International Finance and Hedging Currency Risk. John Board

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1 International Finance and Hedging Currency Risk John Board

2 Country Risk

3 Country Risk The risk that the business environment in the host country changes unexpectedly Increases the risk to multinational enterprises More than if they operated in their home market Maybe more than a foreign local firm would face Two major categories Political Risk Sovereign government changes the rules of the game Financial Risk Unexpected changes in host s economic or financial position 3

4 Political Risks Political Environment Civil war Corruption Military or religious intervention Racial or ethnic tension Terrorism Business Environment Taxes and tariffs Local content and labour relations Intellectual Property Protectionism 4

5 Financial Risks Macro Currency risk Inflation risk Interest rate risk Current account Balance of trade Micro Cancellation of contract by host counterparty Capital controls on repatriation, investment or foreign exchange Expropriation Delays 5

6 Managing Country Risk Negotiate environment with host government Access / monopoly Taxes Exit Buy insurance for Insurable risk Identifiable in time, place, cause and amount Many firms/individuals exposed Loss uncontrollable by insured Structure operations to minimise risk Limit technology transfer Use local partners Raise discount rates Plan for disaster recovery E.g. alternative suppliers 6

7 Currency Effects

8 International Financial Management Two problems 1. Effect of currency fluctuations on financial decisions? 2. How to carry out international capital budgeting? 8

9 The Golden Rule of Currency Trading Always trade the denominator Wine is 8.50 per bottle Wine rate is 8 /bott Dollars are $1.98= 1 Exchange rate is 1.98 $/ (for a US investor) OR 0.51 /$ (for a UK investor. BUT ) The numerator is the home money, the denominator is the asset (currency) being traded Note conventionally, sterling is quoted the wrong way! 9

10 Currency fluctuations With currency fluctuations, there is more uncertainty about returns/ profits When we invest in foreign countries, the total return will fluctuate because domestic uncertainty and currency changes 10

11 Currency Risk Std Devn Std Devn Local US$ Australia 15% 19% Japan 26% 30% UK 17% 19% 11

12 Currency Risk Four factors A. Expected change in spot rate B. Differences in Inflation rates between countries C. Differences in Interest rates between countries D. Difference between Spot rates and forward rates in same country It turns out that these are linked Equal in theory Some are better than others 12

13 Summary A: Expected spot rates v B: Relative Inflation rates Purchasing Power Parity Holds for tradeable assets B: Relative Inflation rates v C: Relative Interest Rates International Fisher Effect Very weak association C: Relative Interest Rates v D: Forward Premium Interest Parity Very Strong relation D: Forward Premium v A: Expected Spot Rates Forward as predictor of spot Poor (for reasons) 13

14 Spot -Forward Forward Premium = (F $/ -S $/ )/S $/ x 100 Premium/Discount $/ (1 yr) = 100 x( )/ = %. Forward rate implies less $ for $1, i.e. the $ is expected to depreciate 14

15 Question dollar/rouble S R/$ = 5/$ OR S $/R = 0.2/R F R/$ = 6/$ OR F $/R = 0.166/R Is the rouble at a forward premium or discount? Answer Dollar (denominator) is at a premium: (R6/$ - R5/$)/(R5/$) = 20% Rouble at discount: ($0.166/R - $0.2/R) / ($0.2/R) = -16.6% 15

16 (A) (B) A: Expected change in spot rate = (Exp[S $/ ] -S $/ )/S $/ B: Expected differences in Inflation = Exp[I $ -I ]/(1+ I ) 16

17 Inflation Rates Purchasing Power Parity theorem B: If Inflation in US lower than in UK then exports from US rise So: $ appreciates depreciates And (A)=(B) Therefore, over long periods PPP will hold so if inflation in US is 2% lower than in UK, will depreciate by 2% 17

18 (B) (C) C The difference in interest rates will be related to changes in inflation rates (i.e. B) FISHER effect - real rates of interest will converge across countries So (B) = (C) in (very) long term (but equity risk premia are different for long periods of time) 18

19 (C) (D) Difference in Interest rates = (r $ -r )/(1+r ) Difference between Forward and Spot Rates = (F $/ -S $/ )/S $/ 19

20 Interest rate Parity Difference in Interest rates = difference in forward-spot e.g. if US= 5% and UK = 7% and Spot rate = 1.5$/, we could borrow $150 at 5% = 100 receive 7% and risklessly arrange forward sale of 107 to $ So no profit if Forward at 1.472$/ 20

21 (D) (A) (D) Difference between Forward and Spot Rates= (F $/ -S $/ )/S $/ (A) Expected change in spot rate = (Exp[S $/ ] -S $/ )/S $/ Forward rates are unbiased estimates of future spots. BUT very noisy. 21

22 Summary A: Expected spot rates v B: Relative Inflation rates Purchasing Power Parity Holds for tradeable assets B: Relative Inflation rates v C: Relative Interest Rates International Fisher Effect Very weak association C: Relative Interest Rates v D: Forward Premium Interest Parity Very Strong relation D: Forward Premium v A: Expected Spot Rates Forward as predictor of spot Poor (for reasons) 22

23 Project appraisal

24 International Capital Budgeting US firm (1) Budget in $ (using expected exchange rate), discount at $ rate of interest (2) Budget in, discount at rate of interest, convert into $ at spot rate. 24

25 WACC for foreign investments (1) assume world Capital market Thus, car firm in Holland should earn same risk premium (and WACC) as car firm in India (2) Assume segregated capital markets Car firms will differ in risk and risk premia and WACC 25

26 Insurance against currency fluctuations Exporters expecting to sell to US at fixed $ prices (1) Selling $ forward. If $ falls, you make money on sale but lose on the receipt of customer s money Cost of insurance = Forward rate- eventual spot rate (2) Borrowing $, sell $ forward and invest in US 26

27 Financing Foreign operations 1. Finance Indian operations in Indian currency 2. Finance Indian operations using US loans 3. Finance Indian operations using cheapest rate of interest No Norm Perhaps (1) is least risky 27

28 Hedging Methods Do nothing Forwards Futures Options Insurance Modify operations (EG invoice in ) Is one of these better than the others? NO Different costs Different payoffs Different residual risks Hedging strategy is an important corporate decision In many ways, the calculations are the easy part 28

29 Using funds from Foreign operations Dividends Interest payments Royalties Management Fees Goods supplied from parent company But Tax effects Transfer payments problem 29

30 Hedging Exchange Risk

31 Topics 1. Risk Transfer / Insurance / Hedging and Speculation 2. Types of Derivatives 1. Forward Contracts 2. Futures 3. Options 4. Swaps 5. Credit Derivatives 31

32 Currency Forward UK exporter prices in $, receipts ($1m) remitted from US every 3 months. value of $1m at t3 is unknown Sell $1m forward for 3 months at current forward rate of $1.6= 1. Guaranteed receipt of 625,000 But why $1.6= 1? Spot rate now is $1.71= 1 32

33 Derivatives Contracts based on other assets Forwards Bilateral, binding agreement to trade on future date at agreed price Futures Standardised forward contracts designed for trade in liquid markets Swaps Exchange of cash flows associated with two assets Options Binding agreement to trade at choice of buyer at an agreed price Swap Exchange of obligations 33

34 Derivatives Derivatives are the equivalent to, complex, combinations of assets and bonds Trade on margin, so may need less capital Can invent new derivatives (e.g. weather futures) Uses: Speculation Hedging Enormous growth in use Is this desirable or not? Arguably, little evidence of undesirable side-effects Regulatory issues 34

35 Forward Contracts Binding agreement to deliver quantity of goods/assets at an agreed price on an agreed future date at an agreed location No cash exchange at initiation Price payable is fixed at initiation Insurance against price changes Anyone can buy/sell forward/futures contracts No requirement to have cash/goods at initiation Buyer of forward/future receives goods at delivery date In principle, Forward contracts are bilaterally negotiated not designed to be traded (price, quantity, delivery etc are negotiated) Futures contracts are standardised forwards, designed for exchange-based trading. All terms except price are fixed to allow trade. Differences between forwards and futures discussed in I.B.3 (next week) 35

36 How can we fix the future price today? Two approaches Analyse demand ad supply and create a model difficult and often unnecessary Simply do a cost-benefit analysis of the forward versus an alternative Easy, provided we can find the correct alternative 36

37 Cost of Carry Example 1: Suppose a forward contract for delivery of IBM shares Alternative investment is to buy shares today and keep them Forward contract Shares Today Benefit Save interest on initial purchase Receive any dividend So, Forward Price = Current Share Price Dividends + Interest saved F = S (1+ r ) D t t tt tt = S(1+ r d ) t tt tt Where D represents total dividends or d is the dividend yield 37

38 Cost of Carry Example 2: Forward contract for US Dollars Benefit Forward contract Save (UK) interest on initial purchase Buy Dollars Today Gain (US) Interest on $ So Forward = Spot Price + UK Interest US Interest 1+ UK Interest Forward = Current Exchange Rate 1 + US Interest 38

39 Self Test Question Suppose: Current price of asset 120 known Dividend announced 18 known Interest Rate (0,T) 4.66% known Time to expiry 3 months known Question 1: What forward price would you expect Question 2: Suppose your bank quotes forward contracts at a price of 111, what might you do? 39

40 Currency Forwards Two ways of removing risk of $ in one period: Borrow $952,381 today and convert now to at today s spot rate, repay $1m Sell $1m forward and borrow in against future proceeds 573, ,224 $952,381 Spot: 1=$1.7 r UK = 9% r US =5% 625,000 Forward: 1 = $1.6 $1m Obviously, option 1 is better costs 13,170 less to offset the same risk 40

41 Hedging, speculation and arbitrage However, this 13,170 also represents an arbitrage profit Borrow at UK rate, convert at spot, deposit at US rate and re-convert Only forward price with no gain is T t 1+ rf Ft = S t 1 r + d Note exchange rate convention I.e. forward price MUST be 1 = $ If not, then plenty of free money Since arbitrageurs will profit until forward is correctly priced, hedgers can ignore this aspect of it and rely on prices Or, if you want to speculate, be honest about it and don t pretend! 41

42 Creating Insurance

43 Futures on Untraded Assets Example - Stock Index Futures You cannot buy an index Based on defined stock market index: FTSE 100, Nikkei 225, S&P 500 Index chosen by exchange as part of contract design Value to traders is that they offer a way of: Trading/speculating on future movements of the market Hedging market risk (beta of the index will be very close to 1) Leaves position only exposed to unique risk 43

44 Contract Specification Index Futures Asset is an index not physically traded Value is determined as index level x contract multiplier Multiplier/multiple is arbitrary value per index point EG London uses 25 per index point If index at 5,000, then the notional value of a contract is 125,000 Cash settled Parties exchange the cash difference between the asset s notional value now and at point of agreement A few contracts are/were physically settled EG the Tokyo Nikkei future But, very inconvenient as delivery of basket of shares required And very expensive to settle 44

45 Example May 2006: Index now at 3,500; you buy futures August contract now Recall: F = S(1+ r d) t Where d is the dividend yield (assume 3%) r if risk free interest rate (assume 8%) t is time to expiry (3 months) I is index level m is multiplier (assume 25) F = (3500 x 25) x ( ) 0.25 = 88,574 Suppose, in August, the index is 3,750 Contract value is 3,750 x 25 = 93,750 Gain to you is 5,176 In reality, most of this would have been transferred via clearing house margin payments 45

46 Question 2 You hold a large portfolio of real estate in a certain south-east asian country Your analysis suggests that there is a considerable risk of Civil unrest Earthquake Questions 1. How could you insure yourself against these risks? 2. How would such insurance affect your profits? 3. Design a forward contract that insures you against these risks 4. Who would act as your counterparty? 46

47 Self test question solution Suppose: Current price of asset 120 known Dividend announced 18 known Interest Rate (0,T) 4.66% known Time to expiry 3 months known Q1: What is the formula forward price? F = S(1+r) D = Q2: You observe a forward price of 111 (i.e. forward overpriced) Sell Forward Buy Stock Borrow Total Now Expiry +111 S T +S T Strategy yields a guaranteed profit of 3.4 (= ) Implementing this strategy will eventually cause prices to change until the arbitrage is eliminated 47

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