International Finance PDF

4. Exchange rate and the firm 4.1. Balance sheet Approach 4.1.1. Description of the Mic-Mac link It is a kind of domino’s effect in the financial sector. How a crisis can mute in another one (Candelon et al. 2013). But also the vulnerabilities from one sector to the another one;...

4. Exchange rate and the firm 4.1. Balance sheet Approach 4.1.1. Description of the Mic-Mac link It is a kind of domino’s effect in the financial sector. How a crisis can mute in another one (Candelon et al. 2013). But also the vulnerabilities from one sector to the another one; Banking to firms Firms to government,... Linking Micro and Macro risks. Micro aspects of exchange rate are linked to the expectation of exchange rate Ee. in the case of a macro risk, if F- leads to a bankrupt that will have impacts on F and on Ee. The risk is an exposure to an uncertain outcome associated with holding financial assets. It could concern the banks, the government, the firms and the households. What are the risks? (1) Credit Risk is possible loss from a fall in credit quality or default of a borrower (Banks, Government and firms). (2) Market Risk is possible loss from changes in financial prices (currency risk, interest rate risk, equity price risk, commodity price risk) ALL PARTICIPANTS. (3) Liquidity Risk is the inability to roll over debt or to liquidate assets in order to raise cash. Operational Risk: inadequate systems, management failures, fraud, human error Legal and Regulatory Risk: uncertainty about changes in codes, regulations, laws firms and banks Business Risk: uncertainty about demand for products firms and banks 4.1.2. The currency risk Currency risk (definition) is the variability in the value of an exposure caused by uncertainty about exchange rate changes currency. Ex. Airbus sells two A380 to Delta airline for 500 million US dollar. The delay of delivery is 6 months. Currently, the spot exchange rate is 1.35, that is one euro buys 1.35 $. But what will be the exchange rate in 6 months? If it goes down by 1%, Airbus is losing $7.8M !!! There is a currency risk. Currency Risk depends on (1) volatility of exchange rates and (2) amount of exposure. Degree of Risk is (1) Low = rate fixed, low exposure (2) High = rate volatile, high exposure 59 Whatever the type of production we have we are exposing to risk. If we (in Belgium) are buying oil for our machine, the change on exchange rate has a huge impact on our consumption. Exchange rate is very volatile because of overshooting. Exchange rate is thus very high. It also depends on our amount of exposure; if we are a national company then we are less exposed while if we are an international company, we are more exposed. 4.1.3. The exposure Long and Short Exposures (1) A person that is, for example, long the pound, has pound denominated assets that exceed in value their pound denominated liabilities. Ex. If we decide to hold a lot of assets in dollars, we are said to be long in dollars. Ex. Brussel Airlines have assets in EUR and liabilities in dollars since they are buying plane in dollars and thus they are long in EUR and short in dollars. (2) A person that is short the pound, has pound denominated liabilities that exceed in value their pound denominated assets. What is an exposure? Liabilities > assets = net exposure (short) Ex. of exposure: Brexit announcement If you are borrowing Yen to buy $ denominated assets? Are you short or long? Our liabilities are in yen and thus we are short in yen and long in dollar, we have an exchange rate risk. Who is long on $? Who is short? Ex. Brussels Airlines, its assets are in € while its liabilities are in $ (because they are buying boeings in $). As a result, they long in € and they short in $ and thus its exposure is in $. 60  4.2. Foreign Exchange rates (FX) markets and Hedging strategies Hedging is the fact of taking an equal and opposite position from that of the exposure, the idea is to remove the microeconomic risk. We take an opposite position of our asset holdings (short in dollar and thus we sell dollar) in order to remove our microeconomics risk. Ex. If we are short in dollar (= liabilities), we take a long position in dollar in order to offset the risk and we call that hedging. Even if we are hedging, we have a potential cost or a potential win. If we are long that means that we think that our currency will appreciate. We have to be long in the currency we think will appreciate and short in the one that will depreciate. Either hedging means that we counterbalance, we remove the risk or we can take the risk be being long in the currency that will increase and short in the currency that will decrease. For example, if Airbus is long the dollar, it would have to take an offsetting short position to hedge their exposure. OR One who is long in a market is betting on an increase in the value of the thing, whereas with a short position they are betting on a fall in its value. Hedging can be performed on the FX market which includes several markets; (1) Futures/forward (2) Option (3) Swap These are called financial derivatives. 4.2.1. Spot Markets (reminder) 4.2.1.1. Market Participants Everybody participate in the foreign exchange market. That’s a very large market in which there is a lot of people who have different utilities and purposes. If we don’t make the same forecasts that means that we haven’t the same exposure to risk. That a necessary position to make the market work because if everybody was thinking and doing the same thing, there wouldn’t be any selling and buying and thus there will be no market. The foreign exchange market consists of two tiers: Five broad categories of participants operate within these two tiers; (1) The interbank or wholesale market (multiples of $1MM US or equivalent in transaction size) (1) bank and nonbank foreign exchange dealers, (2) The client or retail market (specific, smaller (2) individuals and firms, amounts) (3) speculators and arbitragers, (4) central banks and treasuries, (5) and foreign exchange brokers. Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market. Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose. Some of the participants use the market to “hedge” foreign exchange risk. 4.2.1.2. Spot Rate Quotations This is what we are dealing since the beginning of the course. 4.2.1.3. The Bid-Ask Spread This the price a buyer is willing to pay for an exchange rate while the other one is the price the dealer is want to be paid. (1) The bid price is the price a dealer is willing to pay you for something. (2) The ask price is the amount the dealer wants you to pay for the thing. (3) The bid-ask spread is the difference between the bid and ask prices. 61 The higher is the uncertainty, the higher will be the bid-ask spread, which is the difference between the orice of the seller and the price of the buyer. The supply increases with the price and the demand decreases with the price. The bid ask price for a certain quantity is the difference between the price of the seller and the demander. There is an auction system which say that if … higher than … then they will increase the quantity and we call that the Cobb-web. Arrow-Debreu showed that most of the time we were moving to the equilibrium price but when it doesn’t’ happen an auction has to happen. They listed all the cases after which an auction has to happen in order to get the equilibrium price. Sometimes auction mechanism doesn’t lead to the equilibrium price. Ex. A dealer would likely quote these prices as 72-77. It is presumed that anyone trading $10m already knows the “big figure”. 4.2.1.4. Spot FX trading 4.2.1.5. Cross Rates It was a big way to make a lot of money 30 years ago. Imagine we have three market, EUR, dollar and yen and that we can exchange EUR/dollar, dollar/yen and yen/EUR. If we make this transformation, at the end on a perfect market, we $ 𝑑𝑜𝑙𝑙𝑎𝑟 𝑦𝑒𝑛 can get a value of one  ∗ ∗ = 1. We call that a triangular arbitrage. It is used to make money on the 𝐸𝑈𝑅 𝑦𝑒𝑛 𝐸𝑈𝑅 spot market thanks to conversion. Suppose that S($/€) = 1.50 (i.e. $1.50 = €1.00) and that S(¥/€) = 50 (i.e. €1.00 = ¥50). What must the $/¥ cross rate be? $1.50 €1.00 $1.50 ∗ = → $1.00 = ¥33.33 and $0.0300 = ¥1 €1.00 ¥50 ¥50 4.2.2. Triangular arbitrage Suppose we observe these banks posting these exchange rates. First calculate any implied cross rate to see if an arbitrage exists. As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $. Sell $100,000 for £ at S(£/$) = 1.50  receive £150,000 62 Sell our £150,000 for ¥ at S(¥/£) = 85  receive ¥12,750,000 Sell ¥12,750,000 for $ at S(¥/$) = 120  receive $106,250 Profit per round trip = $106,250 – $100,000 = $6,250 Here we have to go “clockwise” to make money—but it doesn’t matter where we start. If we went “counter clockwise” we would be the source of arbitrage profits, not the recipient! As a quick spot method for triangular arbitrage, write the three rates out with a different denominator in each:  1.3285 CHF / USD  0.00851 USD / JPY  88.20 JPY / CHF If there is parity:. If this is greater, or less than, 1 an arbitrage opportunity exists. An answer < 1 means that one of the component rates (fractions) is too low. An answer > 1 mean that one of the rates is too high. If the total is less than one, assume that any of the fractions is too low, e.g. CHF/USD. This would imply that CHF is too low (overvalued vs USD) or USD is too high (undervalued vs CHF); this tells us to either buy the undervalued or sell the overvalued currency. 4.2.3. Hedging can be performed on the Foreign Exchange market 4.2.3.1. Future/Forward (259) The idea here is that historically it was the forward market (first one the rice market). Rice production only happens once a year and thus it is very important for the agriculture to have a current amount of money coming and thus they are selling before the production, their future production. As a result, it preserves the price and it guarantees … of the good. Ex. Cereals and Barilla  The intermediate good for the pasta industry is cereals. The future market has the same idea but with standardized products and thus standardized forward market. A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. 4.2.3.1.1. First (Organized) Forward Market: Osaka Begun at Dojima, Osaka, Japan, in 1670s. World’s only futures market until 1860s. Dojima was center for rice trade, with 91 rice warehouses in 1673. Dojima futures exchange had precise definitions of quality, delivery date and place, experts who evaluated rice quality, and clearinghouses for contracts. Trading floor, daily resettlement, burning fuse, and watermen. 4.2.3.1.2. Futures vs Forwards Contracts Futures contracts differ from forward contracts in that contractors deal with an exchange rather than each other, and thus do not need to assess each other’s credit. They are standardized retail products, rather than custom products. Furthermore, they rely on margin calls to guarantee performance. But almost similar mechanisms. 63 But Success of Futures Over Forwards (1) Futures more liquid: standardized, can be traded again, delivery of range of securities (2) Delivery of range of securities prevents corner (3) Mark to market and margin requirements: avoids default risk (4) Don’t have to deliver: netting 4.2.3.1.3. Futures Contract Mechainism To enter in the future market, we have to put in a bank 10% or 15% of the transaction in order to limit the infine leverage cost. Futures contract is a standardized agreement between two parties committing one to buy and the other to sell at a set price on or before a given date in the future. (1) Margin: performance bonds or good-faith deposits to insure contract performance (2) Initial Margin: Minimum amount required to initiate a trade (3) Maintenance margin: Minimum amount required at all times to sustain a market position (4) Margin call: when margin level is lower than maintenance margin 4.2.3.1.4. Mark-to-market Daily settlement of gains and losses between buyers and sellers. (1) If spot price rises, sellers pay buyers in cash for the change in price (2) If spot prices falls, buyers owe sellers (3) If a futures trader losses too much, more money will need to be put in the margin account. 4.2.3.1.5. Futures characteristics (1) Delivery  Physical delivery (only 1% to 2%)  Cash settlement (2) Long position: buyer of a future contract & Short position: seller of a future contract (3) Trading  Open-outcry: by voice and hand signals  Electronically: by network (4) Floor broker and dual trader execute customer orders (5) Can be terminated by an offsetting transaction 4.2.3.1.6. Contractual Provisions Underlying asset: Commodity, currency, financial instrument index or other item Amount and quality of the underlying asset Delivery cycle: months for which the futures contracts can be traded Expiration date Settlement Mechanism and Delivery Location 4.2.3.1.7. Examples Tick size: $.10 per troy ounce, $10 per contract 100 oz gold A gold price change of $3.00 causes a $300 mark to market Initial margin = $1,053 CME S&P 500 $250 times the Standard & Poor's 500 Stock Price Index.01 index points = $2.50 Initial margin = $19,688 Euro 125,000 Euro $.0001 per Euro = $12.50 per contract Initial margin = $900 64  10-year T-note Face value at maturity of $100,000 Every 1/32 move in the bond price leads to a $15.625 mark to market per contract Initial margin = $1,013 Many contracts have “mini” versions. 4.2.3.1.8. Payoff for futures positions If we are short on the market that means that we expect the price to decrease while if we are long we expect the price to increase. This is a zero-sum game !!! Ex. Consider again the case of Airbus and its A380 sales. The contract amounts US$ 500 million to repatriate in Euro. Airbus is long the US$, so to hedge its exposure it will go short [sell dollar] in the futures market. The face amount of each dollar future contract is US$ 100 million, so the firm will go short 5 contracts. To go short in the future market, they will sell some future contracts in dollar. If the dollar depreciates, the euro value of its contract profits falls, but the futures account generates profits, at least partially offsetting the loss. The opposite holds for an appreciation of the dollar If the spot rate opens at 1.35 (€/$) while the price on a P future opens at 1.34. 6 months after the markets closes at 1.34 and 1.32 respectively. The loss on the underlying position is: (1.34-1.35)500M = -5M€ The gain on the futures position is: (1.34-1.32)5100= 10M€  If Airbus wins then Delta Airlines loses the same amount, we call that a zero sum game. 4.2.3.2. Option 4.2.3.2.1. Currency Options - Vocabulary We are not force to exercise the contract, we can decide whether or not we will exercise it. It is a future contract on which we have the right to exercise it or not. A currency option is a contract that gives the owner the right, but not the obligation, to buy or sell a currency at a specified price at or during a given time. (1) Call Option: An option that gives the owner the right to buy a currency. (2) Put Option: An option that gives the owner the right to sell a currency. How are currency options simultaneously both put & call options? (1) American Option: An option that can be exercised any time before or on the expiration date. (2) European Option: An option that can only be exercised on the expiration date. (1) Exercise or Strike Price: The price (spot exchange rate) at which the option may be exercised. (2) Option Premium: The amount that must be paid to purchase the option contract. (3) Break-Even: The point at which exercising the option exactly matches the premium paid. 65 When I lose I exercise. To put the contract in the market when we benefit and to exercise when I make lost. (1) If the spot rate has not yet reached the exercise price [SX], the option is said to be “in the money.” 4.2.3.2.2. Call Option The holder of a call option expects the underlying currency to appreciate in value. Consider 4 call options on the euro, with a strike price of 152 ($/€) and a premium of 0.94 (both cents per €). The face amount of a euro option is €62,500. The total premium is: $0.0094·4·€62,500=$2,350. Call option: Not exercising the option = out-of-the- money. Between the two we have the break-even point. 4.2.3.2.3. Put Option The holder of a put option expects the underlying currency to depreciate in value. Consider 8 put options on the euro with a strike of 150 ($/€) and a premium of 1.95 (both cents per €). The face amount of a euro option is €62,500. The total premium is: $0.0195·8·€62,500=$9,750. 4.2.3.2.4. Option Pricing & Valuation 4.2.3.2.4.1. Value of a call option at maturity S-X, where S-X>0 [otherwise value is zero], = Intrinsic value 4.2.3.2.4.2. Value of a call option prior to maturity Intrinsic value + Time value Time Value is a function of: Time to expiration, volatility, domestic & foreign interest rate differentials. 66  4.2.3.3. Swaps 4.2.3.3.1. Foreign Currency Swaps A currency swap is an exchange of debt-service obligations denominated in one currency for the service on an agreed upon principal amount of debt denominated in another currency. A currency swap is often the low-cost way of obtaining a liability in a currency in which a firm has difficulty borrowing. A pair of firms simply borrow in currencies they have relative advantage borrowing in, and then trade the obligations of their respective loans, thereby effectively borrowing in their desired currency. Ex. Dell computers would like to borrow in Swiss Francs to hedge its ongoing cash flows from that country... Nestle would like to borrow in Dollars to hedge its sales to the U.S... But both firms are relatively unknown to the respective credit markets, and thus anticipate unfavorable borrowing terms. But an investment bank comes along and suggests that each borrow in the credit markets that are comfortable with them......and then the investment bank will give them sufficient cash flows each period to cover the obligations of these loans... 67...in return for making the payments in the foreign currency that exactly match the other firm’s obligations. In other words, the swap effectively ‘completes the market’. Giving each firm access to the foreign debt market at reasonable terms. 4.2.3.3.2. The All-In Cost of a Swap Clearly, the relative magnitudes of the respective payments determine each firm’s ultimate cost of borrowing. This cost is called the ‘all-in cost’. It is the effective interest rate the firm ends up paying on the money that it raised. It is the discount rate that equates the NPV of future interest and principal payments to the net proceeds received by the issuer. 4.2.3.3.3. Swaps vs. Forwards Notice that on a one-year loan, a currency swap is no different than a one-year forward contract. In fact, a currency swap can really be thought of as a firm taking a domestic currency loan and purchasing a series of forward contracts to convert the payments into known foreign currency obligations. The implied forward rates need not equal the actual forward rates, but taken as a whole, should resemble an average forward rate over the term of the loan. 4.2.3.3.4. Comparative Borrowing Advantage Swaps only exist because there are market imperfections. If firms can access foreign and domestic debt markets at equal cost, clearly swaps are redundant. One important reason that currency swaps are so useful is that firms engaged in a swap need not each have an absolute borrowing advantage in the currency in which they borrow vis-a-vis the counterparty. In fact, it is quite likely that Nestle has better access to both the U.S. and Swiss debt markets than Dell.  Comparative Advantage 68 4.2.3.4. Evolution of the three types of FX markets 69  4.3. Exercises 4.3.1. Exercise 1 This exercise is purely empirical and requires the use of excel as well as the 2 add-ins hpfilter add-ins (which can be downloaded on the web). Upload the monthly spot exchange rate of the US$ per Euro from the federal reserve bank of Saint Louis (Fred economic data) from 1999:1 to 2018:12. 4.3.1.1. Plot the series and interpret the evolution of the nominal exchange rate. Exchange rate cycles Several approaches are available to decompose the trend and the exchange rate cycles Let us consider first the moving averages: 4.3.1.2. Calculate the three following moving averages 12/0/0, 6/0/6, 0/0/12 (where p/1/q represents a moving average taking p periods before, the current observation and q periods ahead). Plot the 3 moving average as well as the current exchange rate. Interpret and give some trading recommendations. Let us now consider the Hodrick-Prescott (HP). 4.3.1.3. Calculate the trend/cycles obtained using the 3 different HP filter (with  =14,400, 300 and 100,000). Plot them and compare the results obtained with these filters. Consider now the case for which  =14,400. 4.3.1.4. Interpret the decision strategies induced by the different MA and the HP filters. 4.3.1.5. Calculate the trend/cycle decomposition obtained using a band pass filter, with frequencies between 2 and 8 years. Compare the results and the implied trading strategies obtained using BP and HP filters. Exchange rate trends The US$/€ exchange rate trend can be linear or stochastic. 4.3.1.6. Explain both concepts and the consequences for forecasters and traders. 4.3.1.7. Fit a linear trend, on the exchange rate growth rate. Interpret the coefficients of the linear trend and forecast the values of the US$/€ trend for the next 6 months (i.e. until June 2018). 4.3.1.8. The IMF prognoses that the US economy will increase by 5% next year. What is the implication for the US$/€ and what implications it has for your trading strategy. 4.3.2. Exercise 2 – Future contract You decide to sell future Swiss franc futures contract (short position) at time t at a price of 1.02 $ per Swiss Franc (CHF). Your initial margin is 100.000$ for a horizon h. 4.3.2.1. Explain what is a future contract as well as the potential benefits and losses. If there is a depreciation, we will get less dollar for one CHF. So, if we have the possibility to … we will get profit out of this margin. A loss is an appreciation of the CHF. 70  4.3.2.2. Explain in which cases you will make benefit and thus what are your expectations in term of the future value of the Swiss Franc vis à vis of the US dollar. 4.3.2.3. Graph your potential pay-off vis-à-vis of the spot rate of the $/Swiss Franc. 4.3.2.4. 3 following exchange rates of the $/Swiss Franc can be imagined: T1: 1.11, T2: 1.02, T3: 0.9 4.3.2.5. Calculate for each case the cash flow and the margin obtain using the future contract. 4.3.3. Exercise 3 – Option contract (optional) Assume that today is March 7, 2018 and, as the newest hire for Goldman Sachs, you must advise a client on the costs and benefits of hedging a transaction with options. Your client (a small U.S. exporting firm) is scheduled to receive a payment of €6,250,000 on April 20, 44 days in the future. Assume that your client can borrow and lend at a 6% p.a. U.S. interest rate. 4.3.3.1. Describe the nature of your client’s transaction exchange risk. … for 44 days and then we will borrow money to make the job and then we execute the contract. The risk here is the possibility to the euros will depreciate. + schema Thibault 4.3.3.2. Use the appropriate American option with an April maturity and a strike price of 129¢/€ to determine the dollar cost today of hedging the transaction with an option strategy. The cost of the call option is 3.93¢/€, and the cost of the put option is 1.58¢/€. If the dollar goes beyond (depreciation of the euros) then we can exercise the option. The cost of the call is equal to 3.93 per EUR and the one of the put is 1.58 per EUR. Here, what we want to do is a put option and thus, we want to buy dollar for euros, for a fixed price. We take the opposite position of our contract! The cost of the contract is equal to; 𝑐𝑜𝑠𝑡 = 6,250,000 ∗ 0.0158 = 98,750 𝑑𝑜𝑙𝑙𝑎𝑟. The minimum amount (the price when we exercise our option) that he will receive in April will be equal to: (1.29*6,250,000)-costs of the option-cost of the loan. Let us remind that the cost of the loan is equal to 44 (1 + (0.06 ∗ )) ∗ 6,250,000. As a result, the minimum amount will be equal 8,062,500 − 98,750 − 45,205 − 3.93 44 (1 + 0.06) ∗ 393 ∗ 6,250,000 = 6,295,205. 4.3.3.3. Graph the pay-off of the option vis-à-vis of the € spot rate. (do not consider here the cost of hedging) 4.3.3.4. What is the minimum dollar revenue your client will receive in April? Remember to take account of the opportunity cost of doing the option hedge. 71 5. Exam It will be a close book exam instead of an open one. As a result, we will have to give some definitions, … 3 hours of exam Marshall Lerner – Robinson condition: Marshall Lerner has two effects; when we devaluate, there are two effects; the price effect (the import are less expensive) and the volume effect (export increases while import decrease). The trade balance deteriorates itself, we expect that the volume effect will dominate in the long run. If the relative elasticity of the export compared to the import is sufficiently large. As a result, when there is a depreciation, the volume effect is bigger and dominate the price effect. The elasticity of the substitution of the export compared to the import is very small and nearly equal to zero. Dornbush-Fisher (forward looking expectations + overshooting effect) and Mundel-Fleming (no expectation and no overshooting, it is based on backward looking expectations). Currency prices: The Dornbusch-Fisher graph when we run an expansionary monetary policy, there will be a depreciation of the exchange rate while when the exchange rate is fixed, we cannot depart from there. As a result, there is a shadow exchange rate that should prevail if there is no international agreement. The shadow one is below the real one and the gap between those two exchange rates correspond to the flow of reserves. In the short run, expectations change while in the long run, there is an adjustment of prices which means that we know that we have the classical dichotomy and interest rate should shift back. The long run is when prices fully adjust while in the short run, prices are fully fixed. In the classical model, we enter the price and the price adjusts. Forward is a cumulation of individual positionings in the market. So if there is a shock, the individual doesn’t know the future shock. The future helps to remove individual uncertainty but not the one of the system. That’s the difference between the individual risk and the market risk for which we cannot cover ourselves. Chapters 14, 15 and 16 of the book 72