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CHAPTER 1: MULTINATIONAL FINANCIAL WHY FIRMS PURSUE INTERNATIONAL

MANAGEMENT: AN OVERVIEW BUSINESS


o THEORY OF COMPETITIVE ADVANTAGE
Agency problem: conflict of goals between a - specialization by countries can increase
firms managers and shareholders production efficiency
Agency costs: ensuring that managers - a country that specializes in some
maximize shareholder wealth products may not produce other
products, so trade between countries is
- agency costs are normally larger for essential
MNC than for purely domestic firms for - allows firm to penetrate foreign markets
several reasons: o IMPERFECT MARKETS THEORY
MNCs with subsidiaries scattered - factors of production are somewhat
around the world may experience immobile
larger agency problems because - there are costs and often restrictions
monitoring the managers of related to the transfer of labor and other
distant subsidiaries in foreign resources used for production
countries is more difficult - MNCs often capitalize on a foreign
Foreign subsidiary managers who countrys particular resources
are raised in diff cultures may not - Imperfect markets provides incentive for
follow uniform goals firms to seek out foreign opportunities
The sheer size of the larger o PRODUCT CYCLE THEORY
MNCs can also create significant - firms become established in the home
agency problems market as a result of some perceived
Some non US managers tend to advantage over existing competitors
downplay the short term effects of - foreign demand will initially be
decisions which may result in accommodated by exporting
decisions for foreign subsidiaries - then produce product in foreign market
of US based MNCs that maximize to reduce transpo costs
subsidiary values or pursue other - as a firm matures, it may recognize
goals additional opportunities outside its home
country
PARENT CONTROL OF AGENCY HOW FIRMS ENGAGE IN INTERNATIONAL
PROBLEMS TRADE
- proper governance o International trade
- clearly communicate the goals for each - relatively conservative approach that
subsidiary to ensure that all of them can be used by firms to: penetrate
focus on maximizing the value of MNC markets (by exporting) or to obtain
- through implementing compensation supplies at a low cost (by importing)
plans that reward managers who satify - minimal risk because firms doesnt place
MNC goals any of its capital at risk
- provide MNCs stock or options to buy o Licensing
as part of compensation - arrangement whereby one firm provides
its technology (copyrights, patents,
MANAGEMENT STRUCTURE OF AN MNC trademarks, or trade names) in
- centralized management style: exchange for fees or others
reduces agency costs because it - Allows firms to use their technology in
allows managers of the parent to control foreign markets without a major
foreign subsidiaries and thus reduces investment and without transportation
the power of subsidiary managers costs that result from exporting
- however, parents managers may make - Major disadvantage: difficult to ensure
poor decisions for the subsidiary if they quality control in foreign production
are less informed than the subsidiarys process
managers about its setting and financial o Franchising
characteristics - one firm provides a specialized sales or
- decentralized management style: service strategy, support assistance,
more likely to result to higher agency and possibly an initial investment in the
costs because subsidiary managers franchise in exchange for periodic fees
may make decisions that fail to - allows firms to penetrate markets
maximize the value of the entire MNC without major investment in foreign
- some MNCs attempt to achieve countries
advantages of both by allowing o Joint ventures
subsidiary managers to make the key - venture that is jointly owned and
decisions while parents management operated by two or more firms
monitors those decisions to ensure they - A firm may enter the foreign market by
are in the MNCs best interest. engaging in a joint venture with firms
that reside in those markets.
- Allows two firms to apply their respective
cooperative advantages in a given
project.

o Acquisitions of Existing Operations


- means of penetrating foreign markets
- give firms full control over their foreign
businesses and enable the MNC to
quickly obtain a large portion of foreign
market share
- however, it can lead to large losses - dollar cash flows: funds received by the firm
because of the large investment minus funds needed to pay expenses or taxes
required or to reinvest in the firm (such as an investment
- some engage in partial international to replace old computers or machinery)
acquisitions in order to obtain a toehold - this is estimated from knowledge about
or stake in foreign operations, this various existing projects
approach lessen the risk because of a - all other things constant, an increase in
smaller investment requirement but the expected cash flows over time increase the
firm will not have complete control value of a firm
-
o Establishment of New foreign - cost of capital: required rate of return
subsidiaries - weighted average of the cost of capital
based on all of the firms project
- requires large investment - all other things constant, an increase in
the firms required rate of return will
- firms can penetrate markets by
reduce the value of the firm because
establishing new operations in foreign
expected cash flows must be discounted
countries.
at a higher interest rate
- Requires a large investment o Multinational Model: cash flows may be
coming from various countries and so may
- Acquiring new as opposed to buying be denominated in different foreign
existing allows operations to be countries
tailored exactly to the firms needs.

- May require smaller investment than


buying existing firm.

SUMMARY OF METHODS

- Any method of increasing international


business that requires a direct
investment in foreign operations is
referred to as direct foreign Valuation of an MNC that uses two
investment (DFI) currencies
- International trade and licensing usually - Could measure its expected dollar cash
not included flows in any period by multiplying the
- Franchising and joint ventures then to expected cash flow in each currency by
require some investment but only to a the expected exchange rate at which
limited degree that currency would be converted to
- Foreign acquisition and establishment of dollars and then summing those two
new foreign subsidiaries represent the products.
largest portion of DFI. Valuation of an MNC that uses
multiple currencies
VALUATION MODEL FOR AN MNC - derive an expected dollar cash flow
value for each currency
o Domestic Model: not engaged in any foreign - combine cash flows among currencies
transactions within a given period
- present value of its expected cash
flows Valuation of an MNCs cash flows over
multiple periods
- apply single period process to all future
periods
- discount the estimated total dollar cash
flow for each period at the weighted cost
of capital

UNCERTAINTY SURROUNDING MNC


CASH FLOWS
o Exposure to international economic Current account: summary of
conditions the flow of funds between one
- If economic conditions in a foreign specified country and all other
country weaken, purchase of products countries due to purchases of
decline and MNC sales in that country goods and services or to the cash
may be lower than expected. flows generated by income-
producing financial assets
Capital account: summary of the
flow of funds resulting from the
sale of assets between one
specified country and all other
countries over a specified period
of time, new foreign investments
made by a country
Financial account- special
types of investments (DFI and
portfolio investment)

For all accounts, inflow of funds


generate positive numbers (credits);
for the countrys balance whereas
transactions that reflect outflows of
funds generate negative numbers
(debits)
o Exposure to international political risk
- A foreign government may increase Current account
taxes or impose barriers on the MNCs 1) Payments for merchandise
subsidiary. (goods) and services
o Exposure to exchange rate risk - Tangible products that are
- If foreign currencies related to the MNC transported between countries
subsidiary weaken against the U.S. - Services represent tourism and other
dollar, the MNC will receive a lower services such as legal, insurance,
amount of dollar cash flows than was and consulting services provided for
expected. customers in other countries
- Diff between total exports and
HOW UNCERTAINTY AFFECTS THE MNCS imports is referred to as the balance
COST OF CAPITAL of trades
- Exports= inflow of funds; import=
- A higher level of uncertainty increases outflow of funds
the required rate of return of investors, 2) Factor income
thus the MNCs cost of obtaining capital, - Interest and dividend payments
which lowers the firms valuation. received by investors on foreign
investments in financial assets
SUMMARY: - Income received= inflow; income
paid= outflow
The valuation model of an MNC shows that the 3) Transfer payments
MNCs value is favorably affected when its - Aid, grants, and gifts from one
expected foreign cash inflows increase, the country to another
currencies denominating those cash inflows
increase, or the MNCs required rate of return Capital account
decreases. Conversely, the MNCs value is - Originally included in the financial
adversely affected when its expected foreign account
cash inflows decrease, the values of currencies - Patents and trademarks
denominating those cash flows decrease - Minor account items compared to
(assuming that they have net cash inflows in financial account items
foreign currencies), or the MNCs required rate
of return increases. Financial account
1) Direct foreign investment
CHAPTER 2: INTERNATIONAL FLOW OF
- Investment in fixed assets that can
FUNDS
be used to conduct business
operations
BALANCE OF PAYMENTS
- Acquisition of a foreign company
- summary of transactions between
domestic and foreign residents for a - Construction of a new manufacturing
plant
specific country over a specified
period of time. - Expansion of plant in a foreign
country
- Transactions by businesses,
2) Portfolio investment
individuals, and the government
- Transactions involving long term trade and thereby create jobs within
financial assets such as stocks and a country:
bonds that do not affect the Restrictions on imports
transfer of control - when govt imposes tax on imported
- Represents purchase of foreign goods (tariffs) and maximum limit
financial assets without changing that can be imported (quotas) to
control of the company discourage imports
3) Other capital investments Subsidies for exporters
- Transactions involving short term - offer subsidies to its domestic firms
financial assets such as money so that they can produce products at
market securities between countries a lower cost than their global
4) Errors and omissions and reserves competitors
- dumping: exporting of products that
IMPACT OF OUTSOURCING ON TRADE were produced with the help of
o Outsourcing: process of subcontracting to government subsidies
a third party in another country to provide Restrictions on Piracy
supplies or services that were previously - a govt that doesnt act to minimize
produced internally piracy may indirectly reduce imports
- increases international trade activity and may even discourage MNCs
- allows MNCs to conduct operations from exporting to that market
at a lower cost Environmental restrictions
FACTORS AFFECTING INTERNATIONAL - when a govt imposes environmental
TRADE FLOWS restrictions, local firms experience
Cost of labor higher costs of production
- firms in countries where labor costs Labor laws
are low typically have an advantage - more restrictive laws, higher
when competing globally, especially expenses for labor, other factors
in labor-intensive industries being equal
Inflation Business laws
- if a countrys inflation rate increases - more restrictive laws, not able to
relative to the countries with which it compete globally
trades, then its current account Tax breaks
should decrease, other things equal - govt financial support that could
- consumers and corporations in that benefit firms that export products
country will most likely purchase Country trade requirements
more goods overseas because of - a govt may require that MNCs
high inflation and the countrys complete various forms or obtain
exports to other countries will decline licenses before they can export
National income products to its country
- if a countrys national income level - causes inefficiency and delays
increases by a higher percentage Government Ownership or
than those of other countries, then its subsidies
current account should decrease, - some govts maintain ownership in
other things being equal firms that are major exporters
- as income rises, so does Country security laws
consumption of goods, increased - Governments may impose certain
demand for foreign goods restrictions when national security is
Credit conditions a concern, which can affect on trade.
- credit conditions tend to tighten when
economic conditions weaken Policies to Punish Country
because corporations are then less Governments
able to repay debt - Many expect countries to restrict
- banks are less willing to provide imports from countries that...
financing to MNCs, reducing - Fail to enforce environmental laws
corporate spending and child labor laws
- As MNCs reduce spending, they also - Initiate war against another
reduce demand for imported supplies country
resulting to a decline in international - Unwilling to participate in a war
trade flows
Government policies EXCHANGE RATES
- each countrys govt wants to - If a countrys currency begins to rise
increase exports because more in value against other currencies
exports lead to more production and then its current account balance
income and may also create jobs. should decrease, other things being
- There are several types of policies equal.
often used to improve balance of - As the currency strengthens, goods
exported by that country will become
more expensive to the importing FACTORS AFFECTING INTERNATIONAL
countries and so the demand for PORTFOLIO INVESTMENT
such goods will decrease o Tax rates on Interest/ Dividends:
investors prefer to invest in country
HOW EXCHANGE RATES MAY CORRECT A where taxes interest/dividend income
BALANCE OF TRADE DEFICIT from investments are relatively low
- When a home currency is exchanged o Interest rates: money tends to flow to
for a foreign currency to buy foreign countries with high interest rates as long
goods, then the home currency as the local currencies are not expected
faces downward pressure, leading to weaken
to increased foreign demand for the o Exchange rates: if a countrys home
countrys products. currency is expected to strengthen, then
foreign investors may be willing to invest
WHY EXCHANGE RATES MAY NOT in that countrys securities in order to
CORRECT A BALANCE OF TRADE DEFICIT benefit from the currency movement
- Exchange rates will not automatically correct
any international trade balances when other CHAPTER 3: INTERNATIONAL FINANCIAL
forces are at work. MARKETS

LIMITATIONS OF A WEAK HOME Foreign exchange market: allows exchange


CURRENCY SOLUTION of one currency for another
- large banks serve this market by
o Competition: when a countrys currency holding inventories of each currency
weakens, foreign companies may lower so that they can accommodate
their prices to remain competitive. requests by individuals or MNCs
o Impact of other currencies: a country that
has balance of trade deficit with many HISTORY OF FOREIGN EXCHANGE
countries is not likely to solve all deficits o Gold standard: from 1876 to 1913,
simultaneously. exchange rates were dictated by the
o Prearranged international trade gold standard, thus, rate between two
transactions: international transactions currencies was determined by their
cannot be adjusted immediately. The lag is relative convertibility rates per ounce of
estimated to be 18 months or longer, gold
leading to a J-curve effect. o Agreements on Fixed Exchange
o Intracompany trade: Many firms purchase Rates
products that are produced by their - Bretton woods agreement:
subsidiaries. These transactions are not agreement that calls for fixed
necessarily affected by currency exchange rates between currencies,
fluctuations. this lasted until 1971
- Smithsonian agreement: US dollar
EXCHANGE RATES AND INTERNATIONAL
became overvalued so officials reset
FRICTION
it
All governments cannot weaken their o Floating Exchange Rate System
home currencies simultaneously. - currencies have been allowed to
Actions by one government to weaken fluctuate in accordance with market
its currency causes another countrys forces; however, their respective
currency to strengthen. central banks are periodically
Government attempts to influence intervening to stabilize exchange
exchange rates can lead to international rates
disputes.
Foreign exchange dealers: serve as
INTERNATIONAL CAPITAL FLOWS intermediaries in the foreign exchange market
FACTORS AFFECTING DFI by exchanging currencies desired by MNCs or
o Changes in restrictions: lowered individuals.
restriction, more DFI
o Privatization: selling of some of their Spot market: most common type of forex
operations to corporations and investors transaction, immediate exchange, exchange
o Potential Economic Growth: greater rate is known as spot rate
potential, more likely to attract DFI - often completed electronically
o Tax rates: countries that impose lower - currencys liquidity affects the ease
tax rates, attract DFI with which it can be bought or sold
o Exchange rates: firms typically pursue by an MNC
DFI in other countries where local
currency is expected to strengthen Interbank market: when a bank begins to
against their own experience shortage of a particular foreign
currency, it can purchase that currency from
other banks
INTERPRETING FOREIGN EXCHANGE
Attributes of Banks that provide FOREX QUOTATIONS
o Competitiveness of quote
o Special relationship with the bank: Direct quotations: quotations that report the
bank can offer cash management value of a foreign currency in dollars
services or be willing to make a special Indirect quotation: number of units of a
effort to find currencies for the foreign currency per dollar, reciprocal of the
corporation direct quotation
o Speed of execution
o Advice about current market - if a currencys direct exchange rate is rising
condition over time, then its indirect exchange rate must
o Forecasting advice be declining over time

FOREIGN EXCHANGE QUOTATIONS Cross exchange rate: reflects the amount of


- at any moment, exchange rate one foreign currency per unit of another foreign
between two currencies should be currency
similar across various banks that
provide FOREX services CURRENCY DERIVATIVE
Bid/Ask Spreads of Banks - contract with a price that is partially
- commercial banks charge fees for derived from the value of the
conducting foreign exchange underlying currency that it
transactions; thus, they buy a represents.
currency from customers at a slightly o Forward contracts
lower price than the price at which - agreement between an MNC and a
they sell it forex dealer that specifies the
- banks bid price (buy quote) for a currencies to be exchanged, forward
foreign currency will always be less rate, and the date at which the
than its ask price (sell quote) transaction will occur
- normally expressed as a percentage - MNCs use this to hedge future
of the ask quote payments that they expect to make
or receive in a foreign currency so
that they need not to worry about
= fluctuations in the spot rate until the

time of their future payments
- spread is larger for illiquid currencies o Forward market
that are less frequently traded - Market in which forward contracts
are traded, OTC market, and its main
FACTORS THAT AFFECT THE SPREAD participants are the foreign exchange
o (+) Order costs: clearing costs and dealers and the MNCs that wish to
recording transactions obtain a forward contract
o (+) Inventory costs: cost of maintaining - hedge receivables and payables
an inventory of a particular currency o Futures contract
- holding an inventory involves an - specifies a standard volume of a
opportunity costs because the funds particular currency to be exchanged
could have been used for some other on a specific settlement date at the
purpose. If interest rates are high, futures rate
then the opportunity cost of holding o Options contract: offer more flexibility
an inventory should be relatively than forward or futures contracts because
high. they are not obligations
o (-) Competition: the more intense the Call option: provides the right to buy
competition, the smaller the spread a specific currency at a specific price
quoted by intermediaries called the strike price or exercise
o (-) Volume: currencies that are more price within a specific period of time
liquid are less likely to experience a - used to hedge future payables
sudden change in price Put option: provides the right to sell
- currency that have a large trading a specific currency at a specific price
volume are more liquid, it has within a specific period of time
enough depth that a few large - used to hedge future receivables
transactions are unlikely to cause the
currencys price to change abruptly
o (+) Currency risk: some currencies CHAPTER 4: EXCHANGE RATE
experience more volatility because DETERMINATION
economic or political conditions that cause
the demand for and supply of the currency Cash flows are highly dependent on
to change abruptly exchange rates
MEASURING EXCHANGE RATE in the amt of pounds supplied (sold) in
MOVEMENTS the market.
Exchange rate: measures value of one
currency in units of another currency o DECREASE IN DEMAND SCHEDULE
Depreciation: decline in currencys - If demand decreases, inward shift in
value the schedule, there will be surplus
Appreciation: increase in currencys - Banks will respond by lowering the
value exchange rate of the pound resulting to
increase in the quantity demanded and
PERCENT CHANGE IN FOREIGN decrease in amount of pounds sold in
CURRENCY VALUE= S- St-1/St-1 the market
o INCREASE IN SUPPLY SCHEDULE
- Positive percentage change indicate that - Supply increases because of British
currency has appreciated and vice versa demand for US dollars, outward shift in
supply schedule, resulting to surplus
Forex movements tend to be larger for - Banks will respond by lowering
longer time horizons exchange rate of the pound
o DECREASE IN SUPPLY SCHEDULE
EXCHANGE RATE EQUILIBRIUM - Suppy decrease because of british firms
- Price of a currency is determined by the needing fewer dollars, inward shift in
demand for that currency relative to its supply schedule, there will be shortage
supply - Banks will respond by increasing the
- A currency should exhibit the price at exchange rate of the pound
which demand equals supply
FACTORS THAT INFLUENCE EXCHANGE
US DOLLAR vs. BRITISH POUND RATES (affects demand and supply)
DEMAND FOR A CURRENCY
- Schedule is downward sloping o RELATIVE INFLATION RATES
- Because corporations and individuals in - Changes can affect international trade
the US would purchase more british activity
goods when pound is worth less and - A sudden jump in US inflation cause
vice versa some US consumers to buy more British
products instead of US products. There
SUPPLY OF A CURRENCY would be an increase in the US demand
- Upward sloping for British goods, which represents an
- Because when the pounds value is increase in the US demand for British
high, british consumers and firms are pounds.
more willing to exchange their pounds - In addition, it would also reduce the
for dollars to purchase US products or British desire for US goods therefore
securities reducing supply of pounds for sale at
any given exchange rate
EQUILIBRIUM
- Shortage: quantity demanded exceeds o RELATIVE INTEREST RATES
supply - Changes can affect investment in
- Surplus: quantity demanded is less foreign securities
than the supply - If US interest rates rise while british
rates remain constant, US investors will
CHANGE IN THE EQUILIBRIUM EXCHANGE likely reduce their demand for pounds,
RATE since US rates are now more attractive
- Exchange rate varies because banks - Since US rates will be more attractive,
that serve as intermediaries in the supply of pounds for sale by british
foreign exchange market adjust the investors should increase as they
price of which they are willing to buy and establish more bank deposits in the US
sell a particular currency in the face of a - There will be an inward shift in demand
sudden shortage or excess of that for pound and outward shift in the supply
currency of pounds for sale, the equilibrium
exchange rate should decrease
o INCREASE IN DEMAND SCHEDULE o REAL INTEREST RATES
- Demand can change any time - A relatively high interest rate may attract
- If demand increases, outward shift in foreign inflows to invest in securities
the schedule (ceteris paribus), there offering high yields, that high rate may
will be a shortage reflect expectations of relatively high
- Banks will respond by raising the inflation
exchange rate of the pound resulting to - High inflation can place downward
a decrease in the quantity demanded in pressure on the local currency, some
the forex market as well as an increase foreign investors may be discouraged
from investing in securities denominated previously invested in the country now
in that currency want to get out
- In such cases, it is useful to consider Impact of Signals on Currency
real interest rates, which adjusts the Speculation
nominal interest rate for inflation - day to day speculation on future
exchange rate movements is typically
REAL INTEREST RATE = NOMINAL driven by signals of future interest rate
INTEREST RATE INFLATION RATE movements
- speculative positions in currencies may
o RELATIVE INCOME LEVELS adjust quickly, increasing exchange rate
- Income can affect the amount of imports volatility
demanded, it can also affect exchange
rates INTERACTION OF FACTORS
- Increase income levels reflect favorable
economic condition, hence, British firms o TRADE FLOWS
would probably increase their - generally less responsive to news
investments in US if income level - inflation, income, trade restrictions
increases there. As a result, supply of o FINANCIAL FLOWS
British pounds in the market will - extremely responsive to news
increase (shift outward) - interest rate, capital flow, exchange rate
- an increase in US income levels could The sensitivity of an exchange rate to these
also have an indirect effect on the factors depends on the volume of international
pounds exchange rate by influencing transactions between the two countries
interest rates
- Under economic growth, business INFLUENCE OF FACTORS ACROSS
demand for loans tends to increase and MULTIPLE CURRENCY MARKETS
thus cause a rise in interest rates - each exchange rate has its own market,
higher interest rates attract foreign meaning its own demand and supply
investors; this is another reason why the conditions
supply schedule of british pounds may - value of the british pound in dollars is
increase enough to offset any effect of influenced by the US demand for
increased US income levels on the pounds and the amounts of pounds
demand schedule supplied to the market
IMPACT OF LIQUIDITY ON EXCHANGE
o GOVERNMENT CONTROLS RATE ADJUSTMENT
1) through imposing foreign exchange - liquidity of a currency affects exchange
barriers rates sensitivity to specific transactions
2) imposing foreign trade barriers - if currencys spot market is liquid then its
3) intervening (buying and selling exchange rate will not be highly
currencies) in the forex market sensitive to a single large purchase or
4) affecting macro variables such as sale, so change in equilibrium exchange
inflation, interest rates, and income rate will be relatively small
levels
CAPITALIZING ON EXPECTED EXCHANGE
o EXPECTATIONS RATE MOVEMENTS
Impact of favorable expectations
- ex: investors may temporarily invest o Institutional speculation based on
funds in Canada if they expect Canadian expected appreciation
interest rates to increase, such rise may - if they believe that a particular currency
cause further capital flows into Canada, is presently valued lower than it should
which would place upward pressure on be in the foreign exchange market, they
the Canadian dollars value may consider investing in that country
- expectations can influence exchange now before it appreciates
rates because they commonly motivate - then they would liquidate their
institutional investors to take foreign investment in that currency after it
currency positions appreciates to benefit from selling it for a
Impact of Unfavorable expectations higher price than they paid
- just as speculators can place upward HOW?
pressure on a currencys value when 1) Borrow money.
they expect it to appreciate, they can 2) Convert the money into the currency
place downward pressure on a currency that will appreciate.
when they expect it to depreciate. 3) Invest the converted money at the
- Expectations of a crisis may lead to an lending rate of the country that is
increase in the supply of the countrys expected to appreciate.
currency for sale in the forex market 4) Use the proceeds from the converted
because foreign investors who money to repay the borrowed money at
the borrowing rate.
5) Subtract to get speculative profit
PREMIUM OR DISCOUNT ON THE
o Institutional speculation based on FORWARD RATE
expected depreciation = (1 + )
- if they believe that a particular currency
is presently valued higher than it should
be in the FOREX market, they may 360
borrow funds in that currency now and =

convert it to their local currency now o Forward premium: percentage by which
- the plan is to repay the loan in that the forward rate exceeds the spot rate
currency after it depreciates
HOW? - when forward rate < spot rate, forward
1) Borrow the currency that is about to premium is negative, and the forward
depreciate. rate exhibits a discount
2) Convert it to your local currency.
3) Lend the money at your country. ARBITRAGE
4) Use the proceeds to repay the borrowed - forward rates typically differ from the
currency. spot rate
5) Subtract to get speculative profit. - If forward rate were the same as the
spot rate then some investors could use
The potential returns from foreign currency arbitrage to earn higher returns than
speculation are high for financial institutions would be possible domestically and
that have large borrowing capacity. without incurring additional risk
- that is why forward rate contains a
THE CARRY TRADE premium or discount that reflects the
- investors attempt to capitalize on the difference between home interest rate
difference in interest rates between two and foreign interest rate
countries
- borrowing a currency with low interest OFFSETTING A FORWARD CONTRACT
rate and investing the funds in a - the MNC can negotiate the forward sale
currency with a high interest rate with the same bank with which it
- the term was derived from cost of carry negotiated the forward purchase to
which in financial markets represents simply offset, the bank will charge a fee
the cost of holding (or carrying) a for the service, which will be the
position in some asset difference between the forward rate at
the time of the forward purchase and the
RISK OF THE CARRY TRADE time it will be offset
- exchange rates may move opposite to
what the investors expected, which USING FORWARD CONTRACTS FOR SWAP
would cause a loss. Just as financial TRANSACTIONS
leverage can magnify gains from a carry - a swap transaction involves a spot
trade, it can also magnify losses from a transaction along with a corresponding
carry trade forward contract that will ultimately
reverse the spot transaction
CHAPTER 5: CURRENCY DERIVATIVES - these do not expose the firm to
exchange rate movements because it
FORWARD MARKET has locked in the rate at which the
- facilitates trading of forward contracts on pesos will be converted back to dollars
currencies
- not used by consumers or small firms Non-deliverable forward contract (NDF):
- MNCs use forward contracts to hedge agreement regarding a position in a specified
their imports amount of a specified currency, a specified
- Ability of a forward contract to lock in an exchange rate, and a specified future
exchange rate can create an opportunity settlement date.
cost in some cases - it does not result to actual exchange of
BID/ASK SPREAD the currencies; no delivery
- tends to be wider for forward contracts - instead, one party makes a payment to
that have an obligation further into the the other party based on the exchange
future rate at the future date
- longer contract leaves the bank more - even though an NDF does not involve
exposed to the risk of appreciation of a delivery, it can effectively hedge future
certain currency foreign currency payments anticipated
- because market for short term forward by an MNC
contracts tends to be more liquid, which CURRENCY FUTURES MARKET
means that banks can more easily o Currency futures contracts: specifying a
create offsetting positions for a given standard volume of a particular currency
forward contract
to be exchanged on a specific settlement o Closing Out a Futures Position
date - close out a position by selling an
- used by MNCs to hedge their foreign identical futures contract
currency positions - gain or loss will depend on the price of
- traded by speculators who hope to purchasing futures versus selling futures
capitalize on their expectations of - price of a futures contract changes over
exchange rate movements time in accordance with movements in
the spot rate and also with changing
Forward Futures expectations about what the spot rates
Size of Customized Standardized value will be on settlement date
contract - if spot rate increases, then futures
Delivery date Customized Standardized
Participants Banks, brokers, Banks, brokers, price is likely to increase as well,
and MNCs. and MNCs. hence, purchase and subsequent
Public Qualified public sale would be profitable
speculation not speculation - most currency futures contracts are
encouraged. encouraged.
closed out before settlement date
Security None as such, Small security
deposit but deposit required
compensating SPECULATION WITH CURRENCY FUTURES
balances or lines - some attempts to capitalize on their
of credit expectations of a currencys future
required
movement
Clearing Handling Handled by
operation contingent on exchange - If they expect a currency to appreciate,
individual banks clearinghouse. they can purchase a futures contract
and brokers. No Daily settlements that will lock in the price at which they
separate to the market buy it, and then sell these at the
clearinghouse price.
prevalent spot rate if their expectation
function.
Marketplace Telecomm Central exchange happened
network floor with
worldwide comm EFFICIENCY OF THE CURRENCY FUTURES
Regulation Self- regulating Commodity MARKET
Futures Trading
Commission
- if a currency futures market is efficient,
Liquidation Most settled by Most by offset; then at any time the futures price for a
actual delivery; very few delivery currency should reflect all available info.
some by offset, Hence, price should represent an
but at a cost unbiased estimate of the currencys spot
Transaction Set by the Negotiated
rate on the settlement date.
costs spread between brokerage fees
banks buy and - There should not be abnormal profits
sell prices
CURRENCY OPTIONS MARKET
PRICING CURRENCY FUTURES
- normally similar to forward rate for a o OVER THE COUNTER MARKET
given currency and settlement date o CURRENCY CALL OPTION
because of potential arbitrage if not o FACTORS AFFECTING CURRENCY
- futures contract and forward contracts of CALL OPTION PREMIUM
a given currency and settlement date HOW FIRMS USE CURRENCY CALL
should have the same price, or else OPTIONS
guaranteed profits are possible (assume o Using Call options to hedge payables
no transaction costs) o Using Call Options to Hedge Project
Bidding
CREDIT RISK OF CURRENCY FUTURES o Using Call Options to Hedge Target
CONTRACTS Bidding
- neither party needs to worry about credit
risk of the counterparty SPECULATING WITH CURRENCY CALL
- imposing margin requirements to cover OPTIONS
fluctuations in the value of a contract
HOW FIRMS USE CURRENCY FUTURES CURRENCY PUT OPTIONS
o Purchasing Futures to Hedge Payables FACTORS AFFECTING CURRENCY PUT
- locks in the price at which a firm can OPTION PREMIUMS
purchase a currency so that we dont HEDGING WITH CURRENCY PUT OPTIONS
have to worry about changes in the spot
rate CHAPTER 6: GOVERNMENT INFLUENCE
o Selling Futures to Hedge Receivables ON EXCHANGE RATES
- locks in the price at which a firm can sell CHAPTER 7: INTERNATIONAL ARBITRAGE
a currency AND INTEREST RATE PARITY
- appropriate if you expect the foreign
currency to depreciate against its home
currency