 even though the
value of the yen rose steadily until the mid-1990s
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BOP Trends in Major Countries (Continued)
U.K. recently experienced continuous current account deficits,
coupled with financial account surpluses
Magnitude is far less than that of the U.S.
Germany traditionally had current account surpluses, but
between 1991-2001 experienced current account deficits
Attributed to German reunification and the resultant need to
absorb more output domestically to rebuild the East German

region
Since 2002, Germany has returned to their earlier pattern
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BOP Trends in Major Countries (Concluded)
China tends to have a surplus on the current account, as well as
the financial account (until recently)
“Global imbalance”
Overall, U.S. and U.K. generally use up more outputs than they
produce, whereas the opposite holds for China, Japan and
Germany
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Top U.S. Trading Partners, 2018 ($b)
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Management of Economic Exposure
Chapter Nine
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This chapter provides a way to measure economic exposure,
discusses its determinants, and presents methods for managing
and hedging economic exposure.
1
Chapter Outline
How to Measure Economic Exposure
Operating Exposure: Definition
Illustration of Operating Exposure
Determinants of Operating Exposure
Managing Operating Exposure
Summary
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Economic Exposure

Changes in exchange rates can affect not only firms that are
directly engaged in international trade but also purely domestic
firms.
Furthermore, changes in exchange rates may affect not only the
operating cash flows of a firm by altering its competitive
position but also dollar (home currency) values of the firm’s
assets and liabilities
Exchange rate changes can systematically affect the value of the
firm by influencing its operating cash flows as well as the
domestic currency values of its assets and liabilities
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Exchange Rate Exposure of U.S. Industry Portfolios
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This exhibit provides an estimate of the U.S. industries’ market
betas as well as the “forex” betas during the period of 2000-
2018.
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How to Measure Economic Exposure

Currency risk (or uncertainty) represents random changes in
exchange rates, while currency exposure measures “what is at
risk”
Exposure to currency risk can be properly measured by the
following:
Sensitivity of the future home currency values of the firm’s
assets and liabilities to random changes in exchange rates
Sensitivity of the firm’s operating cash flows to random
changes in exchange rates
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Channels of Economic Exposure
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Measuring Asset Exposure
From the perspective of a U.S. firm that owns an asset in
Britain, the exposure can be measured by the coefficient (b) in
regressing the dollar value (P) of the British asset on the
dollar/pound exchange rate (S)
P = a + b×S + e

Where
a is the regression constant
e is the random error term with mean zero
the regression coefficient b measures the sensitivity of the
dollar value of the asset (P) to the exchange rate (S)
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Measuring Asset Exposure (Continued)
The exposure coefficient, b, is defined as follows:
Where
Cov(P,S) is the covariance between the dollar value of the asset
and the exchange rate
Var(S) is the variance of the exchange rate
Cov(P,S)
Var(S)
b =
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Example
Suppose a U.S. firm has an asset in Britain whose local
currency price is random.
For simplicity, suppose there are only three states of the world
and each state is equally likely to occur.

The future local currency price of this British asset (P*) as well
as the future exchange rate (S) will be determined, depending
on the realized state of the world.
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Measurement of Currency Exposure
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First, consider Case 1, described in Panel A. Case 1 indicates
that the local currency price of the asset (P*) and the dollar
price of the pound (S) are positively correlated, so that
depreciation (appreciation) of the pound against the dollar is
associated with a declining (rising) local currency price of the
asset. The dollar price of the asset on the future (liquidation)
date can be $1,372, or $1,500 or $1,712, depending on the
realized state of the world. (For illustration, the computations
of the parameter values for Case 1 are shown in the next slide.)
Next, consider Case 2. This case indicates that the local
currency value of the asset is clearly negatively correlated with
the dollar price of the British pound. In fact, the effect of
exchange rate changes is exactly offset by movements of the
local currency price of the asset, rendering the dollar price of

the asset totally insensitive to exchange rate changes. The
future dollar price of the asset will be uniformly $1,400 across
the three states of the world. One thus can say that the British
asset is effectively denominated in terms of the dollar. Although
this case may be unrealistic, it shows that uncertain exchange
rates or exchange risk does not necessarily constitute exchange
exposure.
We now turn to Case 3, where the local currency price of the
asset is fixed at £1,000. In this case, the U.S. firm faces a
“contractual” cash flow that is denominated in pounds. This
case, in fact, represents an example of the special case of
economic exposure, transaction exposure. Intuitively, what is at
risk is £1,000, that is, the exposure coefficient, b, is £1,000.
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Computations of Regression Parameters: Case 1
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Hedging Asset Exposure
Once the magnitude of the exposure is known, the firm can
hedge the exposure by simply selling the exposure forward
We can decompose the variability of the dollar value of the
asset, Var(P), into two separate components: exchange rate-
related and residual
Consequences of hedging the exposure by forward contracts are
illustrated in the next slide

9-12
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The first term in the right-hand side of the equation, b2Var(S),
represents the part of the variability of the dollar value of the
asset that is related to random changes in the exchange rate,
whereas the second term, Var(e), captures the residual part of
the dollar value variability that is independent of exchange rate
movements.
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Consequences of Hedging Currency Exposure
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13
Operating Exposure: Definition
Many managers do not fully understand the effect of volatile
exchange rates on operating cash flows
Operating exposure is the extent to which the firm’s operating

cash flows will be affected by random changes in the exchange
rates
In many cases, operating exposure may account for a larger
portion of the firm’s total exposure than contractual exposure
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Illustration of Operating Exposure
“Suppose a U.S. computer company has a wholly owned British
subsidiary, Albion Computers PLC, that manufactures and sells
PCs in the U.K. market. Albion Computers imports
microprocessors from Intel, which sells them for $512 per unit.
At the current exchange rate of $1.60 per pound, each Intel
microprocessor costs £320. Albion Computers hires British
workers and sources all the other inputs locally. Albion faces a
50 percent income tax rate in the U.K.”
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Projected Operations for Albion Computers PLC: Benchmark
Case ($1.60/)
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Illustration of Operating Exposure (Continued)
Consider the possible effect of a depreciation of the pound on
the projected dollar operating cash flow of Albion Computers.
Assume the pound may depreciate from $1.60 to $1.40 per
pound
The dollar operating cash flow may change following a pound
depreciation due to:
Competitive effect
Conversion effect
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Illustration of Operating Exposure (Concluded)
Consider the following cases with varying degree of realism:
Case 1: No variables change, except the price of the imported
input.
Case 2: The selling price as well as the price of the imported
input changes, with no other changes.
Case 3: All the variables change.
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Projected Operations for Albion Computers PLC: Case 1
($1.40/£)
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19
($1.40/£)
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20

($1.40/£)
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Summary of Operating Exposure Effect of Pound Depreciation
on Albion Computers
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Determinants of Operating Exposure
Operating exposure cannot be readily determined from the
firm’s accounting statements, unlike transaction exposure
A firm’s operating exposure is determined by:
The structure of the markets in which the firm sources its
inputs, such as labor and materials, and selling its products
The firm’s ability to mitigate the effect of exchange rate
changes by adjusting its markets, product mix, and sourcing
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Determinants of Operating Exposure (Continued)
A firm is usually subject to high degrees of operating exposure
when either its cost or its price is sensitive to exchange rate
changes
When both the cost and the price are sensitive or insensitive to
exchange rate changes, the firm has no major operating
exposure
The extent to which a firm is subject to operating exposure
depends on the firm’s ability to stabilize cash flows in the face
of exchange rate changes
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Managing Operating Exposure
Objective of managing operating exposure is to stabilize cash
flows in the fact of fluctuating exchange rates
Firms may use the following strategies for managing operating
exposure:
Selecting low-cost production sites
Flexible sourcing policy
Diversification of the market
Product differentiation and R&D efforts
Financial hedging
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Selecting Low Cost Production Sites
When the domestic currency is strong or expected to become
strong, a firm may choose to locate production facilities in a
foreign country where costs are low
Low costs may be due to either the undervalued currency or
underpriced factors of production
The firm may choose to establish and maintain production
facilities in multiple countries to deal with the effect of
exchange rate changes
Example: Nissan has manufacturing facilities in the U.S., U.K.,
and Mexico, as well as Japan
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Flexible Sourcing Policy
Even if a firm has manufacturing facilities only in the domestic
country, it can substantially lessen the effect of exchange rate
changes by sourcing from where input costs are low
Example: In the early 1980s when the dollar was very strong
against most major currencies, U.S. multinational firms often
purchased materials and components from low-cost foreign
suppliers
Flexible sourcing policy is a strategy for managing operating

exposure that involves sourcing from areas where input costs
are low
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Diversification of the Market
Diversifying the market for the firm’s products is another way
to managing exchange exposure
Example: If GE is selling power generators in Mexico and
Germany, reduced sales in Mexico (due to the dollar
appreciation against the peso) could be compensated by
increased sales in Germany (due to the dollar depreciation
against the euro)
Note that expansion into a new business should be justified on
is own right, not solely as a solution to currency exposure
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R&D Efforts and Product Differentiation
Investment in research and development (R&D) can allow the
firm to maintain and strengthen its competitive position in the
face of adverse exchange rate movements
Successful R&D allows the firm to do the following:
Cut costs and enhance productivity
Introduce new and unique products for which competitors offer

no close substitutes
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Financial Hedging
Financial hedging can be used to stabilize the firm’s cash flows
Financial hedging refers to hedging exchange risk exposure
using financial contracts such as currency forward and options
contracts
If operational hedges, which involve redeployment of resources,
are costly or impractical, financial contracts can provide the
firm with a flexible and economical way of dealing with
exchange exposure
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Management of Transaction Exposure
Chapter Eight
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1
Chapter Outline
Three Types of Exposure
Should the Firm Hedge?
Hedging Foreign Currency Receivables
Hedging Foreign Currency Payables
Cross-Hedging Minor Currency Exposure
Hedging Contingent Exposure
Hedging Recurrent Exposure with Swap Contracts
Hedging through Invoice Currency
Hedging via Lead and Lag
Exposure Netting
What Risk Management Products Do Firms Use?
Summary
8-2
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Three Types of Exposure
It is conventional to classify foreign currency exposures into
three types:
Transaction exposure is the potential change in the value of
financial positions due to changes in the exchange rate between
the inception of a contract and the settlement of the contract
Economic exposure is the possibility that cash flows and the
value of the firm may be affected by unanticipated changes in
the exchange rates
Translation exposure is the effect of an unanticipated change in
the exchange rates on the consolidated financial reports of an
MNC
8-3
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Three Types of Exposure (Continued)
Firm is subject to transaction exposure when it faces contractual
cash flows that are fixed in foreign currencies
Example
Suppose a U.S. firm sold its product to a German client on
three-month credit terms and invoiced €1 million
When the U.S. firm received €1m in three months, it will have
to convert (unless it hedges) the euros into dollars at the spot
exchange rate prevailing on the maturity date, which cannot be
known in advance
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When a firm has foreign-currency-denominated receivables or
payables, it is subject to transaction exposure, and those
settlements are likely to affect the firm’s cash flow position.
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Hedging Transaction Exposure
This chapter focuses on alternative ways of hedging transaction
exposure using various financial contracts and operational
techniques
Financial contracts
Forward contracts, money market instruments, options
contracts, and swap contracts
Operational techniques
Choice of the invoice currency, lead/lag strategy, and exposure
netting
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Should the Firm Hedge?
No consensus on the question of whether a firm should hedge;
Most arguments suggesting corporate exposure management will
not add value to the firm hold in the case of a “perfect” capital

market
One can make a case for corporate risk management based on
various market imperfections:
Information asymmetry
Differential transaction costs
Default costs
Progressive corporate taxes
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Tax Savings from Hedging Exchange Risk Exposure
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Hedging Foreign Currency Receivables
Suppose Boeing Corporation exported a landing gear of Boeing
737 aircraft to British Airways and billed £10 million payable
in one year, with money market interest rates and foreign
exchange rates given as follows:
U.S. interest rate: 6.10% per annum
U.K. interest rate: 9% per annum
Spot exchange rate: $1.50/£

Forward exchange rate: $1.46/£ (1-year maturity)
When Boeing receives £10m in one year, it will convert the
pounds into dollars at the spot exchange rate prevailing at the
time
8-8
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Now, we will look at the various techniques for managing this
transaction exposure.
8
Forward Market Hedge
Most direct and popular way of hedging transaction exposure is
by currency forward contracts
Sell (buy) foreign currency receivables (payables) forward to
eliminate exchange risk exposure
Boeing may sell forward its pounds receivables, £10m, for
delivery in one year, in exchange for a given amount of U.S.
dollars
On the maturity date of the contract, Boeing will have to deliver
£10m to the bank, which is the counterparty of the contract,
and, in return, take delivery of $14.6m ($1.46/£ * £10m),
regardless of the spot exchange rate that may prevail on the
maturity date
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8-‹#›
Refer to example provided in slide 8.
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Dollar Proceeds from the British Sale: Forward Hedge versus
Unhedged Position
8-10
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Forward Market Hedge (Continued)
Suppose that on the maturity date of the forward contract, the
spot rate turns out to be $1.40/£, which is less than the forward
rate, $1.46/£
Boeing would have received $14m instead of $14.6m had it not
entered the forward contract
What if the spot rate had been $1.50/£ at maturity?
Boeing would have received $15m by remaining unhedged
Ex post, forward hedging would have cost Boeing $0.4m
Gains and losses are computed by the following:
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Gains/Losses from Forward Hedge
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Illustration of Gains and Losses from Forward Hedging
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13

Forward Market Hedge (Concluded)
Firm must make decision whether to hedge ex ante
Consider the following scenarios:
T ≈ F
Expected gains or losses are approximately zero, but forward
hedging eliminates exchange exposure
Firm will be inclined to hedge if it is averse to risk
T < F
Firm expects a positive gain from forward hedging and would
be even more includes to hedge than in Scenario 1
T > F
Firm would be less inclined to hedge under this scenario, other
things being equal
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T denotes the firm’s expected spot exchange rate for the
maturity date and F represents the forward rate.
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Currency Futures versus Forwards
A firm could use a currency futures contract, rather than a
forward contract, for hedging purposes
A futures contract is not as suitable as a forward contract for
hedging purposes for two reasons:
Unlike forward contracts that are tailor-made to the firm’s
specific needs, futures contracts are standardized instruments in
terms of contract size, delivery date, etc.

Thus, in most cases, the firm can only hedge approximately
Due to the marking-to-market property, there are interim cash
flows prior to the maturity date of the futures contract that may
have to be invested at uncertain interest rates
Again, this makes exact hedging difficult
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Money Market Hedge
A firm may borrow (lend) in foreign currency to hedge its
foreign currency receivables (payables), thereby matching its
assets and liabilities in the same currency
Boeing can eliminate the exchange exposure arising from the
British sale by first borrowing in pounds, then converting the
loan proceeds into dollars, which then can be invested at the
dollar interest rate
On the maturity date of the loan, Boeing is going to use the
pound receivable to pay off the pound loan
If Boeing borrows a particular pound amount so that the
maturity value of this loan becomes exactly equal to the pound
receivable from the British sale, Boeing’s net pound exposure is
reduced to zero
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Money Market Hedge (Continued)
What amount of pounds should Boeing borrow?
Amount to borrow may be computer as the discounted present
value of the pound receivable
£10m / (1.09) = £9,174,312
Step-by-step procedure of money market hedging:
Borrow £9,174,312
Convert £9,174,312 into $13,761,468 at the current spot
exchange rate of $1.50/£
Invest $13,761,468 in the U.S.
After one year, collect £10m from British Airways and use it to
repay the pound loan
Receive the maturity value of the dollar investment, that is,
$14,600,918 = ($13,761,468)(1.061)
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17
Cash Flow Analysis of a Money
Market Hedge
8-18
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Options Market Hedge
One possible shortcoming of both forward and money market
hedges is that these methods completely eliminate exchange risk
exposure
Ideally, Boeing would like to protect itself only if the pound
weakens, while retaining the opportunity to benefit if the pound
strengthens
Currency options provide a flexible “optional” hedge against
exchange exposure
Firm may buy a foreign currency call (put) option to hedge its
foreign currency payables (receivables)
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Options Market Hedge (Continued)
Suppose that in the OTC market, Boeing purchased a put option
on £10m with an exercise price of $1.46/£ and a one-year
expiration, and assume the option premium (price) was $0.02
per pound
Boeing paid $200,000 (= $0.02 * 10 million) for the option
Provides Boeing with the right, but not the obligation, to sell up
to £10m for $1.46/£, regardless of the future spot rate
Assume the spot exchange rate turns out to be $1.30 on the
expiration date
Upfront cost is equivalent to $212,200 = ($200,000 * 1.061)
Net dollar proceeds are $14,387,800 = $14.6m - $212,200
Boeing is assured of “minimum” dollar receipt of $14,387,800
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Options Market Hedge (Concluded)
Consider an alternative scenario where the pound appreciates
against the dollar, and assume the spot rate turns out to be $1.60
per pound at expiration

Boeing will have no incentive to exercise the option
Rather, it would let the option expire and convert £10m into
$16m at the spot rate
Subtracting $212,200 for the option cost, the net dollar proceeds
will become $15,787,800 under the option hedge
Options hedge allows the firm to limit downside risk while
preserving the upside potential, but firm must pay for this
flexibility in terms of the option premium
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Comparison of Hedging Strategies
Money market hedge versus forward hedge
Money market hedge dominates since the guaranteed dollar
proceeds from the British sale with the money market hedge
exceeds guaranteed proceeds with forward hedge
Money market hedge versus options hedge
Options hedge dominates money market hedge for future spot
rates greater than $1.4813/£, but money market hedge dominates
options hedge for spot rates lower than $1.4813/£
Options hedge versus forward hedge
Options hedge dominates the forward hedge for future spot rates
greater than $1.48 per pound, whereas the opposite holds for
spot rates lower than $1.48 per pound
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Boeing’s Alternative Hedging Strategies for a Foreign Currency
Receivable
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Hedging Foreign Currency Payables
Suppose Boeing imported a Rolls-Royce jet engine for £5
million payable in one year
Market condition is summarized as follows:
The U.S. interest rate: 6.00% per annum
The U.K. interest rate: 6.50% per annum
The spot exchange rate: $1.80/£
The forward exchange rate: $1.75/£ (1-year maturity)
Boeing is concerned about the future dollar cost of this
purchase, and they will try to minimize the dollar cost of paying
off the payable

8-24
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Foreign Currency Payables: Alternatives
Forward market hedge
If Boeing decides to hedge this payable exposure using a
forward contract, it only needs to buy £5m forward in exchange
for the following dollar amount:
$8,750,000 = (£5,000,000) ($1.75/£)
Money market hedge
PV of foreign currency payable: £4,694,836 = £5m / 1.065
Outlay of dollars today: $8,957,747 = ($8,450,705) ($1.80/£)
Future value: $8,957,747 = ($8,450,705) (1.06)
Options market hedge
Purchase a “call” on £5m
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Boeing’s Alternative Hedging Strategies for a Foreign Currency
Payable
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Dollar Costs of Securing the Pound Payable: Alternative
Hedging Strategies
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Cross-Hedging Minor Currency Exposure
If a firm has positions in major currencies (e.g., British pound,
euro, and Japanese yen), it can easily use forward, money
market, or options contracts to manage its exchange risk
exposure

However, if the firm has positions in less liquid currencies
(e.g., Indonesian rupiah, Thai bhat, and Czech koruna), it may
be either very costly or impossible to use financial contracts in
these currencies
In this situation, firms may use cross-hedging, which involves
hedging a position in one asset by taking position in another
asset
8-28
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8-‹#›
28
Hedging Contingent Exposure
Options contract can also provide an effective hedge against
what might be called contingent exposure
Contingent exposure is the risk due to uncertain situations in
which a firm does not know if it will face exchange risk
exposure in the future
Example: Suppose GE is bidding on a hydroelectric project in
Canada. If the bid is accepted, which will be known in three
months, GE is going to receive C$100m to initiate the project.
Since GE may or may not face exchange exposure, it faces a
typical contingent exposure situation
Difficult to manage contingent exposure using traditional
hedging tools like forward contracts, but an alternative is for
GE to buy a put option on C$100m
8-29
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8-‹#›
29
Hedging Recurrent Exposure with Swap Contracts
Firms often must deal with a “sequence” of accounts payable or
receivable in terms of a foreign currency, and these recurrent
cash flows can be best hedged using a currency swap contract
Currency swap contracts are agreements to exchange one
currency for another at a predetermined exchange rate, that is,
the swap rate, on a sequence of future dates
Similar to a portfolio of forward contracts with different
maturities
Very flexible in terms of amount and maturity, with maturity
ranging from a few months to 20 years
8-30
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8-‹#›
30
Hedging through Invoice Currency
Hedging through invoice currency is an operational technique
that allows the firm to shift, share, or diversify exchange risk
by appropriately choosing the currency of invoice

Example: If Boeing invoices $150m rather than £100m for the
sale of aircraft, it does not face exchange exposure anymore.
Though the exchange exposure has not disappeared, it has been
shifted to the British importer.
Another option would be for Boeing to invoice half of the bill
in U.S. dollars and the remaining half in British pounds, thereby
sharing the exchange exposure
Finally, the firm can diversify exchange exposure to some
extent by using currency basket units, such as the SDR, as the
invoice currency
8-31
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8-‹#›
31
Hedging via Lead and Lag
The lead/lag strategy reduces transaction exposure by paying or
collecting foreign financial obligations early (lead) or late (lag)
depending on whether the currency is hard or soft
Challenges associated with this strategy:
If we assume Boeing would like BA to prepay £100m, we can
also assume BA would have no incentive to do so unless they
received a substantial discount to compensate for prepayment
Pushing BA to prepay may hurt future sales efforts by Boeing
To the extent the original invoice price incorporated the
expected depreciation of the pound, Boeing is already partially
protected against depreciation of the pound
Strategy can be employed more effectively to deal with
intrafirm payables and receivables among subsidiaries

8-32
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8-‹#›
32
Exposure Netting: Lufthansa
“In 1984, Lufthansa, a German airline, signed a contract to buy
$3 billion worth of aircraft from Boeing and entered into a
forward contract to purchase $1.5 billion forward for the
purpose of hedging against the expected appreciation of the
dollar against the German mark. This decision, however,
suffered from a major flaw: A significant portion of Lufthansa’s
cash flows was also dollar-denominated.”
Lufthansa had a so-called “natural hedge”
The following year, the dollar depreciated substantially against
the mark and Lufthansa experienced a major foreign exchange
loss from settling the forward contract
The lesson here is that, when a firm has both receivables and
payables in a given foreign currency, it should consider hedging
only its net exposure
8-33
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33
Exposure Netting
Realistically, typical multinational corporations are likely to
have a portfolio of currency positions
In this case, firms should hedge residual exposure rather than
hedge each currency position separately
Exposure netting is hedging only the net exposure by firms that
have both payable and receivables in foreign currencies
For firms that would like to apply this approach aggressively, it
helps to centralize the firm’s exchange exposure management
function in one location
Many MNCs are using a reinvoice center, a financial subsidiary,
as a mechanism for centralizing exposure management functions
8-34
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8-‹#›
34
What Risk Management Products Do Firms Use?
Among U.S. corporations, based on a survey of Fortune 500
firms, the most popular product was the traditional forward
contract
Jesswein, Kwok, and Folks (1995) found 93% of respondents
reported using forward contracts
Kim and Chance (2018) study:
Examined actual currency risk management practices of 101
largest nonfinancial corporations in South Korea

Authors document a great discrepancy between what firms say
they do versus what they actually do, attributing the discord to
attempts by companies to time their hedges
8-35
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Management of Translation Exposure
Chapter Ten
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1
Chapter Outline
Translation Methods
FASB Statement 8
FASB Statement 52
International Accounting Standards
Management of Translation Exposure
Empirical Analysis of the Change from FASB 8 to FASB 52
10-2
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Translation Exposure
Translation exposure, frequently referred to as accounting
exposure, refers to the effect that an unanticipated change in
exchange rates will have on the consolidated financial reports of
a MNC
When exchange rates change, the value of a foreign subsidiary’s
assets and liabilities denominated in a foreign currency change
when they are viewed from the perspective of the parent firm
10-3
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Translation Methods
Four methods of foreign currency translation have been used in
recent years:
Current/noncurrent method
Monetary/nonmonetary method
Temporal method
Current rate method
10-4
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Current/Noncurrent Method
The idea that current assets and liabilities are converted at the
current exchange rate while noncurrent assets and liabilities are
translated at the historical exchange rates is the
current/noncurrent method
Under this method, a foreign subsidiary with current assets in
excess of current liabilities will cause a translation gain (loss)
if the local currency appreciates (depreciates)
This method of foreign currency translation was generally
accepted in the United States from the 1930s until 1975, at
which time FASB 8 became effective
10-5
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5
Monetary/Nonmonetary Method
The idea that monetary balance sheet accounts (e.g., accounts
receivable) are translated at the current exchange rate while
nonmonetary balance sheet accounts (e.g., stockholder’s equity)
are converted at the historical exchange rate is the
monetary/nonmonetary method
Compared to current/noncurrent method, this approach differs
substantially with respect to accounts like inventory, long-term
receivables, and long-term debt
Classifies accounts based on similarity of attributes rather than
similarly of maturities
10-6
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Temporal Method
The idea that current and noncurrent monetary accounts as well
as accounts that are carried on the books at current value are
converted at the current exchange rate is the temporal method
Accounts carried on the books at historical costs are translated
at the historical exchange rate
Fixed assets and inventory are usually carried at historical
costs, and as a result, the temporal method and the
monetary/nonmonetary method will typically provide the same
translation
10-7
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Current Rate Method
The idea that all balance sheet accounts are translated at the
current exchange rate except stockholder’s equity, which is
translated at the exchange rate on the date of issuance, is the
current rate method
Simplest of all translation methods to apply
A “plug” equity account named cumulative translation
adjustment (CTA) is used to make the balance sheet balance,
since translation gains or losses do not go through the income
statement according to this method
10-8
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FASB Statement 8
FASB 8 became effective on January 1, 1976
Objective was to measure in dollars an enterprise’s assets,
liabilities, revenues, or expenses that are denominated in a
foreign currency according to GAAP
Essentially the temporal method of translation, with few
subtleties
Temporal method requires taking foreign exchange gains or
losses through the income statement.
Therefore reported earnings could (and did) fluctuate
substantially from year to year, irritating executives
10-9

rights reserved.
FASB Statement 52
Due to controversary surrounding FASB 8, FASB 52 was issued
in December 1981
Stated objectives of FASB 52:
Provide information that is generally compatible with the
expected economic effects of a rate change on an enterprise’s
cash flows and equity
Reflect in consolidated statements the financial results and
relationship of the individual consolidated entities as measured
in their functional currencies in conformity with U.S. GAAP
10-10
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10
Functional Currency versus
Reporting Currency
The method of translation prescribed by FASB 52 depends upon
the functional currency used by the foreign subsidiary whose
statements are to be translated
Functional currency is the currency of the primary economic
environment in which the entity operates

Reporting currency is the currency in which the MNC prepares
its consolidated financial statements
10-11
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The Mechanics of FASB 52 Translation Process
Two-stage process:
First, determine in which currency the foreign entity keeps its
books
If the local currency in which the foreign entity keeps its books
is not the functional currency, remeasurement into the
functional currency is required
Temporal method used to accomplish remeasurement
Second, when the foreign entity’s functional currency is not the
same as the parent’s currency, the foreign entity’s books are
translated using the current rate method
10-12
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FASB 52 Two-Stage Process
10-13
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Highly Inflationary Economies
In highly inflationary economies, FASB 52 requires foreign
entities to remeasure financial statements using the temporal
method “as if the functional currency were the reporting
currency”
Highly inflationary economy is defined as, “one that has
cumulative inflation of approximately 100 percent or more over
a 3-year period”
10-14
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International Accounting Standards
Since January 2005, all companies doing business in the
European Union must use the accounting standards distributed
by the International Accounting Standards Board (IASB)
Similar to the FASB, the IASB publishes its standards in a
series of pronouncements called International Financial
Reporting Standards
It also adopted and maintains the pronouncements of the IASC,
the IASC, called International Accounting Standards (IAS)
10-15
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Translation versus Transaction Exposure
Some items that are a source of transaction exposure are also a
source of translation exposure, while others are not
Generally, it is not possible to eliminate both translation and
transaction exposure
Because transaction exposure involves real cash flows, it would
be prudent to consider it the more important of the two
A recent survey found 83% of MNCs placed a “significant” or
the “most” emphasis on transaction exposure relative to 37% for
translation exposure
10-16
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Hedging Translation Exposure
If one desires to attempt to control accounting changes in the
historical value of net investment, there are two methods for
dealing with residual translation exposure:
Balance sheet hedge
Derivatives hedge
10-17
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Balance Sheet Hedge
Note that translation exposure is currency specific, not entity
specific
Source is a mismatch of net assets and net liabilities
denominated in the same currency
A balance sheet hedge is intended to reduce translation
exposure of an MNC by eliminating the mismatch of exposed
net assets (and exposed net liabilities) denominated in the same
currency
However, it may create transaction exposure
10-18
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Derivatives Hedge
A derivative product, such as a forward contract, can be used to
attempt to hedge
A derivatives hedge to control translation exposure involves
speculation about foreign exchange rates
FASB 133 establishes accounting and reporting standards for
derivative instruments and hedging activities
To quality for hedge accounting under FASB 133, a company
must identify a clear link between an exposure and a derivative
instrument
10-19
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Translation Exposure versus
Operating Exposure
Depreciation of the local currency may, under certain
circumstances, have a favorable operating effect
For example, a currency depreciation may allow the affiliate to
raise its sales price because the prices of imported competitive
goods are now relatively higher
If costs do not rise proportionately and unit demand remains the
same, the affiliate would experience an operating profit as a
result of the currency depreciation
10-20
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Empirical Analysis of the Change from FASB 8 to FASB 52
Garlicki, Fabozzi, and Fonfeder (1987)
Researchers found no significant positive reaction to the change
or perceived change in the foreign currency translation process
Findings suggest market agents do not react to cosmetic
earnings changes that do not affect value
Results underline the futility of attempting to manage
translation gains and losses
10-21
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International Portfolio Investment
Chapter 15
rights reserved.
CHAPTER 15 covers international portfolio investment. It
documents that the potential benefits from international
diversification are available to all national investors.
1
Chapter Outline
International Correlation Structure and Risk Diversification
Optimal International Portfolio Selection
Effects of Changes in the Exchange Rate
International Bond Investment
International Diversification at Home
Why Home Bias in Portfolio Holdings?
15-2
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2

Introduction
Rapid growth in international portfolio investments in recent
years reflects the globalization of financial markets
In this chapter, we focus on the following issues:
Why investors diversify their portfolios internationally
How much investors can gain from international diversification
Effects of fluctuating exchange rates on international portfolio
investments
How investors can diversify internationally at home
Possible reasons for “home bias” in actual portfolio holdings
rights reserved.
15-3
EXHIBIT 15.1
U.S. Investment in Foreign Equities
15-4
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The dollar value invested in international equities (ADRs and
local shares) by U.S. investors has grown from a rather
negligible level in the early 1980s to $200 billion in 1990 and
$7,900 billion at the end of 2018.

aHoldings of foreign issues, including American Depository
Receipts (ADRs), by U.S. residents.
Source: The Federal Reserve Board, The Financial Accounts of
the United States.
4
Investors can reduce portfolio risk by holding securities that are
less than perfectly correlated
International diversification has a special dimension regarding
portfolio risk diversification
Security returns are substantially less correlated across
countries than within a country
This is true because economic, political, institutional, and even
psychological factors affecting security returns tend to vary a
great deal across countries
Business cycles are often high asynchronous across countries
15-5
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5
EXHIBIT 15.2
Correlations among International Stock Returns
15-6
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The average intracountry correlation is 0.653 for Germany,
0.416 for Japan, 0.698 for the United Kingdom, and 0.439 for
the United States. In contrast, the average intercountry
correlation of the United States is 0.170 with Germany, 0.137
with Japan, and 0.279 with the United Kingdom. The average
correlation of the United Kingdom, on the other hand, is 0.299
with Germany and 0.209 with Japan.
Clearly, stock returns tend to be much less correlated between
countries than within a country. As seen in the exhibit,
international diversification can sharply reduce risk.
6
(Continued)
Solnik (1974) study shows that as a portfolio holds more and
more stocks, the risk of the portfolio steadily declines, and
eventually converges to the systematic (or nondiversifiable) risk
Systematic risk refers to the risk that remains even after
investors fully diversify their portfolio holdings
Results of this study (shown on graphs in the next slide) provide
striking evidence supporting international, as opposed to purely
domestic, diversification
15-7
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7
EXHIBIT 15.3
Risk Reduction: Domestic versus International Diversification
15-8
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This exhibit shows that while a fully diversified U.S. portfolio
is about 27 percent as risky as a typical individual stock, a fully
diversified international portfolio is only about 12 percent as
risky as a typical individual stock.
Additionally, a fully diversified Swiss portfolio is about 44
percent as risky as a typical individual stock. However, this
Swiss portfolio is more than three times as risky as a well-
diversified international portfolio.
8
Cautionary Notes about International Correlation
A number of studies found that correlations between
international stock markets, especially developed markets, have
increased
These correlations are computed at the aggregate stock market
level, not the individual stock level; securities are still less
correlated across countries than within a country
Empirical studies found that international stock markets tend to
move more closely together when the market volatility is higher

Unless investors liquidate their portfolio holdings during the
turbulent period, they can still benefit from international risk
diversification
15-9
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9
EXHIBIT 15.5
Average Return Correlation, 1980-2018
15-10
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Exhibit 15.5 plots the average return correlation among 12
major international stock markets over time.
As can be seen in the exhibit, the average correlation among
returns of international stock market indices was fluctuating
with a mean of 0.36 until the mid-1990s, but it has been
generally increasing since then.
10
Optimal International Portfolio Selection

Rational investors would select portfolios by considering
returns as well as risk
World beta measures the sensitivity of a national market to
world market movements, with a higher number indicating
greater sensitivity to world market movements
Sharpe performance measure (SHP) provides a risk-adjusted
performance measure
i and σi are respectively, the mean and standard deviation of
returns, while Rf is the risk-free interest rate
15-11
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Exhibit 15.4 provides the mean and standard deviation (SD) of
monthly returns and the world beta measure for each market.
The Sharpe measure represents the excess return (above and
beyond the risk-free interest rate) per standard deviation risk.
11
Optimal International Portfolio Selection (Continued)
The optimal international portfolio (OIP) has the highest
possible Sharpe ratio
The OIP can be solved by maximizing the Sharpe ratio with
respect to the portfolio weights
SHP = [E(Rp) − Rf]/σp
After obtaining OIPs, we can measure gains from holding these
portfolios over purely domestic ones in two ways:
Increase in the Sharpe performance measure
Increase in the portfolio return at the domestic-equivalent risk

level
15-12
rights reserved.
Exhibit 15.6 presents the composition of the OIP from the
perspectives of investors domiciled in different countries using
the stock market parameters and the average risk-free rate
computed over the study period of 1980–2018.
12
EXHIBIT 15.6
Composition of the Optimal International Portfolio by
Investor’s Domicile, 1980.1 – 2018.12
15-13
rights reserved.
Exhibit 15.6 presents the composition of the OIP from the
perspectives of investors domiciled in different countries using
the stock market parameters and the average risk-free rate
computed over the study period of 1980–2018. It is clear that
four markets (i.e., Hong Kong, Sweden, Switzerland, and the
United States) are included in every national investor’s optimal
international portfolio.

In their optimal international portfolio, U.S. investors allocate
the largest share, 52.67 percent, of funds to the U.S. home
market, followed by the Swedish (30.04 percent), Hong Kong
(13.97 percent), Dutch (2.82 percent), and Swiss (0.50 percent)
markets.
13
EXHIBIT 15.7 - Selection of the Optimal International Portfolio
for U.S. Investors
15-14
rights reserved.
The realized dollar return for a U.S. resident investing in a
foreign market will depend not only on the return in the foreign
market but also on the change in the exchange rate between the
U.S. dollar and the foreign currency
Rate of return in dollar terms from investing in the ith foreign
market, Ri$, is given by:
where Ri is the local currency rate of return from the ith foreign
market and ei is the rate of change in the exchange rate between
the local currency and the dollar
Effects of Changes in the Exchange Rate
15-15
rights reserved.

Exchange rate changes affect the risk of foreign investment as
follows, where the ΔVar term represents the contribution of the
cross-product term, Riei, to the risk of foreign investment
Exchange rate fluctuations contribute to the risk of foreign
investment through three possible channels:
Its own volatility, Var(ei)
Its covariance with the local market returns, Cov(Ri,ei)
Contribution of the cross-product term, ΔVar
Effects of Changes in the Exchange Rate (Continued)
15-16
rights reserved.
International Bond Investment
World bond market is comparable in terms of capitalization
value to the world stock market, but it has not received as much
attention in international investment literature
Existing studies show that when investors control exchange risk
by using currency forward contracts, they can substantially
enhance the efficiency of international bond portfolios
The advent of the euro altered the risk-return characteristics of
the euro-zone bond markets, enhancing the importance of non-
euro currency bonds
15-17

rights reserved.
EXHIBIT 15.10 - Summary Statistics of the Monthly Returns to
Bonds and the Composition of the Optimal International Bond
Portfolio
15-18
rights reserved.
Exhibit 15.10 provides summary statistics of monthly returns, in
U.S. dollar terms, on long-term government bond indexes from
seven major countries: Australia, Canada, Germany, Japan,
Switzerland, the United Kingdom, and the United States. It also
presents the composition of the optimal international portfolio
for U.S. (dollar-based) investors.
18
International Diversification: Mutual Funds
Purchasing foreign stocks directly from foreign exchanges can
entail significant transaction costs
Other modes of international diversification are less
cumbersome:
U.S.-based international mutual funds invest in securities from
countries other than the U.S.
Advantages of international mutual funds:
Investors can save any extra transaction and/or information
costs they may have to incur when they attempt to invest

directly in foreign markets
Circumvent many legal/institutional barriers to direct portfolio
investments in foreign markets
Benefit from the expertise of professional fund managers
15-19
rights reserved.
Most international funds are open-end mutual funds.
19
International Diversification: Country Funds
A country fund invests exclusively in stocks of a single country
Popular means of international investment in the U.S., as well
as in other developed countries
Using country funds, investors can
Speculate in a single foreign market with minimum costs
Construct their own personal international portfolios using
country funds as building blocks
Diversify into emerging markets that are otherwise practically
inaccessible
15-20
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The majority of country funds available have a closed-end
status.
20

EXHIBIT 15.11 – U.S. and Home Market Betas of Closed-End
Country Funds and their NAVs
15-21
rights reserved.
Exhibit 15.11 provides the historical magnitude of
premiums/discounts for a sample of CECFs. Average premium
varies a great deal across funds, ranging from 63.17 percent (for
the Korea Fund) to −24 percent (for the Brazil Fund).
21
International Diversification: ETFs
In the last several years, there has been a broad shift from
actively managed mutual funds to passive investment vehicles
An exchange-traded fund (ETF) is an investment vehicle that
seeks to track the performance of a specific index, typically an
equity index
ETFs are highly liquid, and it is easy to buy and sell them
Most ETFs are passive, though some active ETFs exist
A family of ETFs called iShares (managed by BlackRock) has
the broadest range of country ETFs with 65 funds across 42
countries
15-22
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22
International Diversification: ADRs
American depository receipts (ADRs) represent receipts for
foreign shares held in the U.S. (depository) banks’ foreign
branches or custodians
ADRs are traded on U.S. exchanges like domestic American
securities
Because the majority of ADRs are from such developed
countries as Australia, Japan, and the U.K., U.S. investors have
a limited opportunity to diversify into emerging markets using
ADRs
However, in a few emerging markets like Mexico, investors can
choose from several ADRs.
15-23
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International Diversification: Hedge Funds
Hedge funds that represent privately pooled investment funds
have experienced a tremendous growth in recent years
May invest in a wide spectrum of securities, such as currencies,
domestic and foreign bonds and stocks, commodities, real
estate, etc.
Many aim to realize positive returns, regardless of market
conditions
Legally, hedge funds are private investment partnerships
Tend to have relatively low correlations with various stock
market benchmarks and thus allow investors to diversify their
portfolio risk

15-24
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International Diversification with Industry, Style, and Factor
Portfolios
Investors can enhance the gains from international investment
by augmenting their portfolios with industry, small-cap, or
factor funds
Studies document greater diversification benefits from investing
across not just countries, but also industries
International diversification can be further enhanced by
employing factor and style investing
Style investing refers to categorizing assets into different styles
based on common characteristics (e.g., large-cap and value
stocks)
Three factors—size, book-to-market, and momentum—have
been widely used in asset pricing models to explain stock
returns
15-25
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25

Home Bias in Portfolio Holdings
In portfolio holdings, the tendency of an investor to hold a
larger portion of the home country securities than is optimum
for diversification of risk is home bias
Though investors could benefit a great deal from international
diversification, the actual portfolios that investors hold are
quite different from those predicted by the theory of
international portfolio investment
U.S. mutual funds, for instance, invested about 87% of their
funds in domestic equities on average during 1998–2007, when
the U.S. stock market only accounted for about 45% of the
world market capitalization value during the period
15-26
rights reserved.
EXHIBIT 15.13 – The Home Bias in Equity Portfolios: Selected
Countries, 1998 - 2007
15-27
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27
Why Home Bias in Portfolio Holdings?
Observed home bias in portfolio holdings leads to the following

possibilities:
Domestic securities may provide investors with certain extra
services, such as hedging against domestic inflation, that
foreign securities do not
There may be barriers, formal or informal, to investing in
foreign securities that keep investors from realizing gains from
international diversification
15-28
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Interest Rate and Currency Swaps
Chapter Fourteen

rights reserved.
CHAPTER 14 covers interest rate and currency swaps, useful
tools for hedging long-term interest rate and currency risk.
1
Chapter Outline
Types of Swaps
Size of the Swap Market
The Swap Bank
Swap Market Quotations
Interest Rate Swaps
Currency Swaps
Variations of Basic Interest Rate and Currency Swaps
Risks of Interest Rate and Currency Swaps
Is the Swap Market Efficient?
14-2
rights reserved.
2
Types of Swaps
In interest rate swap financing, two parties, called
counterparties, make a contractual agreement to exchange cash
flows at periodic intervals
Two types of interest rate swaps:

Single-currency interest rate swaps (i.e., interest rate swaps)
involve swapping interest payments on debt obligations that are
denominated in the same currency
In a cross-currency interest rate swap (i.e., currency swap), one
counterparty exchanges the debt service obligations of a bond
denominated in one currency for the debt service obligations of
the other counterparty that are denominated in another currency
14-3
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Size of the Swap Market
Market for currency swaps developed first, but the interest rate
swap market is larger, where size is measured by notional
principal
In 2018, the notational principal was as follows:
Interest rate swaps at $326,690 billion USD
Currency swaps at $24,858 billion USD
The five most common currencies used to denominate interest
rate and currency swaps were the following:
U.S. dollar, euro, Japanese yen, the British pound sterling, and
the Canadian dollar
14-4
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4

EXHIBIT 14.1
Size of OTC Interest Rate and Currency Swap Markets: Total
Notional Principal Outstanding Amounts in Billions of U.S.D.
14-5
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The Swap Bank
Swap bank is a generic term to describe a financial institution
that facilitates swaps between counterparties
Can be international commercial bank, investment bank,
merchant bank, or independent operator
Serves as either a swap broker or swap dealer
As a broker, the swap bank matches counterparties but does not
assume any of the risks of the swap
As a dealer, the swap bank stands ready to accept either side of
a currency swap, and then later lay it off, or match it with a
counterparty
14-6
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Swap Market Quotations
Swap banks will tailor the terms of interest rate and currency
swaps to customers’ needs.

They also make a market in “plain vanilla” swaps and provide
quotes for these and provide current market quotations
applicable to counterparties with Aa or Aaa credit ratings
14-7
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Swap Market Quotations (Continued)
It is convention for swap banks to quote interest rate swap rates
for a currency against a local standard reference in the same
currency and currency swap rates against dollar LIBOR
For example, for a five-year swap with semiannual payments in
Swiss francs, suppose the bid-ask swap quotation is 6.60–6.70
percent against six-month LIBOR flat
This means the swap bank will pay semiannual fixed-rate SFr
payments at 6.60 percent against receiving six-month SFr
(dollar) LIBOR in an interest rate (a currency) swap, or it will
receive semiannual fixed-rate SFr payments at 6.70 percent
against paying six-month SFr (dollar) LIBOR in an interest rate
(a currency) swap
14-8
rights reserved.
Basic Interest Rate Swap: Bank A
Consider the following example of a fixed-for-floating rate
swap:
Bank A is a AAA-rated international bank located in the United

Kingdom. The bank needs $10,000,000 to finance floating-rate
Eurodollar term loans to its clients.
It is considering issuing five-year floating-rate notes indexed to
LIBOR. Alternatively, the bank could issue five-year fixed-rate
Eurodollar bonds at 10 percent.
The FRNs make the most sense for Bank A.
In this manner, the bank avoids the interest rate risk associated
with a fixed-rate issue.
Without this hedge, Bank A could end up paying a higher rate
than it is receiving on its loans should LIBOR fall substantially.
14-9
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Basic Interest Rate Swap: Company B
Consider the following example of a fixed-for-floating rate
swap:
Company B is a BBB-rated U.S. company. It needs $10,000,000
to finance a capital expenditure with a five-year economic life.
It can issue five-year fixed-rate bonds at a rate of 11.25 percent
in the U.S. bond market. Alternatively, it can issue five-year
FRNs at LIBOR plus 0.50%.
The fixed-rate debt makes the most sense for Company B
because it locks in a financing cost.
The FRN alternative could prove very unwise should LIBOR
increase substantially over the life of the note, and could
possibly result in the project being unprofitable.
14-10
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Basic Interest Rate Swap
A swap bank familiar can set up a fixed-for-floating interest
rate swap that will benefit each counterparty and the swap bank
Assume that the swap bank is quoting five-year U.S. dollar
interest rate swaps at 10.375 – 10.50 percent against LIBOR flat
Necessary condition is a positive quality spread differential
(QSD)
If a positive QSD exists, it is possible for each counterparty to
issue the debt alternative that is least advantageous for it (given
its financing needs), then swap interest payments, such that
each counterparty ends up with the type of interest payment
desired, but at a lower all-in cost than it could arrange on its
own
14-11
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14-12
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EXHIBIT 14.3
Calculation of Quality Spread Differential
A QSD is the difference between the default-risk premium

differential on the fixed-rate debt and the default-risk premium
differential on the floating-rate debt. Typically, the former is
greater than the latter.
12
14-13
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EXHIBIT 14.4
Fixed-for-Floating Interest Rate Swap
Exhibit 14.4 diagrams a possible scenario the swap bank could
arrange for the two counterparties.
13
Basic Currency Swap
Consider the following example:
A U.S. MNC desires to finance a capital expenditure of its
German subsidiary. The project has an economic life of five
years, and the cost of the project is €40,000,000. At the current
exchange rate of $1.30/€1.00, the parent firm could raise
$52,000,000 in the U.S. capital market by issuing 5-year bonds
at 8%. The parent would then convert the dollars to euros to pay
the project cost. The German subsidiary would be expected to
earn enough on the project to meet the annual dollar debt
service and to repay the principal in five years. The only
problem with this situation is that a long-term transaction
exposure is created. If the dollar appreciates against the euro
over the loan period, it may be difficult for the German
subsidiary to earn enough in euros to service the dollar loan.
14-14

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Basic Currency Swap (Continued)
An alternative is for the U.S. parent to raise €40,000,000 in the
international bond market by issuing euro-denominated
Eurobonds.
The U.S. parent might instead issue euro-denominated foreign
bonds in the German capital market.
However, if the U.S. MNC is not well known, it will have
difficulty borrowing at a favorable interest rate.
Suppose the U.S. parent can borrow €40,000,000 for a term of
five years at a fixed rate of 7%. The current normal borrowing
rate for a well-known firm of equivalent creditworthiness is 6%
14-15
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Basic Currency Swap (Concluded)
Assume a German MNC of equivalent creditworthiness has a
mirror-image financing need.
It has a U.S. subsidiary in need of $52,000,000 to finance a
capital expenditure with an economic life of five years.
The German parent could raise €40,000,000 in the German bond
market at a fixed rate of 6% and convert the funds to dollars to
finance the expenditure.
Transaction exposure is created, however, if the euro
appreciates substantially against the dollar. In this event, the

U.S. subsidiary might have difficulty earning enough in dollars
to meet the debt service. The German parent could issue
Eurodollar bonds (or alternatively, Yankee bonds in the U.S.
capital market), but since it is not well known its borrowing
cost would be, say, a fixed rate of 9 percent.
14-16
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Basic Currency Swap
Solution
A swap bank could arrange a currency swap that would solve
the double problem of each MNC, that is, be confronted with
long-term transaction exposure or borrow at a disadvantageous
rate.
The swap bank would instruct each parent firm to raise funds in
its national capital market where it is well known and has a
comparative advantage
14-17
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In order not to complicate this example any more than is
necessary, it is assumed that the bid and ask swap rates charged
by the swap bank are the same; that is, there is no bid-ask
spread. This assumption is relaxed in a later example.
17
14-18
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EXHIBIT 14.5
Interest Savings from Comparative Advantage
18

14-19
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EXHIBIT 14.6
$/€ Currency Swap
There is a combined total of 2 percent that can be saved or
earned through the currency swap, 1 percent on the dollar
notional amount, and 1 percent on the equivalent euro notional
value.
There is a cost savings for each counterparty because of their
relative comparative advantage in their respective national
capital markets.
19
Variations of Basic Interest Rate and Currency Swaps
Several variants of the basic interest rate and currency swaps
are listed below:
Fixed-for-floating interest rate swap

Zero-coupon-for-floating rate swap
Floating-for-floating interest rate swap
Amortizing currency swaps
14-20
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20
Risks of Interest Rate and Currency Swaps
Major risks faced by a swap dealer:
Interest-rate risk refers to the risk of interest rates changing
unfavorably before the swap bank can lay off on an opposing
counterparty the other side of an interest rate swap entered into
with a counterparty
Basis risk refers to a situation in which the floating rates of the
two counterparties are not pegged to the same index
Exchange-rate risk refers to the risk the swap bank faces from
fluctuating exchange rates during the time it takes for the bank
to lay off a swap it undertakes with one counterparty with an

opposing counterparty
14-21
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21
Risks of Interest Rate and Currency Swaps (Continued)
Major risks faced by a swap dealer:
Credit risk refers to the probability that a counterparty, or even
the swap bank, will default
Mismatch risk refers to the difficulty of finding an exact
opposite match for a swap the bank has agreed to take
Sovereign risk refers to the probability that a country will
impose exchange restrictions on a currency involved in a swap
14-22
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22
Is the Swap Market Efficient?
Two primary reasons for a counterparty to use a currency swap:
Obtain debt financing in the swapped currency at an interest
cost reduction (brought about through comparative advantages
each counterparty has in its national capital market)
Benefit of hedging long-run exchange rate exposure
Two primary reasons for swapping interest rates:
Better match maturities of assets and liabilities
Obtain a cost savings (via a positive quality spread differential)
14-23
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If the positive QSD is one of the primary reasons for the
existence of interest rate swaps, one would expect arbitrage to

eliminate it over time and that the growth of the swap market
would decrease. Quite the contrary has happened. Thus, the
arbitrage argument does not seem to have much merit.
23
Is the Swap Market Efficient? (Continued)
One must rely on an argument of market completeness for the
existence and growth of interest rate swaps
All types of debt instruments are not regularly available for all
borrowers
Interest rate swap market assists in tailoring financing to the
type desired by a particular borrower
Both counterparties can benefit (as well as the swap dealer)
through financing that is more suitable for their asset maturity
structures
14-24
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24
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Futures and Options on Foreign Exchange
Chapter 7
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1
Chapter Outline
Futures Contracts: Some Preliminaries
Currency Futures Markets
Basic Currency Futures Relationships

Options Contracts: Some Preliminaries
Currency Options Markets
Currency Futures Options
Basic Option-Pricing Relationships at Expiration
American Option-Pricing Relationships
European Option-Pricing Relationships
Binomial Option-Pricing Model
European Option-Pricing Model
Empirical Tests of Currency Options
Summary
7-2
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BIG chapter
2
Futures Contracts: Preliminaries
Both forward and futures contracts are derivative or contingent
claim securities because their values are derived from or
contingent upon the value of the underlying security

Forward contract
Tailor-made for a client by their international bank
Futures contract
Standardized features (e.g., contract size, maturity date,
delivery months)
Exchange traded
7-3
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3
Futures Contracts: Preliminaries (Continued)
An initial performance bond (formerly called margin) must be
deposited into a collateral account to establish a futures
position
Generally equal to 2% of contract value
Cash or T-bills may be used to meet requirement
Major difference between forward contract and futures contract
is the way the underlying asset is priced for future purchase or

sale
Forward contract states a price for the future transaction, but
futures contract is settled-up, or marked-to-market, daily at the
settlement price
7-4
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The settlement price is a price representative of futures
transaction prices at the close of daily trading on the exchange.
It is determined by a settlement committee for the commodity,
and it may be somewhat arbitrary if trading volume for the
contract has been light for the day.
4
Differences between Futures and Forward Contract
7-5
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5
Currency Futures Markets
Trading in currency futures began at the Chicago Mercantile
Exchange (CME) on May 16, 1972
2 million contracts traded in 1978
230 million contracts traded in 2018
CME Group formed in 2007, through a merger between the
CME and Chicago Board of Trade (CBOT)
In 2008, CME Group acquired the New York Mercantile
Exchange (NYMEX)
7-6
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6
Currency Futures Markets (Continued)
Most CME currency futures trade in a March, June, September,
and December expiration cycle out six quarters into the future,
with the delivery date being the third Wednesday of the
expiration month
Last day of trading for most contracts is the second business
day prior to the delivery date
Trading takes place Sunday through Friday on the GLOBEX
trading system from 5:00 PM to 4:00 PM Chicago time the next
day
Currency futures trading takes place on other exchanges, in
addition to the CME
7-7
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7

Basic Currency Futures Relationships
Information provided on quotes for CME futures contracts
includes the following:
Opening price, high and low quotes for the trading day,
settlement price, and open interest
Open interest is the total number of short or long contracts
outstanding for the particular delivery month
Futures are prices very similarly to forward contracts
Recall from chapter 6, the IRP model states the forward price
for delivery at time T is:
7-8
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We will use the same equation to define the futures price.
8
Option Contracts: Some Preliminaries

An option is a contract giving the owner the right, but now the
obligation, to buy or sell a given quantity of an asset at a
specified price at some time in future
Option to buy is a call, and option to sell is a put
Buying or selling the underlying asset via the option is know as
“exercising” the option
Stated price paid or received is known as the exercise or
striking price
Buyer of an option is often referred to as the long, and the seller
of an option is referred to as the writer (or the short)
European option can be exercised only at maturity or expiration
date of contract, but American option can be exercised any time
during contract
7-9
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Four main positions are as follows: call writer, call buyer, put
writer, and put buyer

9
Currency Option Markets
Prior to 1982, all currency option contracts were OTC options
written by international banks, investment banks, and brokerage
houses
OTC options are tailor-made and generally for large amounts
(i.e., at least $1m of currency serving as underlying assets)
OTC options are typically European style, and they are often
written for U.S. dollars, with the euro, British pound, Japanese
yen, Canadian dollar, and Swiss franc serving as the underlying
currency
In December 1982, Philadelphia Stock Exchange (PHLX) began
trading options on foreign currency
In 2008, PHLX was acquired by NASDAQ OMX Group
7-10
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The volume of OTC currency options trading is much larger
than that of organized-exchange option trading.

10
Currency Futures Options
CME Group trades European style options on several of the
currency futures contracts it offers
With these, the underlying asset is a futures contract on the
foreign currency instead of the physical currency
One futures contract underlies one options contract
Most CME futures options trade with expirations in the March,
June, September, December expiration cycle of the underlying
futures contract and three serial noncycle months
Options expire on the second business day prior to the third
Wednesday of the options contract month
Trading takes place Sunday through Friday on the GLOBEX
system from 5:00 PM to 4:00 PM Chicago time the next day
7-11
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Options on currency futures behave very similarly to options on
the physical currency since the futures price converges to the

spot price as the futures contract nears maturity.
11
Basic Option-Pricing Relationships at Expiration
At expiration, a European option and an American option
(which has not been previously exercised), both with the same
exercise price, will have the same terminal value
For call options the time T expiration value per unit of foreign
currency is stated as the following:
7-12
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Equation definitions
CaT denotes the value of the American call at expiration
CeT is the value of the European call at expiration
E is the exercise price per unit of foreign currency

ST is the expiration date spot price
Max is an abbreviation for denoting the maximum of the
arguments within the brackets
12
Basic Option-Pricing Relationships at Expiration (Continued)
Call (put) option with ST > E (E > ST) expires in-the-money
It will be exercised because the buyer will make money
If ST = E, the option expires at-the-money
It will not be exercised because no money will be made by
doing so
If ST < E (E < ST), the call (put) option expires out-of-the-
money
It will not be exercised because the buyer would lose money by
doing so and is under no obligation to exercise the option
7-13
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13

American Option-Pricing Relationships
American options will satisfy the following basic pricing
relationships at time t prior to expiration:
The above equations state that the American call and put
premiums at time t will be at least as large as the immediate
exercise value, or the intrinsic value, of the call or put option
Longer-term American option will have a market price at least
as large as the short-term option
7-14
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14

American Option-Pricing Relationships (Continued)
Call (put) option with ST > E (E > ST) is trading in-the-money
If ST ≅ E, the option is trading in-the-money
If ST < E (E < ST), the call (put) option is trading out-of-the-
money
Difference between the option premium and the option’s
intrinsic value is nonnegative and is sometimes referred to as
the option’s time value
7-15
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15
Market Value, Time Value, and Intrinsic Value of an American
Call Option
7-16

rights reserved.
16
European Option-Pricing Relationships
Pricing boundaries for European put and call premiums are
more complex
Consider two portfolios:
Portfolio A involves purchasing a European call option and
lending (or investing) an amount equal to the present value of
the exercise price, E, at the U.S. interest rate, i$, which we
assume corresponds to the length of the investment period
Cost of this investment is as follows: Ce + E / (1 + i$)
If ST ≤ E, call owner will let call option expire worthless
If ST > E, call owner will exercise the call, and exercise value
will be ST – E > 0
Portfolio B consists of lending the present value of one unit of
foreign currency, f, at the foreign interest rate, if, which we
assume corresponds to the length of the investment period

Cost of this investment is St /(1 + if)
7-17
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17
Equation for a European Call Option Lower Boundary
7-18
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18

European Option-Pricing Relationships (Continued)
In a rational marketplace, portfolio A will be priced to sell for
at least as much as portfolio B, implying the following:
Similarly, it can be shown the lower boundary pricing
relationship for a European put is:
7-19
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19
European Option-Pricing Relationships (Concluded)
Based on the two equations from the preceding slide, it can be
determined that, when all else remains the same, the call
premium, Ce (put premium, Pe) will increase:
The larger (smaller) is the exchange rate, St

The smaller (larger) is the exercise price, E
The smaller (larger) is the foreign interest rate, if
The larger (smaller) is the dollar interest rate, i$
The larger (smaller) i$ is relative to if
7-20
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20
European Call and Put Prices on Spot Foreign Exchange
Equations 7.6 and 7.7 (see slide 19) may be restated as the
following:
7-21
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21
European Option-Pricing Valuation: Example 7.5
7-22
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22
Binomial Option-Pricing Model
Binomial option-pricing model provides an exact pricing
formula for a European call or put
In this case, binomial model assumes that at the end of the

option period, the underlying foreign exchange has either
appreciated one step upward or depreciated one step downward
from its initial value
Objective is to value the PHLX 112 Sep EUR European call
Option is quoted at a premium of 3.78 cents
Current spot price of the EUR in American terms is S0 = 113.14
cents
Estimate of the option’s volatility is σ = 6.18 percent
Last day of trading in the call option is in 179 days on 9/20/19
At the end of the option period, the EUR will have appreciated
to SuT = S0 ⋅ u or depreciated to SdT = S0 ⋅ d
7-23
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23
PHLX World Currency Options Quotations
7-24

rights reserved.
24
Binomial Option-Pricing Model (Continued)
Binomial option-pricing model relies on the risk-neutral
probabilities of the underlying asset increasing and decreasing
in value
Risk-neutral probability of the EUR appreciating is:
q = (FT − S0 ⋅ d) / S0(u − d)
Use September EUR futures price on 3/25/19 as estimate of
FT($/EUR) = $1.1487
Therefore, q = (114.87 – 108.35) / (118.14 – 108.35) = 0.666
Binomial call option premium is determined by:
C0 = [qCuT + (1 − q)CdT] / (1 + i$)
= [.666(6.14) +.334(0)] / (1.0133 )
= 4.04 cents per EUR
7-25

rights reserved.
FT is the forward (or futures) price that spans the option period.
25
Schematic of Binomial Option-Pricing Example
7-26
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FT is the forward (or futures) price that spans the option period.
26
European Option-Pricing Formula
When the number of subperiods into which the option period is
subdivided goes to infinity, the European call and put pricing

formulas presented (below) are obtained
Exact European call and put pricing formulas:
Invoking IRP allows us to restate these as follows:
7-27
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Interest rates if and i$ are assumed to be annualized and
constant over the term-to-maturity T of the option contract,
which is expressed as a fraction of a year
27
Empirical Tests of Currency Options
Shastri and Tandon (1985)
Discover many violations of the boundary relationships
(discussed in this chapter), but conclude that nonsimultaneous
data could account for most violations
Shastri and Tandon (1986)
Conclude the European option-pricing model works well in
pricing American currency options
Barone-Adesi and Whaley (1987)
Find the European option-pricing model works well for pricing
American currency options that are at or out-of-the-money, but
does not do well in pricing in-the-money calls and pits
7-28
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28
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International Bond Market
Chapter Twelve
rights reserved.
This chapter continues the discussion of international capital
markets and institutions, focusing on the international bond
market.
1
Chapter Outline
The World’s Bond Markets: A Statistical Perspective
Foreign Bonds and Eurobonds
Types of Instruments
Currency Distribution, Nationality, and ype of Issuer
International Bond Market Credit Ratings
Eurobond Market Structure & Practices
International Bond Market Indices

12-2
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The World’s Bond Markets: A Statistical Perspective
Exhibit 12.1, below, presents an overview of the world’s bond
markets
Domestic bonds are issued by a borrower domiciled within a
country, denominated in the currency of that country, and traded
within the country.
International bonds include foreign bonds and Eurobonds
At the end of June 2018, the face value of bonds (long-term
original maturity notes) outstanding in the world was
approximately $114,449.9 billion
12-3
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Foreign Bonds and Eurobonds
International bond market encompasses two basic market
segments: foreign bonds and Eurobonds
A foreign bond is offered by a foreign borrower to investors in
a national capital market and denominated in that nation’s
currency
Example: German MNC issuing dollar-denominated bonds to
U.S. investors
A Eurobond issue is denominated in a particular currency but
sold to investors in national capital markets other than the
country that issued the denominating currency
Example: Dutch borrower issuing dollar-denominated bonds to
investors in the U.K., Switzerland, and the Netherlands
12-4
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Bearer Bonds and Registered Bonds

Eurobonds are usually bearer bonds, bonds in which ownership
is demonstrated through possession of the bond
Issuer does not keep any records indicating who is the current
owner of the bond
Bearer bonds are very attractive to investors desiring privacy
and anonymity, one reason for this being that they enable tax
evasion
Registered bonds, on the other hand, are bonds whose
ownership is demonstrated by associating the buyer’s name with
the bond in the issuer’s records
12-5
rights reserved.
U.S. security regulations require Yankee bonds and U.S.
corporate bonds sold to U.S. citizens to be registered.
5
National Security Regulations
Foreign bonds must meet the security regulations of the country
in which they are issued

As such, Yankee bonds must meet the same regulations as U.S.
domestic bonds
Many foreign borrowers find this level of regulation
burdensome and prefer to raise U.S. dollars in the Eurobond
market
Transactional restrictions prohibit offers and sales of Eurobonds
in the U.S. or to U.S. investors during a 40-day restriction
period that allows for the security to become seasoned in the
secondary market
12-6
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Security Regulations That Ease Bond Issuance
Rule 415, instituted by the SEC in 1982, allows for shelf
registration
Shelf registration allows an issuer to preregister a securities
issue, and then shelve the securities for later sale when
financing is actually needed
Rule 144A, instituted by the SEC in 1990, allows qualified
institutional buyers (QIBs) in the U.S. to trade in private

placement issues that do not have to meet the strict information
disclosure requirements of publicly traded issues
12-7
rights reserved.
Global Bonds
A global bond issue is a very large bond issue that would be
difficult to sell in any one country or region of the world
Global bond issues were first offered in 1989
Simultaneously sold and subsequently traded in major markets
worldwide
Most have been denominated in the U.S. dollar
Portion of a U.S. dollar global bond sold by a U.S. (foreign)
borrower in the U.S. is classified as a domestic (Yankee) bond
and the portion sold elsewhere is a Eurodollar bond
12-8
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Types of Instruments
Straight fixed-rate issues
Euro-medium-term notes
Floating-rate notes
Equity-related bonds
Dual-currency bonds
12-9
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Typical Characteristics of International Bond Market
Instruments
12-10
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