International Finance: Currency Swaps Quiz

International Finance

• Currency Swaps: Counterparties use currency swaps to reduce debt financing costs, leveraging comparative advantages in national capital markets, and hedge exchange rate exposure.

Swap Bank

• Definition: A generic term for a financial institution facilitating swaps between counterparties.
• Types:
  • International commercial bank
  • Investment bank
  • Merchant bank
  • Independent operator

Swap Market Risks

• Dealer Risk: Dealers face higher risks than other market participants.
• Interest Rate Risk: Dealers might agree to fixed or floating rates.
• Basis Risk: Underlying indices or benchmarks don't correlate perfectly.
• Exchange Rate Risk: Currency fluctuations impact currency swap transactions.
  • Currency depreciation increases the cost for transactions.
• Political Risk: Political instability can disrupt markets and impact contracts.
• Sovereign Risk: Government debt and obligations can be affected by political actions.
• Credit Risk: A counterparty is likely to default on the contract.
• Exchange Rate Risk mitigation in Foreign investments: Foreign investments risk stems from currency fluctuation, but this can be avoided up to the limit of no default of the partner country.
• Swap Banks role: A swap bank will be willing to accept both sides of a swap contract.

Floating-for-floating Currency Swaps

• Differences in reference rates exist across various currencies.

Amortizing Currency Swaps

• Debt service is exchanged periodically as principal is amortized, leading to periodic exchange.

Portfolio Risk Diversification

• The classic "don't put all your eggs in one basket" philosophy describes portfolio risk.
• Investors can reduce portfolio risk by diversifying investments with securities with low correlations.
• Low correlation across securities in a portfolio leads to greater risk reduction.

Systematic Risk

• Non-diversifiable risk that remains after diversifying portfolio holdings.
• Risk of market movements.
• Investors can reduce this risk by diversifying portfolio holdings internationally.
• International diversification makes security returns less correlated.
• "Sharpe Performance Measure (SHP)": A risk-adjusted performance measure.

Foreign Stock Market Risk

• Foreign stock markets are less susceptible to fluctuations in currency than in bond markets.
• Foreign investments' risk comes through three channels.
  • Currency instability
  • Impact of cross-product term
  • Covariance with local market returns (but 1 and 3 mostly account for the volatility).

International Mutual Funds

• Allows investors to avoid additional transaction costs and overcome legal barriers in foreign markets.
• Benefits from expertise of fund managers.
• Closed-end mutual funds trade on stock exchanges like corporations.
  • Hedge fund advisors receive fees: 1%-2% of asset value plus 20-25% performance fees.
  • Cross-border acquisitions are usually synergy-generating.

FDI (Foreign Direct Investment)

• Creating MNCs (Multinational corporations)
• Types of FDI: Greenfield investments, cross-border M&A, new production facilities.
• FDI stocks represent past FDI flow totals.
• Alternatives to production overseas: exporting, licensing, avoiding foreign markets altogether.
• China investment reasons: low labor and material costs, being first into large, potentially huge markets.

Factors Influencing Overseas Investment

• Trade barriers
• Imperfect labor markets
• Intangible assets
• Profit maximization
• Global prestige & Competition
• Wage differentials (immobility of labor and different regulations across countries)
• Capital, land, labor, and entrepreneurship are important, but labor market's the least perfect.
• Immigration barriers
• Intangible assets (technological, managerial, marketing expertise, R&D, brand names).

FDI Internalization Theory

• Intangible assets with public good properties lead to more direct investment overseas.

Product Life Cycle Theory

• Early product demand is insensitive to price, allowing high prices.
• U.S. firms generally begin as exporters and become importers over time.

International Diversification

• Shareholders indirectly benefit from diversification in different countries.
• Greenfield investments are less politically sensitive when compared to acquiring an existing firm.
• Cross-border acquisition refers to buying an existing business.
• Synergistic gains occur when a combined firm is worth more than the sum of its parts.

Political Risk

• Losses for MNCs due to adverse political developments in a host country.
• Types: Transfer (capital and knowledge), operational, control.
• OPIC (Overseas Private Investment Corporation) assesses these risks in transactions.

Country Risk

• All risks except political risk.
• Systematic risk = market risk.

Weighted Average Cost of Capital (WACC)

• Calculation accounts for equity and debt costs.

Cost of Equity Capital

• The expected return investors require for a firm's stock.
• Often measured using Capital Asset Pricing Model (CAPM).
• A linear function of inherent systematic risk.
• Market risk premium = expected return - risk-free rate.

Cross-Listing

• Reasons for cross-listing: broadened investor base; more equity/debt capital from international markets, wider investor/consumer exposure.
• Foreign equity restrictions: make it hard/impossible for foreigners to control domestic companies

Pricing-to-market Phenomenon

• Foreign equity ownership restrictions create a premium/discount in pricing.
• Observed in relative prices of foreign shares, for instance, Nestlé shares.