International Master of Business Administration

IMBA
  

Bremen London Marseille Moscow Valencia

Core Module

INTERNATIONAL FINANCE
Part 5 International Financing

AGENDA
Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Global Economics International Accounting Corporate Governance International Investing International Financing Global Value Creating Management Current Topics
I MBA

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

Part 5 International Financing

2

AGENDA

Part

5

International Financing Global Cost & Availability of Capital Sourcing Equity Globally Financial Structure & International Debt Interest Rate & Currency Swaps Foreign Currency Derivatives

Chapter 5.1 Chapter 5.2 Chapter 5.3 Chapter 5.4 Chapter 5.5

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

3

GLOBAL COST AND AVAILABILITY OF CAPITAL (I)
Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home market. A firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and will face limited availability of such capital. This in turn will limit the firm’s ability to compete both internationally and vis-à-vis foreign firms entering its market. Firms resident in small capital markets often source their long-term debt and equity at home in these partially-liquid domestic markets. The costs of funds is slightly better than that of illiquid markets, however, if these firms can tap the highly liquid international capital markets, their competitiveness can be strengthened. Firms resident in segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs.
 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

4

GLOBAL COST AND AVAILABILITY OF CAPITAL (II)

A national capital market is segmented if the required rate of return on securities differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets. Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections. Firms constrained by any of these above conditions must develop a strategy to escape their own limited capital markets and source some of their long-term capital needs abroad.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

5

GLOBAL COST AND AVAILABILITY OF CAPITAL (III)
Local Market Access Global Market Access
Firm-Specific Characteristics Firm’s securities appeal only to domestic investors Firm’s securities appeal to international portfolio investors

Market Liquidity for Firm’s Securities Highly liquid domestic market and broad international participation

Illiquid domestic securities market and limited international liquidity

Effect of Market Segmentation on Firm’s Securities and Cost of Capital Segmented domestic securities market that prices shares according to domestic standards
 

Access to global securities market that prices shares according to international standards
I MBA

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

Part 5 International Financing

6

WEIGHTED AVERAGE COST OF CAPITAL

k WACC
Where ke kd t E D V

E D = k e + k d (1 − t) V V
= risk adjusted cost of equity = before tax cost of debt = tax rate = market value of equity = market value of debt = market value of firm (D+E)
 

kWACC = weighted average cost of capital

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

7

COST OF EQUITY AND DEBT

Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)

k e = k rf + β (k m − k rf )
Where ke krf km = expected rate of return on equity = risk free rate on bonds = expected rate of return on the market

β = coefficient of firm’s systematic risk The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

8

TRIDENT’S WACC

Maria Gonzalez, Trident’s CFO, believes that Trident has access to global capital markets and because it is headquartered in the US, that the US should serve as its base for market risk and equity risk calculations.

k WACC = 17.00%(0.60) +8.00%(1 − 0.35)(0.40) k WACC = 12.28%
Where kWACC = weighted average cost of capital ke kd t E/V D/V
IMBA International Finance (E) Part 5 Lecture

= Trident’s cost of equity is 17.0% = Trident’s before tax cost of debt is 8.0% = tax rate of 35.0% = equity to value ratio of Trident is 60.0% = debt to value ratio of Trident is 40.0%
 
International Master of Business Administration

I MBA

Part 5 International Financing

9

CALCULATING EQUITY RISK PREMIA IN PRACTICE

Using CAPM, there is rising debate over what numerical values should be used in its application, especially the equity risk premium: • • The equity risk premium is the expected average annual return on the market above riskless debt. Typically, the market’s return is calculated on a historical basis yet others feel that the number should be forward looking since it is being used to calculate expected returns.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

10

EQUITY MARKET RISK PREMIUMS IN SELECTED COUNTRIES, 1900-2000

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

11

ALTERNATIVE ESTIMATES OF COST OF EQUITY FOR A HYPOTHETICAL US FIRM

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

12

GLOBAL COST AND AVAILABILITY OF CAPITAL (I)

Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home market. A firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and will face limited availability of such capital. This in turn will limit the firm’s ability to compete both internationally and vis-à-vis foreign firms entering its market. Firms resident in small capital markets often source their long-term debt and equity at home in these partially-liquid domestic markets. The costs of funds is slightly better than that of illiquid markets, however, if these firms can tap the highly liquid international capital markets, their competitiveness can be strengthened. Firms resident in segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

13

GLOBAL COST AND AVAILABILITY OF CAPITAL (II)

A national capital market is segmented if the required rate of return on securities differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets. Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections. Firms constrained by any of these above conditions must develop a strategy to escape their own limited capital markets and source some of their long-term capital needs abroad.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

14

GLOBAL COST AND AVAILABILITY OF CAPITAL (III)
Local Market Access Global Market Access
Firm-Specific Characteristics Firm’s securities appeal only to domestic investors Firm’s securities appeal to international portfolio investors

Market Liquidity for Firm’s Securities Highly liquid domestic market and broad international participation

Illiquid domestic securities market and limited international liquidity

Effect of Market Segmentation on Firm’s Securities and Cost of Capital Segmented domestic securities market that prices shares according to domestic standards
 

Access to global securities market that prices shares according to international standards
I MBA

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

Part 5 International Financing

15

WEIGHTED AVERAGE COST OF CAPITAL

k WACC
Where ke kd t E D V

E D = k e + k d (1 − t) V V
= risk adjusted cost of equity = before tax cost of debt = tax rate = market value of equity = market value of debt = market value of firm (D+E)
 

kWACC = weighted average cost of capital

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

16

COST OF EQUITY AND DEBT
Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)

k e = k rf + β (k m − k rf )
Where ke krf km = expected rate of return on equity = risk free rate on bonds = expected rate of return on the market

β = coefficient of firm’s systematic risk The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

17

TRIDENT’S WACC

Maria Gonzalez, Trident’s CFO, believes that Trident has access to global capital markets and because it is headquartered in the US, that the US should serve as its base for market risk and equity risk calculations.

k WACC = 17.00%(0.60) +8.00%(1 − 0.35)(0.40) k WACC = 12.28%
Where kWACC = weighted average cost of capital ke kd t E/V D/V
IMBA International Finance (E) Part 5 Lecture

= Trident’s cost of equity is 17.0% = Trident’s before tax cost of debt is 8.0% = tax rate of 35.0% = equity to value ratio of Trident is 60.0% = debt to value ratio of Trident is 40.0%
 
International Master of Business Administration

I MBA

Part 5 International Financing

18

CALCULATING EQUITY RISK PREMIA IN PRACTICE

Using CAPM, there is rising debate over what numerical values should be used in its application, especially the equity risk premium: • • The equity risk premium is the expected average annual return on the market above riskless debt. Typically, the market’s return is calculated on a historical basis yet others feel that the number should be forward looking since it is being used to calculate expected returns.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

19

EQUITY MARKET RISK PREMIUMS IN SELECTED COUNTRIES, 1900-2000

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

20

ALTERNATIVE ESTIMATES OF COST OF EQUITY FOR A HYPOTHETICAL US FIRM

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

21

LINK BETWEEN COST & AVAILABILITY OF CAPITAL

Although no consensus exists on the definition of market liquidity, market liquidity can be observed by noting the degree to which a firm can issue new securities without depressing existing market prices. In a domestic case, the underlying assumption is that total availability of capital at anytime for a firm is determined by supply and demand within its domestic the market. In the multinational case, a firm is able to improve market liquidity by raising funds in the Euromarkets, by selling securities abroad, and by tapping local capital markets.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

22

MARKET SEGMENTATION

Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions. Other imperfections are: • • • • • • Asymmetric information. High securities transaction costs. Foreign exchange risks. Political risks. Corporate governance differences. Regulatory barriers.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

23

EFFECTS OF MARKET LIQUIDITY & SEGMENTATION (I)

The degree to which capital markets are illiquid or segmented has an important influence on a firm’s marginal cost of capital. An MNE has a given marginal return on capital at differing budget levels determined by which capital projects it can and chooses to take on. If the firm is limited to raising funds in its domestic market, it has domestic marginal cost of capital at various budget levels.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

24

EFFECTS OF MARKET LIQUIDITY & SEGMENTATION (II)

If an MNE has access to additional sources of capital outside its domestic market, its marginal cost of capital can decrease. If the MNE has unlimited access to capital both domestic and abroad, then its marginal cost of capital decreases even further.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

25

NOVO INDUSTRI A/S (I)

Illustrative case of a Danish multinational that sought to internationalize its capital structure by accessing foreign capital markets. Novo Industri is a Danish industrial enzyme and pharmaceutical firm. In 1977 the management sought to tap in to other capital markets because the Danish market was illiquid and segmented causing Novo to incur a higher cost of capital than that of its international competitors.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

26

NOVO INDUSTRI A/S (II)

The Danish equity markets had at least six factors of market segmentation • • • • • • Asymmetric information for Danish and foreign investors. Taxation. Alternative sets of feasible portfolios. Financial risk. Foreign exchange risk. Political risk.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

27

NOVO INDUSTRI A/S (III)

Asymmetric information • Denmark had a regulation that prohibited Danish investors from holding foreign private sector securities. • This left little incentive for Danish investors to seek out new information or follow developments in other markets.

Another barrier was the lack of equity analysts in Denmark following Danish companies.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

28

NOVO INDUSTRI A/S (IV)

Taxation • • • • • Danish taxation policy charged a capital gains tax of 50% on shares held for over two years. Shares held for less than two years were taxed at a marginal income tax rate as high as 75%. This led to bonds being the security of choice among Danes. Because of the prohibition on foreign security ownership, Danish investors had a limited set of securities from which to choose. Danish stocks offered international investors an opportunity to diversify, but not the reciprocal for Danish investors.

Feasible set of portfolios

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

29

NOVO INDUSTRI A/S (V)

Financial, Foreign exchange and political risks • • • Danish firms were highly leveraged relative to US and UK standards with most debt being short-term. Foreign investors were subject to foreign exchange risk but this was not a big obstacle for investment. Denmark was very stable politically.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

30

NOVO INDUSTRI A/S (VI)

The Road to Globalization • • • When Novo’s management decided to access foreign equity markets in 1977 they had several barriers to overcome. Closing the information gap: Novo now needed to begin disclosing their financials in accordance with international standards. In 1979 Novo had a successful Eurobond issues which lead to more disclosure and international recognition among investors.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

31

NOVO INDUSTRI A/S (VII)

The Road to Globalization • • • • During 1979, Novo also listed its convertibles on the London Stock Exchange (LSE). Also during that year there was a big boom in biotechnology and Novo went to the US to sell investors on their company. The road show worked and Novo’s shares on the Danish exchange and the LSE rose in price from increased demand. This prompted Novo to consider an equity issue in the US.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

32

NOVO INDUSTRI A/S (VIII)

The Road to Globalization • • • During the first half of 1981 Novo prepared an SEC registration. Before the offering over 50% of Novo’s shareholders had become foreign investors. On May 30, 1981 Novo listed in the NYSE and although it had lost 10% of its value in Copenhagen the previous day, the $61 million offering was a success and the share price quickly gained all its losses from the previous day.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

33

COST OF CAPITAL FOR MNES VERSUS DOMESTIC FIRMS (I)

Is the WACC or an MNE higher or lower than for its domestic counterpart? • The answer is a function of The marginal cost of capital The after-tax cost of debt The optimal debt ratio The relative cost of equity

An MNE should have a lower cost of capital because it has access to a global cost and availability of capital. This availability and cost allows the MNE more optimality in capital projects budgets compared to its domestic counterpart. and

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

34

SUMMARY OF LEARNING OBJECTIVES (I)

Gaining access to global capital markets should allow a firm to lower its cost of capital. A firm can improve access to global capital markets by increasing the market liquidity of its shares and by escaping its home capital market. The costs and availability of capital is directly linked to the degree of market liquidity and segmentation. Firms having access to markets with high liquidity and low segmentation should have a lower cost of capital. A firm is able to increase its market liquidity by raising debt in the Euromarket, by selling issues in individual national markets and by tapping capital markets through foreign subsidiaries. This causes the marginal cost of capital to lower for a firm and it results in a firm’s ability to raise even more capital. A national capital market is segmented if the required rate of return on securities in that market differs from the required rate of return on securities of comparable return and risk that are traded in other national capital markets.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

35

SUMMARY OF LEARNING OBJECTIVES (II)

The most important imperfections are asymmetric information, transaction costs, foreign exchange risk, political risk, corporate governance differences, and regulatory barriers. Segmentation results in a higher cost of capital and less availability of capital. If a firm is resident in a segmented capital market, it can still escape from this market by sourcing its debts and equity abroad. The result should be a lower marginal cost of capital, improved liquidity for its securities, and a larger capital budget. Whether or not MNEs have a lower cost of capital than their domestic counterparts depends on their optimal financial structures, systematic risk, availability of capital, and the level of optimal capital budget.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

36

LINK BETWEEN COST & AVAILABILITY OF CAPITAL

Although no consensus exists on the definition of market liquidity, market liquidity can be observed by noting the degree to which a firm can issue new securities without depressing existing market prices. In a domestic case, the underlying assumption is that total availability of capital at anytime for a firm is determined by supply and demand within its domestic the market. In the multinational case, a firm is able to improve market liquidity by raising funds in the Euromarkets, by selling securities abroad, and by tapping local capital markets.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

37

MARKET SEGMENTATION

Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions. Other imperfections are: • • • • • • Asymmetric information. High securities transaction costs. Foreign exchange risks. Political risks. Corporate governance differences. Regulatory barriers.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

38

EFFECTS OF MARKET LIQUIDITY & SEGMENTATION (I)

The degree to which capital markets are illiquid or segmented has an important influence on a firm’s marginal cost of capital. An MNE has a given marginal return on capital at differing budget levels determined by which capital projects it can and chooses to take on. If the firm is limited to raising funds in its domestic market, it has domestic marginal cost of capital at various budget levels.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

39

EFFECTS OF MARKET LIQUIDITY & SEGMENTATION (II)

If an MNE has access to additional sources of capital outside its domestic market, its marginal cost of capital can decrease. If the MNE has unlimited access to capital both domestic and abroad, then its marginal cost of capital decreases even further.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

40

EFFECTS OF MARKET LIQUIDITY & SEGMENTATION (III)
Marginal cost of capital and rate of return (percentage)

MCCF MCCD
20% 15% 13% 10% kD kF

MCCU

kU

MRR

10
IMBA International Finance (E) Part 5 Lecture

20

30
 

40
International Master of Business Administration

50

60

Budget (millions of $)
41

I MBA

Part 5 International Financing

NOVO INDUSTRI A/S (I)

Illustrative case of a Danish multinational that sought to internationalize its capital structure by accessing foreign capital markets. Novo Industri is a Danish industrial enzyme and pharmaceutical firm. In 1977 the management sought to tap in to other capital markets because the Danish market was illiquid and segmented causing Novo to incur a higher cost of capital than that of its international competitors.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

42

NOVO INDUSTRI A/S (II)

The Danish equity markets had at least six factors of market segmentation • • • • • • Asymmetric information for Danish and foreign investors. Taxation. Alternative sets of feasible portfolios. Financial risk. Foreign exchange risk. Political risk.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

43

NOVO INDUSTRI A/S (III)

Asymmetric information • Denmark had a regulation that prohibited Danish investors from holding foreign private sector securities. • This left little incentive for Danish investors to seek out new information or follow developments in other markets.

Another barrier was the lack of equity analysts in Denmark following Danish companies.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

44

NOVO INDUSTRI A/S (IV)

Taxation • • • • • Danish taxation policy charged a capital gains tax of 50% on shares held for over two years. Shares held for less than two years were taxed at a marginal income tax rate as high as 75%. This led to bonds being the security of choice among Danes. Because of the prohibition on foreign security ownership, Danish investors had a limited set of securities from which to choose. Danish stocks offered international investors an opportunity to diversify, but not the reciprocal for Danish investors.

Feasible set of portfolios

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

45

NOVO INDUSTRI A/S (V)

Financial, Foreign exchange and political risks • • • Danish firms were highly leveraged relative to US and UK standards with most debt being short-term. Foreign investors were subject to foreign exchange risk but this was not a big obstacle for investment. Denmark was very stable politically.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

46

NOVO INDUSTRI A/S (VI)

The Road to Globalization • • • When Novo’s management decided to access foreign equity markets in 1977 they had several barriers to overcome. Closing the information gap: Novo now needed to begin disclosing their financials in accordance with international standards. In 1979 Novo had a successful Eurobond issues which lead to more disclosure and international recognition among investors.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

47

NOVO INDUSTRI A/S (VII)

The Road to Globalization • • • • During 1979, Novo also listed its convertibles on the London Stock Exchange (LSE). Also during that year there was a big boom in biotechnology and Novo went to the US to sell investors on their company. The road show worked and Novo’s shares on the Danish exchange and the LSE rose in price from increased demand. This prompted Novo to consider an equity issue in the US.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

48

NOVO INDUSTRI A/S (VIII)

The Road to Globalization • • • During the first half of 1981 Novo prepared an SEC registration. Before the offering over 50% of Novo’s shareholders had become foreign investors. On May 30, 1981 Novo listed in the NYSE and although it had lost 10% of its value in Copenhagen the previous day, the $61 million offering was a success and the share price quickly gained all its losses from the previous day.

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

49

COST OF CAPITAL FOR MNES VERSUS DOMESTIC FIRMS (I)

Is the WACC or an MNE higher or lower than for its domestic counterpart? • The answer is a function of The marginal cost of capital The after-tax cost of debt The optimal debt ratio The relative cost of equity

An MNE should have a lower cost of capital because it has access to a global cost and availability of capital. This availability and cost allows the MNE more optimality in capital projects budgets compared to its domestic counterpart. and

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

50

COST OF CAPITAL FOR MNES VERSUS DOMESTIC FIRMS (II)
Marginal cost of capital and rate of return (percentage)

MCCDC

20% 15% 10% 5%

MCCMNE

MRRMNE MRRDC
100 140
 

300
International Master of Business Administration

350

400

Budget (millions of $)
Part 5 International Financing

I MBA

IMBA International Finance (E) Part 5 Lecture

51

COST OF CAPITAL FOR MNES VERSUS DOMESTIC FIRMS (III)
Is MNEwacc > or < Domesticwacc ? kWACC = ke

[

Equity Value

]

+ kd ( 1 – tx )

[

Debt Value

]

Empirical studies indicate MNEs have a lower debt/capital ratio than domestic counterparts indicating MNEs have a higher cost of capital.

And indications are that MNEs have a lower average cost of debt than domestic counterparts, indicating MNEs have a lower cost of capital. The cost of equity required by investors is higher for multinational firms than for domestic firms. Possible explanations are higher levels of political risk, foreign exchange risk, and higher agency costs of doing business in a multinational managerial environment. However, at relatively high levels of the optimal capital budget, the MNE would have a lower cost of capital.
 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

52

AGENDA

Part

5

International Financing Global Cost & Availability of Capital Sourcing Equity Globally Financial Structure & International Debt Interest Rate & Currency Swaps Foreign Currency Derivatives

Chapter 5.1 Chapter 5.2 Chapter 5.3 Chapter 5.4 Chapter 5.5

 

IMBA International Finance (E) Part 5 Lecture

International Master of Business Administration

I MBA

Part 5 International Financing

53

SOURCING EQUITY GLOBALLY (I)

This requires management to agree upon a long-run financial objective and then choose among various alternative paths to get there. Depositary Receipts • Depositary receipts are negotiable certificates issued by a bank to represent the underlying shares of stock, which are held in trust at a foreign custodian bank. Global Depositary Receipts (GDRs) – refers to certificates traded outside the US. American Depositary Receipts (ADRs) – are certificates traded in the US and denominated in US dollars. ADRs are sold, registered, and transferred in the US in the same manner as any share of stock with each ADR representing some multiple of the underlying foreign share.

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SOURCING EQUITY GLOBALLY (II)

Depositary Receipts This multiple allows the ADRs to possess a price per share conventional for the US market. ADRs are either sponsored or unsponsored. Sponsored ADRs are created at the request of a foreign firm wanting its shares traded in the US; the firm applies to the SEC and a US bank for registration and issuance.

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ALTERNATIVE PATHS
Domestic Financial Market Operations
International Bond Issue -Less Liquid Markets

International Bond Issue -Target Market or Eurobond Market

Equity Listings -- Less Liquid Markets

Equity Issue -- Less Liquid Markets

Equity Listing -- Target Market

Euro equity Issue -- Global Markets

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AMERICAN DEPOSITARY RECEIPTS

Shares

Shares held on deposit at custodial bank

Receipts

Publicly traded firm outside the U.S.

Receipts for shares listed on U.S. exchange
Traded by U.S. investors

Shares
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Arbitrage Activity
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DEPOSITARY RECEIPT PROGRAMS

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FOREIGN EQUITY LISTING & ISSUANCE

By cross-listing and selling its shares on a foreign stock exchange a firm typically tries to accomplish one or more of the following objectives: • • • • • Improve the liquidity of its existing shares and support a liquid secondary market. Increase its share price by overcoming mispricing in a segmented and illiquid home market. Increase the firm’s visibility and political acceptance to its customers, suppliers, creditors & host governments. Establish a secondary market for shares used for acquisitions. Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries.

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IMPROVING LIQUIDITY

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EFFECT OF CROSS-LISTING ON SHARE PRICE

If a firm’s home capital market is segmented, that firm could theoretically benefit by cross-listing in a foreign market if that market values the firm more than does the home market • This was the example of Novo A/S

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OTHER MOTIVES FOR CROSS-LISTING

Increasing visibility and political acceptance • • MNEs list in markets where they have substantial physical operations. Political objectives might include the need to meet local ownership requirements for an MNE’s foreign joint venture.

Increasing potential for share swaps with acquisitions. Compensating management and employees.

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BARRIERS TO CROSS-LISTING AND SELLING EQUITY ABROAD

Commitment to disclosure and investor relations • A decision to cross-list must be balanced against the implied increased commitment to full disclosure and a continuing investor relations program Disclosure is a double-edged sword. Increased firm disclosure should have the effect of lowering the cost of equity capital. On the other hand, this increased disclosure is a costly burden to corporations.

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ALTERNATIVE INSTRUMENTS TO SOURCE EQUITY (I)

Alternative instruments to source equity in global markets include the following: • • • • • Sale of a directed public share issue to investors in a target market. Sale of a Euro equity public issue to investors in more than one market, including both foreign and domestic markets. Private placements under SEC Rule 144A. Sale of shares to private equity funds. Sale of shares to a foreign firm as a part of a strategic alliance.

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ALTERNATIVE INSTRUMENTS TO SOURCE EQUITY (II)

Directed Public Share Issues • Defined as one which is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country Issue may or may not be denominated in the currency of the market. The shares might or might not be cross-listed on a stock exchange in the target market. A foreign share issues, plus cross-listing can provide it with improved liquidity. target

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ALTERNATIVE INSTRUMENTS TO SOURCE EQUITY (III)

Euro equity Public Issue • • Gradual integration of worlds’ capital markets has spawned the emergence of a euro equity market. A firm can now issue equity underwirtten and distributed in multiple foreign equity markets; sometimes simultaneously with distribution the domestic market. in

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ALTERNATIVE INSTRUMENTS TO SOURCE EQUITY (IV)

Private Placement Under SEC Rule 144A • • • • A private placement is the sale of a security to a small set of qualified institutional buyers. Investors are traditionally insurance companies and investment companies. Because shares are not registered for sale, investors typically follow “buy and hold” strategy. Rule 144A allows qualified institutional buyers (QIB) to trade privately placed securities without previous holding period restrictions and without requiring SEC registration.

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ALTERNATIVE INSTRUMENTS TO SOURCE EQUITY (V)

Private Equity Funds • • Limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets. Then invest these funds in mature, family-owned firms located in emerging markets. Normally followed by firms that expect to gain synergies from one or more joint efforts.

Strategic Alliances •

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AGENDA

Part

5

International Financing Global Cost & Availability of Capital Sourcing Equity Globally Financial Structure & International Debt Interest Rate & Currency Swaps Foreign Currency Derivatives

Chapter 5.1 Chapter 5.2 Chapter 5.3 Chapter 5.4 Chapter 5.5

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OPTIMAL FINANCIAL STRUCTURE (I)

When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by an optimal mix of debt and equity that minimizes the firm’s cost of capital • If the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize tradeoffs between business and financial risks.

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OPTIMAL FINANCIAL STRUCTURE (II)
Cost of Capital (%)
30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 20

ke = cost of equity
Minimum cost of capital range

kWACC = weighted average
after-tax cost of capital

kd (1-tx) = after-tax cost of debt

40

60

80

100

Debt Ratio (%) =
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Total Debt (D) Total Assets (V)
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OPTIMAL FINANCIAL STRUCTURE & THE MNE (I)

The domestic theory of optimal capital structure is modified by four additional variables in order to accommodate the MNE • • • • Availability of capital. Diversification of cash flows. Foreign exchange risk. Expectation of international portfolio investors.

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OPTIMAL FINANCIAL STRUCTURE & THE MNE (II)

Availability of capital • • • Allows MNEs to lower cost of capital. Permits MNEs to maintain a desired debt ratio even when new funds are raised. Allows MNEs to operate competitively even if their domestic market is illiquid and segmented. Reduces risk similar to portfolio theory of diversification. Lowers volatility of cash flows among differing subsidiaries and foreign exchange rates.

Diversification of cash flows • •

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OPTIMAL FINANCIAL STRUCTURE & THE MNE (III)

Foreign exchange risk & cost of debt • • When a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repayment in terms of the firm’s own currency. Example: US firm borrows Sfr1,500,000 for one year at 5.00% p.a.; the franc appreciates from Sfr1.500/$ to Sfr1.440/$. Initial dollar amount borrowed.

Sfr1,500,000 = $1,000,000 Sfr1.500/$
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OPTIMAL FINANCIAL STRUCTURE & THE MNE (IV)

At the end of the year, the US firm repays the interest plus principal

Sfr1,500,000 x 1.05 = $1,093,750 Sfr1.440/$
• The actual dollar cost of the loan is not the nominal 5.00% paid in Swiss francs, but 9.375%

$1,093,750 = 1.09375 1,000,000
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OPTIMAL FINANCIAL STRUCTURE & THE MNE (V)

• •

This total home currency cost is higher than expected because of the appreciation of the Swiss franc. This cost is the result of the combined cost of debt and the percentage change in the foreign currency’s value.

k = 1+ k
$ d
Where kd$

[(

Sfr d

) x (1 + s ) ] − 1
76

= Cost of borrowing for US firm in home country

kdSfr = Cost of borrowing for US firm in Swiss francs s = Percentage change in spot rate

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OPTIMAL FINANCIAL STRUCTURE & THE MNE (VI)

The total cost of debt must include the change in the exchange rate The percentage change in the value of the Swiss franc is calculated as

S1 − S2 Sfr1.500/$ - Sfr1.440/$ x 100 = x 100 = 4.1667% S2 Sfr1.40/$
The total cost is then

k $ = [ (1 + .05) x (1 + 0.041667 ) ] − 1 = 0.09375 d
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OPTIMAL FINANCIAL STRUCTURE & THE MNE (VII)

Expectations of International Portfolio Investors • • If firms want to attract and maintain international portfolio investors, they must follow the norms of financial structures. Most international investors for US and the UK follow the norms of a 60% debt ratio.

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FINANCIAL STRUCTURE OF FOREIGN SUBSIDIARIES (I)

Debt borrowed is from sources outside of the MNE (i.e. subsidiary borrows directly from markets) Advantages of localization • • • Localized financial structure reduces criticism of foreign subsidiaries that have been operating with too high (by local standards) proportion of debt. Localized financial structure helps management evaluate return on equity investment relative to local competitors. In economies where interest rates are high because of scarcity of capital and real resources are fully utilized, the penalty paid for borrowing local funds reminds management that unless ROA is greater than local price of capital, misallocation of real resources may occur.

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FINANCIAL STRUCTURE OF FOREIGN SUBSIDIARIES (II)

Disadvantages of localization • • An MNE is expected to have comparative advantage over local firms through better availability of capital and ability to diversify risk. If each subsidiary localizes its financial structure, the resulting consolidated balance sheet might show a structure that doesn’t conform with any one country’s norm; the debt ratio would simply be a weighted average of all outstanding debt. Typically, any subsidiary’s debt is guaranteed by the parent, and the parent won’t allow a default on the part of the subsidiary thus making the debt ratio more cosmetic for the foreign subsidiary.

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FINANCIAL STRUCTURE OF FOREIGN SUBSIDIARIES (III)

Financing the Foreign Subsidiary • In addition to choosing an appropriate financial structure, financial managers need to choose among the alternative sources of funds financing. Sources of funds can be classified as internal and external to the MNE. for

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FINANCIAL STRUCTURE OF FOREIGN SUBSIDIARIES (IV)
Equity Cash Real goods Debt -- cash loans Leads & lags on intra-firm payables

Funds From Within the Multinational Enterprise (MNE)

Funds from parent company

Funds from sister subsidiaries

Debt -- cash loans Leads & lags on intra-firm payables

Subsidiary borrowing with parent guarantee

Funds Generated Internally by the Foreign Subsidiary
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Depreciation & non-cash charges

Retained earnings

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FINANCIAL STRUCTURE OF FOREIGN SUBSIDIARIES (V)

Borrowing from sources in parent country

Banks & other financial institutions Security or money markets

Funds External to the Multinational Enterprise (MNE)

Local currency debt

Borrowing from sources outside of parent country

Third-country currency debt Eurocurrency debt

Individual local shareholders

Local equity
Joint venture partners

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INTERNATIONAL DEBT MARKETS (I)

These markets offer a variety of different maturities, repayment structures and currencies of denomination. They also vary by source of funding, pricing structure, maturity and subordination. Three major sources of funding are • • • International bank loans and syndicated credits. Euronote market. International bond market.

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INTERNATIONAL DEBT MARKETS (II)

Bank loan and syndicated credits • • Traditionally sourced in eurocurrency markets. Also called eurodollar credits or eurocredits. Eurocredits are bank loans denominated in eurocurrencies and extended by banks in countries other than in whose currency the loan is denominated. Enables banks to risk lending large amounts. Arranged by a lead bank with participation of other bank.

Syndicated credits -

Narrow spread, usually less than 100 basis points.

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INTERNATIONAL DEBT MARKETS (III)

Euronote market • • Collective term for medium and short term debt instruments sourced in the Eurocurrency market. Two major groups Underwritten facilities and non-underwritten facilities. Non-underwritten facilities are used for the sale and distribution of Euro-commercial paper (ECP) and Euro Medium-term notes (EMTNs)

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INTERNATIONAL DEBT MARKETS (IV)

Euronote facilities Established market for sale of short-term, negotiable promissory notes in eurocurrency market. These include Revolving Underwriting Facilities, Note Issuance Facilities, and Standby Note Issuance Facilities. Similar to commercial paper issued in domestic markets with maturities of 1,3, and 6 months. Similar to domestic MTNs with maturities of 9 months to 10 years. Bridged the gap between short-term and long-term euro debt instruments.

Euro-commercial paper (ECP) -

Euro Medium-term notes (EMTNs) -

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INTERNATIONAL DEBT MARKETS (V)

International bond market • Fall within two broad categories • Eurobonds Foreign bonds

The distinction between categories is based on whether the borrower is a domestic or foreign resident and whether the issue is denominated in a local or foreign currency.

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INTERNATIONAL DEBT MARKETS (VI)

Eurobonds • A Eurobond is underwritten by an international syndicate of banks and sold exclusively in countries other than the country in whose currency the bond is denominated. Issued by MNEs, large domestic corporations, governments, government enterprises and international institutions. Offered simultaneously in a number of different capital markets.

• •

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INTERNATIONAL DEBT MARKETS (VII)

Eurobonds • Several different types of issues Foreign bonds • • Underwritten by a syndicate and sold principally within the country of the denominated currency, however the issuer is from another country. These include Yankee bonds Samurai bonds Bulldogs Straight Fixed-rate issue Floating rate note (FRN) Equity related issue – convertible bond

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INTERNATIONAL DEBT MARKETS (VIII)

Bank Loans & Syndications
(floating-rate, short-to-medium term)

International Bank Loans Eurocredits Syndicated Credits Euronotes & Euronote Facilities Eurocommercial Paper (ECP) Euro Medium Term Notes (EMTNs) Eurobond
* straight fixed-rate issue * floating-rate note (FRN) * equity-related issue

Euronote Market
(floating-rate, short-to-medium term)

International Bond Market
(fixed & floating-rate, medium-to-long term)

Foreign Bond
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INTERNATIONAL DEBT MARKETS (IX)

Unique characteristics of Eurobond markets • Absence of regulatory interference National governments often impose controls on foreign issuers of securities, however the euromarkets fall outside of governments’ control.

• •

Less stringent disclosure Favorable tax status Eurobonds offer tax anonymity and flexibility

Rating of Eurobonds & other international issues • Moody’s, Fitch and Standard & Poor’s rate bonds just as in US market.

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PROJECT FINANCING (I)

Project Finance is the arrangement of financing for long-term capital projects, large in scale and generally high in risk. Widely used by MNEs in the development of infrastructure projects in emerging markets. Most projects are highly leveraged for two reasons • • Scale of project often precludes a single equity investor or collection of private equity investors Many projects involve subjects funded by governments

This high level of debt requires additional levels of risk reduction.

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PROJECT FINANCING (II)

Four basic properties that are critical to the success of project financing • Separation of the project from its investors • • Project is established as an individual entity, separated legally and financially from the investors. Allows project to achieve its own credit rating and cash flows.

Long-lived and capital intensive singular projects. Cash flow predictability from third-party commitments. Third party commitments are usually suppliers or customers of the project.

Finite projects with finite lives.

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AGENDA

Part

5

International Financing Global Cost & Availability of Capital Sourcing Equity Globally Financial Structure & International Debt Interest Rate & Currency Swaps Foreign Currency Derivatives

Chapter 5.1 Chapter 5.2 Chapter 5.3 Chapter 5.4 Chapter 5.5

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INTEREST RATE RISK

All firms, domestic or multinational, are sensitive to interest rate movements The single largest interest rate risk of a non-financial firm is debt service • For an MNE, differing currencies have differing interest rates thus making this risk a larger concern

The second most prevalent source of interest rate risk is its holding of interest sensitive securities Ever increasing competition has forced financial managers to better manage both sides of the balance sheet

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INTEREST RATE RISK

Whether it is on the left or right hand side, the reference rate of interest calculation merits special attention • • The reference rate is the rate of interest used in a standardized quotation, loan agreement, or financial derivative valuation Most common is LIBOR (London Interbank Offered Rate)

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MANAGEMENT OF INTEREST RATE RISK

The management dilemma is the balance between risk and return Since most treasuries do not act as profit centers, their management practices are typically conservative Before treasury can take any hedging strategy, it must first form an expectation or a directional and/or volatility view Once management has formed its expectations about future interest rate levels and movements, it must then choose the appropriate implementation of a strategy

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CREDIT AND REPRICING RISK

Credit Risk or roll-over risk is the possibility that a borrower’s creditworthiness at the time of renewing a credit, is reclassified by the lender • This can result in higher borrowing rates, fees, or even denial Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is being reset

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CREDIT AND REPRICING RISK

Example: Consider a firm facing three debt strategies • • • Strategy #1: Borrow $1 million for 3 years at a fixed rate Strategy #2: Borrow $1 million for 3 years at a floating rate, LIBOR + 2% to be reset annually Strategy #3: Borrow $1 million for 1 year at a fixed rate, then renew the credit annually

Although the lowest cost of funds is always a major criteria, it is not the only one

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CREDIT AND REPRICING RISK

Strategy #1 assures itself of funding at a known rate for the three years; what is sacrificed is the ability to enjoy a lower interest rate should rates fall over the time period Strategy #2 offers what #1 didn’t, flexibility (repricing risk). It too assures funding for the three years but offers repricing risk when LIBOR changes Strategy #3 offers more flexibility and more risk; in the second year the firm faces repricing and credit risk, thus the funds are not guaranteed for the three years and neither is the price

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TRIDENT’S FLOATING-RATE LOANS

Example using Trident corporation’s loan of US$10 million serviced with annual payments and the principal paid at the end of the third year • • • The loan is priced at US dollar LIBOR + 1.50%; LIBOR is reset every year When the loan is drawn down initially (at time 0), an up-front fee of 1.50% is charged Trident will not know the actual interest cost until the loan has been completely repaid

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TRIDENT’S FLOATING-RATE LOANS

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TRIDENT’S FLOATING-RATE LOANS

If Trident had wished to manage the interest rate risk associated with the loan, it would have a number of alternatives • • Refinancing – Trident could go back to the lender and refinance the entire agreement Forward Rate Agreements (FRAs) – Trident could lock in the future interest rate payment in much the same way that exchange rates are locked in with forward contracts Interest Rate Futures Interest Rate Swaps – Trident could swap the floating rate note for a fixed rate note with a swap dealer

• •

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FORWARD RATE AGREEMENTS (FRAS)

A forward rate agreement is an interbank-traded contract to buy or sell interest rate payments on a notional principal • • • Example: If Trident wished to lock in the first payment it would buy an FRA which locks in a total interest payment at 6.50% If LIBOR rises above 5.00%, then Trident would receive a cash payment from the FRA seller reducing their LIBOR payment to 5.0% If LIBOR falls below 5.00% then Trident would pay the FRA seller a cash amount increasing their LIBOR payment to 5.00%

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INTEREST RATE FUTURES

Interest Rate futures are widely used; their popularity stems from high liquidity of interest rate futures markets, simplicity in use, and the rather standardized interest rate exposures firms posses Traded on an exchange; two most common are the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) The yield is calculated from the settlement price • Example: March ’03 contract with settlement price of 94.76 gives an annual yield of 5.24% (100 – 94.76)

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INTEREST RATE FUTURES

If Trident wanted to hedge a floating rate payment due in March ’03 it would sell a futures contract, or short the contract • • If interest rates rise, the futures price will fall and Trident can offset its interest payment with the proceeds from the sale of the futures contracts If interest rates rise, the futures price will rise and the savings from the interest payment due will offset the losses from the sale of the futures contracts

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STRATEGIES USING INTEREST RATE FUTURES

Exposure or Position Paying interest on futures date

Futures Action Sell a futures (short)

Interest Rates If rates go up

Position Outcome Futures price falls; Short earns profit

If rates go down

Futures price rises; short earns a loss

Earning interest on futures date

Buy a futures (long)

If rates go up

Futures price falls; Long earns a loss

If rates go down

Futures price rises; Long earns profit

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INTEREST RATE SWAPS

Swaps are contractual agreements to exchange or swap a series of cash flows If the agreement is for one party to swap its fixed interest payment for a floating rate payment, its is termed an interest rate swap If the agreement is to swap currencies of debt service it is termed a currency swap A single swap may combine elements of both interest rate and currency swap The swap itself is not a source of capital but an alteration of the cash flows associated with payment

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INTEREST RATE SWAPS

If firm thought that rates would rise it would enter into a swap agreement to pay fixed and receive floating in order to protect it from rising debt-service payments If firm thought that rates would fall it would enter into a swap agreement to pay floating and receive fixed in order to take advantage of lower debt-service payments The cash flows of an interest rate swap are interest rates applied to a set amount of capital, no principal is swapped only the coupon payments

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TRIDENT CORPORATION: SWAPPING TO FIXED RATES

Maria Gonzalez (Trident’s CFO) is concerned about the floating rate loan • • • Maria thinks that rates will rise over the life of the loan and wants to protect Trident from an increased interest payment Maria believes that an interest rate swap to pay fixed/receive floating would be Trident’s best alternative Maria contacts the bank and receives a quote of 5.75% against LIBOR; this means that Trident will receive LIBOR and pay out 5.75% for the three years

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TRIDENT CORPORATION: SWAPPING TO FIXED RATES

The swap does not replace the original loan, Trident must still make its payments at the original rates; the swap only supplements the loan payments Trident’s 1.50% fixed rate above LIBOR must still be paid along with the 5.75% as per the swap agreement; however, Trident now receives LIBOR thus offsetting the floating rate risk in the original loan Trident’s total payment will therefore be 7.25% (5.75% + 1.50%)

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TRIDENT CORPORATION: SWAPPING TO FIXED RATES

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TRIDENT CORP: SWAPPING DOLLARS INTO SWISS FRANCS

After raising the $10 million in floating rate financing and swapping into fixed rate payments, Trident decides it would prefer to make its debt-service payments in Swiss francs • Trident signed a 3-year contract with a Swiss buyer, thus providing a stream of cash flows in Swiss francs

Trident would now enter into a three-year pay Swiss francs and receive US dollars currency swap • • Both interest rates are fixed Trident will pay 2.01% (ask rate) fixed Sfr interest and receive 5.56% (bid rate) fixed US dollars

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TRIDENT CORP: SWAPPING DOLLARS INTO SWISS FRANCS

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TRIDENT CORP: SWAPPING DOLLARS INTO SWISS FRANCS

The spot rate in effect on the date of the agreement establishes what the notional principal is in the target currency • • • In this case, Trident is swapping into francs, at Sfr1.50/$. This is a notional amount of Sfr15,000,000. Thus Trident is committing to payments of Sfr301,500 (2.01% × Sfr15,000,000 = Sfr301,500) Unlike an interest rate swap, the notional amounts are part of the swap agreement

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TRIDENT CORP: SWAPPING DOLLARS INTO SWISS FRANCS

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TRIDENT CORPORATION: UNWINDING SWAPS

As with the original loan agreement, a swap can be entered or unwound if viewpoints change or other developments occur Assume that the three-year contract with the Swiss buyer terminates after one year, Trident no longer needs the currency swap Unwinding a currency swap requires the discounting of the remaining cash flows under the swap agreement at current interest rates then converting the target currency back to the home currency

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TRIDENT CORPORATION: UNWINDING SWAPS

If Trident has two payments of Sfr301,500 and Sfr15,301,500 remaining (interest plus principal in year three) and the 2 year fixed rate for francs is now 2.00%, the PV of Trident’s commitment is francs is

Sfr301,500 Sfr15,301,500 PV(Sfr) = + = Sfr15,002,912 1 2 (1.020) (1.020)

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TRIDENT CORPORATION: UNWINDING SWAPS

At the same time, the PV of the remaining cash flows on the dollar-side of the swap is determined using the current 2 year fixed dollar rate which is now 5.50%

$556,000 $10,556,000 PV(US$) = + = $10,011,078 1 2 (1.055) (1.055)

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TRIDENT CORPORATION: UNWINDING SWAPS

Trident’s currency swap, if unwound now, would yield a PV of net inflows of $10,011,078 and a PV of net outflows of Sfr15,002,912. If the current spot rate is Sfr1.4650/$ the net settlement of the swap is

Sfr15,002,912 Settlement = $10,011,078 = = ($229,818) Sfr1.4650/$
Trident makes a cash payment to the swap dealer of $229,818 to terminate the swap • Trident lost on the swap due to franc appreciation

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COUNTERPARTY RISK

Counterparty Risk is the potential exposure any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations A firm entering into a swap agreement retains the ultimate responsibility for its debtservice In the event that a swap counterpart defaults, the payments would cease and the losses associated with the failed swap would be mitigated The real exposure in a swap is not the total notional principal but the mark-to-market value of the differentials

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A THREE-WAY CROSS CURRENCY SWAP

Sometimes firms enter into loan agreements with a swap already in mind, thus creating a debt issuance coupled with a swap from its inception • Example: the Finnish Export Credit agency (FEC), the Province of Ontario, Canada and the Inter-American Development Bank (IADB) all possessed access to ready sources capital but wished debt service in another market FEC had not raised capital in Canadian dollar Euromarkets and an issuance would be well received; however the FEC had a need for increased debt-service in US dollars, not Canadian dollars

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A THREE-WAY CROSS CURRENCY SWAP

Province of Ontario needed Canadian dollars but due to size of provincial borrowings knew that issues would push up its cost of funds; there was however an attractive market in US dollars IADB had a need for additional US dollar denominated debt-service; however it already raised most of its debt in the US markets but was a welcome newcomer in the Canadian dollar market

Each borrower determined its initial debt amounts and maturities expressly with the needs of the swap

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A THREE-WAY CROSS CURRENCY SWAP

C$300 million

Province of Ontario
(Canada) $260 million Borrows $390 million at US Treasury + 48 bp $130 million

C$150 million

Finish Export Credit
(Finland) Borrows C$300 million at Canadian Treasury + 47 bp

Inter-American Development Bank
Borrows C$150 million at Canadian Treasury + 44 bp

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AGENDA

Part

5

International Financing Global Cost & Availability of Capital Sourcing Equity Globally Financial Structure & International Debt Interest Rate & Currency Swaps Foreign Currency Derivatives

Chapter 5.1 Chapter 5.2 Chapter 5.3 Chapter 5.4 Chapter 5.5

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FOREIGN CURRENCY DERIVATIVES (I)

Financial management in the 21st century needs to consider the use of derivatives.

financial

These derivatives, so named because their values are derived from the underlying asset, are a powerful tool used for two distinct management objectives: • • Speculation – the financial manager takes a position in the expectation of profit. Hedging – the financial manager uses the instruments to reduce the risks of the corporation’s cash flow.

In the wrong hands, derivatives can cause a corporation to collapse (Barings, Allied Irish Bank), but used wisely they allow a financial manager the ability to plan cash flows.

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FOREIGN CURRENCY DERIVATIVES (II)

The financial manager must first understand the basics of the structure and pricing of these tools. The derivatives that will be discussed will be • • Foreign Currency Futures Foreign Currency Options

A foreign currency futures contract is an alternative to a forward contract • • It calls for future delivery of a standard amount of currency at a fixed time and price. These contracts are traded on exchanges with the largest being the International Monetary Market located in the Chicago Mercantile Exchange.

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FOREIGN CURRENCY FUTURES (I)

Contract Specifications • • • Size of contract – called the notional principal, trading in each currency must be done in an even multiple. Method of stating exchange rates – “American terms” are used; quotes are in US dollar cost per unit of foreign currency, also known as direct quotes. Maturity date – contracts mature on the 3rd Wednesday of January, March, April, June, July, September, October or December.

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FOREIGN CURRENCY FUTURES (II)

Contract Specifications • • Last trading day – contracts may be traded through the second business day prior to maturity date. Collateral & maintenance margins – the purchaser or trader must deposit an initial margin or collateral; this requirement is similar to a performance bond. At the end of each trading day, the account is marked to market and the balance in the account is either credited if value of contracts is greater or debited if value of contracts is less than account balance.

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FOREIGN CURRENCY FUTURES (III)

Contract Specifications • Settlement – only 5% of futures contracts are settled by physical delivery, most often buyers and sellers offset their position prior to delivery date. • • The complete buy/sell or sell/buy is termed a round turn. Commissions – customers pay a commission to their broker to execute a round turn and only a single price is quoted. Use of a clearing house as a counterparty – All contracts are agreements between the client and the exchange clearing house. Consequently clients need not worry about the performance of a specific counterparty since the clearing house is guaranteed by all members of the exchange.

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USING FOREIGN CURRENCY FUTURES (I)

Any investor wishing to speculate on the movement of a currency can pursue one of the following strategies • • • Short position – selling a futures contract based on view that currency will fall in value. Long position – purchase a futures contract based on view that currency will rise in value. Example: Amber McClain believes that Mexican peso will fall in value against the US dollar, she looks at quotes in the WSJ for Mexican peso futures.

Her perspective: Selling peso at a time in future, fixing an exchange rate against a peso fall in value
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USING FOREIGN CURRENCY FUTURES (II)

Maturity Mar June Sept

Open .10953 .10790 .10615

High .10988 .10795 .10615

Low .10930 .10778 .10610

Settle .10958 .10773 .10573

Change -------

High .11000 .10800 .10615

Low .09770 .09730 .09930

Open Interest 34,481 3,405 1,4181

All contracts are for 500,000 new Mexican pesos. “Open,” “High” and “Low” all refer to the price on the day. “Settle” is the closing price on the day and “Change” indicates the change in the settle price from the previous day. “High” and “Low” to the right of Change indicates the highest and lowest prices for this specific contact during its trading history. “Open Interest” indicates the number of contracts outstanding.

Source: Wall Street Journal, February 22, 2002, p.C13
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USING FOREIGN CURRENCY FUTURES (III)

Example (cont.): Amber believes that the value of the peso will fall, so she sells March futures contract. By taking a short position on the Mexican peso, Amber locks-in the right to sell 500,000 Mexican pesos at maturity at a set price above their current spot price. Using the quotes from the table, Amber sells one March contract for 500,000 pesos at the settle price: $.10958/Ps.

a

Value at maturity (Short position) = -Notional principal × (Spot – Forward)

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USING FOREIGN CURRENCY FUTURES (IV)

To calculate the value of Amber’s position we use the following formula

Value at maturity (Short position) = -Notional principal × (Spot – Forward)
Using the settle price from the table and assuming a spot rate of $.09500/Ps at maturity, Amber’s profit is

Value = -Ps 500,000 × ($0.09500/ Ps - $.10958/ Ps) = $7,290

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USING FOREIGN CURRENCY FUTURES (V)

If Amber believed that the Mexican peso would rise in value, she would take a long position on the peso

Value at maturity (Long position) = Notional principal × (Spot – Forward)
Using the settle price from the table and assuming a spot rate of $.11000/Ps at maturity, Amber’s profit is

Value = Ps 500,000 × ($0.11000/ Ps - $.10958/ Ps) = $210

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FOREIGN CURRENCY FUTURES VERSUS FORWARD CONTRACTS
Characteristic Size of Contract Maturity Location Pricing Margin/Collateral Settlement Commissions Foreign Currency Futures fixed maturities, longest typically being one year trading occurs on organized exchange open outcry process on exchange floor initial margin that is marked to market on a daily basis Forward Contracts any size desired any maturity up to one year, sometimes longer trading occurs between individuals and banks prices are determined by bid/ask quotes no explicit collateral Standardized contracts per currency

rarely delivered, settlement normally takes contract is delivered place through purchase of offsetting position upon, can offset position single commission covers purchase& sell no explicit commissions; banks earn money through bid/ask spread markets open 24 hours parties in direct contact liquid and relatively large in sales volume
Part 5 International Financing

Trading hours Counterparties Liquidity

traditional exchange hours unknown, go through clearing house liquid but relatively small in total sales volume and value
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FOREIGN CURRENCY OPTIONS (I)

A foreign currency option is a contract giving the purchaser of the option the right to buy or sell a given amount of currency at a fixed price per unit for a specified time period. • • The most important part of clause is the “right, but not the obligation” to take an action. Two basic types of options, calls and puts • Call – buyer has right to purchase currency. Put – buyer has right to sell currency.

The buyer of the option is the holder and the seller of the option is termed the writer.

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FOREIGN CURRENCY OPTIONS (II)

Every option has three different price elements: • • • • • The strike or exercise price is the exchange rate at which the foreign currency can be purchased or sold. The premium, the cost, price or value of the option itself paid at time option is purchased. The underlying or actual spot rate in the market. American options may be exercised at any time during the life of the option. European options may not be exercised until the specified maturity date.

There are two types of option maturities:

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FOREIGN CURRENCY OPTIONS (III)

Options may also be classified as per their payouts: • • • At-the-money (ATM) options have an exercise price equal to the spot rate of the underlying currency. In-the-money (ITM) options may be profitable, excluding premium costs , if exercised immediately. Out-of-the-money (OTM) options would not be profitable, excluding the premium costs, if exercised.

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FOREIGN CURRENCY OPTIONS MARKETS (I)

The increased use of currency options has lead the creation of several markets where financial managers can access these derivative instruments: • Over-the-Counter (OTC) Market – OTC options are most frequently written by banks for US dollars against British pounds, Swiss francs, Japanese yen, Canadian dollars and the euro Main advantage is that they are tailored to purchaser. Counterparty risk exists. Mostly used by individuals and banks.

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FOREIGN CURRENCY OPTIONS MARKETS (II)

Organized Exchanges – similar to the futures market, currency options are traded on an organized exchange floor: The Chicago Mercantile and the Philadelphia Stock Exchange serve options markets. Clearinghouse services are provided by the Options Clearinghouse Corporation (OCC).

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FOREIGN CURRENCY OPTIONS MARKETS (III)

Table shows option prices on Swiss franc taken from the Wall Street Journal Calls - Last Puts - Last

Options & Underlying 58.51 58.51 58.51 58.51 58.51 58.51 58.51

Strike Price 56 56 1/2 57 57 1/2 58 58 1/2 59

Aug --1.13 0.75 0.71 0.50 0.30

Sep ----1.05 -0.66

Dec 2.76 -1.74 -1.28 -1.21

Aug 0.04 0.06 0.10 0.17 0.27 0.50 0.90

Sep 0.22 0.30 0.38 0.55 0.89 0.99 1.36

Dec 1.16 -1.27 -1.81 ---

Each option = 62,500 Swiss francs. The August, September and December listings are the option maturity dates

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FOREIGN CURRENCY OPTIONS MARKETS (IV)

• • •

The spot rate means that 58.51 cents, or $0.5851 was the price of one Swiss franc. The strike price means the price per franc that must be paid for the option. The August call option of 58 ½ means $0.5850/Sfr. The premium, or cost, of the August 58 ½ option was 0.50 per franc, $0.0050/Sfr For a call option on 62,500 Swiss francs, the total cost would be Sfr62,500 x $0.0050/Sfr = $312.50. or

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FOREIGN CURRENCY SPECULATION (I)

Speculating in the spot market • Hans Schmidt is a currency speculator. He is willing to risk his money based on his view of currencies and he may do so in the spot, forward options market. Assume Hans has $100,000 and he believes that the six month spot for Swiss francs will be $0.6000/Sfr. Speculation in the spot market requires that view is currency appreciation. or

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FOREIGN CURRENCY SPECULATION (II)

Speculating in the spot market • • • • • Hans should take the following steps. Use the $100,000 to purchase Sfr170,910.96 today at a spot rate of $0.5851/Sfr. Hold the francs indefinitely, because Hans is in the spot market he is not committed to the six month target. When target exchange rate is reached, sell the Sfr170,910.96 at new spot rate of $0.6000/Sfr, receiving Sfr170,910.96 x $0.6000/Sfr = $102,546.57. This results in a profit of $2,546.57 or 2.5% ignoring cost of interest income and opportunity costs.

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FOREIGN CURRENCY SPECULATION (III)

Speculating in the forward market • • • • If Hans were to speculate in the forward market, his viewpoint would be that the future spot rate will differ from the forward rate. Today, Hans should purchase Sfr173,611.11 forward six months at the forward quote of $0.5760/Sfr. This step requires no cash outlay. In six months, fulfill the contract receiving Sfr173,611.11 at $0.5760/Sfr at a cost of $100,000. Simultaneously sell the Sfr173,611.11 in the spot market at Hans’ expected spot rate of $0.6000/Sfr, receiving Sfr173,611.11 x $0.6000/Sfr = $104,166.67. This results in a profit of $4,166.67 with no investment required.

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FOREIGN CURRENCY SPECULATION (IV)

Speculating in the options market • • • If Hans were to speculate in the options market, his viewpoint would determine what type of option to buy or sell. As a buyer of a call option, Hans purchases the August call on francs at strike price of 58 ½ ($0.5850/Sfr) and a premium of 0.50 or $0.0050/Sfr. a

At spot rates below the strike price, Hans would not exercise his option because he could purchase francs cheaper on the spot market than via his call option.

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FOREIGN CURRENCY SPECULATION (V)

Speculating in the options market • • Hans’ only loss would be limited to the cost of the option, or the ($0.0050/Sfr). premium

At all spot rates above the strike of 58 ½ Hans would exercise the option, paying only the strike price for each Swiss franc. If the franc were at 59 ½, Hans would exercise his options buying Swiss francs at 58 ½ instead of 59 ½.

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FOREIGN CURRENCY SPECULATION (VI)

Speculating in the options market • Hans could then sell his Swiss francs on the spot market at 59 ½ for a profit

Profit = Spot rate – (Strike price + Premium) = $0.595/Sfr – ($0.585/Sfr + $0.005/Sfr) = $0.005/Sfr

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FOREIGN CURRENCY SPECULATION (VII)

Speculating in the options market • • Hans could also wait to see if the Swiss franc appreciates more, this is the value to the holder of a call option – limited loss, unlimited upside. Hans’ break-even price can also be calculated by combining the premium cost of $0.005/Sfr with the cost of exercising the option, $0.585/Sfr. This matched the proceeds from exercising the option at a price $0.590/Sfr. of

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PROFIT & LOSS FOR THE BUYER OF A CALL OPTION
Profit (US cents/SF) + 1.00 + 0.50 0 - 0.50 - 1.00 Loss The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates less than 58.5 (“out of the money”), and an unlimited profit potential at spot rates above 58.5 cents/SF (“in the money”).
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“At the money” Strike price “In the money”

“Out of the money”

Unlimited profit 57.5 58.0 Limited loss 58.5 59.0 59.5 Spot price (US cents/SF)

Break-even price

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FOREIGN CURRENCY SPECULATION (VIII)

Speculating in the options market • Hans could also write a call, if the future spot rate is below 58 ½, then the holder of the option would not exercise it and Hans would keep the premium. If Hans went uncovered and the option was exercised against him, he would have to purchase Swiss francs on the spot market at a higher rate than he is obligated to sell them at. Here the writer of a call option has limited profit and unlimited losses uncovered. if

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FOREIGN CURRENCY SPECULATION (IX)

Speculating in the options market • Hans’ payout on writing a call option would be

Profit = Premium – (Spot rate - Strike price) = $0.005/Sfr – ($0.595/Sfr + $0.585/Sfr) = - $0.005/Sfr

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PROFIT & LOSS FOR THE WRITER OF A CALL OPTION
Profit (US cents/SF) + 1.00 + 0.50 0 - 0.50 - 1.00 Loss The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates less than 58.5, and an unlimited loss potential at spot rates above (to the right of) 59.0 cents/SF.
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“At the money” Strike price

Limited profit 57.5 58.0 58.5 59.0

Break-even price 59.5 Spot price (US cents/SF)

Unlimited loss

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FOREIGN CURRENCY SPECULATION (XI)

Speculating in the options market • • • • • Hans could also buy a put, the only difference from buying a call is that Hans now has the right to sell currency at the strike price. If the franc drops to $0.575/Sfr Hans will deliver to the writer of the put and receive $0.585/Sfr. The francs can be purchased on the spot market at $0.575/Sfr. With the cost of the option being $0.005/Sfr, Hans realizes a net gain of $0.005/Sfr. As with a call option - limited loss, unlimited gain.

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FOREIGN CURRENCY SPECULATION (XII)

Speculating in the options market • Hans’ payout on buying a put option would be

Profit = Strike price – (Spot rate + Premium) = $0.585/Sfr – ($0.575/Sfr + $0.005/Sfr) = $0.005/Sfr

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PROFIT & LOSS FOR THE BUYER OF A PUT OPTION
Profit (US cents/SF) “In the money” + 1.00 + 0.50 0 - 0.50 - 1.00 Loss The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates greater than 58.5 (“out of the money”), and an unlimited profit potential at spot rates less than 58.5 cents/SF (“in the money”) up to 58.0 cents.
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“At the money” Strike price “Out of the money”

Profit up to 58.0 57.5 58.0 58.5 59.0 59.5 Limited loss Spot price (US cents/SF)

Break-even price

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FOREIGN CURRENCY SPECULATION (XIII)

Speculating in the options market • • • • And of course, Hans could write a put, thereby obliging him to purchase francs at the strike price. If the franc drops below 58 ½ Hans will lose more than the premium received. If the spot rate does not fall below 58 ½ then the option will not be exercised and Hans will keep the premium from the option. As with a call option - unlimited loss, limited gain.

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FOREIGN CURRENCY SPECULATION (XIV)

Speculating in the options market • Hans’ payout on writing a put option would be

Profit = Premium – (Strike price - Spot rate)

= $0.005/Sfr – ($0.585/Sfr + $0.575/Sfr)

= - $0.005/Sfr

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PROFIT & LOSS FOR THE WRITER OF A PUT OPTION
“At the money” Profit (US cents/SF) + 1.00 + 0.50 0 - 0.50 - 1.00 Loss The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates greater than 58.5, and an unlimited loss potential at spot rates less than 58.5 cents/SF up to 58.0 cents.
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Strike price

Break-even price

Limited profit 58.5 59.0 59.5 Spot price (US cents/SF)

57.5

58.0

Unlimited loss up to 58.0

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OPTION PRICING AND VALUATION (I)

The pricing of any option combines six elements • • • • • • Present spot rate, $1.70/£. Time to maturity, 90 days. Forward rate for matching maturity (90 days), $1.70/£. US dollar interest rate, 8.00% p.a. British pound interest rate, 8.00% p.a. Volatility, the standard deviation of daily spot rate movement, 10.00% p.a.

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OPTION PRICING AND VALUATION (II)

The intrinsic value is the financial gain if the option is exercised immediately the-money) • • • This value will reach zero when the option is out-of-the-money. When the spot rate rises above the strike price, the option will be the-money. At maturity date, the option will have a value equal to its intrinsic value.

(at-

in-

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OPTION PRICING AND VALUATION (III)

When the spot rate is $1.74/£, the option is ITM and has an intrinsic value of $1.74 $1.70/£, or 4 cents per pound. When the spot rate is $1.70/£, the option is ATM and its intrinsic value is $1.70 $1.70/£, or zero cents per pound. When the spot rate is $1.66/£, the option is OTM and has no intrinsic value, only a fool would exercise this option.

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OPTION PRICING AND VALUATION (IV)
Option Premium (US cents/£)
6.0 5.0 4.0 3.0 2.0 1.0 0.0 1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.67

Strike Price of $1.70/£ -- Valuation on first day of 90-day maturity -Total value
5.67

4.00 3.30

Time value

Intrinsic value

Spot rate ($/£)
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OPTION PRICING AND VALUATION (V)

The time value of the option exists because the price of the underlying currency can potentially move further into the money between today and maturity • In the exhibit, time value is shown as the area between total value and intrinsic value.

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OPTION PRICING AND VALUATION (VI)

Option volatility is defined as the standard deviation of the daily percentage changes in the underlying exchange rate • It is the most important variable because of the exchange rate’s perceived likelihood to move either in or out of the range in which the option would be exercised. Volatility is stated per annum. Example: 12.6% p.a. volatility would have to be converted for a single day as follows.

• •

12.6% 12.6% = = 0.66% daily volatility 365 19.105

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OPTION PRICING AND VALUATION (VII)

For our $1.70/£ call option, an increase in annual volatility of 1 percentage point will increase the option premium from $0.033/£ to $0 .036/£ • The marginal change in option premium is equal to the change in option premium itself divided by the change in volatility.

Δ premium $0.036 − $0.033 = = 0.30 Δ volatility .11 − .10

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OPTION PRICING AND VALUATION (VIII)

The primary problem with volatility is that it is unobservable, there is no single correct method for its calculation. Thus, volatility is viewed in three ways • • • Historic – normally measured as the percentage movement in the spot rate on a daily basis, or other time period. Forward-looking – a trader may adjust recent historic volatilities for expected market swings. Implied – calculated by backing out of the market option premium.

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