International Financial Management

INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright 2009 by The McGraw-Hill Companies, Inc.All rights reserved. McGraw-Hill/Irwin Evolution of the International Monetary System Current Exchange Rate Arrangements European Monetary System Euro and the European Monetary Union The Mexican Peso Crisis The Asian Currency Crisis The Argentine Peso Crisis Fixed versus Flexible Exchange Rate Regimes Chapter Two Outline 2-1 Evolution of theInternational Monetary System Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973-Present 2-2 Bimetallism: Before 1875 A double standard in the sense that both gold and silver were used as money. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents.2-3 Greshams Law Greshams Law implied that it would be the least valuable metal that would tend to circulate.2-4 Classical Gold Standard:1875-1914 During this period in most major countries: Gold alone was assured of unrestricted coinage There was two-way convertibility between gold and national currencies at a stable ratio. Gold could be freely exported or imported. The exchange rate between two countrys currencies would be determined by their relative gold contents. 2-5 Classical Gold Standard:1875-1914 Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism. 2-6 Price-Specie-Flow Mechanism Suppose Great Britain exported more to France than France imported from Great Britain. This cannot persist under a gold standard. Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France. 2-7 Humes Chal l enge: t he Pr i c e-Spec i e Fl owMec hani sm Hume (mi d-18t h c ent ur y): mai nt ai ni ng at r ade sur pl us f or everi s i mpossi bl e. Tr ade sur pl us i nf l owofspec i e i nf l owofspec i e i nc r eased Ms

i nc r eased Ms hi gherpr i c es (and w ages) hi gherpr i c es l ow erex por t s and hi gheri mpor t s Classical Gold Standard:1875-1914 There are shortcomings: The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. Even if the world returned to a gold standard, any national government could abandon the standard. 2-9 Interwar Period: 1915-1944 Exchange rates fluctuated as countries widely used predatory depreciations of their currencies as a means of gaining advantage in the world export market. Attempts were made to restore the gold standard, but participants lacked the political will to follow the rules of the game. The result for international trade and investment was profoundly detrimental. 2-10 Bretton Woods System:1945-1972 Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank. 2-11 Bretton Woods System:1945-1972 Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within 1% of the adopted par value by buying or selling foreign reserves as necessary. The Bretton Woods system was a dollar-based gold exchange standard. 2-12 Bretton Woods System:1945-1972 German mark British pound French franc U.S. dollar Gold Pegged at $35/oz. Par Value 2-13 Collapse of Bretton Woods In 1960 Robert Triffin noticed that holding dollars was more valuable than gold because constant U.S. balance of payments deficits helped to keep the system liquid and fuel economic growth. What would later come to be known as Triffin's Dilemma was predicted when Triffin noted that if the U.S. failed to keep running deficits the system would lose its liquidity, not be able to keep up with the world's economic growth, and, thus, bring the system to a halt. Throughout the 1960s countries with large $ reserves began buying gold from the U.S. in increasing quantities threatening the gold reserves of the U.S. Collapse of Bretton Woods Large U.S. budget deficits and high money growth created exchange rate imbalances that could not be sustained, i.e. the $ was overvalued and the DM and were undervalued. Several attempts were made at re-alignment but eventually the run on U.S. gold supplies prompted the suspension of convertibility in September 1971. Smithsonian Agreement December 1971 Collapse of Bretton Woods Collapse of Bretton Woods Collapse of Bretton Woods Collapse of Bretton Woods Collapse of Bretton Woods Collapse of Bretton Woods The Flexible Exchange Rate Regime: 1973-Present. Flexible exchange rates were declared acceptable to the IMF members. Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities. Gold was abandoned as an international reserve asset. 2-22 Current Exchange Rate Arrangements Free Float The largest number of countries, about 48, allow market forces to determine their currencys value. Managed Float About 25 countries combine government intervention with market forces to set exchange rates. Pegged to another currency Such as the U.S. dollar or euro (through franc or mark). No national currency Some countries do not bother printing their own currency. For example, Ecuador, Panama, and El Salvador have dollarized. Montenegro and San Marino use the euro. 2-23 European Monetary System European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives: To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis--vis non-European currencies. To pave the way for the European Monetary Union. 2-24 The Spirit of the European Monetary System, 1979 The European Monetary System (EMS) was built upon three building blocks: the European Currency Unit (ECU) as an accounting currency , the Exchange Rate Mechanism (ERM) as a fixing exchange rates onto the European Currency Unit (ECU) in order to stabilise exchange rates and counter inflation, and the European Monetary Cooperation Fund (EMCF). The Spirit of the European Monetary System, 1979 The European Currency Unit was a basket of the currencies of the European Community member states, used as the unit of account of the European Community before being replaced by the euro on January 1, 1999, at parity. The ECU itself replaced the European Unit of Account, also at parity, on March 13, 1979. The ECU was also used in some international financial transactions, where its advantage was that securities denominated in ECUs provided investors with the opportunity for foreign diversification without reliance on the currency of a single country. The Spirit of the European Monetary System, 1979 All member countries :Fix a par value for each exchange rate in terms of the European Currency Unit, a basket weighted according to country size. Keep exchange rates stable in the short-run by limiting movements in bilateral rates - the Exchange Rate Mechanism. Hold foreign exchange reserves primarily in ECUs with the European Monetary Cooperation Fund, and reduce US$ reserves. The Spirit of the European Monetary System, 1979 The three building blocks of the EMS linked together Europeanexchange rates and monetary policies until the chaotic events of 1992 and 1993 Leaders reached agreement on currency union with the Maastricht Treaty, signed on 7 February 1992. It agreed to create a single currency, although without the participation of the United Kingdom, by January 1999. Gaining approval for the treaty was a challenge. Germany was cautious about giving up its stable currency, i.e. the German Mark, France approved the treaty by a narrow margin. Denmark refused to ratify until they got an opt out from monetary union as the United Kingdom, an opt-out which they maintain as of 2010. On 16 September 1992, known in the UK as Black Wednesday, the British pound sterling was forced to withdraw from the fixed exchange rate system due to a rapid fall in the value of the pound. The European Monetary System as aGreater DM Area, 1979-1998 In practice, the DM was the centerpiece of the ERM, and German monetary policy formed the anchor for the EMS price level. Member countries except Germany: Intervene to stabilize currency values vis--vis the DM. Germany: Remain passive in the foreign exchange market with respect to other EMS countries. Set German monetary policy independently to serve as an anchor for the EMS price level. EMU (European Monetary Union Some European leaders wanted to achieve an even closer economic and social union. The Delors report of 1989 set out a plan to introduce the EMU in three stages and it included the creation of institutions such as the European System of Central Banks (ESCB), Under the EMU, a single central bank would set monetary policy for a single European money. The 1991 Maastricht Treaty spelled out the steps needed to transfer the responsibilities for monetary policy and national monies to a new EC institution.Three of steps EMU Beginning the first of these steps, on 1 J uly 1990, exchange controls were abolished, thus capital movements were completely liberalised in the European Economic Community. Leaders reached agreement on currency union with the Maastricht Treaty, signed on 7 February 1992. It agreed to create a single currency, although without the participation of the United Kingdom, by J anuary 1999. EMU (European Monetary Union The Spirit of the European Economic and Monetary Union, 1999 The EMU was launched on J anuary 1, 1999 with 11 member countries. The European Central Bank (ECB) has sole responsibility for monetary policy among EMU countries. National governments set other economic policies such as taxation and expenditures within a set of commonly agreed rules. Old legacy currencies (replacing the name Ecu used for the previous accounting currency), are exchanged for the new surviving currency, the euro. The Spirit of the European Economic and Monetary Union, 1999 In order to participate in the new currency, member states had to meet strict criteria such as a budget deficit of less than 3% of their GDP, a debt ratio of less than 60% of GDP, low inflation, and interest rates close to the EU average. Greece failed to meet the criteria and was excluded from participating on 1 January 1999.What Is the Euro? The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 J anuary 1999. These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands. 2-34 Euro Area Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, The Netherlands, Portugal, Slovenia, Spain 2-35 The Long-Term Impact of the Euro As the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a United States of Europe feasible. It is likely that the U.S. dollar will lose its place as the dominant world currency. The euro and the U.S. dollar will be the two major currencies. 2-36 Costs of Monetary Union The main cost of monetary union is the loss of national monetary and exchange rate policy independence. The more trade-dependent and less diversified a countrys economy is the more prone to asymmetric shocks that countrys economy would be. 2-37 Costs of Monetary Union As an example, if the economy of Oklahoma was dependent on gas and oil, and oil prices fall on the world market, then Oklahoma might be better off if it had its own currency rather than relying on the U.S. dollar. This example shows that perhaps the benefits of monetary union typically outweigh the costs. 2-38 The Mexican Peso Crisis On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency traders expectations about the future value of the peso. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent. 2-39 The Mexican Peso Crisis The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. 2-40 The Mexican Peso Crisis Two lessons emerge: It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. An influx of foreign capital can lead to an overvaluation in the first place. 2-41 Asian Crisis, 1997-98 Economic and financial crisis Began in financial sector, spread to real economy Began in Thailand, spread to nearby countries (contagion) Asian Crisis, 1997-98 Hot economies had attracted a lot of foreign investment - much of it short term that could be quickly withdrawn at first sign of trouble Banking systems and financial systems couldnt handle all this capital - much of it went into questionable loans, real estate, stock market, etc. Other internal problems:tax regulation, nepotism (protectionism), expectation of government bailout (rescue) if investments went bad Asian Crisis, 1997-98 External Factor Strength of U.S. Dollar U.S. dollar rose by 50% against J apanese yen, 1995-97 Each country used basket peg with $ as dominant currency in basket (80%+) Rising dollar meant each currency was also rising, so big export slowdown Trade was 30-40 percent of GDP Asian Crisis, 1997-98 Speculative bubble () of inflated prices burst ( ) (stock, real estate, etc.), then capital flight out of country as investments turned sour Pegged exchange rates couldnt hold, so currencies devalued, then floated Asian Currency Values versus U.S. $ 1997-1998 Asian Crisis, 1997-98 From J uly 1, 1997 to J anuary 24, 1998 Thai baht fell by 55% against dollar Malaysian ringgit fell by 45% Korean won fell by 49% Philippine peso fell by 39% Indonesian rupiah fell by 84% All now floating except the ringgit Asian Crisis, 1997-98 in 1998, negative real GDP growth ranging from -0.6% (Philippines) to -13.2% percent (Indonesia) severe recession weak J apanese economy couldnt provide support needed for quick recovery Asian Crisis, 1997-98 All five countries returned to positive real growth in 1999, but some have still not fully recovered from crisis this contrasts with case of Mexico, which was expanding nicely one year after its 1995 crisis, due to booming U.S. economy The Asian Currency Crisis The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession. The Argentinean Peso Crisis In 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar at parity. The initial economic effects were positive: Argentinas chronic inflation was curtailed Foreign investment poured in As the U.S. dollar appreciated on the world market the Argentine peso became stronger as well. 2-51 The Argentinean Peso Crisis The strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of pesodollar parity in J anuary 2002. The unemployment rate rose above 20 percent The inflation rate reached a monthly rate of 20 percent 2-52 The Argentinean Peso Crisis There are at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis: Lack of fiscal discipline Labor market inflexibility Contagion from the financial crises in Brazil and Russia 2-53 Currency Crisis Explanations In theory, a currencys value mirrors the fundamental strength of its underlying economy, relative to other economies. In the long run. In the short run, currency traders expectations play a much more important role. In todays environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to get to the exits first. Thus, fears of depreciation become self-fulfilling prophecies. 2-54 Fixed versus FlexibleExchange Rate Regimes Arguments in favor of flexible exchange rates: Easier external adjustments. National policy autonomy. Arguments against flexible exchange rates: Exchange rate uncertainty may hamper international trade. No safeguards to prevent crises. 2-55 Fixed versus FlexibleExchange Rate Regimes Suppose the exchange rate is $1.40/ today. In the next slide, we see that demand for euro far exceeds supply at this exchange rate. The U.S. experiences trade deficits. 2-56 Fixed versus FlexibleExchange Rate Regimes QS QD Q of Dollar price per (exchange rate) $1.40 Trade deficit Demand (D) Supply (S) 2-57 FlexibleExchange Rate Regimes Under a flexible exchange rate regime, the dollar will simply depreciate to $1.60/, the price at which supply equals demand and the trade deficit disappears.2-58 Fixed versus FlexibleExchange Rate Regimes Supply (S) Demand (D) Demand (D*) QD =QS Dollar depreciates (flexible regime) Q of Dollar price per (exchange rate) $1.60 $1.40 2-59 Fixed versus FlexibleExchange Rate Regimes Instead, suppose the exchange rate is fixed at $1.40/, and thus the imbalance between supply and demand cannot be eliminated by a price change. The government would have to shift the demand curve from D to D* In this example this corresponds to contractionary monetary and fiscal policies. 2-60 Fixed versus FlexibleExchange Rate Regimes Supply (S) Demand (D) Demand (D*) QD* =QS Contractionary policies (fixed regime) Q of Dollar price per (exchange rate) $1.40 2-61 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright 2009 by The McGraw-Hill Companies, Inc.All rights reserved. McGraw-Hill/Irwin Human Resources University Chapter II:Balance of Payments Chapter Outline This chapter serves to introduce the student to the balance of payments. How it is constructed and how balance of payments data may be interpreted Balance of Payments Accounting Balance of Payments Accounts The Current Account The Capital Account Statistical Discrepancy Official Reserves Account The Balance of Payments Identity Balance of Payments Trends in Major Countries 3-1 Balance of Payments Accounting The Balance of Payments is the statistical record of a countrys international transactions over a certain period of time presented in the form of double-entry bookkeeping. N.B. when we say a countrys balance of payments we are referring to the transactions of its citizens and government. 3-2 Balance of Payments Example Suppose that Maplewood Bicycle in Maplewood, Missouri, USAimports $100,000 worth of bicycle frames from Mercian Bicycles in Darby England. There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewoods bank account. This will lead to a rise in the supply of dollars and the demand for British pounds. 3-3 The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations. They are composed of the following: The Current Account The Capital Account The Official Reserves Account Statistical Discrepancy Balance of Payments Accounts 3-4 The Current Account Includes all imports and exports of goods and services. Includes unilateral transfers of foreign aid. If the debits exceed the credits, then a country is running a trade deficit. If the credits exceed the debits, then a country is running a trade surplus. 3-5 The Capital Account The capital account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets. In 2006, the U.S. enjoyed a $826 billion capital account surplusabsent of U.S. borrowing from foreigners, this finances our trade deficit. The capital account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments. 3-6 Statistical Discrepancy Theres going to be some omissions and misrecorded transactionsso we use a plug figure to get things to balance. Exhibit 3.1 shows a discrepancy of $18 billion in 2006. 3-7 The Official Reserves Account Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF. 3-8 Collapse of Bretton Woods Collapse of Bretton Woods Collapse of Bretton Woods Collapse of Bretton Woods The Balance of Payments Identity BCA + BKA + BRA = 0 where BCA =balance on current account BKA =balance on capital account BRA =balance on the reserves account Under a pure flexible exchange rate regime, BCA + BKA = 0 3-13 U.S. Balance of Payments Data 2006

Credits Debits Current Account

1 Exports $2,096.3

2 Imports

($2,818.0) 3 Unilateral Transfers $24.4 ($114.0) Balance on Current Account ($811.3) Capital Account

4 Direct Investment $180.6 ($235.4) 5 Portfolio Investment $1,017.4 ($426.1) 6 Other Investments $690.4 ($400) Balance on Capital Account $826.9 7 Statistical Discrepancies

Overall Balance ($2.4)

Official Reserve Account $2.4 ($18) 3-14 U.S. Balance of Payments Data 2006 In 2004, the U.S. imported more than it exported, thus running a current account deficit of $811.3 billion.


1 Exports $2,096.3

2 Imports




Official Reserve Account $2.4 ($18) 3-15 U.S. Balance of Payments Data 2006 During the same year, the U.S. attracted net investment of $826.9 billionclearly the rest of the world found the U.S. to be a good place to invest.


1 Exports $2,096.3

2 Imports




Official Reserve Account $2.4 ($18) 3-16 U.S. Balance of Payments Data 2006 Under a pure flexible exchange rate regime, these numbers would balance each other out.


1 Exports $2,096.3

2 Imports




Official Reserve Account $2.4 ($18) 3-17 U.S. Balance of Payments Data 2006 In the real world, there is a statistical discrepancy.


1 Exports $2,096.3

2 Imports




Official Reserve Account $2.4 ($18) 3-18 U.S. Balance of Payments Data 2006 Including that, the balance of payments identity should hold: BCA +BKA = BRA ($811.3) +$826.9 +($18) =($2.4)


1 Exports $2,096.3

2 Imports




Official Reserve Account $2.4 ($18) 3-19 Balance of Payments and the Exchange Rate Q P Exchange rate $ S D


1 Exports $2,096.3

2 Imports




Official Reserve Account $2.4 ($18) 3-20 Balance of Payments and the Exchange Rate Q P As U.S. citizens import, they are supply dollars to the FOREX market. Exchange rate $ S D


1 Exports $2,096.3

2 Imports




Official Reserve Account $2.4 ($18) 3-21 Balance of Payments and the Exchange Rate Q P As U.S. citizens export, others demand dollars at the FOREX market. Exchange rate $ S D


1 Exports $2,096.3

2 Imports




Official Reserve Account $2.4 ($18) 3-22 Balance of Payments and the Exchange Rate Q PS D As the U.S. government sells dollars, the supply of dollars increases. S1 Exchange rate $ Credits Debits Current Account

1 Exports $2,096.3

2 Imports




Official Reserve Account $2.4 ($18) 3-23 The U.S. Current Account Balance, 2005 (Millions of Dollars) International Transactions:Data Components of theU.S. Financial Account, 2005(Millions of Dollars) International Transactions:Data Private Flows in the U.S. Financial Account, 2005 (Millions of Dollars) International Transactions:Data FDI Sovereign Wealth Funds Government-controlled investment funds are playing an increasingly visible role in international investments. SWFs are mostly domiciled in Asian and Mid-East countries usually are responsible for recycling foreign exchange reserves of these countries swelled by trade surpluses and oil revenues. 3-27 The J-Curve Effect Change in the Trade Balance Time Following a currency depreciation, the trade balance may at first deteriorate before it improves. The shape depends on the elasticity of the imports and exports. As an example, consider an imported good for which there is no domestic producer. If demand is price inelastic, then following a depreciation the trade balance gets worse (until domestic production begins). 3-28 Balance of Payments Trends Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account. During the same period, J apan has experienced the opposite. 3-29 Source: IMF International Financial Statistics Yearbook, various issues U.S. Balance of Payments 1982-2006-1000-800-600-400-200020040060080010001982 1987 1992 1997 2002 2007YearBalance of PaymentsU.S. BCAU.S. BKA3-30 Source: IMF International Financial Statistics Yearbook, various issues Japan Balance of Payments 1982-2006-150-100-500501001502001980 1985 1990 1995 2000 2005 2010Bal ance of PaymentsYearJ apan BCAJ apan BKA3-31 Balance of Payments Trends Germany traditionally had current account surpluses. From 1991 to 2001Germany experienced current account deficits. This was largely due to German reunification and the resultant need to absorb more output domestically to rebuild the former East Germany. Since 2001 Germany returned to its earlier pattern. What matters is the nature and causes of the disequilibrium. 3-32 Source: IMF International Financial Statistics Yearbook, various issues Balance of Payments Trends in Major Countries 1982-2006-1000-500050010001982 1987 1992 1997 2002 2007YearBalance of PaymentsChina BCAChina BKAJ apan BCAJ apan BKAGermany BCAGermany BKAUK BCAUK BKAU.S. BCAU.S. BKA3-33 Mercantilism and the Balance of Payments Mercantilism holds that a country should avoid trade deficits at all costs, even to imposing various restrictions on imports. Mercantilist ideas were criticized in the 18th century by such British thinkers as Adam Smith, David Ricardo, and David Hume. They argued that the main source of wealth in a country is its productive capacity not its trade surpluses.3-34 End Chapter Three Start Chapter 3 appendix. 3-35 Relationship between Balance of Payments and National Income Accounting National income (Y), or gross domestic product (GDP) is equal to the sum of the nominal consumption (C) of goods and services, private investment (I), government spending (G), and the difference between exports (X) and imports (M): Y GDP C + I + G + (X M) 3-36 Relationship between Balance of Payments and National Income Accounting Private savings is defined as the amount left from national income after consumption and taxes (T) are paid: S Y C T orS C + I + G + (X M) C T Note that BCA X M and we can rearrange the last equation as (S I) + (T G) X M BCA 3-37 Relationship between Balance of Payments and National Income Accounting (S I) + (T G) X M BCA This shows that there is an intimate relationship between a countrys BCA and how it finances its domestic investment and pays for government spending. If (S I) < 0 then a countrys domestic savings is insufficient to finance domestic in vestment. Similarly, if(T G) < 0, then tax revenue is insufficient to cover government spending and a government budget deficit exists. 3-38 Relationship between Balance of Payments and National Income Accounting (S I) + (T G) X M BCA When BCA < 0, government budget deficits and or part of domestic investment are being financed by foreign-controlled capital. To reduce a BCA deficit, one of the following must occur: For a given level of S and I, the government budget deficit (T G) must be reduced For a given level of I and (T G), S must be increased For a given level S and (T G), I must fall. 3-39 End Chapter Three 3-40 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright 2009 by The McGraw-Hill Companies, Inc.All rights reserved. McGraw-Hill/Irwin Human Resources University Chapter III: The Market for Foreign Exchange Chapter Objective: This chapter serves to introduce the student to theinstitutionalframeworkwithinwhich exchange rates are determined.This chapter lays the foundation for much of the discussion throughout the remainder of the text, thus it deserves your careful attention. 5-1 Function and Structure of the FX Market The Spot Market The Forward Market Exchange-Traded Currency Funds Function and Structure of the FX Market FX Market Participants Correspondent Banking Relationships The Spot Market The Forward Market Exchange-Traded Currency Funds Function and Structure of the FX Market The Spot Market Spot Rate Quotations The Bid-Ask Spread Spot FX Trading Cross Exchange Rate Quotations Triangular Arbitrage Spot Foreign Exchange Market Microstructure The Forward Market Function and Structure of the FX Market The Spot Market The Forward Market Forward Rate Quotations Long and Short Forward Positions Forward Cross-Exchange Rates Swap Transactions Forward Premium Exchange-Traded Currency Funds Function and Structure of the FX Market The Spot Market The Forward Market Exchange-Traded Currency Funds 5-2 Function and Structure of the FX Market FX Market Participants Correspondent Banking Relationships 5-3 FX Market Participants The FX market is a two-tiered market: Interbank Market (Wholesale) About 100-200 banks worldwide stand ready to make a market in foreign exchange. Nonbank dealers account for about 40% of the market. There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. Client Market (Retail) Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks. 5-4 Market participants Banks: The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily.

Commercial companies: An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators Central Bank: National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Hedge funds as speculators: About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Investment management firms: Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and mutual funds) use the foreign exchange market to facilitate transactions in foreign securities. Retail foreign exchange brokers: There are two types of retail brokers offering the opportunity for speculative trading: retail foreign exchange brokers and market makers. Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks. Non-bank foreign exchange companies: Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. Money transfer/remittance companies: Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, theestimated that there were $369 billion of remittances (an increase of 8% on the previous year). The largest and best known provider is Western Union with 345,000 agents globally.Circadian Rhythms of the FX Market Electronic Conversations per Hour0500010000150002000025000300003500040000450001:00 10 aminTokyo3:00Lunchhour inTokyo5:00 Europecoming in07:00 9:00 Asiagoing out11:00Lunchhour inLondon1:00 Americascoming in15:00 5:00Londongoing out19:00 9:00NewZealandcoming in11:00 6 pminNYaverage peak5-9 Correspondent Banking Relationships Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the FX market. 5-10 Correspondent Banking Relationships Bank A is in London, Bank B is in New York. The current exchange rate is 1.00 = $2.00. A currency trader employed at Bank A buys 100m from a currency trader at Bank B for $200m settled using its correspondent relationship. Bank A London Bank B NYC $200 100 5-11 $600m 400m$1200m 100m 100m $1,200m400m $600m You can check your work: make sure that 1,300m = $1,200x(1/$2) +100 + 600 $200 100 Bank A buys 100m from Bank B for $200m Correspondent Banking Relationships AssetsLiabilities deposit at B300m Other Assets600m Bs Deposit $1,000m Other L&E600m Total Assets 1,300mTotal L&E1,300m AssetsLiabilities $ deposit at A $1000m Other Assets$800m As Deposit300m Other L&E$800m Total Assets$2,200mTotal L&E $2,200m Bs Deposit200m deposit at A200mAs Deposit$800m Bank A London Bank B NYC $ deposit at B$800m 5-12 Correspondent Banking Relationships International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions. 5-13 The Spot Market Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates 5-14 Spot Rate Quotations Direct quotation the U.S. dollar equivalent e.g. a J apanese Yen is worth about a penny Indirect Quotation the price of a U.S. dollar in the foreign currency e.g. you get 100 yen to the dollar See exhibit 5.4 in your textbook. 5-15 .5072 1 9717.1 = Spot Rate Quotations Currencies J anuary 4, 2008 U.S.-dollar foreign-exchange rates in late New York trading. --------Friday------- Country/currencyin US$ per US$ Euro area euro1.4744 .6783 1-mos forward1.4747.6781 3-most forward1.4744.6782 6-mos forward1.4726.6791 UK pound1.9717.5072 1-mos forward1.9700.5076 3-most forward1.9663.5086 6-mos forward1.9593.5104 The direct quote for the pound is: 1 = $1.9717 The indirect quote for the pound is: .5072 = $1 Note that the direct quote is the reciprocal of the indirect quote: 5072. 1 9717.1 = Currencies J anuary 4, 2008 U.S.-dollar foreign-exchange rates in late New York trading. --------Friday---------------Friday------- Country/currencyin US$ per US$Country/currencyin US$ per US$ Canada dollar.99841.0016Euro area euro1.4744 .6783 1-mos forward.99861.00141-mos forward1.4747.6781 3-most forward.99881.00123-most forward1.4744.6782 6-mos forward.99791.00216-mos forward1.4726.6791 Japan yen.009220108.46UK pound1.9717.5072 1-mos forward.009250108.111-mos forward1.9700.5076 3-most forward.009306107.463-most forward1.9663.5086 6-mos forward.009378106.636-mos forward1.9593.5104 5-16 The Bid-Ask Spread The bid price is the price a dealer is willing to pay you for something. The ask price is the amount the dealer wants you to pay for the thing. It doesnt matter if were talking used cars or used currencies: the bid-ask spread is the difference between ask prices and the bid price. 5-17 0.0339% =x 100 $1.4744 $1.4739 $1.4744The Bid-Ask Spread A dealer could offer bid price of $1.4739per ask price of $1.4744 per While there are a variety of ways to quote that, the bid-ask spread represents the dealers expected profit. Percent Spread = 100 Ask Price Bid PriceAsk Price5-18 big figure small figure The Bid-Ask Spread A dealer pricing pounds in terms of dollars would likely quote these prices as 1217. Anyone trading $10m knows the big figure. USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds1.97121.9717.5072.5073 5-19 The Bid-Ask Spread USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds1.97121.9717.5072.5073 Notice that the reciprocal of the S($/) bid is the S(/$) ask.= 1.00 $1.9712 .5073 $1.00 5-20 Dealer will pay $1.9715 for 1 GBP; he is asking $1.9720. He will pay .5071 for $1 and will charge .5072 for $1 $10,000 1 $1.9720 = 5,071 Currency Conversion with Bid-Ask Spreads A speculator in New York wants to take a $10,000 position in the pound. After his trade, what will be his position? 1.9715 20 .5071 72 S($/) S(/$) Bid Ask 5-21 Sample Problem A businessman has just completed transactions in Italy and England. He is now holding 250,000 and 500,000 and wants to convert to U.S. dollars. His currency dealer provides this quotation: GBP/USD 0.5025 76 USD/EUR 1.4739 44 Assuming no other fees, what are his proceeds from conversion?5-22 When he sells 250,000 he will trade with a dealer at the dealers bid price of $1.4739 per : GBP/USD0.5025 76 When he sells 500,000 he will trade with a dealer at the dealers ask price of 0.5076 per $: 250,000 x $1.4739 1.00 =$368,475 500,000 x $1.00 .5076 =$985,027.58 USD/EUR1.4739 44 $1,353,502.58 Sample Problem Solution 5-23 Spot FX trading In the interbank market, the standard size trade is about U.S. $10 million. A bank trading room is a noisy, active place. The stakes are high. The long term is about 10 minutes. 5-24 0.75 1.00 = $1.501.00 1.00$2.00 1.00 = 0.75 Pay attention to your currency algebra! Cross Rates Suppose that S($/) = 1.50 i.e. $1.50 =1.00 and that S($/) = 2.00 i.e. 1.00 =$2.00 What must the / cross rate be? 5-25 Cross Rate Bid-Ask Spread To find the / cross bid rate, consider a retail customer who: USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds1.97121.9717.5072.5073 Euros1.47381.4742.6783.6785 10,000 $1.9712 1.00 .6783 $1.00 = 13,370.65 Starts with 10,000, sells for $, buys : He has effectively sold at a / bid price of1.3371/ 5-26 Cross Rate Bid-Ask Spread To find the / cross ask rate, consider a retail customer who: USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds1.97121.9717.5072.5073 Euros1.47381.4742.6783.6785 10,000 $1.00 .6785 1.00 $1.9717 = 7,474.96 Starts with 10,000, sells for $, buys : He has effectively bought at a / ask price of1.3378/ 5-27 Cross Rate Bid-Ask Spread Bank Quotations American TermsEuropean Terms BidAskBidAsk :$$1.9712$1.9717.5072.5073 :$$1.4738$1.4742.6783.6785 :1.33711.33780.74750.7479 direct indirect Recall that the reciprocal of the S(/) bid is the S(/) ask.= .7479 1.00 1.3371 1.00 5-28 Triangular Arbitrage Bank QuotationsBidAsk Deutsche Bank :$$1.9712$1.9717 Credit Lyonnais :$$1.4738$1.4742 Credit Agricole:1.33101.3317 No Arbitrage:1.33711.3378 Suppose we observe these banks posting these exchange rates. As we have calculated the no arbitrage / cross bid and ask rates, we can see that there is an arbitrage opportunity: 1 $1.9712 1.00 1.00 $1.4742 = 1.3371 5-29 Triangular Arbitrage Bank QuotationsBidAsk Deutsche Bank :$$1.9712$1.9717 Credit Lyonnais :$$1.4738$1.4742 Credit Agricole:1.33101.3317 No Arbitrage:1.33711.3378 By going through Deutsche Bank and Credit Lyonnais, we can sell pounds for 1.3371.The arbitrage is to buy those pounds from Credit Agricole for 1.33171 $1.9712 1.00 1.00 $1.4742 = 1.3371 5-30 Triangular Arbitrage Bank QuotationsBidAsk Deutsche Bank :$$1.9712$1.9717 Credit Lyonnais :$$1.4738$1.4742 Credit Agricole:1.33101.3317 Start with1m: sell to Deutsche Bank for $1,971,200. Buy euro from Credit Lyonnais receive 1,337,132 $1,971,200 1.00 $1.4742 = 1,337,132. Buy from Credit Agricole receive 1,004,078.89 10,000,000 $1.9712 1.00 = $1,971,200. 5-31 Spot Foreign Exchange Microstructure Market Microstructure refers to the mechanics of how a marketplace operates. Bid-Ask spreads in the spot FX market: increase with FX exchange rate volatility and decrease with dealer competition. Private information is an important determinant of spot exchange rates. 5-32 The Forward Market Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium 5-33 The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract. 5-34 Forward Rate Quotations The forward market for FX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term swaps are available. 5-35 Forward Rate Quotations Consider these exchange rates: for British pounds, the spot exchange rate is$1.9717 = 1.00 while the 180-day forward rate is $1.9593 = 1.00 Whats up with that? Country/currencyin US$ per US$ UK pound1.9717.5072 1-mos forward1.9700.5076 3-most forward1.9663.5086 6-mos forward1.9593.5104 Clearly market participants expect that the pound will be worth less in dollars in six months. 5-36 Forward Rate Quotations Consider the (dollar) holding period return of a dollar-based investor who buys 1 million at the spot exchange rate and sells them forward: $HPR= gain pain $1,959,300 $1,971,700 $1,971,700 =$12,400 $1,97,1700 =$HPR = 0.00629 Annualized dollar HPR = 1.26% =0.629% 2 5-37 Forward Premium The interest rate differential implied by forward premium or discount. For example, suppose the is appreciating from S($/) = 1.55 to F180($/) = 1.60 The 180-day forward premium is given by: = 0.0645 or 6.45% 1.60 1.55 1.55 2=f180,v$ F180($/) S($/)S($/) = 360 180 5-38 Long and Short Forward Positions If you have agreed to sell anything (spot or forward), you are short. If you have agreed to buy anything (forward or spot), you are long. If you have agreed to sell FX forward, you are short. If you have agreed to buy FX forward, you are long. 5-39 Payoff Profiles 0 S180($/) F180($/) =.009524 Short positionloss profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain. If you agree to sell anything in the future at a set price and the spot price later rises then you lose. 5-40 Payoff Profiles loss 0 S180(/$) F180(/$) =105 -F180(/$) profit Whether the payoff profile slopes up or down depends upon whether you use the direct or indirect quote: F180(/$) =105 orF180($/) =.009524. short position 5-41 Payoff Profiles loss 0 S180(/$) F180(/$) =105 -F180(/$) When the short entered into this forward contract, he agreed to sell in 180 days at F180(/$) =105profit short position 5-42 Payoff Profiles loss 0 S180(/$) F180(/$) =105 -F180(/$) 120 If, in 180 days, S180(/$) =120, the short will make a profit by buying at S180(/$) =120 and delivering at F180(/$) =105.15 profit short position 5-43 Payoff Profiles loss 0 S180(/$) F180(/$) =105 Long position-F180(/$) F180(/$) short position profit Since this is a zero-sum game, the long position payoff is the opposite of the short. 5-44 Payoff Profiles loss 0 S180(/$) F180(/$) =105 Long position -F180(/$) profit The long in this forward contract agreed to BUY in 180 days at F180(/$) =105If, in 180 days, S180(/$) =120, the long will lose by having to buy at S180(/$) =120 and delivering at F180(/$) =105.120 15 5-45 Forward Market Hedge If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract. If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract. 5-46 Forward Market Hedge: an Example You are a U.S. importer of British woolens and have justorderednextyearsinventory.Paymentof100M is due in one year. Question:How can you fix the cash outflow in dollars? Answer: One way is to put yourself in a position that delivers 100M in one yeara long forward contract on the pound.5-47 Forward Market Hedge: an Example Step 4 Pay supplier 100 million Step 1 Order Inventory; agree to pay supplier 100 in 1 year. 01 Step 2 Take a Long position in a Forward Contract on 100 million. Step 3 Fulfill your contractual obligation to forward contract counterparty and buy 100 million for $195 million. (Suppose that the forward rate is $1.95/.) 5-48 Forward Market Hedge $1.95/ Value of 1 in $ in one year Suppose the forward exchange rate is $1.95/.If he does not hedge the 100m payable, in one year his gain (loss) on the unhedged position is shown in green.$0 $1.65/$2.25/ $30m $30m Unhedged payable The importer will be better off if the pound depreciates: he still buys 100m but at an exchange rate of only $1.65/ he saves $30 million relative to $1.95/ But he will be worse off if the pound appreciates. 5-49 Forward Market Hedge $1.95/ Value of 1 in $ in one year$2.25/ If he agrees to buy 100m in one year at $1.95/ his gain (loss) on the forward are shown in blue.$0 $30m $1.65/ $30m Long forward If you agree to buy 100 million at a price of $1.95 per pound, you will lose $30 million if the price of a pound is only $1.65. If you agree to buy 100 million at a price of $1.95 per pound, you will make $30 million if the price of a pound reaches $2.25. 5-50 Forward Market Hedge $1.95/ Value of 1 in $ in one year$2.25/ The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position. $0 $30 m $1.65/ $30 m Long forward Unhedged payable Hedged payable 5-51 Forward Cross Exchange Rates Its just an delayed example of the spot cross rate discussed above. In generic terms ) / ($) / ($) / (and) / ($) / ($) / (k Fj Fj k Fj Fk Fk j FNNNNNN==Notice that the $s cancel. 5-52 Forward Cross Rates Currencies J anuary 4, 2008 U.S.-dollar foreign-exchange rates in late New York trading. --------Friday------- Country/currencyin US$ per US$ Euro area euro1.4744 .6783 1-mos forward1.4747.6781 3-mos forward1.4744.6782 6-mos forward1.4726.6791 UK pound1.9717.5072 1-mos forward1.9700.5076 3-mos forward1.9663.5086 6-mos forward1.9593.5104 The 3-month forward / cross rate is 0.7498 1.00 = $1.47441.00 1.00$1.9663 5-53 = 749,834.72 $1.47441.00 1.00$1.9663 x1m x Sell the euro forward for dollars Buy the pound forward. If you had bid-ask spreads, then you sell the at the bid and buy at the ask. Cross-Currency Hedge --------Friday------- Country/currencyin US$ per US$ Euro area euro1.4744 .6783 1-mos forward1.4747.6781 3-mos forward1.4744.6782 6-mos forward1.4726.6791 UK pound1.9717.5072 1-mos forward1.9700.5076 3-mos forward1.9663.5086 6-mos forward1.9593.5104 Suppose that you are a U.K.-based exporter who has sold 1,000,000 order to an Italian retailer. Payment due in 90 days. Hedge this into pounds. --------Friday------- Country/currencyin US$ per US$ Euro area euro1.4744 .6783 1-mos forward1.4747.6781 3-mos forward1.4744.6782 6-mos forward1.4726.6791 UK pound1.9717.5072 1-mos forward1.9700.5076 3-mos forward1.9663.5086 6-mos forward1.9593.5104 5-54 Currency Symbols In addition to the familiar currency symbols (e.g. , , , $) there are three-letter codes for all currencies. It is a long list, but selected codes include: CHFSwiss francs GBPBritish pound ZAR South African rand CAD Canadian dollar J PYJ apanese yen 5-55 SWAPS A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. Often on a recurring basise.g. every six months for five years. Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent. Swaps are covered fully in chapter 14. 5-56 Exchange Traded Currency Funds An ETF where each share represents 100 euros. Individual shares are denominated in the U.S. dollar and trade on the New York Stock Exchange. The price of one share at any point in time will reflect the spot dollar value of 100 euros plus accumulated interest minus expenses. Six additional currency trusts exist on the Australian dollar, British pound sterling, Canadian dollar, Mexican peso, Swedish krona, and the Swiss franc. Currency is now recognized as a distinct asset class, like stocks and bonds. Currency ETFs facilitate investing in these currencies. 5-57 Summary Spot rate quotations Direct and indirect quotes Bid and ask prices Cross Rates Triangular arbitrage Forward Rate Quotations Forward premium (discount) Forward points 5-58 End Chapter Five 5-60 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright 2009 by The McGraw-Hill Companies, Inc.All rights reserved. McGraw-Hill/Irwin Human Resources University Chapter IV:Futures and Options on Foreign Exchange Chapter Outline This chapter discusses exchange-traded currencyfutures contracts, options contracts, and options oncurrency futures. Futures Contracts: Preliminaries Currency Futures Markets Basic Currency Futures Relationships Eurodollar Interest Rate Futures Contracts Options Contracts: Preliminaries Currency Options Markets Currency Futures Options 7-1 Chapter Outline (continued) Basic Option Pricing Relationships at Expiry American Option Pricing Relationships European Option Pricing Relationships Binomial Option Pricing Model European Option Pricing Model Empirical Tests of Currency Option Models 7-2 Futures Contracts: Preliminaries A futures contract is like a forward contract: It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today. A futures contract is different from a forward contract: Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse. 7-3 Futures Contracts: Preliminaries Standardizing Features: Contract Size Delivery Month Daily resettlement Initial performance bond (about 2 percent of contract value, cash or T-bills held in a street name at your brokerage). 7-4 Daily Resettlement: An Example Consider a long position in the CME Euro/U.S. Dollar contract. It is written on 125,000 and quoted in $ per . The strike price is $1.30 the maturity is 3 months. At initiation of the contract, the long posts an initial performance bond of $6,500. The maintenance performance bond is $4,000. 7-6 Daily Resettlement: An Example Recall that an investor with a long position gains from increases in the price of the underlying asset. Our investor has agreed to BUY 125,000 at $1.30 per euro in three months time. With a forward contract, at the end of three months, if the euro was worth $1.24, he would lose $7,500 = ($1.24 $1.30) 125,000. If instead at maturity the euro was worth $1.35, the counterparty to his forward contract would pay him $6,250 = ($1.35 $1.30) 125,000. 7-7 Daily Resettlement: An Example With futures, we have daily resettlement of gains an losses rather than one big settlement at maturity. Every trading day: if the price goes down, the long pays the short if the price goes up, the short pays the long After the daily resettlement, each party has a new contract at the new price with one-day-shorter maturity. 7-8 Performance Bond Money Each days losses are subtracted from the investors account. Each days gains are added to the account. In this example, at initiation the long posts an initial performance bond of $6,500. The maintenance level is $4,000. If this investor loses more than $2,500 he has a decision to make: he can maintain his long position only by adding more fundsif he fails to do so, his position will be closed out with an offsetting short position. 7-9 Daily Resettlement: An Example Over the first 3 days, the euro strengthens then depreciates in dollar terms: $1,250 $1,250 $1.31 $1.30 $1.27$3,750 Gain/LossSettle = ($1.31 $1.30)125,000$7,750 $6,500 $2,750 Account Balance = $6,500 + $1,250 On third day suppose our investor keeps his long position open by posting an additional $3,750. + $3,750 = $6,5007-10 Daily Resettlement: An Example Over the next 2 days, the long keeps losing money and closes out his position at the end of day five. $1,250 $1,250 $1.31 $1.30 $1.27 $1.26 $1.24 $3,750 $1,250 $2,500 Gain/LossSettle $7,750 $6,500 $2,750 + $3,750 = $6,500$5,250 $2,750 Account Balance = $6,500 $1,250 7-11 Toting UpAt the end of his adventures, our investor has three ways of computing his gains and losses: Sum of daily gains and losses $7,500 = $1,250 $1,250 $3,750 $1,250 $2,500Contract size times the difference between initial contract price and last settlement price. $7,500 = ($1.24/ $1.30/) 125,000 Ending balance on account minus beginning balance on account, adjusted for deposits or withdrawals. $7,500 =$2,750 ($6,500 + $3,750) 7-12 Daily Resettlement: An Example Total loss = $7,500 $1,250 $1,250 $1.31 $1.30 $1.27 $1.26 $1.24 $3,750 $1,250 $2,500 Gain/LossSettle $7,750 $6,500 $2,750 + $3,750 $5,250 $2,750 Account Balance =$2,750 ($6,500 + $3,750) $$1.30$6,500 = ($1.24 $1.30) 125,000 7-13 Currency Futures Markets The Chicago Mercantile Exchange (CME) is by far the largest. Others include: The Philadelphia Board of Trade (PBOT) The MidAmerica Commodities Exchange The Tokyo International Financial Futures Exchange The London International Financial Futures Exchange 7-14 The Chicago Mercantile Exchange Expiry cycle: March, J une, September, December. Delivery date third Wednesday of delivery month. Last trading day is the second business day preceding the delivery day. CMEhours 7:20 a.m. to 2:00 p.m. CST. 7-15 CME After Hours Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST. The Singapore Exchange offers interchangeable contracts. There are other markets, but none are close to CME and SIMEX trading volume. 7-16 Reading Currency Futures Quotes OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)125,000; $ per 1.47481.48301.47001.4777.0029Mar172,396 1.47371.48181.46931.4763.0026J un2,266 Highest price that day Lowest price that day Closing price Daily Change Number of open contracts Expiry month Opening price 7-17 Basic Currency Futures Relationships Open Interest refers to the number of contracts outstanding for a particular delivery month. Open interest is a good proxy (alternative) for demand for a contract. Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding. 7-18 Reading Currency Futures Quotes Notice that open interest is greatest in the nearby contract, in this case March, 2008. In general, open interest typically decreases with term to maturity of most futures contracts. OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)125,000; $ per 1.47481.48301.47001.4777.0029Mar172,396 1.47371.48181.46931.4763.0026J un2,266 7-19 Basic Currency Futures Relationships The holder of a long position is committing himself to pay $1.4777 per euro for 125,000a $184,712.50 position. As there are 172,396 such contracts outstanding, this represents a notational principal of over $31.8 billion! OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)125,000; $ per 1.47481.48301.47001.4777.0029Mar172,396 1.47371.48181.46931.4763.0026J un2,266 7-20 Reading Currency Futures Quotes 1 + i 1 + i$ F($/) S($/) = Recall from chapter 6, our interest rate parity condition: OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)125,000; $ per 1.47481.48301.47001.4777.0029Mar172,396 1.47371.48181.46931.4763.0026J un2,266 7-21 Reading Currency Futures Quotes From March to J une 2008 we should expect lower interest rates in dollar denominated accounts: if we find a higher rate in a euro denominated account, we may have found an arbitrage. OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)125,000; $ per 1.47481.48301.47001.4777.0029Mar172,396 1.47371.48181.46931.4763.0026J un2,266 7-22 Eurodollar Interest RateFutures Contracts Widely used futures contract for hedging short-term U.S. dollar interest rate risk. The underlying asset is a hypothetical $1,000,000 90-day Eurodollar depositthe contract is cash settled. Traded on the CME and the Singapore International Monetary Exchange. The contract trades in the March, J une, September and December cycle. 7-23 Eurodollar Interest Rate Futures Contracts Many Banks and large corporations will use Eurodollar futures to hedge future interest rate exposure. Sellers hedge against the risk of rising interest rates, While buyers hedges against the risk of falling interest rates Other parties that use Eurodollar futures are speculators purely looking to make bets on future directional changes in interest rates Reading Eurodollar Futures Quotes

Eurodollar futures prices are stated as an index number of three-month LIBOR (London interbank offered rate) calculated as F =100 LIBOR. The closing price for the J une contract is 96.56 thus the implied yield is 3.44 percent =100 96.56 Since it is a 3-month contract one basis point corresponds to a $25 price change: .01 percent of $1 million represents $100 on an annual basis.OPENHIGHLOWSETTLECHG OPEN INTYLDCHG Eurodollar (CME)1,000,000; pts of 100% 96.5796.5896.5596.56-.013.44-J un1,398,959 7-25 Reading Eurodollar Futures Quotes EURODOLLAR (CME)$1 million; pts of 100%

Open High Low SettleChg Yield Settle Change Open Interest July 94.69 94.69 94.68 94.68 -.01 5.32 +.01 47,417

Eurodollar futures prices are stated as an index number of three-month LIBOR (London Inter-Bank Offer Rate) calculated as F =100 LIBOR. The closing price for the J uly contract is 94.68 thus the implied yield is 5.32 percent =100 94.68 The change was .01 percent of $1 million representing $100 on an annual basis. Since it is a 3-month contract one basis point corresponds to a $25 price change. =>% Change will be paid to the Seller of Eurodollar Options Contracts: Preliminaries An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today. Calls vs. Puts Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. Put options gives the holder the right, but not the obligation, to sell a given quantity of some asset at some time in the future, at prices agreed upon today. 7-28 Options Contracts: Preliminaries European vs. American options European options can only be exercised on the expiration date. American options can be exercised at any time up to and including the expiration date. Since this option to exercise early generally has value, American options are usually worth more than European options, other things equal. 7-29 Options Contracts: Preliminaries In-the-money The exercise price is less than the spot price of the underlying asset. At-the-money The exercise price is equal to the spot price of the underlying asset. Out-of-the-money The exercise price is more than the spot price of the underlying asset. 7-30 Options Contracts: Preliminaries Intrinsic Value The difference between the exercise price of the option and the spot price of the underlying asset. Speculative Value The difference between the option premium and the intrinsic value of the option. Option Premium = Intrinsic Value Speculative Value + 7-31 Currency Options Markets PHLX HKFE 20-hour trading day. OTC volume is much bigger than exchange volume. Trading is in six major currencies against the U.S. dollar. 7-32 PHLX Currency Option Specifications CurrencyContract Size Australian dollarAD10,000 British pound10,000 Canadian dollarCAD10,000 Euro10,000 J apanese yen1,000,000 Swiss francSF10,000 http://www.phlx.com/products/xdc_specs.htm7-33 Basic Option PricingRelationships at Expiry At expiry, an American call option is worth the same as a European option with the same characteristics. If the call is in-the-money, it is worth ST E. If the call is out-of-the-money, it is worthless. CaT = CeT = Max[ST - E, 0] 7-34 Basic Option PricingRelationships at Expiry At expiry, an American put option is worth the same as a European option with the same characteristics. If the put is in-the-money, it is worth E - ST. If the put is out-of-the-money, it is worthless. PaT = PeT = Max[E ST, 0] 7-35 Basic Option Profit Profiles E ST Profit loss c0 E +c0 Long 1 call If the call is in-the-money, it is worth ST E.If the call is out-of-the-money, it is worthless and the buyer of the call loses his entire investment of c0. In-the-moneyOut-of-the-money Owner of the call 7-36 Basic Option Profit Profiles E ST Profit loss c0 E +c0 short 1 call If the call is in-the-money, the writer loses ST E.If the call is out-of-the-money, the writer keeps the option premium. In-the-moneyOut-of-the-money Seller of the call 7-37 Basic Option Profit Profiles E ST Profit loss p0 E p0 long 1 put E p0 If the put is in-the-money, it is worth E ST. The maximum gain is E p0 If the put is out-of-the-money, it is worthless and the buyer of the put loses his entire investment of p0. Out-of-the-moneyIn-the-money Owner of the put 7-38 Basic Option Profit Profiles E ST Profit loss p0 E p0 short 1 put E + p0 If the put is in-the-money, it is worth E ST. The maximum loss is E+ p0 If the put is out-of-the-money, it is worthless and the seller of the put keeps the option premium of p0. Seller of the put 7-39 Example $1.50 ST Profit loss $0.25 $1.75 Long 1 call on 1 pound Consider a call option on 31,250. The option premium is $0.25 per The exercise price is $1.50 per . 7-40 Example $1.50 ST Profit loss $7,812.50 $1.75 Long 1 call on 31,250 Consider a call option on 31,250. The option premium is $0.25 per The exercise price is $1.50 per . 7-41 Example $1.50 ST Profit loss $42,187.50 $1.35Long 1 put on 31,250 Consider a put option on 31,250. The option premium is $0.15 per The exercise price is $1.50 per euro. What is the maximum gain on this put option? At what exchange rate do you break even? $4,687.50 $42,187.50 = 31,250($1.50 $0.15)/ $4,687.50 = 31,250($0.15)/ 7-42 American Option Pricing Relationships With an American option, you can do everything that you can do with a European option AND you can exercise prior to expirythis option to exercise early has value, thus: CaT > CeT = Max[ST - E, 0] PaT > PeT = Max[E - ST, 0] 7-43 Market Value, Time Value and Intrinsic Value for an American Call E ST Profit loss Long 1 call The red line shows the payoff at maturity, not profit, of a call option. Note that even an out-of-the-money option has valuetime value. Intrinsic value Time value In-the-moneyOut-of-the-money 7-44 European Option Pricing Relationships Consider two investments 1 Buy a European call option on the British pound futures contract. The cash flow today is Ce 2 Replicate the upside payoff of the call by1 Borrowing (lending) the present value of the dollar exercise price of the call in the U.S. at i$ E (1 +i$) The cash flow today is2 Lending the present value of ST at i ST (1 +i) The cash flow today is 7-45 European Option Pricing Relationships When the option is in-the-money both strategies have the same payoff. When the option is out-of-the-money it has a higher payoff than the borrowing and lending strategy.Thus: Ce > Max ST E(1 + i)(1 + i$) , 0 7-46 European Option Pricing Relationships Using a similar portfolio to replicate the upside potential of a put, we can show that: Pe > Max ST E(1 + i)(1 + i$) , 0 7-47 The Hedge Ratio This ratio gives the number of units of the underlying asset we should hold for each call option we sell in order to create a riskless hedge. The hedge ratio of a option is the ratio of change in the price of the option to the change in the price of the underlying asset: Sup = S0 . u; Sdown = S0 . d u= e.T ; d=1/u ; = 9.065% ; T=contract time/365 H = C C S1 S1 downup downup 7-48 Hedge Ratio This practice of the construction of a riskless hedge is called delta hedging. The delta of a call option is positive. The delta of a put option is negative. Deltas change through time. 7-49 Currency Futures Options Are an option on a currency futures contract. Exercise of a currency futures option results in a long futures position for the holder of a call or the writer of a put. Exercise of a currency futures option results in a short futures position for the seller of a call or the buyer of a put. If the futures position is not offset prior to its expiration, foreign currency will change hands. 7-50 Currency Futures Options Why a derivative on a derivative? Transactions costs and liquidity. For some assets, the futures contract can have lower transactions costs and greater liquidity than the underlying asset. Tax consequences matter as well, and for some users an option contract on a future is more tax efficient. The proof is in the fact that they exist. 7-51 For example a GBPUSD FX option might be specified by a contract giving the owner the right but not the obligation to sell 1,000,000 and buy $2,000,000 on December 31. In this case the pre-agreed exchange rate, or strike price, is 2.0000 USD per GBP (or 0.5000 GBP per USD) and the notional are 1,000,000 and $2,000,000. If the rate is lower than 2.0000 come December 31 (say at 1.9000), meaning that the dollar is stronger and the pound is weaker, then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 GBPUSD - 1.9000 GBPUSD)*1,000,000 GBP = 100,000 USD in the process. If they immediately exchange their profit into GBP this amounts to 100,000/1.9000 = 52,631.58 GBP. INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright 2009 by The McGraw-Hill Companies, Inc.All rights reserved. McGraw-Hill/Irwin Human Resources University Chapter V:Management of Transaction Exposure Chapter Outline This chapter discusses various methods available for the management of transaction exposure facing multinational firms. This chapter ties together chapters 5, 6, and 7. Forward Market Hedge Money Market Hedge Options Market Hedge Cross-Hedging Minor Currency Exposure Hedging Contingent Exposure Hedging Recurrent Exposure with Swap Contracts 8-1 2 Chapter Outline (continued) Hedging Through Invoice Currency Hedging via Lead and Lag Exposure Netting Should the Firm Hedge? What Risk Management Products do Firms Use? 8-2 Forward Market Hedge If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract. If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract. 8-3 Forward Market Hedge: an Example You are a U.S. importer of Italian shoes and have justorderednextyearsinventory.Paymentof100M is due in one year. Question:How can you fix the cash outflow in dollars? Answer: One way is to put yourself in a position that delivers 100M in one yeara long forward contract on the euro.8-4 5 Forward Market Hedge $1.50/ Value of 1 in $ in one year Suppose the forward exchange rate is $1.50/.If he does not hedge the 100m payable, in one year his gain (loss) on the unhedged position is shown in green.$0 $1.20/$1.80/ $30m $30m Unhedged payable The importer will be better off if the euro depreciates: he still buys 100m but at an exchange rate of only $1.20/ he saves $30 million relative to $1.50/ But he will be worse off if the pound appreciates. 8-5 6 Forward Market Hedge $1.50/ Value of 1 in $ in one year$1.80/ If he agrees to buy 100m in one year at $1.50/ his gain (loss) on the forward are shown in blue.$0 $30m $1.20/ $30m Long forward If you agree to buy 100 million at a price of $1.50 per pound, you will lose $30 million if the price of the euro falls to $1.20/. If you agree to buy 100 million at a price of $1.50/, you will make $30 million if the price of the euro reaches $1.80. 8-6 Forward Market Hedge $1.50/ Value of 1 in $ in one year$1.80/ The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position. $0 $30 m $1.20/ $30 m Long forward Unhedged payable Hedged payable 8-7 Futures Market Cross-Currency Hedge Your firm is a U.K.-based exporter of bicycles. You have sold 750,000 worth of bicycles to an Italian retailer. Payment (in euro) is due in six months. Your firm wants to hedge the receivable into pounds. Sizes of forward contracts are shown.Country U.S. $ equiv. Currency per U.S. $ Britain (62,500) $2.0000 0.5000 1 Month Forward $1.9900 0.5025 3 Months Forward $1.9800 0.5051 6 Months Forward $2.0000 0.5000 12 Months Forward $2.1000 0.4762 Euro (125,000) $1.4700 0.6803 1 Month Forward $1.4800 0.6757 3 Months Forward $1.4900 0.6711 6 Months Forward $1.5000 0.6667 12 Months Forward $1.5100 0.6623 8-8 Futures Market Cross-Currency Hedge: Step One You have to convert the 750,000 receivable first into dollars and then into pounds. If we sell the 750,000 receivable forward at the six-month forward rate of $1.50/ we can do this with a SHORT position in 6 six-month euro futures contracts. 6 contracts=750,000 125,000/contract 8-9 Futures Market Cross-Currency Hedge: Step Two Selling the 750,000 forward at the six-month forward rate of $1.50/ generates $1,125,000: 9 contracts=562,500 62,500/contract $1,125,000 = 750,000 1 $1.50 At the six-month forward exchange rate of$2/, $1,125,000 will buy 562,500. We can secure this trade with a LONG position in 9 six-month pound futures contracts: 8-10 Money Market Hedge This is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it. Buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable. 8-11 A Little More Sophisticated Hedging Strategies Activity to HedgeStrategy Payable in domestic currencyNothing, no FX risk. Payable in foreign currencyBorrow at the domestic interest rate i and convert the proceeds to foreign currency. Lend at the foreign interest rate i*. When payable comes due, sell foreign asset and make payable. Use domestic currency reserved for payable to pay off loan.Receivable in domestic currencyNo FX risk. Receivable in foreign currencyBorrow amount of receivable at the foreign interest rate i* and convert the proceeds to domestic currency. When receivable is paid, use foreign currency to pay off loan. Money Market Hedge A U.S.based importer of Italian bicycles In one year owes 100,000 to an Italian supplier. The spot exchange rate is $1.50 =1.00 The one-year interest rate in Italy is i =4% $1.50 1.00 Dollar cost today = $144,230.77 = 96,153.85 100,000 1.04 96,153.85 = Can hedge this payable by buying today and investing 96,153.85 at 4% in Italy for one year. At maturity, he will have 100,000 = 96,153.85 (1.04) 8-13 Money Market Hedge $148,557.69 = $144,230.77 (1.03) With this money market hedge, we have redenominated a one-year 100,000 payable into a $144,230.77 payable due today. If the U.S. interest rate is i$ =3% we could borrow the $144,230.77 today and owe in one year $148,557.69 = 100,000 (1+ i)T (1+ i$)T S($/) 8-14 Money Market Hedge: Step One Suppose you want to hedge a payable in the amount of y with a maturity of T: i. Borrow $x att =0 on a loan at a rate of i$ per year. $x = S($/) y (1+ i)T 0T $x$x(1 + i$)T Repay the loan in T years 8-15 Money Market Hedge: Step Two at the prevailing spot rate. y (1+ i)T ii. Exchange the borrowed $x for Invest at i for the maturity of the payable. y (1+ i)T At maturity, you will owe a $x(1 + i$)T.Your British investments will have grown to y. This amount will service your payable and you will have no exposure to the pound. 8-16 Money Market Hedge 1. Calculate the present value of y at i y (1+ i)T 2. Borrow the U.S. dollar value of receivable at the spot rate. $x = S($/) y (1+ i)T 3. Exchangefor y (1+ i)T 4. Investat i for T years. y (1+ i)T 5. At maturity your pound sterling investment pays your receivable.6. Repay your dollar-denominated loan with $x(1 + i$)T. 8-17 Money Market Cross-Currency Hedge Your firm is a U.K.-based importer of bicycles. You have bought 750,000 worth of bicycles from an Italian firm. Payment (in euro) is due in one year. Your firm wants to hedge the payable into pounds. Spot exchange rates are $2/ and $1.55/ The interest rates are 3% in , 6% in $ and 4% in , all quoted as an APR.What should you do to redenominate this 1-year-denominated payable into a -denominated payable with a 1-year maturity? 8-18 Money Market Cross-Currency Hedge Sell pounds for dollars at spot exchange rate, buy euro at spot exchange rate with the dollars, invest in the euro zone for one year at i =3%, all such that the future value of the investment equals 750,000.Using the numbers we have: Step 1: Borrow 564,320.39 at i =4%,Step 2: Sell pounds for dollars, receive $1,128,640.78Step 3: Buy euro with the dollars, receive 728,155.34 Step 4: Invest in the euro zone for 12 months at 3% APR (the future value of the investment equals 750,000.) Step 5: Repay your borrowing with 586,893.208-19 Money Market Cross-Currency Hedge Where do the numbers come from? 586,893.20 =564,320.39 (1.04)728,155.34 =750,000 (1.03) $1,128,640.77 =728,155.34 1 $1.55 564,320.39 =$1,128,640.77 $2 1 8-20 Options Market Hedge Options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable buy calls on the currency. If the currency appreciates, your call option lets you buy the currency at the exercise price of the call. To hedge a foreign currency receivable buy puts on the currency. If the currency depreciates, your put option lets you sell the currency for the exercise price. 8-21 Options Market Hedge $1.50/ Value of 1 in $ in one year Suppose the forward exchange rate is $1.50/.If an importer who owes 100m does not hedge the payable, in one year his gain (loss) on the unhedged position is shown in green.$0 $1.20/$1.80/ $30m $30m Unhedged payable The importer will be better off if the euro depreciates: he still buys 100m but at an exchange rate of only $1.20/ he saves $30 million relative to $1.50/ But he will be worse off if the euro appreciates. 8-22 Options Markets Hedge Profit loss $5m$1.55/ Long call on 100mSuppose our importer buys a call option on 100m with an exercise price of $1.50 per pound.He pays $.05 per euro for the call. $1.50/ Value of 1 in $ in one year 8-23 Value of 1 in $ in one year Options Markets Hedge Profit loss $5m$1.45 / Long call on 100mThe payoff of the portfolio of a call and a payable is shown in red. He can still profit from decreases in the exchange rate below $1.45/ but has a hedge against unfavorable increases in the exchange rate. $1.50/ Unhedged payable $1.20/ $25m 8-24 $30 m $1.80/ Value of 1 in $ in one year Options Markets Hedge Profit loss $5 m$1.45/ Long call on 100mIf the exchange rate increases to $1.80/ the importer makes $25 m on the call but loses $30 m on the payable for a maximum loss of $5 million. This can be thought of as an insurance premium. $1.50/ Unhedged payable $25 m 8-25 Options Markets Hedge IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS. If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports. If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price.EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS. If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports. If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.With an exercise price denominated in local currency 8-26 Hedging Exports with Put Options Show the portfolio payoff of an exporter who is owed 1 million in one year. The current one-year forward rate is 1 = $2. Instead of entering into a short forward contract, he buys a put option written on 1 million with a maturity of one year and a strike price of 1 = $2. The cost of this option is $0.05 per pound. 8-27 28 S($/)360 $2m $2 Long put $1,950,000 $50k Options Market Hedge: Exporter buys a put option to protect the dollar value of his receivable. $50k $2.05 8-28 29 S($/)360 $2 The exporter who buys a put option to protect the dollar value of his receivable $50k $2.05 has essentially purchased a call. 8-29 Hedging Imports with Call Options Show the portfolio payoff of an importer who owes 1 million in one year. The current one-year forward rate is 1 =$1.80; but instead of entering into a long forward contract, He buys a call option written on 1 million with an expiry of one year and a strike of 1 =$1.80 The cost of this option is $0.08 per pound.8-30 31 LOSS (TOTAL) GAIN (TOTAL) S($/)360 Long currency forward Accounts Payable =Short Currency position Forward Market Hedge: Importer buys 1m forward. This forward hedge fixes the dollar value of the payable at $1.80m. $1.80 8-31 32 $1.8mS($/)360 $1.80 Call$80k $1.88 $1,720,000 $1.72 Call option limits the potential cost of servicing the payable. Options Market Hedge: Importer buys call option on 1m. 8-32 33 S($/)360 $1.80 $1,720,000 $1.72 Our importer who buys a call to protect himself from increases in the value of the pound creates a synthetic put option on the pound.He makes money if the pound falls in value. $80k The cost of this insurance policy is $80,000 8-33 Taking it to the Next Level Suppose our importer can absorb small amounts of exchange rate risk, but his competitive position will suffer with big movements in the exchange rate. Large dollar depreciations increase the cost of his imports Large dollar appreciations increase the foreign currency cost of his competitors exports, costing him customersas his competitors renew their focus on the domestic market. 8-34 35 Our Importer Buys a Second Call Option S($/)360 $1.80 $1,720,000 $1.72 $80k This position is called a straddle $1.64$1.96 $1,640,000 $160k 2ndCall$1.88 Importers synthetic put 8-35 36 S($/)360 $1.80 $1,720,000 $1.72 Suppose instead that our importer is willing to risk large exchange rate changes but wants to profit from small changes in the exchange rate, he could lay on a butterfly spread. $80k A butterfly spread is analogous to an interest rate collar; indeed its sometimes called a zero-cost collar. Selling the 2 puts comes close to offsetting the cost of buying the other 2 puts. $2 buy a put $2 strike butterfly spread Sell 2 puts $1.90 strike. $1.90 Importers synthetic put 8-36 37 Options A motivated financial engineer can create almost any risk-return profile that a company might wish to consider. Straddles and butterfly spreads are quite common. Notice that the butterfly spread costs our importer quite a bit less than a nave strategy of buying call options. 8-37 Cross-HedgingMinor Currency Exposure The major currencies are the: U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and J apanese yen. Everything else is a minor currency, like the Thai bhat. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies. 8-38 Cross-HedgingMinor Currency Exposure Cross-Hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging depends upon how well the assets are correlated. An example would be a U.S. importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way. 8-39 Hedging Contingent Exposure If only certain contingencies give rise to exposure, then options can be effective insurance. For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options. 8-40 Hedging Recurrent Exposurewith Swaps Recall that swap contracts can be viewed as a portfolio of forward contracts. Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. It is also the case that swaps are available in longer-terms than futures and forwards. 8-41 Hedging throughInvoice Currency The firm can shift, share, or diversify: shift exchange rate risk by invoicing foreign sales in home currency share exchange rate risk by pro-rating the currency of the invoice between foreign and home currencies diversify exchange rate risk by using a market basket index 8-42 Hedging via Lead and Lag If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow. 8-43 Exposure Netting A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. As an example, consider a U.S.-based multinational with Korean won receivables and J apanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. Even if its not a perfect hedge, it may be too expensive or impractical to hedge each currency separately. 8-44 Exposure Netting Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging. In the following slides, a firm faces the following exchange rates: 1.00=$2.00 1.00=$1.50 SFr 1.00=$0.90 8-45 150 150 150 150 $150 $150 SFr150 SFr150 Exposure Netting 8-46 150 150 150 150 $150 $150 SFr150 SFr150 SFr150 SFr1 $0.90 = $135 $135 $135 150 1 $2.00 = $300 $300 $300 150 1 $1.50 = $225 $225 $225$225 $225 $300 $300 $150 $150 $135 $135 Exposure Netting 8-47 $225 $225 $300 $300 $150 $150 $135 $135 $15 $75 $75 $165 $75 $165 $75 $15 Exposure Netting 8-48 $75 $165 $75 $15$15 $180 = $165 + $15 $180 $180 Exposure Netting 8-49 50 Exposure Netting: an Example Consider a U.S. MNC with three subsidiaries and the following foreign exchange transactions: $10$35$40$30 $20 $25$60 $40 $10 $30 $20 $30 8-50 51 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $10$35$40$30 $20 $40 $30 $20 $30 $20 $30 $10 $40$30 $10 $30 $20 $60 $10$35$25 $60 $40 $20 $25$10 $25$10 $15$10 8-51 Multilateral Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $25$10 $20 $10 $10$10 $15$10 $10 $30 $15$10 $10 $40 $15 $15 $40 $40 $158-52 Should the Firm Hedge? Not everyone agrees that a firm should hedge: Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges. 8-53 Should the Firm Hedge? In the presence of market imperfections, the firm should hedge. Information Asymmetry The managers may have better information than the shareholders. Differential Transactions Costs The firm may be able to hedge at better prices than the shareholders. Default Costs Hedging may reduce the firms cost of capital if it reduces the probability of default. 8-54 Should the Firm Hedge? Taxes can be a large market imperfection. Corporations that face progressive tax rates may find that they pay less in taxes if they can manage earnings by hedging than if they have boom and bust cycles in their earnings stream. 8-55 What Risk Management Products do Firms Use? Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts. The greater the degree ofinternational involvement, the greater the firms use of foreign exchange risk management. 8-56 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright 2009 by The McGraw-Hill Companies, Inc.All rights reserved. McGraw-Hill/Irwin Human Resources University Chapter VI:Interest Rate and Currency Swaps 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? 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? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps

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