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CHAPTER 1:

FOREIGN EXCHANGE MARKET


1.1

Introduction

The world has become so small. Businessmen and individual can legitimately move from
one country to another. However with existence of comparative advantages and imperfect
market, investors, tourists and businessmen have induced trade internationally. The
foreign currencies are vital to enable those dealing internationally to execute their
international transactions. The foreign currency is made available through foreign
exchange market.

1.2

The FOREX Market Definition

The foreign exchange market is an international market in which national currencies are
traded.

It is not an organized market trading place in the same sense as stock or

commodity exchanges are. That is there is no single, physical site where buy and sell
orders are executed. Rather it consist an enormous, highly sophisticated, and efficient
global communication system in which most transactions are communicated verbally by
two parties and executed by telephone or telex. In summary we can say that, the FOREX
Market is an electronically linked network of participants that facilitates trade by trading
in foreign exchange.
The principle purpose of the FOREX market it to finance international trade and other
forms of international operations that regularly needs firms to MAKE and RECEIVE
payments in different foreign currencies. A Foreign currency refers to the currency of
other countries. For instance for Tanzanian living in the United Republic of Tanzania, a
foreign currency is any currency other than a Tanzanian shilling.
The FOREX market is a worldwide market and thus is extremely large. The London
FOREX market is the largest foreign exchange market followed by New York and then
Tokyo. Other important foreign exchange centres are Zurich and Frankfurt. 90% of
foreign currency deals are executed in US $; approximately 60% spot, 35% forward, 5%
futures and options

The FOREX market is highly competitive:

There are many buyers and sellers

The commodity is homogeneous

Via computer systems there is near perfect information on prices charged

Since the market is highly competitive, the prices of currencies are determined by supply
and demand forces. Virtually no differences exist between one FOREX market (e.g.
London) and another (e.g. Tokyo).
1.3

Functions of Foreign Exchange Market

1.3.1

Transfer of Purchasing Power

An international transaction involves parties from different countries with different


currencies. Each party would like to trade in its own currency. Foreign currency market
permit transfers of purchasing power denominated in one currency to another. For
instance, if a Japanese exporter invoices in Japanese yen for Suzuki Escudo exported to
Tanzanian Importer, then Tanzanian importer should buy Japanese yen with Tanzania
shilling or any other acceptable currency.
1.3.2

Facilitating International Trade and Investment

International trade and investment would not be possible without the ability to buy and
sell foreign currencies. Currencies must be bought and sold to enable those who need
certain currencies to get them.
1.3.3

Provision of Credit

The foreign exchange market provides a third source of credit. This is made through
specialized instruments such as bankers` acceptances and letters of credit. These
documents enable to finance international trade before delivery of goods.

1.3.4

Minimization of Foreign Exchange Risk

International dealings are subjected to foreign exchange risk. This risk is associated with
unexpected change that may have positive or negative impact on the international
transactions. A change in exchange rate is said to be positive if it leads to material gain
and it is said negative if it leads to material loss. Since it is difficult to predict the
direction of expected change in exchange rate, then traders are uncertain of their future
position. In this case they would like to reduce the uncertainty through hedging i.e. the
forex market provides such an opportunity.
1.4

Participants in the Foreign Exchange Market

Participants in foreign exchange market refer to the actors who make foreign exchange
market active. They buy and sell foreign currencies for different purposes. The following
are participants in the foreign exchange market:
1.4.1

Large Commercial Banks

They are considered as the dominant players (main dealers) in the market.

The

commercial banks hold inventories of FOREX which consist of deposit balances in


other bank (denominated in different currencies).

These deposits are used to meet

customer requests. The banks deal either directly with other banks or more usually
through foreign exchange brokers.
1.4.2

Individuals

Individuals and firms use foreign exchange market for various purposes. Some may use
foreign exchange market for international portfolio investment, some may use foreign
exchange for purpose of hedging foreign exchange risk, and others use foreign exchange
market to facilitate commercial transactions e.g. exportation, importation, tourism etc.

1.4.3

Speculators, Hedgers and Arbitrages

Speculators these are the persons attempting to profit by trading on expectations about
prices in the future. They speculate by taking an open (unhedged) position in a foreign
currency and then closing that position after the exchange rate has moved one step in the
expected direction.
Hedgers - a currency trader is hedging if he or she enters into a contract to protect
oneself from a downside loss. However by hedging the trader also forfeits the potential
for an upside gain. The hedging can be done by entering in a forward contract, where the
traders can fix the exchange rate to be used in the future when the transaction crystallizes.
Arbitragers - arbitrage, generally means buying a product when its price is low and then
reselling it after its price rises in order to make a riskless profit. Currency arbitrage means
buying a currency in one market (say New York) at a low price and reselling, moments
later, in another market at a higher price.
1.4.4

Central Banks and Treasuries

They use the market to acquire or spend their foreign exchange reserves so as to
influence the price at which their own currency is traded. Central bank can influence
prices by raising interest rate, thus leads the home currency to depreciate relative to
foreign currencies or it can decrease interest rate, hence strengthen the home currency
relative to foreign currencies.
For example the Bank of Tanzania (BOT) may intervene in the market either to stabilize
the volatility of exchange rate trends or to stop the depreciation of the TZS when it
believes the TZS moves too far from an economically realistic valuation.
1.4.5

Foreign Exchange Brokers

These are agents who facilitate trading between dealers without themselves becoming
principals in the transaction. Brokers are experts in matching demand and supplies of
foreign currencies among their clients. They possess a knowledge which enables them

to find at any time a dealer who wants to buy or sell any currency. For this service, they
charge small commission
1.4.6

International Investors

Most of the daily currencies transactions are made by investors. These investors, be they
investment companies, insurance companies, banks or others, are dealing with foreign
currency transactions. Many of these companies are charged to manage the savings of
others. Pension plans and mutual funds in some developed countries buy and sell billions
of dollars worth of assets daily. Banks, in the temporary possession of the deposits of
others do the same (this is also the case in Tanzania). Insurance companies manage large
portfolios which act as their capital to be used to pay off claims on accidents, casualties
and deaths. More and more of these companies look internationally to make the most of
their investments. Evidence indicates that much of the currency exchanges are done by
international investors rather than importers and exporters.
1.5

Exchange Rates

An exchange rate is the price of a currency expressed in terms of another currency.


The most heavily traded currency is the US dollar which is also known as the vehicle
currency i.e. a currency that is widely used to denominate international transactions.
Therefore normally all currencies are quoted against the US dollar.
For example, the value of the TZS is quoted as TZS 1,200/$, or one dollar can be
exchanged in the foreign exchange market for TZS 1,200. Evidently an exchange rate is
interpreted as the amount of a currency required to purchase one unit of the other
currency.
In the exchange rate quotation, the home currency is called underlying currency and the
foreign currency known as reference currency. That is, for the exchange rate TZS
1,200/$, TZS is the underlying currency and $ is the reference currency.

1.6

Quotations of Foreign Exchange Rates

There are two types of exchange rate quotations. These are direct quote and indirect
quote.
1.6.1

Direct Quotation

A direct quote expresses the number of units a home currency can buy one unit of foreign
currency. For instance, if the local currency is Tanzanian shilling and the foreign
currency is Norwegian Kroner (NOK). Then, the direct quote of Nok in Tanzania will be
TZS100/NOK.
Direct quotation can also be presented as:

TZS /NOK

100

TZS 100 =

1 NOK

NOK : TZS

100

Worldwide, quotations normally follow the direct quotation except the US and UK, that
follow indirect quotation style. So around the world:
Country (Currency)

Quotation

Brazil (Real)

Real 2.6640/$

Japan (Yen)

117.68/$

Singapore (S$)

S$173.40/$

Switzerland (Swiss Franc)

SF1.6158/$

1.6.2

Indirect Quotation

Indirect quote states the number of units a foreign currency can buy one unit of local
currency. Indirect quote of the currency can be obtained by taking the reciprocal of direct
quote and vice versa. Using the above example, the indirect quote of NOK in Tanzania is
NOK 0.01/TZS. That is the reciprocal of TZS100/NOK. Indirect quotation for the NOK
can also be presented as:

NOK/ TZS

0.01

NOK 0.01 =

TZS 1

TZS : NOK

0.01

1.7

Exchange Rate Systems/Regimes

The role played by national governments to a great extent defines the manner in which
exchange rates are determined. The following five exchange rate regimes are described
below:
1.7.1

Freely Fluctuating Exchange Rates

Under a pure freely fluctuating exchange regime currencies are allowed to float (i.e.
move upward or downward) freely with no government intervention in the market or
restrictions on who may change money.

The foreign exchange market would closely

approximate the economic model of pure competition. That is the price of any national
currency would be determined by the interaction between the supply and demand for that
currency.
1.7.2

Managed Floating Rate Regime

The exchange rates here are allowed to float in response to demand and supply forces, but
not as free and complete as it would be under a pure freely fluctuating rate regime. The
government (through central banks) may occasionally intervene (this constitutes the
managed feature of the regime) in the FOREX market in order to influence (smoothen
the fluctuations) the rates of exchange.

Since the actions of the government are

unpredictable, it follows that the managed floats (dirty-float) cause problems to exchange
forecasters.
1.7.3

Fixed Rate Systems

Government endeavour to maintain target exchange rate through the national monetary
authorities (i.e. central banks or treasury agencies) operations and economic policies.
Under a fixed exchange rate system the authorities are obliged to purchase their

currencies when there is excess supply and sell the currency when there is excess
demand, in order to prevent the exchange rate from rising or falling above or below the
fixed par value.
Again in case of persistent balance of payment deficit or surplus, relatively large
devaluations or re-evaluations would occur. Predicting when devaluation will occur will
cause problems for forecasters.
1.7.4

Controlled Rate Regime

In such a regime, national governments directly affect exchange rates by imposing and
enforcing legal controls on private dealings in FOREX. The national governments use
their sovereign power to control the overall demand for, and/or supply of FOREX. Some
forms in which governments may exercise their powers include:

Licensing requirement where residents have to apply to the exchange control


authorities for licenses to import goods and to acquire the exchange needed for those
goods;

Residents may be required to obtain FOREX only from specified sources that have
been designed to operate as part of the exchange control mechanism;

Similarly residents are required by law to sell all the FOREX to these official
agencies etc.

1.7.5

Pegged Currency

Currency linked to a major trading currency or a basket of currencies (currency blocs)


and keeps that relationship fixed. Many countries link the value of their currencies to the
US dollar.
1.8

The Bid and Offer Quotation

Quotations in the wholesale foreign exchange market are recorded indicating whether the
currency is for sale or purchase. So it is a two-way (pair wise) quotation.

1.8.1

A Bid

A bid is the dealers buying rate. Putting it more precisely, a bid is the price (exchange
rate) in one currency at which a dealer will buy another currency.
1.8.2

An Offer

An offer (Ask) is the dealers selling rate. That is the exchange rate at which the dealer
will sell the other currency. Usually dealers buy (bid) at a lower price and offer (sell) at a
slightly higher price. In the foreign exchange markets, quotations are typically shown
with five significant digits.
Look at the quotations below:
BID

OFFER

$1.0873/

$1.0879/

You can buy dollars


from a bank or broker
at this rate

You can sell dollars


to a bank or broker
at this rate

The above quotation implies that the bank is willing to purchase one euro for $1.0873
(and sell dollars) or to sell one euro for $1.0879 (and buy dollars). As you might have
noted these quotations are given by the bank or broker to you, a customer. In shorthand,
the bank normally quotes 873-879.
1.9

The Bid Ask Spread

The representation of the quotation shown above is called the bid-offer spread, where
the first rate refers to the bid or buy price for the specified currency and the second rate
refers to the sell or offer price for that same currency. Banks do not charge commission
in the wholesale foreign exchange market. But they profit from purchase and sale of
foreign currency through the bid-offer spread.

The transaction cost is measured by:


Spread =

(Offer price Bid price) x 100 = ( $1.0879/ $1.0873/ ) x 100 = 0.055%


Offer price

$1.0873 /

So, the % spread on the euro (the reference currency) quoted above equals 0.055%.
The width of the bid-offer spread reflects the breadth and depth of market trading as
well as the currency's underlying volatility. Currencies such as the US dollar, the euro,
and Japanese yen, which are traded globally in substantial volumes both in the spot and
forward markets, will tend to have comparatively narrower bid-offer spreads than less
well traded or more regional currencies. The underlying riskness of holding the currency
is also critical. Holders of a volatile currency have to be compensated for accepting the
risk of an asset whose value is potentially unpredictable and unstable. In general the bid
offer spread depends on:

The depth of trading and volume of trade

Riskness of holding the currency

Holding and administrative costs

1.10

Appreciation and Depreciation of a Currency

The values of currencies never become constant. Currencies tend to fluctuate in value.
That is a value of a currency may decrease or increase relative to the value of another
currency. The increase in value of a currency is called appreciation and the decrease in
value of a currency is called depreciation.

1.10.1 Currency Appreciation


A currency appreciates relative to another when its value rises in terms of the other. The
dollar appreciates with respect to the Tanzania shilling if the TZS/US$ exchange rate
rises.

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For instance, if in April, 2005 the value of a dollar against Tanzania shilling was
TZS1000/US$ and in May, 2005, the value of the same currency becomes Tsh1070/$.
Then it can be said the value of US$ has increased (appreciated) relative to TZS.

1.10.2 Currency Depreciation


A currency depreciates with respect to another when its value falls in terms of the other.
The dollar depreciates with respect to the Tanzania shilling if the TZS/US$ exchange rate
falls. Referring to the case above, the value of Tanzania shilling has depreciated in May.
This is because with one unit of US dollar you can get more of Tanzanian shillings
compared to the previous.
Generally it can be noted that when the TZS/US$ rate rises, then its reciprocal, the
US$/TZS rate falls. Since the US$/TZS rate represents the value of Tanzania shilling in
terms of dollars, this means that when the dollar appreciates with respect to the Tanzania
shilling, the Tanzania shilling must depreciate with respect to the dollar.

1.11

Currency Change

As seen above, the volatile behaviour of currency values lead to their appreciation and
depreciation against a target currency. The percentage change in the value of a currency
over some period of time is called the rate of change (i.e. appreciation or depreciation).

1.11.1 Periodic Rate of Change


The rate of Change which looks at how the currency has been changing over time is
called periodic rate of change and is determined by the following formula.
Rate of Change (%) =

Prevailing rate Previous rate


100
Pr evious rate

Illustration 1:
The price of $ at the beginning of May 1996 was (Yen) 105. At the end of April, 1998
the value of $ become 116. Determine the periodic rate of change and state of $
currency has appreciated or depreciated.

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Solution:
Using the above formula we have:
Rate of Change (%) =

Prevailing rate Previous rate


100
Pr evious rate

116 105
100 = 10.5%
105

The calculation above represents the rate of change of the $ in terms of Yen. Since the
percentage change is positive, it means that the dollar has appreciated by 10.5% relative
to the Yen during the past years.

Illustration 2:
At the beginning of Jan 1997 the value of $ was 0.59 and at the beginning of Jan 1996,
the value of $ was 0.65. Determine the rate of change of $ and state whether the $ has
appreciated or depreciated.

Solution:
Using our formula we have:
Rate of Change (%) =

Prevailing rate Previous rate


100
Pr evious rate

0.59 0.65
100 = 9.2%
0.65

We have calculated the change in the value of the $ in terms of the Pound, and since the
percentage change is negative; this means that the dollar has depreciated by 9.2% relative
to the pound during the past year.

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1.11.2 Annualised Rate of Change


When the length of the period varies, then for comparative purposes, a more robust
indicator is based on the annualised rate of change: this can also be obtained using the
following formula:

1
Pr evailing rate T
Annualised Rate of Change1 = Pr evious rate
-1
Where T measures the period in years

Illustration 3
At the beginning of January 2000, the price of the $ was 102.355; what was the rate of
change in the $ currency if at the beginning of August 2001, it was worth 124.755?

Solution
Rate of Change [$] =

124.755 - 102.355
= 21.88%
102.355

Using the same figures, on an annualised basis the rate of change will be:

124.755
Annualised Rate of Change [$] = 102.355

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20
- 1= 12.61%

The $ appreciated at an average annual rate of about 12.6% over the specified period. As
a measure of average change in the value of the $ over the specified period, the rate of
change provides no information on the variability around that rate or the variations of
that change. The exchange rate may fluctuate widely and occasionally show falls in its
value in spite of the overall upward trend. The figure below shows how currency change
conceals volatility.

30
Pr evailing rate No Days
1
Monthly rate of change = Pr evious rate
-1

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Figure 1: Currency Fluctuations

As it can be observed from the figure 1, the Yen/US$ exchange rate raised sharply
between December 1999 and March 2000, before it fell again sharply between March and
June, 2000. This variation between December, 1999 and June, 2000 can not precisely be
explained by the rate of change as calculated above. That is why we are saying the
exchange rate fluctuation has been concealed by the annual rate i.e. 12.6%.
It can also be observed that as a currency appreciates the reciprocal currency do
depreciate. The rates of appreciation and depreciation measured by their respective
formula are not equal in absolute terms, although the difference becomes less significant
as rates tend to zero.

1.11.3 Factors Influencing the Exchange Rates

The political stability of a country

Government Intervention in the form of exchange control, that is when the exchange
rates are not influenced by the forces of demand and supply, but the government fixes
it at a certain rate

1.12

Spot and Forward Quotations

Exchange rate falls into two categories, spot and forward exchange rates. The exchange
rate that prevails at the market on the date when the transaction takes place is called spot

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rate; and the exchange rate that is fixed to day but is used in future date i.e. 30, 60, 90 or
180 days to effect transaction is called forward exchange rate.
The exchange rate existing in the market in the future date is called future spot rate. This
rate can be the same as spot rate if there is no any factor that may influence the changes
in spot exchange rates. It should be noted that future spot rates and forward rates are not
the same. Forward rates are predetermined and fixed at the date of entering the contract
while future spot rates are the actual rates that exist in the market.

1.13

Determination of Premium and Discount Amount

The forward exchange rate may be quoted as an outright rate or as a premium or discount
of the equivalent spot rate. Commercial customers are usually quoted the outright rate
(a.k.a. the actual price). In the interbank market, dealers quote the forward rate only as a
premium on, or discount from the spot rate.
A foreign currency is at premium (more expensive) when the forward rate is above the
spot rate and a discount (less expensive) otherwise.
For instance, if the three-month forward exchange rate is Sk/ = 9.8385 and that spot rate
is Sk/ = 9.8340, the euro quotes with a premium of 0.0045 Swedish kroner per euro.
The three-month forward and the spot rates of the euro in terms of (against the) Swedish
kroner are /Sk = 0.101642 and 0.101688 respectively. The Swedish kroner, is at a
relative discount because the forward rate is less than the spot rate. This suggests that the
euro is strong relative to the Swedish kroner.
Knowing whether the forward rate is at premium or discount is easy. One can just
observe the movements of bid points and ask points or observe bid rate and ask rate. As
said previously, if ask in points is greater than bid in points, then the forward rate is at
premium and vice versa. However if outright ask rate is greater than outright bid rate,
then the forward rate is at premium. To know the actual amount or percentage of
premium the following formula is used.

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From the above example, one can obtain the forward rate by adding premiums to and
subtracting discounts from spot rates. However the forward discount or premium is
calculate as an annualized percentage.
The formula for determining the implied annualised premium / discount of the forward
contract for the reference currency is:

Forward rate Spot rate

12

The annualized premium/discount =


Spot rate

Maturity in Months
Or
Forward rate Spot rate

360

Spot rate

No of days in a Contract

Premium/Discount (annualized) =

If the result is positive, then the forward rate is at premium and if it is negative, then the
forward rate is at discount
9.8385 9.8340 12
The annualized premium/discount =
= 0.183%
9.8340

Illustration 4
The spot rate of U.S dollar in Tanzania is sold at Tshs 990/= and six month forward, one
U.S dollar in Tanzania is sold at Tshs 999/=. Determine if the U.S dollar is sold at
premium or discount. Show computations.

Solution:

Spot rate Forward rate


Forward premium/discount =
Forward rate

999 990
=
990

360

No. of days in a contract

360

= 1.82%
180

The U.S dollar is selling at premium of 1.82 percent.


The formula for determining the implied annualised premium / discount of the forward
contract for the underlying currency is:

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Spot rate Forward rate


The annualized premium/discount =
Forward rate

12

Maturity in Months

Or
Spot rate Forward rate
Forward rate

Premium/Discount (annualized) =

360

No. of days in a Contract

If the result is positive, then the forward rate is at premium and if it is negative, then the
forward rate is at discount.

1.14

Forward Differential

In the inter-bank foreign exchange market, traders quote the forward rate of the reference
currency as a differential from the respective spot rate. The foreign exchange quotes in
this wholesale market supply the forward differential as the bid-offer spread, from which
the forward outright rates can be calculated. This forward differential is also referred to
as the SWAP rate. There are two forms in which swap rates can be quoted.
These are:

Point form

Cent form

In calculating the forward outright rates, it is important to remember that the forward
spread is always greater than the spot spread because of the increased risk of having to
hold at some future date a specified amount of designated currency for the exchange.

1.15

Conversion of Swap Rates to Outright Rates: Point Form

A point is the last digit of a quotation to the right of the decimal point. In the financial
press the US dollar is usually quoted to four decimal points (others to two decimal points)
and therefore a point is equal to 1/10,000 or 0.0001. The points do not represent a
foreign exchange but rather the difference between the forward rate and the spot rate.
Note that the spot rate is never given on a point basis

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Illustration 5
River Side Motors is a very famous specialist in Garage services and Auto Spares. The
Managing Director imports genuine parts direct from Japan. His supplier has invoiced
him 100million Japanese yen for spare parts imported. He has been allowed to pay the
amount due over three instalments or pay the entire amount at once if he wishes. While
still scrutinizing on the payment plan of the amount due, he come across with the inter
bank market quotations.
Spot outright rate:

Tshs 300.00/yen- Tshs 400.00/yen

One month forward:

10- 20

Three months forward:

50- 80

Six month forward is

90- 100

The managing director of River Side Motors is not familiar with the terms used in the
inter bank market, he asks you to use such information and advise him on the exchange
rates that will exist in each of the three periods above.

Solution
By observing the forward quotation in point above, we can know that the forward rates
are at premium. This is because the forward offer rate in points are grater than forward
bid rate in points. To get outright rate the points should be added to the outright spot
rates.
One month
Spot outright rate
Add: Forward premiums
Forward rates

300.00- 400.00
00.10 - 00.20
300.10- 400.20

Three months
300.00- 400.00
00. 50 - 00.80
300.50-400.80

Six months
300.00- 400.00
00.90 - 01.00
300.90-401.00

Note. If the forward rates in points could be in discount, then we should have deducted
from outright spot rate to get outright forward rate

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Derivation of the outright forward rates requires applying either of the following rules:

IF

THEN

If the bid-offer spread on the forward is less than the

Subtract the forward bid-offer spread from the outright

bid-offer spread on the spot, then the underlying

spot rates to derive the outright forward rates.

currency is at a forward premium.


If the bid-offer spread on the forward is greater than

Add the forward bid-offer spread to the outright spot

the bid-offer spread on the spot, then the underlying

rates to derive the outright forward rates.

currency is at a forward discount.

Illustration 6
The trading screen presents the following rates:

Currency

Contract

Bid - Offer Rates

Spread

Sf/

Spot

1.4804 - 1.4814

10

3-month Forward

Sk/

54 -

50

3-month Forward

1.4750 - 1.4764

14

Spot

9.8325 - 9.8355

30

3-month Forward
3-month Forward

25 -

65

40

9.8350 - 9.8420

70

Falling points (when the bid in points is larger than the offer in points) in a swap
quotation indicate that the underlying currency (Sf) is trading at a forward premium
against the reference currency (). Falling Points Are Deducted From The Spot Rate

BID

ASK

Spot: Sf/

1.4804

1.4814

Less:

3-months forward

1.4750

54

50

1.4764

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Rising points (when the bid in points is smaller than the offer in points) in a swap
quotation indicate that the underlying currency (Sk) is trading at a forward discount
against the reference currency (). RISING POINTS ARE ADDED TO THE SPOT
RATE!!

BID

ASK

Spot: Sk/

9.8325

9.8355

Add:

3-months forward

9.8350

25

65

9.8420

Finally, notice that the sum of the spreads on the spot rates and the bid-offer forward
contract equals the spread on the forward outright rate.

1.16

Conversion of Swap Rates to Outright Rates: Cent Form

Illustration 7
Consider the following quote:
Spot rate US$/

1.4815 1.4965

1-month

0.39 0.37 cents premium

forward

The US$ in this case stands at a forward premium. In other words, the sterling is
weakening relative to the US$.

To determine the outright forward quote from the

premium quote, simply add on the discount or take off the premium from the spot rate.
In general, the rule is:

ADD a discount

DEDUCT a premium

BID

ASK

Spot US$/

1.4815

1.4965

DEDUCT

- 0.0039

- 0.0037

1.4776

1.4928

One month forward

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1.17

Cross Rates

In some cases both currencies related to the transactions are not quoted in either of the
currency. However, the currencies are quoted against a single reference currency, mainly
the US $. Where one currency appears in two rates there is a third implied exchange rate
called the cross exchange rate. To find the exchange rate between the currencies we
should work out through the relationship to the third currency in which each currency is
quoted.

Illustration 8
In Dar-Es-Salaam on February 26th 2004, the following rates are quoted:
British []

Tshs 2045/ and

US [$]

Tshs 1085/$

Calculate the implied rates for the two currencies in the two countries.
In UK the price of US dollar is:
Tshs 2045 /
Tshs 1085 / $ = $1.8848/

In New York the price of sterling pound is:


Tshs 1085/$
Tshs 2045 / = 0.5306/$
Note that the currency symbols are dimensionally conformal in the formulas. The Tshs
symbol, which appears in both the numerator and the denominator, is cancelled out. The
denominator currency symbol becomes the underlying currency unit, the currency used to
purchase one unit of the reference currency.
Alternatively, the common currency can be expressed as reference currency and other
currencies as underlying currencies, then workout for cross rates. Using the above
example then the cross rates will be as follows

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In UK, the price of US dollar is:


0.000488997555/Tshs
= $1.8848/
$0.0009216589862 / Tsh
In US the price of Sterling pound is:
$0.0009216589862/Tsh
= 0.5306/$
0.000488997555/Tsh

Illustration 9
Mathew is a senior lecturer in International Finance at Mzumbe University Tanzania. On
July 2002, he imported an International Finance Student Guide from France. He is
planning to buy French franc to settle the debt, but he is not certain how much Tanzania
shilling will be given to buy one unit of French Franc. This uncertainty is due to the fact
that, Tanzania shilling is not quoted against French franc. After long conversation with
Mfalisayo, an import merchant trader, they realized that Both currencies are quoted
against U.S. dollar. The buying rate for the French franc is $0.15 and the Tanzania
shilling is selling at $0.00125. What will be the exchange rate between Tanzania shilling
and French franc?

Solution:
Because both currencies are quoted against U.S. dollar, then to get the exchange rate
between Tanzania shilling and French franc we should find the cross rate i.e. use the
relationship of third currency.

How to determining cross rates:


First express the common currency as reference currency and other currencies as
underlying currencies. That is how much each currency will buy one unit of U.S dollar
for this case?
Then, the direct quote of $0.15 is FF6.6667/$, and direct quote of $0.00125 is Tsh800/$.

22

Therefore, the cross rate will be 800/6.6667, that is Tsh119.9994/FF or (6.6667/800) FF


0.0083/Tsh

Illustration 10
The Tanzanian importer needs Zambian kwancha to pay a Zambian exporter for the
goods purchased from him. The amount to be paid is kwancha, 1,000 mil. Tanzanian
shilling is not quoted against Zambian kwacha, but both currencies are quoted against
U.S dollar. The trader contracted for spot rate basis. At that time the quotes against dollar
were Tshs 900/U.S$, and the kwacha 100/US$.

Required:
(a) What will be the exchange rate between Tanzanian shilling and Zambian kwacha?
(b) How much Tanzania shillings should be given to get 1,000mil kwacha to effect
payment to Zambian exporter?

Solution:
(a) the exchange rate Tanzanian shilling and Zambian kwacha
Tsh900 / $
= Tshs9 / kwacha
Kwacha100 / $

or
Kwacha100 / $
= kwacha 0.111 / Tsh
Tshs900 / $

(b) Tanzanian shillings to be paid to Zambian exporter will 9000mil (9x1000).

1.18

Approach For Determining Cross Rates:

It is easy to get confused when making cross-rate computations. The following points
need to be noted:

All currencies should be quoted against the common currency. So a first thing to do,
is to make sure that you measure the cross-rate in the right direction by looking at the
symbols;

23

The second thing to do is make sure that you maximize the bid ask spread. To get
the bid cross-rate, which is the smaller rate, you put the smaller figure in the
numerator and the larger figure in the denominator.

1.18.1 The Tabular Approach


The main approach for determining cross rate is a tabular form. To be able to calculate
the cross rates it is important to ensure that the common currency has its prices given
directly in terms of both currencies, and then draw a cross against the exchange rates

Tshs/US$

BID

ASK

1000

1100

BID

ASK

100

110

Kshs/US$

Produce exchange rate pairs


[Tshs 1000/US$]BID
[Kshs 110/US $]ASK
[Tshs 1100/US$]ASK
[Kshs 100/US$]BID

Calculate the cross-rate such that the currency to be quoted directly forms the
denominator in the computation and identify the selling and buying rates

Illustration 11
Suppose that sterling is quoted at $1.7019-36, while the Deutch mark is quoted at
$0.6250-67. What is the direct quote for the pound in Frankfurt?

24

Solution
In this question the pound is not quoted against Deutch mark, but both currencies are
quoted against U.S dollar. In this case the cross rate should be found. However it should
be noted that the quotation given is for bid and offer. This is direct quote of pound in U.S
and direct quote of Deutch mark in U.S.
The direct quote of pound in Frankfurt can computed as follows:
Selling one currency means buying another currency. In this case, the relation between
selling price and buying price is considered. For direct quote, the rule is, sell high- buy
low.

Bid price =

Buying price of in U.S


Selling price of DM in U.S

This implies that the pound is sold for dollar and the dollar obtained is converted into
DM. this gives,

Offer price =

$1.7019/
= DM 2.7157 /
$0.6267/DM

Selling price of in U.S


Buying price of DM in U.S
$1.7036/
= DM 2.7258 /
$0.6267/DM

The direct quote of pound in Frankfurt is DM2.7157/- DM2.7258/

1.19

Forward Cross Rates

Forward cross rates are figured in much the same way as spot cross-rates. For instance,
suppose a customer wants to sell one-month forward lire (lit) against Dutch guider (Dfl)
delivery. The market rates (expressed in European terms of foreign currency units per
dollar) are
$: Lit spot

1,890.00- 1,892.00

One month forward

1,894.25-1,897.50

25

$:Dfl spot

3.582- 3.4600

One-month forward

3.4530- 3.4553

1.19.1 Computations of forward selling price of Lire against Guilders


Note that the $ is a common currency of Lire and Guilder.
Based on these rates, the forward cross rate for selling lire against guiders as follows:
Forward

BID

ASK

$: Lit

1,894.25

1,897.50

Forward

BID

ASK

$:Dfl

3.4530

3.4553

From the above presentation, the forward selling price for lire against guiders is lit
1,897.50/3.453 = lit 549.52 and the forward buying rate for lire against guiders is lit
1,894.25/3.4553 = Lit 548.22

1.19.2 Computation for spot selling and buying cross rate of Lire against Guilder
Based on these rates, the spot cross rate for selling lire against guiders as follows:
Spot

BID

ASK

$: Lit

1,890.00

1,892.00

Spot

BID

ASK

$:Dfl

3.582

3.4600

From the tabulation presentation, it can be seen that the spot selling rate is 1892/3.4582 =
547.11 and the spot buying rates Lit 1890.00/3.46

26

Therefore forward discount on selling Lire against Dfl delivery equals (F-S)/S which is
equal to

1.20

549.52 547.11
= 0.0044 or 0.0044x12 = 5.29% per annum
547.11

The Importance Of Cross-Exchange Rates

Used to determine the exchange rates between currencies;

Used to check if the opportunities for intermarket arbitrage exist.

1.21

Arbitrage in the Foreign Exchange Market

One of the most important implications deriving form the close communications of
buyers and sellers in the forex market is that there is almost instantaneous arbitrage
across currencies and financial centres (triangular arbitrage). This is possible only when
disequilibrium prevail in the forex markets
Arbitrage is the process of buying and selling equivalent or similar assets in order to
exploit price differentials for riskless guaranteed profits.

1.21.1 Cross-Currency Arbitrage


If the three linked rates do not match up then there are certain profit possibilities
(arbitrage). Suppose the rate in the market is 0.5000:1$ [i.e. $s cheaper than they
should be!], what would be the arbitrage strategy?
To check for opportunity of profit, the arbitrageur compares the cross-rates and the actual
market quotations. If the two differ, then opportunities for profits do exist simply by
selling the currencies. Triangular arbitrage involves the following steps:
(i)

Exchange the first currency (the Undervalued currency) for the common currency
in the spot market at the spot exchange rate.

(ii)

Convert the common currency into the second currency (the Overvalued
currency) in the spot at the spot exchange rate.

(iii)

Exchange the second currency for the first currency in the spot market at the spot
exchange rate

27

Figure 2: The Cross-Currency Arbitrage Process

COMMON
CURRENCY

STEP 2

STEP 1

1st currency
UNDERVALUED

2nd currency
OVERVALUED

STEP 3

The amount at the end will be bigger than that at the beginning. The profit will be the
difference of the 1st currency at the beginning and at the end of the process. This is a risk
free profit because the arbitrageur knows right from the beginning the amount of profit to
be realized at the end of the arbitrage process. In addition, no original borrowing is
required. The process will continue until the market equilibrium is re-established, when
the spot rate equals the cross-rate. The increased supply of dollars would quickly
depreciate its rate against the pound to 0.5306/$ level.

Illustration 12
Suppose that the pound sterling is bid at $0.6251 in Frankfurt. At the same time, London
banks are offering pounds sterling at DM3.1650.

Solution:
First find the reciprocal of DM3.1650 which is equal to 0.3160/DM

28

Cross rate will be =

0.6251
= $1.9784 /
0.31586

In this case the intermarket arbitrage will be as follows.

Sell dollar for Deutsche marks in Frankfurt

Use the Deutsche mark to acquire pounds sterling in London

Sell the pounds in York at the rate of $1.9784/

1.21.2 Financial Centre [Locational] Arbitrage


This type of arbitrage ensures that the exchange rate quoted in one countrys exchange
market will be the same as that quoted in other countrys financial centres. It eliminates
the possibilities of buying and selling currencies in the foreign exchange markets of two
or more countries so as to profit from price mismatches. This is because if the exchange
rate is $2/ in, say, New York but only $1.98/ in London, it would be profitable for
banks to buy pounds in London and simultaneously sell them in New York and make a
guaranteed profit of 2 cents per each pound bought and sold.

This will lead to

depreciation of the dollar in London and appreciation of the same in New York.
Ultimately the rates in the different countries will equalise, and therefore arbitrage
transaction will conclude as parity is restored. In the figure below the arbitrageur made
$2 due to price mismatch in London and New York stock exchanges.

29

Figure 3: The Locational Arbitrage Process


Locational Arbitrage

100

100

Spot rate
$1.98/

Spot rate
$2/

200
200

198

London

New York

Despite the above


benefits,profit
incidents
of spatial arbitrage are extremely rare since most
Arbitrage
= $200-$198=$2
currencies are quoted against a single reference currency, usually the US $, and traders
have employed automatic programmed arbitrage trading to exploit price differentials if
they ever appear.

1.22

Banks Dealing With Non- Bank Customers

In their dealing with non-bank customers, banks in most countries use a system of direct
quotation. A direct exchange rate quote gives the home currency price of a certain
quantity of the foreign currency quoted (usually 100 units, but only one unit in the case of
the U.S dollar or the pound sterling). For example, the price of foreign currency is
expressed in French francs (FF) in France and in Euro German. Thus, in France, the
Deutsche mark might be quoted at FF4 while, in German the franc would be quoted at

0.25.
1.23

Selling and Buying Currency with Banks

When currency is indirectly quoted, that is the local currency is expressed in terms of
number of units of foreign currency which can buy one unit of local currency, the higher

30

figure will be the buying rate for the bank and the lower figure will be the banks selling
figure. The rate at which customers sell is the rate at which banks buys and verse versa.
Suppose the following quotation is given;
Kshs 0.1/Tsh Kshs 0.08/tsh
Bank selling is Ksh0.1/Tsh and Bank buying price is Ksh 0.08/Tsh. That is to say the
bank will sell one Tshs for Kshs 0.1 and buy one Tshs for Kshs 0.08

Illustration 13
The following exchange rates are given.
US$

1.4620-1.4785

Canada$

2.0350-2.0560

Required:
(a) If a customer wanted to obtain Canadian $20,000 from his bank. How much the bank
would sell the currency?
(b) If a customer had Canadian $20,000 which he wanted to exchange for sterling. How
much the bank would sell the currency?

Solution:
The selling rate of bank will be Canadian $2.0350 and the buying rate will be
Canadian $ 2.0560
(a) The bank would sell the currency for, 20,000

= 9,828.01

2.0350
(b) The bank would buy the currency for, 20,000

= 9,727.63

2.0560

Note: the rule for banks selling and buying rates is that Sell low, buy high- bank
quotation rates

31

RFERENCE
Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.
Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Review Questions
1. Answer the following questions on the basis that the euro/US $ exchange rate is
1.1168 1.1173
(i)

What is the cost of buying 200,000?

(ii)

How much would it cost to purchase US$ 4m?

(iii)

How many dollars would be received from selling 800,000?

(iv)

How many euros would be received from selling US$ 240,000?

2.

Consider the tabulation below which comprises foreign exchange quotations given
by

a bank to a customer. The figures given are for the US Dollar and Deutsche

Marks Against sterling pounds and the word premium or discount implies that the
foreign

Currency quoted at the head of the column is at the premium or discount

respectively.
$

DM

1.6915-25

2.80-2.801\4

Premium

Premium

1 month forward

1-0.90cents

21\2-21\4pfennings

2 months forward

1.60-1.50cents

41\2-41\4pfennings

3 month forward

2.10-2.10-2.00cents

51\2-51\4pfennings

Spot

Required
(i)

At what rate will the bank buy spot dollars against sterling?

(ii)

At what rate will the customer sell dollars one month forward against sterling?
32

(iii)

At what rate will the customer buy Deutch Marks spot against sterling?

(iv)

At what rate will the customer buy dollars two months forward against sterling?

(v)

At what rate will the bank sell dollars two months forward against sterling?

(vi)

At what rate will bank buy Deutch Marks three months forward against sterling?

(vii)

At what rate will the bank buy dollars three months forward against sterling?

3. Describe the difference between the spot and forward currency markets.
4. Given below are spot and forward rates expressed in terms of US$ per unit of the DM
and .

Rate

DM

Spot

0.5393

1.6030

30 Days forward

0.5406

1.6006

60 Days forward

0.5425

1.6000

90 Days forward

0.5431

1.5945

180 Days forward

0.5478

1.5859

Required:
(i)

Is the 90 days forward DM at a discount or at a premium?

(ii)

Is the 90-day forward contract in pound trading at a discount or at a premium?

(iii)

Relative to the pound is the 180-day forward dollar quoted at a discount?

5. The following quotes are received for spot, one month, three month and six month
Swiss Francs (Sf) and pound sterling ().
Spot

One-month

Three-month

Six-month

: $ 2.0015 30

19 -17

26 22

42 35

Sf: $ 0.6963 68

46

9 14

25 -38

Required:
Convert the above swap rates in outright rates.
6. The US $ appreciated by 20% against the Thai baht the bath/$ prevailing rate is
30/$. By what percent did the baht depreciate against the dollar?

33

7. Determine the forward premium [discount] for the currency and maturity as specified
in each row of the following table of rates quoted as HuFI/$ [HuFI denotes Hungarian
Florint].
Currency

spot rate

forward rate

Maturity

247.785

267.25

12months

HuFI

247.785

252.805

3months

8. The euro is quoted as $/ = 1.1610 1.1615, and the Swiss franc is quoted Sf/$ =
1.4100 1.4120. What is the implicit Sf/ quotation?
9. The following exchange rates are available:
Dutch guilders (fl) per US dollar (US$) = 1.9025
Canadian dollar (C$) per US dollar (US$) = 1.2646
Dutch guilders (fl) per Canadian dollar (C$) = 1.5214
Are there any opportunities for market arbitrage? Show how Dutch investor with fl
1,000,000 can benefit from the possible arbitrage between the three markets.
10. Assuming no transaction costs, suppose: 1 = $2.4110 in New York; $ = FF 3.997 in
Paris, and FF1 = 0.1088 in London. How would you take profitable advantage of
these rates?
11. Here are some quotes of the Japanese Yen /US$ spot exchange rate given
simultaneously on the phone by three banks
Sokomoko

121.15 121.25

Nagayuki

121.30 121.35

Samakimoto

121.15 121.35

Are these quotes reasonable? Do you have an arbitrage opportunity?

34

PARITY RELATIONSHIP IN INTERNATIONAL FINANCE


2.1

Definition

Parity relationships in International finance are economic relationships which help to


explain the exchange rate movements. There are five Parity relationships in International
finance:

The first one explains the impact of change of inflation to the change in exchange
rates between the countries. This is known as Purchasing Power Parity (PPP).

The second parity relationship explains the impact of change in interest rates between
the countries to the change in exchange rates. This is called Interest rate parity (IRP).

The third parity relationship is called Fisher effect (FE). This parity links nominal
interest rates to a real interest rates and inflation

The fourth parity relationship is known as International Fisher Effect (IFE).


Essentially it links interest rates of different countries to exchange rate movements

The last one is known as Expectations Hypothesis (EH). Provides a linkage between
forward rates to expected spot rates.

2.2

Purchasing Power Parity (PPP)

Purchasing power parity (PPP) is a theory of exchange rate determination and a way to
compare the average costs of goods and services between countries. According to this
parity theory, the value of a currency in one country is determined by the amount of
goods and services that can be purchased with a unit of the currency. This is called the
purchasing power of the currency.
If there is more than one currency, the exchange rate between currencies must provide the
same purchasing power for each currency. In other words, a unit of home currency should
have the same purchasing power worldwide. Thats to say if Tanzania shilling buys one
bottle of coca cola in Tanzania; it should buy the same volume of coca cola in any other
country. This relationship is called purchasing power parity.
In view of the above arguments, it can observed that where there is a cross country price
differences, the importers and exporters will be motivated to take advantages of such
price differences. Thats, importer will like to buy in a country where the price is lower
35

and sale where the price is higher. Moreover, the exporter will generally sell in a country
where the price for his/her product is higher. Eventually, their actions will induce
changes in the spot exchange rate.
In the country where the price for the products is lower, the demand will be higher, this
will entails for high demand of foreign currency to pay for goods purchased from other
countries. The higher demand for foreign currency will eventually lead to rise of
exchange rate and hence higher price for the goods. Similarly, in the country where the
price for goods is higher, will attract more supply. The effect of which would lead to fall
in price of goods and hence decrease in exchange rates.

Purchasing power parity attempts to explain changes in exchange rates as the result of
changes in the rate of inflation in different countries. The theory states that the exchange
rate of a currency depends on the purchasing power of the currency in its own, as
compared with the purchasing power of another currency in its own country.
For example, if the rate of exchange between Tanzania shilling and Kenya shilling is
Tsh10/Ksh and inflation is running at 4%p.a in Tanzania and 6% in Kenya, the Tsh
would strengthen against Ksh by factor

(1 + 0.04) that is 0.98 per annum After one year


(1 + 0.06)

the exchange rate would be 0.98 x 10 = Tsh 9.8/Ksh

Generally, PPP theory is based on an extension and variation of the "law of one price" as
applied to the aggregate economy. To explain the theory it is best, first, to review the idea
behind the law of one price.

2.3

The Law of One Price (LOP)

At its simplest level, the law of one price states that, in the situation where identical
product or service are sold in two different markets and where there are not transportation
costs cost of moving the products or service to the required place or differential taxes or
subsidies, the price for the products or services would be the same. Even though the
markets are of different countries, the price for the commodity would be the same in all
countries provided that there are no transport costs and differential taxes. Using this law
of one price, it is possible to determine the exchange rates between the currencies.

36

If the prices of identical commodity in the two countries are known, then we can work
out for exchange rate by taking the price of commodity in one country divided by the
price of a commodity in another country. For instance, If the price of Coca Cola in
Tanzania is Tsh250 per bottle and the price of coca Cola in Kenya is Ksh 25 per bottle,
then the exchange rate between currencies will be. Tsh250/Ksh25 = tsh10/Ksh.

Illustration 1
Consider the following information about movie video tapes sold in the US and Mexican
markets.
Price of videos in US market (P$v)

$20

Price of videos in Mexican market (Ppv)

p150

Spot exchange rate (Ep/$)

10 p/$

According to the LOP, Exchange rate = Price of commodity in one country divide by
a price of a same commodity in anothter country
Therefore, the dollar price of videos sold in Mexico can be calculated by dividing the
video price in pesos by the spot exchange rate as shown,

The dollar price of video sold in mexco market = Price of video in peso 150
=
= $15 per video
Exchange rate between peso and dollar
10

To see why the peso price is divided by the exchange rate (rather than multiplied) notice
the conversion of units shown in the brackets. If the law of one price held, then the dollar
price in Mexico should match the price in the US. Since the dollar price of the video is
less than the dollar price in the US, the law of one price does not hold in this
circumstance.

2.4

What Would Happen If The Law Of One Price Does Not Hold?

The law of one price does not hold if there is different in prices on the same commodity
world wide. If this situation occurs, then there would be possibility for arbitration. Thats

37

traders would try to benefit from such price differences by buying from the country
where the price is lower and selling in the country where the price is higher. For
instance, as it can be seen above, while price of Video in US market is $20, the price in of
Video in Mexico market is $10. In this case there would be incentive to purchase the
Video from the country where its price is the lowest (That is from Mexico) and resell it in
the country where its price is the highest (In this case in US market).
An arbitrage opportunity arises whenever one can buy something at a low price in one
location and resell at a higher price and thus make a profit.

2.5

When Arbitrage Process Stops?

When the prices for the similar goods are the same in all the markets, then there would be
no incentive to buy from one market and resell in other market. The arbitration process
would stop when the prices for similar goods between the markets becomes equal. At a
long run this process of arbitrage will tend to produce the same price for the given
commodity in all countries by decreasing its price where the supply is high and increase
price where arbitragers purchase the commodity more. For example, using basic supply
and demand theory, the increase in demand for videos in Mexico would push the price of
videos up. The increase supply of videos on the US market would force the price down in
the US. In the end the price of videos in Mexico may rise to, say, 180 pesos while the
price of videos in the US may fall to $18. At these new prices the law of one price holds
since,

Where Ppv implies Price of videos in Mexican market and Ep/$ Spot exchange rate

2.6

Purchasing Power Parities and Exchange Rate Determination

The exchange rates in PPP can be determined in two alternatives. These alternatives are
commonly called as PPP versions. These are:

38

Absolute version of purchasing power parity.

Relative version of purchasing power parity.

2.6.1

Absolute Version Of Purchasing Power Parity

The purchasing power parity theory is really just the law of one price applied in the
aggregate, but, with a slight twist added. If it makes sense from the law of one price that
identical goods should sell for identical prices in different markets, then the law ought to
hold for all identical goods sold in both markets.
If this applies, then the cost of basket of goods let say in US would be CB$ and the cost of
basket of goods let say in Mexico would be CBp. whereby, CB$ represents the dollar
cost of purchasing all of the items in the market basket and CBp represents the Pesso cost
of purchasing all of the items in the market basket

Note here that, the basket is determined by surveying the quantity of different items
purchased by many different households and then determining on average how many
units of each item is purchased by the typical house hold. We can describe the market
basket easily as a collection or set of quantities let say Q1, Q2, Q3, ... Qn, where Q1 may be
quantity of coca cola, Q2 another items and so on. Each quantity has a price. Therefore
for the quantities survey may have a set of prices such as P1, P2, P3, .... Pn
Therefore, the cost of the market basket (CB), is found by summing the product of the
price and quantity for each item. That is, CB = P1Q1 + P2Q2 + P3Q3 + ... + PnQn or

This uses CB or CPI of different countries to determine the exchange rates. If the law of
one price holds for each individual item in the market basket, then it should hold for the
market baskets as well. This can be expressed quantitatively as,

39

Rewriting the right-hand side equation allows us to put the relationship in the form
commonly used to describe absolute purchasing power parity. Namely,

If this condition holds between two countries then we would say PPP is satisfied. The
condition says that the PPP exchange rate (pesos per dollars) will equal the ratio of the
costs of the two market baskets of goods denominated in local currency units. Note that
PPP
the reciprocal relationship E $/p
=

2.6.2

CB$
CB P

is also valid.

Relative Version of PPP

There is an alternative version of the PPP theory called the "relative PPP theory." This
uses the inflation rate to determine the exchange rates. Since absolute PPP suggests that
the exchange rate may respond to inflation, we can imagine that the exchange rate would
change in a systematic way given that a continual change in the price level (inflation) is
occurring. In other words, the exchange rate between the home currency and any foreign
currency will adjust to reflect changes in the price levels of the countries. However, Price
level changes with change in inflation.
If the price level between countries is to be the same, then the change in inflation
between countries should be the same as well other wise the values of the currencies will
be different.
NB. If inflation is higher, then the value of currency will fall relative to other countries.
To equalise the values of currencies, then the value of currency in highly inflated country
should rise to the tune of differences in inflation rate.

Illustration 3
If inflation is 5% in Tanzania and 1% in Kenya, then in order to equalise the price of
goods in two countries, then the TSH value of Ksh must rise by about 4%. This also

40

implies that, Ksh is stronger by 4% while TSH is weaker by (5%- 1%), 4%. To make all
currencies equal value, then TSH value should rise by 4%
According to the power parity, exchange rate over the period is determined by relative
change in prices between countries over period of time. Any change in the differential
rate of inflation between the countries will tend to influence the change in exchange rate
between the countries.

Example: If rh and rf are the periodic rate of inflation in the country of the
underlying currency and in the country of reference currency respectively and e0 is the
value of one currency relative to one unit of another currency at the beginning of the
period, and et is the spot exchange rate in period t, then according to the relative version
of PPP,
et/ e0

= (1 + rh)t/ (1 + rf )t

Where, rh inflation of underlying currency and rf inflation of reference currency.

if et is not known and e0 is known, then we can use the relation to get spot exchange
rate at period t (et)

therefore, et = (1 + rh)t x e0
(1 + rf )t

Illustration 4
If Tanzania and Kenya are running annual inflation of 5% and 3%, respectively, and the
initial exchange rate was Tsh10/Ksh. What would be the value of Kenya Shilling in three
years?

Solution:
The exchange rate at time t is given by
et = (1 + rh)t x e0
(1 + rf )t

41

Where, t = 3years; rh is inflation rate of underlying currency = 5%; rf is inflation


rate of reference currency =3%; e0 is spot exchange rate = Tsh 10/Ksh and

et is

exchange rate at time t


Therefore, et = ( 1+ 0.05)3 x 10
(1 + 0.03)3
=Tsh 10.6/Ksh
The implication of relative PPP is that if the Tanzanian inflation rate exceeds the Kenyan
inflation rate, then the Ksh will appreciate by that differential over the same period.
Thats the Ksh will appreciate by (5%-3%) 2%
In summary, an increase in Tanzanian prices relative to the change in Kenyan prices
(i.e., more rapid inflation in Tanzania than in the Kenya) will cause the Kenya shilling to
appreciate and the Tanzania Shilling to depreciate according to the purchasing power
parity theory.

Illustration 5
Suppose the current price level in U.S is at 112 while the German price level is at Euro
107, relative to base price level of 100. If the initial value of the Euro was $0.48, then
according to PPP to how extent the dollar value of the Euro should rise?

Solution:
112 x 0.48 = $0.5024
107
The dollar value of the Euro should have risen to approximately $0.5024

The main justification for purchasing power parity is that if a county experiences
inflation rate higher than those of its main trading partners, and its exchange rate does not
change, its exports of goods and services will become less competitive with comparable

42

products produced elsewhere. Imports from abroad will also become more prices
competitive with higher priced domestic products.

2.7

Is It True That The Law Of One Price Normally Holds?

Of course, for many reasons the law of one price does not hold even between markets
within a country. The price of beer, gasoline and stereos will likely be different in New
York City than in Los Angeles. The price of these items will also be different in other
countries when converted at current exchange rates. The simple reason for the
discrepancies is that though this law assumes that there would be no transport costs, this
is not true, how the goods can move from one location of market to another?, for this
reason we see that there are costs to transport goods between locations that may differ
from country to country and this may lead to price variations between the markets for the
similar goods.
Generally, it can be said that the law of one price will hold if the price of the goods after
adjusting for the all the costs including transportation costs taxes are the same; and also
when all factors that can lead to the change in the price are the same.

2.8

Problems with the PPP Theory

The main problem with the PPP theory is that the PPP condition is rarely satisfied within
a country. There are quite a few reasons that can explain this and so, given the logic of
the theory, which makes sense, economists have been reluctant to discard the theory on
the basis of lack of supporting evidence. Below we consider some of the reasons PPP
may not hold.

2.8.1

Transportation Costs And Trade Restrictions

Since the PPP theory is derived from the law of one price, the same assumptions are
needed for both theories. The law of one price assumed that there are no transportation
costs and no differential taxes applied between the two markets. These means that there
can be no tariffs on imports or other types of restrictions on trade. Since transport costs
and trade restrictions do exist in the real world this would tend to drive prices for similar
goods apart. Transport costs should make a good cheaper in the exporting market and

43

more expensive in the importing market. Similarly, an import tariff would drive a wedge
between the prices of an identical good in two trading countries' markets, raising it in the
import market relative to the export market price. Thus the greater are transportation
costs and trade restrictions between countries, the less likely for the costs of market
baskets to be equalized.

2.8.2

Costs of Non-Tradable Inputs

Many items that are homogeneous, nevertheless sell for different prices because they
require a non-tradable input in the production process. As an example consider why the
price of a McDonald's Big Mac hamburger sold in downtown New York city is higher
than the price of the same product in the New York city suburbs. Because the rent for
restaurant space is much higher in the city centre, the restaurant will pass along its higher
costs in the form of higher prices. Substitute products in the city centre (other fast food
restaurants) will face the same high rental costs and thus will charge higher prices as
well. Because it would be impractical (i.e., costly) to produce the burgers at a cheaper
suburban location and then transport them for sale in the city, competition would not
drive the prices together in the two locations.

2.8.3

Perfect Information

The law of one price assumes that individuals have good, even perfect, information
about the prices of goods in other markets. Only with this knowledge will profit-seekers
begin to export goods to the high price market and import goods from the low priced
market. Consider a case in which there is imperfect information. Perhaps some price
deviations are known to traders but other deviations are not known. Or maybe only a
small group of traders know about a price discrepancy and that group is unable to achieve
the scale of trade needed to equalize the prices for that product. (Perhaps they face capital
constraints and can't borrow enough money to finance the scale of trade needed to
equalize prices). In either case, traders without information about price differences will
not respond to the profit opportunities and thus prices will not be equalized. Thus, the law
of one price may not hold for some products which would imply that PPP would not hold
either.

44

2.8.4

Other Market Participants

Notice that in the PPP equilibrium stories, it is the behaviour of profit-seeking importers
and exporters that forces the exchange rate to adjust to the PPP level. These activities
would be recorded on the current account of a country's balance of payments. Thus, it is
reasonable to say that the PPP theory is based on current account transactions. This
contrasts with the interest rate parity theory in which the behaviour of investors seeking
the highest rates of return on investments motivates adjustments in the exchange rate.
Since investors are trading assets, these transactions would appear on a country's capital
account of its balance of payments. Thus, the interest rate parity theory is based on
capital account transactions.
It is estimated that there are approximately $1 trillion dollars worth of currency
exchanged every day on international Forex markets. That's one-eighth US GDP, which
is the value of production in the US in an entire year! Plus, the $1 trillion estimate is
made by counting only one side of each currency trade. Thus, that's an enormous amount
of trade. If one considers the total amount of world trade each year and then divide by
365, one can get the average amount of goods and services traded daily. This number is
less than $100 billion dollars. This means that the amount of daily currency transactions
is more than ten times the amount of daily trade. This fact would seem to suggest that the
primary effect on the daily exchange rate must be caused by the actions of investors
rather than importers and exporters. Thus, the participation of other traders in the foreign
exchange market, who are motivated by other concerns, may lead the exchange rate to a
value that is not consistent with PPP.

2.9

The Interest Rate Parity Condition

Interest rate parity relates the exchange rate to the interest rates. This theory also holds
when the rate of return in deposit in one country is equal to the rate of return in deposit in
another country. Therefore, if currencies involved let say are dollars and Dutch mark,

45

then the Interest rate parity (IRP) holds when the rate of return on dollar deposits is just
equal to the expected rate of return on German deposits, i.e.,

Quantitatively this can be expressed as follows:

Note that the currency of a country, where investment is done, thats a foreign countrys
currency should always expressed be as reference currency

This condition is often simplified by dropping for this case the final German interest term
and become

From that formula the theory of interest rate parity (IRP) states that the difference in the
national interest rates for securities of similar risk and maturity should be equal to, but
opposite in sign to, the forward rate discount or premium for the foreign currency, except
for transaction costs. Remember to get forward premium or discount, and then the right
hand side should be multiplied by 360/n days and 100
However, we need to be very carefully of this approximate version since would not give
an accurate representation of rates of return when interest rates in a country are high. The
most important thing is to use the first version other than approximate version.
In other words, it can be said that IRP holds when the deposit at home yield the same
return as depositing abroad. In this case the investor needs to invest abroad by converting
the home currency into foreign currency using spot rate and then deposit it. After earning
interest rate in foreign currency he will reconvert back the interest and principle amount
into home currency using forward rate or exchange rate existing at that date. If the result

46

is the same as the result of inverting at home then the IRP hold, but if not then IRP does
not hold. For this case he will invest where the return is higher. Quantitatively this can be
expressed in the following formula.
(1+ ih) = Spot rate (1+ if)

Forward rate
Where ih interest rate/investment rate at home and if in foreign country
In this case the currency of a country where investment is done,( a foreign countrys
currency should be expressed as underlying currency). Thats how much foreign currency
is equivalent to one unit of a home currency

Illustration 6
Consider the following data for interest rates and exchange rates in the US and Italy. Note
that Italian currency is in lira (L).
i$

5.45% per year

iL

10.31% per year

e$/L96

1573 L/$

e$/L97

1540 L/$

Again imagine that the decision is to be made in 1996, looking forward into 1997.
However, we calculate this in hindsight after we know what the 1997 exchange is. Thus,
we plug in the 97 rate for the expected exchange rate and use the 96 rate as the current
spot rate.
Before calculating the rate of return it is necessary to convert the exchange rate to the lira
equivalent rather than the dollar equivalent. Thus,

and
Now, the ex-post (i.e. after the fact) rate of return on Italian deposits is given by,

47

This simplifies to

In this case an investor would have made money (in dollar terms) by purchasing the
Italian asset.
Now since RoR$ = 5.45% < RoRL = 12.69% the investor seeking the highest rate of
return should have deposited their money in the Italian account. While investing in US
will give an investor a total of $1.054 per each dollar invested, the investment or deposit
in Italy will give him a total of $1.1269 0r $ 1.127 for each dollar invested.
The computation above could also be worked out in other way round as follows:

(1+ i$) = Spot rate (1+ iL)

Forward rate

(1+0.0545) = 1573(1+0.1031)
1540
= 1.126737857
$1.0545

= $1.127

Since investing abroad gives the higher return, then the investor will invest his dollar
amount in Italy.

Illustration 7
Consider the following data for interest rates and exchange rates in the US and Germany.
i$

5.45% per year

48

iDM

3.65% per year

e$/DM96

.6944 $/DM

e$/DM97

.6369 $/DM

We imagine that the decision is to be made in 1996, looking forward into 1997. However,
we calculate this in hindsight after we know what the 1997 exchange rate is. Thus, we
plug in the 97 rate for the expected exchange rate and use the 96 rate as the current spot
rate. Thus, the ex-post (i.e. after the fact) rate of return on German deposits is given by,

Which simplifies to

A negative rate of return means that the investor would have lost money (in dollar terms)
by purchasing the German asset.
Since RoR$ = 5.45% > RoRDM = - 4.93% the investor seeking the highest rate of return
should have deposited their money in the US account.

Or
We can express Dm as an underlying currency and compare the return that can be yielded
by each investment approach.
96
DM /e$

=1/.6944 = Dm 1.4401/$ and

DM/

e$97 =1/.6369 = Dm1.5701/$

Therefore,
(1+ 0.0545) = 1.4401 (1+0.0365)
1.5701
$1.0545

= $0.9507

49

In this case the investor will invest in US other than in Germany

Illustration 8
Consider the following data for interest rates and exchange rates in the US and Japan.
i$

5.45% per year

0.55% per year

e$/96

105 /$

e$/97

116 /$

Again imagine that the decision is to be made in 1996, looking forward into 1997.
However, we calculate this in hindsight after we know what the 1997 exchange is. Thus,
we plug in the 97 rate for the expected exchange rate and use the 96 rate as the current
spot rate.
Before calculating the rate of return it is necessary to convert the exchange rate to the yen
equivalent rather than the dollar equivalent. Thus,

and
Now, the ex-post (i.e. after the fact) rate of return on Japanese deposits is given by,

Which simplifies to

A negative rate of return means that the investor would have lost money (in dollar terms)
by purchasing the Japanese asset.
Now since RoR$ = 5.45% > RoR = -8.97% the investor seeking the highest rate of return
should have deposited their money in the US account.

50

Illustrations 9
Consider the following data for interest rates and exchange rates in the US and Italy. Note
that Italian currency is in lira (L).
i$

5.45% per year

iL

10.31% per year

e$/L96

1573 L/$

e$/L97

1540 L/$

Again imagine that the decision is to be made in 1996, looking forward into 1997.
However, we calculate this in hindsight after we know what the 1997 exchange is. Thus,
we plug in the 97 rate for the expected exchange rate and use the 96 rate as the current
spot rate.
Before calculating the rate of return it is necessary to convert the exchange rate to the lira
equivalent rather than the dollar equivalent. Thus,

and
Now, the ex-post (i.e. after the fact) rate of return on Italian deposits is given by,

Which simplifies to

In this case an investor would have made money (in dollar terms) by purchasing the
Italian asset.

2.10

The Effect of Changes in Interest Rates on the Spot Exchange Rate

51

Suppose that the foreign exchange is initially in equilibrium such that Ksh = Tsh at the
exchange rate e1Tsh/Ksh. any increase in interest rate let say in Kenya, will raises the rate of
return on Kenyan assets, RoRKsh, than a comparable asset of another country. The
consequence of this will be raise the demand for Kenya shilling as the foreign investors
will likely to buy Kenya shillings with their currencies to invest in Kenya for the seek of
getting higher average return on Kenyan assets. Moreover it will also lower the supply of
Kshs by Kenyan investors who decide to invest at home rather than abroad.
Because the interest rate changes forcing the demand for the currency to increase while
decreasing the supply, the price (exchange rates) will also raise against other currency.
Thats the currency will appreciate against other currency and hence reducing the demand
for such currency. If this is possible the currency becomes now expensive to buy.
In this case the forward rate, using IRP is given by:
Foward rate =

(1 + i of underlying currency) xspote rate . Where is are an interest rates of


(1 + i of reference currency )

underlying currency and reference currency .This formula applies for single period only.
For multi-period, the forward rate using IRP is given as follows:
Forward rate =

spot rate x (1+i of underlying currency)t


(1+i of reference currency)t

Illustration 11
Assume the spot rate between pound sterling and the U.S dollar is $ 1.40/ and that the
12 months risk free interest rate (e.g on the government stocks) are U.S 5% and UK 8%.

a) Using IRP theory, what will be the 12 month forward rate?

b) What will happen to the value of Pound sterling against dollar as the result of the
higher interest rate in UK?

c) What would happen if interest rate parity did not hold and therefore the forward rate
only moves to, $ 1.36?

52

d) Take an investor who borrows $ 2,000. Calculate the risk free profit that could be
made by carrying out covered interest arbitrage.

Solution:
(a)

The 12 month forward rate, as predicted by IRP will be.


Forward rate = spot rate x (1 + i$)/(1+iuk)

= 1.40 x 1.05/1.08
= $1.361/pound

(b)

The higher UK interest rate will cause the pound sterling to weaken against the $
on the forward market (put another way. The $ will stand at a forward premium
against the pound sterling). IRP suggest that any gain that can be achieved from
the higher interest rates in UK will be countered by corresponding depreciation in
the value of the pound sterling on the forward market.

(c)

If the interest rate parity did not hold and therefore the forward rate only moves
by $1.39/pound, the higher UK interest rates would make it possible to make a
profit by

Raising a loan in $ at the low interest rate

Selling the $ at the spot rate in order to buy Pound sterling

Placing the pound sterling on deposit to earn the high interest rate

Buy back the $ which will be needed in the 12 months in order to pay off the loan.
This can be done by using a forward contract which will fix the exchange rate for 13
months time thereby removing the exchange rate risk.

(d)

An investor.

Will raise loan $2,000

Sell the $ at the spot rate and receive 2000/1.40 = Pound 1429

Place the pound 1429 on deposit to accrue to pound 1429x1.08 = pound 1543

Buy back $ using a forward contract in order to pay off the loan. Obtain $2,145 (1543
x 1.39) for 1543. Amount of $ loan plus interest, 2,000 x1, 05 = $2100. Risk free
profit will be $ 45 ( thats $2145- $2100)

53

As a result of many people carrying out this transaction the $ will weaken on the spot
market (because of people selling $ and therefore increasing the supply of the $) and
strengthen on the forward market (because of people buying back $) causing the $ to
stand at a forward premium (over the spot rate) in terms of pound sterling, as predicted
by IRP.

2.11

Implied Forward Exchange rate using bid-ask spread

The interest rate parity relation only holds at a given point in time; one has to compare
interest rates and exchange rates quoted at the same point in time.

Illustration 12
Spot exchange rates are Tshs 2000.00/- 10
One-year interest rates:
Tanzania

14%-15%

UK

10%-12%

Determine the implied bid- ask forward exchange rates

Solution:
The bid forward exchange rates can be calculated as:

(1 + 0.14) x2000 = Tsh2035.7143 /


(1 + 0.12)
(1 + 0.15) x 2000 = Tsh2090.9091 /
Ask forward Tsh/ =
(1 + 0.10)
Bid forward Tsh/ =

Important tips to the students

If you look at the Tsh/ forward rate, the Tsh interest rate (underlying currency)
should be on a top, and the (reference currency) interest rate should be at the bottom
of the fraction

to obtain the bid forward exchange rates, take the combination of bid and ask quotes (
for spot rate and for interest rates) that lead to the smallest quote for the forward
exchange rate

To obtain the ask forward exchange rate, take the combination o bid and ask quote
(for the spot exchange rate and for the interest rates) that leads to the largest quotes
for the forward exchange rate

54

2.12

Covered Interest Arbitrage (CIA)

When the spot and forward exchange rates being in disequilibrium state, the investor will
take advantage of such disequilibrium by investing in whichever currency offers the
higher return on a covered basis. Since forward markets provide a way of eliminating
exchange rate uncertainty, arbitragers will arbitrage between various assets using forward
contracts to take care of the exchange risk. This kind of arbitrage called Covered Interest
Arbitrage (CIA). This is possible because when the market is not in equilibrium; arbitrage
profit (potential risk free) exists. In this situation, any arbitrager who happens to realise
will make use of this disequilibrium by investing in which ever currency offers the higher
return in covered basis.
Covered Interest arbitrage is the process of borrowing a currency where it is invested, and
selling this second currency forward against initial currency. Risk less profits are derived
from discrepancies between interest rate differentials and the percentage discount or
premium between the currencies involved in the forward transaction.

Illustration 13
For example, a crown is currency trading company. In 1999 it had $1,000,000 to invest i
alternative investment portfolio. The spot exchange rate between Dollar and yen is yen
106.00/$ for 1999 and six month. Six month forward rate in the same year was yen
103.50/$ and the interest rate in dollar market is 4% per annum. Show how CIA
transactions can be implemented.

Solution:
Opportunity for profitable covered Interest arbitrage will exist if IRP does not hold.
Thats if interest rate differential between countries is not equal to forward premium or
discount (but in opposite sign)

For IRP to hold, differential in interest rates between countries should be equal in amount
but in opposite direction for forward premium or discount. Thats IRP hold if,

55

F s i f ih
=
s
1 + ih
Where, F implies forward rate, S spot rate, if interest rate foreign and ih interest rate
home. If there are differences between differential in interest rates between countries and
forward premium or discount, then IRP does not hold and the opportunity for arbitration
exists.
103.50/$-106.00/$

Steps
1) The company can convert $1,000,000 at the spot rate of yen 106.00 to get yen
106,000,000
2) Invest the proceeds, yen 106,000,000, in a Euroyen account for six months, earning
4% interest per annum
3) Simultaneously sell the proceeds (yen 108,120,000) forward for dollar at the 180 day
forward rate of yen 103.50/$. This action locks in gross dollar revenues of $1,044,638
4) Calculate the cost (opportunity cost) of funds used at the Eurodollar rate of 8% per
annum 0r 4% for six months, with principal and interest, totalling $1,040,000 profit
on CIA at the end.

2.13

The Fisher Effect

Because virtually all financial contracts are states in nominal terms, the real interest rate
must be adjusted to reflect expected inflation.
The Fisher Effect states that the nominal interest rates in each country are equal to the
required real rate of return plus compensation for expected inflation. The Fisher effect
states also that the nominal interest rate r is made up of two components:

A real required rate of return

Inflation premium or expected amount of inflation

56

The interest rates that are quoted in the financial press are nominal rates. Thats they are
expected as the rate of exchange between current and future dollars. What matters is the
real interest rate, thats the rate after adjusting for inflation.
Because all financial contracts are stated in nominal terms, the real interest rate must be
adjusted to reflect expected inflation.
Formally, Fisher effect is,
1+Nominal rate = (1 + real rate)(1+Expected inflation rate)

Illustration 14
If the required real return is 3% and the expected inflation is 10%, then Fisher effect says
the nominal rate of return will be
1 + Nominal rate = (1+0.03)(1+0.1)
Nominal rate = 1.133-1 = 0.133 or 13.3%
The generalised version of the Fisher effect asserts that real return are equalised across
countries through arbitrage. Through arbitrage, if expected real returns were higher in one
currency than another, capital would flow from the second to the first currency. This
process of arbitrage would continue, in the absence of government intervention, until
expected real returns were equalised.
In equilibrium, then, with no government interference, it should follow that the nominal
interest rate differential will approximately equal the anticipated inflation rate
differential.

1 + rh 1 + ih
=
1 + rf 1 + i f
In effect, the generalized version of the Fisher effect says that currencies with high rates
of inflation should bear higher interest rates those currencies with lower rates of inflation

57

2.14

The International Fisher Effect

The relationship between the percentage change in the spot exchange rate over time and
the differential between comparable interest rates in different national capital markets is
known as the international Fisher effect. This can be expressed as

S 2 S1 i$ i
=
S1
1 + i
The international Fisher effect, tries to justify that investors must be rewarded or
penalised to offset the expected change in exchange rates
e\t = ( 1+ i of underlying currency )t x e0
( 1 + i of reference currency )t
Where e\t is the expected exchange rate in the period t
According to IFE, a rise in the inflation rate in one country relative to those of other
countries will be associated with.

a fall in the value of currency in that country

rise in interest rate relative to foreign interest rates

Why this situation?


This is because.

Higher inflation leads to too much money in the circulation

Too much money leads to high price for goods and also people will need much
money to buy one unit of good

Too much inflation lower the value of home currency, hence to get one unit of foreign
currency become expensive, the import will decline and export will increase because
it becomes cheap to buy our goods by foreigner and expensive to buy foreign goods

Too much home currency will be needed to convert to get foreign currency to pay for
import. In this case, the borrowings will increase, hence banks will rise the interest
rates

The increase in interest rates will lead to increase in value of home currency. This is
because, the high interest rate will borrowings expensive, hence borrowings will
decrease and money in the circulation will decrease, hence rise the value of money.

58

NB: In effect, the IFE says that currencies with lower interest rates are expected to
appreciate relative to currencies with high interest rates

Illustration 15
In July, the one year interest rate is 4% on Swiss francs and 13% on U.S dollar.
a) If the current exchange rate is SF 1= $ 0.63, what is the expected future exchange rate
in one year?
b) If a change in expectations regarding future U.S inflation causes the expected future
spot rate to rise to $0.70, what should happen to the U.S interest?

Solution:
a) According to the international Fisher effect, the Spot exchange rate expected in one
year will be equal to $ 0.6845, that is

(1.13x0.63)
(1.04)

if rus is the unknown U.S interest rate, and the Swiss Interest rate stayed at 4% ( because
there has been no change in expectations of Swiss inflation), then according to the
international Fisher effect,

2.15

(1 + rus )

(1 + 0.04)

0.7 0.7 x1.04


=
= 15.56%
0.63
0.63

Relationship Between Forward Rates and Future Spot Rate

Normally both spot and forward rates are influenced by future events and these rates tend
to move in tandem (together), with the link between them based on interest differentials.
New information, such as change in interest rate differential is reflected almost
immediately in both spot and forward rates. However, spot and forward rates are
influence by future events where there is no government intervention in the market
Pressure from the forward market is usually transmitted to the spot market and vice versa.
Equilibrium is achieved when the forward differential equals the expected change in
exchange rate. At this point there is no longer any incentive to buy or sell the currency
forward

59

A formal statement of unbiased nature of the forward rate (UFR) is that forward rate
should reflect the expected future spot rate on date of settlement of the forward contract
f1 = -e1
Where:
e1 implies the expected exchange rate at time 1 (units of home currency per unit of
foreign currency)
f1 means the forward rate for settlement at time 1
This relationship can be expressed as follows

f 1 e0 e1 e0
=
e0
e0
Where f1 forward rate, e1 expected exchange rate, e0 spot rate. It should however be noted
that the unbiased nature of the forward rates is an empirical, and not a theoretical issue

2.16

Forward Rate as an Unbiased Predictor of the Future Spot Rate

Some forecasters believe that for the major floating currencies, foreign exchange market
are efficient and forward exchange rates are unbiased predictor of future spot exchange
rates. When the forward rate is termed as unbiased predictor of the future spot rate, it
means the forward rate overestimates and underestimates the future spot rate with
relatively equal frequency and amount. The some of the errors equals to zero.
By being unbiased predictor does not mean the future spot rate will actually be equal to
what the forward rate predicts. The forward rate may in fact never actually equal the
future spot rate. The future spot rate may be greater or less than forward rate depending
with operating circumstances that may influence the change of exchange rates

2.17

Uncovered Interest Rate Parity (UIP)

The proceeds from foreign investment denominated in foreign currency are reconverted
into domestic currency at the spot exchange rate prevailing on the maturity date of the
investment rather than at the forward rate (pre- determined exchange rate).
As some times the prevailing exchange rate may be lower than spot rate, there is foreign
exchange risk that may lead to exchange rate loss to the firm

60

The Uncovered Interest parity equilibrium (UIP) can be explained in different conditional
relations as follows:

(1 + i ) = S (1 + i )
S

. This relation tells us that gross domestic return is equal to

expected (uncovered) gross foreign return. The gross return is measured in terms of
the initial amount invested and the interest earned from the investment

se
i = (1 + r ) 1 . In other words, net domestic return is equal to expected (uncovered)
s

net foreign return. Net return here is the yield or interest rate earned.

i i* = S e (1 + i*). In other words, it can be said that interest rate differential between

countries is equal to the expected percentage change in the exchange rate adjusted for
by the factor that is equal to one plus the foreign interest rate.

i i * = S e . This condition relation explain that the interest rate differential is equal to

the expected percentage change in the exchange rate

2.18

The Effect of Uncovered Arbitrage

2.18.1 Equilibrium (Arbitrage)


Under this situation, gross domestic return is equal to expected (uncovered) gross foreign
return. Thats (1 + i ) =

Se
1 + i * . In this question there would be not arbitration as the
S

investor may get the same return abroad as that can be obtained at home.

2.18.2 Outward Uncovered Arbitration


This is a situation that exists when gross domestic return is less gross expected foreign
return. Thats when (1 + i ) <

Se
1 + i * . In this case, investors would like to invest in the
S

foreign market

Outward Uncovered Arbitration work as follows

61

Arbitragers borrows at the domestic interest rate, i

They convert the borrowed funds at S, obtaining 1/S foreign currency units per unit of
the domestic currency. This amount is then invested at the foreign interest rate i*

The foreign currency value of the invested amount at the end of the investment period
is (1/S)1+i*)

This amount is reconverted into domestic currency at the spot exchange rate expected
to prevail on maturity, Se , to obtain Se/S(1+i*)

The value of the loan plus interest per unit of the domestic currency is (1+i)

Expected net profit per unit of the domestic currency borrowed (i.e. the expected
return on uncovered arbitrage) is the difference between the amounts expected to be
received at the end of the investment period and borrowed amount plus interest. This
equal to Se/S(1+i*)-(1+i). If Se/S(1+i*)-(1+i)>0, the investor expect to make profit
from that condition.

2.19

Inward Uncovered Arbitrage

This is the situation where the investor has to borrow foreign currency using foreign
interest rate and convert the amount borrowed into local currency and inverts at home
using local interest rate
This type of arbitrage work in the following way

Arbitrages borrow at foreign interest rate i*

Convert the borrowed funds at S, obtaining S domestic currency. Then this amount is
invested at the domestic interest rate, i

The domestic currency value of the invested amount at the end of the investment
period will be S (1+i)

The amount is reconverted into foreign currency at the expected spot rate to obtain
S/Se (1+i*)

The value of the loan plus interest rate per unit of the domestic currency is (i+i*)

The expected net profit per unit of the foreign currency borrowed (return on inward
uncovered arbitrage) is the difference between the amount obtained on transaction
including the initial amount and the total amount invested

62

RFERENCE
Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA
Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.
Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by
Palgrave MACMILLAN, UK
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Review Questions
1. Between 1999 and 2000, the rate of inflation in Tanzania was 6%, and the rate of
inflation in Kenya was 5%. In this connection the Kenya Shilling revalue from Tsh10
in 1999 to Tsh 12 in 2000.

Required
Determine the real exchange rate in 2000.
2. Now lets consider an investor with $1,000,000 to invest and has comparable Swiss
Franc (SF) monetary investments. The spot exchange rate between Dollar and Swiss
franc is SF1.4800/$ and three month forward rate is SF1.4655/$. The interest rate in
dollar market is 8% per annum, and in Swiss franc money market is 4% per annum.
The investor can make use of the money on the following alternatives.

Required:
(a)

Determine the rate of return in Swiss

(b)

Where should the investor invest the money?

(c)

What will be the total return if investment is done?

3. In February 2004 the US dollar - Mexican peso exchange rate was 11p/$. The price of
a hotel room in Mexico City was 1000 pesos. The price of a hotel room in New York
City was $200.

63

(a)

Calculate the price of the Mexican hotel room in US dollars

(b)

Calculate the price of the US hotel room in Mexican pesos.

(c)

Suppose the exchange rate rises to 12 pesos per $. What does the exchange rate
change indicate has happened to the value of the US dollar? ... to the value of the
Mexican peso?

(d)

Does the currency change benefit the US tourist travelling to Mexico City or the
Mexican tourist travelling to New York City? Explain why.

4. Consider the following data collected on February 9, 2004. The interest rate given is
for a one-year money market deposit. The spot exchange rate is the rate for February
9. The expected exchange rate is the one-year forward rate.

iC$

2.5%

E$/C$

.7541 $/C$

Ee$/C$

.7468 $/C$

(a) Use both RoR formulae to calculate the expected rate of return on the Canadian
money market deposit and show that both formulae generate the same answer.
(Express each answer as a percentage.)
(b) What part of the rate of return arises only due to the interest earned on the deposit?
(Express the answer as a percentage.)
(c) What part of the rate of return arises from the percentage change in the value of the
principal due to the change in the exchange rate? (Express the answer as a
percentage.)
(d) What component of the rate of return arises from the percentage change in the value
of the interest payments due to the change in the exchange rate? (Again, express the
answer as a percentage.)

64

5. Consider the following data collected on February 9, 2004. The interest rate given is
for a one-year money market deposit. The spot exchange rate is the rate for February
9. The expected exchange rate is the one-year forward rate.

(a)

4.5%

E$/

1.8574 $/

Ee$/

1.7956 $/

Use both RoR formulae to calculate the expected rate of return on the British
money market deposit and show that both formulae generate the same answer.
(Express each answer as a percentage.)

(b)

What part of the rate of return arises only due to the interest earned on the
deposit? (Express the answer as a percentage.)

What part of the rate of return arises from the percentage change in the value of
the principal due to the change in the exchange rate? (Express the answer as a
percentage.)

(d)

What component of the rate of return arises from the percentage change in the
value of the interest payments due to the change in the exchange rate? (Again,
express the answer as a percentage.)

6. Assume that an investor has 1000,000 sterling pounds to invest for a period of one
year. The exchange rate quotation for the US dollar is $1.610000 spot and $1.530949
for 13 months forward. Twelvemonths interest rates are 8 15/16 for Eurodollar
deposit and 14 9/16 for Euro sterling deposits.

Required
a) Show whether opportunity for profit covered interest arbitrage exist
b) State whether interest rate parity hold
c) Show how the investor can avoid foreign exchange risk

65

7.

The United State and German are running annual inflation rates of 5% and 3%
respectively. The initial exchange is DM 1 = $0.75. Calculate the value of the DM in
three years (Assume the PPP holds)

66

CHAPTER 3
EFFICIENCY MARKETS AND EXCHANGE RATE FORECASTING
3.1

Introduction

Foreign exchange market consists of various participants and cheaply available


information that can easier be accessed by each participant in the market. In this market,
new information are accessible by each participants and the activities involved in this
market cause prices to rapidly adjust to available information.
From the points of view of the above, Efficiency market can be defied as a market in
which information is widely and cheaply available to investors and that all relevant and
ascertainable information is already reflected in the prices. In this condition it is not
possible to make abnormal profit.
Additionally, Efficiency market can also be said to be the market in which prices reflect
all available information so that excess risk-adjusted are not possible. Thats to say a
market is efficient if transaction prices fully reflect in an unbiased way all relevant
information available to market participants at the time the transaction takes place.

3.2

Characteristics Of Efficient Market


Information is readily available and every participant can easier access to such
information

Information arrives in the market in a random manner in such a way that it is not
easier to predict the kind of information that will come

3.3

Implication of the efficient market definition

The implications of the market efficient definition are as follows:

It is not possible to predict price movements from available information because this
information is already reflected in prices.

Since the arrival of information is random and given that new information is reflected
in prices very quickly, the period-to-period changes in prices tend to be random

67

It is not possible to earn abnormal (higher) returns through active trading as compared
to what can be obtained from a passive buy and- hold strategy.

It is not possible to earn profit through speculation and arbitrage where the market is
efficient. This is because no one can charge different prices for different customers as
each participant is well informed of the prices in the market

3.4

Assumptions Underlying Efficiency Foreign Exchange Market

The efficiency foreign exchange market assumes that:

All relevant information is quickly reflected in both the spot and forward exchange
markets. This will enable the information to be available to a sufficient number of
investors

Transaction costs are low

No individual participant is of sufficient wealth that can in any sense dominate the
market.

Instruments denominated in different currencies are perfect substitutes for one


another.

3.5

Implications of the Efficient Markets Assumptions

a) Financial Management Functions


If the assumptions hold, then a companys true financial position will be reflected in its
prices. If a company markets good financial decision this will be reflected in an increase
in its prices

b) New Issue
Many firms issue shares when share prices are generally high, but if the market is
efficient, the new issue can be made regardless of the share price levels in the Market

Investment Analysis
For the efficient market assumption to hold, it is necessary to analyse and attempt to
interpret the information available, so as we can make viable decision about the

68

investments. The existence of an efficient market does not guarantee the viability of
various investments.

3.6

Levels Of Efficiency

The levels of efficiency of the market are defined with reference to the contents of the
underlying information set. In this context, there are three levels of market efficiency:

a) Weak Efficiency
In this level of market efficiency, current price reflects all the information contained in
the past behaviour of prices. This proves to be week efficient because it excludes the
effect of other relevant variables. As current prices already reflect all past price changes
and any other information, there can be no relationship between past changes and future
price changes. So if the foreign exchange market is weakly efficient, it means that past
market data cannot be of any use in predicting future prices behaviour.

b) Semi- Strong Efficiency


The set of past information prices behaviour and other all publicly available information
are reflected in the current prices. Here publicly available information refers to variables
that affect exchange rates, economic and otherwise. E.g economic news as released by
the authorities is publicly available since it is reported by a media as soon as it is
released. In most case, the information which is publicly available includes those relating
to inflation, unemployment, the balance of payment, the money supply, public debt etc.
The implication is that, any attempt to act on new information by investors once it is
publicly released, can not derive above-average profits because the price already reflects
the effects of the new public information

c) Strong Efficiency
It is said a market is strong efficiency if Prices reflect all available information including
private, public, insider information and otherwise. In side information can be obtained
from officials working in the reserve Banks by having talks privately with them. If the
foreign exchange market is strong efficient, then no group has a monopolistic access to

69

information and no group should be able to consistently earn above average profits. In
other words it can be said that no insider and private information can help to predict the
future behaviour of exchange rates or to make abnormal profits

3.7

Market Efficiency and Trading Rules

With Market efficiency there is no possibility for an active trading strategy to produce
superior profit than what can be obtained from a passive buy hold strategy. The reason is
no matter what, strategy can be made; will not influence the price to differ from the
prices charged by other participants for the similar security.
Market efficiency is governed by two basic types of rules. These are

Filter rules. A currency is bought when it appreciates by certain percent from its most
depression and sold when it depreciates by certain percent from its most recent peak.

Moving Average rules. It is the simple average of the daily values of the last of days.
A moving average rule depends on the behaviour of one or two moving averages in
relation to the actual exchange rate and to each other. Under moving average rules,
the most recent observed information is more relevant to the future behaviour than
that conveyed by old observation

3.8

Basic concepts of foreign exchange market efficiency

a) Spot Market Efficiency


This implies that spot exchange rates move in a random and unpredictable way, reflecting
the random arrival of new information. This means that one can not make profit by
speculating in the foreign exchange by buying and selling currencies actively

b) Forward Market Efficiency


Where spot and future information are embodied in the forward rate, the foreign
exchange market is said to be efficiency. The forward rate performs this function because
represents the collective knowledge of many well- informed profit- seeking traders and
also because it revises quickly as new information becomes available

70

c) Cross Sectional Efficiency


In this market two or variables that can influence the price behaviour in the market
operate. The market is said to be cross sectional efficiency if the variables congregate.
Two variables are said to congregate (work together) if they are linked by a long-run
relationship such that they cannot draft too far apart

3.9

Exchange Rate Forecasting

Forecasting is a formal process of generating expectations which used as an input in the


decision making process. Exchange rate forecasting is an important element in decisionmaking process of international business firms. This is attributed by the fact that the
quality of an MNCs corporate decisions depends on the accuracy of exchange rate
projection. Forecasting exchange rate is important because it has an influence on the
operations of an MNC. However, exchange rate forecasting is crucial because the future
or forward exchange ate is not certain.

3.10

Reasons for need of exchange rate forecasting

Among other reasons the following are some of reasons for forecasting needs of the
Multinational Firms

a) Hedging Decision
A firms hedge decision may be determined by its forecasts of foreign currency value.
Firms engage in many international transactions in which case their expected cash flows
are vulnerable to risks associated to exchange rate fluctuations. Firms need to protect
themselves against such risks. This can be done through hedging. However, this largely
depends on the expected exchange rates. For instance, the decision whether or not to
hedge a foreign exchange exposure resulting from payables or receivables depends on the
spot exchange rate expected to prevail when the payables and receivables are due

b) Short Term Financing Decision


The firms financing decision involves the choice of the currency to serve as the
denomination of a bond issue. The firms will borrow in a currency which exhibit a low

71

interest rate, and which weaken in value relative to home currency over the financing
period. This will enable the firm to pay back the loan with fewer home currencies when
convention is done. This financial decision will also be influenced by exchange rate
forecasts of any currencies available for financing.

c) Short- Term Investment Decision


The choice of the currency for short-term investment depends on the rate of return on
assets denominated and whether or not it is expected to appreciate over the investment
horizon. The multinational firms would invest their excess cash in currency which exhibit
a high interest rate and which strengthen in value over the home currency over the
investment period. This will enable more home currency be received at the end of the
period if foreign currency received is converted to home currency. To be able to
determine where the excess cash available is to be invested, exchange rate forecasts of
the currencies are necessary.

d) Capital Budgeting Decision


To decide on whether to invest or not, future cash flow for the inspired investment
should be determined. This future cash flow forecast would depend on future currency
value which is determined by forecasting exchange rates.

e) Pricing Decision
Exchange rate forecasting is important for international business firms selling their
products in foreign currencies. If a particular domestic currency price is chosen, for
example, to implement a market penetration objective, then exchange rate forecasting is
essential.

f) Strategic Planning
Exchange rate forecasting is also important for strategic planning, such as the choice of
the production location and the foreign market

g) Macroeconomic Condition
The forecasting process provides an extensive discussion of macroeconomic conditions in
each country.
72

h) Central Bank Intervention


Exchange rate forecasting is needed by central banks and economic decision- making
authorities. If central bank or if exchange rate exhibits that the currency will go in an
desired direction, the central will intervene the foreign exchange market rate converge on
the desired path

i) Options speculation
A long call or short put position will be taken if the underlying currency is expected to
appreciate, while a short call or long put position will be taken if the currency is expected
to depreciate. There is need therefore to forecast the level of underlying exchange rate.

j) Spot-Forward Speculation
If it is expected that the spot rate in future will be higher than the forward rate on the
maturity date, a speculator will buy forward and sell spot upon delivery. However, if the
forecasts reveal that the spot exchange rate will be lower than the forward rate, then the
speculator will sell forward and buy spot. The information about the exchange rates will
be obtained through forecasts and the foreign exchange forecasts is needed for that
purpose.

3.11

Exchange Rates Forecasting Models

To be able to forecast exchange rates, different forecasting techniques are critical


important. There are several forecasting techniques. However, three major techniques are
used. These are:

Econometric Forecasting Model

Time Series forecasting model

Technical Analysis and forecasting


3.11.1 Econometric Forecasting Model
This method is based on some economic theory and estimates. Econometric models are
classified into single equation model and multi-equation econometric modules. For a
single equation model, the exchange rate depends on one or more variables. One variable

73

being independent and others explanatory variables. For multi-equation econometric


modules exchange rate depend on more variable.

3.11.2 Time Series Forecasting Model


This model is based entirely on the past history of the exchange rate. The level of the
exchange rate is assumed to depend on its past levels e.g. which implies that there is no
underlying economic theory. The function relationship is normally specified in a linear
form, i.e. S t = f ( S t 1, S t 2 ...S t n )

3.11.3 Technical Analysis And Forecasting


This model focuses on past price and volume movements, ignoring economic and
political factors. Technical analysis utilises the exchange rates past history to forecast its
future level, but these models tend to be less formal and less rigorous (precise). It is a
market based technique. The rationales for technical analysis are:

Market value is determined by the interaction of supply and demand

Supply and demand are governed by numerous factors, both rational and irrational

Changes in trend are caused by shifts in supply and demand

History tends to repeat itself. Therefore past patterns of behaviour will recur in the
future and can thus be used for predictive purpose.

The main method of technical analysis is Chartism; this encompasses the use of bar
charts or trend analysis (various mathematic computations)
Under Chartism method, historical data are plotted on a chart. The technical analysis
relies on the study of historical data by plotting them on a chart. For this reason, this
method is also known as charting. This method uses three major types of charts. These
are:

Line charts- A plot against time, normally of daily closing exchange rates

Bar charts- it plots the high and low closing exchange rates for each day

74

Point and figures charts. These charts are used to highlight major market trends. They
do not show small exchange rate movements and they are not time-related to the
extent that initially they look very confusing

3.12 Exchange Rate Patterns


Exchange rate movements may reveal different patterns. The following are the patterns
which exchange rates can reveal:
Trend lines and Trading Ranges - A trend may be upward, downward or sideways.
Upward trend is a situation where the chart shows series of ascending bottom. Down
ward trend is a situation where a chart is characterized by a series of descending tops.
The market is said to be in a trading range when the market moves sideways thats when
the tops and bottoms are at the same level. The trend in this case will be recognised by
drawing trend lines connecting the tops and bottoms
Flags- These are continuation patterns. In this case the poles are the continuation of a
previous trend. A flag occurs when major trends are interrupted. When this takes place,
some market participants wait for the move to continue, while others get in hoping that
the trend will proceed. The increase in buying will increase pressure and consequently
upward trend will continue
Triangles- This can be ascending, or descending. An ascending triangle occurs when
buyers come into the market at progressively higher levels while sellers get out at the
same level. The buyers in this case will lead the exchange rate to rise as the pressure for
buying will increase. Consequently, will be a continuation of the trend.

3.13 Composite Forecasting


Composite forecasting is based on two or more forecasts that are derived independently.
The basis idea behind composite forecasting is that the forecasting accuracy can be
increased by pooling different forecasts and deriving some sort of an average. In this case
the simple average of two forecasts is taken. For instance, T is a forecast based on time
series and P is a forecast based on the PPP, therefore the composite forecast based on
simple average will be as follows:

75

S0 =

T +P
2

However, this formula can be modified by incorporating weighted average and hence
find econometric forecasting. For this case, if weighted average is given by W1 and W2
respectively, then the composite forecasting based on econometric forecasting will be
given by:
^

S = W1 S + W2 S
c

Reference
Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA
Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.
Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by
Palgrave MACMILLAN, UK
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003
Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

76

Review Questions
1. Discuss different models that can be used in exchange rate forecasting and state their
differences
2. Why Exchange rate forecasting important for the MNC and for other participant in
the Foreign exchange market?
3. Exchange rate movements may reveal different patterns identify and explain different
exchange rate patterns that can be demonstrated by exchange rate movements.
4. Discuss the differences between Outward and Inward covered arbitrage and state how
an investor can make use of each of the two to realise gain.
5. What it meant by market efficiency and Discuss different levels of market efficiency
6. Brother Nyundo has forecasted the following inflation rates in two different countries.
Zimbabwe 10% and Tanzania 5%. The prevailing exchange rate at the time of
forecast was Tsh50/Z$. Using the PPP forecast the exchange rate after one year that
will prevail after two years
7. Mr Seven is much specialised in exchange rate forecasting using inflation rates
between countries. He has been provided the following information by the United
Republic of Kenge. It has been revealed that the inflation rate in Zawe country will
ran to 5% in 2006 and 8% in Kowa Country. Additionally the information reveals that
in Zawe the inflation rate will be 10% in 2007 and 9% in Kowa. If the todays
exchange rate between the currencies of these two countries is K10/Z. Determine
exchange rate that will exist in 2007.

77

CHAPTER 4
FINANCIAL DERIVATIVES
4.1 Introduction
Business environment is changing quickly, resulting in more and more sophisticated
financing instruments being used to provide better return on invested capital. Moreover
as the results of globalization, businesses have become borderless in their operations. As
such the risks have increased. Significant amount of money is currently used by
organizations to buy and sell term contracts, and benefit from opportunities resulting
from exchange rates and interest rate variations between countries. In other words it can
be said that financial derivatives are important instruments for increasing shareholders
wealth. More importantly, financial derivatives are increasingly used as tools for hedging
risks of price fluctuations and managing rate of cost of capital.

4.2 Definition of Financial Derivatives


Financial derivatives are commonly known as financial instruments. Are contracts that
give rise to a financial asset of one entity and financial liability or equity instrument of
another entity.

Financial assets will or are likely to lead to a company receiving cash in the future

Financial liabilities will, or are likely to , lead to a company paying out cash in the
future

An equity instrument evidences a residual interest in the assets of the company after
deducting all its liabilities

Derivatives provide an opportunity for contracts to those who have specific expectations
about future currency movement. Derivatives are contracts which give the right, and
sometimes the obligation, to buy or sell a quantity of the underlying asset, or benefit in
another way from a rise or fall in the value of the underlying asset. These rights are assets
which have values and can be purchased or sold in the specific market.

4.3 Types of Financial Derivatives


There are many types of financial derivatives, however, this manuals covers only the
following derivatives:

78

Currency future contracts

Forward contracts

Options contacts

4.3.1

Currency Futures Contracts

The markets providing an opportunity for speculating on the future value of a foreign
currency is known as currency futures market. With currency future market, traders
hedge against price fluctuations of a currency.
The transactions in the currency future markets are known as currency future contracts.
These are contracts for the delivery of a specified quantity of currency at an agreed price
or exchange rate at a named future date. It involves purchase of currency to be delivered
at a specified future date at a price agreed at the moment.
Currency futures contracts act as a means of hedging or insuring against serious
fluctuations in price. Some times the speculator can purchase currency future contract in
order to benefit from currency future movement.
Futures are contracts specifying a standard volume of a particular currency to be
exchanged on a specific settlement future date or set the size of each contract, the units of
price quotation, minimum price fluctuations, the grade and the place for delivery.
The economic purpose of doing so is to enable trading firms to fix in advance exchange
rates or prices which will be used in future to effect the transaction. In other words,
Currency future allows one to lock in the price to be paid for a given currency at a future
date. For instance, for agricultural commodities, the type or grade is fixed in the future
contract (e.g wheat of a particular quality or variety). The futures exchange sets the
minimum contract size (e.g. Y bushels of wheat), delivery dates (e.g. March, may, June
for wheat)
For instance, if a speculator expects the NOK to appreciate in the future, he might
purchase a futures contract that will lock in the price at which they can buy NOK at a
specified settlement date. On the settlement date, they can purchase their pounds at the
rate specified by the future contract, and then sell these NOK at the spot rate. If the spot

79

rate has appreciated by this time in accordance with their expectations, they will profit
from this strategy
The speculator will speculate in the following ways.

If speculator expects a currency to depreciate relative to other currency, the


speculator will want to sell now the currency which is expected to depreciate in future
and buy it back after it has depreciated using strong currency enabling him to get
much of that currency again

If the expectation is for an appreciation, the speculator will want to buy the currency
now and sell it later when it is stronger relative to other currencies.

Illustration 1
A trader may contract to buy NOK 200,000 at future contract at rate of NOK10/. In this
case, the trader in a settlement date will pay 20,000 (that is NOK200,000/10) to obtain
NOK 200,000. If at settlement date, the spot rate is NOK 5/, thats the price existing in
the future date, then the trader will sell NOK at price of NOK 5/ and get 40,000 (that
is, 200,000/5).The profit to the trader will then be 20,000 (that is 40,000-20,000)

4.3.1.1 Gain in the future contracts


The gain or loss to the firm from the currency future contract is dependent of the price of
purchasing futures versus selling futures. If the selling future is greater than purchasing
future contract, then the firm will get profit. The price of a future contract changes over
time to reflect the markets anticipation of the future spot rate.
By holding futures contracts, the firm does not have to worry about the changing spot rate
of the currency over time because future contracts lock in the price to be paid for a given
currency at a future point in time.

4.3.1.2 Margins and Marking to Market


Futures are traded on a regulated exchange. In this market there is no direct transaction
between seller and buyer. The clearing house becomes a formal counterparty to every
transaction.

80

Since future contracts (unlike forward contracts) are traded on an exchange, there needs
to be some standardization of the contracts and price quotes. Also, to minimize default
risk, a clearing house and some collateral are required to compensate a trader if another
trader defaults (this is taken care of with the margin requirement). For this purpose
certain percentage of the total value of the contract is paid to provide financial protection
in case one of the counterparties to the futures contracts defaults. The amount paid is
called initial margins. It is collateral that must be posted to transact in a futures or
options contract, in order to ensure the clearing house against credit risk.
It is important to understand that the initial margin is not a payment for the future
contract. It is a good faith deposit to ensure that the terms of the future contract are
honoured.

4.3.1.3 Marking to market


To enable the clearing house to maintain the initial margin and protect it from falling
below the maintenance value, normally it operates a system of daily marking to the

market. This refers to the act of revaluing securities to current market values (and taking
account of accruals of interest on bonds).
Futures price fluctuate every day and even every instant. Therefore, all contract positions
are marked to market at the end of every day. if the price movements induce a gain on the
position, the customer immediately receives cash in the amount of gain. However, if there
is a loss, the customer must cover the loss. Normally as soon as a customers account
falls below the maintenance margin, the customer receives a margin call to reconstitute a
margin. If this is not done immediately, the broker will close the position on the market.
This will involve terminating the contract, which will amount the loss of the initial
margin by one of the party who defaults the contract.
Marking to the market work as:

Counterpartys profits or losses are established as a result of that days price change

81

The counterparty that makes a loss, his/her margin account is debited. This action will
require him to inject more cash, on the following day to cover the loss below the
threshold amount- called the maintenance margin

Failure to pay the daily loss causes a default and the contract is closed to protect the
clearing house from possibility of further losses

The profit that occur due to daily credits and debits to members account (marking-tomarket) are known as the variation margin

Illustration 2
Assume the initial margin is $2600 per contract and the maintenance margin is $1,600.
Assume that you buy one March contract on February 1999 at $0.7049/SF and you
deposit, in cash, an initial margin of $2,600. Listed below are the future quotations
(settlement price) observed on three successive days:
Feb. 19

0.7049

Feb .20

0.7009

Feb. 21

0.6949

Feb. 22

0.7089

Note the one contract is equivalent to SF125,000


Determine the cash flows associated with these price fluctuations

Solution
You bought a contract to sell SF. that means you will like to sell when SF appreciates so
as you get more $ for each SF sold.
On Feb. 20 you lose 0.0040 dollars per franc or $500 per contract (thats 0.7009-0.7049).
The loss is debited from your initial deposit. This makes your margin to fall to $2100
(thats 2600-500). But this is still above your maintenance margin of $1,600.
For that reason, you do not need to reconstitute the margin
On February 21, you lose 0.0060 dollar per franc, that is (0.6949-0.7049) or $750 per
contract. In this case, your margin is now $ 1350 thats (2100-750). Because $1350 is

82

below the maintenance margin, you will require to constitute the initial margin up to
2,600 by transferring $1250 to your margin account.
Feb. 22 you gain 0.0140 dollars per franc, or $1750 per contract. You can use the $1750
as you like since your initial margin is intact at $2,600

Note:
The result on Feb 22, is that you have net gain of $500, thats:
The Gain in Feb.22 per contract

$1750

Less:
Loss in Feb.19

$500

Loss in Fe. 20

$750

Net gain

(12500)
$500 per contract

Now let us say you decided in Feb. 22 to sell back the contract, your margin deposit of
$2,600 would be given back to you and also the gain of $500 will be users

Illustration 3
Suppose you purchase one US T-Bond futures contract at noon on day 1 when the current
future price Fo= $98 (per $100 nominal) and one contract is for $100,000 nominal. Let us
act as clearing house and define one tick as a change in F of 1 unit
The tick value of a change in F of 1 point is therefore (1/100x 100,000), which is equal to
$1000. The initial margin we take as $5000 and the maintenance margin is $4000. That is
when you purchase the contract at $98 you deposit your initial margin of $5000
Suppose that by the end of day 1 the futures prices falls dramatically, from Fo = $98 to
F1 = $94. The futures price at the close of day 2 falls to F2 = $93.50. On day 3, the
investor reverses his position and closes out at F3 = 98.50 (makes an increase of 5 points.

Solution:
In day one the investor has a loss of $4000 since at the end of day 1 she can now only
sell her futures contract for $94,000 (94 x1000) in stead for $98,000 (98 x 1000). Now

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the balance at the end of day 1 of $1000 is below the maintenance margin. Hence the next
morning, the investor must immediately pay a variation margin of $4000 (so that the
balance in the margin account at the beginning of day 2 is back to $5000)
In year two there is additional loss of $500, (thats 93.5-94,)x1000, which brings the
balance in the margin to $4500, (5000-500). Since the long has previously paid in
$5000+ $4000 then the net profit over three day 3 is $ 500, (98.5-98)x1000, which is
equal to the change in the future prices (F3-Fo) grossed up by the tick value.

4.3.1.4 The Basis


A futures price approaches the spot price at delivery. The difference between the two is
called the basis. The basis is often expressed as a percentage of the spot price.
Thefore, the basis is given by:
Future- Spot Price
Future

Table 1: Differences between Forward and Future Contracts


Forward Contracts

Future Contracts

Customized contracts in terms of size and Standardised contracts in terms of size


delivery

and delivery

Private contracts between two parties

Standardised contracts between customer


and clearing house

Impossible to reverse a contract

Contract may be freely traded in the


market

Profit or loss on a position is realized only All contracts are marked to market;
on the delivery date

profits

and

losses

are

realised

immediately.
Margins are set once, on the day of the Margins must be maintained to reflect
initial transaction

price movements

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4.3.1.5 Hedging with Futures


Hedging the risk of an individual asset is easy if futures contracts on that specific asset
exist. In some cases, future contracts do not exist in some assets. Here arises then a
question of which futures contracts should be used and in what amount? This being the
case, a hedging strategy needs to be designed.
Classification hedge contracts can generally be classified as a cash hedge or an
anticipatory hedge. A cash hedge is the hedging of an existing position in the spot (cash)
market. It involves selling future contracts to cover a cash position and also it is known as
short hedge. Anticipatory hedge involves buying future contract in anticipation of a cash
purchase. This is also known as long hedge because the investor is long in future
contract.

Illustration 4
One a Swiss portfolio Manager expects to receive $1million in his account in a week
from a client who purchased goods on credit from him. He plan that this cash flow will be
invested in short term Euro deposits. The current interest rate in Euro market is 10%, but
the manager worries that that rate will drop before he receives the money a invest.
Therefore, he decides to lock this interest rat by buying one Eurodollar future contract.
One week later, the three-month interest rate drops to 9% and the Eurodollar futures price
is 91. One week later, the manager receives the money as expected and invests. Show
how the manager realised profit from this transaction.

Solution:
Note first that, the future contract was bought at 90. this is because short term futures
contracts are quoted as 100-the annual interest rates (even for three months deposits)
This is a profit on future contract
Therefore, the profit per unit equals to the future price variation divided by four
(quarterly interest rate) times principal amount. That is

(91% 90% ) x$1000,000 = $2,500


4

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This is a profit on deposit (investment). The cash was deposited at 9%, this also gives a
return of $1000000 x 9% x 1/4 = $22,500.
Total profit will be 22,500+ 2,500= $25,000
If the investment was made before interest rate drops, that when it was 10% interest, then
the investor would have gained $25,000. Thats (10%x 1000,000)/4. But because he
invested at 9%, there is a loss of $2,500. Now since he purchased future contract, the
profit gained on future contract compensate the loss of $2500.

4.3.1.6 Cross Hedging


Unfortunately, futures contracts exist for only a few assets; the chance of matching a
future contract is very small. In this case a cross hedge has to be constructed in order to
hedge the volatility of a specific security in a portfolio.
A cross hedge means that the futures contract used is different from the initial asset to be
hedged. For example, a U.K gilt (long term government bond) contract can be used to
hedge a specific British Corporate bond. Clearly, the price of the selected futures contract
will be closely related with the price of the initial asset

4.3.1.7 Hedging Ratio


The success of hedging strategy depends on the proper hedging ration, because price
movements of the asset and of the futures often differ in magnitude (see an example of
how portfolio manager succeeded to hedge the drop of 10% interest rate).
The hedge ratio here is defined as the ratio of the principal (face value) of the futures
contracts used to hedge relative to the principal (face value) of the cash asset position.
The hedge ratio if given by:
Hedger ratio = Number of contracts x Size of Contract x spot price/Market value of asset
position
=

N x Size
V

x S

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Where;

N is the number of future contracts used to hedge

Size is the quantity of assets (e.g 125,000 Euros) or the face value of securities (e.g,
$1000,000 worth of Treasury bonds or $1000,000 worth of Eurodollars)

S is the spot price of the asset

V is the market value of the cash asset position

Illustration 5
If an investor holds 1,000 ounces of gold (spot price $400 per once) and decides to short
ten contracts of 100 ounce (futures price $413 per ounce0, the hedge ratio is equal to:

N x Size
h=
V

x S

10 x 100 x 400
=1
400000
=

Illustration 6
An investor would sell $400,000 worth of gold futures or approximately 9.69 contracts.
The price of the ounce is $400. The contract size is 100

Required
Determine the hedge ratio.

Solution:

9 . 69 x 100 x 400
400000
The hedge ratio =

= 0 . 969

4.3.1.8 Minimum Variance Approach


Because of cross-hedge and basis risks, it is usually impossible to build a perfect hedge.
Therefore, a minimum variability in the value of hedged portfolio is determined.
Investors would like to minimise the variance of the return on the hedged portfolio.
The optimal hedge ratio is equal to the covariance of the asset, or portfolio, return to be
hedged with the return on the futures divided by the variance of the futures:
h= PF/ 2F

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This optimal hedge ration can also be estimated as the slope coefficient of the regression
of the asset, or portfolio, return on the future return
Rp = hRF
where,
Rp is the return on the asset or portfolio, RF is the return on the futures, and a is constant
term.

Hedge efficiency =

Profit/ loss on future contract


profit / loss on spaot market

4.3.1.9 Pricing Foreign Currency Futures


Foreign currency futures contracts can be valued using two equivalent instruments. These
are risk less domestic debt and risk less foreign debt
If an investor has an amount in dollars he converts these dollars into pounds and invests
in risk less debt e.g treasury bills. The investor will convert back the earnings plus
principal amount into dollar. To guarantees the exchange rate he will do so with a future
contract
Future sterling rate =

[(1 + R($) )] xSpot rate


[1 + R()]

Illustration 7
Assume Euro sterling interest rate R()= 11%; Eurodollar interest rate R($)

= 6%;

30-day Euro sterling interest rate = 0.11x30/365; 30-day Eurodollar interest rate =
0.06x30/365; Sterling spot rate $1.50%. What is the 30-days sterling future rate?

Solution
So the 30-day sterling futures rate is

[(1 + (0.06 x30 / 365))] x1.50 = $1.494


[1 + (0.11x30365)]
4.3.1.10

Closing Out A Futures Position

In practice most traders close out their position before the expiration of the future
contract. They therefore make a gain or loss depending on the difference between the
initial future price and the futures price at which they close the contract. In other words it

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can be said the gain or loss to the firm from its previous futures position depends on the
purchasing futures versus selling futures. A currency futures contract decided before
settlement date can be closed out if the firms no longer want to hold such position. That is
closing out position involves shorting the contract before maturity date. This can be done
by selling out the contact at the price existing at that particular date.

Illustration 8
A British trader has imported goods valued $4,000,000 from one of the famous exporting
Company in USA. The transaction took place on April 1, 2001, and it was agreed to
effect the payment on 10th May 2001. The company wishes to protect itself from adverse
movements in the spot rate that might occur before the payment is due. Assume that the
standardized size of a dollar/sterling future contract is 25,000
The following information also pertains to the transaction.
Spot rate

$1.6149\

June futures

$1.6000\

Required
Show how the company can protect itself against exchange rate risk using future
contracts.

Solution:
The hedging future contracts will be as follows.
On I April the company should sell 100 June sterling futures contracts at a price of
$1.600/ ( 25,000x 1.600x No of contract = $4000,000). The contracts are sold because
sterling needs to be sold in order to acquire dollars. The importer would need
(4,000,000\1.600) which is equivalent to 2,500,000 to buy $ 4,000,000.
If on 10th May the spot rate is $1.5850\ and the June futures is $1.5720\, therefore,
The actual payment for goods on May 10th will be made by exchanging sterling pounds
into dollar on the spot market.
The company will close out the futures contracts at the market price prevailing at that
time. Therefore to get $4,000,000 at May spot rate the importer will need 2,523,659.
Thats $4,000,000\1.5850. If the settlement would be immediately, thats on April 1, the
importer would have incurred 2,476,933 for $4,000,000. This means $4,000,000\1.6149

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This will result to loss on spot market of 46,726 , (2,523,659-2,476,933)


In order to protect against possible loss on exchange rate movement, the importer sell
sterling pound to get enough money to buy dollar (close out a future position). This
enabled him to get the profit which offset the loss on spot market.
Therefore, the profit on future contract would be 4,000,000\1.5720- 4,000,000\1.600 =
44,529. This profit on future contract can be offset to loss on spot market. In this case
the overall net loss will be 46,726-44,529, which is equal to 2197 loss. This loss is
due to appreciation of dollar against sterling pound or hedge efficiency of 95.3%.
Hedge efficiency =

4.3.1.11

Profit/loss on future contract 44,529


=
= 95.3%
profit /loss on spaot market 46,726

Selling currency futures

Currency futures are often sold by speculators who expect that the spot rate of a currency
will be less than the rate for which they would be obligated to sell it. By selling a futures
contract, the firm is locking in the price at which it will be able to sell the currency as of
settlement date. This can be appropriate if the firm expects this currency to depreciate
against its home currency.

For example;
Assume a speculator wants to purchase 125,000 marks in the spot market and sell it in
future contract. A mark futures contract specifies a price of $0.54 per mark. The spot rate
is expected to be $0.50 on the settlement date.
If the expectations are correct:

The speculator will be able to purchase 125,000 marks for $62,500 in the spot market.
Thats 125,000 x 0.5

The speculator will then sell their mark at $0.54 par mark as specified by the futures
contract, and receive $67,500. The gain is $5000. Thats the difference between the
purchase price and selling price of future contract.

90

4.3.1.12

Straddle and Tick

A straddle position is where an equal number of the same currency futures contracts are
simultaneously bought and sold. Short-term interest rate futures prices are quoted as 100
minus the rate of interest on the instrument involved. Thus an interest rate of 10% would
be priced at 90.0 for one future contract

Tick size is a minimum price fluctuation. Tick is Units in which price movements are
usually measured. It is a smallest permissible price fluctuation of a security. On most
contracts a tick is 1/100 of a 1% or 0.01 per cent (This is also referred to as a basis point).

Illustration 9
An investor has a $ 1,000,000 floating rate bond yielding 9% and is worried about
interest rate fluctuations during the next 3-months. He /she want to use 3-month
Eurodollar interest rate future contract to protect against interest rate changes. Assume
the interest rate fall to 9%. At what price the investor will sell the future contract, and
what will the yields from the bond?

Solution:
The investor will sell futures contracts at 100-9= 91 and the Profit will be equal to
0.01/100 x $1000,000 x 3/12 = $25 per tick

For 100 tick, profit is 25x100 = $2500

Bond yield will be equal to 9/100x3/12x1, 000,000+ 2,500 (Profit from the contract)
= $22,500 +2500= $25,000

Effective yield =

$25,000 12
x x100%
1,000,00 3

=10%
If interest rates rise to 11% the investor sells futures at a loss. From the above example,
the losses will be (89-90) = loss of 100 ticks at $25 per tick which is equal to $2,500.This
loss will be reduced from interest earned on investment:

91

Here interest earned on investment =

11 3
x x$1,000,000 = $27,500
100 12

Less loss on interest rate

2,500
$25,000

Effective Yield:

$25,000 12
x x100% = 10%
1,000,000 3

Tick value - This is the monetary value of one Tick. It is calculated as the minimum
price movement (Tick size) multiplied by the contract size. Therefore, given the contract
size and Tick size, then the Tick value can be obtained as follows:

Tick value = contract size x Tick size. For instance, if three month sterling contract size is
500,000 on LIFFE future contract, what would be the Tick value per contract?

Solution:
Normally Tick size is given by 0.01% or 0.01/100 = 0.0001. Therefore, for the three
month contract, the Tick value will be equal to 500,000x0.0001x 3/12 =12.50

Illustration 10
NESTA plc is a company operating in the USA which imports goods from NECTA plc in
UK. NESTA plc is due to pay 650,000 to NECTA plc on 20 February 2002. It is now 12
November 2001. The following futures contracts (contract size 62,500) are available on
the Philadelphia exchange:

Expiry

Current futures rate

December

1.4900$/

March

1.4960$/

Required
Illustrate how NESTA plc can use futures contracts to reduce the transaction risk if, on 20
February, the spot rate is 1.5030$/ and March futures are trading at 1.5120$/. The spot
rate on 12 November is 1.4850$/. Calculate the hedge efficiency

92

Solution:
Step 1: Choose the appropriate futures contract.
In this case, it will be the March contract. The December futures contract will expire
before the exposure period (i.e. 12 November to 20 February) is over. It is normally
advisable to select the futures contract that will expire soonest after the end of the
exposure period

Step 2: Determine the number of contracts:


650,000/62,500 = 10.4 or approximated to 10 contracts. This implies that, NESTA plc
will buy 10 March contracts now (12 November) at 1.4960$/ and sell 10 contracts on 20
February for 1.5120$/, thus making a profit from the futures trading that will largely,
but not totally, negate the loss from the spot market (i.e. the fact that sterling has
strengthened between 12 November and 20 February from 1.4850$/ marking NESTA
plcs imports from the UK more expensive if payment is to be made in s)

Step 3: Determine the spot/loss from the futures contracts trade.


(a)

Calculate the tick movement


1.5120- 1.4960 = 0.0160 (i.e. 160 ticks, remember, one tick = 0.0001)

(b)

Calculate tick value per contract


62,500x0.0001= $6.25

(c)

Calculate the profit:


10contracts x160 x $6.25 = $10,000

Step 4. Calculate the overall cost and hedge efficiency


On 20 February, NESTA plc will exchange $ for . 650,000 will cost on the spot
market:

93

650,000 x 1.5030 = $976,950 (Note: With futures trading you still exchange at the
prevailing spot rate-unlike a forward contract)
The net cost to NESTA is therefore, $976,950- $10,000 = $966,950
The spot on 12 November was 1.4859$/. So 650,000 would have cost $965,250, and
the loss on the spot market is $976,950-965,250 = $11,700
The hedge efficiency is therefore the futures contract profit divided by the spot market
loss.
$10,000
x100 = 85.5%
11,700
The efficiency is due to;
Rounding the contract to 10 from 10.4
Basis risk- The fact that the movement on the futures prices has not exactly equalled the
movement on the spot rate

4.3.2

Spot And Forward Markets

The transactions in the foreign exchange market can be dealt in the spot or forward
market. These forms of market forms the bases through which the exchange rate is to be
quoted.

4.3.2.1 Spot Market


A spot market involves purchases or sells of foreign currencies with the delivery and
payment between banks to take place, normally on the second following business day. It
requires immediately payment and delivery of foreign currencies. In the spot market, the
currency is sold or bought at its spot rate. The transactions in the spot market is known as
spot transactions and the rate at which the transactions are effected in the spot market is
known as spot rate

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4.3.2.2 Forward Market


Forward contract requires the delivery of a specified amount of foreign currency for a
specified amount of another currency at a future value date. One buys forward contract
for exchange of one currency for another at a specified future date and at agreed
exchange rate. Although the exchange rate is fixed at the time of agreement, the payment
and delivery of foreign currency is effected in the future date. The transactions dealt in
the forward market are called forward transactions and rate at which forward transactions
will be dealt is known as forward rate. The forward exchange rate is the rate today for
exchanging one currency for another at a specified future date. Traders/firms can use
forward market to protect themselves against foreign exchange fluctuations.

4.3.2.3 The Forward Exchange Market


It is possible for agents in the exchange market to agree today to exchange currencies at
some specified time in the future. The exchange rate, which is fixed at the time when the
contract is entered into, defined by the specified amount of one currency in exchange for
the other currency, is referred to as the forward rate. The forward contracts, most
commonly for deeply traded currencies such as , $, and , are typically for a month,
two, three, six and twelve months.

However, most foreign exchange traders are

agreeable to tailoring the maturity of the forward contract to the needs of the customer.
The forward market for less well-traded and exotic currencies often does not exist and
may have to be simulated.

95

Example
A US company buys textile from England with payment of 1,000,000 due in 90
days. The importer, thus, is shorter of pounds that is it owes pounds for future
delivery. Suppose the present price of the pound is $1.71. Over the next 90 days,
however, the pound might rise against the dollar, raising the dollar cost of the
textiles.

The importer can guard against this exchange risk by immediately

negotiating a 90 day forward contract with a bank at a price of, say, 1 = $1.72.
According to the forward contract, in 90 days the bank will give the importer
1,000,000 (which it will use to pay for its textile order), and the importer will
give the bank $1.72 million, which is the dollar equivalent to 1million at the
forward rate of $1.72
In technical terms the importer is offsetting a short position in pounds by going
long in the forward market that is buying pounds for future delivery.

4.3.2.4 The Participants in the Forward Market


The major participants in the forward market are:

Arbitrageurs the act of arbitrage is to exploit price differences on the same


instrument or similar assets. So they use forward contracts to earn risk-free profits by
taking advantage of differences in interest rates among countries.

Hedgers enter into forward transactions to protect assets and liabilities denominated
in foreign currencies against exchange rate fluctuations.

Speculators engage in buying and selling forward with a view to obtaining profit on
exchange rate fluctuations. They accept high risk in anticipation of high reward.

96

4.3.2.5 Forward Contracts


Forward contracts refer to the contracts between two parties to deliver certain amount of
currency or a product at future date at fixed prices. The exchange rate or price to be used
at the maturity date is fixed at the date of agreement. In forward contracts each part is
obliged to complete a deal as agreed.

For instance, if X enter into forward contract to buy $1000,000 in 30th June for
Tsh1070/$ from Y bank, then at 30th June, X will pay Tshs 107,000,0000.00 to Y bank
and Y bank give $1000,000 to X. doing so the contract will be concluded and closed.

4.3.2.6 Calculating Forward Rates


A forward contract on a given currency or commodity call for future delivery of a given
amount of currency or commodity at a fixed time and price. Forward contracts uses
forward exchange rates which is fixed at the date of agreement. Normally, forward rates
are quoted on the basis of the prevailing spot rate and the interest rate differential for the
currencies in question.
According to the IRP, the return from investing a given sum of money in the domestic
capital market will be the same as that produced by:

Converting the sum into foreign currency at the prevailing spot rates

Investing this in the foreign capital market at the going rate of interest; and

Contracting to convert the gross proceeds from this investment back into the
domestic currency at the prevailing forward rate

Using this theory, then forward rate can be defined as follows:


F0, t = s 0

(1 + rh )t

(1 + r )

where: F0,1

is the forward exchange rate. Thats the rate quoted to day for delivery of
foreign

currency at the end of the period

S0

is the spot rate of exchange

rh

is the interest rate of underlying currency annualized

rf

is the interest rate of reference currency

Time period (expiry date of the period)


97

Illustration 11
It is estimated that in three months to come the Interest rate in Tanzania will be 8% and
that of U.K be 4%. If the spot rate is Tsh2000/, what would be the exchange rates in
three months?

1 + 0.08
f 3 = 2000

1 + 0.04

f 3 = Tsh 2239.76/
Using relative purchasing power parity theory, the forward rate can also be computed.
According to the power parity, any change in the differential rate of inflation between the
countries will tend to influence the change in exchange rate between the countries. Where
the spot rate between the currencies is known and where there is change in inflation rates
over the periods, then the spot exchange rate will change. The future spot rate is called
forward exchange rate and it is determined using the following formula
F0, t = s 0

(1 + rh )t

(1 + r )

Where rh refer to inflation underlying and rf refers to inflation reference and t refer to
time period

Illustration 12
If Tanzania and Kenya are running annual inflation of 5% and 3%, respectively, and the
initial exchange rate was Tsh10/Ksh. What would be the value of Kenya Shilling in three
years?

Solution:
The forward exchange rate at the their year will be
3
(
1 + 0.05)
F0,3 = 10
(1 + 0.03)3

= Tsh 10.6/Ksh

98

4.3.2.7 Speculating In The Spot Market


To speculate in spot market, the speculator should believe that, the foreign currency will
appreciate in value. For example A speculator in Holland is willing to risk money on his
own option about future currency prices. The speculator may speculate in the spot rate,
forward rate, or options markets.
The German mark is currently quoted as follows:
Spot rate

$0.5851\DM

Six month forward rate

$0.5760\DM

The speculator has $100,000 with which to speculate, and he believes in six months the
spot rate for the mark will be $0.6000\DM. Therefore the speculator will speculate
$100,000 as follows:
1. Use the amount to buy mark at spot rate $0.5851\DM. He will get
($100,000\ $0.5851) DM170, 910.96.
2. Hold DM170, 910.96 indefinitely. Although the mark is expected to rise to the target
value in six months, the speculator is not committed to that time horizon.
3. Sell DM170, 910.96 at the new spot rate of $0.6000\DM, receiving $102,546.57.
(DM170910.96 x $0.6000\DM )
Profit for the speculator will be ($102,546.57 - $100,000), = $2,546.57 for committing
$100,000 for six month.

4.3.2.8 Speculating in the Forward market


To speculate in the forward market speculator should believe that the spot rate at some
future date will differ from the present forward rate. If this situation is believed to happen
in the future date then speculator will sign the forward contract using forward rate.
Using an example above, the following steps will be taken by the speculator speculating
in the forward market.
1. To day buy DM173,611.11 forward six months at the forward quote of $0.5760\DM.
2. In six months, fulfil the forward contract, receiving DM173,611.11 at $0.5760\DM
for a cost of $100,000

99

3. Simultaneously sell the DM173,611.11 in the spot market, receiving $104,166.67,


(DM173,611.11 x $0.6000\DM)
4. The speculator will make profit of $4,116.67, ($104,166.67- $100,000)

The profit of $4,116.67 is for six month forward rate, the situation could be different if in
six month the value of Mark has devalued to zero. In this case, the speculator could get a
loss of $100,000 the whole amount invested.

4.3.2.9 Benefits of Forward Exchange Hedge


Your organization can receive the following benefits from forward exchange hedge:

Reduced earnings volatility

Improved cash flow forecasting

Maintained or improved corporate credit ratings

Defined risk management and hedge methodologies (regulatory and internal

risk

management compliance)

Improved currency exposure forecasting and measurement capabilities

4.3.2.10

The Challenge

An effective hedging program does not attempt to eliminate all risk. Rather, it attempts to
transform unacceptable risks into an acceptable form. The key challenge for the corporate
risk manager is to determine the risks the company is willing to bear and the ones it
wishes to transform by hedging. The goal of any hedging program should be to help the
corporation achieve the optimal risk profile that balances the benefits of protection
against the costs of hedging

4.3.3

Options Contracts

Currency option is a contract giving the option holder the right, but not the obligation, to
buy or sell a given amount of foreign currency on or before specified future date at a
specified price called strike or exercise price and in an amount called contract size which
is fixed in advance. For the privilege of having a choice of whether or not to exercise the
option, the upfront called premium/price has to be paid.

100

4.3.3.1 Types Of Options


There are two types of options. Thats Call option and put option.

A call is an option to buy foreign currency or an asset. The buyer of an option is


termed the holder of put option. The owner of a currency call option is granted the
right to buy a specific currency at a specific period of time. However, the holder of
call option has a choice as to whether or not to exercise the option and buy the asset at
a fixed price, at a certain time in the future. The buyer of call option will buy only the
underlying asset when it is profitable to do so. If it is not profitable then the hold of
call option will leave it lapse at the maturity date. That leave the right unused.

A put is an option to sell foreign currency or an asset. The seller of a put is called
writer or grantor. The seller here can sell only the underlying asset when it is
profitable to do so, otherwise will leave the option lapse un- excised

4.3.3.2 Options Quotations and Prices


Every option has three price elements.

The exercise or strike price. This is the exchange rate at which the foreign currency
can be purchased or sold. It is a price at which the owner is allowed option is allowed
to buy or sell the currency/ underlying asset. This price is fixed at the time the
contract is signed

The premium. This is the cost or value of the option itself. Is the amount initially paid
by the owner of the option for the right to purchase or sell the currency/underlying
asset. This is non-refundable money. Thats whether the hold of option excises it or
not, the money is not refunded back. It is a cost of acquiring a right to soothing.

The underlying or actual spot exchange rate in the market. This is the actual
prevailing market price of the assets in question. Thats the price of an asset existing
at the maturity date of the option.

4.3.3.3 Determinants of Currency Option Prices


Option prices depend on the number of factors. The following are some factors that
determine the option prices:

101

The time to expiry of option. The longer the period to expiry the more expensive the
option will be as there is a greater chance that exchange rates will move in favour of
the option buyer

The striking price or exercise price. The more favourable the striking price to buyer
of the option, the higher will be the option price

Current spot and forward market rates for the period of the option

The expected volatility during the life of the of the currency in which the option is
being purchased

Whether an American or European option is to be purchased

Current interest rates that could be earned on the option premium

4.3.3.4 When The Option Can Or Not Be Exercised?


As it has been said, the holder of option is not obliged to use his/her right at the maturity
date. Thats he/she may use it if and only if by doing so it is profitable. In other words the
option will not be excised if the price is not favourable to the holder of the option
A call option can be exercised if the strike price is lower than prevailing market price. If
this situation prevails, then the holder will be able to buy an asset from the seller at lower
price and resale it in the market at higher price. Under this situation, the price is
favourable to the holder of the call option and by exercising it he/she will get profit. In
case the prevailing market price of the asset is lower than the strike price, the holder of
option will not get any profit by buying and reselling the asset. This is because the buying
price will be higher than the price he may sale in the market. For this matter the call
option will be left to lapse un-excised.
So it can be summarized that the call option can be exercised when strike price less than
Underlying market price of an asset (K<S)

A put option can be excised if its strike price is higher than the underlying market price.
In this case it implies that the put option holder will be able to sale at higher price than
the real value of underling asset. However, if the strike price is lower than the prevailing
market price, then the holder will not excise it, as by excising it will lead to big loss.

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Moreover, it can be summarized in this case that the put option can be excised when
strike price greater than Underlying market price of an asset (K>S)

4.3.3.5 The Impact of Deciding Not To Excise an Option


The holder of call option or put option will excise the options when it is favourable to
them, otherwise they will leave the options lapse un-exercised. There is an impact on
deciding not to excise the option when the price is not favourable. The impact here is
that, because the cost called premium is paid at the time of acquiring the option, then by
letting the option un-excised means incurring loss equal to the premium paid. It should be
noted that this loss is smaller than the loss that could be incurred by excising the option
when the price is not favourable to the holder of the option

Illustration 13
Assume the strike price of an option to buy 100 Tanzanian Government bond is Tsh
30,000.00. The buy of the option pays a premium of Tsh5, 000.00 per contact. It is agreed
that the maturity date of the contract in July 2005. If the end of July 2005 the value of the
bond is Tsh28, 000.00, will the buyer excise its right? What would be the impact of any
decision that may be arrived?

Solution:
Since this is a call option giving the holder to buy the bond at the end of July, the holder
will not buy the bond because the buying price is greater than the value of the bond or the
price he/she may re-sale the bond in the market. For this reason the holder will lave it
lapse. The impact of this decision will be losing only Tsh5, 000.00 per contact.
However, if the holder exercises it, then he will get a loss equal to:

marke price - (strike price + premium )


= Tsh28,000 - (30,000 + 5000 )
= Tsh 7,000.00 per contract
As can be observed above, the loss of excising is greater than the loss of deciding not to
exercise

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4.3.3.6 Options Styles


There are two styles of options. One is called American style and another known as
European style.

American style of option can be exercised at any time up to the expiration date. The
holder of it does not need to wait until the maturity date to exercise it. He can exercise
at any time provided that it pays to do so.

European style of option is one which can not be exercised until the maturity date.
Thats the day of expiration. That is to say even though the holder may find it
profitable to exercise before the expiration date, can not do so.

Note, however that European and American options can be sold to another market
participant at any time (but one who buys European option has to wait until maturity
date)

Illustration 14
In May, 2005 a trader purchased an option to buy 1000, 000 at the end of August, 2005.
The premium paid for such option is $20,000. The agreed excise price is $1,500,000. The
movement of prices thought the period have been as follows.
May

$1.5/

June

$1.6/

July

$1.7/

August

$1.6/

Required:
Assume it is an American option, should the trader wait until the maturity date? What is
the impact of such decision? If the option is a European one, what would be the profit or
loss to the trader?

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Solution:

If the call option was an American one, then the holder of it could exercise it at any
time until the date of expiration provided that it pays to do so. Since it was agreed to
buy 1000, 000 for $1,500,000, it means that the strike price per contract was
$1,500,00
= $1.5 / . This also implies that the number of contacts is 1000,000
1000,000

Because July market price is greater than the exercise price of $1.5/ the holder will buy
the option in July and resale it at higher price of $1.7/ per contract. And get a profit of
1.7-(1.5+0.02) per contract. This equals to 0.18 x 1000, 000 = $180,000

If the option is a European one, then the holder has aright to exercise it until the
expiration date. For this case he/she will wait until August when the market price is
$1.6/. The holder will buy 1000, 000 at $1.5 per contract and resale it in the market
at $1.6 per contract.

Therefore,
Effective cost will be: = Contract size x exercise price
= 1000, 000 x 1.5
= $1,500,000.00
The Premium cost

= contract size x premium cost per contract


= 1000, 000 x 0.02
= $20,000

Total cost

= Effective cost + Premium cost


= $1,500,000+ 20,000
= 1,520,000.00

Total Revenue

= Market price/ market value of an asset x contract size


= 1.6 x1000, 000
= $1,600,000

Profit or loss

= Revenue- Total cost


=$1,600,000-1,520,000
= $80,000

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or
The profit /loss can be obtained as 1,600,000- (1,500,000+ 20,000) = $80,000

4.3.3.7 Positions in Options


It should now be clear that there are two sides of the market for calls and puts. The two
parties to each option contract are classified as follows:

Long call and Short call

Long put and short Put

4.3.3.7.1

Long call (buy) and Short call (sell)

Long call means buying a call option and short call means writing or selling a call option.
Thus where there is a buyer of option, there should be a seller of such option. While the
buyer gets right to buy it but not obliged to do so, the seller of it has no option other than
meaning the promise unless the buyer decides not to exercise the right. The writer of put
option has no option to go away from the contract because by receiving the premium
from the buyer grantees that he will sell the underlying asset as agreed. So it is binding
contract to the writer but not to the buyer
From this reasoning it can also be seen that, while the buyer of put option is getting profit
from the transaction, the writer gets loss and the reverse is true. However, the buyer of
the call option limits downside risk to a call premium he pays, but can benefit from any
upside potential

Illustration 15
The Managing Director of NICO plc in January 2005 purchased a European call option
on the shares of BINGO Ltd. One stock contract is a contract to buy or sell 10,000 shares.
Managing Director of NICO paid a premium of $300 per share. It was agreed that NICO
plc would be allowed to buy the shares at the end of agreed period for $800 per share.
The expiry date of the contract is March. At the end of March, the market price of
BINGO shares was $850 per share

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Solution:
Given;
K (strike price) = $800 per share; C (premium or cost of option) = $300 per share; ST
(market price of option at time T) = $850 per share
But the holder of call option will exercise it if and only if ST>K. since $850> $800, then
the Managing Director of NICO will buy the option at $800 and resale it in the market at
$850
The breakeven point for NICO would be equal to K+C, thats $800+$300= 830 per share
or $8,300,000 for 10,000 shares
The profit of the transaction will be;
Net profit = S-(K-C) or S- Breakeven point
= $850- (800+300)
=$200 per share
Therefore, for 10,000 shares the total net profit would be $ 2000, 000
The case of writer would be different from the buyer. The net profit of the writer of a call
option is given by K+C-ST , where by K is the selling price of option to the buyer and C
is the premium received on transaction (it is also a revenue to the writer), S is the cost or
value of the asset being sold at the agreed period
Using an example above, the writer here will get a loss of $200 per share, making a total
loss of $2000,000 for 10,000 shares. That is ( 800+300-850) x10,000

Illustration 16
Assume the market price of shares of BINGO Ltd in illustration two, becomes $600 at the
end of March instead of $850. What would happen to the net profit of both buyer and
writer of a call option?
Given,

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S = $600; K=$800 and C=$30


Since S<K, then the managing director of NICO will not buy the shares of BINGO. He
will let his right lapse unused and get a minimum of loss equal to the premium paid.
Thats a loss equal to $300 per share. For 10,000 shares makes a total loss of $3,000,000.
However, if the managing Director of NICO make unwise decision and decides to buy
the shares of BINGO at $800. He will make a loss equal to 600-(800+300) =$500 per
share, thus $5000, 000 for 10,000 shares. This loss is greater than if the option is not
exercised.
In this case the writer will benefit in all scenarios. If the Managing Director decides not
to exercise, then the writer of call option (BINGO Ltd) will get a profit of $300 per share,
thats the amount equal to premium received. This is equal to $3,000,000 profit for
10,000 shares. If the option is exercised, then the writer will get a profit equal to the loss
incurred by the buyer for exercising his write. Thats the total of $5,000,000 profit will be
obtained

4.3.3.7.2

Long and Short Put

Long put means buying put option and short put selling put option. The buyer of a put
option granted by the seller of put option that he will sell him the asset at the maturity
date. For the assurance he gets from the seller, pays an amount of money called premium.
This money is revenue to the seller of a put option but an expense or cost to the buyer of
the put option. It should be noted here that while it is legal binding to the seller of put
option that he has to fulfil the promise, it is not obligation to the buyer. The buyer may
decide to walk away from the contract if find that the market price at the expiration date
is not paying. By doing so he will be losing only the premium paid.
A speculator who expects that a certain currency will depreciate, he could purchase that
currency put options, which would entitle him to sell that currency at specified strike
price. The buyer of the put option will buy it with intention to sell the underlying
currency at the exercise price when the market price of such currency drops. The buyer of
the put option will get profit if the spot price is lower than the strike price. At any

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exchange rate above the strike price, the buyer of the put would not exercise the option,
and if the trend continue, thats is the strike price continue being lower than any exchange
rate, the buyer will retain the option even until the expiry date and lose the amount i,e the
premium paid on option. Generally, it can be seen that while the seller is getting profit the
buyer of put option is getting loss and that when the seller is getting loss the buyer is
getting profit. The minimum profit of the buyer is premium received on contract and the
minimum loss of the seller is premium paid on contract

Illustration 17
The following information relates to Wasukuma put option transaction for the period of
2005.
Strike price

0.585\$

Spot price

0.575\$

Premium

0.005\$

Required:
1.

Compute the break even price for the buyer of the put

2.

Compute the profit of the buyer of the put.

Solution:
Breakeven price = K-C (premium)
0.5850\$ - 0.005\$
= 0.5800\$
If ST>K then the speculator will not exercise the put, he will let it expire worthless and
lose the put premium of 0.005/$
Now since K<ST, then the speculator will not exercise the put option. If decides to
exercise then he will get a loss equal to 0.015 per dollar
Net lo = Strike price (Spot Rate + premium)
= 0.5850\$( 0.595\$ + 0.005\$)

= -0.015/$

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4.3.3.8 In, Out and At The Money

A call option is said to be in-the-money if Current Spot Price is greater than strike
price (S> K) and a put option is in-the-money if K>S

A call or put option is At-the-Money when current spot price is equal to strike price
(S=K )

A call option is Out-of-the-money when current spot price is less than strike price (S<
K) and a put option is out-of the money if K<S

4.3.3.9 Types of Option trading strategies


Option trading can be made in various strategies. The following are the type of options
trading strategies.

Naked Options

A currency option is naked when the buyer or seller does not hold

an offsetting position in the contracted currency (or currencies)

Covered Options

A currency option is covered when the writer holds an offsetting

position in the contracted currency (covered option buying)

Option spreads

An option spread involves the simultaneous purchase and sale of

two options of the same type but with different exercise prices or terms until maturity

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Reference
Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA
Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.
Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by
Palgrave MACMILLAN, UK
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003
Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review Questions
1. An American investor believes that the dollar will depreciate and buys one call option
on the euro at an exercise price of 110 cents per euro. The option premium is 1 cent
per euro, or $625 per contract of 62, 500 euros (Philadelphia):
a. For what range of exchange rates should the investor exercise the call option at
expiration?
b. For what range of exchange rates will the investor realize a net profit, taking the
original cost into account?
c. If the investor had purchased a put with the same exercise price and premium,
instead of a call, how would you answer the previous two questions?
2. Willem Koopmans is considering a different call option on German mark than what
he bought previously. He can also buy an August call option with a strike price of
59.0 cents per Deutschemark. The premium for this option is 0.30 cents per
Deutschemark.

Required:
a. what is a breakeven price for Koopmans
b. What would Koopmans expect as the profit or loss on this call option if by August
the spot exchange rate is $0.6000/DM?
3. Willem Koopmans is considering a different call option on German mark than what
he bought previously. He can also buy a September put option with a strike price of

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58.5 cents per deutschmarks.. The premium for this option is much higher 0.99 cents
per deutschemark.

Required:
a. what is a breakeven price for Koopmans
b. What would Koopmans expect as the profit or loss on this put option if the spot
exchange rate is $0.5700/DM?
4. Which options are in the money and which are out of the money if the spot price is
$800?

Type of security

Exercise price

call

put

T-Bond

$700

55.5

17.5

K-Nipel

$750

28

40

5. Explain briefly what is meant by foreign currency options and give examples of the
advantages and disadvantages of exchange traded foreign currency options to
financial manager

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CHAPTER 5
FOREIGN EXCHANGE EXPOSURE MEASUREMENT AND RISK
MANAGEMENT
5.1

Introduction

As a result of globalization, businesses nowadays operate worldwide. This has also led to
increase in international transactions. As many businesses engage in international
transactions, they become vulnerable to various market risks.

5.2

Exposure and Risks

The vulnerability to market risk is known as risk exposure. For a specific risk at which a
firm if vulnerable, let says foreign currency fluctuation, the exposure is known as foreign
currency exposure. The principal market risks that businesses face in connection to
international transactions is are:

Foreign exchange-rates, generating translation and transaction gains and losses.

Interest rate and other risks related to financial assets and liabilities.

Equity price risks relating to the equity securities we hold of certain of our
collaboration partners.

Foreign exchange risk is a risk that results from exchange rate fluctuations. It is a result
of foreign currency exposures. It is a risk because exchange rates are always changing
and that the direction of the exchange rates movement is normally uncertain as it is
difficult to predict with certainty. In most cases, foreign exchange volatility exposes
multinational corporations which typically have investments, assets, funding, cash
inflows and outflows denominated in various foreign currencies to significant foreign
exchange risk.
Foreign exchange rate risk frequently leads to earnings volatility and cash flow
uncertainty. It represents the risk that a companys performance will be affected by
exchange rate movements. It reflects uncertainty about the future cash flows since the

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firms can not accurately predict future net cash flows due to potential exchange rate
fluctuations
As such, its management is vital not for seek of reducing it only but also to be our self in
the piece of mind. Here we say risk need to be reduced not eliminated because risks can
not be totally eliminated. If foreign exchange exposure remains unmanaged, the impacts
may be severe to the businesses earnings and expected cash flows if risk materialises

5.3

Foreign Exchange Exposure Measurement

Refers to the determination of the extent to which foreign operations are at risk from
exchange rate changes. It indicates the degree to which foreign operation has an impact
on the firms operations. Measuring the exposure of a firm to the risk of losses from
changes in the exchange rate is an important issue since this exposure is often the basis
for the decision on whether such risk should be avoided, neutralized or carried
There are three ways of measuring Foreign currency vulnerability ( exposures), namely:

Transaction exposure

Economic exposure

Translation exposure

5.3.1

Transaction Exposure

Transaction exposure represents the change in the value of outstanding financial


obligations incurred prior to a change in exchange rates but due to be settled until after
the exchange rate has changed. Transaction exposure arises out from various types of
transactions that require settlement to be made in future in terms of a foreign currency.
Because cash is received or paid later, the exchange rate may not be the same as that
prevailed at the date when transaction took place. For this reason the value of cash flows
denominated in various foreign currencies will be affected by exchange rate movement.
The change in value of expected revenue or financial obligation due to change in
exchange rate may lead to gains or losses.

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If the value of expected cash inflow after the change in exchange rate is higher than the
value of expected cash inflow before the change in exchange rate, then there would be
gain resulting from exchange rate movement and verse versa. If the value of cash outflow
after the change in exchange rate is higher than the value of cash outflow before the
change in exchange rate, then there would be a loss resulting from exchange rate
movement and the verse versa.

Illustration 1
Winome Wood Works Ltd, a Tanzanian Company sells wooded furniture to Waningu Ltd
a Kenyan Company for Ksh70, 000,000.00. It is agreed that payment to be made 60 days
from the date of invoice. The exchange rate (spot) at the date of transaction was Ksh
0.1/Tsh. During the day of settlement the value of Tanzania shilling was Ksh 0.125/Tsh
Because a Tanzanian firm will converted Ksh it Tsh after receiving the payment from
Waningu Company, so it will get an equivalent to Tsh560,000,000.00, that is
1
70,000,000 . But if this was paid at spot, then Winome could have received, Tsh
0.125
700,000,000, that is

1
70,000,000 . In this case exposure arises because Winome will
0 .1

receive something other than Tsh 700,000,000. What it receives after the change in
exchange rate is small than what it could receive if the payment could be done at spot.

5.3.1.1 Causes (Sources) of Transaction Exposure


Transaction exposure arises from many ways. The following are the basic causes of
transaction exposure:

Purchasing good/services on credit whose price is denominated in foreign currency

Selling goods/services on credit whose price is denominated in foreign currency

Borrowing or lending and when repayment is to be made in foreign currency

Acquiring assets or liabilities denominated in foreign currency

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5.3.1.2 Management of Transaction Exposure/Risk


As we have said before, foreign exchange risk may cause severe impacts to the
businesses if materialises. To be in the piece of mind, businesses need to manage such
risks. Managing here refers to reduction of the expected risks by using different strategies
such as hedging. There are various Techniques by which transaction exposure can be
managed or protected against. The use of derivatives is very common. However, other
techniques such as leading and lagging, and sharing risks can be used.

a) Currency Risk Sharing


This is done through contractual agreement between the seller and the buyer to split or
share the impacts of exchange rate movements on payments between them. This
technique is mostly used by those companies who are involved in long -term trade
contracts

b) Internal Asset And Liability Management


Internal asset liability management refers to the manipulation of foreign currency assets
and liabilities in order to reduce foreign exchange exposure. It is mostly associated with
the management of transaction exposure, where a company might try to equalize the
value of assets and liabilities in a particular foreign currency to leave a zero currency
exposure, but it may also be used as part of transaction exposure management.
The possible manipulation of assets and liabilities might include:

Borrowing or investing in foreign currencies in an opposing manner to expected


export/import transaction cash flows

Moving funds from countries where currencies are expected to depreciate in value
into relatively hard currency countries

Collecting in debts as quickly as possible in a depreciating-prone currency, and


reducing financial investments in such currencies

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Deciding to purchase goods from a country to which export sales are made, the
purchase price being met by proceeds from the export sales.

c) The Currency of Invoice


The transaction exposure can be avoided if exports and imports are denominated in the
home currency other than in the foreign currency. In this case the expected cash receipts
from export is not needed to be converted into other currency because it is already in a
home currency and that the there is no need to find a foreign currency to pay for the debt
as it is denominated in our home currency

d) Leading and Lagging


Firm can reduce transaction exposure by accelerating or decelerating the timing of
payments. These techniques are known as leading and lagging. To lead is pay early,
thats payment an obligation in advance of the due date. A firm can lead payments if it is
anticipated that the home currency will drop in value and much of it will be needed to
buy foreign currency to settle the foreign debt.
To lag is to pay debt obligation late, and this is done if it is expected that the home
currency will appreciate and less of it will be needed to buy foreign currency to pay for
the debt. However, leading and lagging techniques are constrained by the exchange
control regulations of individual countries. It is important that when deciding for the
hedging strategy, firms take this into account.

5.3.2

Economic Exposure

The degree to which a firms present value of future cash flows can be influenced by
exchange rate fluctuations is referred to as economic exposure to exchange rates.
Economic exposure is also called, operating exposure, competitive exposure, or strategic
exposure. Economic exposure measures the change in the present value of the firm
resulting from any change in the future operating cash flows of the firm caused by an
unexpected change in exchange rates.

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The change in value depends on the effects of the exchange rate change of future sales
volume, price, or costs. Economic exposure exists because of unexpected changes in
future cash flows. Planning for operating exposure is a total management responsibility
because it involves the interaction of strategies in finance, marketing, purchasing, and
production.
The exchange rate fluctuations may lead to appreciation or depreciation of currencies.
The appreciation or depreciation of currency will affect the overall future sales volume,
prices or costs. If the local currency appreciates:

The future sales volume will tend to decrease

Cash inflows from exports denominated in local currency would likely be reduced as
a result of appreciation in local currency. This is because foreign importer would need
more of their own currency to pay for those goods.

However exports dynamited in the foreign currency would likely reduce cash inflows

5.3.2.1 Managing Economic Exposure


The efficient management of both operating and transaction exposure is to anticipate and
influence the effect of unexpected changes in exchange rates on a firms future cash
flows, rather than merely hoping for the best. Though economic exposure is very difficult
to measure precisely, companies must be able to respond quickly to significant economic
exposure effects. There are different ways that can be used to manage economic
exposure. The techniques are categorised into diversification, marketing management of
economic exposure, changing of operational policies and, production management of
economic exposure

a)

Diversifying Operations

This involves diversifying location facilities and raw materials sources. If the firms
operation is diversified internationally, management will be positioned both to recognise
disequilibrium when it occurs and react competitively. Although the disequilibrium of
PPP may have been unpredictable, management can often recognise its symptoms as

118

soon as they occur. For instance a firm may notes a change in competitive costs in the
firms own plant located n different countries. It might also observe changed profit
margin or sales volume in one area compared to another, depending on price and income
elasticitys of demand and competitive reactions
Recognising a temporary change in world wide competitive conditions permits
management to take changes in operating strategies, e.g. shift of sourcing of raw material,
components, or finished products.
Even if management does not actively distort normal operations when exchange rates
change, the firm should experience some beneficial portfolio effects. The variability of its
cash flows is probably reduced by international diversification of its production,
sourcing, and sales because exchange rate changes under disequilibrium conditions are
likely to increase the firms competitiveness in some markets while reducing it in others.

b)

Diversifying Financing

If a firm diversifies its financing sources, it will be positioned to take advantage of


temporary deviations from the international fisher effect. If interest rate differential do
not equal expected changes in exchange rates, opportunities to lower a firms cost of
capital will exist.

c)

Changing Operational Policies

Operating and transaction exposures can be partially managed by adopting policies that
deviate from normal domestic oriented policies but have the virtue of reducing foreign
exchange exposure.
Three of operating policies commonly employed to managed operating and transaction
exposure. These are:

Leads

Firms can reduce both operating and transaction exposure by accelerating the timing of
payments that must be made or received in foreign currencies. To lead is to pay early.

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Firm pays early if hoping that the foreign currency will appreciate and much of home
currency will be needed to pay the foreign denominated currency debt

Lags

The firm will lag payment (decelerate) if hopes that the home currency will appreciate
and less of home currency will be needed to acquire foreign currency to pay for the
foreign currency denominated debt

Sharing The Risk Through Currency Clause

An alternative arrangement for managing long term cash flow exposure between firms
with continuing buyer supplier relationship is risk sharing. Risk sharing is a contractual
arrangement in which the buyer and seller agree to share or split currency movement
impacts on payments between them.

5.3.2.2 Marketing Management of Economic Exposure


a)

Market selection

Deciding of international markets the company wishes to operate in, and whether
opportunities in the selected markets will achieve the objectives of the company. The
market strategy can be adjusted if the change in exchange rate continues

b)

Pricing Strategy

The Company may decide to put the price of its home currency fixed or reducing. Each
decision has an impact on the markets for its products. If a company let say Tanzanian
company keep TSH price fixed relative to other currency, it can loose the market share
but protecting profits. However, if the company reduces TSH prices, it can sustain the
market share currently held but decrease its profits.

c)

Promotion Strategy

Companies will wish to change their promotional strategy with exchange rate changes.
For instance, if an exporter faces difficulties in getting market abroad due to the strong

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position of the home currency, the exporter may educe advertisement expenditure, or
change production image through different advertisement media and slogans

5.3.2.3 Production Management of Economic Exposure


This can involve varying of various factors that are affected by economic exposure. The
following factors are involved:

a)

Plant Location

This involves selection of foreign branch to locate a plant. The location to be selected is
that which will give the cost advantage and the maximum unit profitability. This will also
involves determining the longevity of which the location selected will continue giving the
cost advantage to the firm

b)

Shifting Production Among Plants

The companies will change the location of production to the countries whose currencies
have been devalued. In other words, it can be said that MNC can avoid risks by shifting
of production in line with changing elative production costs.

5.3.3

Translation Exposure

In preparing consolidated financial statements, foreign subsidiaries accounts have to be


reproduced in terms of the parent companys currency. This act may lead to translation
exposure. That is to say, translation exposure (a.k.a Accounting Exposure) arises because
foreign currency financial statements of foreign affiliates must be translated in the parents
reporting currencies if the parent is to prepare consolidated financial statements
The process of changing the amount from foreign currency to home currency is
commonly referred to as translation. Students normally confuse and refer this as the same
as conversion, actually it is not. Translation is simply a change in monetary expression
and not a physical exchange of one currency for another as it is in conversion.

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Although the main purpose of translation is to prepare consolidated statements, translated


statements are also used by management to assess the performance of foreign affiliates.
Translation exposure is dependent on.

The degree of foreign involvement by foreign subsidiaries. The greater the percentage
of a business conducted by its foreign subsidiaries, the larger will be the percentage
of a given financial statement item that is susceptible to translation exposure

The location of foreign subsidiary. This can influence the degree of translation
exposure since the financial items of each subsidiary are typically measured by that
countrys home currency

The accounting method used. Accounting procedure used to translate when


consolidating financial statement data an greatly affect the accounting exposure

5.3.3.1 Methods For Translating Foreign Transaction


It is beyond the scope of this manual to discuss the details of the methods of translating
the financial statements of companies having foreign operations or foreign subsidiaries.
This topic is covered in financial accounting. So the authors presume that students
reading this manual are knowledgeable and fully conversant with the whole mechanism
regarding the methods of translation.
However, it is worth mentioning at this juncture that the following accounting standards
are now operational and should be adhered to when translating the financial statements of
Multinational Corporations. These are:

International Accounting Standard (IAS) 21 -The Effects of Changes in Foreign


Exchange Rates

International Accounting Standard (IAS) 27 - Consolidated and Separate Financial


Statements

International Financial Reporting Standard (IFRS) 3 - Business Combinations

122

5.4

Use of Derivatives To Reduce Transaction Risks

The use of financial derives to manage foreign exchange risk is done through hedging.
This involves employing contractual hedges such as forward market, money market,
future market and options market. Sometimes these derivatives are called hedge tools
A well-designed hedging program reduces both risks and costs. Hedging frees up
resources and allows management to focus on the aspects of the business in which it has a
competitive advantage by minimizing the risks that are not central to the basic business.
Ultimately, hedging increases shareholder value by reducing the cost of capital and
stabilizing earnings. To be able to know how derivatives can reduce transaction exposure
it is better to use quantitative illustration as follows.

Illustration 2
Winome Wood Works Ltd, a Tanzanian Company sells wooded furniture to Waningu Ltd
a Kenyan Company on 30th April for Ksh70, 000,000.00. It is agreed that payment to be
made 90 days effectively from the date of invoice, thats in July. Economists have
anticipated that the Tanzanian economy is likely to boom in the future and this will call
for value of Tanzanian shilling to appreciate. The financial time indicates the following
quotes which are the same as those provided in the BOT newsletter.
Spot exchange rate

Tsh10/Ksh

Three moths forward rate

Tsh8/Kth

Three months borrowing interest rate in Kenya 2.5% and investment rate is 2% for three
months
Three months borrowing rate is 2% and investment rate 1.5% in Tanzania
July put option in the over the counter (bank) for Ksh70, 000,000, strike price Tsh 7.5
and premium is 2%

123

Required:
Show how Winome can use forward market hedge, money market hedge and option
market hedge to protect against transaction exposure.

Solution:
a) Using Forward Market Hedge
Forward market cover involves taking a contract to exchange two currencies at an agreed
future date at a predetermined rate of exchange. The forward contract requires a future
source of funds to fulfil the contract. It is a legally binding contract which must be
fulfilled. A hedge can be open or uncovered. This occurs when funds for the forward
exchange contract are not already available or due later. These funds need to be
purchased on the spot market at some future date.
Using the above case, should Winome wish to hedge transaction exposure in the forward
market, he will do so by selling the currency denominated receivable forward, thats Ksh
70,000,000, at fixed forward exchange rate of Tsh 8/Ksh. Three months later, Winome
will receive Ksh 70,000,000 and exchange it against forward rate. He will receive Tsh
560,000,000.00. Could the exchange late at the end of July have been let say Tsh12/Ksh,
Winome could yet receive Tsh560, 000,000. But if the receivable was un-hedged then
Winome could have received Tsh840, 000,000.00. By hedging forward he is assured of
the amount he is going to receive in terms of home currency hence eliminating the risk of
adverse exchange rate fluctuation

b) Using Money Market Hedge


This involves a contract and a source of fund to fulfil a contract like in forward market
hedge. In this case, Winome need to borrow in one currency and exchange the amount
borrowed in another currency. It is important that the amount to be borrowed should not
exceed the account receivable. For that matter to know how much to borrow, it is
important to note that the interest rate on borrowing plus principal amount should be
equal to account receivable. Using the borrowing interest rate in Kenya of 2.5% for three
months, then Winome will borrow:

124

1.025P= Ksh70, 000,000.00


P=

Ksh70,000,000
= Ksh68292682.93
1.025

This borrowed amount will be converted into TSH using spot rate and get Tsh
682,926,829.3. This amount will be used for various purposes, mainly for running of the
business, or if the firm has idle liquidity, then the amount can be reinvested and generate
more income
At the end of July Winome will pay Ksh 1,707,317.07 as interest plus Ksh68, 292,682.93
principal amounts. In total Winome will pay Ksh 70,000,000. The source of this sum will
be the account receivable he is going to receive from Waningu

c) Using Option Hedge


For an account receivable, put option is an appropriate type of option to be used. This
option gives the holder a right to sell a foreign currency after receiving it at a specified
exchange rate called strike price.
The size of option is Ksh 70,000,000
Spot rate Tsh10/Ksh
Strike price

Tsh 7.5

Premium = 20%x10 = Tsh2 per contract


Winome will buy a put option and pay a premium of 2x70, 000,000 = Tsh140, 000,000
At the end of July he will receive Ksh 70,000,000 and either deliver it against put option,
receiving Tsh 525,00,000; or sell Ksh70,000,000 in the market if prevailing spot rate is
greater than Tsh7.5/Ksh. This is possible because it is not obligation for Winome to sell
Ksh70, 000,000 against put option. He will do so only if it is profitable.

125

5.4.1

Hedging Accounts Payable

Account payables are the financial obligations of a firm. The firm enter in such obligation
and payments are made in later days. If the obligations are denominated in the foreign
currency, there is a risk that in future the transaction may lead to financial gain or loss
due exchange rate fluctuation. For this reason, firms can reduce/manage this anticipated
risk through hedging
Hedging account payable may be different from hedging account receivable in some
circumstances. However the approach in using forward market will be the same. The
different will be in using money market hedge and option hedge. While put option is used
to hedge account receivable against risk, call option is used to hedge account payable
against risk. Moreover, while local currencies is needed to be converted into denominated
foreign currency debt and be invested there to earn interest for account payable hedge, for
account receivable hedge, certain amount of foreign debt is borrowed immediately for
specific uses and the debt is used to refund the loan

Illustration 3
Wambao Wood Works Ltd, a Tanzanian Company purchased building materials furniture
from Waningu Ltd a Kenyan Company on 30th April for Ksh70, 000,000.00. It is agreed
that payment to be made 90 days effectively from the date of invoice, thats in July. The
following information relates also to the transaction.
Spot exchange rate

Tsh10/Ksh

Three moths forward rate

Tsh8/Kth

Three months borrowing interest rate in Kenya 2.5% and investment rate is 2% for three
months
Three months borrowing rate is 2% and investment rate 1.5% in Tanzania
July call option in the over the counter (bank) for Ksh70, 000,000, strike price Tsh 7.5
and premium is 2%

126

Required:
Show how Wambao can use forward market hedge, money market hedge and option
market hedge to protect against transaction exposure.

a) Using Forward Contract Hedge


In this case Winome will need KSH to pay for the goods purchased on credit. Should
Winome wish to hedge transaction exposure in the forward market, he will do so by
buying the currency denominated account payable forward, thats Ksh 70,000,000, at
fixed forward exchange rate of Tsh 8/Ksh at total TSH 560,000,000.00. Three months
later, Winome will receive Ksh 70,000,000 against Tsh 560,000,000.00 and pay the debt.
Exchange it against forward rate. He will receive Tsh 560,000,000.00. Could the
exchange late at the end of July have been let say Tsh12/Ksh, Winome could yet pay
Tsh560, 000,000 and receive Ksh 70,000,000. However, if the account payable was unhedged then Winome could have paid Tsh840, 000,000.00 for Ksh 70,000,000.00. By
hedging forward he is assured of the amount he is going to pay in terms of home currency
for the foreign currency needed and hence eliminating the risk of adverse exchange rate
fluctuation

b) Using Money Market Hedge


This technique works different in account payable management from that of account
receivable management. It can be defined as the process of borrowing in the money
markets, converting the funds borrowed at the spot rate into the currency in which
payment is due, and investing in the second country. The total receipts, i.e. principal plus
interest from foreign currency investment are then used to make payment for the goods.
In this case, Winome need to borrow TSH and exchange the amount borrowed at spot
rate so as to get foreign currency for this case KHS and invest it there at Kenyan interest
rate for 90 days. The interest and principle at the end of 90 days will be used to pay Ksh
70,000,000 debt.

127

To know how much to invest in Kenya, it is important to note that the interest amount on
investment plus principal amount should exactly be equal to account payable. This can
easier be determined by discounting Ksh70, 000,000.00 using investment interest rate in
Kenya for 90 days. Using the investment interest rate in Kenya of 2% for three months,
then Winome will need Kenya Shilling equal to:
P=

Ksh70,000,000
= Ksh 68,627,450.98
1.02

To get Ksh 68,627,450.98 now Winome will need to borrow TSH68, 627, 4509.8 and
convert it at the spot rate Tsh10/Ksh.

c) Using Option Hedge


For hedging an account payable, call option is an appropriate type of option to be used.
This option gives the holder a right to buy a foreign currency at a specified exchange rate
called strike price. The currency so bought will be used to pay the debt
The size of option is Ksh 70,000,000
Spot rate Tsh10/Ksh
Strike price

Tsh 7.50

Premium = 20%x10 = Tsh2 per contract


Winome will buy a call option and pay a premium of 2x70, 000,000 = Tsh140, 000,000
If the spot rate in 90 days is less than Tsh8/Ksh, the option will would be allowed to
expire but if is greater than Tsh7.5/Ksh then the call option will be exercised. The total
cost of call option hedge if exercised will be as falls:
Exercise call option 70,000,000x7.5= Tsh 525, 000,000
Add premium paid 2x 70,000,000

= 140,000,000

Total maximum expenses for call option Tshs 665,000,000

128

Therefore, Winome will pay TSH 665,000,000 and receive Ksh 70,000,000. This will be
used to pay the debt.

Illustration 4
Suppose an importer of BMWs is expecting a shipment in 60 days. Suppose that upon
arrival the importer must pay DM150,000. The current spot exchange rate is 1.5 DM/$
thus if the payment were made today it would cost $100,000. Suppose further that the
importer is fearful of a $ depreciation. He doesn't currently have the $100,000 but expects
to earn more than enough in sales over the next two months. If the $ falls in value to, say,
1.4 DM/$ in 60 days time, how much would cost the importer in dollars to purchase the
BMW shipment?
A. The shipment would still cost DM150,000. To find out how much this is in dollars
take DM150,000/ 1.4 DM/$ = $107,143. Note this is more than $7000 more for the cars
simply because the $ value changed.
One way the importer could protect himself against this potential loss is to purchase a
forward contract to buy DM for $ in 60 days. The exchange rate on the forward contract
will likely be different from the current spot exchange rate. In part its value will reflect
market expectations about the degree to which currency values will change in the next
two months. Suppose the current 60-day forward exchange rate is 1.48 DM/$ reflecting
the expectation that the $ value will fall. If the importer purchases a 60-day contract to
buy DM150,000 it will cost him (150,000/1.48) = $101,351. Although this is higher than
what it would cost if the exchange were made today, the importer does not have the cash
available to make the trade today, and the forward contract would protect the importer
from even an even greater $-depreciation.

Reference
Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA

129

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.
Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by
Palgrave MACMILLAN, UK
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003
Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review Questions
1. For instance, a Tanzanian company expect to receive 10mil Kenya shilling three
month from now. The present price of Kenya shilling is Tshs 10.00. Over the three
months the price of Kenya shilling is expected to be Tshs 12.00. In this case, the
Tanzanian company will enter into forward contract with bank to sell Kenya shilling
at exchange rate of Tshs 12.00 per Kenya shilling. At maturity date, the bank will
receive, 10mil Kenya shilling and deliver Tshs 12mil to the Company.
a. What would happen if the actual spot rate at the end of three month would
have been Tsh 20.00/Ksh?
b. The Tanzanian company would still get Tsh12mil and deliver 10mil Kenya
shilling. The forward rate would be used as agreed by the parties.
c. What would happen if there was no agreement between the parties?
In this case, the company would receive 20mil Tanzania shilling in exchange of
10mil Kenya shilling. Actual spot rate would be used.
2. It is now approaching a farming season in most parts of Tanzania. The tractors are
highly demanded particularly in Southern highlands regions. To meet this increasing
demand of tractors, a Tanzanian importer known as Masilingi has just contracted to
buy Massey Ferguson Tractors from UK on 90 days credit, at a price of 1,000,000
(payable in ). Exchange rates published by bank of Tanzania show that on 1st
September, 2005 were Tshs 2000 2005/ and that the exchange rates on 30th
November will be Tshs1999- 2000/. Further information reveals the following
Borrowing rates
UK

14%

Lending rates
10%

130

TZ

7%

4%

Masilingi is very experienced importer and is also knowledgeable on how to


manage exchange rate exposures. Given the exchange rates provided by the Bank
of Tanzania, he decided hedge through leading payment so that to minimize the
amount of TSHS that will be needed to by 1000,000

Required:
How much cash he will require now in order to make payment? If decide to
borrow the amount what will be the total cost after three months?
3.

Exchange traded foreign currency option prices in London for dollar/sterling


contracts are shown below:
Sterling (12,500) contracts
Calls

Puts

Exercise Price

September

December

September

December

1.90

5.55

7.95

0.42

1.95

1.95

2.75

3.85

4.15

3.80

2.00

0.25

1.00

9.40

2.05

0.20

Option price are in cents per . The currency spot exchange rate is $1.9405-$1.9425/.

Required
Assume that you work for a US company that has exported goods to the UK and is due to
receive a payment of 1,625,000 in three months time. It is now the end of June.
Calculate and explain whether your company should hedge its sterling exposure on the
foreign currency option market if the companys treasury believes the spot rate in
3months time will be:
$1.8950-$1.8970/
$2.0240-$2.0260/
4. Explain what is meant by the terms foreign exchange translation exposure,
transactions exposure and economic exposure. What is the significance of these
different types of exposure to financial manager
5. Discuss different methods that can be used to protect against transaction risk

131

6. Widambe is a Tanzania importer of used tractors from UK. The company has
contracted to purchase 30 tractors at a price of 1800. Three months credit is allowed
before payment is due. Widambe currently has no surplus cash, but can not borrow
short term at 2% above bank base rate or invest short term at 2% below base rate in
either the U.K or Tanzania
Exchange rates:
Tsh/
Spot

2000-2020

1 month forward

50-40 premium

3 months forward

60-50 premium

(The premium relates to TSH)

Current bank base rates


Tanzania

10%p.a

UK

5% P.a

Required
(a) Explain and illustrate three policies that Widambe might adopt with respect to
the foreign exchange exposure of this transaction. Recommend which policy
the company should adopt. Assume that interest rates will not change during
the next three month
(b) If the UK supplier were to offer 2.5% discount on the purchase price for
payment within one month, evaluate whether you would alter your
recommendation in (i) above
(c) If annual inflation levels are currently at 2% in UK and 6% in Tanzania, and
the levels move during the next year to 3% in UK and 9% in Tanzania, what
effect are these in inflation like on the relative value of the UK and TSH
(d) Discuss the advantages and disadvantages to a company of invoicing an
export sale in a foreign currency.

132

CHAPTER 6
INTEREST RATE RISK MANAGEMENT
6.1

Introduction

Interest rate volatility has increased significantly in the international capital market.
Firms both small and larger have become very sensitive to interest rate movements.
Interest risks have significant impact on the expected interest revenue or payments of the
firm. The risk arises because net interest income is likely to be different from the interest
liabilities. As such firms need to manage the risks that may occur as the result of interest
rate changes. Various techniques can be used to manage interest rate risk. Swap is one of
the hedging techniques.

6.2

SWAPS

A swap is defined as an agreement between two (or more) parties to exchange cash flows
related to specific underlying obligations. In other words it can be said that a swap is an
exchange of one stream of future cash flows for another stream of future cash flows with
different characteristics. For instance, one can agree to swap payments of fixed rate
interest on an agreed sum for a fixed period for payments on a floating rate basis.
There are two basic types of swaps:

Interest rate swaps

Currency swap

6.2.1

Interest Rate Swap

An interest rate swap is a contract between two parties to exchange one stream of interest
rate payments for another. It involves the exchange of interest rate streams, not an
exchange of principal. Interest rate swaps are conducted in a single currency.

133

Illustration 1
Lupembe plc prefers to raise a 4 million capital through issuing debt security which has
fixed interest rate. Because the company is currently facing poor credit rating than used
to be, the managing director Mwakitwange considers a debenture issue to be out of the
question and the best fixed interest rate loan it can secure given the present reputation is
at 12.5% p.a. Lupembe can also borrow the variable rate of LIBOR (London Inter-Bank
Offered Rate)+0.5%. Lwasenga Plc is also a famous company managed by Mharuka. The
manager is indenting to borrow 4million to expand the business operation in
Scandinavia countries. The manager prefers to raise capital through floating rate (variable
rate) loan LIBOR. However, he can also borrow by issuing debenture at a fixed rate of
11%.
The managers of the two companies arrange a swap to fulfil their desires. Lupembe plc
agrees to pay Lwasenga a fixed interest rate of 113/4 on 4 million and Lwasenga agrees
to pay Lupembe an interest of LIBOR (variable) on the same amount of loan.

Required:
Show how the two companies can implement swap transaction and determine the savings
that can be achieved.

Solution:
If the companies arrange the swap, the following steps must be taken.

Lupembe plc borrows 4 million at variable rate of LIBOR + 0.5%

Lwasenga borrow 4 million at the fixed rate of 11%

Lupembe plc agrees to pay Lwasenga a fixed interest rate of 113/4% on 4 million
and Lwasenga agrees to pay Lupembe an interest of LIBOR (variable) on the same
amount of loan.

The net financing to each party of the swap transaction will be as follows:

134

Lupembe plc
Interest payable on borrowing (variable rate loan)

LIBOR + 0.5%

Interest received from Lwasenga

LIBOR

Total cost

0.5%

Interest payment to Lwasenga (paid on behalf of Lwasenga)

11.75%

Net cost

121/4 (fixed)

Lwasenga plc
Interest on borrowing (payable on fixed loan)

11%

Less: Interest received from Lupembe

113/4

Total cost

()

Add: Interest payment to Lwasenga

LIBOR

Net cost

LIBOR-3/4%

(variable)

Savings for each party


Lupembe if there would be no swap arrangement could have paid an interest on fixed
loan at 12.5%, now with swap arrangements pays an interest on loan at 121/4%. This
leads a saving of %, thats (12.5%- 12.25%)
However, Lwasenga could have paid LIBOR on variable loan if no swap arrangement.
With swap arrangement pays on LIBOR-3/4, making a saving of % thats LIBOR(LIBOR-3/4)

Illustration 2
Chakwale plc can borrow for six months at a fixed interest rate of 10% and at a floating
rate of LIBOR + 3/8%. Pakwale plc has a lower credit rating and can only borrow at a
fixed interest rate of 11.5% and a floating rate of LIBO + 1%

135

Required:
Evaluate, showing relevant swap transactions, whether it is possible for both companies
to benefit from a six-month interest rate swap on loans of 10 million.

Solution:
Chakwale

Pakwale

Fixed rate

10%

11.5%

1.5%

Floating rate

LIBOR+3/8%

LIBOR +1%

5/8%

Differences (gain by Chakwale)

Relative advantage

0.875%

If the gain is shared equally, then Pakwale is cost of 11.5% that has to be paid to
Chakwale on behalf will be reduce by that share of gain which is 0.875/2= 0.4375%.
Therefore, Pakwale will pay fixed rate on behalf of Chakwale at 11.0625% (11.5-0.4375)
In this case Chakwale has relative advantage in both floating and fixed rates; however it
will borrow in fixed rate, which offer it greater relative advantages And Pakwale will
borrow at floating rate.
Swap transaction will be as follows:

Chakwale borrow fixed rate at 10%

Pakwale borrows variable interest rate at LIBOR + 1%

Chakwale pays Pakwale floating rate interest at LIBOR +1

Pakwale pays Chakwale fixed rate interest at 11.0625%

136

Chakwale
Interest paid on loan (fixed)

(10%)

Interest received (paid by Pakwale on its behalf)

11.0625%

Interest gained

1.0625%

Interest paid on Swap


Overall cost

LIBOR+1%
LIBOR 0.0625

Average saving 0.4375%. An arbitrage saving of 0.4375% on 10 million for six months
is 21,875 for each company

Pakwale
Interest paid on loan

LIBOR + 1%

Interest received (paid by Chakwale on behalf)

LIBOR + 1%

Net cost

0%

Interest paid

11.0625%

Overall cost

11.0625%

Arbitrage saving 0.4375%

Illustration 3
International Oil plc is interested in raising 100 million in order to carry out further oil
exploitation. International oil is an AA-rated company and, as such can borrow for six
months at a fixed rate of 12% or a floating rate of LIBOR +30 basis points
London property Ltd has a lower credit rating, and wishes to raise a similar sum for
investment in the housing market. London property can only borrow at a fixed interest
rate of 14% and a floating rate of LIBOR + 80 basis points. Security Pacific Bank has
been recommended as the best continuous swap managers and the keenest on prices. For
arranging a swap, a fee of 50,000 is payable by each party.

Required:
Show how the parties can benefit from the swap arrangement?

137

Solution:
First determine the comparative advantages
International Oil
Fixed rate

London Property

12%

Floating rate LIBOR + 0.3%

Comparative advantage

14%

2%

LIBOR + 0.8%

0.5%

From above computation, it can be observed that International Oil is better to borrow at
the fixed rate and London Property to borrow at a floating rate. However, it can be
observed that International Oil has relative comparative advantage in both floating and
fixed rates. The difference of comparative advantage is a net gain that can be enjoyed by
International Oil from the swap. This is equal to 1.5% thats (2%-0.5%). Now if this gain
is shared equally, then each company would benefit at 0.75%, thats 1.5/2= 0.75%
In this case London Property would require to pay a fixed rate less of a gain, thats 14%0.75 = 13.25% on behalf of International Oil
Therefore, the swap transaction will be as follows:
International Oil borrows at the fixed rate of 12%
London Property borrows at the floating rate of LIBOR + 80 basis points
International Oil pays London LIBOR + 80 basis points
London Property pays International Oil fixed rate of 13.25%
International Oil London Property
Interest paid on borrowing

(12%)

(LIBOR + 0.8%)

Interest received on swap

13.25%

LIBOR + 0.8%

1.25%

0%

Paid in swap

LIBOR +0.8%

13.25%

Overall cost(paid in swap-net benefit)

LIBOR -0.45%

13.25%

Net cost or benefit

138

In other words, the overall cost for International Oil would be equal to amount that is
required to be paid on floating if no swap arrangement less benefit that can be arrived on
swap arrangement. For this case, overall cost o would be equal to LIBOR + 0.3% - 0.75%
This gives the cost to LIBOR-0.45%. Similarly, for London property, the overall cost if
borrows fixed cost on swap will be equal to cost without swap less gain on swap. Thats
14%- 0.75% = 13.25%
Savings from undertaking swap can be calculated as follows:
Overall cost after swap cost that could be paid if swap could not be taken

For International Oil


Saving = LIBOR -0.45 %-( LIBOR+0.3%)
=LIBOR 0.45%-LIBOR-0.3%
= -0.75%, thats the cost is reduced by 0.75%, which in other words can be said to
be the benefit realised from the swap transaction.

For London Property


Saving = 13.25 %-14%
= -0.75%, thats the cost is reduced by 0.75%, which in other words can be
denoted as the benefit realised from the swap transaction

Illustration 4
Consider XYZ plc, a manufacturing firm which wants to raise $100 million a 5-year
fixed rate dollar funding to finance an expansion project. Its credit rating is not very high,
say BBB. It finds that it will have to pay 2% over 5-year treasury notes which are
currently yielding 9%. In the floating rate market it can issue 5-year FRNs at a margin of
0.75% over the prime rate. On the other hand, ABC inc., a large bank looking for floating
rate funding finds that it will have to pay prime rate while in the fixed rate market it can
raise 5-year funds at 50 base points (bp) or 0.50% above T-notes due to its AAA rating

139

for the loan of $100 million. Thus the spread demanded by the market between an AAA
and a BBB credit is 150%bp in the fixed rate segment while it is only 75 bp in the
floating rate segment. This differential is known as quality spread differential (QSD).

Required:
Show the swap transaction can be implemented and determine the benefits that can be
derived from the transaction.

Solution:
The requirements and access of the two parties are summarised below:
XYZ

ABC

Requirement

Fixed Rate $

Floating Rate $

Differences

Cost Fixed $

11%

9.5%

1.5%

Cost Floating $

Prime + 0.75%

Prime

0.75%

Benefit on swap is equal to different in differences 1.5%-0.75% = 0.75%


From the above, the bank ABC has an absolute advantage over the XYZ plc in both the
markets but the company has comparative advantage in the floating rate market. Both can
achieve cost saving by each borrowing in the market where it has a comparative
advantage and then doing a fixed-to-floating interest rate swap
Therefore, the terms of the swap arranged by a swap bank can be as follows:

ABC borrows $100 million at 9.5% s.a fixed. XYZ borrows $100 million floating at
prime + 0.75

ABC pays the swap bank (Prime 0.25%) on $100 million every six months. The
swap bank passes this on to XYZ. And then XYZ pays the swap bank 9.75% s.a
(thats 9.5 plus the profit element of 0.25 or cost attributable to swap bank) 0n $100
million. The swap bank pays ABC 9.5% (Thats retain part of profit element paid by
XYZ of 0.25 attributable to swap bank)

140

Note that the profits realised of 0.75% is shared equally to the three parties of the
transaction. Thats XYZ, ABC and Swap bank. Each gets 25%, thats 0.75%/3
Therefore, the overall cost for XYZ on borrowing fixed late and arranging swap would
be; Cost that could be paid if no swaps less benefit on swap. Thats 11% -0.25 = 10.75%
The overall cost for ABC for borrowing floating and arranging swap with XYZ through
swap bank would be equal to cost of floating if no swap less benefit on swap. Thats to
say Prime-0.25%

6.2.2

Currency Swap

A currency swap is a contract between two parties to exchange payments denominated in


one currency for payments denominated in another.
In a currency swap, the two payment streams being exchanged are denominated in two
different currencies. Usually, an exchange of principal amounts at the beginning and a reexchange at termination are also a feature of a currency swap.
Currency swap can be fixed-to-fixed currency swap , floating to floating swap or a fixedto floating currency swap
A typical fixed-to-fixed currency swap works as follows:
One party raises a fixed rate liability in currency X say US$ while the other raises fixed
rate funding in currency Y say TSH. The principal amounts are exchanged, where first
party gets TSH and the second party takes US$. However, the first party markets periodic
TSH payment and the second party markets a periodic payment of US$ against interest
rate in each respective country. At the maturity, the principal
The floating to-floating currency swap will have both payments at floating rate but in
different currencies
A fixed-to-floating currency swap is a combination of a fixed-to-fixed currency swap and
a fixed-to- floating interest rate swap. In this type of swap, one payment stream is at fixed
rate in currency X while the other is at a floating rate in currency Y

141

Illustration 5
Kalumanzila plc, a UK company, wishes to hedge a one-year foreign exchange risk on an
investment in Chile. The company has been offered a currency swap by a Chilean bank as
a possible alternative to conventional hedging. The foreign investment is for 800 million
escudos and is expected to yield an after-tax return of 35% for the year. The bank has
offered a currency swap at the rate of 22 escudos/, with the bank making interest
payments of 4% to the UK company in pounds.
The current spot rates are:
28.000escoudos/
1.51600US dollars/
18.46965/US$
Interest rates are:
Borrowing

Lending

UK

15%

12%

Chile

N/A

25%

Show how the company can use of currency swap to hedge against risk

Possible scenarios

Do not hedge. If no hedge is done, the investment will require 800 million escudos at
28escoudo/. This will give a total of 28,571,429. If the loan is financed through UK
borrowing, the interest cost will be:

28,571,429 at 15%= 4,285,714

Currency swap: If the currency swap is used, the amount of pound required to get
escudo 800 million will be: 800million at 22 escudos/ = 36,363,636

If financed by UK borrowing the interest cost is: 36,363,636 at 15% = 5,454,545

142

Interest received is: 36,363,636 at 4%

= 1,454,545

Total cost 4,000,000 thats (5,454,545- 1,454,545). This is a gain over not hedging of
285,714

6.2.3

Benefits Of Swaps

Swaps offer many potential benefits to companies including:

The ability to obtain cheaper fianc than would be possible by borrowing directly in
the relevant market

The opportunity to restructure the companys capital profile without physically


redeeming debt or raising new debt. For example, the proportion of debt on which
fixed and floating rate interest is paid can be altered without incurring expensive
transactions costs associated with redemption or new issues

Access to markets in which it is impossible to borrow directly. For instance,


companies with relatively low credit rating might not be able to borrow directly in
some fixed rate markets, but can arrange fixed rate debt servicing through swaps.

Used in long term hedging. swaps can be arranged for periods of up to 10years

Hedging against foreign exchange risk. Currency swaps are especially useful in less
developed countries with volatile exchanges rates and exchange controls.

6.3

Interest Rate Movement

As in foreign exchange exposure management, the firm cannot undertake informed


management or hedge strategies without forming expectation about the direction and
volatility of interest rate movements. Normally forecasting of interest rate begins with the
markets own implied forecast the series or strip of forward interest rates.
Forward interest rates, also called forward spot rates, are interest rates for specified time
periods beginning at future dates

143

6.3.1

Selection of the Appropriate Tool or Technique

Once management has formed expectations about future interest rate level, it must choose
the appropriate instrument or technique for managing the exposure. Various techniques
can be used. The following are some of techniques:

Forward rate agreement (FRA)

Interest rate Caps

Interest Rate Floor

Interest Rate Collar

Interest rate caps, Interest rate floor and Interest rate collar are interest rate options that
traded or written over the counter.

6.3.1.1 Forward Rate Agreement (FRA)


A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest
rate payments on a notional principal.

These contracts are settled in cash.

The buyer of an FRA obtains the right to effectively lock in an interest for a desired
term that begins at a future date.

In case of increase in interest rate expenses, the seller of the FRA will pay the buyer
increased interest expense on a nominal sum (notional principal) of money if interest
rates rise above the agreed rate

Forward rate agreements are purchased when a firm intends to borrow in the future or
faces a variable rate interest payment in the future, but expects interest rates to rise.
However, a firm planning to invest funds at a future date, but fearing a fall in market
interest rates, can purchase a FRA to lock in an investment rate that will be used in
future.

144

Illustration 6
Assume the agreed rate is 7.5% per annum on $, 2000,000, with 91 days in the threemonth period. Three months from now, at the beginning of the FRA period, the actual
three-month rate is 9%. Because the actual rate of 9% is above the agreed rate of 7.5%,
the firm that purchased the FRA (the holder) will receive from the seller of the FRA the
difference in the interest expenses. Therefore, the seller will repay:
n

Repayment amount = P (r1t r0 )x


360

91
$2,000,000x ( (0.09 0.075)x
= $7,583.33
360

Where P= the principle amount

r1 = the current interest rate


r0 = the spot interest rate

Because the differential cash flow of the FRA is settled at the beginning of the three
month period (and not at the end of as in a normal interest payment), the cash flow must
be discounted back the three months of the FRA period. The actual rate of 9% is used as
the discounting factor

$7,583.33
= $7,414.65 . Therefore, the actual payment to the buyer FRA is

91
1 + 0.900 x 360


therefore $7,414.65
The impact on the firms borrowing costs can be seen by isolating the various actual
interest and FRA cash flows. The interest expense, independent of the FRA, payable at
the end of the six-month period is
91

$2000,000 x 0.9 x
= $45,500.00
360

145

Therefore, net payment would be $37,916.67 thats:


Interest payment on borrowing

$45,500.00

Less interest received on compensation

$ 7,583.33

Net payment

$37,916.67

The firm locked in borrowing rate by entering forward rate of 7.5% per annum,
$37,196.67 on $2,000,000

6.3.1.2 Interest Rate Caps


It is an option to fix a ceiling or maximum short-term interest rate payment. The buyer of
the Cap will receive a cash payment as a compensation for the raise of market interest
above the agreed rate (strike rate). The amount to be received as compensation is equal to
the difference between the actual market interest rates and the Cap strike rate on the
notional principal (the amount of loan or amount hedged).
For the right the buyer receives from the seller of the Interest Rate Cap, the buyer pays an
upfront amount called premium. The premium here is stated as annual percentage
consistent with that of the strike rate
The cap is excised if and only if the market interest rate on the predetermined date is
greater than the strike rate. In this situation the buyer will be compensated the differences
by the seller of the cap.
The buyer of the Cap will be pay Interest on the principal amount using the market
interest rate, and if that rate is higher than the strike rate, then he/she will be compensated
by the difference amount.
The interest payment is computed as follows:

Interest payment =

p r x

360

Where,

146

P is notional principal
r is market interest rate
n is number of days in a contract
Received cap cash Flow: Thats amount to be compensated in case the market interest
rate is higher than strike interest rate is given by:

(
)
P
r

r
x
0
Received Cap Cash Flow =
1
360

Whereby,
P = notional principal

r1 = market interest rate


r0 = Strike Interest Cap
n = number of days in a contract

6.3.1.2.1

Cap Premium Payment

It is normally paid at the date of the transaction. It is a single lump sum payment which is
paid at the beginning of the contract. This payment should also be annualised in order to
determine the total cost of the capped payment. This amount is added to the Interest cap
amount paid. The annualised cap premium is determined as follows:
Period Payment =

Present Value
1

1

t
r r x (1 + r )

Where,
Present value is the current loan amount
t is the number of periods

147

r is the rate of interest per period

Illustration 7
Makauki is a famous dealer in Political Science books. He normally buys the books from
US and sells them in Tanzania where the demand has proved to be very high as the
education system in a country is encouraging political Science education. The numbers of
secondary schools have increased drastically and Makauki has projected the drastic
increase in demand for the books. Kamanyola, her marketing advisor has advised him to
increase the order for the books. To meet this order, Makauki borrows $10,000,000 and
buys Interest rate Cap to protect against interest rate fluctuation risk. Thats decides to
lock the interest rate that he will pay on the loan.
The bank ha provided the following information to the customer:
Maturity:

3 Years

Strike rate

10%

Reference rate:

3-mont U.S dollar LIBOR

Total Periods:

12 (4 periods per year for 3 years)

Premium:

10basis point (or 0.1%)

Fixed borrowing rate: 12%


Further information reveals that, the three month LIBOR rate (reference rate) will rise
above the strike rate to 12%

Required:
Determine the total cost of the cap that will be incurred by Makauki.

148

Solution
The value of this type of cap option comprises of the three elements of values. These
values need to be determined so as to reach to a total cost or value of the cap. The
following are elements of values:
The actual Interest rate payments on the loan. This is the obligation of the buyer of the
cap. In any case, the buyer is responsible to pay interest on the notional principal basing
on the market interest rate.
Therefore, for the three months period of actual 90 days:

Interest payment

p rx

360

$10,000,000 x 0.12 x
=

90
360

$300,000

Since the three month LIBOR rate has risen above the cap rate on the rest date, the cap is
activated and the buyer of the cap receives a cash payment from the seller equal to the
difference between the actual three-month LOBOR rate and the cap rate (strike rate).
Therefore,

The received cap cash Flow

P
(
r

r
)
x
0
=
1
360

90

= $10,000,000 x (0.12 - 0.1)x


360

= $50,000

So, Makauki will receive a compensation of $50,000 from the seller of the interest cap.
This will reduce the amount of interest paid on loan.

149

6.3.1.2.2

Amortized Cap Premium Payment

The upfront amount paid for the right and protection received from the seller of the cap
should be amortized over the 12 reset periods.
Therefore, quarterly premium will be equal to:
Period Payment =

Present Value
1

1

t
r r x (1 + r )
0.1%
1

12
0.03 0.03 x (1 + 0.03)

0 .1 %
33.33 23.38

0.001
9.95

=0.01% on quarterly bases and 0.04% on annually basis


The premium amount will then be $1000 per quarter
Note. Borrowing rate is 12% per year, for a quarter will be 3%, (12/4)
Therefore, the total or All-in-cost will determined as follows:
Cap component

Annualised interest cost

Quarterly cash payment

Interest payment outflow

12%

$300,000

Cap cash payment inflow

(12%-10%)= 2%

-$50,000

Cap Premium payment

0.04%

$1000

10.04

$250,000

Total or All-in-cost

150

Effective cost = $300,000- 50,000


= $250,000

6.3.1.3 Interest Rate Floor Valuation


Interest rate floor is equivalent to put option on an interest rate. A floor guarantees the
buyer of the floor option a minimum interest rate to be received for a specified
reinvestment period or series of periods. An investor who have money to invest and fears
that the interest rate on investment in future will drop, then he/she may purchase floor.
This will guarantee the investor the minimum effective rate investment.
It should be understood that, normally investors would prefer to invest when interest rate
is higher. A such in case at the maturity date the actual market rate is less than the strike
rate, then the buyer will be compensated by the seller (writer) the differences in form of
cash settlement.

Illustration 8
Mdotta & Kitove plc is a famous gambler in Tanzania. It is recently the company has
received enormous amount to the tune of US$10,000,000 resulting from its gambling
activities. The managing director of the company Mr. Mikosi had no plan before of how
the money if the company win a gamble would be used. Mr Mikosi approaches the
experienced investor Mr. Bahati to seek for the advice. Thank Mr. Bahati is not selfish,
he advised Mr. Mikosi to invest the money in a very paying investment portfolio. They
agreed, but the fear remains of the expected drop of interest rate on investment. This was
decided to buy an interest rate floor. The following information also pattern to the this
hedging strategy.
Maturity:

2 Years

Strike rate

10%

Reference rate:

6-month U.S dollar LIBOR

Total Periods:

4 (2 periods per year for 2 years)

151

Floor Premium:

10 basis point (or 0.1%)

Fixed borrowing rate: 12%


Further information reveals that, at end of the three month LIBOR rate (reference rate)
dropped below the strike rate to 5%

Required:
Determine the total yield of the floor option

Solution:

Interest payment/Yield

p r x

360

Where;
P

= $10,000,000

= 5%

= 180

Interest payment/Yield = $10,000,000 x 0.05 x

180
360

=$250,000
Floor cash payment inflow

The received cap cash Flow

P
(
r

r
)
x
1
0
=

360

180

= $10,000,000 x (0.1 - 0.05)x


360

= $250,000

152

Amortized Floor Premium payment


:
Periodic payment =

Present Value
1

1

t
r r x (1 + r )
0.1%

4
0.06 0.06 x (1 + 0.06 )

0 .1 %
16.67 13.20

0.001
3.47

= 0.029% on semi annual basis and 0.058% on annual basis


Premium paid semi annual will be $2,900
Therefore, the total Yield of the floor will determined as follows:
Floor component
1

Interest payment inflow

Floor cash payment inflow

Floor Premium payment outflow


Total Yield or All-in-Yield

Annualised interest cost

Semi annual cash Flow

5%

$250,000

(10%-5%)= 5%

$250,000

0.058%

-$2,900

10.04

$497,100

6.3.1.4 Interest Rate Collars


This is a simultaneous purchase (sale) of a cap and sale (purchase) of a floor. By
simultaneous buying and selling of the cap and floor enables investors to earn premium

153

from sale of one side to cover in part or in full the premium expenses of purchasing the
other of the collar. If the two premiums are equal, the position is usually called a zero
premium collar. This hedging strategy allows investors to retain some of the benefits of
declining rates while removing the unpleasantness of paying an up-front option premium
for the cap.
An interest rate collar is an arrangement under which a corporate user Buys an interest
rate cap from bank, and sells an interest rate floor to the bank

6.4 Swaptions
A swaption gives the firm the right but not obligation to enter into swap on a
predetermined notional principle at some defined future date at a specified strike rate.
The holder of swaption will exercise it when the rate rise above the strike rate, otherwise,
the holder may leave it unexercised and take advantage of lower rate environment
If swaption is valuable, buyer may require seller to enter into an interest rate swap in
which,

Buyer pays fixed rate (and receives floating rate)

Buyer pays floating rate (and receives fixed rate

6.4.1

Uses of Swaptions

Swaptions are used mostly in tender scenarios where:

The tender will be awarded at some future date

Investor will have to borrow larger amounts of funds for a larger period of time

To protect against future rate movement

154

Reference
Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA
Demirag, I and Goddard, S (1994), Financial Management for International Business.
McGraw-Hill International UK
Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.
Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by
Palgrave MACMILLAN, UK
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003
Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

155

Review Question
1. William Copson has just purchased the following interest rate cap agreement which
he believe is the best hedging strategy for his loan portfolio of $ 250,000,000.
Maturity:

2 Years

Strike rate

10%

Reference rate:

6-month U.S dollar LIBOR

Total Periods:
Floor Premium:

4 (2 periods per year for 2 years)


10 basis point (or 0.1%)

Fixed borrowing rate:

10%

Further information reveals that, at end of the three month LIBOR rate (reference
rate) rose to 15%

Required:
Determine annualised interest cost and semi-annual cash payment by filling the
following table
Cap component

annualised interest cost

semi-annual cash payment

Interest rate outflow

Cap cash payment inflow

Cap premium payment outflow

Total Cost or All-in cost

2. The Kampaboy is highly in need of fund to establish a wooded furniture workshop.


The money needed amounts to Tsh 1,000,000,000, that he think may be borrowed fro
the bank in 90 days. The Kampaboy can access the floating market at the interest
bank plus 3%. The loan will have a maturity of 180 days, at which time all of the
interest and principal will be repaid. To hedge the uncertainty of future rate,
Kampaboy purchases a cap at 15% for a premium of 20 basis points. The current
inter-bank borrowing rate is 10%

Required
Determine the amount Kampaboy will payback for both future interbank rates of 8%
and 12%.

156

3. The PACHA is a building company specialised in road and complex building


construction. By the nature of its activities and the volume deals it wins, the company
is required by law, to hold a minimum percentage of its assets in highly liquid interest
deposit of 360 days maturity or less. Because of the recent continuing decline in the
market interest rates, PACHA has purchased a floor agreement for the entirely of its
money market portfolio of $ 36, billion. The following information relates also to this
heading strategy
Maturity:

2 Years

Strike rate

6%

Reference rate:

6-month U.S dollar LIBOR

Total Periods:
Floor Premium:

4 (2 periods per year for 2 years)


105 basis point

Fixed borrowing rate:

10%

Further information reveals that, at end of the three month LIBOR rate (reference
rate) dropped to 5%

Required:
Determine annualised interest yield and semi-annual cash Flows by filling the
following table
Floor component

Annualised interest yield

semi-annual cash Flow

Interest rate Payment inflow

Floor cash payment inflow

Floor premium outflow

Total Yield or All-in Yield

4. AIKA Company limited has taken on a floating loan to fianc new project. The
financing bank is worried about the impact on the project performance if inter-bank
rate raise above 8%. At the same time the bank is ready to forgo the benefit of 3
months inter-bank rate falling below 5%. CRDB Bank is ready to write AIKA
company a cap at a premium cost of 4% flat for a period of 5 years. AIKA company
sales a 5% 5 years floor on 3 month inter-bank rate at a premium of 2%

157

Required
What would be the adjusted inter-bank rate in the above question. What is the
effective price of a collar?
5. Mapatano Company is tendering for the $ 60 million contract for a 3 years project on
which it is budgeted interest cost must not exceed 7%. The current 3-year swap rate is
6%. The contract will be awarded in three months time. Mapatano buys a three year
7% payers swaption which is execrable in 3 months time at a premium of 0.35% flat

Required
With example illustrate what would happen to Mapatano if the company wins the
tender or loose the tender.
6. Makwesa the managing director of Concern limited company intends to reduce the
interest expenses of the company on $600 million floating rate loan based on a 3
months inter-bank rate for a year at a level of 12%. The loan next re-fixed on 30th
June 2002. The Santego bank writes an interest cap at a premium of 15basis point to
Makwesa.

Required
What would happen to the concerns position if the inter-bank rate re-fixed at a level
above or below 12% on 30th June 2005?
7. Winome and PACHA Corporations both seek funding at the lowest possible cost.
They face the following rate structure:

Credit rating
Cost of fixed-rate borrowing
Cost of floating-rate borrowing

Winome

PACHA

AA

BB

10.0%

13.0%

LIBOR+ 0.5%

LIBOR+1.0%

Required:
a. In what type of borrowing does Winome have a comparative advantage?
b. In what type of borrowing does PACHA have a comparative advantage? Why?
c. If a swap were arranged, what is the maximum savings that could be divided between
the two parties?

158

d. Illustrate a transaction that would generate such a savings divided equally between
the two firms
8. Lankee plc would like to borrow floating-rate dollars, which it can do at
LIBOR+0.5%. It can also borrow fixed-rate Sterling pound at 6%. Sokomoko plc has
a strong preference for fixed-rated sterling pound debt, which will cost it 7%.
Sokomoko could borrow floating dollars at LIBOR + 1%

Required
State the possible range of savings to Lankee plc from engaging in a combined
interest and currency swap with Sokomoko.

159

CHAPTER 7
MULTINATIONAL CAPITAL BUDGETING
7.1 Introduction
The globalisation process has enabled most of large $2,900making direct foreign
investment is not an easier task; critical evaluation of multinational project proposals
requires to be made before the fund is committed. This process is called Multinational
capital budgeting analysis. Through this process, MNCs would be able to decide whether
or not to invest. Thus Capital budgeting is necessary for all long term projects that
deserve consideration. Multinational capital budgeting focuses on the cash inflows and
cash outflows associated with prospective long term investment project. Cash inflows
are expected revenues that are generated by a projects and cash outflows are expected
expenses for running a projects including initial capital investment.

7.2 Evaluation of MN Projects for capital budgeting


The evaluation of MN projects is similar to the evaluation of a domestic one. NPV or
IRR can be used for evaluation. The project which yields positive NPV or higher required
rate of return is selected. However, to be able to evaluate a project or an investment,
various steps need to be followed. The following are the basic steps in Multinational
capital budgeting.

Identify the initial capital invested or put at risk

Estimate cash flows to be derived from the project overtime including an estimate of
the terminal or salvage value of the investment

Identify the appropriate discounting rate for determining the present value of the
expected cash flows

Apply traditional capital budgeting decision criteria. Such as NPV, IRR, or modified
internal rate of return (MIRR) to determine the acceptability of, or priority ranking of,
potential projects.

160

7.3 Data Needed for Multinational Capital Budgeting:


Capital budgeting requires various inputs. Those inputs have influence on the net
expected cash flows and on the decision criteria (such as NPV/IRR) of the projects. For
that reason they need to be incorporated in the budgeting processes so that to arrive at
correct net cash flow and decision criteria. The following are the most important data in
the capital budgeting:

Cash flows i.e. revenues (both Price per unit and Quantities); Costs, including
variable costs and fixed costs; and initial investment

The duration of a project or project life time (the time period a project is expected to
take to be accomplished)

Salvage Value. The value of a project remaining after the end of the project. This can
be value of plants and other equipments. If these salvages are disposed off, then adds
to the cash inflow of the project. However, salvage value is not taxable, and does not
form part of the revenue subject to withhold tax. Therefore it is added to after tax
profit of the project for the parent perspective.

Depreciation. This refers to the allocation of the cost of an asset to expense in the
periods in which services are received from the asset. This is non-cash item, but it is
included in the expense list to arrive at after tax earnings of subsidiary. When the
subsidiary remit fund to the parent company, this element of depreciation is added
back to after tax earnings of subsidiary to get net cash flow to be remitted to
subsidiary.

Taxes. This is a tax imposed by parent companys government on revenue received


from subsidiary company. Where there is an agreement that the tax should not be
double taxed, then it will be charged by host government or parent companys
government but not both. The rate of tax should be known and taken into account
when making capital budgeting for multinational projects

Exchange Rates. Exchange rates never stable and this has significant impact to the
expected cash flows of a project. When a subsidiary transfer fund to the parent
161

company, it has to convert it into the reporting currency of the parent company using
the prevailing exchange rates for each year in case the company did not hedge the
expected cash flows

Required Rate of Return (k). This is the rate of return at which the project requires in
order to be carried out. It is the rate which project needs to be compensated for the
inverted capital. It reflects the rate of revenue generated which find its way to the
project. Once the relevant cash flows of a proposed project are estimated, they can be
discounted at the projects required rate of return.

Restrictions to cash Outflows. This refers to the host government imposing restriction
from the subsidiary remitting all the revenue earned there to the parent companys
country. The host government restrict transfers of all revenue through imposing
certain percentage as withhold tax on revenue generated. Normally withhold revenue
is deducted from subsidiary total cash inflow before convention to the parent
company reporting currency is done.

7.4 Should Capital Budget Base on Subsidiary or Parent Perspective?


The decision of whether to invest or not particularly in multinational projects is very
difficult. The decision whether capital budgeting for multinational projects be conducted
from the view point of the subsidiary or parent should be made. Mangers face dilemma in
this matter. The dilemma arises because each approach produces different results. A
project can be profitable from the subsidiary perspective but not from the parent
perspective

Illustration 1
PACHA is UK Firms Subsidiary in US. The following information pattern relates to the
PACHA subsidiary.
Initial investment

$ 480,000

Annual cash

$ 350,000

Corporate tax:US

None

162

UK

25%

Required rate of return

18%

Exchange rate:
Year 0

Year 1

Year 2

0.50\ $

0.52\ $

0.54\ $

Compute NPV in both subsidiary and parent perspectives

Solution:
From the Subsidiary Perspective (Decentralised approach)
Year 0

Year 1

Year 2

Annual cash flows

-480,000

350,000

350,000

Discounting factor

0.8475

0.7182

PV of cash flows

-480,000

296610

251365

Therefore NPV

= -480,000+296610+251365
=

$67975.

It is positive NPV; hence accept the project basing on subsidiary perspectives

From the Parent Perspective (Centralised approach)

In this case, the currency should be translated or converted into the currency used by
parent Company.

Subsidiary will withhold tax. So cash flow remitted should be deducted withhold tax.
The amount remitted will be converted into parent Currency to get cash flows.

Compute PV of Cash flows

Compute NPV. Note! the discounting factor will be as in case one above

163

Year 0

Year 1

Year 2

-480,000

350,000

350,000

(35,000)

(35,000)

Remitted fund in $

- 480,000

315,000

315,000

Convert into :

0.50\ $

0.52\ $

0.54\ $

Cash flow in

-240,000

163,800

170,100

1.0000

0.8475

0.7182

-240,000

104110

91622

Cash flows
Less: with hold tax 10%

Discounting Factors
PV
NPV

-44268

The NPV to subsidiary Company is positive, but the NPV to Parent Company is negative,
hence the project will not be accepted because it does not add cash flow to the Parent
company.

7.5 Cash flows Difference between the Parent and the Subsidiary
There are various factors that may lead the after tax cash inflow of subsidiary to differ
from those of parent Company. The following factors are fundamental:

7.5.1

Tax Differentials

If the parents government imposes a high tax rate on the remitted funds, the project may
be feasible from the subsidiarys point of view, but not from the parents point of view.
Under such situation, the parent should not consider financing a project even though it
appears feasible from the subsidiarys perspectives.

7.5.2

Restricted Remittances

Some country may restrict a certain percentage of subsidiary earnings from being sent to
the parent company. Since the parent may never have access to such funds, the project is
not attractive to parent.

164

7.5.3

Excessive Remittances

If parent charge high administrative fee to subsidiary, the subsidiary may appear to have
law earnings and parents may appear to have high earnings due to administrative charge
being cost or expenses to subsidiary and revenue to parents. Considering the parent view
point the project will be accepted, but if we base on subsidiary point of view, there is
danger of rejecting the project.

7.5.4

Exchange Rate Movement

Where earnings are remitted to the parent, they are normally converted from the
subsidiarys local currency to the parents currency. The amount of funds received by the
parent is therefore influenced by the existing exchange rate.
Because of such differences in NPVs between parents and subsidiary, greater care in this
point is needed as there is possibility of rejecting a project thinking that it is not profitable
while not or accepting non-profit making projects.
To avoid some confusion in multinational capital budgeting, an overseas capital project
may be looked at from at least two standpoints.

Incremental project cash flows. This is concerned with foreign currency cash flows.

Incremental parent cash flows. This means cash flows which may find their way back
to the parent.

That is to say, a foreign project should be judged on its net present value from the view
point of funds that can be freely remitted to the parent. The capital budgeting should be
made in view of parent other than in subsidiary, because the parent is one which finances
the project, and also because subsidiary is subset of parent company. The cash flows to
the parent is important because it helps the parent Company:

For paying dividends to the stockholders

For reinvestment else where in the world

For repayment of corporate debt act


165

7.6 The Use of Risk Free Rate Of Interest In Capital Budgeting


In case there is a risk free rate of interest, then for capital budgeting purposes:

The expected change in spot rates should be determined.

The expected change will be used to estimate the future spot rate

The expected change is considered as annual rate of depreciation or inflation in parent


currency.

To determine the spot rate in each following year, use the following formula

(1 + i )
Expected spot rate (e ) =

(1 + i )

present spot rate (e 0 )

Illustration 2
UK Company establishing a Subsidiary in US
Post tax nominal cash flows are:
Year 0

Year 1

Year 2

Year 3

Year 4

Cash flows in $

- 5,000

1200

1900

25000

2500

Current Spot rate

$2\

Risk free rate of interest:UK

8%

US

10%

Expected rate of inflation in US 4%


Parent Companys required rate of return 17%

Required:
Evaluate the project by:
Discounting cash flows in using nominal rate of discount in

166

Solution:
Discounting cash flow in sterling using nominal rate of discount

Estimate future spot rate using the above following formula


Where by:if = 8%
ih = 10%

Then future spot rate will be:-

Year

Future Spot Rate

Year 0

2.00

2.0000

Year 1

(1.08) x 2.00
(1.1)

1.9636

Year 2

(1.08)2
(1.1)2

1.9279

Year 3

(1.08)3 x 2.00 )
(1.1)3

1.8929

Year 4

(1.08)4
(1.1)4

1.8585

x 2.00

x 2.00

Compute discounting factors for each year and apply them for determining PV for
each year

167

Year 0

Year 1

Year 2

Year 3

Year 4

Cash flow $

-5000

1200

1900

2500

2500

Spot rate $/

2.000

1.9036

1.92.79

1.8929

1.8585

Cash flow

-2500

611

986

1321

1345

Discounting factor

1.000

0.8547

0.7305

0.6244

0.5337

PV of cash flow

-2500

522

720

823

717

NPV

-2500 + 522 +720 +823 + 717

285 at 17%

7.7 The International Capital Budgeting Complications


Capital budgeting for foreign projects involves many complexities that do not exist in
domestic projects. These are:

Project cash flows and parent cash flows differ. Each of these two types of flows
contributes to a different view of value

Parent cash flows often depend on the form of financing. Thus cash flows cannot be
clearly separated from financing decision, as is done in domestic capital budgeting.

Part of the parent input is via equipment. This can be difficult to treat at the level of
incremental cash flows

Exchange rates are not expected to be constant throughout the project life.

Different rates of tax apply in the country of the project and in the parents country

Royalties and management fees are involved

Full remittances of cash flows arising from a project are restricted in terms of
payment to the parent.

168

7.8 The Cost of Capital For The Foreign Investments


The central question concerning MNC is whether the required rate of return of foreign
projects should be higher, lower, or the same as that for domestic projects

7.8.1

Cost of Capital

For a given investment, the cost of capital is the minimum risk-adjusted return required
by shareholders of the firm for undertaking that investment.
The required rate of return is met only if the net present value of future project cash
flows, using the projects cost of capital as the discount rate, is positive.
The value of the firm will increase if the investment generates sufficient funds to repay
suppliers of capital. This is possible if the firm generates positive NPV of the future cash
flow of the project

7.8.2

The Cost of Equity

The minimum rate of return necessary to attract investors to buy or retain the firms stocks
is called the cost of equity. The rate required here should cover all time value and the risk
associated to the capital supplied.
Therefore it can be said that the required return equals a basic yield covering the time
value of money plus a premium for risk.
The cost of equity is the rate used to capitalise total cash flows. As such it can be said that
the cost of equity is the weighted average of the required rates of the return on the firms
individual activities.

7.8.3

Approaches to Determine the Cost of Equity

Two approaches can be used:

7.8.3.1 CAPM
This model is based on the modern capital market theory. According to this theory, an
equilibrium relationship exists between an assets required return and its associated risks.

169

Capital Asset Pricing Model is given by

r i = r f + B i ( rm r f )

Where;
ri = equilibrium expected return for asset i
rf = rate of return on a risk free asset
rm = expected return on the market portfolio consisting of risk assets
CAPM is based on the notion that intelligent risk-averse shareholders will seek to
diversify their risks, and as a consequence, the only risk that will be rewarded with a risk
premium will be systematic risk
Note that the risk premium associated with a particular asset i is assumed to be equal to
(rm-rf), where Bi is the systematic or risk that can not be diversified

measure the return the correlation between returns on a particular asset and returns on
the market portfolio. The (rm-rf) is called market risk premium

7.8.3.2 Gordon Model Approach


Another approach of determining cost of equity is called Gordon modal. This model
discounts the expected future dividends.
Therefore according to this modal,

DIV1
DV1
Ke =
+g
k

g
p
e
0
Po =
this can be simplified as
Where Ke = companys cost of equity capital
DV1 = expected dividend in year 1
P0 = current stock price
g = average expected annual dividend growth rate

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7.8.4

Weighted Average Cost of Capital For Foreign Projects

The required rate of return on equity for a particular investment assumes that the financial
structure and risk of the project is similar to that for the firm as a whole.

To get the WACC for the parent and project as a whole, the cost of equity capital Ke is
combined with the cost of debt KD. Because interest is tax deductible, then the after tax
cost of debt is used for this case.
Therefore WACC for the project and for the parent is calculated as follows

K0 = (1 L)Ke + Lid (1 t )
Where;
L is the parents debt ratio. Thats debt/asset.

Note! This cost of capital is then used as discounting rate in evaluating the specific
foreign investment
If the net present value of those cash flows-discounted at the weighted average cost of
capital is positive, the investment should be undertaken, if negative, the investment
should be rejected.
It should be understood that that Ke is the required return on the firms stock given the
particular debt ration selected

Reference
Bruno, S (2000), International Investments, Wesley Longman. Inc US, 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA
Demirag, I and Goddard, S (1994), Financial Management for International Business.
McGraw-Hill International UK

171

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.
Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by
Palgrave MACMILLAN, UK
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003
Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review Questions
1. Identify and discuss the complications in Multinational capital budgeting?
2. What factors should be considered in Multinational capital budgeting?
3. Should Multinationals budget the capital investment on the basis of parent or
subsidiary perspectives? Why? Explain. What are differences between the two
approaches?
4. Discuss to approaches that can be used to determine cost of equity for the
Multinationals
5. MARPOL, a UK Company establishing a Subsidiary company called SECURCO in
US. The projected pre-tax cash flows to be generated by the subsidiary company are
as follows:
Year
Cash flows in $

- 5,000

1200

1900

2500

2500

MARPOL Company is very famous in UK and its long lasting reputation in security
services has enabled it demand higher required rate of return on its investments. For that
reason, the required rate of return on MARPOL stocks is 17%. To evaluate the projects, it
was agreed that the company will be using the required rate of return of the parent
company only.

172

The Financial Times of UK has provided the following data, which may assist the
investors in evaluating the multinational projects for capital budgeting purposes:
Current Spot rate

$2/

Risk free rate of interest:US

8%

UK

10%

It is a practise for the host country to charge a withhold tax of 2% and parent
companys country charges a corporate tax of 30%

Required:
Evaluate the project using NPV decision criteria and state if the project should be
accepted or not

173

CHAPTER 8
STRATEGIC ISSUES IN DIRECT FOREIGN INVESTMENT
8.1 Introduction
MNCS are increasingly attracted to do business beyond their domestics markets. The
main reason for this is said to be the growth of the international trade and the increase of
world economic interdependent. As such Foreign Direct Investment (FDI) has become an
important source of private capital for developing countries. Direct foreign investment
leads to private international capital flows, which are vital for national economic
development efforts. It is important because it represents additional investment and
hence provides employment. This is good from the host government point of view.

8.2 What is Foreign Direct Investment


The IMF defines FDI as "an investment that is made to acquire a lasting interest in an
enterprise operating in an economy other than that of the investor, the investor's purpose
being to have an effective voice in the management of the enterprise.

Distinguishing Foreign Aid and Direct Investment

The concept of Control

The concern about control

8.3 Managerial Decision in DFI


Three main managerial decisions that need to be considered before investment can be
made:

Whether to export its finished goods,

Whether to invest abroad. If the decision is to invest abroad, then decision should be
made on where to invest and how to invest

. Whether the overseas operations be structured as a branch or subsidiary etc

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8.4 Motives Behind Overseas Investment Decisions


In drawing up its strategic plan, a coy may Identify Direct foreign investment as a means
of fulfilling its strategic objectives. There are several possible motives for a corporation
becoming more internationalized. These are

8.4.1

Production Efficiency Motives

MNC often attempt to set up production in a location or countries where factors of


Production (Raw materials, Labour) are cheaper. In addition to that fully benefits from
economies of scale may be achieved by expanding production in other countries. By
doing this the corporation may increase its earnings and shareholders wealth due to the
economies of scale.

8.4.2

Demand Led Motives

When the MNC has reached a stage where growth is limited in their home country, then
it can attract new sources of demand. This may be also due to the intense competition for
the product they sell. Thus a possible solution is to consider foreign markets where there
is potential demand.

8.4.3

Profit Motive

Inter markets where excessive profits are possible .If excessive earnings can be realized
in other market MNC may also decide to sell in that market or invest in that market.

8.4.4

Raw Materials

A county or MNC may develop the product in the country where the raw materials can be
found for export or further processing and sale in the host country e.g oil, mining wtc..
This may lead to reduction of transportation cost of material.

8.4.5

Knowledge Motives

MNC may establish overseas plants or acquire existing overseas plants to learn about the
technology or managerial expertise of foreign countries. This technology is then used to
improve their production process at all subsidiary plants around the world.

175

8.4.6

To Avoid Tardifs

Same countries impose tariffs to frustrate imports. A MNC might establish a base in that
country in order to avoid being subject to the Tariffs. The IMF defines FDI as as
investment that is made to acquire a lasting interest in an enterprise operating in an
economy other than that of the Investor, the investors purpose being to have an effective
voice in the Management of the Enterprise.

8.4.7

Exploit Monopolistic Advantages

Some county may posses an advantage over other countries in the market. However even
within a given country some firm may posses an advantage over other firms in these
market eg, if a particular firm possesses advanced technology and has exploited this
advantage successfully in local markets it may attempt to exploit it internally as well.

8.4.8

Diversification Motives

The reason why firms conduct international business is international diversification. This
also helps to reduce risk.

8.4.9

Reaction to Currency Fluctuations

When a foreign currency is perceived by a firm undervalued the firm may consider direct
foreign investment in their country.

8.4.10 React To Trade Restrictions


If there are trade restrictions in home country, a county may think of going
internationally. Export to new market where there are no trade restrictions if restrictions
are tightened in existing export market.

8.4.11 Political Safety Motives


A MNC coy established in a politically unstable country would be attracted to acquire or
establish new operations in countries that are considered to be politically stable i.e.
countries that are whitely to interfere with private enterprises. However a MNC establish
a subsidiary in markets where the government does not control the price of products.

176

8.5 Designing A Global Expansion Strategy


The world market has become very competitive. Some firms are very strong and pose
greater competition and barrier to entry in the market. However, firms need to keep on
systematically pursuing policies and investments that are congruent with worldwide
survival and growth. This approach involves five interrelated elements. These elements
are:

8.5.1

Awareness of Investments Which Are Likely To Be Most Profitable

The firm need to be aware of these investments and capitalise on. By doing that the firms
may enhance the differential advantage possessed by the firm; that is, an investment
strategy should focus explicitly on building competitive advantage

8.5.2

Continual Audit of The Entry Model

Firms must continue auditing the effectiveness of current entry models, bearing in mind
that a markets sales potential is at least partially a function of the entry strategy. As
knowledge about a foreign market increases or sales potential grows, the optimal market
penetration strategy will likely change.

8.5.3

Make a Systematic Investment Analysis

It is important that investment analysis requires the use of appropriate evaluation criteria.
This is important because it will lead the firms to make right investment decision that
may give the firm high return. Nevertheless, despite the importance of using appropriate
evaluation criteria, most firms use the rule of thumb in selecting projects to undertake.
Analytical techniques are used as a rough screening device or as a final check off before
project approval. The use of rules of thumb may be dangerous, as sometimes may lead to
select unprofitable projects.

8.5.4

Estimate the Longevity of Particular Form of Competitive Advantage

If a firm have certain competitive advantage and wants to enter in multinational market to
befit such competitive advantage, it is important to estimate how long the firm will
continue enjoying such competitive advantage. If the competitive advantage of a form is

177

easier replicated, by both local and foreign competitors, it is likely that the firm will not
take long to apply the same concept, process to their operations. The resulting
competition will erode profits to a point where the MNC can no longer justify its
existence in the market. For this reason, the firms competitive advantage should be
constantly monitored and maintained to ensure the existence of an effective barrier to
entry into the market. Should these entry barrier break down, the firm must be able to
react quickly and either reconstruct them or build new ones.

8.5.5

Forms of Entity for International Operations

Different forms of expansion overseas are available to meet various strategic objectives.
These include:

8.5.5.1 Export From the Home Country


A coy may decide not to establish any permanent set-up in the foreign country,
Government instead to export its goods directly from home country. Exporting is a safer
way to break into anew market since there is less to lose if the strategy fails. The initial
cost of producing at home and exporting is low relative to establish a subsidiary

Advantages

Immediate returns

Low risk

Low capital needs and start-up costs.

High learning Possibilities.

Disadvantages

Little knowledge of local market gained.

Slow response to market charges.

It is difficult for customers to contact the company,

Sales could be frustrated by the imposition of tariffs barriers on imports


178

8.5.5.2 Set-up an Overseas Subsidiary


This demonstrates buyer-term commitment to operations in the foreign country. There
may be tax advantages since home country taxation will not be incurred until profits are
remitted home are there may be opportunities to set transfer prices to reduce worldwide
tax liabilities. The disadvantage is that there will be legal costs associated with setting up
the coy and on going costs in resourcing it.

8.5.5.3 Mergers and Acquisition


This is a situation where by one coy acquires/purchase another company or two
companies of similar size merges to form one big coy A firm might take over or merge
with established firms abroad. This provides a means of purchasing market information
market share and distribution channels. If a speed of entry into overseas market is a high
priority, then acquisition may be preferred to start up. ho

Advantages

Quicker way to establish presence in a host country.

Economies of scale and scope.

Reduction of forex exposure.

Knowledge exploitation.

May be a cost-effective way to capture valuable technology or underutilized assets.

Disadvantages

Cultural differences (nationality, customs)

The price paid by the acquirer way be to high.

Unfavourable host country political reactions.

179

8.5.5.4 Joint Venture


A Joint venture between a MNC and a host country partner is a viable strategy if, and
only if, one finds the right local partner. In this method, each partner is operating in its
own country, but each one send goods to his/her partners country to be traded there
under the supervision of the partners in respective country.

Advantages

The existing Management has a detailed knowledge of the overseas market.

The overseas government may treat the venture more favourably than if it was all
overseas owned and so grants way be available.

Enables ventures to pool their expertise and are less risky.

Access to local capital markets due to the local partners reputation.

Access to local loans, government approval and tax ancestries.

Use of established distribution networks, trained labours, raw materials Suppliers and
local Government.

Disadvantages

They can take up large amounts of Management time with few returns.

Disagreement about future cause of action on matters such as dividend policy,


remuneration, marketing strategy, transfer of technology etc.

8.5.5.5 Strategic alliances


One form cross-border strategic alliance is where two firms exchange a share of
ownership with each other.

180

8.5.5.6 Licensing agreement


Licensing is a popular for non multinational firm to profit from foreign markets without
the need to commit sizable fund .Such agreements permits a foreign firm to manufacture
the companys products in return for loyalty payments. They are cheap, low-risky way of
rapidly expanding into foreign markets. The problems with this may be

Poor quantity the goods produced by the inclusive, which may damage the value of
brand.

The cash them from licensing compared to exporting

The possibility that the foreign coy may use the knowledge it has learnt to compete
against the home coy after the expiration of the licensing period.

8.6 Theories of Foreign Direct Investment


Certain theorists have attempted to address limitation of International Trade Theories
under the rubric/rules of FDI. It has long been recognized that all MNCs are oligopolies
and that multimodality and oligopoly are linked via the notion of imperfection. The
imperfection is also related to product and factor markets or financial markets.

8.6.1

The Market imperfection Theory (MIT)

The ability of a firm to transfer its competitive advantage (built at home market) abroad
depends and binding product or factor market imperfection.
The theory states that firms constantly seek market opportunities and their decision to
invest overseas is explained as a strategy to capitalize on certain capabilities not shared
by competitions in foreign countries.

The perfect market theory dictates that firms produce homogeneous products and enjoy
the same level of access to FOPs. However the reality of imperfect competition, which is
reflected in Industrial organization theory porter determine that firms gain different types
of competitive advantage and each to verging degrees.

181

Market imperfections occur naturally, but they are usually caused by policies of the firms
and government in developing country tax-breaks, tariff protection from later entrants
etc.
Nevertheless, MIT does not explain why foreign production is considered the most
desirable means of harnessing the firms advantage.

8.6.2

International Production Theory (IPT) Location-Specific Factors

IPT suggests that the propensity of a firm to initiate foreign production will depend on
the specific attractions of its home country compared with resource implications and
advantages of locating in another country.
Not only resource differentials and Advantages but also Foreign Government actions may
significantly influence the piece need attract ness and entry conditions for firm.

8.6.3

Internalization Theory

Competitive advantage and market imperfections are necessary but not sufficient to
guarantee direct foreign investment. For FDI to occur, competitive advantage must be
firm specific, not easily copied, and in a form that allows them to be transferred to
foreign subsidiaries. Internalization concerns extending the direct operations of the firm
and bringing under common ownership and control the activities conducted by
intermediate markets (form of vertical integration) that link the firm to customers. Firms
will gain in creating their own internal markets such that transactions can be carried out
at a lower cost within the firm. The key ingredient for maintaining a firm-specific
company Advantage is the possession of proprietary informational and control of human
capital (could competence) who can generate new information through expertise in
research, management and Technology.

8.6.4

Follow-the-leader Theory

This is mostly applicable in small number of Producer oligopolistic industries where


when one competitor undertakes a foreign direct investment, others follow with defensive

182

direct investments. The followers are competed by a desire to deny any company
Advantages, e.g. benefits occurs of scale to others.

8.7 Strategies of Multinational Enterprises


An understanding of the strategies followed by MNCs in defending and exploiting the
barriers to entry created by product and fact market imperfections is crucial to any
systematic evaluation of investment opportunities. Such an understanding would:

Suggest those projects that are most compatible with a firms international expansion

Help to uncover new and potentially profitable projects

Some MNCs rely on product innovation, other on product differentiation, and others on
cartels and collusion to protect themselves from competitive threats.
The following are categories of multinationals:

8.7.1

Innovative- Based Multinationals

These Multinationals have high innovative ability and they normally create barrier to
entry by continually introducing new products and differentiating existing ones. They
normally spend large amounts of money on research and development and have a high
ratio of technical factory personnel. Their products are designed to fill a need of both
local and abroad markets.

8.7.2

The Mature Multinationals

These are larger firms that have been in the industry for quite a long time. They produce
the products at large scale hence benefiting from economies of scale. These firms use
economies of scale technique as a barrier for multinational entry by other firms. The
existence of economies of scale means that there are inherent cost advantages to being
larger. The more significant these economies of scale are, the greater will be the cost
disadvantage faced by a new entrant to the market.
Some companies such as Coca-Cola , take advantage of enormous advertisement
expenditures and highly developed marketing skills to differentiate their products and

183

keep out potential competitors that are wary of the high marketing costs o new product
introduction. By selling in foreign markets, these firms can exploit the premium
associated with their strong brand names

8.8 Investment Concerns - International or Domestic


8.8.1

Rate of return

The percentage change in the value of an asset over some period of time is referred to as
the rate of return. Investors purchase assets as a way of saving for the future. Anytime
an asset is purchased the purchaser is forgoing current consumption for future
consumption. In order to make such a transaction worthwhile the investors hopes
(sometimes expects) to have more money for future consumption than the amount they
give up in the present. Thus investors would like to have as high a rate of return on their
investments as possible.

Illustration 1
Suppose a Picasso painting is purchased in 1996 for $500,000. One year later the painting
is resold for $600,000. The rate of return is calculated as,

Example 2: $1000 is placed is a savings account for 1 year at an annual interest rate of
10%. The interest earned after one year is $1000 x 0.10 = $100. Thus the value of the
account after 1 year is $1100. The rate of return is,

This means that the rate of return on a domestic interest bearing account is merely the
interest rate.

184

8.8.2

Risk

The second primary concern of an investor is the riskness of the assets. Generally, the
greater the expected rate of return, the greater the risk. Invest in an oil wildcat endeavour
and you might get a 1000% return on your investment ... if you strike oil. The chances of
doing so are likely to be very low however. Thus, a key concern of investors is how to
manage the tradeoffs between risk and return.

8.8.3

Liquidity

Liquidity essentially means the speed with which assets can be converted to cash.
Insurance companies need to have assets which are fairly liquid in the event that they
need to pay out a large number of claims. Banks have to stand ready to make payout to
depositors etc.

Reference
Bruno, S (2000), International Investments, Wesley Longman. Inc US, 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA
Demirag, I and Goddard, S (1994), Financial Management for International Business.
McGraw-Hill International UK
Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.
Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by
Palgrave MACMILLAN, UK
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003
Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

185

Review Questions
1.

Discuss different categories of Multinationals

2. Discuss the major Investment Concerns of Internationals when considering


investing

abroad

3. Discuss different theories that explain Foreign Direct Investment


4. Identify and explain different forms of Entity for International Operations
5. The world market has become very competitive. Some firms are very strong and
pose greater competition and barrier to entry in the market. However, firms need
to keep on systematically pursuing policies and investments that are congruent
with worldwide survival and growth. For the firm need to be aware of different
factors before it decide to enter into foreign market. identify and discuss the thats
that the multinational firms need to take into the account when considering to
enter into the foreign market.
6.

Foreign Direct Investment (FDI) is an important source of private capital for


developing countries. Direct foreign investment leads to private international
capital flows, which are vital for national economic development efforts. It is
important because it represents additional investment and hence provides
employment. This is good from the host government point of view. While the
governments of many nations are increasing strategies to encourage international
investors, international investors too are increasing pumping their fund to new
investment portfolios in foreign countries. The motives behind this are not known
by most of the citizens of the host countries.

Required:
As you are learned brother or sister in direct foreign investment issues, you are
requested to prepare a brief presentation slides highlighting the motives for direct
foreign investment

186

TOPIC 9
PORTFOLIO THEORY AND INTERNATIONAL DIVERSIFICATION
9.1 Introduction
One approach in dealing with uncertainty in project returns is to increase the required rate
of return on risky projects. This is the approach normally taken by investors. For
example, if they are comparing equity investments in a food retailing company against a
similar investment in a computer electronics company, investors would usually demand
higher returns from the electronics investment to reflect its higher risk. However, this
approach is not as simple as it sounds. That is why investors seldom hold securities in
isolation. They attempt to reduce their risks by not putting all their eggs into one
basket and therefore hold a portfolio of securities.
Portfolio theory therefore is concerned with establishing guidelines for building up a
portfolio of stocks and shares, or portfolio of investment projects. A portfolio describes
the collection of various different investments that make up on investors total
investments. It is a combination of two or more security or assets. A risk adverse investor
would hold a well diversified portfolio, instead of a single or a few securities, in order to
reduce risk.

9.2 Portfolio Diversification


The principle behind the use of portfolio theory is that by diversifying between various
investments one is potentially able to affect the total degree of risk involved. The theory
argues that an investor selects from among an efficient group of portfolio that gives a
higher return for the same level of risk. A procedure of diversifying investments allows
the investor to reduce the risk associated with the portfolio. Therefore International
diversification is identified as a method for reducing MNCS risks. It also saves as
corporate motives for increasing international business.

187

9.3 Choice of Optimal International portfolio


The basic principles of portfolio selection are that investors try to increase the expected
return on their portfolio and reduce the standard deviation of that return. A portfolio that
gives the highest expected return for a given SD, or the lowest SD for a given expected
return is known as an efficient portfolio. To work out which portfolios are efficient, an
investor must be able to state the expected return and SD of each stock and the degree of
correlation between each pair of stocks. Once the optimal portfolio is identified, investors
allocate their wealth between the optimal portfolio and the risk free asset to achieve the
desired combination of risk and return

9.4 Assumptions Underlying Optimal International Portfolio

Investors can lend or borrow at the risk free interest of return

Investors are not allowed to sell stocks short, thats investors cannot hold stocks in
negative amounts

Investors diversify internationally by investing in national stock market indices,


rather than individual stocks

Investors use their respective domestic currencies to measure returns

9.5 The benefits of Portfolio Diversification


A portfolio is simply a combination of investments. If an investor divides his fund in more
than one investment, then it is possible than any misfortune in one investment may be to
some extent offset by the performance of another investment.
This can be demonstrated in the following graphs. Assume we have two companies, A and
B, where when A does well B does badly and vice versa.

188

Rate
of
return
Investment A returns

Time
Rate
of
return
Investment B returns

Time

Both investment A and investment B show fluctuating returns over time. They both have
roughly the same amount of variability. There fortunes are inversely correlated. If both
investments are held, the resulting portfolio will generate a greater average [absolute]
return than with either one alone but a greatly reduced risk, because the ups of A cancel
the downs of B and vice versa.

Rate of
return
(Average of
A and B)

Portfolio return

Time

Illustrating the same effect numerically, consider the following two traders with different
returns due to changes in weather:

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State

Sun

Rain

Average

Risk

Probability

0.5

0.5

Contribution: Ice creams

200

20

110

High

Contribution: Umbrellas

20

200

110

High

Both businesses seem to be profitable but the traders are unhappy about the risk involved.
Also they never talk to each other because when one is happy, the other is miserable and
vice versa. Lucky enough the two traders have been persuaded to pool their resources
together such that each holds half their stock. When it is sunny they both make [0.5 x
200] + [0.5 x 20] = 110, and when it rains they both make [0.5 x 20] + [0.5 x 200] = 110.
State

Sun

Rain

Probability

0.5

0.5

Contribution:

110

110

Average

Risk

110

Zero

Now both are happy all the time because each has as much money as before but it is
earned risk-free.

9.6 Correlation
Correlation is a statistical measure of how strong the connection is between two
variables. In portfolio theory the two variables are returns of two investments
The extent, to which risk is reduced by combining the investments, however depends on
how highly the individual securities included in the portfolio are correlated. The less
highly correlated the individual securities are, the less risky the portfolio becomes.

9.6.1

Positive Correlation

When there is positive correlation between investments, then investment does well ( or
badly) is likely to affect even the other to perform likewise. Thats the circumstances that
influence one stock to perform badly or well will likely influence other stocks in the
portfolio to behave the same.

190

Consider a portfolio consisting of two stocks. If returns to these stocks are highly
positively correlated so they move up and down together, the possibility of risk reduction
by holding these stocks is minimal. In other hand high positive correlation means that
both investments tend to show increases [or decreases] in return at the same time.

9.6.2

No correlation

If returns to the two stocks are not correlated with each other, risk reduction is very
substantial, and as a result, the portfolio will be much less risky than either of the two
stocks. In this case, the performance of one investment will be independent of how one
performs. If you hold shares in company A selling Cement and others in company B
selling soft drinks, it is likely that there would be no relationship between the companies
returns

9.6.3

Negative correlated

If one investment does well the other will do badly, and vice-versa. Thus if you hold
shares in one company making let say umbrellas and others which sells ice-cream, the
weather will affect the companies differently. So it can be said that if returns of two
stocks are highly negative correlated then, as returns on one stock increase, returns on
another stock decrease.

9.7 Estimating the Return and Risk of International Diversification


It is generally known that, an investor may reduce investment risk by holding risky assets
in a portfolio. As long as the asset returns are not perfectly positively correlated, risk
reduction can be achieved because some of the fluctuations of the assets returns will
affect each other.

9.7.1

Expected return on Portfolio

Individual stocks have expected returns. The stocks here can be domestic and foreign
stocks. Then the weighted average of the expected stocks forming the portfolio is called
expected returns of the portfolio. The estimation of the benefits of international
diversification follows the same basic rules of a two-asset portfolio with weights or

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proportions of capital investment W1 and W2 respectively, and where W1 +W2 = 1. .


Let

rd and rrw

be the expected returns on the domestic and rest-of-the-world portfolios

respectively. Therefore, the expected portfolio return can be estimated as follows


rp =

wrd + wrrw

Where, W1 and W2 are proportions of funds invested in security d (domestic) and rw (rest
of the world)

9.7.2

The Portfolio Risk

The risk of portfolio investment represents the deviation of actual return and expected
return. Thats the actual return from investment may be different from the expected
returns. A wise investor will want to avoid too much risk, and hope that the actual returns
from his portfolio are more or less the same as what he has been expecting them to be.
Hence the estimation of risk of a portfolio is important.
As in the case of stocks expected returns, stocks have different expected risks. Hence
because stocks are combined to form a portfolio, then the expected risks of individual
stocks should be combined to get expected risk of portfolio. The risk of portfolio is
measured by the standard deviation of expected returns of portfolio. Let

rd and rrw

be

the expected returns on the domestic and rest-of-the-world portfolios respectively; p the
correlation coefficient between the two markets or stocks and

d and rw be the

expected risks (SD) of returns on the domestic and rest-of-the-world portfolios.


Therefore, the portfolio standard deviation [Risk] is give by:
2
2 = w1 2 d2 + w2 2 rw
+ 2 w1 w2 p d ,rw d rw

Illustration 1
Assume you have equally invested your portfolio in Mzumbeland and UK stocks. The
standard deviations are 18.2% and 34.4% in Mzumbeland and the UK respectively. The

192

correlation coefficient between the two markets is 0.33. What is the standard deviation of
the internationally diversified portfolio?
2
2 = 0.5 2 (18.2) d2 + 0.5 2 (34.4) rw
+ 2 0.5 0.5 0.33 18.2 d 34.4 rw

= 21.95%

The risk is significantly below the risk of the UK.

Illustration 2
Assume that the expected return of risk assets 1 and 2 are 14% and 18% respectively.
Their SD is 15% and 20% respectively. The correlation coefficient is 0.5. If an investor
invests 0.4 in asset 1 and 0.6 in asset 2;
a. What will be the expected return of the investment portfolio?
b. What is the risk/SD of the investment portfolio?

Solution:
(a) Er p = 0.4x0.14 + 0.6x0.18
=16.4%
(b) 2 = (0.4) 2 (0.15) + (0.6 ) (0.2 ) + 2(0.4 )(0.6 )(0.5)(0.15)(0.2 )
2

= 0.159 or 15.9%
As long the correlation coefficient is smaller than 1.0, some of the fluctuations of the
asset returns will offset each other, resulting in risk reduction. The lower the correlation
coefficient, the greater the opportunity for risk diversification

9.8 The Risk and Return of Portfolios with associated probabilities


The risk of an investment can be measured by the standard deviation of its expected
return. If possible returns are R1, R2 Rn, with associated probabilities P1, P2 Pn,
then the standard deviation is calculated as:

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= Ri R Pi

Where

Ri

= return if event i occurs, Pi = probability of event i

Ri P i
occurring and R = the average return,
Normally the portfolio has an expected return which is equal to the weighted average of
the two investment returns, but its risk, as measured by the standard deviation, is lower
than either of the two original investments.

9.9 Covariance and Correlation


The effects of diversification occur when security returns are not perfectly correlated.
One way of computing the correlation coefficient is to first compute the covariance.

9.9.1

Covariance

Covariance is a measure of degree of co-movement between two variables, which is


defined as:

)(

Cov X ,Y = p x x y y

Where x and y are corresponding returns from investments X and Y arising with
probability p.
- Cov(X, Y) > 0 => X and Y move in the same direction [positive correlation but the
strength is not quantified]
- Cov(X, Y) < 0 => X and Y move in the opposite direction
The covariance of Return provides a measure of the extent to which returns on two
assets/securities are correlated or otherwise.

9.9.2

Correlation coefficient

The correlation coefficient (r) is a standardised measure of the linear relationship between
two variables. The correlation coefficient is the ratio of the covariance to the product of
the two standard deviations. Correlation coefficient always lies in the range from -1 to 1.
a positive correlation coefficient indicates that the returns from two securities generally

194

move in the same direction, while a negative correlation coefficient implies that they
generally move in the opposite direction

X ,Y =
Correlation,

9.10

Cov X ,Y

x y

Formulae for the Two Security Portfolio

In general, the risk of a two security portfolio will depend on

The risk of the constituent investments in isolation

The correlation between them

The proportion in which the investments are mixed

Let

=proportion of asset X
=proportion of asset Y; = 1 -

Portfolio return: R = X + Y
Portfolio risk:

Var (R p ) = 2Var ( X ) + 2Var (Y ) + 2 Cov( X , Y )

Illustration 3

195

Assume 90% of the funds are placed in A; calculate the portfolio expected return and
standard deviation.

9.10 General rule in portfolio theory:


Portfolio returns are a weighted average of the expected returns on the individual
investment.
BUT
Portfolio standard deviation is less than the weighted average risk of the individual
investments, except for perfectly positively correlated investments.

9.11 Risk/Return Nature of International Investments


The local currency return on a foreign investment depends on the following:

Foreign currency return

Currency change [i.e. gains/loss]

Accordingly, the currency change brings into mind the question of exchange risk. It is
this prospect of exchange rate fluctuation that makes investors to have preference for
home country investments rather than foreign investments. Thus investors would like to
be rewarded or compensated for takings such risk. The local currency rate of return
required by investors can be approximated as:
Rh = R F + g
Where

Rf =

foreign currency return and g = currency change

The standard deviation of the local currency return,

h = is given as

2
2
h = f + g + 2 f g f , g

Where

2f

= the variance of the foreign currency return

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g2
f ,g

= the variance of the change in the exchange rate

= the correlation between the foreign currency return and the exchange rate change

From the above equation, it can be observed that the foreign exchange risk associated
with a foreign investment depends on the standard deviation of the foreign exchange rate
fluctuation and the covariance between the exchange rate fluctuation and the foreign
currency return on the investment. This implies that, exchange risk could lower the risk
of investing across borders. However this can only be possible when there is sufficient
large negative correlation between the exchange rate fluctuation and the foreign currency
return.

9.12 The Benefits of International Diversification


The major attraction for investing internationally is that international investment focus
provides more opportunities than domestic focus. Because, for instance, if you want to
invest in products with huge worldwide markets [e.g. in electronics industry], you will
find that most of the highly successful companies are based abroad. With this view
therefore, given the growth and availability of international investments, there are high
chances that investors may gain a better risk-return trade-off by focusing on international
diversification rather than entirely focusing at home investments alone.
By risk-return trade-off we mean that investors should be able to get higher returns for
the same level of risk or less risk for the same level of expected returns.
As it is well known that diversifying across industries leads to lower level of risk for a
given level of expected return [especially when there is a negative correlation].
Similarly, through international diversification, with different cyclical economic
fluctuations investors should be able to reduce significantly the risks of their returns,
rather than by adding more domestic investments to a portfolio. This should be true
following the basic rule of portfolio diversification that the more investments you hold
the more stable the returns and more diffuse are the risks.

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9.13

The Expected Return on an International Portfolio and the Portfolio Risk

One way to estimate the benefits of international diversification is to consider the


expected return and deviation of return for a portfolio consisting of a fraction, w1,
invested in domestic country and the remaining fraction, w2, invested in foreign stocks.
Define E(Rd) and E(Rf) to be the expected returns on the domestic country and local
country. The expected return E(Rp) can be calculated as:
E(Rp) = W1(Rd) + W2(Rf)

Portfolio standard deviation =

wd d2 + w f 2f + 2 ww d f fd
2

9.14 Barriers to International Diversification


The benefit to international diversification will be limited to the extent that there are
barriers to investing overseas. Such barriers include

Legal restrictions. This exists in some markets, limiting the ownership of securities by
foreigners investors

Foreign exchange regulations. This may prohibit international investments or make it


more expensive

Double taxation of income from foreign investment may deter investors

There are likely to be higher information and transaction costs associated with
investing in foreign securities. Lack of adequate information can significantly
increase the perceived risk ness of foreign securities, giving investors an added
incentive to keep their money at home

Lack of liquidity. The ability to buy and sell securities efficiently is major obstacle

Lack of readily accessible and comparable information on potential foreign securities


acquisitions. Lack of adequate information can significantly increase the perceived
risk ness of foreign investments, particularly for the less-developed capital markets

Currency controls
198

Exchange rate fluctuations [risk]

Differing tax regulations e.g. withholding taxes

9.15

Limitations of portfolio Theory

Forecasting returns and the correlations betweens returns will be hazardous in practice

It is a single period model. Measuring risk as the standard deviation as the expected
returns is not the only component of risk, there are other costs such as the risk of
bankruptcy etc.

Risk is assessed in terms of the total risk of individual investments, but in practice
much of this risk will be diversified away when the investment is added to an already
well diversified portfolio

Different shareholders will have different attitudes to risk, hence the concept of a
single set of shareholders is unrealistic etc

Portfolio theory is not a practical method of project appraisal for financial managers.
However, it is usefully introduces managers to the concept of risk reduction through
diversification, and it leads on to the capital asset pricing model which is more useful
in practice.

9.16 Capital and Asset Pricing Model (CAPM)


This model describes the relationship between risk and expected rate of return. The
premise of this model is that risks can be reduced i.e. eliminate the unsystematic risk, by
diversification, but there are some risk that remain un eliminated.
The CAPM model is a theoretical model, derived from portfolio theory. It estimates the
expected return on individual security and it can be expressed as follows:
Rj = Rf + j (Rm-Rf)
Where: j = the beta coefficient for security j

199

Rj = the expected return of security j


Rf = the expected return of risk free investment
Rm = the expected return on the market as a whole
The difference between expected return on the market as a whole and expected return of
risk free investment (Rm-Rf) is called excess return. It is also known as market risk
premium. Capital assets pricing model make use of the principle that return on shares in
the market as a whole are expected to be higher than the returns on the risk free
investment

9.16.1 Measuring Foreign Market Risk


Foreign market beta () measures the market risk. It is an index of systematic risk. It
measures the sensitivity of stocks returns on the market portfolio.

The beta may be

derived from Capital Asset Pricing Model (CAPM) or calculated relative to the domestic
market.
The beta of a portfolio is simply a weighted average of the individual stock betas in the
portfolio with the weights being the proportion of the total portfolio market value
represented by each stock. However, the beta of a foreign market (individual security)
may be obtained by dividing the covariance of returns on the foreign market (f) with
returns for the domestic market (market as a whole) by the variance of returns for the
domestic market (d).
Bf =

Cov(d , f )
Var (d )

The beta factor of the domestic market (d) is 1.0. Market risk makes market returns
volatile and the beta factor is a yardstick against which the risk of other investments can
be measured.

A foreign market of beta = 1, tends to have returns which move in line with the
domestic market.

200

A foreign market beta greater than 1.0 tends to show amplified return movements e.g.
Kenya has a beta of 1.55, so when the Tanzanian return rises say by 10%, the returns
of Kenya will tend to rise by 15.5%

A foreign market beta less that 1.0, will vary less that the domestic market

Alternatively, the foreign market beta can be calculated from a pair of data representing
returns from the domestic market and those of the foreign market. In that situations, the
following formula will apply:

Bf =

(nd df )

(nd

d2)

Where Bf = the foreign market beta


d = return from the domestic market
f = return from the foreign market
n = number of pairs of data from d and f

9.16.2 Assumption of CAPM

Investors are well informed

Transaction costs are low

There are negligible restrictions as investment

No investors is large enough to affect the market price of stock

9.16.3 Uses of CAPM

To identify the appropriate required rate of return on a given asset. This required rate
of return can be used as discount rate in investment appraised decisions

To determine the appropriate current price of an asset given its riskness

To evaluate the performance of a portfolio

201

9.16.4 Limitations of the CAPM

In practice the market portfolio cannot be observed. It is therefore usual practice to


use the returns on a broad-based market index. Such an index is by definition, an
approximation to the true market portfolio

The beta coefficient in practice cannot be an unambiguous measure of risk since the
value calculated for the beta depends upon the index which is used to represent the
market portfolio

Empirical evidence suggests that in its basic form CAPM overstates the required rate
of return on high beta securities and understates the required rate of return on low
beta stock.

It is a single period model capable of appraising investment projects lasting for a


single period. Many projects would, however, last for several years

9.17

Measuring Total Return From Foreign Investments

To ensure the return associated with investing in securities issued in different markets
and denominated in a variety of currencies we assume that the US$ is our domestic
currency. However, any currency can be used for this purpose. In general, the total dollar
return on an investment can be decomposed into three elements

Dividend/Interest Income

Capital gain(Loses)

Currency Gain (losses)

9.17.1 Return from Foreign Bond Investment


The one period total Tshs return on a foreign bond investment (RTshs) can be computed as
follows:
Total domestic currency return = Total local Currency Return x Currency gain (Loss)

202

( B B0 + C )
Rd = 1 + 1
(1 + g ) 1
B0

Where B0 = Local currency (LC) bond price at time 0


B1 = Local Currency bond Price at time 1
C= Local Currency Coupon Income
g = percentage change in dollar value of the local currency

9.17.2 Measuring total Returns from Foreign stock Investment


The one-period total Tshs return on a foreign stock investment (RTshs) can be calculated
as follows:
Total domestic currency return = total local Currency Return x Currency gain (Loss)

P P0 + DIV
Rd = 1 + 1
(1 + g ) 1
P0

Where;
P0 = Local Currency Stock Price at time 0
P1 = Local Currency stock price at time 1
Div = Local currency dividend income

Reference
Bruno, S (2000), International Investments, Wesley Longman. Inc US, 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA
Demirag, I and Goddard, S (1994), Financial Management for International Business.
McGraw-Hill International UK
Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.
203

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by


Palgrave MACMILLAN, UK
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003
Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review Questions
1. The initial price of Tanzania Government bond is 95/=, the coupon income is 8/= and
the end of the period bond price is 97/=. Assume that the Tanzanian shilling
appreciates by 3% against the U.S dollar during the period. What is the total dollar
return on Tanzanian Government bond?
2. ABC is a Tanzanian based company. At the beginning of the year 2000 the
companys share price was 50/=, the dividend income was 1/=. The end of the period
stock price is 48/=. During the year the Tanzania shilling depreciated by 5% against
the U.S dollar. Calculate the dollar return on the ABC Companys share.
3. During the first half of the 1990, the Swiss Government bonds yielded a local
currency return of -1.6%. However the Swiss Franc rose by 8% against the dollar
over this six- month period. Corresponding figures for France were 1.8% and 2.6%.
Which bond earned higher U.S dollar return? What was the return?
4. During the year Toyota motors Company shares went from yen 9000 to yen 11200,
while paying a dividend of yen 60. At the same time, the exchange rate went from
yen145/$ to Yen 120/$. What was the total dollar return, in percent, on Toyota stock
for the year?
5. During the year the British Government Bond went from 102 to 106, while paying
a coupon of 9. at the same time, the exchange rate went from $1.76 to $1.62. What
was the total dollar return, in % on the British government bond for the year?

204

6. Here are some data on the stock market returns and exchange rate changes during
2000 for some of the worlds stock markets
Country
Australia
Tanzania
Canada
Germany

Return in local currency


%
14.5
25.0
10.9
27.9

Currency units per U.S Dollar


31/12/1999
31/12/2000
1.41
1.17
800
900
1.29
1.20
1.68
1.85

Required:
Determine the dollar return on each of these markets
7. A Tanzanian Portfolio Manager is considering the benefits of increasing his
diversification by investing overseas. He can purchase shares in individual country
funds with the following characteristics:
Expected return
Standard deviation
Correlation with Tanzania

Tanzania (%)
15
10
1.0

United kingdom(%)
12
9
0.33

Spain (%)
5
4
0.06

Required:
(a) What is the expected return and standard deviation of return of a portfolio with 25%
invested in the united Kingdom and 75% in Tanzania
(b) What is the expected return and standard deviation of return of a portfolio with 25%
invested in the Spain and 75% in Tanzania
(c) What is the expected return and standard deviation of a portfolio with 50% invested
in the United Kingdom and 50% in Tanzania

205

8. Given the following information


Country

Correlation with Tanzania Standard deviation of Return


market

Tanzania

1.00

18.2

Canada

0.60

21.9

UK

0.33

34.4

Required:
(a) calculate the foreign market betas relative to the Tanzania market
(b) Calculate the risk of an internationally diversified portfolio that is equally in Tanzania
and in each of the individual foreign country markets. State in each case whether the
risk of the internationally diversified portfolio is considerably below or above the risk
of the Tanzania portfolio
9. A portfolio manger has decided to invest a total of Tsh.2million on Tanzanian and
Kenyan portfolios. The expected returns are 12% on the Tanzanian portfolio and 20%
on the Kenyan Portfolio.

Required:
a. What is the expected return of an international portfolio with 40% invested in the
Tanzania portfolio and 60% invested in the Kenyan portfolio?
b. How much should be invested in Kenya portfolio for the international portfolio to
yield an expected rate of return of 15%

206

10. A Tanzanian portfolio manager has gathered the following information on three
different stock exchanges
DSM

LONDON

NAIROBI

NEW YORK

Expected return

12%

8%

9%

10%

Standard deviation

9%

8.1%

15.3%

7%

0.9

1.7

Market beta relative to DSM stock Exchange

Required:
(a) Determine whether return from each of the individual foreign markets are positively
or negatively correlated with those of the DSE and state in each case whether the
benefit of international portfolio diversification in the form of risk reduction can be
attained
(b) Determine the risk of an internationally diversified portfolio which is 75% invested in
the DSE and 25% in each of the three foreign markets.

207

CHAPTER 10
DESIGNING A GLOBAL FINANCIAL STRATEGY
10.1 Introduction
Multinational Corporation need enough funds global operations of their activities. Due to
the nature of the funds the MNC need, making global financial strategy is important.
Therefore, designing global financial strategy involves choosing among alternative
sources of funds to fianc foreign affiliates. However, availability of different sources of
funds is important factor for Multinational Corporation in selecting an appropriate
strategy for financing (MNC).

10.2 Variables In Evaluating Global Financial Strategy


Designing global financial strategy is not an easier task; many variables that may affect
the cost of the funding strategy being selected should be taken together into
consideration. The following are key variables that need to be considered when selecting
the global financial strategy:

Firms capital structure (mixture of the firms capital)

Taxes

Exchange risk

Diversification of fund sources

The freedom to move funds across borders

Variety of government credit and capital control

Political risk implication

10.3 Objectives of Financing International Operations


The financing of international operations can be separated into three objectives

208

Minimize expected after tax Tax financing costs

Reduce the Riskness of operating cash flows

Achieve on Appropriate worldwide Financial structure

10.3.1 Minimize Expected After Tax Financing Costs


Multinational Corporation prefers to select financing strategies that are priced at belowmarket rates. Due to the competition that exists in the world markets for funds, firms are
likely find difficult to obtain bargainpriced funds.
The choice among the sources of funds ideally involves simultaneously minimizing the
cost of external funds after adjusting for foreign exchange risk and taxes. Therefore, it is
important that selection among the sources of funds for financing should take into
account of the cost associated and the effect of these sources on the firms operating risks
and ensuring that managerial motivation in the foreign affiliates is geared toward
minimizing the firms consolidated worldwide cost of capital, rather than the foreign
affiliates cost of capital
Many firms consider debt financing to be less expensive than equity financing because
interest expense is tax deductible, where dividend are paid out of after tax income.
However, firms may choose internal sources in order to minimise worldwide taxes and
political risks.
Moreover, it is most important that the funding strategy selected must reconcile a variety
of potentially conflicting objectives, such as minimising expected financing costs,
reducing economic exposure, providing protection from currency control and other forms
of political risk

10.3.2 Reducing Operating Risks


After taking advantage of the opportunities available to lower its risk-adjusted financing
costs, the firm should arrange its additional financing in such a way that the risk exposure
of the company is kept at manageable levels. The risks we refer here are those arising
from currency fluctuations, political instability, and changing access to funds. To the

209

extent that a particular element of risk contributes materially to the firms total risk,
management will want to lay off that risk as long the cost of doing so is not too great.

10.3.2.1

Exchange Risk.

The risk arising from foreign currency fluctuation is referred to as exchange risk. If this
arises, may adversely affect the expected cash flows. For example the firm may be
obliged to pay more debt denominated in foreign currency. If financing opportunities in
various currencies are fairly priced, firms can structure their liabilities so as to reduce
their exposure to foreign exchange risk at no added cost to shareholders. Firms may inter
contractual agreement such as forward contracts and futures with the aim of offsetting
unanticipated changes in the dollar value of its cash flows with identical changes in the
dollar cost of servicing liabilities

10.3.2.2

Political Risks

Global financing is associated with many risks. Political risk is among the risks that faces
MNC when finance their operation globally. Political risk here associates to exchange
control, currency inconvertibility, and transfer restrictions. Firms need to use financing
strategy to reduce such risks. This involves mechanisms to avoid or at least educe the
impact of certain risk itself. For instance, firms may reduce currency inconvertibility by
arranging their affiliates financing. The strategy for reducing this kind of risk may
involve investing parents funds as debt rather than equity, arranging back-to-back and
parallel loans and using local financing
Another approach that may help to reduce political risk is financing foreign operation
with funds from the host and other government, international development agencies,
overseas banks

10.3.3 Changing access to funds


Effective Multinational firms operational is vital for competition and confidence building
to the customers and stakeholders. However, this depends in part on its ability to secure
continual access to funds as reasonable cost and without onerous restrictions. If firms
have continual access to funds, it can be able to meet temporary shortfalls of cash and

210

also take advantage of profitable investment opportunities without having to sell off
assets or otherwise disrupt operations. Though this may be possible, but firms always
fear that during some future period of monetary stringency, fund suppliers may reduce
the quantity of credit available to them while their competitors retain access to funds in a
broader range of markets. In such conditions of uneven credit allocation, the market
shares of their own business would be at risk because the scale of their operations would
be limited by the scale of available finance
Therefore, firms need to ensure adequate and reliable access of funds. For this purposes,
firms may maintain unused debt capacity and liquid assets. It can also diversify its fund
sources and indirectly buy insurance through excess borrowing. Having these extra
financial resources signals competitors, customers as well as other stakeholders that the
firm is financially healthy and has staying power; and that temporary setbacks will not
become permanent ones

Diversification of Fund sources a key element of any MNCs global financial strategy
should be to gain access to a broad range of fund sources to lessen its dependence on any
one financial market. The benefit to diversification of fund sources is that the firm
broadens its sources of economic and financial information.

Excess borrowing most firms have lines of credit with a number of banks that give
them the right to borrow up to an agreed-upon credit limit. Unused balances carry a
commitment fee, normally on the order of 0.5% per annum. Some firms are willing to
borrow funds that they do not require (and then place them on deposit) in order to
maintain their credit limit in the event of tight money situation. In effect, they are buying
insurance against the possibility of being squeezed out of the money market. The measure
of the cost of this policy is the difference between the borrowing rate and the deposit rate,
multiplied by the average amount of borrowed funds placed on deposit

10.3.4 Establishing a Worldwide Capital Structure


The capital structure problem for multinational enterprise is to determine the mix of debt
and equity for the parent entity and for all consolidated and unconsolidated subsidiaries

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that maximises shareholder wealth. To be able to determine the financing mix, the
knowledge of cost and benefit of each source of fund is important.
Once a decision has been made regarding the appropriate mix of debt and equity for the
entire corporation, question about individual operations can be raised. How should MNCs
arrange the capital structures of their foreign affiliates? And what factors are relevant in
making this decision? Specifically, the problem is whether foreign subsidiary capital
structure should:

Conform to capital structure of the parent company

Reflect the capitalization norms in each foreign country

Vary to take advantage of opportunities to minimise the MNCs cost of capital

Disregarding public and government relations and legal requirements for the moment, the
parent company could finance its foreign affiliates by raising funds in its own country
and investing these funds as equity. The overseas operations would then have a zero debt
ratio (debt/total assets). Alternatively, the parent could hold only one dollar of share
capital in each affiliate and require all to borrow on their own, with or without
guarantees; in this case, affiliate debt ratio will approach 100%. Or the parent can itself
borrow and lend monies as intracorporate advances.
A subsidiary with a capital structure similar to its parent may forgo profitable
opportunities to lower its cost of funds

Reference
Bruno, S (2000), International Investments, Wesley Longman. Inc US, 4th ed.
Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,
Wesley and Sons, Inc, USA
Demirag, I and Goddard, S (1994), Financial Management for International Business.
McGraw-Hill International UK
Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th
ed.

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Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by


Palgrave MACMILLAN, UK
Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003
Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review questions
1.

Discuss various sources of long term financing available to Multinational


Corporation for raising capital

2.

Discuss the objectives of Financing International Operations

3.

Designing global financial strategy is not an easier task; many variables that may
affect the cost of the funding strategy being selected should be taken together into
consideration. Discuss the key variables that need to be considered when selecting
the global financial strategy:

4.

Effective Multinational firms operational is vital for competition and confidence


building to the customers and stakeholders. However, this depends in part on its
ability to secure continual access to funds as reasonable cost and without onerous
restrictions. Discuss various techniques firms may use to ensure continual access
of fund for the operations.

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