International Finance Master Class Test Two PDF

Internation al Finance Master Class. Test Two Prepared by: Younis Al-Qawasmi Source:International Financial Management, 10th Edition, Cheol S. EUN, McGraw Hill LLC International Finance Swap The primary reasons for a counterp...

Internation al Finance Master Class. Test Two Prepared by: Younis Al-Qawasmi Source:International Financial Management, 10th Edition, Cheol S. EUN, McGraw Hill LLC International Finance Swap The primary reasons for a counterparty to use a currency swap are to obtain debt financing in the swapped currency at an interest cost reduction brought about through comparative advantages each counterparty has in its national capital market, and the benefit of hedging long-run exchange rate exposure. 2  International Finance A is a U.S.-based MNC with AAA credit; B is an Italian firm with AAA credit. Firm A wants to borrow €1,000,000 for one year and B wants to borrow $2,000,000 for one year. The spot exchange rate is $2.00 = €1.00, a swap bank makes the following quotes for 1-year swaps and AAA-rated firms against USD SOFR. Swap Bank 1 USD € $ borrowing Year Quotation Euro The firms external borrowing opportunities Are borrowin Bid Ask Bid Ask g 6.1 8% 8.1% 6% % A € 7% $ 8% B € 6% $ 9% Is there a mutually beneficial swap? 3 International Finance Answer: Yes, Firm A swaps with the swap bank, $ at bid and € at ask. Firm B swaps with the swap bank, $ at ask and € at bid. Firms A and B would each save 90bp and the swap bank would earn 20bp. 4 Internation al Finance  Swap Bank 5  International Finance  Dealers carries greater risks than dealer In the swap market.  Suppose the quote for a five-year swap with semiannual payments is 8.40–8.50 percent. This means that if the swap bank is successful in getting counterparties to both legs of the swap at these prices, it will have an annual profit of ten basis points.  The following represent the risks that a swap dealer confronts: 1. interest rate risk A swap dealer might agree to pay a fixed rate and receive a floating rate, or vice versa. 2. basis risk. Basis risk occurs when the underlying indices or benchmarks for the two legs of a swap do not move in perfect correlation. 6 International Finance 3. exchange rate risk. For swaps involving different currencies, exchange rate risk arises from fluctuations in currency values. Dealers are exposed to the risk that the currency in which they are making payments weakens against the currency they are receiving, or vice versa. In a currency swap where the dealer pays euros and receives U.S. dollars, a depreciation of the U.S. dollar against the euro increases the cost of the euro payments in dollar terms. 4. political risk. Political risk is the possibility of losses due to adverse political events or instability in a country where the dealer operates or where counterparties are based. These events can disrupt markets, impose restrictions, or even nullify contracts. 5. sovereign risk. Sovereign risk is the risk that a government entity involved in a swap, or a party backed by a government, defaults on its obligations. This can also include the risk of a country unilaterally altering the terms of contracts through legal or regulatory changes. 7  International Finance  A major risk faced by a swap dealer is credit risk which is the probability that a counterparty will default.  A major risk that can be eliminated through a swap is exchange rate risk. But only to the extent that the foreign counterparty, or swap bank, will not default in the currency swap.  When a swap bank serves as a dealer, the swap bank stands willing to accept either side of a swap.  The two primary reasons for an interest rate swap are to better match maturities of assets and liabilities; to obtain cost savings via the quality spread differential 8  International Finance Floating-for-floating currency swaps have different reference rates for the different currencies: e.g. dollar SOFR versus euro SOFR. (Secured Overnight Financing Rate) Amortizing currency swaps: Decrease the debt service exchanges periodically through time as the hypothetical notational principal is amortized. Incorporate an amortization feature in which periodically the amortized portions of the notational principals are re-exchanged 9 International Finance Portfolio risk diversification refers in the context of investments in securities (stocks and bonds), are: 1.The classic saying "Don't put all your eggs in one basket" advises against concentrating all resources in one place. 2. Investors can mitigate portfolio risk by diversifying their holdings with securities that are not perfectly correlated. 3. The lower the correlation between securities in a portfolio, the greater the reduction in overall portfolio risk. 10 International Finance Systematic risk is non-diversifiable risk and the risk that remains even after investors fully diversify their portfolio holdings, is also known as non-diversifiable risk or market risk. Investors can reduce portfolio risk by holding securities that are A) less than perfectly correlated. B) diversifying portfolio holdings internationally. When we use the mechanical of international portfolio diversification, security returns are much less correlated across countries than within a county. The "Sharpe performance measure" (SHP) is a "risk-adjusted" performance measure, as well as the excess return (above and beyond the risk-free interest rate) per standard deviation risk. The "world beta" measures the sensitivity of returns on a security to world market movements. 11 International Finance Compared with bond markets the risk of investing in foreign stock markets is, to a lesser degree, attributable to exchange rate uncertainty. Exchange rate fluctuations introduce risk to foreign investments through three primary channels: 1.The volatility of the investment itself due to the exchange rate's instability. 2.The impact of the cross-product term. 3.The covariance with local market returns. But 1 and 3 contributes and accounts for most of the volatility 12 International Finance Investing in international mutual funds allows investors to: 1.Avoid additional transaction and information costs that come with direct foreign market investments. 2.Overcome legal and institutional barriers associated with direct portfolio investments in foreign markets. 3.Potentially benefit from the expertise of professional fund managers. A closed-end mutual fund trades on a stock exchange just like a publicly traded corporation. Hedge fund advisors typically receive a management fee, often 1 to 2 percent of the fund asset value as compensation, plus performance fee that can be 20-25 percent of capital appreciation. Cross-border acquisitions are generally found to be synergy-generating corporate activities. 13 International Finance When firms undertake FDI foreign direct investment, they become MNCs. FDI can take the form of A) Greenfield investment, B) cross-border M &A (merger and acquisition) the Ford Motor Company recently acquired Mazda, a Japanese auto maker, and Jaguar, a British auto maker, C) Establishing new production facilities in a foreign country. FDI stocks represent the accumulation of previous years' FDI flows. Alternatives to firms locating production overseas include: 1.Exporting from the home country. 2.Licensing production to a local firm in the host country. 3.Choosing not to enter the foreign market. 14  International Finance Why MNCs have invested in China? Low material cost Lower labor cost Desire to preempt the entry of rivals in china’s potentially huge market 15 International Finance The key factors influencing a firm's decision to invest overseas include: 1.Trade barriers, an imperfect labor market, and intangible assets. 2.Profit maximization, global prestige, and competition. Severe imperfections in the labor market result in persistent wage differentials among countries due to the following reasons: 1.Workers are not permitted to move freely across national borders to seek higher wages. 2.Workers may opt not to move across national borders to seek higher wages due to cultural differences. Factors of production include land, labor, capital, and entrepreneurial ability. Of all the factor markets, the most imperfect is the labor market. 16 International Finance Severe imperfections in the labor market arise from immobility of workers due to immigration barriers. As a response, firms should consider moving to countries where labor services are underpriced relative to productivity. Examples of intangible assets include: 1. Technological, managerial, and marketing expertise. 2. Advanced R&D capabilities. 3. Brand names. According to the internalization theory of FDI, firms that have intangible assets with a public good property tend to invest directly in foreign countries. 17 International Finance FDI vertical integration is backward when FDI involves an industry abroad that produces inputs for MNCs. An example of forward vertical integration when U.S. car makers were forced to build their own network of dealerships to enter the Japanese market. Product Life Cycle Theory:  In the early stages of the product life cycle, demand for the new product is relatively insensitive to price, allowing a pioneering firm to charge a higher price.  The theory predicts that over time, the U.S. transitions from being an exporter of new products to an importer.  The quantity sold over time forms an "S"-shaped curve when plotted. 18 International Finance When a firm holds assets in many countries, shareholders of the firm can indirectly benefit from international diversification even if they are not directly holding foreign shares. A "greenfield" investment s generally less politically sensitive than the acquisition of an existing foreign firm. Cross-border acquisition involves buying an existing foreign business. Synergistic gains refers to gains obtained when the value of the acquiring and target firms, combined, is greater than the stand-alone valuations of the individual firms. It also refers to gains arising if the combined companies can save on the costs of production, marketing, distribution, and R&D. 19 International Finance Political risk refers to the potential losses to the parent firm of an MNC resulting from adverse political developments in the host country. OPIC is the Overseas Private Investment Corporation Depending on the manner in which firms are affected, political risk can be classified into transfer, operational, and control risk. Transfer risk refers to the risk which arises from the uncertainty about cross-border flows of capital, payment, know-how, and the like. Operational risk refers to the risk which arises from the uncertainty about the host's country's policies affecting the local operations of an MNC. 20 International Finance Country risk refers to every risk except political risk. Systematic risk 21 International Finance K = weighted average cost of capital Kl = cost of equity capital for a leveraged firm i = before-tax borrowing cost τ = marginal corporate income tax rate λ = debt-to-total-market-value ratio weighted average cost of capital that is computed by: 1. weighing the pre-tax borrowing cost of the firm and the cost of equity capital, using the debt as the weight. 2. weighing the after-tax borrowing cost of the firm and the cost of equity capital, using the debt as the weight. 22 International Finance Solution: K= (1 − (2/3)) (0.124) + (2/3) (1 − 0.40) (0.08)=.0733=7.33% 23 International Finance Corporations are becoming multinational not only in the scope of their business activities but also in their capital structure by raising funds from foreign as well as domestic sources. The cost of equity capital is: The expected return on the firm's stock that investors require. Often estimated using the Capital Asset Pricing Model (CAPM). Typically regarded as a linear function of the systematic risk inherent in the security. The market risk premium can be defined by the difference between the expected market return and the risk-free rate. 24 International Finance A firm may cross-list its shares to: Establish a broader investor base for its stock. Gain name recognition in foreign capital markets, paving the way to source new equity and debt capital from international investors. Increase exposure to a wider group of investors and consumers. One explanation for foreign equity ownership restrictions is to make it difficult or impossible for foreigners to gain control of a domestic company. 25 International Finance The pricing-to-market phenomenon: Refers to the potential impact of foreign equity ownership restrictions. Describes the premium or discount faced by foreign shareholders relative to domestic investors in a stock's price due to legal restrictions on foreign equity ownership. Was observed in the relative prices of Nestlé shares before November 17, 1988. 26 End  Thank you and Good Luck  If you have any question, you can reach to your instructor Or Reach me through Teams or email: [email protected] 27