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Questions and Answers
What is basis risk in the context of a swap?
What is basis risk in the context of a swap?
What event can increase the cost of euro payments in dollar terms in a currency swap?
What event can increase the cost of euro payments in dollar terms in a currency swap?
Which type of risk arises from adverse political events in a country where a dealer operates?
Which type of risk arises from adverse political events in a country where a dealer operates?
How does sovereign risk affect a swap agreement?
How does sovereign risk affect a swap agreement?
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What is a major risk that a swap dealer faces?
What is a major risk that a swap dealer faces?
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What is a primary purpose of an interest rate swap?
What is a primary purpose of an interest rate swap?
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What characterizes floating-for-floating currency swaps?
What characterizes floating-for-floating currency swaps?
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What does an amortizing currency swap do over time?
What does an amortizing currency swap do over time?
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What type of risk does transfer risk specifically refer to in the context of political risk?
What type of risk does transfer risk specifically refer to in the context of political risk?
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Which of the following accurately describes operational risk according to the content provided?
Which of the following accurately describes operational risk according to the content provided?
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What is meant by country risk as defined in the provided content?
What is meant by country risk as defined in the provided content?
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What type of integration does backward vertical integration represent in FDI?
What type of integration does backward vertical integration represent in FDI?
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What are synergistic gains in the context of mergers and acquisitions?
What are synergistic gains in the context of mergers and acquisitions?
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Which aspect of portfolio risk diversification is primarily highlighted by the adage 'Don't put all your eggs in one basket'?
Which aspect of portfolio risk diversification is primarily highlighted by the adage 'Don't put all your eggs in one basket'?
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Which of the following statements about a 'greenfield' investment is true according to the content?
Which of the following statements about a 'greenfield' investment is true according to the content?
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According to the internalization theory of FDI, firms with what kind of assets are inclined to direct foreign investment?
According to the internalization theory of FDI, firms with what kind of assets are inclined to direct foreign investment?
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What is the primary characteristic of systematic risk in relation to portfolio diversification?
What is the primary characteristic of systematic risk in relation to portfolio diversification?
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What does the Product Life Cycle Theory predict about the U.S. market over time?
What does the Product Life Cycle Theory predict about the U.S. market over time?
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How does international portfolio diversification primarily reduce risk?
How does international portfolio diversification primarily reduce risk?
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Which of the following statements about exchange rate fluctuations is correct?
Which of the following statements about exchange rate fluctuations is correct?
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Which statement regarding the Sharpe performance measure (SHP) is accurate?
Which statement regarding the Sharpe performance measure (SHP) is accurate?
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In the context of political and sovereign risk, which of the following is a potential consequence for investors?
In the context of political and sovereign risk, which of the following is a potential consequence for investors?
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Which aspect of investing in international mutual funds is a major advantage?
Which aspect of investing in international mutual funds is a major advantage?
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What is the significance of the 'world beta' measure in international finance?
What is the significance of the 'world beta' measure in international finance?
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Study Notes
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.
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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.
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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.
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Description
Test your knowledge on international finance with a focus on currency swaps. This quiz covers the definition and types of swap banks, risks associated with the swap market, and the implications of various financial factors. Improve your understanding of how currency swaps function in global markets.
