Fin 3305 Final Notes PDF

lOMoARcPSD|48377775 Final notes - Summary International Financial Management International Financial Management (Douglas College) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university...

lOMoARcPSD|48377775 Final notes - Summary International Financial Management International Financial Management (Douglas College) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 CHEATSHEET CHAP 6 Interest Rate Parity: Purchasing Power Parity: Exact: (F/S)(1 + i£) = (1 + i$) Approximate: Fisher effect: International Fisher Effect: Exact: Approximate: CHAP 7 Face value of open interest = # of contracts x size of contract Long call: Profit = (# of contracts x size of contract) x [spot price – (exercise price + premium)]/10,000 changes in the performance bond account current balance + [(exercise price1 – spot price1) + [(exercise Short futures price2 – spot price2) + …] x contract size current balance + [(spot price1 - exercise price1) + [(spot Long futures price2 - exercise price2) + …] x contract size Call option Put option In-the-money exercise price < spot price Exercise, spot price – Expire, 0 At-the-money exercise price = spot price exercise price Exercise, exercise price Out-of-the-money exercise price > spot price Expire, 0 – spot price Option Premium = Intrinsic Value + Speculative Value |exercise price - spot price| Option premium – intrinsic value Loss Break even Gain Long call __/ Limited = - premium Exercise price + premium Unlimited Long put \__ Limited = - premium Unlimited Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 Short call ¯¯\ Unlimited Limited = premium Short put /¯¯ Unlimited Limited = premium CHAP 14 Interest rate swaps NO SWAP BANK Net borrowing cost all-in (swapped) cost Floating rate payer = fixed - float = = float - QSD/2 Fixed rate payer = float - fixed = = fix - QSD/2 QSD = abs (fixed rate differential) - abs (floating rate differential) SWAP BANK all-in (swapped) cost Floating rate payer = fixed + float - bank lower fixed Fixed rate payer = float + bank higher fixed - bank float QSD = abs (fixed rate differential) - abs (floating rate differential) Bank profit = QSD - saves of borrowing cost of counterparties Currency swap annually 6-month $1 x1% y1% LIBOR for $1 $2 x2% y2% LIBOR for $2 enter into - pay $2 payments @ x2%/year - receive $2 payments @ y2% $1/$2 - receive 6-month $1 LIBOR flat - pay 6-month $1 LIBOR flat currency - pay annual $1 payments @x1% - receive annual $1 payments @y1% swap - receive 6-month $2 payments @y2% - pay annual $2 payments @ x2% Arbitrage Ask: bank sell, Bid: bank buy. Ask > bid. Spread = ask – bid Step Determine Price Future/ Forward Long or short? future > current Short (buy @ current price) 1 Call or put? future ≤ current Long (sell @ current price) Borrow cash or return rate of arbitrage > interest rate, borrow money 2 underlying asset? return rate of arbitrage < interest rate, borrow asset Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 CHAP 7 Derivatives’ value is ‘derived’ or contingent on an underlying asset, like stocks, currencies or bonds. Futures, options or forward contracts are derivatives. Futures contract Forward contract It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today standardized contracts trading on organized Tailor-made contracts on OTC market exchanges with daily resettlement useful for speculation and hedging, usually Almost contracts are delivered. closed out in a reversing trade speculator hedgers attempts to profit from a change desires to avoid price variation Purpose in the futures price take a long or short position in a locking in a purchase price of the futures contract depending on underlying asset through a long How expectations of future price position in a futures contract or a movement. sales price through a short position An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today. Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 CHAP 14 Swap: two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. 2 types:  Single currency interest rate swap: “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.  Cross-Currency interest rate swap: “currency swap”; fixed for fixed rate debt service in two (or more) currencies. Swaps are off-the-books transactions. Swap bank: a financial institution that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer. swap broker Swap dealer arranges a swap between two counterparties for market maker of swaps and assumes a risk a fee without taking a risk position in the swap position in matching opposite sides of a swap and in assuring that each counterparty fulfills its contractual obligation to the other. Quality Spread Differential (QSD): the potential gains from the swap that can be shared between the counterparties and the swap bank. Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 For a fixed-for-floating interest rate swap to be possible it is necessary for a quality spread differential to exist. Risks of Interest Rate and Currency Swaps:  Interest Rate Risk: Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position.  Basis Risk: If the floating rates of the two counterparties are not pegged to the same index.  Exchange rate Risk: In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.  Credit Risk: This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap.  Mismatch Risk: It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.  Sovereign Risk: The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap. Variations swaps: Interest rate swaps Currency swaps zero-coupon-for-floating rate swaps: fixed rate fixed-for-floating payer makes only one zero-coupon payment at maturity on the notional value. Floating-for-floating rate swaps: each side is floating-for-floating tied to a different floating rate index or a different frequency of the same index. CHAP 9 Exchange rate changes can affect a firm’s value by influencing its operating cash flows and the domestic currency value of assets and liabilities.  The competitive effect: exchange rate changes may affect operating cash flows by altering the firm’s competitive position.  The conversion effect: A given operating cash flows in terms of a foreign currency will be converted into higher or lower dollar (home currency) amounts as the exchange rate changes Foreign currency exposure is classed as economic, transaction and translation exposure. Exposure to currency risk can be measured by the coefficient in regressing the dollar value of the foreign asset on the exchange rate. Once the exposure is known it can be hedged. Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 Operating exposure depends on the effect of random exchange rate changes on the firm’s future cash flows, something not easily measurable. The firm’s operating exposure is determined by:  The structure of the markets in which the firm sources its inputs and sells its products;  The firm’s ability to mitigate the effects of exchange rate changes by adjusting markets, product mix and sourcing; A firm can manage exposure by:  Choosing low cost production sites;  Maintaining flexible sourcing policies;  Diversification of the market;  Product differentiation;  Financial hedging. CHAP 16 FDI involves either establishment of new production facilities in foreign countries or acquisition of new businesses in foreign countries; The US, UK, France, Germany and the Netherlands are the leading sources of FDI, and these countries are also the leading recipients (with China) of FDI. China attracted a great deal of FDI recently because foreign firms want to: - take advantage of inexpensive labor and resources - gain access to the Chinese market that is often not accessible otherwise. Existing theories emphasize market imperfections, such as product, factor and capital markets, as key forces driving FDI. The internalization theory of FDI proposes that firms that have intangible assets with a public good property tend to directly invest in foreign countries in order to invest on a larger scale plus avoid misappropriation that could occur if the firm solely engaged in trade. Many foreign firms might have been motivated to gain access to technical know-how residing in U.S. firms and at the same time monopolize its use. Product life cycle theory described the experience of US firms during the 1960’s, and explained the migration of production from more developed countries to less-developed countries as the need to cut production costs rose and products became more standardized. Japanese MNCs have invested heavily in Southeast Asia in order to take advantage of under priced labor services and cheaper land and other factors of production. Refer to the life-cycle theory of FDI. Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 Cross border acquisitions have recently become more popular. Synergistic gains may be possible if the acquirer can take advantage of market imperfections. Intangibles may be an important source of gains from market imperfection. Forward internalization Backward internalization MNCs with intangible assets make FDI in order to MNCs acquire foreign firms in order to gain utilize the assets on a larger scale and at the access to the intangible assets residing in the same time internalize any possible externalities foreign firms and at the same time internalize generated by the assets any externalities generated by the assets. The host country tends to view green field investments as creating new production facilities and new job opportunities. In contrast, cross-border acquisitions can be viewed as foreign takeover of existing domestic firms, without creating new job opportunities. Political risks arise from a number of factors: - political/government systems - integration into the world political/economic system - ethnic and religious stability - regional security - key economic factors. CHAP 15 International portfolio investment (IPI) has been growing rapidly in recent years due to (a) the deregulation of financial markets, and (b) the introduction of such investment vehicles as international mutual funds, country funds, and internationally cross-listed stocks. Security returns are found to be less correlated across countries than within a country. The world beta measures the sensitivity of returns to a security to returns to the world market portfolio. It is a measure of the systematic risk of the security in a global setting. The Sharpe performance measure (SHP) is a risk-adjusted performance measure. It is defined as the mean excess return to a portfolio above the risk-free rate divided by the portfolio’s standard deviation. Investors diversify to reduce risk; the extent to which the risk is reduced by diversification depends on the covariances among individual securities making up the portfolio. Since security returns tend to covary much less across countries than within a country, investors can reduce portfolio risk more by diversifying internationally than purely domestically. Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 Investors can gain from international diversification in terms of “extra” returns at the “domestic- equivalent” risk level. Empirical evidence indicates that regardless of domicile and the numeraire currency used to measure returns, investors can capture extra returns when they hold their optimal international portfolios. Foreign exchange rate uncertainty contributes to the risk of foreign investment through its own volatility as well as through its covariance with local market returns. Generally speaking, exchange rates are substantially more volatile than bond market returns but less so than stock market returns. This suggests that investors can enhance their gains from international diversification, when they hedge exchange risk using, say, forward contracts. U.S.-based international mutual funds that investors actually held did provide investors with an effective global risk diversification. In addition, the majority of them outperformed the U.S. stock market index in terms of the Sharpe performance measure. Closed-end country funds (CECFs) also provided U.S. investors with an opportunity to achieve international diversification at home. CECFs, however, were found to behave more like U.S. securities in comparison with their underlying net asset values (NAVs). Despite sizable potential gains from international diversification, investors allocate a disproportionate share of their funds to domestic securities, displaying “home bias”. CHAP 11 International banks facilitate imports and exports by arranging trade financing. They also arrange foreign currency exchange, assist in hedging exchange rate exposure, trade foreign exchange for their own account, and make a market in currency derivative products. Various types of international banking offices include correspondent bank relationships, representative offices, foreign branches, subsidiaries and affiliates, Edge Act banks, offshore banking centers, and International Banking Facilities. The reasons for the various types of international banking offices and the services they provide vary considerably. A Eurocurrency is a time deposit of money in an international bank located in a country different from the country that issued the currency. For example Eurodollars are deposits of U.S. dollars in banks outside of the United States. The Eurocurrency market is headquartered in London. Other main international money market instruments include forward rate agreements, Euronotes, Eurocommercial paper, and Eurodollar interest rate futures. Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 Capital adequacy refers to the amount of equity capital and other securities a bank holds as reserves to reduce the probability of a bank failure. The global financial crisis that began in mid-2007 illustrated how quickly and severely liquidity risks can crystallize and certain sources of funding can evaporate. The international debt crisis was caused by international banks lending more to Third World sovereign governments than they should have. The Asian crisis began in mid-1997. The crisis followed a period of economic expansion in the region financed by record private capital inflows. The global financial crisis began in the United States in the summer of 2007 as a credit crunch, or the inability of borrowers to easily obtain credit. The origin of the credit crunch can be traced back to three key contributing factors: liberalization of banking and securities regulation, a global savings glut, and the low interest rate environment created by the Federal Reserve in the earlier part of the decade. Low interest rates created the means for first-time homeowners to afford mortgage financing and for existing homeowners to trade up to more expensive homes. The Euro as Common Money, not a Single Currency The euro crisis forces us to completely rethink European monetary policy. The European Central Bank’s policy of buying back sovereign debt does not address the real problem: it is only a way of propping up a system that has already failed. A structural response to the crisis would consist of giving states back the power to act, but in a way that would not destroy the monetary union. This paper suggest a way in which, while preserving the Eurozone, each state would put into circulation in its own territory a complementary currency guaranteed by tax revenue and pegged to the euro, what we call a “fiscal currency”. This parallel currency would be a “popular” currency, issued as bills in small denominations and intended for day-to-day purchases. The euro would continue to be used for large transactions, transactions occurring at the European level, and for savings. The kind of monetary federalism we propose would end the private banking system’s monopoly on currency issuance. Alongside a common currency regulated by European monetary authorities, it would create complementary national currencies subject to individual governments. At the same time, it would offer a response to the current crisis, though its scope is not limited to the problems afflicting the Eurozone’s “peripheral” countries. More fundamentally, we affirm that a currency’s organizing principles must be consistent with a political community’s foundational values. In the case of the European Union, the goal is to transpose Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 onto monetary policy the old maxim “unity in diversity” and to recognize monetary policy as a tool that must be available to a sovereign people to ensure its survival. A decentralized fiscal currency—whether it be national, regional, or local, as it is perfectly possible to envisage several levels of issuance, providing they are backed up by anticipated fiscal revenue—is first of all a form of short-term credit that is cheaper than credit offered by financial markets. But its goals could also be more ambitious: it can be designed as a full-fledged means of payments, a currency that permanently circulates through the local economy alongside the euro. To this end, it must be accepted by the population, and its implementation must be negotiated with the private sector. To do so, the government must actively build trust in the new currency and ensure its convertibility into euros. The third goal of a fiscal currency is to force states to pursue more responsible fiscal and financial policies. When a superior federal currency exists, a state issuing its own means of payment has every interest in maintaining its value: inflationary policies would reduce the value of its own future revenue and undermine its credibility and thus viability by increasing its dependence on federal authorities. The need for internal convertibility and the defense of euro parity distinguishes our proposal from other ideas that have been recently advanced in the European debate, notably relating to the crisis in Greece, where a parallel currency would be devalued as soon as it was established. Creating a parallel fiscal currency and defending its parity are challenging but feasible political actions, as several international political experiments indicate. Ultimately, it is an attempt to reform public governance in the midst of a crisis of confidence in the usual procedures of neoliberal “good governance.” Its success depends on the capacity of issuing authorities to win the trust of their populations: a fiscal currency issued by a state or local government must be seen as legitimate as the euro itself The Greek Debt Crisis: Overview and Implications for the United States Crisis Overview Greece’s economy has been in crisis since 2009. While concerns have focused on the sustainability of the government’s debt, the crisis has also resulted in a general collapse of the Greek economy. Greece’s debt level has increased from 103% of GDP to over 170% of GDP, its economy has contracted by 25%, unemployment has tripled to 25%, and the Greek banking system has become increasingly unstable. Although other Eurozone governments, the International Monetary Fund (IMF), and the European Central Bank (ECB) have taken a number of policy measures to contain the crisis, Greece continues to face serious economic challenges. The economic crisis in Greece has also evolved into a broader political crisis in Europe that many analysts believe could represent the most significant setback in over 60 years of European integration. Analysts argue that the acrimonious debates among European leaders about the appropriate crisis Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 response have heightened political tensions (especially between Germany and France) to a degree that could negatively impact the EU over the longer term. In particular, the crisis in Greece has exposed problems with the institutional architecture of the Eurozone, whose member states share a common currency and monetary policy, but retain national control over fiscal and banking policies. Recent Developments and Outlook Between mid-2014 and mid-2015, the Greek government was in a stalemate with other Eurozone governments and the IMF over disbursements of previously committed financial assistance. The Greek government wanted more flexibility on reforms and debt relief from European creditors. Meanwhile, European creditors, led by Germany, expressed frustration with Greece’s repeated delays in implementing reforms and demanded further austerity measures. Elections in January 2015 of a new, far-left, anti-austerity Greek government heightened tensions considerably. In late June 2015, the stalemate reached a critical point, as the Greek government was running out of cash. The Greek government closed the banks, imposed capital controls, and missed a payment to the IMF. In a July 5 referendum, more than 60% of Greek voters rejected reforms demanded by other Eurozone governments and the IMF. There was speculation that Greece might leave the Eurozone. On July 12, Eurozone heads of government reached an agreement to begin negotiating a third financial assistance package to Greece in exchange for reforms by the Greek government, while affirming Greece’s membership in the Eurozone. The July agreement helped stabilize the economic situation in Greece in the short term, and paved the way for a bridge loan that Greece used to make overdue payments to the IMF. Agreement on the terms of third package was reached in August. The Eurozone rescue facility will provide up to €86 billion (about $94 billion) to Greece over the next three years. The IMF has not made a financial commitment to the third program, and it is calling for debt relief for Greece. Longer-term, there is debate about whether the new program will resolve the crisis, allow Europe to continue “muddling through” the crisis, or ultimately result in a Greek exit from the Eurozone. Downloaded by Annie Pham ([email protected])  lOMoARcPSD|48377775 Issues for Congress Impact on the U.S. Economy: Although direct U.S. exposure to Greece is limited, Europe as a whole is a major economic partner of the United States. Continuing uncertainty in Europe could threaten its financial stability and cause the dollar to strengthen, making U.S. exports less competitive. IMF Involvement: Some analysts have been skeptical of IMF involvement in Greece, including extending large loans to a developed economy with unsustainable debt. Other analysts have argued that IMF financial assistance helped stem contagion of the crisis and ensure stability in the global economy. U.S.-European Cooperation: The United States looks to Europe for partnership in addressing a range of global challenges. Political tensions in Europe and a focus on the Greek crisis could prevent the EU from focusing more intently on other key U.S.-European policy priorities, such as cooperation on Russia sanctions and concluding negotiations on the proposed Transatlantic Trade and Investment Partnership (T-TIP). Downloaded by Annie Pham ([email protected])