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    This document provides an overview of an international finance management course, including the topics that will be covered throughout the semester. Some of the key topics include exchange rates and foreign exchange markets, foreign exchange derivatives, government intervention in currency markets, arbitrage and equilibrium in currency markets, and foreign exchange risk management. The course will also cover foreign direct investment, international diversification, multinational capital budgeting, and short-term and long-term international financing. The document outlines the chapters that correspond to each topic and provides background concepts that students should already be familiar with.

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    IFM - Lecture Notes

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    This document provides an overview of an international finance management course, including the topics that will be covered throughout the semester. Some of the key topics include exchange rates and foreign exchange markets, foreign exchange derivatives, government intervention in currency markets, arbitrage and equilibrium in currency markets, and foreign exchange risk management. The course will also cover foreign direct investment, international diversification, multinational capital budgeting, and short-term and long-term international financing. The document outlines the chapters that correspond to each topic and provides background concepts that students should already be familiar with.

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    This document provides an overview of an international finance management course, including the topics that will be covered throughout the semester. Some of the key topics include exchange rates and foreign exchange markets, foreign exchange derivatives, government intervention in currency markets, arbitrage and equilibrium in currency markets, and foreign exchange risk management. The course will also cover foreign direct investment, international diversification, multinational capital budgeting, and short-term and long-term international financing. The document outlines the chapters that correspond to each topic and provides background concepts that students should already be familiar with.

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    IFM - Lecture Notes

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    This document provides an overview of an international finance management course, including the topics that will be covered throughout the semester. Some of the key topics include exchange rates and foreign exchange markets, foreign exchange derivatives, government intervention in currency markets, arbitrage and equilibrium in currency markets, and foreign exchange risk management. The course will also cover foreign direct investment, international diversification, multinational capital budgeting, and short-term and long-term international financing. The document outlines the chapters that correspond to each topic and provides background concepts that students should already be familiar with.

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    of 256

    FINA 4360 – International Financial Management

    Rauli Susmel
    Dept. of Finance
    Bauer College of Business
    Univ. of Houston

    2018 - Lecture Notes

    Chapter 0 – Introduction to International Finance


    Many of the concepts and techniques are the same as the one used in other Finance classes (Investments,
    Corporate). For example, an international bond is valued using the same NPV formulas used to value a
    domestic bond. The CAPM also applies to Japanese or Mexican stocks.

    Q: What makes international Finance different?


    Two distinctive features: Exchange Rates  FX Risk
    (with associated risks) Different National Policies  Country Risk

    0.1 Topics to be Covered


    • Exchange Rates, FX Markets, and Determinants of Exchange Rates. (Chapters 3, 4)
    • FX Derivatives (Futures, Forwards, Options) (Chapters 5, 11)
    • Government Role and Intervention in FX Markets (Chapter 6)
    • Arbitrage and Equilibrium in the FX Market (Chapters 7, 8)
    • Forecasting Exchange Rates (Chapter 9)
    • FX Risk, FX Risk Management (Chapters 10, 11, 12)
    • Direct Foreign Investment (DFI), International Diversification (Chapter 13)
    • Multinational Capital Budgeting (Chapter 14)
    • Country Risk and Discount Rates (Chapter 16)
    • Cost of Capital for MNCs (Chapter 17)
    • Long-term Financing (Bonds, Swaps) (Chapter 18)
    • Short-term Financing and Borrowing (Chapters 20, 21)

    0.2 Background Concepts that you should know (we’ll review some of the concepts in class)
    • Supply and Demand (Chapter 3, 4)
    • Basic concepts of Monetary Policy (Central Bank behavior, Open Market Operations) (Chapter 6)
    • Arbitrage and Equilibrium (Chapter 7, 8)
    • Expected value, Variance and Covariance, Correlation Coefficient (Chapter 8, 9, 10, 11, 12, 20, 21)
    • Probability Distribution (Chapters 5, 8, 9, 10, 11, 12, 20, 21)
    • Regression, Testing Null Hypothesis (Chapter 8, 9, 10, 12)
    • CAPM, ß (Chapter 13, 17)
    • NPV, discount rates (Chapter 14, 15, 16, 18)
    • Basic Bond Pricing Concept (Par, YTM, spread, bps, etc.) (Chapter 18)
    • The Term Structure of interest rates (Chapter 18)

    IFM-LN.1
    Chapter 3 - Foreign Exchange (FX) Markets
    We will go over three topics:
    1) Exchange Rates (definition, overview)
    2) Currency Markets (organization, characteristics, players)
    3) Segments of the FX Market

    3.1. Exchange Rates


    Definition: An exchange rate is a price: The relative price of two currencies.

    Example: The price of a Euro (EUR) in terms of USD is USD 1.115 per EUR
     St = 1.115 USD/EUR. ¶

    Exchange Rate: Just a Price


    An exchange rate is just like any other price.
     Price of a gallon of milk: USD 3.75 (or 3.75 USD/milk).
     Price of a British pound (GBP): USD 1.40 (or 1.40 USD/GBP)

    Think of the currency in the denominator as the currency you buy.

    Both the numerator (USD) and the denominator (GBP) are easily exchanged for each other.

    Like any other price, St is determined by supply and demand.

     Supply and Demand: The price of milk (Pt)

    Figure 3.1: Demand and Supply in the Market for Milk

    Pt Supply of Milk
    (DC/1 gal Milk)

    PtE = USD 3.75

    Demand of Milk
    Quantity of Milk (gallons)

    Figure 3.1 shows the determination of the equilibrium price of milk, PtE = USD 3.75/milk, which is
    determined in the Wholesale market. Interpretation of notation (Pt = 3.75 USD/milk):
    1 gallon of milk = USD 3.75

    Note: In the case of the price of milk, only one good (USD) can be used to buy the other. It’ll be very

    IFM-LN.2
    difficult to go to Walmart with 10 gallons of milk and get USD 37.50.

    What makes an exchange rate tricky is that any of the two goods traded (DC and FC) can be exchanged
    for the other. You can go to a bank with EUR 1 and get USD or with USD 1 and get EUR.

     Supply and Demand determine St.

    Figure 3.2: Demand and Supply in the FX Market

    St Supply of GBP
    (USD/GBP)

    StE = USD 1.40

    Demand for GBP


    Quantity of GBP

    The price of one GBP is determined in the FX (wholesale) market, as shown in Figure 3.2:
    GBP 1 = USD 1.40 (St = 1.40 USD/GBP).

    Note: According to this notation, we are in the U.S. The currency in the numerator is the DC. This is the
    way prices are quoted in the domestic economic. DC units per good we want to buy.

    Every time supply and demand move, St changes. For example, suppose the FX market is at point A,
    with an equilibrium exchange rate, StE, equal to 1.40 USD/GBP. All of the sudden, there is a craze for
    British goods. Then, the demand for GBP increases to pay for the British imports (D moves up to D’).
    As a result, the value of the GBP increases (more USD are needed to buy GBP 1). The new equilibrium
    is point B, with StE = 1.45 USD/GBP.

    Figure 3.3: Movements of D & S curves in the FX Market

    St S
    (USD/GBP)

    StE = USD 1.45 B

    StE = USD 1.40


    A
    D’
    D
    Q of GBP

    The GBP becomes more expensive in terms of USD. We say the GBP appreciates against the USD (or

    IFM-LN.3
    the USD depreciates against the GPB). In general, an appreciation of the foreign currency helps
    domestic exporters and hurts domestic importers.

    Remark: Do not confuse movements of the curve (the demand curve shifts up), with movements along
    the curve (movement along the supply curve from A to B).

     Just a Price, but an Important One


    St plays a very important role in the economy since it directly influences imports, exports, & cross-
    border investments. It has an indirect effect on other economic variables, such as the domestic price
    level, Pd, and real wages. For example:
    - When St↑, foreign imports become more expensive in USD
    ⇒ Pd ↑ & real wages ↓ (through a reduction in purchasing power).
    - When St↑, USD-denominated goods and assets are more affordable to foreigners. Foreigners buy more
    goods and assets in the U.S. (exports, real estate, bonds, companies, etc.)
    . ⇒ Aggregate demand ↑ ⇒ Yd ↑

    • The Real Exchange Rate (Rt)


    The nominal exchange rate, St, is a nominal variable: The price (in DC) of one unit of FC. Economists
    like to distinguish between nominal and real values. After all, an increase in St does not necessarily
    mean that domestic goods are cheaper to foreigners: domestic prices can increase so much that
    domestic goods, once translated to FC, are more expensive. To easily compare where things are more
    expensive, the real exchange rate, Rt, is used:

    Rt = St Pf / Pd,

    where Pf is the price of foreign goods (in FC) and Pd is the price of domestic goods (in DC).

    If Rt increases, we say the DC depreciates in real terms  domestic goods become more competitive
    (cheaper) relative to foreign goods.

    Rt gives a measure of competitiveness. It is a useful variable to explain trade patterns and GDP.

    3.2. Currency Markets


    Q: How is the FX market organized?
    A: It is organized in two tiers:
    ⋄ The retail tier
    ⋄ The wholesale tier (the "FX or Forex market")

    Retail Tier: Where small agents buy and sell FX.

    Wholesale Tier: Informal network of about 2,000 banks and currency brokerage firms that deal with
    each other and with large corporations.

    • Characteristics of the FX Market


    ⋄ Largest of all financial markets in the world.

    IFM-LN.4
    ⋄ OTC market, with market makers and dealers.
    ⋄ Geographically dispersed (NY, LA, NZ, Tokyo, HK, Singapore, Moscow, Zurich, London).
    ⋄ London is the largest market with 41% of total turnover, followed by NY (19%) & Tokyo (6%).
    ⋄ Open 24 hours a day.
    ⋄ Typical transaction in USD is about 10 million ("ten dollars").
    ⋄ Currencies are noted by a three-letter code, the ISO 4217 (USD, EUR, JPY, GBP, CHF, MXN)
    ⋄ Daily volume of trading (turnover) -spot, forward and FX swap-: USD 5.1 trillion (2016).
    Q: What is USD 5.1 trillion? 25 times the daily volume of international trade flows.
    130% of the total U.S. GDP (USD 18 trillion in 2016).
    40% of total official FX reserves.
    ⋄ USD, EUR, and JPY are the major currencies
    . ⋄ USD is the dominant currency: involved in 88% of transactions
    ⋄ USD/EUR most traded currency pair (23% of turnover), followed by USD/JPY (18%)
    ⋄ Emerging market currencies account for 21% of turnover (USD/CYN pair 4% of turnover).
    ⋄ 58% of transactions involve a cross-border counterpart.
    ⋄ Very small bid-ask spreads for actively traded pairs, usually no more than 3 pips –i.e., 0.0003.
    ⋄ Electronic trading platforms dominate; only 15% of FX transactions are done via phone.

    Example: A bid/ask quote of EUR/USD: 1.2397/1.2398 (spread: one pip). See screenshot from
    electronic trading platform EBS below:

    Take the EUR/USD quote. The first number in black, 1.23, represents the “big figure” –i.e., the first
    digits of the quote. The big numbers in yellow, within the green/blue squares, represent the last digits of
    the quote to form 1.2397-1.2398. The number in black by the ask (“offer”) 98 (11) represents an irregular
    amount (say USD 11 million); if no number is by the bid/ask quote, then the “usual” amount is in play
    (say, USD 10 million, usually set by the exchange and may differ by currency). These irregular amounts
    have a better price quote than the regular amounts. The best regular quotes are on the sides 97 & 99. ¶

    • Settlement of FX transactions

    IFM-LN.5
    At the wholesale tier, no real money changes hands:
     electronic transactions using the international clearing system.

    Two banks involved in a FX transaction simply transfer bank deposits.

    Example: Transaction: BRL for JPY


    Parties: Argentine Bank: Banco de Galicia (BG),
    Malayan Bank: Malayan Banking Berhard (MB).

    Transaction: BG sells BRL (Brazilian real) to MBB for JPY.


    Settlement: a transfer of two bank deposits:
    (1) BG turns over to MB a BRL deposit at a bank in Brazil,
    (2) MB turns over to BG a JPY deposit at a bank in Japan.

    If BG doesn’t have a branch in Brazil, an associated bank, called a correspondent bank, will hold the
    deposit in BG’s name. Same situation applies for MB in Japan. ¶

    Financial institutions are involved in the majority of total trading volume (93%).
    ⋄ 42% interbank (between dealers).
    ⋄ 51% other financial institutions (22% non-reporting dealers, 16% institutional investors,
    8% hedge funds).

    • Activities
    - Speculation (open or "naked" positions)
    - Hedging (covered positions)
    - Arbitrage (establish positions to take advantage of pricing mistakes in one or more markets)
    ⋄ Types of arbitrage: Local/spatial (one good, one market)
    Triangular (two related goods, one market)
    Covered (two related markets, futures and spot transactions)

    • Players and Dealers


    - Players
    ⋄ Big Corporations
    ⋄ Mutual funds, Pension funds, Hedge funds, Insurance companies
    ⋄ Financial Institutions (Banks, Investment banks)
    ⋄ Big Speculators
    ⋄ Central Banks (hold, buy and sell FC)

    - Dealers:
    ⋄ Market-makers: provide a two-way quote: bid and ask. Live off the spread.
     Short-term and high volume. Small profits per transactions are expected.
    ⋄ Speculators: trade with a proprietary system. The dealer’s own capital is put at risk.
     Capital can be at risk for extended periods. Large profits are expected.
    ⋄ Brokers: find the best price for another player. Live off commissions.

    • In the U.S., there are over 90 institutions considered active dealers in the FX market (some are

    IFM-LN.6
    market makers, others are brokers, some are all). Almost 90% of them are commercial banks. Ten
    institutions handled over 50% of the FX turnover in the U.S.

    • The majority of the trading is done through electronic platforms. But, dealer institutions still have
    traditional trading rooms with traders specializing in areas: spot, forwards, options, etc. They have
    “back offices,” where transactions are confirmed and finalized through a clearing system. Increasingly,
    there is also a “mid-office,” where the validity of valuations/strategies is checked.

    • Typical “voice-trader” (circa 1995): DEM trader (DEM: German Mark)


    ⋄ Executed about 270 transactions a day (one every 67'').
    ⋄ Average daily volume traded: USD 1.2 billion.
    ⋄ For large transactions brokers were used.
    ⋄ Median spread: DEM .0003 (.02% of the spot rate).

    • Electronic Trading
    Today, much of the trading has moved to electronic platforms, like EBS (Electronic Broking
    System), Reuters Dealing 3000 Matching (D2), and Bloomberg Tradebook. The major trading
    banks (Barclays, UBS) have their own electronic platforms (single-bank trading systems). There
    are also multi-bank trading platforms (FXall, FXConnect, Hotspot). Trades are increasingly
    taking place through multilateral ‘electronic non-bank market makers’ like XTX Markets, Virtu
    Financial, Citadel Securities, GTS and Jump Trading.

    In 2016, electronic trading captured 85% of all FX transactions (up from 20% in 2001). This move
    towards electronic trading should improve costs and transparency (better price discovery).

    For many years, the main electronic trading platforms were EBS and Reuters.
    - EBS: main venue for EUR/USD, USD/JPY, EUR/JPY, USD/CHF and EUR/CHF. (the main bulk
    of the interbank spot market.)
    - Reuters D2: primary venue for all other interbank currency pairs.

    But, competition from single-bank trading systems (internalization of flows) is big and driving
    significantly down volume at both venues (traded volume at EBS went from 60% in 2011 to 19%
    in 2016). A big percentage of the FX trading is done through algorithmic trading. In the EBS
    platform, algorithm trading represents 75% of the volume.

    3. Segments of the FX Market


    All transactions in the FX Market are classified into different segments, see Exhibit 3.1 below. The
    daily turnover (USD 5.1 trillion) is divided into:
    - USD 1.7 trillion in spot transactions (33%)
    - USD 714 billion in outright forwards (14%)
    - USD 2.4 trillion in FX swaps (47%)
    - USD 255 billion estimated gaps in options, currency swaps, etc. (6%)

    IFM-LN.7
    Exhibit 3.1: Size of FX Market by Segments

    • Segment 1: The Spot Market


    The spot market is the exchange market for payment and delivery today. In practice, "today" means
    today only in the retailer tier. Usually, it means 2 business days.

    The Spot Market represents 33% of total daily turnover (USD 1.7 trillion in 2016).

    Example: Bank of America (BOFA) buys GBP 1M in the spot market at St = 1.30 USD/GBP.
    In 2 business days, BOFA will receive a GBP 1M deposit and will transfer to the counterparty USD
    1.3M. ¶

    Two quote systems:


    ⋄ Indirect quote or "European" quote
    S(indirect) = units of foreign currency that one domestic unit will buy.
    ⋄ Direct quote or "American" quote.
    S(direct) = units of domestic currency that one foreign unit will buy.

    Remark: Indirect quotation = Reciprocal of the direct quotation.

    Example: A U.S. tourist wishes to buy JPY at LAX.


    (A) Indirect quotation (JPY/USD).
    A quote of JPY 110.34-111.09 means the dealer is willing to buy one USD for JPY 110.34 (bid) and
    sell one USD for JPY 111.09 (ask).

    For each round-trip USD transaction, she makes a profit of JPY .75.

    (B) Direct quotation (USD/JPY).


    If the dealer at LAX uses direct quotations, the bid-ask quote will be .009002-.009063 USD/JPY. ¶

    IFM-LN.8
    Note: S(direct)bid = 1/S(indirect)ask,
    S(direct)ask = 1/S(indirect)bid.

    Remark: In class, we will use direct quotations.

    Most currencies are quotes against the USD, so that cross-rates must be calculated from USD
    quotations. (Think of liquidity!)

    Rule for cross-rates (based on triangular arbitrage. We will see this topic again in Chapter 7):
     (Quote X/Z)/(Quote Y/Z) = Quote X/Y ( currency Z has to cancel out!)

    Example: Calculate the CHF/EUR cross rate:


    St = 1.00 CHF/USD
    St = 0.97 EUR/USD

    SCHF/EUR,t = 1.00 CHF/USD / 0.97 EUR/USD = 1.03093 CHF/EUR. ¶

    Example: JPY/GBP cross rate.


    St = 0.00833 USD/JPY = 120 JPY/USD.
    St = 1.30 USD/GBP

    SJPY/GBP,t = 120 JPY/USD x 1.30 USD/GBP = 92.3077 JPY/GBP. ¶

    • Segment 2: The Forward Market


    A forward transaction is generally the same as a spot transaction:
     but settlement is deferred much further into the future, at a later time T.
    - T (=Maturity): 7-day, 1-, 2-, 3- and 12-month settlements. (Up to 10-year contracts.)
    - Forward transactions are tailor-made.
    - Forward contracts allow firms and investors to transfer risk.
    - Notation. Ft,T: Forward price at time t, with a T day maturity.
    - Forward transactions are classified into two classes: outright and swap.
     Outright forward transaction: an uncovered speculative position in a currency (though it
    might be part of a currency hedge to the other side).

    - The (outright) Forward Market represents 14% of total daily turnover (USD 0.7 trillion in 2016).
    - 40% of outright forwards have duration of less than 7 days.

    Example: BOFA holds British bonds worth GBP 1,000,000. BOFA fears the GBP will lose value
    against the USD in 7 days. BOFA sells a 7-day GBP forward contract at Ft,7-day=1.305 USD/GBP to
    transfer the currency risk of her position.

    In 7 days, BOFA will receive USD 1,305,000 and will transfer to the counterparty GBP 1M. ¶

    Forward transactions are classified into two classes: outright and swap.
     Outright forward transaction: an uncovered speculative position in a currency (though it

    IFM-LN.9
    might be part of a currency hedge to the other side).

    • Segment 3: The FX Swap


    FX swap transaction (a “package trade”): The simultaneous sale (or purchase) of spot foreign
    exchange against a forward purchase (or sale) of approximately an equal amount of the foreign
    currency.

    Motivation for a FX swap transaction: A position taken to reduce the exposure in a forward trade.

    The FX Swap Market represents 47% of total daily turnover (USD 2.4 trillion). The majority of FX
    Swaps (70%) are short-term (7 days or less).

    Example: A U.S. trader wants to invest in a GBP bond position for a 7-day period. (Assume the U.S.
    trader thinks interest rates in the U.K. will go downs and is worried about the GBP/USD exchange
    rate.)
    Simultaneously, the U.S. trader
    (1) Buys GBP 1M spot at St = 1.60 USD/GBP,
    (2) Buys the short-term GBP 1M bond position, and
    (3) Sells GBP 1M forward at Ft,7-day=1.605 USD/GBP.

    The sale of GBP 1M forward protects against an appreciation of the USD.

    Transactions (1) and (3) are classified as an FX Swap transaction. ¶

    IFM-LN.10
    CHAPTER 3 – BRIEF ASSESMENT

    1) In the USD/GBP market, draw the effect on the equilibrium St of the following movements of
    the curves:
    a) The supply of GBP increases.
    b) The demand for GBP decreases.

    2) Calculate the CHF/JPY cross rate, using the following exchange rates:
    St = 1.00 CHF/USD
    St = 112 JPY/USD

    3) Structure an FX swap for a U.K. trader wants to invest in a US T- bond for a 15-day period.

    IFM-LN.11
    Chapter 3 - BONUS COVERAGE: A Shift vs. A Movement
    In economics, a movement and a shift in relation to the supply and demand curves represent very different
    market events.

    1. A Movement
    A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both
    price and quantity demanded from one point to another on the curve. The movement implies that the
    demand relationship remains unchanged. Therefore, a movement along the demand curve will occur when
    the price of the good changes and the quantity demanded changes in accordance to the original demand
    relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by
    a change in price, and vice versa.

    Figure 3.4: A Movement Along the Demand Curve

    Pt
    (USD/milk)

    P1 = USD 2.60

    P2 = USD 2.20

    D
    Q1 Q2 Quantity of milk

    Similarly, a movement along the demand curve, a movement along the supply curve means that the supply
    relationship remains unchanged. Therefore, a movement along the supply curve will occur when the price
    of the good changes and the quantity supplied changes in accordance to the original supply relationship. In
    other words, a movement occurs when a change in quantity supplied is caused only by a change in price,
    and vice versa.

    2. A Shift
    A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even
    though price remains the same. For instance, if the price for a gallon of milk was USD 2.60 and the
    quantity of milk demanded increased from Q1 to Q2, then there would be a shift in the demand for milk.
    Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity
    demand is affected by a factor other than price. A shift in the demand relationship would occur if, for
    instance, cereal for breakfast –a complimentary good- suddenly became very inexpensive. As a result of the
    shift in demand, the final price is USD 3.10 (new equilibrium is Point B).

    IFM-LN.12
    Figure 3.5: A Shift in the Demand Curve

    Pt
    S
    (USD/milk)

    B
    P3=USD 3.10
    A
    P1=USD 2.60

    D2
    D1

    Q1 Q2 Quantity of milk

    Conversely, if the price for a gallon of milk was USD 2.60 and the quantity supplied decreased from Q1 to
    Q2, then there would be a shift in the supply of milk. Like a shift in the demand curve, a shift in the supply
    curve implies that the original supply curve has changed, that is, the quantity supplied is affected by a
    factor other than price. A shift in the supply curve would occur if, for instance, a virus caused a significant
    reduction in the stock of cows; milk producers would be forced to supply less milk for the same price.

    IFM-LN.13
    Chapter 4 – Determinants of FX Rates

    Review from Chapter 3:


    FX is a huge market (the biggest financial market)
    - Open 24/7
    - 3 segments: Spot, Forward, and FX swap (biggest)
    - Supply and Demand determines St –always expressed as DC/FC. Figure 4.1 shows the
    equilibrium price in the GBP/USD Market.

    Figure 4.1: Supply and Demand Determines St

    St Supply of GBP
    (USD/GBP)

    StE = USD 1.40

    Demand for GBP

    Quantity of GBP

    In this class we study the economic factors that determine S & D.

    • Economic Activities behind Supply & Demand


    Think about the economic activities that determine the USD/GBP exchange rate.
    Q: What kind of activities demand and/or supply GBP in the FX market (say, in the US market)?
    ⋄ International Trade: Exports to the UK (supply GBP)
    Imports from the UK (demand GBP)
    ⋄ International Investing: British Investors investing in the US (supply GBP)
    US Investors investing in the UK (demand GBP)
    ⋄ International Tourism: British tourism to the US (supply GBP)
    US tourism to the UK (demand GBP)
    ⋄ Investment Income: British Investors/Companies sending income back home (Dem GBP)
    U.S. Investors/Companies sending income back home (Sup GBP)

    • Balance of Payments
    At the national accounts level, the above activities are reflected in the Balance of Payments (BOP):
    BOP = Current Account (CA) + Capital Account (KA)
    CA = Net Exports of goods and services (main component) + Net Investment Income + Net Transfers
    KA = Financial capital inflows – Financial capital outflows

    The BOP = 0  The CA is financed by the KA.

    IFM-LN.14
    • Factors Affecting the BOP
    Q: Now, what economic variables (“Fundamentals”) affect Supply & Demand (or the BOP)?
    A: Several variables:
    - Interest rates (iUSD – iGBP): Affect savings and investments (KA).
    - Inflation rates (IUSD – IGBP): Affect trade (CA).
    - Income growth rates (yUS – yUK): Affect everything (both CA & KA).
    - Others: Tariffs, quotas, other trade barriers, expectations, taxes, uncertainty, tastes, etc.

    We will analyze the effect on St of a change of only one variable at a time.

    • A Word about Models


    In the economy variables are interrelated, a change of one variable can have an effect on many markets.
    We will use a model to simplify the interactions and focus on the main impact, say money markets,
    goods markets, etc. These models that focus on the equilibrium in only one market, say the goods market,
    are called partial equilibrium models.

    There are other models, general equilibrium models, where we study equilibrium in all markets, say the
    goods market, the money market, and the BOP. We will mention these models, but we will not cover
    them.

    • Changes in Economic Variables and St


    1. Changes in interest rates: (iUSD – iGBP) 

    Figure 4.2: Effect of a Change in the Interest Differential on St

    St S
    (USD/GBP)
    S’
    S0 = USD 1.60

    S1 = USD 1.55
    D
    D’
    Q of GBP

    Main impact of a change in relative interest rates: capital flows (KA), think of short-term CDs.

    (iUSD – iGBP)   US CDs are more attractive than UK CDs.


    - More investments in the US from UK residents (supply moves to S’)
    - Less investments in the UK from US residents (demand moves to D’)

    As Figure 4.2 shows, the GBP depreciates against the USD (becomes less expensive in terms of USD).
    Or, we can also say that the USD appreciates against the GBP.

    Check: (iUSD – iGBP)   St 

    IFM-LN.15
    2. Changes in inflation rates: (IUSD – IGBP) 

    Figure 4.3: Effect of a Change in the Inflation Rate Differential on St

    St S’
    (USD/GBP)
    S
    S1 = USD 1.70

    S0 = USD 1.60
    D’
    D
    Q of GBP

    Main impact of a change in relative inflation rates: trade flows (CA).

    (IUSD – IGBP)   US goods are relatively more expensive than UK goods.


    - Less purchases of US goods by UK residents –less US exports (supply moves to S’).
    - More purchases of UK goods by US residents –more US imports (demand moves to D’).

    As shown in Figure 4.3, the GBP appreciates against the USD (becomes more expensive in terms of
    USD). Or the USD depreciates against the GBP.

    Check: (IUSD – IGBP)   St 

    3. Changes in income growth rates: (yUS – yUK) . Suppose YUS  (& YUK remains the same).

    When YUS  we tend to increase all our demands: we demand more of everything (domestic goods,
    foreign goods, investments, money, etc.). The final effect on St depends on which variable (market) has
    a bigger impact on S&D.

    There are two main equilibrium stories:


    ⋄ Balance of Trade Approach (Approach in Madura’s textbook)
    ⋄ Monetary Approach (MA)

    3.1 BT Approach
    Under the BT approach, trade flows –i.e., exports and imports- are the main factors influencing demand
    and supply for FC. The CA is the main determinant of St. (This is the story in the textbook, standard
    view before the financial liberalization of the ‘70s.)

    BT: YUS  (& no change in YUK)  More US demand of everything, among them imports (M) from

    IFM-LN.16
    UK. The TBUS (=X-M) ↓. Demand for GBP increases  St  (Figure 4.4 shows these dynamics.)
    (Note: We can think that under the BT approach, YUS  has no significant effect on US interest rates.)

    Figure 4.4: Effect of a Change in US Income (under BT Approach)

    St
    (USD/GBP)
    S

    S1 = USD 1.63

    S0 = USD 1.60
    D’
    D
    Q of GBP

    Note: Things are dynamic. As UK exports more, YUK . Then, US exports more to the UK (S also
    moves). The net effect on the TBUS will depend on imports and exports income elasticities. Strange
    things can happen, but, in general, we expect an increase in the TB to appreciate the domestic currency.

    3.2 Monetary Approach


    Under the MA, St is determined in equilibrium by relative money demand and money supply between
    the two currencies involved. Each currency is just another asset, whose yield is given by iDC & iFC. Thus,
    interest rates and income will influence demand for money and, thus, currency. Money supply will also
    be a relevant variable that affects the yield.

    MA: YUS   More US demand of everything, among them domestic money (USD). Demand for US
    money increases  iUSD   (iUSD – iGBP)  (capital flows move in favor to the U.S.)  St 

    Remark: Financial variables, like interest rates and exchange rates, adjust very quickly to changes. It
    will take longer for companies to adjust trade flows, due to long-term contracts, bureaucracy, etc.

    The MA is the usual story reported by the press, since exchange rates will adjust very quickly to changes
    in interest rates. When a country grows, in the short-run, its currency tends to appreciate.

    Note: There is a variation of the MA, called the portfolio-balance approach, where relative demands
    and supplies of domestic and foreign bonds also play a role in determining St. For this approach to work,
    domestic and foreign bond have to be imperfect substitutes (otherwise, they will have the same price
    and relative demands/supplies will be irrelevant).

    For example, an increase in the relative supply of domestic bonds to foreign bonds comes with an
    increased compensation (otherwise, no incentive to hold them) on the domestic bonds that will make the
    DC depreciate in the spot market (St ↑).
     If the expected future spot rate, Et[St+T], is unchanged the expected rate of appreciation
    (depreciation) over the future T days increases (decreases).

    IFM-LN.17
    4. Other:
    ⋄ Quotas: Affect foreign trade and the CA.
    ⋄ Expected Rates of Return on financial assets/real estate: Affect the KA.
    ⋄ Uncertainty: Political problems, war, terrorism, etc.
    ⋄ Tastes: A sudden increase in tastes for foreign goods, say luxury goods.
    ⋄ Worker’s skills/Technology: Anything that improves worker productivity/production costs.
    ⋄ Expectations: If a lot of people expect the GBP to depreciate, it is optimal to sell GBP, regardless of
    the truth behind the expectation. The GBP can depreciate in a hurry (think of the Keynesian beauty
    contest). Recall that financial assets are influenced by expectations about the future value of the
    asset.

    • Remarks:
    ⋄ Interactions among variables: So far, we have assumed that only one variable changes (the ceteris
    paribus assumption). But, in economics, variables are interrelated. Higher inflation means a higher
    interest rate; restrictions to trade affect income, etc. In these situations, when we are drawing the S&D
    curves, we need to make assumptions about which curve moves more –that is, which effect is the
    dominant one.

    ⋄ No dynamics: In all the S&D graphs above, we presented two situations: initial equilibrium (with S0)
    and final equilibrium (with S1). We have paid no attention to the adjustment process –i.e., how St moves
    from S0 to S1.

    • Exchange Rates Move a Lot


    The Federal Reserve constructs an index to reflect the value of the USD against a basket of currencies
    (TWC). The basket includes the EUR (58%), the JPY (14%), the GBP (12%), the CAD (9%), the SEK
    (4%), and the CHF (4%). It is quoted in TWC/USD terms.

    Exhibit 4.1 shows the performance of the USD against the TWC since 1973, just after the U.S.
    abandoned the fixed exchange rate system (see Chapter 6). As it can be seen, the USD moves a lot,
    though, in general, slowly over time.

    IFM-LN.18
    Exhibit 4.1
    The Value of the USD against the TWD, St (TWC/USD)

    IFM-LN.19
    CHAPTER 4 - APPENDIX: KEYNES’ BEAUTY CONTEST AND INVESTORS

    “Professional investment may be likened to those newspaper


    competitions in which the competitors have to pick out the
    six prettiest faces from a hundred photographs, the prize
    being awarded to the competitor whose choice most nearly
    corresponds to the average preferences of the competitors as
    a whole; so that each competitor has to pick, not those faces
    which he himself finds prettiest, but those which he thinks
    likeliest to catch the fancy of the other competitors, all of
    whom are looking at the problem from the same point of
    view.”

    From the perspective of modern economics, Keynes’ beauty


    contest is a coordination game -i.e., a game where the
    participants get high (low) payoff if they choose the same (a
    different) action. You may sell (or buy) an asset, say GBP,
    not because you think it is overvalued. You may sell GBP
    because you think the other investors think it is overvalued!

    IFM-LN.20
    CHAPTER 4 – BRIEF ASSESMENT

    1) In the MXN/USD market, draw a graph showing the effect on St of the following surprises:
    a) Interest rates in Mexico increase (everything else remains the same).
    b) The inflation rate in Mexico decreases (everything else remains the same).
    c) The Mexican economy slows down (everything else remains the same). Be specific about the
    theoretical approach you use to answer this question.

    2) Suppose a European country surprisingly votes to exit the European Union. What is the effect
    of this decision on the EUR/USD exchange rate. Draw a graph.

    3) The U.S. government decides to increase tariffs on Mexican imports (“border-adjustment tax”).
    What is the effect of this new tariff on the USD/MXN exchange rate?

    4) UAE’s economy is very dependent on oil exports. Draw a graph showing the effect on St
    (AED/USD) of a sudden increase in the price of oil.

    IFM-LN.21
    Chapter 5 - Currency Derivatives (FX Management Tools)

    St changes with several variables: (iUSD – iGBP), (IUSD – IGBP), (yUS – yUK).
    Interest rates, in particular, change all the time. St will also change. (See Exhibit 4.1.) This introduces
    exchange rate risk (one form of price risk).

    Currency Derivatives can reduce the risk in FX transactions.


    1. Currency Futures/Forwards
    2. Currency options
    3. Money Market (Replication of IRP. Chapter 10)
    4. Other hedging tools (Ch 10-12): - Pricing in DC
    - Risk-sharing
    - Matching Outflows & Inflows

    In this chapter, we will present two FX Derivatives:


    - Currency Futures/Forwards (agreement to buy/sell FC at a given price at time T)
    - Currency Options (right to buy/sell FC at a given price during a period of time, t to T)

    5.1 Currency Risk


    Definition: The risk that the value of an asset/liability/financial instrument will (negatively) change due
    to changes in FX rates. (Financial risk applied to international finance!)

    Example: ABYZ, a U.S. company, imports wine from France. ABYZ has to pay EUR 5,000,000 on
    January 2. Today, September 4, the exchange rate is 1.29 USD/EUR.

    Situation: Payment due on January 2: EUR 5,000,000.


    SSep 4 = 1.29 USD/EUR.

    Problem: St is difficult to forecast  Uncertainty.


    Uncertainty  Risk.
    Example: on January 2, St=Jan 2 > or < 1.29 USD/EUR.

    At SSep 4, ABYZ total payment would be: EUR 5M x 1.29 USD/EUR = USD 6.45M.

    On January 2 we have two potential scenarios relative to Sep 4:


    If the SJan 2  (USD appreciates)  ABYZ will pay less USD.
    If the SJan 2  (USD depreciates)  ABYZ will pay more USD.

    The second scenario introduces Currency Risk. ¶

    If the value of an asset/liability does not change “a lot” when St moves, we will consider the asset/liability
    to have low currency risk. (Of course, if it does not change in value at all, it does not face currency risk.)

    In finance, we relate “a lot” to the variance or volatility. For currency risk, we will look at the volatility

    IFM-LN.22
    of FX rates:  more volatile currencies, higher currency risk.

    Example (continuation): Consider the following situations:


    (A) SJan 2 can be with 50% either scenario:
    (i) 1.28 USD/EUR, for a total payment: EUR 5M x 1.28 USD/EUR = USD 6.40M.
    (ii) 1.30 USD/EUR, for a total payment: EUR 5M x 1.30 USD/EUR = USD 6.50M.

    (B) SJan 2 can be with 50% either scenario:


    (i) 1.09 USD/EUR, for a total payment: EUR 5M x 1.09 USD/EUR = USD 5.45M.
    (ii) 1.49 USD/EUR, for a total payment: EUR 5M x 1.49 USD/EUR = USD 7.45M.

    Both situations have the same expected value (expected payment: USD 6.45 M), but different levels of
    risk. Situation B is riskier (more volatile) for ABYZ, since it may result in a higher payment.

    Note: Under situation B, ABYZ may end up paying a lot less than in situation A. That’s the usual
    risk/reward trade-off in finance: No pain (risk, volatility), no gain (in this case, lower payments)! ¶

    Currency (financial) risk is evaluated using probability distributions. For example: the normal
    distribution. Two different normal distributions are plotted in Figure 5.1 with the same mean (0), but
    different volatilities (standard deviations, SD). The blue distribution (SD=2) would be considered riskier
    than the red distribution.

    Figure 5.1: Normal Distributions with Different Standard Deviations

    Recall that a probability distribution completely describes the behavior of a random variable. (For us:
    the random variable: St. The behavior we want to be described: the variability of St.)

    Before making decisions regarding FX derivative instruments, a company should take into consideration
    the distribution (the behavior) of future St. In the previous example, under Situation A, ABYZ can ignore
    FX risk; but under Situation B, ignoring FX risk is risky!

    • Brief Aside: Characteristics of the Distribution of FX Rates

    Below, Table 5.1 shows the distribution of ef,t for selected currencies (annualized mean & SD), using

    IFM-LN.23
    1990-2017 monthly data (336 observations).

    TABLE 5.1: Descriptive Statistics for selected currencies (1990-2017) using monthly data

    Standard Excess
    Currency Mean Deviation Skewness Kurtosis Normal?
    GBP/USD 0.0090 0.0951 0.9681 3.4004 No
    CHF/USD -0.0097 0.1101 0.2171 1.3365 No
    DKK/USD 0.0118 0.1030 0.4803 1.2113 No
    EUR/USD 0.0166 0.1102 0.5253 1.2145 No
    INR/USD 0.0565 0.0820 3.0932 24.1434 No
    JPY/USD -0.0010 0.1056 -0.1936 1.9347 No
    KRW/USD 0.0295 0.1247 1.7968 15.9320 No
    THB/USD 0.0179 0.1055 2.6493 32.3567 No
    SGD/USD -0.0095 0.0563 0.5677 2.9251 No
    CNYUSD* -0.0122 0.0160 -0.4484 7.9325 No
    KWD/USD 0.0024 0.0446 2.1568 74.9592 No
    SAR/USD 0.0000 0.0030 3.3228 119.9623 No
    CAD/USD 0.0106 0.0792 0.8378 5.7371 No
    MXN/USD 0.0818 0.1359 5.0008 51.7441 No
    ZAR/USD 0.08053 0.14163 0.08053 2.1010 No
    EGP/USD* 0.04084 0.05303 0.04084 216.7728 No
    NGN/USD* 0.1666 0.5804 15.7821 259.9828 No
    AUD/USD 0.01062 0.11436 0.01062 4.3249 No
    Average 0.0349 0.1180 2.7443 38.4349 No

    Notes: * shorter sample: CNY (9/1994-12/2017), EGP (1/1995-12/2017) & NGN (1/1994-12/2017).

    - On average, since 1990, the USD appreciated against international currencies at an annualized mean
    of 3.49%. The average annualized SD is 11.80%.
    - USD against developed currencies (in blue): 0.5% annualized appreciation, with a 9.51% SD.
    - Excess Kurtosis. It describes the fatness of the tails. Under normality, excess kurtosis equals 0. All the

    IFM-LN.24
    currencies show excess kurtosis, that is, the tails are fatter than the tails of a normal –i.e., probability of
    a tail event is higher than what the normal distribution implies. The tails are very thick, reflecting higher
    extremes, in emerging markets.
    - Skewness. If the distribution is symmetric (mean=median, for example, a normal), skewness is 0.
    Almost all the currencies show positive skewness (mean>median); that is, the fat part of the curve is on
    the left. Again, emerging market currencies show higher skewness.
    - From the last column, which shows the results of a test of normality, the Jarque-Bera (1980) test, we
    can say that ef,t does not follow a normal distribution. Not a surprising result, given the big skewness and
    excess kurtosis.

    The last three results are typical of financial time series.

    5.2 Currency Futures or Forward Contracts


    FX Forward/Futures are agreements that set, today, the price of the exchange rate at a given future date.
    The agreement also specifies a given quantity.

    • Basic Terminology
    ⋄ Short: Agreement to Sell.
    ⋄ Long: Agreement to Buy.
    ⋄ Contract size: Number of units of foreign currency in each contract.
    ⋄ Maturity (T): Date in which the agreement has to be settled.
    ⋄ Futures/Forward price (Ft,T): Price at which the forward transaction at maturity will be executed.

    • Forwards vs Futures
    ⋄ Forward markets: Tailor-made contracts.
    Location: none (OTC traded contracts).
    Reputation/collateral guarantees the contract.

    ⋄ Futures markets: Standardized contracts (standardized duration, size, collateral).


    Location: organized exchanges (CME, Euronext (LIFFE), Tokyo FX)
    Clearinghouse guarantees the contract.

    CME Standardized sizes: GBP 62,500, AUD 100,000, EUR 125,000, JPY 12.5M. There is a smaller
    sized-contract (E-micro), the size is 10% of standardized size.
    CME expiration dates: Mar, June, Sep, and Dec + Two nearby months
    Margin account: Amount of money you deposit with a broker to cover your possible losses involved in
    a futures/forward contract. Two important quantities:
    - Initial Margin: Initial level of margin account.
    - Maintenance Margin: Lower bound allowed for margin account.
    Mechanism: If margin account goes below maintenance level, a margin call is issued:
     Funds have to be added to restore the account to the initial level.

    Example: GBP/USD CME futures


    Initial margin: USD 2,800

    IFM-LN.25
    Maintenance margin: USD 2,100

    If losses do not exceed USD 700, no margin call will be issued.


    If losses accumulate to USD 850, USD 850 will be added to account. ¶

    Table 5.2 summarizes the main differences between the two contracts.

    TABLE 5.2: Comparison of Futures and Forward Contracts

    Futures Forward
    Amount Standardized Negotiated
    Delivery Date Standardized Negotiated
    Counter-party Clearinghouse Bank
    Collateral Margin account Negotiated
    Market Auction market Dealer market
    Costs Brokerage and exchange fees Bid-ask spread
    Secondary market Very liquid Highly illiquid
    Regulation Government Self-regulated
    Location Central exchange floor Worldwide

    • Real Life Examples of Forwards and Futures


    Pizza delivery: Customer buys future pizza; pays with USD (domestic currency)
    Pizza Hut sells future pizza; gets paid with USD (domestic currency)
    Terms of contract:
    Size: One pizza
    Duration: 30’ or less.
    Collateral: Credit card or None

    • Using FX Forwards and Futures


    Q: Who buys/sells FX Forward and Futures Contracts?
    A: Hedgers and Speculators

    Example: IBM has to pay in 90 days EUR 5M to a French supplier.


    Problem: IBM is concerned about a depreciation of the USD against the EUR in the near future.
    Solution: IBM buys from Chase a EUR forward contract.
    Size = EUR 5M
    Maturity = 90 days.
    Ft,90 = 1.31 USD/AUD

    Note: IBM knows that, in 90 days, it will pay USD 6.55M (=EUR 5M*1.31 USD/EUR) to the supplier.
    As shown in Figure 5.2, there is no uncertainty whatsoever about this amount: St+90 does not affect the
    amount to receive in 90 days. (No uncertainty, no volatility => No FX risk).

    IFM-LN.26
    Figure 5.2: CFs under an FX Futures
    Payoff Diagram for IBM

    Amount
    Received
    in t+90

    Forward
    USD 6.55M

    St+90

    Hedging Note:
    - Underlying position: Short EUR 5 M.
    - Hedging position: Long 90 days futures for EUR 5 M. ¶

    Example: A U.S. investor has GBP 1 million invested in British gilts (UK government bonds).
    Problem: Uncertain about future value of USD/GBP in December.
    Solution: Sell GBP Dec futures.
    Situation: It is Sep 12.
    Underlying position: British bonds worth GBP 1,000,000.
    FSep 12,Dec = 1.55 USD/GBP
    Futures contract size: GBP 62,500.
    SSep 12: 1.60 USD/GBP.
    number of contracts = ?

    Hedging position: The investor sells GBP 1,000,000/(62,500 GBP/contract) = 16 contracts.

    Note: If the U.S. investor decides to sell her British gilts in December she will receive exactly USD
    1.55M. No uncertainty whatsoever about this amount.

    But, if she decides not to sell the gilts, there will be a cash flow from the difference between SDec -
    FDec,Dec. ¶

    Hedging Note:
    - Underlying position: Long GBP 1 M.
    - Hedging position: Short futures for GBP 1 M.

    From both hedging notes  Hedging is very simple: Take an opposite position!

    We call the hedger with a long FX futures/forward position, the long hedger. Similarly, we call the
    hedger with a short FX futures/forward position, the short hedger.

    IFM-LN.27
    5.3 Currency Options
    An option is a contract that gives the holder the right to do something for a certain amount of time or at a
    certain date. The holder of the option buys this right at a cost: the premium.

    In the FX market, the “right to do something” is the right to buy/sell an amount of FC at a given price.

    • Options: Brief Review


    - Major types of option contracts:
    ⋄ Calls gives the holder the right to buy a certain amount of the underlying asset
    ⋄ Puts gives the holder the right to sell a certain amount of the underlying asset.
    - The complete definition of an option must specify:
    ⋄ Exercise or strike price (X): price at which the right is "exercised."
    ⋄ Expiration date (T): date when the right expires.
    ⋄ Size: Amount of the underlying asset.
    ⋄ When the option can be exercised: Anytime (American)
    At expiration (European).
    - The option to buy or sell an asset has a price: the premium (paid upfront).
    - Options are priced using variations of the Black-Scholes formula.
    - Currency premiums are affected by six factors:
    i. St (underlying asset’s market price)
    ii. X. (exercise or strike price)
    iii. T-t (time till expiration)
    iv. σ (volatility of underlying asset)
    v. id (domestic interest rate)
    vi. if (foreign interest rate)
    - Moneyness. The relation between St, and the option’s strike price, X, determines the moneyness of the
    option (if exercised today how profitable the option is for the holder). An option can be:.
    ⋄ At-the-money (ATM) if St = X
    ⋄ In-the-money (ITM) if St > X (calls)
    if St < X (puts)
    ⋄ Out-the-money (OTM) if St < X (calls)
    if St > X (puts)

    • Real Life Examples of Options


    Insurance, layaways, tuition, movie tickets.

    Example 1: An advance purchase of a movie ticket.


    I have the right to go to a movie. If I have something better to do, I do not have to go.
    Size: 1 ticket.
    Premium: ticket price.
    Maturity: time at which the movie ends.

    Example 2: College tuition and Moneyness.


    Paying tuition allows a student to come to class. Unless attendance is mandatory, some students only
    attend when it is convenient/valuable –i.e., when, for them, the option is ITM. Usually, the class before

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    the exam is considered by all students ITM. On the other hand, the class after the exam is considered,
    for many students, OTM.

    • OTC and Exchange-traded Currency Options


    There are 2 markets for FX options:

    (1) Interbank (OTC) market centered in London, New York, and Tokyo.
    OTC options are tailor-made as to size, maturity, and exercise price.

    (2) Exchange-based markets centered in Philadelphia (PHLX) or NY (ISE).


    PHLX options are on spot amounts of 10,000 units for the main FC (JPY: 1M, MXN: 100K).
    PHLX maturities: 1, 3, 6, and 12 months.
    PHLX expiration dates: March, June, September, December, and the two nearby months.

    Exercise price of an option at the PHLX or CME is stated as the price in USD cents of a unit of FC. A
    typical newspaper option quote is shown in Exhibit 5.1.

    Exhibit 5.1: PHLX Option quote

    OPTIONS
    PHILADELPHIA EXCHANGE
    May 15, 2013
    Calls Puts
    Vol. Last Vol. Last
    Euro 135.54 ( St = 1.3554 USD/EUR)
    10,000 Euro-cents per unit.( Size of EUR contract)
    132 Oct .... 0.01 3 0.38
    134 Sep 3 1.74 90 0.15
    134 Oct 3 1.90 .... ....
    134 Dec 2 2.17 25 1.70 (Premium in USD cents=USD .017 per EUR)
    136 Dec 8 1.85 12 2.83
    138 Oct 75 0.43 .... 0.01
    142 Dec 1 0.08 1 7.81
    Australian Dollar 95.37
    10,000 Australian Dollars-cents per unit.
    94 Oct .... 0.01 20 0.31
    95 Sep 20 0.30 .... ....
    96 Oct 30 0.42 .... 0.01

    Q: Who buys options?


    A: Speculators/Hedgers

    Q: Why options and not futures?


    A: Options simply expire if St moves in a beneficial way. (But not free. There is an upfront payment.)

    IFM-LN.29
    Example: We buy a EUR Dec call with X=1.34 USD/EUR and also a futures contract with Ft,Dec=1.34
    USD/EUR.

    If St > 1.34 USD/EUR, we exercise the call and we get EUR at USD 1.34.
    with the future contract we get EUR at USD 1.34.
    If St < 1.34 USD/EUR, we do not exercise the option and we get EUR at less than USD 1.34.
    with the future contract we get EUR at USD 1.34.

    Figure 5.3 shows the net cashflows in December associated with the long Dec call with X=1.34
    USD/EUR.

    Figure 5.3: Profit Diagram for a Long Call

    premium (p)

    out-of-the-money in-the-money
    (OTM, no exercise) (ITM, exercise)

    X=1.34 St=Dec (USD/EUR)


    USD -.0217

    • Hedging with Currency Options


    Hedging with options is simple:

    - Situation 1: Underlying position: Short in foreign currency.


    Hedging position: Long in foreign currency calls.

    - Situation 2: Underlying position: Long in foreign currency.


    Hedging position: Long in foreign currency puts.

    Example: Situation 1 - A U.S. investor is considering buying U.K bonds for GBP 1M in December.
    She hedges using Dec call options with X= USD 1.60 (at-the-money).

    Underlying position: Short GBP 1,000,000.


    St = 1.60 USD/GBP.
    Size of the PHLX contract: GBP 10,000.
    X = USD 1.60
    P = premium of Dec call = USD .05.

    Cost of Dec calls = 1,000,000 x USD .05 = USD 50,000. (Cost of Dec call is a sunk cost.)

    IFM-LN.30
    Number of contracts = GBP 1,000,000/ GBP 10,000 = 100 contracts.

    There are 3 situations at exercise (third Wednesday of December):


    1) St=Dec < X (call is out-of-the-money, OTM)
    Suppose that on Dec, SDec =1.30 USD/GBP, option is not exercised.
     If the U.S. investor decides to buy the UK bonds, she will pay USD 1.30M.
    2) St=Dec = X (call is at-the-money, ATM)
    Suppose that on Dec, SDec =1.60 USD/GBP, option is not exercised (technically, indifferent).
     If the U.S. investor decides to buy the UK bonds, she will pay USD 1.60M.
    3) St=Dec > X (call is in-the-money, ITM)
    Suppose that on Dec SDec =1.80 USD/GBP, option is exercised.
     If the U.S. investor decides to buy the UK bonds, she will pay USD 1.60M.

    Figure 5.4: CFs under an FX Call

    Net CFs
    Payed in Dec
    Call
    USD 1.65M

    X=1.60 St=Dec (USD/GBP)

    As shown in Figure 5.4, the maximum Net Amount to Pay is (USD 1.60M+USD .5M) = USD 1.65M.

    Note: The U.S. investor has established a cap: Maximum net amount she may pay is USD 1.65M. ¶

    Example: Situation 2 - IBM will receive a EUR 5M payment in 90 days from a French customer.
    Date: September 15, 2016 (90 days from today).
    Underlying Position = Short EUR 5,000,000.
    Hedging Position = EUR Sep put options: X =1.34 USD/EUR (Premium= USD 0.0217 per EUR)
    St = 1.3554 USD/EUR.

    Number of contracts = EUR 5M/EUR 10,000 = 500 contracts.


    Cost of Sep puts = 5M x USD .0217 = USD 108,500.
    Minimum amount received = EUR 5M x 1.34 USD/EUR = USD 6.70M (Net = USD 6.6915M)

    If St=Sep < 1.34 USD/EUR, put is ITM:


     IBM will exercise the put option. IBM will receive USD 6.70M
    If St=Sep > 1.34 USD/EUR, put is OTM:
     IBM will not exercise the put option. IBM will receive more than USD 6.70M.

    Figure 5.5 shows the net cash flows for IBM in 90 days.

    IFM-LN.31
    Figure 5.5: CFs under an FX Put

    Net CFs Put


    Received in Sep

    USD 6.6915M

    X=1.34 St+90 (USD/EUR)

    Minimum Net Amount to Receive: USD 6.70M - USD .1085M = USD 6.5915M.

    Note: IBM has established a floor: Minimum amount IBM will receive is USD 6.70M. ¶

     Hedging Strategies
    Hedging strategies with options can be more sophisticated:
     Investors can play with several exercise prices with options only.

    Example: Hedgers can choose different options for the same maturity:
    - Out-of-the-money (OTM, least expensive)
    - At-the-money (ATM, expensive)
    - In-the-money options (ITM, most expensive). ¶

     Same trade-off of car insurance: High deductible/high floor (cheap)


    Low deductible/low floor (expensive)

    Example: It is June 15, 2014.


    UP = Long bond position EUR 1,000,000.
    HP= EUR Dec put options: X =134 and X=136.
    St = 1.3554 USD/EUR.

    (A) OTM Sep 134 put.


    Total cost = USD .0170 x 1,000,000 = USD 17,000
    Floor = 1.34 USD/EUR x EUR 1,000,000 = USD 1,340,000.

    (B) OTM Sep 136 put.


    Total cost = USD .0283 x 1,000,000 = USD 28,300
    Floor = 1.36 USD/EUR x EUR 1,000,000 = USD 1,360,000

    Typical trade-off: A higher minimum (floor) amount for the UP (USD 1,360,000) is achieved by

    IFM-LN.32
    paying a higher premium (USD 28,300). ¶
    CHAPTER 5 – BRIEF ASSESMENT

    1. Walmart has to pay in 180 days GBP 5M to a U.K. supplier. Walmart is offered a forward contract
    at 1.40 USD/GBP. Draw a graph showing the GBP cash flow (in USD) in 180 days relative to St+180.
    Does Walmart face uncertainty regarding the amount to pay (in USD) in 180 days?

    2. Fifi Bank sold a call option on GBP for USD .03 per unit. The strike price was 1.45 USD/GBP,
    and the spot rate at the time the option was exercised was 1.40 USD/GBP. Using the following
    table, fill in the net profit (or loss) per unit to Fifi Bank, based on the listed possible spot rates of the
    GBP on the expiration date.

    Possible St (USD/GBP) Net Profit (Loss) per Unit


    on Expiration Date if St Occurs
    1.31
    1.36
    1.39
    1.42
    1.45
    1.49

    What is the maximum net profit and the maximum net loss per unit?

    3. It is September 2017. Pez Inc., a Houston-based fishing company, has a GBP 20 million payable
    due in November 2017. Pez decides to use options to reduce FX risk. Available options with
    November maturity are:
    X Calls Puts
    1.38 USD/CAD 3.77 0.65
    1.42 USD/CAD 1.08 2.88
    1.45 USD/CAD 0.16 5.40,
    where X represents the strike price and premiums are expressed in USD cents –i.e., 1.08 equals to
    USD 0.0108.
    The exchange rate is 1.40 USD/GBP.

    Calculate the premium cost and use a graph to describe the net cash flows, including premium paid,
    (in USD) in December 2017 for Pez Oil under the following choices:
    i) in-the-money option
    ii) out-of-the money option

    4. Using an example, explain how a U.K. company with BRL receivables can establish a floor (in
    GBP).

    5. Using an example, explain how a U.K. company with BRL payables can establish a cap (in GBP).

    IFM-LN.33
    Chapter 6 - Government Influence on FX Rates
    In this chapter we cover the different FX systems that are adopted by different central banks (CT) around
    the world.

    • FX Rate Systems
    There are two pure FX Rate Systems: Flexible exchange rate (free float) system
    Fixed exchange rate system

    One way to characterize these two systems is to look at the role of the Central Bank (CB) –i.e., the
    institution in charge of the domestic currency, domestic money supply and domestic interest rates.

    • CB: Brief Review


    A CB is a "bank." It holds:
    ⋄ Assets: Foreign (international reserves of FC (mainly in FC bonds) + Gold + Domestic (mainly
    loans to domestic institutions and government securities)
    ⋄ Liabilities: DC outstanding (backed by assets the CB owns) + Deposits of banks.

    Note: Change in assets = Change in liabilities. That is, a purchase of an asset, say FC (or the unusual
    assets bought by CBs during the 07-08 financial crisis), results in an increase in the liabilities, through
    an increase in the domestic money supply (MS).

    But, a CB is not a bank in the sense that it is given the responsibility to keep an eye on inflation (low)
    and the economy (full employment). Many times, conflicting targets (say, higher St promotes exports &
    economic growth, but increases Id).

    Around the world, CBs have different names: U.S. Federal Reserve System (“The Fed”), European
    Central Bank (ECB), Central Bank of UAE, Central Reserve Bank of Peru, Bank of Mexico, Swiss
    National Bank, Monetary Authority of Singapore, etc.

    6.1. Flexible Exchange Rate System (free float)


    In a flexible FX rate system the CB allows St to adjust to equate the supply and demand for foreign
    currency, as shown below in Figure 6.1:

    IFM-LN.34
    Figure 6.1: Free Float - CB allows Supply and Demand to determine St

    St Supply of GBP
    (USD/GBP)

    StE = USD 1.40

    Demand for GBP


    Quantity of GBP

    All the variables mentioned in Chapter 4 will affect St. In particular, international capital inflows
    (outflows) will decrease (increase) St. Whatever St is, the CB is fine with it.

    • Features of a Flexible FX System


    ⋄ St reflects economic activity, through S & D for FC.
    ⋄ The exchange rate is subject to volatility.
    ⋄ Money supply is exogenous  The CB can have an independent monetary policy.
    ⋄ Under certain assumptions (IS-LM model, perfect capital mobility) fiscal policy does not work.
    ⋄ External shocks (say, oil shocks or sudden outflows of capital) can be quickly absorbed by changes
    in StE  Quick(er) adjustments to shocks/disequilibrium.

    With respect to the last point, Milton Friedman, Nobel Prize Winner, (1953) argued that under flexible
    exchange rates “changes in St occur rapidly, automatically, and continuously and so tend to produce
    corrective movements before tensions can accumulate and a crisis develop.”

    • Brief Aside: The Mundell-Fleming Model = IS-LM + Perfect Capital Mobility


    Open macroeconomic model combining:
    (1) Aggregate demand (IS and LM curves, representing equilibrium in goods and money markets)
    (2) Aggregate supply (production function and labor market)
    (3) BOP (=CA + KA)

    The assumptions behind the Mundell-Fleming Model:


    - Exchange rate regime: Flexible (Fixed, in the next section)
    - Perfect capital mobility.
    - Under utilized resources & no supply constraints –i.e., Keynesian world
    - The Marshall-Lerner condition is satisfied –i.e., St ↑ (↓)  CA ↑ (↓)
    - The price level, Pd, is fixed (in particular, no FX rate pass-through)
    - No currency substitution (say, dollarization).
    - Exchange rate expectations are static and/or there is no risk premium.
    - Pf, Yf, & if are given –i.e., not influenced at all by domestic changes.

    Mundell-Fleming Model in a Free Float Economy

    IFM-LN.35
    Monetary Policy: Increase in the Money Supply (MS↑)  LM (curve) ↓
    Fiscal Policy: More government spending (G ↑)  IS (curve) ↑ .
    Figure 6.2 shows the typical equilibrium IS-LM curves + BB (BOP equilibrium, id = if):

    Figure 6.2: Equilibrium under Mundel-Fleming model - IS-LM + BB

    i
    d
    LM (Money Market equilibrium)

    i BB (BOP equilibrium)
    f

    IS (Goods Market equilibrium)

    Y
    d
    • Why does monetary policy work (more government spending, MS ↑)?
    MS ↑  LM ↓  id ↓  Foreign Capital outflows  St ↑
     CA ↑ (IS ↑)  Yd ↑
    • Why doesn’t fiscal policy work (more government spending, G ↑)?
    G↑  IS ↑  id ↑  Foreign Capital inflows  St ↓
     CA ↓  IS ↓ (back to original position)

    6.2. Fixed Exchange Rate System


    In a fixed FX rate system the CB is ready to buy and sell unlimited amounts of foreign currency at a
    fixed price, say S*= 3 DC/FC. Sometimes, the CB pegs the value of the DC to a basket of currencies,
    say S*= 1.273 DC/FCBasket, where FCBasket is the price of a basket of exchange rates, usually trade-
    weighted.

    Example: Hong Kong has a fixed exchange rate (a peg) system since October 17, 1983. The
    exchange rate is 7.8052 HKD/USD.

    Note: The HKD is not fixed against all currencies, only against the USD. When the USD moves,
    the HKD moves. From 2010 to 2015, the USD moved widely against the EUR, taking the HKD for
    a ride, going from 11.50 HKD/EUR (April 24, 2011) to 9.15 HKD/EUR (January 8, 2015). ¶

    In order to support the fixed parity S*, a CB needs enough FC reserves to make the system viable. At
    least, a CB needs to have enough reserves to purchase the total currency circulating in the public plus
    required bank’s reserves at the CB i.e., high-powered monetary base at the fixed exchange rate, S*.
    When a CB holds this amount, it holds 100% FC reserves.

    Having enough reserves may be a problem for CBs. A CB credibility plays a big role. If there is not

    IFM-LN.36
    enough FC reserves and the demand for FC cannot be met, the CB has a problem: A currency crisis.

    A solution to the potential lack of FC reserves is to keep 100% reserves outside the reach of a
    CB/government. This arrangement is called Currency Board. Small Caribbean countries (Grenada,
    Saint Lucia, Dominica, etc.) have a fixed exchange rate system (pegged to the USD) with a currency
    board.

    Every time somebody buys FC from the CB, the domestic money supply decreases. Every time
    somebody sells FC to the CB, the domestic money supply increases. Thus, the domestic money
    supply is endogenous. Thus, international capital flows will affect the domestic money supply.

    A CB gives up the control of the MS under a fixed system.

    Example: International capital inflows


    For most of the past 30 years, China has maintained a fixed FX rate system and received vast
    amounts of capital inflows. Under this situation, the People’s Bank of China (PBOC, China’s CB)
    exchanges yuans (CNY) for FC, say USD. Exhibit 6.1 displays the currency exchange between the
    PBOC and foreign investors in China:

    Exhibit 6.1: Effect of Capital Inflows under a Fixed FX System

    CNY
    Capital PBOC Foreign
    Inflows (China’s CB) Investors
    USD

    That is, international capital inflows increase not only the PBOC’s international reserves of FC,
    but also China’s money supply.

    Note: The PBOC may not like this increase in the money supply (along with lower interest rates
    and inflationary pressures) and may take some counteraction to nullify or mitigate the increase in
    China’s money supply. A CB counteraction is called sterilization. For example, the PBOC can
    increase the bank’s reserve-requirement ratio. ¶

    • Terminology: Devaluation/Revaluation
    A devaluation (revaluation) occurs when the price of FC under a fixed FX rate regime is increased
    (decreased) by the CB. (Remember: depreciation/appreciation occurs in a flexible FX rate system.)

    Example: During the previous decade, China's yuan (CNY) was fixed at 8.27 per USD. On July 21,
    2005, it was revalued to 8.11 CNY/USD, following the removal of the peg to the USD. ¶

    Note: In a Fixed FX rate system, the possibility of a currency crisis creates risk: devaluation risk. The
    magnitude of this risk depends on the CB credibility –i.e., very credible CB, devaluation risk is near
    zero.

    • Fixed FX System: Variations

    IFM-LN.37
    Some CBs have a fixed exchange rate system, but St is not really fixed:
    - “Target zone system,” where the exchange rate is kept within a band (the target zone).
    - “Crawling peg system,” where the fixed exchange rate is regularly adjusted, usually to keep
    up with domestic inflation.

    Example: On July 21, 2005, the People's Bank of China (China’s CB) announced that the CNY would
    be pegged to a basket of foreign currencies, rather than being only tied to the USD.

    The CNY would trade within a narrow 0.3% band against the basket of currencies. The basket is
    dominated by the USD, EUR, JPY and KOW.

    The Central Bank of Chile, in 1983 (adjusted in 1984), adopted a crawling peg with a fluctuation band
    of ±0.5. The CLP/USD was adjusted according to the previous month’s inflation minus an estimate of
    U.S. inflation (around 2% annually). ¶

    • Black Market
    In some countries, the exchange rate is fixed by the government, say at S*. But, it is not a fixed exchange
    rate system. The government sells FC at the official rate only for some transactions, for example,
    “favored” imports. For all non-official transactions, a free market -or in some cases, a black market- is
    created. Obviously, S* is set below the equilibrium StE.

    Example: In 2013, Argentina had three loosely recognized exchange rates. The official (“white”)
    rate was 6.205 ARS/USD; the tourist rate (official + 35% tax) 9.377 ARS/USD and the black
    market rate (“blue”) was 9.62 ARS/USD.

    If Argentina were to have a true fixed exchange rate system, an equilibrium exchange rate can be easily
    found: Monetary Base (in ARS)/CB Reserves (in USD). For 2013,
    Sfixed=2013 (fixed equilibrium) = ARS 342,132/USD 31,100 = 11.001 ARS/USD. ¶

    • Features of a Fixed FX Rate System


    ⋄ Money supply is endogenous (A CB does not have an independent monetary policy!).
    ⋄ Exchange rate has no/low volatility; actually, St inherits the volatility of the FC the CB fixes the
    DC against. (No or low volatility: Good for trade, investments and inflation control.)
    ⋄ Under certain assumptions (same as above), fiscal policy works.
    ⋄ If a CB does not have enough reserves, credibility is crucial.
    ⋄ Since St is fixed, external shocks have to be absorbed through prices.

    With respect to the last point, since prices tend to be rigid, adjustments to shocks and/or imbalances tend
    to be slower.

    • Mundell-Fleming Model in a Fixed FX Rate Economy


    Why dose fiscal policy work (more government spending, G ↑)?
    G↑  IS ↑  id ↑  Foreign Capital inflows  MS ↑
     LM ↓ expansion of MS amplifies effect on Yd
    (fiscal + monetary effects!)

    IFM-LN.38
    • Trilemma (due to Robert Mundell (1962), Nobel Prize Winner)
    It is impossible for a country to have at the same time:
    ⋄ A stable (fixed) FX regime.
    ⋄ Free international capital mobility -i.e., no capital controls.
    ⋄ An independent monetary policy.

    A country that attempts to have these three policies at the same time is said to have an inconsistent fixed
    exchange rate system. Only two of the three are possible, as illustrated in Figure 6.2. This policy
    trilemma is also called “the impossible trinity.”

    Figure 6.2: The Impossible Trinity

    Typical Trilemma problem


    Under a fixed exchange rate regime, the local government substantially increases the domestic money
    supply (MSd) to finance deficit spending or to mitigate an external shock: Higher MSd  id ↓  (id - if)
    ↓  Capital will leave the country (international capital outflows)  CB’s FC reserves ↓. In a free
    float, St ↑ (>S*).

    Note: If we think of the free float St as the “true equilibrium” (or “shadow”) exchange rate, the
    divergence between St and the fixed S* signals a potential profit opportunity for speculators.

    • Currency crisis
    When faced with an increasing gap between the shadow St and S*, speculators realize that if the CB
    abandons the fixed FX rate system, a sizable profit can be made from buying FC at S* (usually, by
    borrowing DC to buy FC).

    Q: Why would a CB stop supporting S*? Because it is running out of FC reserves. Then, when a CB
    does not have enough reserves and/or loses credibility, speculators (and everybody else!) will run to
    exchange DC for FC at the fixed exchange rate, S*. This is called a “currency run” or “speculative
    attack.” The CB will soon run out of FC (currency crisis).

    Usual solution: In general, governments do not like to devalue the DC, since it increases inflation and
    decreases real wages, they often try to make it difficult to buy FC, imposing a set of restrictions on FC
    transactions. Typical measures: import bans, new capital outflows regulations and travel restrictions.
    These measures are, at best, temporary solutions. They create a black market, with an increasing gap
    between the shadow St and S*.

    Definite solution to a currency crisis: Float the currency.

    IFM-LN.39
    Example of the “usual” solution: In January 2016, the Nigerian President, Muhammadu Buhari,
    rejected a devaluation of the naira (NGN). During the previous months, the Central Bank of Nigeria
    (CBN) restricted the supply of USD, banned the import of a long list of goods, from shovels and rice to
    toothpicks. In January 2016, the official exchange rate was 199 NGN/USD, while the black market rate
    was around 300 NGN/USD.

    Finally, in June 2016, the CBN decided to float the currency, which quickly depreciated to 285
    NGN/USD. ¶

    Currency crises are not uncommon. They are often related to an “inconsistent” fixed exchange rate
    system. In these cases, the credibility of a CB monetary policy weakens and the likelihood of a
    speculative attack increases. Understanding what may trigger a currency crisis can be very profitable!

    Predictors of a currency crisis (“early warning signals”): High government deficits, low real
    exchange rate (DC overvalued, often due to high domestic inflation), weak financial system, high
    short-term debt, asset/real estate bubbles financed by easy credit, etc.

    Examples of currency crises: India ’91, U.K. ’92 (Black Wednesday), Mexico ‘94 (Tequila crisis),
    Thailand/Malaysia ‘97 (Rice crisis), Russia ‘98 (vodka crisis), Argentina ‘01 (Tango crisis), Iceland ’08,
    Nigeria ‘16. Exhibit 6.2 shows the MXN/USD before and after the Tequila crisis (mid-Dec ’94).

    Exhibit 6.2: USD/MXN and the Tequila Crisis

    Run on the FX Market: Tequila Crisis

    8
    7
    MXN/USD

    6
    5
    4
    3
    8/4/1994

    9/4/1994

    10/4/1994

    11/4/1994

    12/4/1994

    1/4/1995

    2/4/1995

    3/4/1995

    4/4/1995

    Mexican USD reserves went from USD 18 billion in October 1994 to USD 5 billion in December
    1994, when the decision to abandon the fixed exchange rate against the USD was made.

    Overall, Mexico spent USD 25B in FC reserves and borrowed USD 25B (from the U.S. Fed) to
    defend the peso’s USD peg. ¶

    On average, a currency crisis is followed by a 30% drop of the value of DC. In many cases there is
    a temporary higher drop (say, 50%), before reverting to a value closer to the average. When a crisis

    IFM-LN.40
    is very serious, a 75% or higher drop is possible (Indonesia ‘97, Argentina ’01).

    • Fixed FX Rate Regime in Emerging Markets: Importing good behavior


    A fixed FX rate is considered transparent and a simple anchor for monetary policy. Countries with weak
    institutions, usually less developed/emerging markets, can “import” monetary credibility by anchoring
    to a currency with a credible central bank, say the Fed or the ECB.

    Another advantage for emerging markets: A fixed FX regime tends to reduce transaction costs and FX
    risk. In countries with less developed financial sectors, economic agents may not have the financial tools
    to hedge long-term currency risks. A fixed FX regime will help in this regard.

    • Fixed or Floating?
    Both regimes have pros and cons. There is no clear winner. Regime choices should reflect the individual
    characteristics of an economy. However, we do observe that large economies with sound monetary and
    fiscal policies and good institutions (say, an independent CB) prefer a flexible FX rate regime. This is
    fine: a flexible FX rate regime tends to insulate better a country from external shocks and/or imbalances.

    On the other hand, we also observe that small or less developed countries with a history of poor
    institutions and/or credibility problems have relied on fixed FX rate regimes to fix problems. Some of
    these countries have had consistent monetary policies, since the adoption of the fixed FX rate, and the
    fixed FX rate regime has served them well. For this reason, they have been reluctant to change the FX
    rate regime.

    As Timothy Adams, Treasury Under Secretary for International Affairs, said in 2006, regarding
    the choice of FX rate regime: “In particular, there is no substitute for sound fiscal and monetary
    policies and resilient institutions.”

    6.3. Mixed FX System


    In practice, the exchange rate system in many countries is a mixture: managed floating (also called, dirty
    floating):

    A CB allows the FX Market to determine St. But, from time to time, the CB takes some actions
    with the intention to influence St. These actions are called Central Bank intervention in the FX
    Market. For example, the central bank can buy or sell foreign currency to change St.

    This is the usual FX rate system in developed countries.

    • Central Bank Intervention


    CBs have economic models to determine what they believe is an equilibrium St. Using these models,
    a CB determines a range for St (a trading band)  St should move between St,L and St,U.

    If St is within the range (St,L < St < St,U), CB does nothing (free float system!)
    If St is above St,U (St>St,U), CB determines FC is overvalued (or “too” expensive)  CB intervention
    If St is under St,L (St< St.L), CB determines FC is undervalued (or “too” cheap)  CB intervention

    IFM-LN.41
    Summary: CB Intervention
    “Appreciating” FC (St>St,U)  CB sells FC.
    “Depreciating” FC (St< St,L)  CB buys FC.

    Example: The Fed (U.S. CB) considers the CHF overvalued or St>St,U.
     The Fed intervenes in the FX market to stop the appreciation of the CHF against the
    USD, as shown below in Figure 6.3:

    Figure 6.3: Central Bank Intervention in the FX Market

    FX Market
    St S0
    (USD/CHF) S1
    Fed Sells CHF
    St = .80

    SU = .78
    St = .77

    D0
    Quantity of CHF

    The Fed determined SU=.78 USD/CHF.

    Now, demand for CHF has increased –suppose Swiss interest rates are up. New St = .80 USD/CHF.
    The Fed determines the St= .80 USD/CHF is too high (CHF too expensive) since St>St,U.
    Fed FX intervention  Sell CHF

    Exhibit 6.3: CB Intervention in the FX Market – Effect on Money Supply

    CHF
    FX Int Fed Reserve Banks
    USD

    As shown in Exhibit 6.4, the Fed’s FC reserves (CHF) and the U.S. Money supply are decreased.

    Note: The arrows above are a simplification of three transactions. Technically speaking, the Fed
    sells Swiss government securities (in CHF) to a Swiss commercial bank, which pays the Fed through
    a deposit in a U.S. commercial bank. Then, the Fed debits the reserves of the U.S. commercial bank.

    In general, CB FX intervention is justified by arguing that the CB has better information (CB knows
    the true model for St) to determine StE –i.e., the equilibrium value for St. If this is not the case, the
    CB may be setting a “wrong rate,” which can have side effects.

    • CB FX Intervention Issues:

    IFM-LN.42
    1. Implicit notion of "overvaluation/undervaluation" in FX market. The wrong rate problem.
     Q: Do CB have "superior" information –i.e., do they know better than the FX Mkt?
    A: Not clear consensus in the academic literature: Sometimes CBs lose millions, sometimes
    CBs make millions. However, there is some evidence that shows that CB purchases of FC
    tend to be associated with subsequent FC appreciation. This evidence is taken to support the
    leaning-against-the wind behavior by CBs.
    2. CB can generate FX instability:
     Uncertainty over CB actions increases FX volatility and risk (what a CB dislikes!)
    Academic studies tend to find that CB intervention does increase FX volatility.
    3. Potential conflict with other countries:
     When a CB intervenes in the FX market to depreciate the DC to boost domestic exports,
    trading partners will be affected. This type of FX intervention is called beggar-they-
    neighbor devaluation. Popular in the 1930s.

    Despite these issues and the academic sentiment that FX intervention is not worth it, central banks
    do intervene in FX markets. In a 1999 BIS survey of CBs, the percentage of business days on which
    CB report intervening from 0.5% to 40% percent, with a 4.5% median.

    The largest player by far is Japan. For example, between April 1991 and December 2000, the Bank
    of Japan bought USD on 168 occasions for a cumulative amount of USD 304 billion and sold USD
    on 33 occasions for a cumulative amount of USD 38 billion.

    Japanese interventions dwarf all other countries' official intervention in the foreign exchange
    market; for example, it exceeds U.S. intervention over the same period by a factor of more than 30.

    • CB Intervention: Details
    According to a 1999 BIS survey, CB interventions transactions almost always (95%) are
    conducted at least partially in spot markets. Some CBs also use the forward market, perhaps in
    conjunction with the spot market to create a swap transaction.

    During FX intervention, CBs tend to deal with major domestic and, less often, foreign banks.

    Some countries have large FX reserves, which can be used to influence the value of exchange
    rates. For example, by the end of 2014, China and Japan had the largest FX reserves in the world,
    USD 3.9 trillion and USD 1.2 trillion, respectively. Saudi Arabia was in third place with USD 0.74
    trillion (& the U.S. was in 13th place with USD 0.13 trillion.)

    But, large FX reserves are not necessary in many markets. In emerging markets, CBs have a huge
    potential “firepower,” since the ratio of official reserves to average daily turnover is very high. On
    average, official reserves were 15 times the size of daily turnover in emerging market currencies,
    compared with less than half in smaller industrial countries.

    When a CB has firepower, sometimes just a rumor or the verbal threat of CB FX intervention can
    bring the FX market in line with the CB’s desired valuation. This type of verbal intervention is
    referred as jawboning. It is cheap and, sometimes, effective.

    IFM-LN.43
    Example: Jawboning at work
    On September 6, 2011, the Swiss National Bank (SNB) announced a “minimum” exchange rate of
    1.20 CHF/EUR, saying that the SNB would buy “unlimited quantities of foreign currency.” The
    CHF fell from 1.11 CHF/EUR to 1.20 CHF/EUR almost immediately. ¶

    The actual size of a CB FX intervention depends on the reaction of the FX market. In general, if
    the CB finds the initial response to be positive, the size of the intervention will be cut. Neely
    (2001) found, in a sample of 24 countries, that in 39% of cases it took just a few minutes to
    observe the desired effect –but, in 49% it took a few days or more!

    On average, during 2002-2004, the size of an FX intervention –as a percentage of average daily
    FX market turnover– was in the interval 5% to 12%.

    Most central banks intervene secretly, releasing actual intervention data with a lag, if at all. Some
    authorities, like the SNB, always publicize interventions at the time they occur.

    6.3.1 CB Intervention: Sterilized and Non-Sterilized


    FX Intervention affects Money Markets => Money supply is affected (& also interest rates).

    A CB might not like to change interest rates in the domestic economy, especially increasing
    interest rates if the economy is in a recession or decreasing interest rates if the economy is doing
    well.

    The counter actions taken by the CB to neutralize/mitigate the effect of CB FX intervention in


    domestic Money Market are called sterilization. If the CB coordinates FX Intervention with a
    counteraction to mitigate the effects on domestic Money Markets, the intervention is called
    sterilized. If, on the other hand, the CB allows the FX Intervention to affect domestic Money
    Markets, the intervention is called non-sterilized.

    Usual sterilization tools: Open Market Operation (OMO), bank reserve-requirement ratios.

    Example (continuation): The Fed considers the CHF overvalued :


    Fed FX intervention  Fed Sells CHF & Receives USD

    As shown in Figure 6.4, the effect of the Fed’s intervention is a decrease in the U.S. money supply,
    increasing interest rates from 4% to 5%.

    IFM-LN.44
    Figure 6.4: CB Intervention in the FX Market - Effect on Money Markets

    U.S. Money Market


    MS,1
    iUSD Fed Sells CHF & Receives USD
    B MS,0
    i1= .05
    A
    i0= .04

    L0

    Quantity of Money (in US)

    Fed’s unwanted effect from FX Intervention (Fed sells CHF): MS   interest rates (iUSD) 

    Sterilization: The Fed uses an OMO to counteract the effect of FX intervention in Money Markets.
     OMO: Fed buys T-Bills to increase MS (sterilized intervention), as shown in Exhibit 6.3.

    Exhibit 6.3: OMO to Sterilize Effect of CB Intervention on FX Market

    USD
    OMO Fed Reserve Banks
    U.S. T-bills

    Figure 6.5 shows the sterilizing effect on the U.S. Money Supply of the OMO.

    Figure 6.5: CB Sterilized Intervention – No Effect on Money Markets

    U.S. Money Market


    MS,1
    iUSD
    B MS,0
    i1= .05
    A
    i0= .04
    OMO
    L0

    Quantity of Money (in US)

    Exhibit 6.4 shows the net effect of a well executed sterilized intervention.

    IFM-LN.45
    Exhibit 6.4: Net effect: OMO + Fed FX Intervention

    CHF
    Fed Reserve Banks
    U.S. T-bills

    Note: Instead of using an OMO, the Fed can decrease the bank reserve-requirement ratio. This will
    also increase the U.S. money supply. ¶

    • Sterilized Interventions: Side Effects


    Although sterilized intervention does not change the domestic MS, it does change the composition of
    the Fed’s (and, in equilibrium, the public’s) mix of domestic and foreign assets. This creates a balance
    sheet effect. Depending on the rates of return of the assets involved, this effect can be positive or
    negative for the CB. In general, for major currencies, this effect is very small. But for minor currencies,
    the balance sheet effect can be substantial.

    Another side effect may materialize if the CB can successfully maintain for a while St artificially
    high/low and, then, keep money markets out of sync with the FX Market. For example, suppose a
    CB keeps sterilizing to keep St low (DC overvalued). Then, the CB is forcing the economy, as whole,
    to subsidize the import sector (and domestic consumption) and leaving its domestic producers in a
    tough competitive situation.

    For a short time, the side effects can be tolerated; for a long time, they can lead to resource allocation
    problems.

    In addition, banks may not like the situation of having to hold large amounts of government bills
    (T-bills) and/or having high reserve-requirement ratios. Both situations will reduce bank’s profits.

    Example: The Banco de México (Banxico, México’s CB) considers the USD undervalued, say St<
    SL, with SL=10.8 MXN/USD
    ⇒ Banxico decides to intervene, but does not want to affect local interest rates. Thus, it will
    use an OMO (CETES: Mexican T-bills).

    Original Situation: Point A (S0= 10 USD/MXN and i0=7%)


    Banxico intervention in FX market (Buy USD/Sell MXN) Point B (S1= 11 USD/MXN and i1=6%)
    Sterilization intervention (OMO: Buy MXN/Sell CETES) Point C (S1= 11 USD/MXN and i0=7%)

    IFM-LN.46
    FX Market
    St FX intervention S0
    (MXN/USD)
    B
    S1= 11
    SL = 10.8
    S0= 10
    A
    D1

    D0
    Quantity of USD

    Mexican Money Market MS,0


    iMXN
    OMO
    A=C MS,1
    i0= 7%
    B
    i1= 6%

    FX L0
    intervention
    Quantity of Money (MXN)

    Net effect: OMO + BOM Intervention

    CETES
    Banxico Banks
    USD

    Banxico will invest the USD in U.S. T-bills, which have a lower effective yield than the CETES
    (now, with even a greater yield: 7%!) creating a negative balance sheet effect (if sterilization works
    the change in St is zero).

    Note: If Banxico keeps sterilizing for a long time, keeping St>StE, Mexico subsidizes its export
    sector (and protects its domestic sector from foreign competition). In addition, for the given St,
    Mexican interest rates will be higher, affecting consumption and investments. ¶

    • Sterilized Interventions: Durable Effects on St


    There are two main channels through which sterilization can have a more durable effect on St: (1) the
    portfolio balance channel and (2) the signaling channel.
    (1) Portfolio balance channel: Suppose the BOM intervenes to support the USD. Then, banks buy
    CETES and sell USD, which used to be held in T-bills. Then, the relative supply of domestic to
    foreign bonds increases. If domestic and foreign bonds are imperfect substitutes, then, their relative

    IFM-LN.47
    prices would change in favor of the foreign bonds, increasing St.
    (2) Signaling channel: Agents perceive a CB intervention as signaling a CB’s intentions, regarding its
    future monetary policy.

    • Sterilized Interventions: Do They Work?


    In the short-run, sterilizations tend to work, affecting St in the direction the CB wanted. But the
    evidence regarding lasting effects on St is mixed and it tends to be on the negative side, especially
    for major currencies.

    Sustaining sterilizations can be costly, due to the balance sheet effects. In the Banxico example,
    CETES yield 7%, while US T-bills have a substantial lower yield. Over time, these costs can be
    difficult to bear.

    Mohanty and Turner (2005) report that, between 2000 and 2004, the CBs of Korea, the Czech
    Republic, and Israel issued currency-stabilizing bonds of values equivalent to 300%, 200% and,
    150% of their respective reserve money for the purpose of sterilization operations. Interest
    payments, when domestic interest rates go up, render sterilization operations too costly to last.

    IFM-LN.48
    CHAPTER 6 – BRIEF ASSESMENT

    1. Compare the effect of capital outflows in St and the FX Central Bank reserves under a floating
    exchange rate system and a fixed exchange rate system.

    2. Brunei has fixed its currency, the Brunei dollar (BND), to the Singapore dollar (SGD), fixing the parity at
    1. During the recent past, oil prices have decrease substantially. Brunei’s economy is heavily dependent on
    oil.
    (a) Describe the pressures the BND faces due to the increase in oil prices? What does the CB of Brunei have
    to do in order to support the fixed FX exchange rate? Do the FX reserves increase or decrease in the BND?
    (b) What is the impact on Brunei’s domestic money supply and interest rates?
    (c) How can the CB neutralize (sterilize) the effect of low oil prices on Brunei’s money supply?

    3. Before a national election, many governments engage in expansionary policies to stimulate the
    economy. Suppose that one of these countries has a fixed exchange rate system. Describe how an
    expansionary monetary policy can generate a currency crisis. If a government decides to keep the
    fixed exchange rate system and the expansionary monetary policy, what measures can the
    government take to delay a currency run?

    4. The Banco Central de Chile (BCC) considers the USD overvalued. BCC decides to intervene, but
    does not want to affect local interest rates. Using graphs, describe the effect of central bank
    intervention on the CLP/USD exchange rate, on CLP interest rates and on Chilean money supply.
    (CLP: Chilean peso.)

    IFM-LN.49
    CHAPTER 6 - BONUS COVERAGE: CENTRAL BANKS
    A CB is a "bank." It holds assets (foreign exchange, gold, and other financial assets) and liabilities (mainly the
    currency outstanding, backed by assets the CB owns). A CB may "create" new money, usually backed by the
    full faith and credit of the government.

    CBs generally earn money by issuing currency notes and "selling" them to the public for interest-bearing assets,
    such as government bonds. Since currency usually pays no interest, the difference in interest generates income.
    In most CB systems –for example, in the U.S. and in Europe-, this income is remitted to the government.

    Although a CB generally holds government debt, in some countries the outstanding amount of government debt
    is smaller than the amount the CB may wish to hold. In many countries, CBs hold significant amounts of assets
    denominated in foreign currency, rather than assets in their own national currency, particularly when the
    national currency is fixed to other currencies.

    Any central bank purchase (sale) of assets automatically results in an increase (decrease) in the domestic money
    supply.

    Table Appendix 6
    U.S. Federal Reserve Balance Sheet (December 2017)

    Consolidated U.S. Fed Balance Sheet (in USD billions)


    Liabilities Assets
    Federal Reserve Notes 1,569.1 U.S. Treasuries 2,454.2
    Reverse Repurchase Agreements 386.8 Mortgage Backed Securities 1,764.9
    Deposits 2,445.1 Gold 11.0
    Other liabilities 6.3 SDR 5.2
    Total 4,407.3 Foreign Currency Denominated Assets 21.2
    Central Bank Liquidity Swaps 12.0
    Capital Account 41.4 Other assets 180.2
    Capital paid in 31.4 Total 4,448.7
    Surplus 10.0

    The difference between the Assets and Liabilities represents the Capital Account (USD 41.4 billion) –i.e., the
    earnings of the U.S. Fed. In the Capital Account, the surplus represents the retained earnings not paid to the
    Department of Treasury (USD 10 billion).

    Originally, central banks were created as lenders of last resort (“bank of banks”) and as supervisor of
    banks. This is the banking aspect of a central bank. But, later central bank were given other
    responsibilities: keep an eye on inflation (low) and the economy (full employment). Many times, these
    are conflicting targets. For example, in a recession, a lower St promotes exports and, thus, economic
    growth, but, a lower exchange rate increases the prices of imports and, thus, inflation.

    • Policy instruments
    A CB has two main targets: keep inflation low and the economy close to full employment. To achieve these
    goals, CBs have several monetary policy instruments. The most important ones are:
    ⋄ Open market operation (OMO)
    ⋄ Bank reserve requirement
    ⋄ Interest rate policy

    IFM-LN.50
    • OMO (Open Market Operations)
    Through OMO, a CB puts money in and takes money out of the banking system. This is done through the
    sale and purchase of government securities. Each time it buys securities, exchanging money for the security,
    it raises the money supply. Conversely, selling of securities lowers the money supply. Buying of securities
    thus amounts to printing new money while lowering supply of the specific security.

    The main OMOs are:


    ⋄ Temporary lending/borrowing of money for collateral securities ("Reverse Operations" or "repurchase
    operations", otherwise known as the "repo" market). These operations are carried out on a regular basis,
    where fixed maturity loans are auctioned off.
    ⋄ Buying or selling government securities ("direct operations") on ad-hoc basis.
    ⋄ Foreign exchange operations such as FX swaps.

    All of these interventions can also influence the FX market and, thus, St. For example the People's Bank of
    China and the Bank of Japan have on occasion bought several hundred billions of U.S. Treasuries, in order
    to stop the decline of the USD against the CNY and the JPY, respectively.

    IFM-LN.51
    Chapter 7 - Arbitrage in FX Markets
    In Chapter 6, we went over the effect of government on St
    ⋄ FX rate regimes: Fixed, free float & mixed.
    ⋄ CB sterilized (no effect on domestic Money Markets) and non-sterilized interventions.

    In this lecture we will study the effect of arbitrage on St

    Arbitrage
    Definition: It involves no risk and no capital of your own. It is an activity that takes advantages of pricing
    mistakes in financial instruments in one or more markets. That is, arbitrage involves
    (1) Pricing mistake
    (2) No own capital
    (3) No Risk

    Note: The definition we used presents the ideal view of (riskless) arbitrage. “Arbitrage,” in the real
    world, involves some risk (the lower, the closer to the pure definition of arbitrage). We will call this
    arbitrage pseudo arbitrage.

    There are 3 types of arbitrage:


    (1) Local (sets uniform rates across banks)
    (2) Triangular (sets cross rates)
    (3) Covered (sets forward rates)

    7.1. Local Arbitrage (One good, one market)


    It sets the price of one good in one market. Law of one price: the same good should trade for the same
    price in the same market.

    Example: Suppose two banks have the following bid-ask FX quotes:


    Bank A Bank B
    USD/GBP 1.50 1.51 1.53 1.55

    Taking both quotes together, Bank A sells the GBP too low relative to Bank B’s prices. (Or, conversely,
    Bank B buys the GBP too high relative to Bank A’s prices). This is the pricing mistake!

    Sketch of Local Arbitrage strategy:


    (1) Borrow USD 1.51 (<= No own capital!)
    (2) Buy a GBP from Bank A (at ask price SAt,ask = USD 1.51)
    (3) Sell GBP to Bank B (at bid price SBt,bid = USD 1.53)
    (4) Return USD 1.51 and make a π = USD .02 profit (1.31% per USD 1.51 borrowed)

    Local Arbitrage Notes:


    ⋄ All steps should be done simultaneously. Otherwise, there is risk! (Prices might change).
    ⋄ Bank A and Bank B will notice a book imbalance:
    - Bank A: all activity at the ask side (buy GBP orders –i.e., “GBP undervalued at SAt,ask”)

    IFM-LN.52
    - Bank B: all activity at the bid side (sell GBP orders –i.e., “GBP overvalued at SBt,bid”).
    Both banks will notice the imbalance and they will adjust the quotes. For example, Bank A will increase
    SAt,ask and Bank B will reduce SBt,bid, say to 1.530 USD/GBP and 1.525 USD/GBP, respectively. ¶

    7.2. Triangular Arbitrage (Two related goods, one market)


    Triangular arbitrage is a process where two related goods set a third price. In the FX Market,
    triangular arbitrage sets FX cross rates. Cross rates are exchange rates that do not involve the
    USD. Most currencies are quoted against the USD. Thus, cross-rates are calculated from USD
    quotations –i.e., the most liquid quotes.

    The cross-rates are calculated in such a way that arbitrageurs cannot take advantage of the quoted
    prices. Otherwise, triangular arbitrage strategies would be possible.

    Example: Suppose Bank One gives the following quotes:


    SJPY/USD,t = 100 JPY/USD
    SUSD/GBP,t = 1.60 USD/GBP
    SJPY/GBP,t = 140 JPY/GBP
    Take the first two quotes. Then, the implied (no-arbitrage) JPY/GBP quote should be:
    SIJPY/GBP,t = SJPY/USD,t x SUSD/GBP,t = 160 JPY/GBP > SJPY/GBP,t
    ⇒ At SJPY/GBP,t = 140 JPY/GBP, Bank One undervalues the GBP against the JPY (with respect to the
    first two quotes). This is the pricing mistake!

    Sketch of Triangular Arbitrage (Key: Buy undervalued GPB with the overvalued JPY):
    (1) Borrow USD 1
    (2) Sell USD/Buy JPY at SJPY/USD,t = 100 JPY/USD –i,e, sell the USD for JPY 100.
    (3) Sell JPY/Buy GBP at SJPY/GBP,t = 140 JPY/GBP –i.e., sell JPY 100 for GBP 0.7143
    (4) Sell GBP/Buy USD at SUSD/GBP,t = 1.60 USD/GBP –i.e., sell the GPB 0.7143 for USD 1.1429
    (5) Return loan, keep profits: π: USD 0.1429 (14.29% per USD borrowed).

    The triangle:
    JPY
    ⋄
    Sell USD at Sell JPY at
    St = 100 JPY/USD St = 140 JPY/GBP
    USD ⋄ ⋄ GBP
    Sell GBP at St = 1.60 USD/GBP

    Note: Bank One will notice a book imbalance (all the activity involves selling USD for JPY, selling
    JPY for GBP, selling GBP for USD.) and will adjust quotes. Say:
    SJPY/USD,t ↓ (say, SJPY/USD,t = 93 JPY/USD).
    SUSD/GBP,t ↓ (say, SUSD/GBP,t = 1.56 USD/GBP).
    SJPY/GBP,t ↑ (say, SJPY/GBP,t = 145 JPY/GBP).

    There is convergence between SIJPY/GBP,t & SJPY/GBP,t:


    SIJPY/GBP,t ↓ (= SJPY/USD,t ↓ x SUSD/GBP,t ↓ ) ⇔ SJPY/GBP,t ↑ ¶

    IFM-LN.53
    Again, all the steps in the triangular arbitrage strategy should be done at the same time. Otherwise,
    there will be risk and what we are doing should be considered pseudo-arbitrage.

    It does not matter which currency you borrow (USD, GBP, JPY) in step (1). As long as the strategy
    involves the step Sell JPY/Buy GBP (following the direction of the arrows in the triangle above!),
    you should get the same profit as a %.

    7.3. Covered Interest Arbitrage (Four instruments -two goods per market-, two markets)
    Open the third section of the WSJ: Brazilian bonds yield 10% and Japanese bonds 1%.

    Q: Why wouldn't capital flow to Brazil from Japan?


    A: FX risk: Once JPY are exchanged for BRL (Brazilian reals), there is no guarantee that the BRL will
    not depreciate against the JPY. The only way to avoid this FX risk is to be covered with a forward FX
    contract.

    Intuition: Suppose we have the following data:


    iJPY = 1% for 1 year (T=1 year)
    iBRL = 10% for 1 year (T=1 year)
    St = .025 BRL/JPY

    We construct the following strategy, called carry trade, to “profit” from the interest rate differential:
    Today, at time t=0, we do the following (1)-(3) transactions:
    (1) Borrow JPY 1,000 at 1% for 1 year. (At T=1 year, we will need to repay JPY 1,010.)
    (2) Convert to BRL at St = .025 BRL/JPY. Get BRL 25.
    (3) Deposit BRL 25 at 10% for 1 year. (At T=1 year, we will receive BRL 27.50.)

    Now, we wait 1 year. At time T=1 year, we do the final step:


    (4) Exchange BRL 27.50 for JPY at St+T.

    Problem with this carry trade: Today, we do not know St+T=1-year. Note:
    - If St+T = .022 JPY/BRL, we will receive JPY 1250, for a profit of JPY 240.
    - If St+T = .025 JPY/BRL, we will receive JPY 1100, for a profit of JPY 90.
    - If St+T = .027 JPY/BRL, we will receive JPY 1019, for a profit of JPY 9.
    - If St+T = .030 JPY/BRL, we will receive JPY 916, for a profit of JPY -74.
     We are facing FX risk. That is, (1)-(4) is not an arbitrage strategy.

    Now, at time t=0, we can use the FX forward market to insure a certain exchange rate for the JPY/BRL.
    Suppose we get a quote of Ft,1-yr =.026 JPY.BRL. At time t=0, we re-do step (4):
    (4’) Sell BRL forward at .026 JPY/BRL. (We will receive JPY 1058, for a sure profit of JPY 48.)
     We are facing no FX risk. That is, (1)-(4’) is an arbitrage strategy (covered arbitrage).

    Now, instead of borrowing JPY 1,000, we will try to borrow JPY 1 billion (and make a JPY 48M profit)
    or more. Obviously, no bank will offer a .026 JPY/BRL forward contract!

    IFM-LN.54
    7.3.1 Interest Rate Parity Theorem
    Q: How do banks price FX forward contracts?
    A: In such a way that arbitrageurs cannot take advantage of their quotes.

    To price a forward contract, banks consider covered arbitrage strategies.

    Review of Notation:
    id = domestic nominal T days interest rate.
    if = foreign nominal T days interest rate.
    St = time t spot rate (direct quote, for example USD/GBP).
    Ft,T = forward rate for delivery at date T, at time t.
    Note: In developed markets (like the USA), all interest rates are quoted on annualized basis. We will use
    annualized interest rates (The textbook is completely mistaken when it quotes periodic rates!!)

    Now, consider the following (covered) strategy:

    (1) At time 0, we borrow from a foreign bank 1 unit of a foreign currency (FC) for T days.
     At time=T, We pay the foreign bank (1 + if x T/360) units of the FC.

    (2) At time 0, we exchange FC 1 at St  for 1 unit of FC we get St.

    (3) We deposit St in a domestic bank for T days.


     At time T, we receive St (1 + id x T/360) (in DC).

    (4) At time 0, we buy a T days forward contract to exchange domestic currency (DC) for FC at a Ft,T.
     At time T, we exchange the DC St(1 + id x T/360) for FC, using Ft,T.
     We get St(1 + id x T/360)/Ft,T units of FC.

    If we do (1)-(4) simultaneously, this strategy faces No Risk. In equilibrium, no risk = no profits! This
    strategy will not be profitable if, at time T, what we receive in FC is less or equal to what we have to
    pay in FC. That is, arbitrage will ensure that

    St (1 + id x T/360)/Ft,T = (1 + if x T/360). (This is a No Arbitrage Condition!)

    Solving for Ft,T, we obtain the following expression:


    (1  id xT / 360)
    Ft ,T  S t (Interest Rate Parity Theorem or IRPT)
    (1  i f xT / 360)
    The IRP theory, also called covered IRPT, as presented above was first clearly exposed by John
    Maynard Keynes (1923).

    It is common to use the following linear IRPT approximation:

    Ft,T St [1 + (id - if) x T/360].

    IFM-LN.55
    This linear approximation is quite accurate for small id & if (say, less than 10%).

    Notes:
    ⋄ Steps (2) and (4) simultaneously done produce a FX swap transaction! In this case, we buy the FC
    forward at Ft,T and go sell the FC at St. We can think of (Ft,T - St) as a profit from the FX swap.
    ⋄ We get the same IRPT equation if we start the covered strategy by (1) borrowing DC at id; (2)
    exchanging DC for FC at St; (3) depositing the FC at if; and (4) selling the FC forward at Ft,T.

    Example: IRPT at work.


    Data:
    St = 106 JPY/USD.
    id=JPY = .034.
    if=USD = .050.
    Ft,1-year = ?
    Using the IRPT formula:
    Ft,1-year-IRPT = 106 JPY/USD x (1+.034)/(1+.050) = 104.384 JPY/USD.
    Using the linear approximation:
    Ft,1-year-IRPT = 106 JPY/USD x (1 - .016) = 104.304 JPY/USD.
     The approximation error is less than 0.08%.

    Note: If a bank sets FAt,1-year = 104.384 JPY/USD arbitrageurs cannot profit from the bank’s quotes. ¶

    Arbitrageurs can profit from any violation of IRPT.

    Example 1: Violation of IRPT 1 - Undervaluation of forward FC (=USD, in this example).


    Suppose IRPT is violated. Bank A offers: FAt,1-year=100 JPY/USD.
     FAt,1-year = 100 JPY/USD < Ft,1-year-IRPT = 104.384 JPY/USD (a pricing mistake!): Bank A
    undervalues the forward USD against the JPY.
     Take advantage of Bank A’s undervaluation: Buy USD forward at FAt,1-yr.

    Sketch of a covered arbitrage strategy, summarized in Figure 7.1:


    (1) Borrow USD 1 from a U.S. bank for one year at 5%.
    (2) Convert USD to JPY at St = 106 JPY/USD
    (3) Deposit the JPY in a Japanese bank at 3.4%.
    (4) Cover. Buy USD forward/Sell forward JPY at FAt,1-yr =100 JPY/USD

    Cash flows at time T=1 year,


    (i) We get: JPY 106 x (1+.034)/(100 JPY/USD) = USD 1.096
    (ii) We pay: USD 1 x (1+.05) = USD 1.05
    Profit = П = USD 1.096 – USD 1.05 = USD .046 (or 4.6% per USD borrowed)

    After one year, the U.S. investor realizes a risk-free profit of USD. 046 per USD borrowed.

    IFM-LN.56
    Figure 7.1: IRPT At Work
    t=today T = 1 year
    Borrow 1 USD 5% USD 1.05

    Deposit JPY 106 3.4% JPY 109.6

    Note: Bank A will observe a lot of buying USD forward at FAt,1-yr =100 JPY/USD. Bank A will quickly
    increase the quote until it converges to Ft,1-yr = 104.38 JPY/USD. ¶

    Example 2: Violation of IRPT 2 - Overvaluation of forward FC (=USD).


    Now, suppose Bank X offers: FXt,1-year=110 JPY/USD.
    Then, FXt,1-year > Ft,1-year-IRPT (pricing mistake!)  The forward USD is overvalued against the JPY.
     Take advantage of Bank X’s overvaluation: Sell USD forward.

    Sketch of a covered arbitrage strategy (shown in Graph 7.1):


    (1) Borrow JPY 1 from for one year at 3.4%.
    (2) Convert JPY to USD at St = 106 JPY/USD
    (3) Deposit the USD at 5% for one year
    (4) Cover. Sell USD forward/Buy forward JPY at FXt,1-yr=110 JPY/USD.

    Cash flows at T=1 year:


    (i) We get: USD 1/106 x (1+.05) x (110 JPY/USD) = JPY 1.0896
    (ii) We pay: JPY 1 x (1+.034) = JPY 1.034
    П = JPY1.0896 – JPY 1.034 = JPY .0556 (or 5.56% per JPY borrowed)

    Note: Arbitrage will ensure that Bank X’s quote quickly converges to Ft,1-yr = 104.38 JPY/USD. ¶

    7.3.2 IRPT: Assumptions


    Behind the covered arbitrage strategy -steps (1) to (4)-, we have implicitly assumed:
    (1) Funding is available. Step (1) can be executed.
    (2) Free capital mobility. No barriers to international capital flow –i.e., step (2) and, later, step (4) can
    be implemented.
    (3) No default/country risk. Steps (3) and (4) are safe.
    (4) Absence of significant frictions. Typical examples: transaction costs & taxes. Small transactions
    costs are OK, as long as they do not impede arbitrage.

    We are also implicitly assuming that the forward contract for the desired maturity T is available. This
    may not be true. In general, the forward market is liquid for short maturities (up to 1 year). For many
    currencies, say from emerging market, the forward market may be liquid for much shorter maturities
    (up to 30 days).

    IFM-LN.57
    7.3.3 IRPT and the Forward Premium
    Consider linearized IRPT. After some algebra, (Ft,T-St)/St  (id - if)x T/360. Let T=360. Then,

    p = [(Ft,T-St)/St] x 360/T  id - if.

    p measures the annualized return from a long (short) position in the FX spot market and a short (long)
    position in the FX forward market. That is, it measures the return from an FX Swap transaction. We
    say if:
    p>0  premium currency (“the FC trades at a premium against the DC for delivery in T days”)
    p<0  discount currency (“the FC trades at a discount”)

    Equilibrium: p exactly compensates (id - if) → No arbitrage opportunities


    → No capital flows (because of pricing mistakes).

    In Figure 7.2, the equilibrium points are along the 45º IRPT Line. Any pair (id -if, p) far from the IRPT
    Line represents an arbitrage opportunity.

    Example: Violations of IRPT and Capital Flows


    B - Go back to Example 1
    p = [(Ft,T-St)/St] x 360/T = [(100 – 106)/106] x 360/360 = - 0.0566 => USD trades at a discount.
    p = - 0.0566 < (id - if) = - 0.016  Arbitrage possible (pricing mistake!)  capital flows!

    Check Steps (1)-(3) in Example 1: Foreign (U.S.) capital flows to Japan (capital inflows to Japan).

    A - Go back to Example 2
    p = [(Ft,T-St)/St] x 360/T = [(110 – 106)/106] x 360/360 = 0.0377 => USD trades at a premium.
    p = 0.0377 > (id - if) = - 0.016  Arbitrage possible (pricing mistake!)  capital flows!

    Check Steps (1)-(3) in Example 2: Domestic (Japanese) capital flows to USA (capital outflows). ¶

    Figure 7.2: IRPT Line


    id -if

     B (Capital inflows) IRPT Line


    - Example 1

     A (Capital outflows) - Example 2

    p (forward premium)

    Consider a point under the IRPT line, say A (like in Example 2): p > id -if (or p + if > id)  a long

    IFM-LN.58
    spot/short forward position has a higher yield than borrowing abroad at if and investing at home at id
     Arbitrage is possible! (There is a pricing mistake).

    Covered Arbitrage Strategy:


    (1) Borrow DC at id for T days
    (2) Convert DC to FC (the long position in FC)
    (3) Deposit FC at if for T days
    (4) Sell forward FC at Ft,T (the short forward position)

    That is, today, at a point like A, domestic capital fly to the foreign country: What an investor pays in
    domestic interest rate, id, is more than compensated by the high forward premium, p, and the foreign
    interest rate, if.

    • IRPT: Evidence
    Starting from Frenkel and Levich (1975), there is a lot of evidence that supports IRPT. For example,
    Figure 7.3 plots the daily interest rate differential against the annualized forward premium. They plot
    very much along the 45° line. Moreover, the correlation coefficient between these two series is
    0.995, highly correlated series!

    Figure 7.3: IRPT Line – USD/GBP (daily, 1990-2015)

    0.02

    0.00
    ‐0.10 ‐0.08 ‐0.06 ‐0.04 ‐0.02 0.00 0.02
    ‐0.02
    i_USD‐i_GBP

    ‐0.04

    ‐0.06

    ‐0.08

    ‐0.10
    premium_1Y

    Using intra-daily data (10’ intervals), Taylor (1989) also find strong support for IRPT. At the tick-
    by-tick data, Akram, Rice and Sarno (2008, 2009) show that there are short-lived (from 30 seconds
    up to 4 minutes) departures from IRP, with a potential profit range of 0.0002-0.0006 per unit. The
    short-lived nature and small profit range point out to a fairly efficient market, with the data close to
    the IRPT line.

    There are situations, however, where we observe significant and more persistent deviations from the

    IFM-LN.59
    IRPT line. These situations are usually attributed to monetary policy, credit risk, funding conditions,
    risk aversion of investors, lack of capital mobility, default risk, country risk, and market
    microstructure effects.

    For example, during the 2008-2009 financial crisis there were several violations of IRPT (in Graph
    7.2, the point well over the line (-.0154,-.0005) is from May 2009). These violations are attributed to
    funding constraints –i.e., difficulties to do step (1): borrow. See Baba and Parker (2009) and Griffoli
    and Ranaldo (2011).

    Chapter 7 - Appendix – Taylor Series


    Definition: Taylor Series
    Suppose f is an infinitely often differentiable function on a set D and c ∈D. Then, the series
    Tf(x, c) = Σn [ f(n)(c)/n!] (x - c)n
    is called the (formal) Taylor series of f centered at, or around, c.

    Note: If c=0, the series is also called MacLaurin Series.

    Taylor Series Theorem


    Suppose f ∈ Cn+1([a, b]) -i.e., f is (n+1)-times continuously differentiable on [a, b]. Then, for c ∈
    [a,b] we have:
    f c  f (n)  x 0 
    x  c 0  f c  x  c 1  f c  x  c 2   
    / //
    f ( x )  T ( x, c )  R   x  x 0 n  R
    0! 1! 2! n!
    1
    where Rn 1 ( x)   f (n1 )  p x  p  dp
    n

    n!

    In particular, the Tf(x, c) for an infinitely often differentiable function f converges to f iff the remainder
    R(n+1)(x) →converges to 0 as n → ∞.

    Example: 1st-order Taylor series expansion, around c=0, of f(x) = log(1+xd) , where d is a constant
    f(x) = log(1+x d) f’ (x0=0) = 0
    f’ (x) = d/(1+x d) f ’(x0=1) = d

    => 1st-order Taylor’s series formula (n=1):


    log(1+x d) T(x; c) = 0 + d (x-0) = x d => if d=1, then log(1+x) x

    Application: IRP Approximation


    (1  id xT / 360)
    We start with IRP: Ft ,T  S t
    (1  i f xT / 360)
    Now, take logs: log(Ft ,T )  log(S t )  log(1  id xT / 360)  log(1  i f xT / 360)

    After simple algebra: log(Ft ,T )  log(S t )  log(1  id xT / 360)  log(1  i f xT / 360)


    Ft ,T  S t
    Recall that log changes can approximate percentage changes: log(Ft ,T )  log(S t ) 
    St
    Ft ,T  S t
     i d xT / 360  i f xT / 360
    St

    IFM-LN.60
    Then, using the approximation for log(1+xd) = x d, we get

    Solving for Ft,T, gets the linearized approximation to IRP.

    IFM-LN.61
    CHAPTER 7 – BRIEF ASSESMENT
    1. Assume the following information:
    St.USD/AUD = .8 USD/AUD
    St,USD/GBP = 1.40 USD/GBP
    St,AUD/GBP = 1.80 AUD/GBP

    Is triangular arbitrage possible? If so, explain the steps that would reflect triangular arbitrage, and
    compute the profit from this strategy (expressed as a % per unit borrowed). Explain how market
    forces move to eliminate triangular arbitrage’s profits.

    2. Difficult. Let’s complicate triangular arbitrage, by introducing bid-ask spreads. Assume the
    following information:
    St,USD/AUD = .81-.82 USD/AUD
    St,USD/GBP = 1.40-1.42 USD/GBP
    Calculate an arbitrage-free cross rate (AUD/GBP) quote (with bid-ask spread).

    3. Assume the following information:


    St = 1.10 USD/EUR
    iEUR = 1.50%
    iUSD = 2.75%
    T = 180 days
    (A) Determine the arbitrage-free 180-day forward rate (use IRP).
    (B) Suppose Bank Q offers FQt,180 = 1.12 USD/EUR. Given this information, is covered interest
    arbitrage possible? Design a covered arbitrage strategy and calculate its profits.
    (C) Suppose Bank P offers FPt,180 = 1.08 USD/EUR. Given this information, is covered interest
    arbitrage possible? Design a covered arbitrage strategy and calculate its profits.

    4. Assume the following information:


    St = 1.40 USD/GBP
    FQt,270 = 1.42 USD/GBP
    iGBP = 2.50%
    iUSD = 2.75%
    T = 180 days
    Calculate p (the forward premium) and the interest rate differential. What kind of capital flows the
    U.K. economy will experience?

    IFM-LN.62
    CHAPTER 7 - BONUS COVERAGE: IRPT with Bid-Ask Spreads
    Exchange rates and interest rates are quoted with bid-ask spreads.

    Consider a trader in the interbank market:


    She will have to buy or borrow at the other party's ask price.
    She will sell or lend at the bid price.

    There are two roads to take for arbitrageurs: borrow domestic currency or borrow foreign currency.

    • Bid’s Bound: Borrow Domestic Currency

    (1) A trader borrows DC 1 at time t=0, and repays 1+iask,d at time=T.


    (2) Using the borrowed DC 1, she can buy spot FC at (1/Sask,t).
    (3) She deposits the FC at the foreign interest rate, ibid,f.
    (4) She sells the FC forward for T days at Fbid,t,T

    This strategy would yield, in terms of DC:

    (1/Sask,t) (1+ibid,f) Fbid,t,T.

    In equilibrium, this strategy should yield no profit. That is,

    (1/Sask,t) (1+ibid,f) Fbid,t,T  (1+iask,d).

    Solving for Fbid,t,T,

    Fbid,t,T  Sask,t [(1+iask,d)/(1+ibid,f)] = Ubid.

    • Ask’s Bound: Borrow Foreign Currency

    (1) The trader borrows FC 1 at time t=0, and repay 1+iask,f.


    (2) Using the borrowed FC 1, she can buy spot DC at Sask,t.
    (3) She deposits the DC at the foreign interest rate, ibid,d.
    (4) She buys the FC forward for T days at Fask,t,T

    Following a similar procedure as the one detailed above, we get:

    Fask,t,T  Sbid,t [(1+ibid,d)/(1+iask,f)] = Lask.

    Together with Fask,t,T > Fbid,t,T, these bounds are used by traders to establish arbitrage-free quotes. Figure 7.4
    illustrates the bounds.

    IFM-LN.63
    Figure 7.4: Trading bounds for the Forward bid and the Forward ask.

    Fask,t,T

    Fbid,t,T

    Lask Ubid Ft,T

    Example: IRPT bounds at work.


    Data: St = 1.6540-1.6620 USD/GBP
    iUSD = 7¼-½,
    iGBP = 8 1/8–3/8,
    Ft,one-year = 1.6400-1.6450 USD/GBP.

    Check if there is an arbitrage opportunity (we need to check the bid’s bound and ask’s bound).

    i) Bid’s bound covered arbitrage strategy:


    1) Borrow USD 1 at 7.50% for 1 year => we will repay USD 1.07500 at T=1 year
    2) Convert to GBP => we get GBP 1/1.6620 = GBP 0.6017
    3) Deposit GBP 0.6017 at 8.25%
    4) Sell GBP forward at 1.64 USD/GBP => we get (1/1.6620) x (1 + .08125)x1.64 = USD 1.06694
    => No arbitrage opportunity. For each USD we borrow, we lose USD .00806.

    ii) Ask’s bound covered arbitrage strategy:


    1) Borrow GBP 1 at 8.375% for 1 year => we will repay GBP 1.08375 at T=1 year
    2) Convert to USD => we get USD 1.6540
    3) Deposit USD 1.6540 at 7.250%
    4) Buy GBP forward at 1.645 USD/GBP => we get 1.6540x(1 + .07250)x(1/1.6450) = GBP 1.07837
    => No arbitrage opportunity. For each GBP we borrow, we lose GBP 0.0054.

    Note: The bid-ask forward quote is consistent with no arbitrage. That is, the forward quote is within the IRPT
    bounds. Check:

    Ubid = Sask,t[(1+iask,d)/(1+ibid,f)] = 1.6620x[1.0750/1.08125] = 1.6524 USD/GBP  Fbid,t,T = 1.6400 USD/GBP.

    Lask = Sbid,t[(1+ibid,d)/(1+iask,f)] = 1.6540x[1.0725/1.08375] = 1.6368 USD/GBP  Fask,t,T = 1.6450 USD/GBP. ¶

    IFM-LN.64
    Chapter 8 – Theories of FX Determination – Part 1
    In Chapter 4, we briefly mentioned two theories of exchange rate determination: The Balance of
    Trade (BT) Approach and the Monetary Approach (MA)

    Under the BT Approach, net trade flows (X-M) are the main determinants of St. According to this
    approach, we expect an increase (decrease) in the TB to depreciate (appreciate) the FC. That is,
    ef,t = (St/St-1) -1 = f(TBt), where f’<0.

    Under the MA, St is determined by the relative money demand and money supply between the two
    currencies:
    St = f(Ld,T / Lf,T , MSd,T / MSf,T,,...), where f1<0 & f2>0.

    In this chapter, we develop more theories to explain St. The emphasis will be on arbitrage, actually
    pseudo-arbitrage, theories, focusing on equilibrium in only one market. That is, we will rely on
    partial equilibrium stories to explain St.

    Our goal is to find an explicit functional form for St , say St = α+β Xt, where Xt. is a variable or set
    of variables determined by a theory. Different theories will have different Xt and or different f(.).

    Eventually, we would like to have a precise mathematical formula to forecast St+T.

    Q: How do we know the formula of St is any good?

    • Testing a Theory
    We will judge a theory by how well it explains the behavior of the observed St. For example, a
    good theory should match the observed behavior of the MXN/USD exchange rate for the 1987-
    2017 period, as shown in Figure 8.1.

    IFM-LN.65
    Figure 8.1: Behavior of the MXN/USD (1987-2017)

    MXN/USD: FX Rate (1987-2017)


    25

    20

    15
    S(t)

    10

    5
    USD/MXN
    0
    10/1/1992
    12/1/1993

    10/1/1999
    12/1/2000

    10/1/2006
    12/1/2007

    10/1/2013
    12/1/2014
    2/1/1988
    4/1/1989
    6/1/1990
    8/1/1991

    2/1/1995
    4/1/1996
    6/1/1997
    8/1/1998

    2/1/2002
    4/1/2003
    6/1/2004
    8/1/2005

    2/1/2009
    4/1/2010
    6/1/2011
    8/1/2012

    2/1/2016
    4/1/2017
    Like many macroeconomic series, exchange rates have a trend, see Figure 8.1 above –in statistics,
    these trends in macroeconomic series are called stochastic trends. It is better to work with changes,
    not levels. As can be seen in Figure 8.2, the trend is gone after calculating changes in St.

    Figure 8.2: Behavior of the Changes in MXN/USD (1987-2017)

    MXN/USD: Monthly Percentage Change (1987-2017)


    0.50

    0.40

    0.30

    0.20

    0.10

    0.00

    -0.10
    -0.20
    February‐88
    March‐89

    June‐92
    July‐93
    August‐94

    October‐96
    November‐97

    January‐00
    February‐01
    March‐02

    June‐05
    July‐06
    August‐07

    October‐09
    November‐10

    January‐13
    February‐14
    March‐15
    April‐90
    May‐91

    September‐95

    December‐98

    April‐03
    May‐04

    September‐08

    December‐11

    April‐16

    Now, the trend, which in many cases is easy to explain, is gone. Our goal will be to explain ef,t, the

    IFM-LN.66
    percentage change in St.

    Goal: St = f( id, if,Id, If,…). But, it will be easier to explain ef,t= (St - St-1)/St-1 = f( id, if,Id, If,…).
    Once we get ef,t, we get St  St = St-1 x (1+ef,t)
    The St that we’ll obtain will be an equilibrium value. That is, the St we’ll be calculated using a model
    that assumes some kind of equilibrium in the FX market.

    Q: How are we going to test our equilibrium values?


    A: We would like our theory to match the data, say the mean and standard deviation of St.

    Figure 8.3 plots the distribution of ef.(MXN/USD); calculated from monthly data during 1987-2017.
    Below Figure 8.3, we show the descriptive statistics for the distribution of ef.(MXN/USD).

    Figure 8.3: Distribution of the Changes in MXN/USD (1987-2017)

    MXN/USD: Histogram for ef,t


    160
    140
    120
    Frequency

    100
    80
    60
    40
    20
    0

    Descriptive Stats for ef (MXN/USD):


    ef (USD/MXN)

    Mean 0.006732
    Standard Error 0.002024
    Median 0.00306
    Mode 0
    Standard Deviation 0.037973
    Sample Variance 0.001442
    Kurtosis 55.83344
    Skewness 5.217048
    Range 0.58129
    Minimum ‐0.12822
    Maximum 0.453066
    Sum 2.369586
    Count 352

    IFM-LN.67
    The usual (average, expected) monthly percentage change represents a 0.67% appreciation of the USD
    against the MXN (annualized change: 8.38%). The standard deviation is 3.80%. The mean, standard
    deviation, skewness and kurtosis are called unconditional moments. Theories also produce conditional
    moments -i.e., conditional on the theory. In general, we associate matching unconditional moments with
    long-run features of a model; while we associate matching conditional moments with short-run features
    of a model.

    • Review from Chapter 7


    Effect of arbitrage on FX Markets:
    Local arbitrage  sets consistent rates across banks
    Triangular arbitrage  sets cross rates
    Covered arbitrage  sets a relation between Ft,T, St ,id, if (IRPT)
     Ft,T = St (1 + id x T/360)/(1 + if x T/360).

    In this class, we will study the effect of “arbitrage” in goods (PPP) and financial flows (IFE) on FX
    Markets. We will generate explicit models for St.

    8.1. Purchasing Power Parity (PPP)


    PPP is based on the law of one price (LOOP): same goods once denominated in a common currency
    should have the same price. If they are not, then pseudo-arbitrage is possible.

    Example: LOOP for Oil.


    Poil-USA = USD 40.
    Poil-SWIT = CHF 80.
    LOOP: Poil-SWIT StLOOP = Poil-USA  StLOOP= Poil-USA/Poil-SWIT =USD 40/CHF 80 =0.50 USD/CHF.

    Suppose St = 0.75 USD/CHF  Poil-SWIT (in USD) = CHF 80 x 0.75 USD/CHF = USD 60.
    That is, a barrel of oil in Switzerland is more expensive -once denominated in USD- than in the US.

    Arbitrageurs/traders will buy oil in the U.S. (to export it to Switzerland) and simultaneously sell oil in
    Switzerland. This movement of oil will simultaneously increase the price of oil in the U.S. (Poil-USA ↑);
    decrease the price of oil in Switzerland (Poil-SWIT ↓); and appreciate the USD against the CHF (St ↓). ¶

    LOOP Notes:
    ⋄ LOOP gives an equilibrium exchange rate (EER, in the econ lit). Equilibrium will be reached
    when there is no trade in oil (because of pricing mistakes). That is, when the LOOP holds for oil.
    ⋄ LOOP is telling us what St should be (in equilibrium): StLOOP. It is not telling what St is in the
    market. It is just an implied rate from market prices.
    ⋄ Using the LOOP, we have generated a model for St. (Recall that a model is an attempt to explain
    and predict economic phenomena.) When applied to a price index, we will call this model, the
    PPP model.
    ⋄ The generated model, like all models, is a simplification of the real world. For example, we have
    ignored (or implicitly assumed negligible) trade frictions (transportation costs, tariffs, etc.).

    IFM-LN.68
    Problem for the LOOP: There are many traded goods in the economy.
    Solution: Work with baskets of goods that represent many goods. For example, the CPI basket (in the
    U.S., we use the CPI-U, which reflects spending patterns for urban consumers), which includes housing
    (41%), transportation (17%), food & beverages (15%), health care (7%), recreation (6%), etc. The price
    of a basket is the weighted average price of the components. For example:
    Price CPI-U basket = .41 x Price of housing + .17 x Price of transportation + ...

    The price of the CPI basket is usually referred as the “price level” of an economy.

    8.1.1 Absolute version of PPP


    The FX rate between two currencies is simply the ratio of the two countries' general price levels:

    StPPP = Domestic Price level / Foreign Price level = Pd / Pf (Absolute PPP)

    Example: Law of one price for CPIs.


    CPI-basketUSA = USD 755.3
    CPI-basketSWIT = CHF 1241.2
     StPPP = USD 755.3/CHF 1241.2 = 0.6085 USD/CHF.

    If St  0.6085 USD/CHF, there will be trade of the goods in the basket between Switzerland and US.
    Suppose St = 0.70 USD/CHF > StPPP = 0.6085 USD/CHF.

    Then CPI-basketSWIT (in USD) = CHF 1241.2*0.70 USD/CHF = USD 868.70 > CPI-basketUSA

    “Things” –i.e., the components in the CPI basket- are, on average, cheaper in the U.S. There is a potential
    profit from trading the CPI basket’s components:
    Potential profit: USD 868.70 – USD 755.3 = USD 93.40

    Traders will do the following “pseudo-arbitrage” strategy:


    1) Borrow USD
    2) Buy the CPI-basket in the US (CPI-basketUSA ↑)
    3) Sell the CPI-basket, purchase in the US, in Switzerland. (CPI-basketSWIT ↓)  StPPP ↑
    4) Sell CHF/Buy USD (St (USD/CHF) ↓)
    5) Repay the USD loan, keep the profits.

    Note: Prices move and push St (market price) & StPPP (equilibrium price) towards convergence. ¶

    Under PPP, a USD buys the same amount of goods in the U.S. and in Switzerland. That is, a USD has
    the same purchasing power in the U.S. & in Switzerland. Vice versa, a CHF buys the same amount of
    goods in Switzerland and in the U.S.

    • Absolute PPP: The Real Exchange Rate


    The absolute version of the PPP theory is expressed in terms of St, the nominal exchange rate.

    IFM-LN.69
    We can express the absolute version of the PPP relationship in terms of the real exchange rate, Rt. That
    is,
    Rt = St Pf / Pd.

    The real exchange rate allows us to compare foreign prices, translated into domestic terms, with
    domestic prices. It is common to associate Rt > 1 with a more efficient/productive domestic economy.

    If absolute PPP holds  Rt = 1.

    Terminology: If Rt ↑, foreign goods become more expensive relative to domestic goods. We say there
    is “a real depreciation of the DC”. Similarly, if Rt ↓, we say there is “a real appreciation of the DC.”

    Example: Suppose a basket –the Big Mac (sesame-seed bun, onions, pickles, cheese, lettuce, beef
    patty and special sauce)– costs CHF 6.50 and USD 4.93 in Switzerland and in the U.S., respectively.
    Pf = CHF 6.50
    Pd = USD 4.93
    St = 0.9909 USD/CHF.

    Rt = St PSWIT / PUS = 0.9908 USD/CHF x CHF 6.50/USD 4.93 = 1.3065.

    Taking the Big Mac as our basket, the U.S. is more competitive than Switzerland. Swiss prices are
    higher (Rt -1 = 30.7% higher!) than U.S. prices, after taking into account the nominal exchange rate.
    That is, with one USD, we consume 30.7% more in the U.S. than in Switzerland.

    To bring the economy back to equilibrium –no trade on Big Macs-, we expect the USD to appreciate
    against the CHF. According to PPP, the USD is undervalued against the CHF:
     Trading signal: Buy USD/Sell CHF.

    Note: Obviously, we do not expect to see Swiss consumers importing Big Macs from the U.S.; but the
    components of the Big Mac are internationally traded. Trade would happen in the components! ¶

    Indicator of under/over-valuation: Rt > 1  FC is overvalued.

    Note: In the short-run, we will not take our cars to Mexico to be repaired, because a mechanic’s
    hour is cheaper than in the U.S. But in the long-run, resources (capital, labor) will move, likely to
    produce cars in Mexico to export them to the U.S. We can think of the over-/under-valuation as an
    indicator of movement of resources.

    Remark: If St changes, but Pf & Pd move in such a way that Rt remains constant, changes in St do not
    affect firms. There is no change in real cash flows.

    • Absolute PPP: Real v. Nominal Exchange Rates


    Economists think that monetary variables affect nominal variables, like prices and the nominal exchange
    rate, St. But, monetary variables do not affect real variables. In this case, only relative demands and

    IFM-LN.70
    supplies affect Rt.

    For example, an increase in U.S. output relative to European output (say, because of a technological
    innovation) will decrease PUS relative to PEUR  Rt ↑ (a real depreciation of the USD). On the other
    hand, a monetary approach to exchange rates, predicts that an increase in the U.S. money supply will
    increase PUS and, thus, an increase in St, but no effect on Rt.

    • Absolute PPP: Does it hold?


    We use a basket of goods to test PPP. To get better results, it is a good idea to use the same basket (or
    comparable baskets). For example, the Big Mac.

    Example: The Economist’s Big Mac Index, shown in Exhibit 8.1, shows the over/undervaluation of a
    currency relative to the USD. That is, it shows the real exchange rate, Rt - 1.
    Rt = St PBigMac,d / PBigMac,d,f
    Test: If Absolute PPP holds  Rt = 1 (& over/undervaluation=0!).

    Exhibit 8.1: The Economist’s Big Mac Index (January 2018)

    Check: http://www.economist.com/content/big-mac-index

    IFM-LN.71
    There are big deviations from Absolute PPP, which can vary a lot over time. See Figure 8.4 below for
    two Rt series (April 2000 – January 2016): CHF/USD, purple line; and BLR/USD, green line.

    Figure 8.4: PPP – Persistent deviation from Rt=1 (2000-2016)

    CHF/USD & BRL/USD : Big Mac R(t)


    2.1
    1.9
    CHF/USD
    1.7
    1.5
    1.3
    1.1
    0.9
    0.7 BRL/USD
    0.5
    Dec‐…

    Dec‐…

    Dec‐…
    Aug‐…

    Aug‐…

    Aug‐…
    Apr‐00
    Feb‐01

    Apr‐05
    Feb‐06

    Apr‐10
    Feb‐11

    Apr‐15
    Oct‐02

    Jun‐04

    Oct‐07

    Jun‐09

    Oct‐12

    Jun‐14
    With some exceptions, the Big-Mac tends to be more expensive in developed countries (Euro area,
    Australia) than in less developed countries (Egypt, South Africa, China). ¶

    Empirical Fact: Price levels in richer countries are consistently higher than in poorer ones. It is estimated
    that a doubling of income per capita is associated with a 48% increase in the price level. This empirical
    fact is called the Penn effect. Many explanations, the most popular: The Balassa-Samuelson (BS) effect.

    • Absolute PPP: Qualifications


    The big deviations from absolute PPP are usually attributed to different reasons:
    (1) PPP emphasizes only trade and price levels. Other financial, economic, political factors are ignored.
    (2) Absence of trade frictions. This is an implicit assumption: No tariffs, no quotas, no transactions costs.
    Realistic? It is estimated that transportation costs add 7% to the price of U.S. imports of meat and
    16% to the import price of vegetables. Some products are heavily protected, even in the U.S. For
    example, peanut imports are subject to a tariff between 131.8% (for shelled peanuts) and 163.8%
    (for unshelled peanuts).
    (3) Perfect competition. Imperfect competition, usually related to (2) can create price discrimination.
    For example, U.S. pharmaceuticals sell the same drug in the U.S. and in Canada at different prices.
    (4) Instantaneous adjustments. Another implicit PPP assumption, related to another trade friction. Not
    realistic. Trade takes time and it also takes time to adjust contracts. Think of PPP as long-run model.
    (5) PPP assumes Pf and Pd represent the same basket, not the usual situation for CPI baskets. This is why
    the Big Mac is a popular basket: it is standardized around the world with an easy to get price.
    (6) Internationally non-traded (NT) goods (~50%-60% of GDP) –i.e., haircuts, hotels, restaurants, home
    & car repairs, medical services, real estate, etc. NT goods have a big weight on the CPI basket.
    (7) The NT sector also has an effect on the price of traded goods. For example, rent, distribution and

    IFM-LN.72
    utilities costs affect the price of a Big Mac. (It is estimated that 25% of Big Mac’s cost is due to NT
    goods.)

    • Borders Matter
    You may look at the Big Mac Index and think: “No big deal: there is also a big dispersion in prices
    within the U.S., within Texas, and, even, within Houston!” It is true that prices vary within the U.S. For
    example, in 2015, the price of a Big Mac (and Big Mac Meal) in New York was USD 5.23 (USD 7.45),
    in Texas was USD 4.39 (USD 6.26) and in Mississippi was USD 3.91 (USD 5.69).

    Engel and Rogers (1996) computed the variance of LOOP deviations for city pairs within the U.S.,
    within Canada, and across the border. They found that distance between cities within a country matter,
    but the border effect is very significant. To explain the difference between prices across the border using
    the estimate distance effects within a country, they estimate the U.S.-Canada border should have a width
    of 75,000 miles!

    This huge estimate of the implied border width between the U.S. and Canada has been revised downward
    in subsequent studies, but a large positive border effect remains.

    • Balassa-Samuelson Effect
    Balassa (1964) and Samuelson (1964) developed a general equilibrium model of the real exchange rate
    (BS model). The model explains the above mentioned empirical fact: richer countries have consistently
    higher prices.

    Labor costs affect all prices. We expect average prices to be cheaper in poor countries than in rich
    ones because labor costs are lower. Rich countries have higher productivity, and higher wages, in
    the traded-goods sector than poor countries do. In the NT goods sector, productivity is similar.

    But, because of competition for labor, wages in NT goods and services are also higher in rich
    countries. Then, overall prices are lower in poor countries. For example, the productivity of
    McDonald’s employees around the world is probably very similar, but the wages are not. In 2000,
    a typical McDonald’s worker in the U.S. made USD 6.50/hour, while in China made USD
    0.42/hour. This difference in NT costs may partly explain over/under-valuations when we compare
    currencies from developed to less developed countries.

    Again, standard applications of PPP, like in the Big Mac example above, will not be very
    informative. We need to “adjust” prices to incorporate the effect of GDP per capita in the price level.

    Usually, this correction involves a regression of prices against GDP levels or GDP per capita in
    different countries. The regression line tells us what the “expected price” in a country is, once we
    take into consideration its GDP level, that is, the adjusted StPPP. We use this expectation relative to
    the observed price to calculate over/undervaluation. A typical regression is shown in Figure 8.5
    below (taken from The Economist, January 2017):

    Figure 8.5: PPP – Regression to Adjust Big Mac Prices by GDP per capita

    IFM-LN.73
    Switzerland
    Brazil

    Hong Kong

    In Brazil, the expected price (in USD), given its GDP per capita, is USD 3.05; while the actual USD
    price is 5.12, for a 67% overvaluation. But, according to the unadjusted prices, Brazil’s currency was
    not overvalued. That is, these adjustments to PPP implied exchange rates can be significant. See
    Exhibit 8.2 below from The Economist for July 2011.

    Exhibit 8.2: The Economist’s Adjusted-Big Mac Index (January 2011)

    The Balassa-Samuelson effect can explain (or partially explain) why absolute PPP does not hold
    between a developed country and a less developed country, for example, after correcting for the BS
    effect, China’s currency is no longer undervalued. But the BS effect cannot explain why PPP does not

    IFM-LN.74
    hold among developed countries (say, Switzerland and the U.S.) or among less developed countries (say,
    Brazil and Argentina).

    • Pricing-to-market
    Krugman (1987) offers an alternative explanation for the strong positive relationship between GDP and
    price levels: Pricing-to-market –i.e., price discrimination. Based on price elasticities, producers
    discriminate: the same exact good is sold to rich countries (lower price elasticity) at higher prices than
    to poorer countries (higher price elasticity). For example, Alessandria and Kaboski (2008) report that
    U.S. exporters, on average, charge the richest country a 48% higher price than the poorest country.

    Again, pricing-to-market struggles to explain why PPP does not hold among developed countries with
    similar incomes. For example, Baxter and Landry (2012) report that IKEA prices deviate 16% from the
    LOOP in Canada, but only 1% in the U.S.

    • Absolute PPP: Empirical Evidence


    Several tests of the absolute version have been performed. The absolute version of PPP, in general, fails
    (especially, in the short run), even when using the same basket or the same good. No surprise here, see
    the Big Mac example above, where Rt 1. Trade frictions, especially transportation and distribution
    costs, are considered a major problem for absolute PPP.

    8.1.2 Relative PPP


    A more flexible version of PPP: The rate of change in the prices of products should be similar when
    measured in a common currency. (As long as trade frictions are unchanged). Thus, Relative PPP
    addresses the assumption of no trade frictions. (All the other qualifications still apply!)

    The following formula states the relative version of PPP:


    S t T (1  I d )
    f ,T  1 1
    e PPP (Relative PPP),
    St (1  I f )
    where
    If = foreign inflation rate from t to t+T
    Id = domestic inflation rate from t to t+T.

    Linear approximation (from a 1st-order Taylor series): ef,TPPP  Id - If

    Example: Suppose that, from t=0 to t=1, prices increase 10% in Mexico relative to those in Switzerland.
    Then, SMXN/CHF,t should increase 10%; say, from S0=9 MXN/CHF to S1=9.9 MXN/CHF. If, at t=1, S1=11
    MXN/CHF > S1PPP = 9.9 MXN/CHF, then according to Relative PPP the CHF is overvalued. ¶

    Example: Forecasting St (USD/ZAR) using PPP (ZAR=South Africa).


    It’s 2015. You have the following information:
    CPIUS,2015=104.5,

    IFM-LN.75
    CPISA,2015=100.0, S2015 =.2035 USD/ZAR.

    You are given the 2016 CPI’s forecast for the U.S. and SA: E[CPIUS,2016]=110.8, E[CPISA,2016]=102.5.

    You want to forecast S2016 using the relative (linearized) version of PPP.
    E[IUS-2016]= (110.8/104.5) - 1 = .06029
    E[ISA-2016]= (102.5/100) - 1 = .025

    E[S2016] = S2015 x (1 + E[IUS]- E[ISA]) = .2035 USD/ZAR x (1 + .06029 - .025) = .2107 USD/ZAR. ¶

    • Relative PPP: Implications


    (1) Under relative PPP, Rt remains constant (it can be different from 1!).
    (2) Relative PPP does not imply that St is easy to forecast.
    (3) Without relative price changes, a multinational corporation faces no real operating exchange risk (as
    long as the firm avoids fixed contracts denominated in foreign currency).

    • Relative PPP: Absolute versus Relative


    Absolute PPP compares price levels, while Relative PPP compares price changes (or movements).
    Under Absolute PPP prices are equalized across countries, but under Relative PPP exchange rates
    move by the same amount as the inflation rate differential (original prices can be different).

    Relative PPP is a weaker condition than the absolute one: Rt can be different from 1.

    Example: Absolute vs Relative

    Absolute PPP: "A mattress costs GBP 200 (= USD 320) in the U.K. and BRL 800 (=USD 320) in
    Brazil –i.e., same cost in both countries." (St =1.6 USD/GBP & St =0.4 USD/BRL.)

    Relative PPP: "U.K. inflation was 2% while Brazilian inflation was 8%. Meanwhile, the BRL
    depreciated 6% against the GBP. Then, relative cost comparison remains the same." ¶

    • Relative PPP: General Evidence


    Key: On average, what we expect to happen, ef,TPPP, should happen, ef,T.
     Q: Is, on average, ef,TPPP  Id – If = ef,T?
    Under PPP, we should see ef,T and (Id – If) aligned around a 45º line, like in Figure 8.6.

    IFM-LN.76
    Figure 8.6: PPP Line

    Id -If
    PPP Line

    ef,T

    1. Visual Evidence
    Figure 8.7 plots (Id-If) between Japan and the U.S. against ef(JPY/USD), using 1970-2017 monthly data.

    Figure 8.6: PPP Line for the JPY/USD (1970-2017)?

    Relative PPP: JPY/USD
    0.15

    0.1

    0.05
    Ijpy‐Iusd

    0
    ‐0.04 ‐0.03 ‐0.02 ‐0.01 0 0.01 0.02 0.03 0.04
    ‐0.05

    ‐0.1

    ‐0.15
    e(JPY/USD)

    There is no clear 45º line in the plot, like in Graph 8.1! (See also Graphs in book) => PPP does not track
    short-term movements.

    Figure 8.7 plots Rt to check if it is constant (ideally, under absolute PPP, close to 1, but we do not have
    prices, but indices. Rt is arbitrary set to 1 in Jan 1971):

    IFM-LN.77
    Figure 8.7: Real Exchange Rate for the JPY/USD (1970-2017)

    R(t)=JPY/USD ‐ Real Exchange Rate
    3.5
    3
    2.5
    2
    R(t)

    1.5
    1
    0.5
    0
    1/1/1971
    4/1/1973
    7/1/1975
    10/1/1977
    1/1/1980
    4/1/1982
    7/1/1984
    10/1/1986
    1/1/1989
    4/1/1991
    7/1/1993
    10/1/1995
    1/1/1998
    4/1/2000
    7/1/2002
    10/1/2004
    1/1/2007
    4/1/2009
    7/1/2011
    10/1/2013
    1/1/2016
    Clearly, Rt is not constant! In general, we have some evidence for mean reversion for Rt in the long run.
    Loosely speaking, Rt moves around some mean number, which we associate with a long-run PPP parity
    (for the JPY/USD the average Rt is 1.95). But, the deviations from the long-run PPP parity are very
    persistent –i.e., very slow to adjust. Note that the deviations from long-run PPP parity are big (up to 66%
    from the mean) and happen in every decade.

    Economists usually report the number of years that a PPP deviation is expected to decay by 50% (the
    half-life) is in the range of 3 to 5 years for developed currencies. Very slow!

    2. Statistical Evidence
    Let’s look at the usual descriptive statistics for (Id - If)t and ef,t, using the 1971-2017 monthly data used
    above. For the JPY/USD, they have similar means, but quite different standard deviations (look at the
    very different minimum and maximum stats). A simple t-test for equality of means (t-test=-0.976) cannot
    reject the null hypothesis of equal means, which is expected given the large SDs, especially for ef,t.

    IJP IUS IUS-IJP ef,T (JPY/USD) Rt

    Mean 0.0020 0.0033 0.0013 0.0026 1.9485


    SD 0.0062 0.0038 0.0060 0.0324 0.4261
    Min -0.0108 -0.0191 -0.0339 -0.0984 0.9977
    Median 0.0011 0.0030 -0.0019 0.0004 1.9318
    Max 0.0424 0.0177 0.0197 0.1729 3.3218

    If we think of the average over the whole sample, as a long-run value, we cannot reject PPP in the long-
    run! But, the average relation over the whole sample is not that informative, especially with such a big

    IFM-LN.78
    SD. We are more interested in the short-run, in the contemporaneous relation between ef;T and (Id - If)t.
    That is, what happens to ef;T when (Id - If)t changes?

    To test the contemporaneous relation we have a more formal test, a regression:


    ef;T = (St+T - St)/St = α + β (Id - If)t + εt, (where εt is the regression error, E[εt]=0).

    The null hypothesis is: H0 (Relative PPP holds): α=0 & β=1
    H1 (Relative PPP does not hold): α≠0 and/or β≠1

    Tests: t-test (individual tests on the estimated α and β) and F-test (joint test):
    (1) t-test = tθ = θ0 = [ – θ0] / S.E.( ) ~ tv (v = N-K = degrees of freedom).
    (2) F-test = {[RSS(H0) - RSS(H1)]/J}/{RSS(H1)/(N-K)} ~ FJ,N-K (J = # of restrictions in H0).

    Notation for tests:


    θ = (α, β)
    = Estimated θ
    et residuals ef;T - [ + (Id - If)t ]
    H0 (theory is true): θ = θ0
    N = # of observations
    K = # of parameters in our model, in the PPP case 2: (α, β)
    RSS = Residual Sum of Squares = Σt (et)2.
    J = # of restrictions in H0, in the PPP case 2: α=0 & β=1 .
    α = significance level –most popular, α =.05 (5 %).
    tv = t-distribution with v degrees of freedom (df). (When v > 30, it follows a normal).
    FJ,N-K = F-distribution with J df in the numerator and N-K df in the denominator.

    Rules for tests:


    If |t-test| > |tv,α/2|, reject H0 at the α level. (When α = .05 & v > 30, t.025 = 1.96.)
    If F-test > FJ,N-K,α, reject H0 at the α level. (When α = .05 & N-K > 300, F2,300+,.05 3.)

    Example: We want to test relative PPP for the JPY/USD exchange rate (we use α = .05). We use the
    monthly Japanese and U.S. data from the graph (1/1971-12/2015). We fit the following regression:
    ef,t (JPY/USD) = (St - St-1)/St-1 = α + β (IJAP – IUS) t + εt.

    R2 = 0.000123
    Standard Error (σ) = 0.0316
    F-stat (slopes=0 –i.e., β=0) = 0.066 (p-value = 0.7978)
    F-test (H0: α=0 and β=1) = 11.155 (p-value: lower than 0.0001) => reject at 5% level (F2,535,.05 = 3.015)
    Observations = 537
    Coefficients Stand Error t Stat P-value
    Intercept ( ) -0.00155 0.00139 -1.1150 0.26503
    (IJAP – IUS) ( ) -0.05757 0.2241 -0.2569 0.79734

    Note: You can find this example in my homepage: www.bauer.uh.edu/rsusmel/4386/ppp-example.xls

    Let’s test H0, using t-tests (t535.025 = 1.96 –when N-K>30, t.025 = 1.96):

    IFM-LN.79
    tα=0 (t-test for α = 0): (-0.00155–0)/ 0.00139= -1.1150 (p-value = .265) ⇒ cannot reject at the 5% level
    tβ=1 (t-test for β = 1): (-0.05757-1)/ 0.2241 = -4.7192 (p-value = .00001) ⇒ reject at the 5% level

    Regression Notes:
    ⋄ If we look at the R2, the variability of monthly (IJAP – IUS) explain very little, 0.01%, of the

    variability of monthly ef,t.


    ⋄ We can modify the regression to incorporate the Balassa-Samuelson effect, by incorporating GDP

    differentials. Say,
    ef,t (JPY/USD) = α + β (IJAP – IUS) t + δ (GDP_capJAP – GDP_capUS) t + εt. ¶

    Relative PPP tends to be rejected in the short-run (like in the example above). In the long-run, there is a
    debate about its validity. As mentioned above there is some evidence of (slow) mean reversion. In the
    long-run, inflation differential matter: Currencies with high inflation rate differentials tend to depreciate.

    • PPP: Rt and St
    Research shows that Rt is much more variable when St is allowed to float. Rt‘s variability tends to be
    highly correlated with St‘s variability. This finding comes from Mussa (1986).

    Figure 8.8: Nominal and Real Exchange Rate for the USD/GBP (1970-2017)

    USD/GBP: Real and Nominal FX Rate (1971-2017)


    3
    S(t)
    2.5
    R(t)
    2
    R(t), S(t)

    1.5

    0.5

    0
    11/1/1972

    11/1/1983

    11/1/1994

    11/1/2005

    11/1/2016
    1/1/1971

    9/1/1974
    7/1/1976
    5/1/1978
    3/1/1980
    1/1/1982

    9/1/1985
    7/1/1987
    5/1/1989
    3/1/1991
    1/1/1993

    9/1/1996
    7/1/1998
    5/1/2000
    3/1/2002
    1/1/2004

    9/1/2007
    7/1/2009
    5/1/2011
    3/1/2013
    1/1/2015

    In the Figure 8.8 above, we see the finding of Mussa (1986) for the USD/GBP exchange rate: After
    1973, when floating exchange rates were adopted, Rt moves like St. As a check to the visual evidence:
    the monthly volatility of changes in Rt is 2.94% and the monthly volatility of changes in St is 2.91%,
    with a correlation coefficient of .979. Almost the same!

    IFM-LN.80
    In the graph above, we see the finding of Mussa (1986) for the USD/GBP exchange rate: After 1973,
    when floating exchange rates were adopted, Rt moves like St. As a check to the visual evidence: the
    monthly volatility of changes in Rt is 2.94% and the monthly volatility of changes in St is 2.91%, with a
    correlation coefficient of .979. Almost the same!

    Recall that economists tend to think that nominal variables cannot affect nominal variables, but not real
    variables. The above graph shows that St moves like Rt, which we think is affected by real factors. We
    can easily incorporate this idea into St (using the definition of Rt, we solve St):

    St = Rt Pd / Pf.

    Now, we have St affected by real factors (through Rt) and nominal factors (through Pd / Pf).

    • PPP: Sticky Prices


    From the above USD/GBP graph, which is representative of the usual behavior of Rt and St, we infer
    that price levels play a minor role in explaining the movements of Rt (&St). Prices are sticky/rigid –i.e.,
    they take a while to adjust to shocks/disequilibria.

    A potential justification for the implied price rigidity: NT goods. Price levels include traded and NT
    goods; traded-goods should obey the LOOP. But, Engel (1999) and others report that prices are sticky
    also for traded-goods (measured by disaggregated producer price indexes). A strange result for many of
    us that observe gas prices change frequently!

    Possible explanations:
    (a) Contracts
    Prices cannot be continuously adjusted due to contracts. In a stable economy, with low inflation,
    contracts may be longer. We find that economies with high inflation (contracts with very short duration)
    PPP deviations are not very persistent.

    (b) Mark-up adjustments


    There is a tendency of manufacturers and retailers to moderate any increase in their prices in order to
    preserve their market share. For example, changes in St are only partially transmitted or pass-through to
    import/export prices. The average ERPT (exchange rate pass-through) is around 50% over one quarter
    and 64% over the long run for OECD countries (for the U.S., 25% in the short-run and 40% over the
    long run). The average ERPT seems to be declining since the 1990s. Income matters: ERPT tends to be
    bigger in low income countries (2-3 times bigger) than in high countries.

    (c) Repricing costs (menu costs)


    It is expensive to adjust continuously prices; in a restaurant, the repricing cost is re-doing the menu. For
    example, Goldberg and Hallerstein (2007) estimate that the cost of repricing in the imported beer market
    is 0.4% of firm revenue for manufacturers and 0.1% of firm revenue for retailers.

    (d) Aggregation
    Q: Is price rigidity a result of aggregation –i.e., the use of price index? Empirical work using detailed
    micro level data –say, same good (exact UPC barcode!) in Canadian and U.S. grocery stores– show that

    IFM-LN.81
    on average product-level Rt –i.e., constructed using the same traded goods– move closely with St. But,
    individual micro level prices show a lot of idiosyncratic movements, mainly unrelated to St: Only 10%
    of the deviations from PPP are accounted by St.

    • PPP: Puzzle
    The fact that no single model of exchange rate determination can accommodate both the high persistent
    of PPP deviations and the high correlation between Rt and St has been called the “PPP puzzle.” See
    Rogoff (1996).

    • PPP: Summary of Empirical Evidence


    ⋄ Rt and St are highly correlated, domestic prices (even for traded-goods) tend to be sticky.
    ⋄ In the short run, PPP is a very poor model to explain short-term exchange rate movements.
    ⋄ PPP deviation are very persistent. It takes a long time (years!) to disappear.
    ⋄ In the long run, there is some evidence of mean reversion, though very slow, for Rt. That is, StPPP
    has long-run information: Currencies that consistently have high inflation rate differentials –i.e., (Id-
    If) positive- tend to depreciate.

    The long-run interpretation for PPP is the one that economist like and use. PPP is seen as a benchmark,
    a figure towards which the current exchange rate should move.

    • Calculating StPPP (Long-Run FX Rate)


    We want to calculate StPPP = Pd,t / Pf,t over time. Steps:
    (i) Divide and multiply StPPP by SoPPP = Pd,o/Pf,o (where t=0 is our starting point or base year).
    (ii) After some algebra,
    StPPP = SoPPP x [Pd,t / Pd,o] x [Pf,o/Pf,t]

    By assuming SoPPP = So, we can plot StPPP over time. (Note: SoPPP = So assumes that at time 0, the
    economy was in equilibrium. This may not be true. That is, be careful when selecting a base year.)

    Figure 8.9 plots StPPP and St for the MXN/USD exchange rate during the 1987-2013 period. During the
    sample, Mexican inflation rates were consistently higher than U.S. inflation rates –actually, 322% higher
    during the 1987-2015 sample period). Relative PPP predicts a consistent appreciation of the USD against
    the MXM.

    IFM-LN.82
    Figure 8.9: StPPP and St for the MXN/USD (1987-2013)

    Actual vs Long Run PPP (MXN/USD)
    25

    20

    15

    10

    5 Actual
    Long Run PPP
    0
    May‐…

    Nov‐…

    May‐…

    Nov‐…
    Mar‐…

    Mar‐…
    Jul‐95

    Jul‐08
    Dec‐87
    Jan‐89
    Feb‐90

    Apr‐92

    Jun‐94

    Aug‐96
    Sep‐97
    Oct‐98

    Dec‐00
    Jan‐02
    Feb‐03

    Apr‐05

    Jun‐07

    Aug‐09
    Sep‐10
    Oct‐11

    Dec‐13
    In the short-run, Relative PPP is missing the target, St. But, in the long-run, PPP gets the trend right.
    (As predicted by PPP, the high Mexican inflation rates differentials against the U.S depreciate the
    MXN against the USD.)

    Similar behavior is observed for the JPY/USD, as shown in Figure 8.10. The inflation rates in the U.S.
    have been consistently higher than in Japan (57% higher during the 1971-2015 period), then, according
    to Relative PPP, the USD should depreciate against the JPY. PPP gets the long term trend right, but
    misses St in the short-run.

    Figure 8.10: StPPP and St for the JPY/USD (1987-2013)

    Actual vs Long Run PPP (JPY/USD)
    500.0
    450.0 Actual
    400.0
    Long Run PPP
    350.0
    300.0
    250.0
    200.0
    150.0
    100.0
    50.0
    0.0
    May‐…

    May‐…

    May‐…

    May‐…

    May‐…

    May‐…

    May‐…

    May‐…
    Sep‐72

    Sep‐77

    Sep‐82

    Sep‐87

    Sep‐92

    Sep‐97

    Sep‐02

    Sep‐07

    Sep‐12
    Jan‐71

    Jan‐76

    Jan‐81

    Jan‐86

    Jan‐91

    Jan‐96

    Jan‐01

    Jan‐06

    Jan‐11

    Note that in both graphs, StPPP is smoother than St.

    IFM-LN.83
    • PPP: Summary of Applications
    ⋄ Equilibrium (“long-run”) exchange rates. A CB can use StPPP to determine intervention bands.
    ⋄ Explanation of St movements (“currencies with high inflation rate differentials tend to depreciate”).
    ⋄ Indicator of competitiveness or under/over-valuation: Rt > 1 => FC is overvalued (& Foreign prices
    are not competitive).
    ⋄ International GDP comparisons: Instead of using St, StPPP is used. (An additional advantage: since
    StPPP is smoother, GDP comparisons will not be subjected to big swings.) For example, per capita
    GDP (World Bank figures, in 2012) are reported below in Table 8.1:

    Table 8.1: GDP per capita in Nominal and PPP Prices (in USD) - 2012

    GDP per capita (in USD) - 2012


    Country Nominal PPP
    Luxembourg 107,476 91,388
    USA 49,965 49,965
    Japan 46,720 35,178
    Venezuela 12,767 13,485
    Brazil 11,340 11,909
    Lebanon 9,705 14,610
    China 6,091 9,233
    India 1,489 3,876
    Ethiopia 410 1,139

    Example: Nominal vs PPP - Calculations for China


    Data:
    Nominal GDP per capita: CNY 38,068.75
    St = 0.16 USD/CNY
    StPPP = 0.2425 USD/CNY ⇒ “goods in the U.S. are 51.58% more expensive than in China.”

    - Nominal GDP per capita in USD = CNY 38,068.75 x 0.16 USD/CNY = USD 6,091.
    - PPP GDP per capita in USD = CNY 38,068.75 x 0.2425 USD/CNY = USD 9,233. ¶

    Chapter 8 - Appendix – Taylor Series


    Definition: Taylor Series
    Suppose f is an infinitely often differentiable function on a set D and c ∈D. Then, the series
    Tf(x, c) = Σn [ f(n)(c)/n!] (x – c)n
    is called the (formal) Taylor series of f centered at, or around, c.

    Note: If c=0, the series is also called MacLaurin Series.

    Taylor Series Theorem


    Suppose f ∈ Cn+1([a, b]) -i.e., f is (n+1)-times continuously differentiable on [a, b]. Then, for c ∈
    [a,b] we have:

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    f c  f / c  f // c  f (n)  x 0 
    f ( x )  T ( x, c )  R  x  c  
    0
    x  c  
    1
    x  c    
    2
     x  x 0 n  R
    0! 1! 2! n!
    1
    where Rn 1 ( x)   f (n1 )  p x  p  dp
    n

    n!

    In particular, the Tf(x, c) for an infinitely often differentiable function f converges to f iff the remainder
    R(n+1)(x) →converges to 0 as n → ∞.

    Example: 1st-order Taylor series expansion, around c=1, of f(x)=5+2x + x2


    f(x) = 5+2x + x2 f’ (x0=1) = 8
    f’ (x) = 2 + 2x f ’(x0=1) = 4
    f’’ (x) = 2 f ‘’(x0=1) = 2
    f’’’(x) = 0 f ’’’(x0=1) = 0

     1st-order Taylor’s series formula (n=1):


    f(x) T(x; c) = 8 + 4 (x-1) = 4 + 4x

    • Now, for the Relative PPP approximation, we use a Taylor series expansion, Tf(x, c), for a bivariate
    series:
    f c , d    f c , d 
    T ( x, y, c, d )  x  c 0  y  d 0  f x c , d  x  c 1  y  y  d 1 
    0! 1! 1!
    1
    [ f xx c , d  x  c   f xy c , d  x  c  y  d   f yy c , d  y  d  ]  
    2 2

    2!

    Example: Taylor series expansion, around d=c=0, of f(x,y ) = [(1+x)/(1+y)] -1


    f(x,y )= [(1+x)/(1+y)] – 1  f(c=0,d=0) = [(1+0)/(1+0)] - 1 = 0
    fx = 1/(1+y)  fx(c=0,d=0) = 1
    fx = (-1)(1+x)/(1+y)2  fy(c=0,d=0) = -1

     1st-order Taylor’s series formula:


    f(x,y) T(x,y; c,d) = 0 + 1 (x-0) + (-1) (y-0) = x – y

    Application to Relative PPP: ef,TPPP = [(1 + Id)/(1 + If)] – 1 Id – If) ¶

    Chapter 8 – Measuring Persistence


    We estimate a regression for Rt using as explanatory variable Rt-1 –i.e., the lagged real exchange
    rate:
    Rt = + ρ Rt-1 + εt,

    In finance and economics, this very simple equation describes the behavior over time of a lot
    of variables. Given this equation, we use ρ as a measure of persistence.

    Three cases:

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    (1) If ρ=0, past Rt‘s have no effect on today’s Rt. There is no dynamics in Rt; no persistence of
    shocks to the real exchange rate –i.e., full adjustment to long-run PPP parity:
    Rt = + εt,

    In this case, it is easy to calculate long-run PPP parity –i.e., the mean of Rt over time:
    E[Rt] = (since E[εt]=0).

    Suppose last period there was a shock that deviate Rt from PPP parity. If ρ=0, last period’s shock has
    no effect on today’s Rt .On average, we are on the long run PPP parity, given by :
    Et[Rt] = (since Et[εt]=0.)

    (2) If 0<ρ<1, there is a gradual adjustment to shocks, depending on ρ. The higher ρ, the slower
    the adjustment to long run PPP parity. Shocks are persistent. On average:
    Et[Rt] = + ρ Rt-1

    With a little bit of algebra we can calculate the mean of Rt over time:
    E[Rt] = + ρ E[Rt-1]  E[Rt] = / 1‐ ρ)

    (3) If ρ=1, we say that the process generating Rt contains a unit root. We also say Rt follows a
    random walk process. Shocks never disappear! On average:
    Et[Rt] = + Rt-1

    In this case, changes in Rt are predictable: on average, they would be equal to the estimated
    value :
    E[Rt – Rt-1] = (since E[εt]=0.)

    But Rt would, however, not be predictable, even in the long run. Notice that the change each
    period would be equal to a constant plus an unpredictable random element, εt. In the long-run,
    Rt will be equal to the sum of the constant each period plus the sum of the εt’s.

    Half-life (H): how long it takes for the initial deviation from Rt and Rt= ∞ (long run PPP parity) to
    be cut in half. It is estimated by
    H=- ln(2)/ln(ρ)

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    Example: JPY/USD Real exchange rate (Monthly data from 1971-2013)
    We estimate a regression for Rt:
    Rt = + ρ Rt-1 + εt,

    Regression Statistics
    Multiple R 0.986754
    R Square 0.973682
    Adjusted R Square 0.973631
    Standard Error 0.032929
    Observations 515

    Standard
    Coefficients Error t Stat P-value
    Intercept ( 0.017278 0.006803 2.539632 0.011391
    Rt-1 ρ 0.982179 0.007129 137.7669 0

    Calculation of H: H = -ln(2)/ln(.982179) = 38.547 months (or 3.2122 years).

    Note: ρ is very high  slow adjustment (high persistence of shocks –i.e., PPP deviations!)
    E[Rt] = long-run PPP parity = / 1 – ρ) = 0.017278/(1 – .982179) = 0.96953. ¶

    The man behind PPP - Karl Gustav Cassel, Sweden (1866 – 1945)

    Apart from PPP theory, he produced an 'overconsumption' theory of the


    trade cycle (1918). He also worked on the German reparations problem.
    Two of his students, Ohlin and Myrdal, won the Nobel Prize in
    Economics.

    IFM-LN.87
    Chapter 8 - Theories of FX Determination – Part 2
    Goal: Get a formula for St. St = f( id, if,Id, If,…)

    • Review from Chapter 8 – Part 1:


    Effect of LOOP (arbitrage through trade) on FX Markets.
    Derive “equilibrium” (i.e., no-trade) St:
    Absolute PPP: St = Pd / Pf (Rejected, existence of transaction costs, borders a problem)
    Relative PPP: ef,  Id - If (Rejected in the short-run, some long-run support)

    • In this class, we will continue the search for a functional form that explains St. We will go over IFE,
    another pseudo-arbitrage theory, and the expectations hypothesis, which actually is about the expected
    value of St+T.

    8.2. International Fisher Effect (IFE)


    IFE builds on the law of one price, but for financial transactions.

    Idea: Expected returns to international investors who invest in money markets in their home country
    should be equal to the expected returns they would get if they invest in foreign money markets once
    adjusted for currency fluctuations. Exchange rates will be set in such a way that international investors
    cannot profit from interest rate differentials.

    The "effective" T-day return on a foreign bank deposit is:

    rf (in DC) = (1 + if * T/360) (1 + ef,T) – 1.

    On the other hand, the effective T-day return on a home bank deposit is:

    rd (in DC) = id * T/360.

    Setting rd (in DC) = rf (in DC) and solving for ef,T = (St+T/St – 1) we get:
    S T t (1  i d * T / 360)
    f ,T  1  1
    e IFE (IFE).
    St (1  i f * T / 360)

    Using a linear approximation: eIFEf,T  (id - if) x T/360.

    eIFEf,,T represents an expectation –i.e., E[ef,,T]. It’s the expected change in St from t to t+T that makes
    looking for the “extra yield” in international money markets not profitable.

    Since the investors equalize expected returns, IFE assumes the international investors are risk neutral –
    i.e., they pay no attention to the riskiness of a FC investment. Under risk-aversion, a risk premium would
    be demanded!

    If ef,,T = eIFEf,,T  No profits from carry trades –i.e., borrow the low interest rate currency, convert it to

    IFM-LN.88
    the currency with the higher interest rate and deposit at the higher interest rate. An investor would get
    the same expected return investing at the low interest rate, since the currency appreciation would
    compensate for the lower interest rate yield.

    IFE Notes:
    ⋄ Like PPP, IFE is built on implied assumptions (no barriers to capital mobility, no country risk, no
    default risk, no preference for domestic (certain) investments, etc.)
    ⋄ IFE also produces an equilibrium exchange rate (EER). Equilibrium will be reached when there is
    no capital flows from one country to another to take advantage of interest rate differentials. The
    equilibrium SIFEt+T is:
    SIFEt+T = St x (1 + eIFEf,T ) (Again, SIFEt+T represents an expectation –i.e., SIFEt+T=Et[St+T].)

    Example: Forecasting St using IFE.


    It’s 2015:I. You work for a Swiss Bank. You have the following information: S2015:I=1.0659 USD/EUR.
    iUSD,2015:I=1.5%
    iEUR,2015:I=0.5%.
    T = 1 semester = 180 days.

    eIFEf,,2015:II = [1+ iUSD,2015:I x (T/360)]/[1+ iEUR,2015:I x (T/360)] – 1 =


    = [1+.015*(180/360))]/[1+.005*(180/360)] – 1 = 0.0049875
    E[S2015:II] = S2015:I x (1+eIFEf,,2015:II ) = 1.0659 USD/EUR *(1 + 0.0049875) = 1.0712 USD/EUR

    That is, you expect the USD to depreciate against the EUR by 0.5% to compensate for the higher US
    interest rates (the linear approximation works very well!).¶

    • IFE: Implications
    If IFE holds, the expected cost of borrowing funds is identical across currencies. Also, the expected
    return of lending is identical across currencies.

    Carry trades –i.e., borrowing the low interest currency to invest in the high interest currency- should not
    be profitable. But, if departures from IFE are consistent, investors can profit from them.

    Example: Mexican peso depreciated by 5% a year during the early 90s.


    Annual interest rate differential (iMEX - iUSD) ranged between 7% and 16%.
    The E[ef,T ]= -5% > eIFEf,T  Pseudo-arbitrage is possible (According to IFE, the MXN at t+T is
    overvalued!)

    Carry Trade Strategy:


    1) Borrow USD funds (at iUSD)
    2) Convert to MXN at St
    3) Invest in Mexican funds (at iMEX)
    4) Wait until T. Then, convert back to USD at St+T. (<= There is risk in waiting!)

    Expected foreign exchange loss 5% (E[ef,T ] = -5%)


    Assume (iUSD – iMXN) = -7%. (For example: iUSD = 5%, iMXN = 12%, (T=1 year).)

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    The E[ef,T ] = -5% > eIFEf,T = -7%  “on average” strategy (1)-(4) should work.

    Expected return (MXN investment): rd (f) = (1 + iMXNxT/360)(1 + ef,T) -1 = (1.12)*(1-.05) -1 = 0.064


    Payment for USD borrowing rd (d) = id x T/360 = .05 (Expected Profit = .014 per year)
    Overall expected profits ranged from: 1.4% to 11%.

    Note: Fidelity used this uncovered strategy during the early 90s. In Dec. 94, after the Tequila devaluation
    of the MXN against the USD, lost everything it gained before. Not surprised, after all the strategy is a
    “pseudo-arbitrage” strategy! These extreme risks are usually described as crash risk. ¶

    The IFE pseudo-arbitrage strategy differs from covered arbitrage in the final step. Step (4) involves no
    coverage. It’s an uncovered strategy. IFE is also called Uncovered Interest Rate Parity (UIRP).

    • IFE: Evidence
    Testing IFE: Similar to PPP.

    1. Visual evidence. Based on linearized IFE: ef,,T  (id - if) x T/360


    Expect a 45 degree line in a plot of ef,T against (id - if)  usually, rejects IFE.

    Example: IFE plot for the monthly USD/EUR exchange rate (1999:Jan - 2015:March)

    IFE: USD/EUR
    0.08

    0.06

    0.04
    e(USD/EUR)

    0.02

    0
    -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04
    -0.02

    -0.04

    -0.06
    i(USD)-i(EUR)

    No 45 degree line  Visual evidence rejects IFE. ¶

    2. Do a regression
    ef,T = (St+T - St)/St = α + β (id - if)t + εt, (where εt is the regression error, E[εt]=0).

    The null hypothesis is: H0 (IFE true): α=0 & β=1


    H0 (IFE not true): α≠0 and/or β≠1

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    Example: Testing IFE for the USD/EUR
    We collected monthly interest rates differentials (iUSD – iEUR) and ef (USD/EUR) from January 1999 to
    March 2015 (195 observations). We estimate the following regression:
    ef,T = (St+T - St)/St = α + β (iUSD – iEUR)t + εt
    R2 = 0.01331
    Standard Error = 0.01815
    F-statistic (slopes=0) = 2.6034 (p-value=0.1083)
    F-test (α=0 and β=1) = 68.63369 (p-value= lower than 0.0001) ⇒ rejects H0 at the 5% level (F2,193,.05=3.05)
    Observations = 195

    Coefficients Stand Error t-Stat P-value


    Intercept ( ) 0.000658 0.001308 0.503047 0.615505
    (IJAP – IUS) ( ) -0.16014 0.099247 -1.61351 0.108268

    Note: You can find this example in my homepage: www.bauer.uh.edu/rsusmel/4386/ife-example.xls

    Let’s test H0, using t-tests (t104,.05 = 1.96):


    tα=0 (t-test for α = 0): (0.00065 – 0)/ 0.001308 = 0.503  cannot reject at the 5% level.
    tβ=1 (t-test for β = 1): (-0.16014 – 1)/ 0.099247= -11.695  reject at the 5% level.

    Formally, IFE is rejected in the short-run (both the joint test and the t-test reject H0). Also, note that β is
    negative, not positive as IFE expects.

    Note: During the 1999-2015 period, the average monthly (iUSD – iEUR) was 0.001454/12=.000121. That
    is, ef,tIFE = 0.0121% per month (IFE expects a 0.0121% monthly appreciation of the EUR). But, the actual
    average monthly change in the USD/EUR was .000425/12=.000035 (ef,t =0.0035% per month) , which
    is different from ef,tIFE.

    If we use the regression to derive an expectation, the regression expects E[ef,t] = .000658-
    .16014*.0001454 = 0.0006347. That is, we expect a 0.06% appreciation of the EUR against the USD
    per month, which is different from ef,tIFE, but a bit closer to the actual ef,t.

    Recall that consistent deviations from IFE point out that carry trades are profitable: During the 1999-
    2015 period, USD-EUR carry trades should have been profitable. ¶

    Similar to PPP, there is no short-run evidence. As pointed out above, consistent IFE departures make
    carry trades profitable: Burnside (2008) show that the average excess return of an equally weighted carry
    trade strategy, based on up to 20 currencies and executed monthly over the period 1976–2007, was about
    5% per year. Lower than excess returns for equity markets, but with a Sharpe ratio twice as big as the
    S&P500! (Annualized volatility of the carry trade returns was much less than that for stocks).

    Again, similar to PPP, some long-run support for IFE:


     Currencies with high interest rate differentials tend to depreciate.
    (For example, the Mexican peso finally depreciated in Dec. 1994.)

    IFM-LN.91
    8.3. Expectations Hypothesis of Exchange Rates
    Expectations hypothesis (EH) of exchange rates:
    Et[St+T] = Ft,T.

    Example: Suppose that over time, investors do not behave according to EH.
    Data: Ft,180 = 5.17 ZAR/USD.
    An investor expects: Et[St+180] = 5.34 ZAR/USD. (A potential profit exists.)

    Strategy for the non-EH investor:


    1. Buy USD forward at ZAR 5.17
    2. In 180 days, sell the USD at the expected rate. Get ZAR 5.34.

    Now, suppose everybody expects St+180 = 5.34 ZAR/USD


     Disequilibrium: Everybody buys USD forward (nobody sells USD forward), Ft,180↑. In 180
    days, everybody will be selling USD, E[St+180] ↓. Prices should adjust until EH holds.

    Since an expectation is involved, sometimes you’ll have a loss, but, on average, you’ll make a profit. ¶

    Key question behind EH: Are forward rates good predictors of future spot rates?

    • Expectations Hypothesis: IFE (UIRP) Revisited


    EH: Et[St+T] = Ft,T.
    Replace Ft,T by IRP, say the linearized version: Et[St+T] ≈ St [1 + (id - if) x T/360].
    A little bit of algebra gives: (E[St+T] - St)/St ≈ (id - if) x T/360 <= IFE linearized!

    • Expectations Hypothesis: Implications


    Et[St+T] = Ft,T  Ft,T is an unbiased predictors of St+T.

    That is, St+T - Ft,T = unpredictable (surprise: Et[St+T - Ft,T] = Et[εt] = 0!). This result will be the basis for
    testing.

    For a firm, EH means that the expected cash flows associated with hedging or not hedging currency risk
    are the same.

    Example: You work for a company that wants to forecast the quarterly USD/GBP exchange rate. You
    are given the interest rate differential (in %) and St. Then, using IRP you calculate Ft,90:
    Ft,90 = St [1 + (iUS – iUK)t x T/360].

    Suppose today it is the end of the second quarter of 2014 (2014:II). Data available:
    St=2014:II = 1.6883 USD/GBP
    (iUS-iUK)t=2014:II = -0.304%.
    Then,
    Ft,90 = 1.6883 USD/GBP x [1 – 0.00304 x 90/360] = 1.68702 USD/GBP

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    Then, you use Ft,90 to forecast St+90 (Et[St+90]=SFt+90 ). That is, SFt+90= 1.68702 USD/GBP.

    You can also calculate the forecasting error, εt =St - SFt, which you can use later to compare different
    forecasting models.

    Doing this forecasting exercise each period generates the following quarterly forecasts and forecasting
    errors, εt:

    Quarter (iUS-iUK) St SFt+90 = Ft,90 εt = St - SFt


    2014:II -0.304 1.6883
    2014:III -0.395 1.6889 1.68702 0.0019
    2014:IV -0.350 1.5999 1.68723 -0.0873
    2015:I -0.312 1.5026 1.59850 -0.0959
    2015:II -0.415 1.5328 1.50143 0.0314
    2015:III -0.495 1.5634 1.53121 0.0322
    2015:IV 1.5445 1.56146 -0.0170

    Calculation of the forecasting error for 2014:III: εt=2014:III = 1.6889 -1.68702 = 0.0019. ¶

    • Expectations Hypothesis: Evidence


    In general, expectations are unobservable. However, some companies and organizations survey
    “experts” and compile FX expectations (Bloomberg, in the U.S., Japan Center for International
    Finance, in Japan, Banxico, in Mexico, etc.). EH is not tested based on these surveys, but on the
    implications of the EH.

    Under EH, Et[St+T] = Ft,T → Et[St+T – Ft,T] = 0

    Empirical tests of the EH are based on a regression:


    (St+T – Ft,T)/St = α + β Zt + εt, (where E[εt]=0)

    where Zt represents any economic variable that might have power to explain St, for example, (id-if).

    The null hypothesis is H0: α=0 and β=0. (Recall (St+T - Ft) should be unpredictable!)

    Usual Finding: β < 0 (and significant) when Zt=(id-if). R2 is low.

    Note: EH can also be tested based on the Uncovered IRP (IFE) formulation:
    (St+T – St)/St = ef,T = α + β (id – if) + εt.

    The null hypothesis is H0: α=0 and β=1.

    Usual Result: β < 0  when (id-if)=2%, the exchange rate appreciates by (β x .02)
    (instead of depreciating by 2% as predicted by UIRP!)

    Example: Check the IFE test for the monthly USD/EUR. The estimated β was negative and significant

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    (-0.26342). The R2 was also low (0.057). ¶

    Summary: Forward rates have little power for forecasting spot rates  Puzzle!

    8.3.1 Explanations for the Forward Bias


    Explanation 1: Risk Premium
    The risk premium of a given security is the return on this security, over and above the risk-free return.

    Q: Is a risk premium justified in the FX market?


    A: Only if exchange rate risk is not diversifiable.

    After some simple algebra, we find that the expected excess return on the FX market is given by:
    (Et[St+T] – Ft,T)/St = Pt,t+T.

    A risk premium, P, in FX markets implies: Et[St+T] = Ft,T + St Pt,t+T.

    In general, we think of Pt,t+T as a function of the uncertainty related to St+T and the risk attitudes of
    investors (under risk neutrality, Pt,t+T=0).

    If Pt,t+T is consistently different from zero, say positive, markets will display a forward bias.

    Evidence for a risk premium: Weak.

    Explanation 2: Errors in Forming Expectations


    Investors make consistent errors in forecasting exchange rates.
     It takes time for investors to learn about new market conditions.

    Example: There is a new chairman on the Bank of Japan. It might take years to learn the Bank of Japan's
    new monetary policy. ¶

    Explanation 3: The "Peso Problem"


    For long periods of time investors assign a small (positive) probability to certain infrequent events (such
    as devaluations) which may never materialize in a limited sample period.

    The expectation of such rare and extreme events will be reflected in today's forward exchange rate.
    The events may never materialize, but markets show a forward bias.

    Example: The Mexican peso used to show a real and continuous appreciation until the Mexican
    government finally devalued the peso (generally after an election). Before the devaluation, the Mexican
    peso used to have a strong forward bias. ¶

    8.4. The Martingale-Random Walk Model


    A random walk is a time series independent of its own history. Your last step has no influence in your
    next step. The past does not help to explain the future.

    IFM-LN.94
    (Technically, in a random walk process the uncorrelated steps are independently and identically
    distributed –i.e., they are independent and come from the same distribution. A martingale process only
    requires the steps to be uncorrelated.)

    Intuitive notion: The FX market is a "fair game" i.e., there are no exploitable trends.

    • Martingale-Random Walk Model: Implications


    The Martingale-Random Walk Model (RWM) implies:
    Et[St+T] = St.

    If St follows a RW, exchange rates cannot be forecasted: St is the forecast! That is, a firm should not
    spend any resources to forecast St+T.

    Powerful theory: At time t, all the info about St+T is summarized by St. Only relevant information to
    forecast St+T: St  Changes in St are unpredictable.

    The RWM is an old model. It was first proposed by the French mathematician Bachelier in 1900 to
    describe the behavior of French bonds.

    Theoretical Justification: Efficient Markets Hypothesis (EMH): All available information is


    incorporated into today’s St. Under the practical version of the EMH, it is very difficult for investors
    to consistently obtain above average returns –i.e., forecast St+T consistently better than the
    competition.

    Example: Forecasting with RWM


    St = 1.60 USD/GBP
    Et[St+7-day] = 1.60 USD/GBP
    Et[St+180-day] = 1.60 USD/GBP
    Et[St+10-year] = 1.60 USD/GBP.

    Note: The forecast error is the change in exchange rates. That is, εt+T = St+T - Et[St+T] = St+T - St. ¶

    • Martingale-Random Walk Model: Evidence

    IFM-LN.95
    Meese and Rogoff (1983, Journal of International Economics) tested the short-term forecasting
    performance of different models for the four most traded exchange rates. They considered economic
    models (PPP, IFE/UIRP, Monetary Approach, etc.) and the RWM.
     They found that the RWM performed as well as any other model.
    Metric used: MSE (mean squared error)  MSE = Σt (St+TForecast - St+T)2/Q, t=1,2,...,Q.

    Cheung, Chinn and Pascual (2005) checked the Meese and Rogoff’s results with 20 more years of data
     RWM still the best model in the short-run.

    The results from Meese and Rogoff (1983) were very surprising. The paper started a big literature;
    which, in general, confirms the results in the short-run (say, up to 6-months or 1-year), but for longer
    horizons (say, 4 years), some models based can do better. These long-horizon successes are based on
    models such as PPP and IFE and incorporate statistical features of FX rates and the predictable behavior
    of Central banks.

    Example: MSE - Forecasting with Forwards and the RWM


    You work for a company that wants to forecast the quarterly USD/GBP exchange rate. You are given
    the interest rate differential (in %) and St, which you used above to calculate the forward rate, Ft,90,
    and, then, to forecast Et[St+90]=SFt+90. You also use the RWM to forecast Et[St+90]= St. Then, to check
    the accuracy of the forecasts, you calculate the MSE.

    Quarter (iUS-iUK) St Forward Rate Random Walk


    SFt+90 = Ft,90 εt-FR = St - SFt SFt+90=St εt-RW = St - SFt
    2014:II -0.304 1.6883
    2014:III -0.395 1.6889 1.6870 0.0019 1.6883 0.0006
    2014:IV -0.350 1.5999 1.6872 -0.0873 1.6889 -0.0890
    2015:I -0.312 1.5026 1.5985 -0.0959 1.5999 -0.0973
    2015:II -0.415 1.5328 1.5014 0.0314 1.5026 0.0302
    2015:III -0.495 1.5634 1.5312 0.0322 1.5328 0.0306
    2015:IV 1.5445 1.5615 -0.0170 1.5634 -0.0189

    MSE 0.00319 0.00327

    Both MSEs are similar, though the Forward Rate’s MSE is a bit smaller (2% lower).

    Calculation of MSE for Forward Rate:


    MSE = [0.00192 + (-0.0873)2 + (-0.0959)2 + 0.03142 + 0.03222 + (-0.0170)2] / 6 = 0.00319. ¶

    • Martingale-Random Walk Model: Many Empirical Models Trying to Compete


    As illustrated above, models of exchange rates determination based on economic fundamentals have
    problems explaining the short-run behavior of St (though, there is some hope for the long-run behavior
    of St). This is not good news if the aim of the model is to forecast St.

    As a result of this failure, a lot of empirical models, modifying the traditional fundamental-driven
    models, have been developed to better explain equilibrium exchange rates (EERs). Some models are
    built to explain the medium- or long-run behavior of St, others are built to beat (or get closer to) the

    IFM-LN.96
    forecasting performance of the RWM.

    A short list of the new models includes CHEERs, ITMEERs, BEERs, PEERs, FEERs, APEERs, PEERs,
    and NATREX. Below, I include Table 8.1, taken from Driver and Westaway (2003, Bank of England),
    which describes the main models used to explain EERs.

    Table 8.1: Summary of Empirical Approaches to Estimating Equilibrium Exchange Rates

    IFM-LN.97
    Table 8.1: Summary of Empirical Approaches to Estimating Equilibrium Exchange Rates
    (continuation)

    IFM-LN.98
    CHAPTER 8 – BRIEF ASSESMENT

    1. Assume the following cost for the CPI baskets:


    CPI-basketUSA = USD 755.3
    CPI-basketCAD = CAD 928.8

    (A) Calculate StPPP.


    (B) Suposse = 1.31 CAD/USD. Calculate Rt. Which country is more efficient?
    (C) Describe how market forces act when St and StPPP move towards convergence.

    2. Suppose you have the following data:


    St-1 = 1.40 USD/GBP.
    IGBP,t = 1.50%
    IUSD,t = 2.00%
    (A) According to relative PPP, what should be St?
    (B) Suppose St = 1.37 USD/GBP, according to relative PPP, is the GBP overvalued or undervalued?

    3. Suppose you have the following information:


    S2017:I = 1.31 USD/CAD.
    iUSD,2017:I = 2.00%
    iCAD,2015:I = 2.5%.
    T = 1 semester = 180 days.
    (A) Using IFE, calculate E[S2017:II].
    (B) Using the RW model, calculate E[S2017:II].

    4. Suppose you have the following data:


    E[S2017:II] = 1.31 USD/CAD.
    Ft, 2017:II = 1.30 USD/CAD.
    Describe how you can take advantage of this violation of the EH.

    5. You run the following regression: changes in the JPY/USD exchange rate against inflation rate
    differentials (IJPY-IUS). Below, you have the excel regression output. Let RSS(H0)= 0.5214. Using
    individual t-tests and a joint F-test, test relative PPP.

    IFM-LN.99
    CHAPTER 8 - BONUS COVERAGE I: A Random Walk
    This is a computer generated random walk of 1,000 steps going nowhere:

    The RW model does not only appear in Finance and Economics. Many physical processes such as Brownian
    motion, electron transport through metals, and round off errors on computers are modeled as a random walk. In
    the above computer generated RW, many steps are taken with the direction of each step independent of the
    direction of the previous one.

    The RWM is an old model. It was formally introduced by the French mathematician Bachelier
    (1900), who used it to study bond prices on the Paris Bourse. Since then it has been proposed
    for all financial assets. Malkiel’s (1973) A Random Walk Down Wall Street popularized the idea
    of the unpredictability of asset prices. (BTW, the book is in its 11th edition and sold over 1.5
    million copies). Lo and MacKinlay’s (2002) A Non-Random Walk Down Wall Street
    summarized results that show that financial assets display statistically significant deviations
    from the RWM. There are some predictable components. Nonetheless, from a forecasting point
    of view, beating the RWM, in the short-run, is very, very difficult.

    BONUS COVERAGE II: The man behind IFE - Irving Fisher (1867–1947).
    Today, Fisher is remembered in neoclassical economics for his theory of capital, investment, and interest
    rates, first exposited in his The Nature of Capital and Income (1906) and elaborated on in The Rate of Interest
    (1907). His 1930 treatise, The Theory of Interest, summed up a lifetime's research into capital, capital
    budgeting, credit markets, and the factors (including inflation) that determine interest rates.

    The Fisher equation, where the nominal interest rate is approximated by the real interest rate, k, plus the
    (expected) inflation rate, is named after him:
    i = k + E[I]

    But, for investors, he may be best remembered for predicting, three days before the October 1929 crash:
    "Stock prices have reached what looks like a permanently high plateau.”

    IFM-LN.100
    BONUS COVERAGE III: Asset Approach to Exchange Rates
    The flows (exports and imports) approach to exchange rate determination was very popular until the late 1960s.
    But, these models did not work well. During the 1970s, economists began to think of currencies as any other
    asset. Thus, exchange rates are asset prices that adjust to equilibrate international trade in financial assets.
    Exchange rates are relative prices between two currencies and these relative prices are determined by the desire
    of residents to hold domestic and foreign financial assets. Like other asset prices, exchange rates are determined
    by expectations about the future. Therefore, past or present trade flows cannot influence exchange rates to the
    extent that they have already been expected. This approach, which treats currencies as assets, is called the asset
    approach.

    • Monetary Approach (MA)


    The asset approach assumes a high degree of capital mobility between assets denominated in different
    currencies. We need to specify the domestic and foreign assets to be included in the portfolio of a domestic
    resident. Since exchange rates are relative prices between two currencies, a simple model is to consider domestic
    money and foreign money. This simple asset model is called the monetary approach (MA) model.

    BC.1 A Simple Monetary Approach Model


    The traditional MA is a long-run theory that assumes that prices are flexible. Through PPP, the monetary
    approach relates the factors that affect prices with exchange rates. The determination of prices is based on the
    Quantitative Theory of Money (QTM):

    MS V = P Y,

    V: velocity of money,
    P: price level
    Y: real output
    MS: Money supply (in equilibrium, MS: Ld, Ld: Money demand, L stands for liquidity.)

    This equation assumes that prices are fully flexible. If MS changes then prices adjust instantaneously.

    Solving for P, we obtain: P = (MS V)/Y.

    The MA model needs an equation that relates the QMT to exchange rates. We already know a theory that relates
    domestic and foreign prices to exchange rates: PPP. Using the subscripts d and f to denote domestic and foreign
    quantities, and after simple substitutions, the spot rate is determined by:

    St = Pd/Pf = (Vd/Vf) x (Yf/Yd) x (MSd/MSf). (BC.1)

    BC.1 assumes not only fully flexible prices, but also that PPP holds continuously. Assume V is constant in the
    short-run and after some algebra (taking logs and creating log differences), we get:

    st+T = ef,t+T = yf,T - yd,T + mSd,T - mSf,T,

    where small letters represent percent changes (growth rates) in the underlying variables.

    BC.2 A More Sophisticated Monetary Approach Model


    The previous monetary model was very simple. Implicitly, we have paid no attention to money demand and,

    IFM-LN.101
    implicitly, assumed that monetary variables are exogenous variables. However, in equilibrium, monetary
    variables are jointly determined by supply and demand. Let’s complicate the MA model by introducing the
    demand for real-money holdings, LD. In equilibrium, LD equals MS/P:

    MS/P = LD.

    Now, let us model LD as a function of income, Y, and interest rates, i. For example,

    LD = k Ya eb i,

    where k represents the inverse of velocity of money, V.

    After some substitutions and using PPP, we obtain:

    ln(ST) = a[ln(Yf,T) - ln(Yd,T)] + b(if,T - id,T) + [ln(kf) - ln(kS)] + [ln(MSd,T) - ln(MSf,T)].

    Again, like in the IFE model, interest rate differentials play a role in the determination of exchange rates. Under
    the MA, interest rate differentials play a role through the impact on LD. The same can be said about income
    growth rate differentials, they influence St through LD.

    Note: Expectations about future St into the MA model. Recall the interest rate differentials provides information
    about the expected change in exchange rates, {E(St+T)/St - 1}. That is, the St today depends on expectations
    about the expected St+T. Through several substitutions, it is easy to see that the exchange rate today depends on
    the expected path of future exchange rates.

    BC.3 Monetary Approach: Implications


    The MA presented has very precise implications. It predicts that St behaves like any other speculative asset
    price; St changes whenever relevant information is released.

    “Relevant information”: id, if, yd, yf, MSd, MSf. (Expectations about the future these variables matter.)

    Example: Suppose the money supply in the U.S. market increases unexpectedly by 2% and all the other
    variables remain constant. According to the monetary approach, an increase in the money supply of 2% leads
    to an increase of 2% in St (a depreciation of the USD).

    Now, suppose that investors expect the U.S. Fed to quickly increase U.S. interest rates to offset this increase in
    the money supply, then the USD might appreciate instead of depreciate. ¶

    IFM-LN.102
    Chapter 9 - Forecasting Exchange Rates
    In Chapter 8, we studied FX determination: St = f(iDC-iFC, IDC-IFC, yD-yF, other)
    Not very successful to explain St –especially in the short-run:
    - PPP (Absolute and Relative): Rejected
    - IFE: Rejected
    Q: What determines St in the short-run?
    A: Still an open question. Random Walk Model for St has a good forecasting performance.

    Q: Can we forecast St+T?


    A: It seems very difficult. But, firms and “experts” constantly try. In this chapter, we will also try.

    • Brief Review and Notation


    A forecast is an expectation: Et[St+T]  Expectation of St+T taken at time t.

    (Remember, in statistics, the expectation is an expected value. Think of it as an average.)

    In general, it is easier to predict changes. In this class, we will concentrate on Et[ef,t+T].

    Note: From Et[ef,t+1], we get Et[St+T]  Et[St+T] = St x (1+Et[ef,t+1])

    The forecast Et[St+T] will be a function of some data set. That is, Et[St+T] = f(Xt), where Xt is a dataset.

    Example: For the PPP model, Xt = Inflation rate differentials (Id,t - If,t)
    f(Xt) = Id,t - If,t

    • Main Forecasting Methods


    There are two pure approaches to forecasting FX rates:
    (1) The fundamental approach (based on data considered fundamental).
    (2) The technical approach (based on data that incorporates only past prices).

    9.1. Method I: Fundamental Approach


    • We generate Et[St+T] = f(Xt), where Xt is a dataset regarded as fundamental economic variables:
    GNP growth rate, Current Account, Interest rates, Inflation rates, Money growth rate, etc.

    • In general, the fundamental forecast is based on an economic model (PPP, IFE, combinations).
     the economic model tells us how the fundamental data relates to St.
    That is, the economic model specifies f(Xt) -for PPP, f(Xt) = Id,t - If,t

    • The economic model usually incorporates:


    ⋄ Statistical characteristics of the data (seasonality, etc.)
    ⋄ Experience of the forecaster (what info to use, lags, etc.)
     Mixture of art and science.

    IFM-LN.103
    • Fundamental Forecasting involves several steps:
    (1) Selection of Model (for example, PPP model) used to generate the forecasts.
    (2) Collection of St, Xt (in the case of PPP, exchange rates and CPI data needed.)
    (3) Estimation of model, if needed (regression, other methods). Test model.
    (4) Generation of forecasts based on estimated model. Assumptions about Xt+T may be
    needed.
    (5) Evaluation. Forecasts are evaluated. If forecasts are very bad, model must be changed.
     MSE (Mean Square Error) is a measure used to asses forecasting models.

    Exhibit 9.1 shows a typical process to build out-of-sample forecasts model.

    Exhibit 9.1
    Fundamental Forecasting: Process for Building Forecasting Model

    Example: Forecasting St+T with Relative PPP (Et[St+T])


    Formulas needed:
    Economic Model (PPP): ef,t = (St/St-1) – 1  Id,t – If,t = IUS,t – IUK,t
    Forecasting equation for ef,t+1: Et[ef,t+1] = (Et[St+1]/St) – 1  Id,t+1 – If,t+1 = IUS,t+1 - IUK,t+1
    Forecasting the spot rate: Et[St+1] = SFt+1 = St x (1 + Et[ef,t+1]) = St x (1 + Et[IUS,t+1 – IUK,t+1]) .

    Forecast error: t+1= St+1 – Et[St+1] (quality of forecast)

    Mean Square Error = MSE = [(t+1)2 + (t+2)2 + (t+3)2 + ... + (t+Q)2 ]/Q (evaluation measure)

    IFM-LN.104
    Example (continuation): Forecasting St+T with Relative PPP (Et[St+T])
    It’s February 2007. We want to forecast monthly USD/GBP exchange rates using Relative PPP.

    • Forecasting Model
    E2007:2[S2007:3] = S2007:2 x (1 + E2007:2[IUS,2007:3 - IUK,2007:3]).

    • Data
    We have CPI data and St data from Jan. 2007 to Feb. 2007. We want to forecast St=March, 07.

    We have already done: (1) Selection of Model; (2) Collection of St, Xt; and (3) No estimation is needed. We
    need to do (4) Generation of forecasts based on model and (5) Evaluation of forecasts.

    Date CPI U.S. CPI U.K. IUS IUK Et[St+1]= SFt+1 Actual (St) t+1=St+1-SFt+1
    2007:Jan 117.5 110.91 ... ... 1.9334 -
    2007:Feb 118.2 111.45 .005957 .004868 ... 1.9512 -
    2007:Mar 119.3 111.98 .009306 .004756 1.9533249 1.9318 -0.0215249
    2007:Apr ... ... 1.9405912 1.9718 0.0312088

    • Generation of forecasts (GF)


    Calculations for the 2007:3 forecast:
    GF.1. Inflation rates
    IUS,2007:2 = (USCPI2007:2/USCPI2007:1) - 1 = (118.2/117.5) – 1 = .005957.
    IUK,2007:2 = (UKCPI2007:2/UKCPI2007:1) - 1 = (111.45/110.901) – 1 = .004868

    GF.2. We need a forecast for IUS,2007:3 -IUK,2007:3


    RW forecast: Last year inflation rate is a good predictor of this year inflation rate –i.e., Et[It+1]=It
    Et[ef,t+1] = (Et[St+1]/St) – 1  Et[Id,t+1] – Et[If,t+1] = Id,,t – If,,t.

    GF.3. Now, we can predict ef ,2007:3 and S2003:3:


    Et=2003:2[ef ,2007:3] = IUS,2007:2 - IUK,2007:2 = .005957 - .004868 = .001089.
    Et=2003:2[S,2007:3] = SF2007:3 = S2007:2 x (1 + Et[ef ,2007:3]) = 1.9512 x (1 + .001089) = 1.9533249

    • Evaluation of forecasts (EVF)


    EVF.1. At the end of 2007:3, we can also calculate the forecasting error:
    2007:3 = S2007:3 - SF2007:3 = 1.9318 – 1.9533249 = -0.0215249.

    EVF.2. At the end of 2007:3, we can also generate a forecast for St=April, 07
    Calculating the MSE for the 2007:3-2007:4 period:
    MSEPPP = [(-0.0215249)2 + (0.031208800)2]/2 = 0.00071865526

    EVF.3 Compare the MSE of the PPP forecasting model with the RWM. Under the RWM: Et[St+1]= St
    2007:3 = S2007:3 - SF2007:3 = S2007:3 - S2007:2 = 1.9318 - 1.9512 = -0.0194.
    2007:4 = S2007:4 - SF2007:4 = S2007:4 - S2007:3 = 1.9718 - 1.9318 = 0.0400.
    MSERW = [(-0.0194)2 + (0.04)2]/2 = 0.000988

    IFM-LN.105
    For these two forecasts, on average, the PPP model does better than the RW model. ¶

    Example: Forecasting FX with an Ad-hoc Model


    A U.S. company uses an economic linear model to forecast monthly exchange rates (USD/GBP):
    Economic Regression Model: ef,,t = a0 + a1 INFt + a2 INTt + a3 INCt + εt, (*)

    INFt: inflation rates differential between U.S. and the U.K.


    INTt: interest rates differential between U.S. and the U.K.
    INCt: income growth rates differential between U.S. and the U.K.

    Objective: Calculate Et[ef,t+1].


    • Forecasting Model
    Et[ef,t+1] = a0 + a1 Et[INFt+1] + a2 Et[INTt+1] + a3 Et[INCt+1].. (Recall: Et[εt+1]=0).

    Inputs for the forecast: 1) a0, a1, a2, a3 (estimated through a regression).
    2) Et[INFt+1] and Et[INCt+1] (potential problem!)

    • Data
    Income growth rates, interest rates, inflation rates and exchange rates. Suppose we have quarterly data
    from 1978 to 2008 (21 years).
    Suppose S2008:IV = 1.7037 USD/GBP.

    • Estimation
    We run a regression to estimate (*). Excel output:

    SUMMARY OUTPUT

    Regression Statistics
    Multiple R 0.216036
    R Square 0.046672
    Adjusted R
    Square 0.022434
    Standard
    Error 0.050911
    Observations 122

    ANOVA
    Significance
    df SS MS F F
    Regression 3 0.014973 0.004991 1.925622 0.129173
    Residual 118 0.305851 0.002592
    Total 121 0.320825

    Standard
    Coefficients Error t Stat P-value Lower 95% Upper 95%
    Intercept -0.01082 0.007553 -1.43285 0.154545 -0.02578 0.004134

    IFM-LN.106
    INFt 0.648128 0.547068 1.184732 0.238504 -0.43521 1.731471
    INTt -0.00482 0.002188 -2.20088 0.029691 -0.00915 -0.00048
    INCt 0.000945 0.001613 0.585963 0.559019 -0.00225 0.00414

    Analysis:
    t-statistics: only the interest rate differential coefficient is bigger than two (in absolute value).
    R2 = .047 (INF, INT & INC explain 4.7% of the variability of changes in the USD/GBP).

    (Note: It doesn’t look like a great model, but we’ll use it anyway.)

    • Generation of forecasts
    i. Suppose we have the following forecasts for next month:
    Et[INFt+1] = 1.68%, Et[INTt+1] = -2.2%, Et[INCt+1] = 1.23%.
    Then,
    Et[ef,,t+1] = -.010802 + .6481 x (.0168) + (-0.00482) x (-.022) + .000945 x (0.0123) = 0.000204.

     The USD is predicted to depreciate 0.02% against the USD next month.

    ii. Now, we can forecast SF t+1:


    Et[St+1] = SFt+1 = St x (1+Et[ef,t+1]) = 1.7037 USD/GBP x (1.000204) = 1.704048 USD/GBP.
    • Evaluation of forecasts
    Suppose S2009:I = 1.5239 USD/GBP, we can calculate the forecast error:
    t+1= St+1 - Et[St+1] = 1.5239 USD/GBP – 1.704048 USD/GBP= -0.180148 (Model)
    t+1= St+1 - EtRW[St+1] = 1.5239 USD/GBP – 1.7037 USD/GBP = -0.179800 (RWM).

    Note: The RWM forecast error is smaller, but just by a very small amount.
     RWM advantage: No complicated estimation/model, very similar forecasts! ¶

    • Practical Issues in Fundamental Forecasting


    ⋄ Are we using the "right model?" (Is Linear ad-hoc model OK?)
    ⋄ Estimation of the model. (Is linear regression fine?)
    ⋄ Some explanatory variables are contemporaneous. We need a model to forecast these variables too.

    • Fundamental Forecasting: Evidence


    Recall the Meese and Rogoff’s (1983) findings. They tested the short-run forecasting performance of
    different models (PPP, monetary approach, IFE, pure statistical (time series) models, and the RWM)
    for the four most liquid exchange rates. The RWM performed as well or better than any other model.

    More recently, Cheung, Chinn and Pascual (2005) revisited the Meese and Rogoff’s results with 20
    more years of data. They still found the RWM to be the “best” model in the short-run. For longer
    horizons, Cheung, Chinn and Pascual (2005), along other papers, they report that some models do better
    than the RWM.

    Note: The more modern approach to fundamental forecasting incorporates an attempt to forecast what

    IFM-LN.107
    the CB does to adjust interest rates. Usually, this involves the so-called “Taylor rule.” Some economists
    find that this approach has some success over the RWM, especially over longer horizons (say, 6 to 12
    months or longer).

    Forecasting: Note on Estimation and Generation of Out-of-sample forecasts


    In general, practitioners will divide the sample in two parts: a longer sample (estimation period) and
    a shorter sample (validation period). The estimation period is used to select the model and to
    estimate its parameters. The forecasts made inside the estimation period are not “true forecasts,” are
    just fitted values.

    The data in the validation period are not used during model and parameter estimation. The forecasts
    made in this period are “true forecasts,” their error statistics are representative of errors that will be
    made in forecasting the future. A forecaster will use the results from this validation step to decide if
    the selected model can be used to generate outside the sample (out-of-sample) forecasts.

    Figure 9.1 shows a typical partition of the sample. Suppose that today is March 2015 and a forecaster
    wants to generate monthly forecasts until January 2016. The estimation period covers from February
    1978 to December 2009. Different models are estimated using this sample. Based on some statistical
    measures, the best model is selected. The validation period covers from January 2010 to March
    2015. This period is used to check the forecasting performance of the model. If the forecaster is
    happy with the performance of the forecasts during the validation period, then the forecaster will
    use the selected model to generate out-of-sample forecasts.

    Figure 9.1: Estimation, Validation & Out-of-sample Periods.

    In Exhibit 9.2, we incorporate the partition of the data in the flow chart presented in Exhibit 9.1. It is
    easy to visualize how to generate out-of-sample forecasts.

    IFM-LN.108
    Exhibit 9.2
    Out-of-sample Forecasting: The Role of the Estimation and Validation Periods

    9.2 Method II: Technical Analysis (TA) approach


    We generate Et[St+T] = f(Xt), where Xt is a a small set of the available data: Past price information.
     Xt = {St, St-1, St-2,....}

    ⋄ TA does not pay attention to fundamentals (say, Id,t - If,t). The market efficiently “discounts” public
    information regarding fundamentals.
    No need to research or forecast fundamentals.
    ⋄ TA looks for the repetition of history; in particular, the repetition of specific price patterns.
     Discovering these patterns is an art (not science).
    ⋄ TA believes that assets move in trends. TA attempts to discover trends (“the trend is your friend”) and
    turning points.
     Based on these trends & turning points, TA generates signals.
    ⋄ TA models range from very simple (say, looking at price charts) or very sophisticated, incorporating
    neural networks and genetic algorithms.

    • TA: Two Popular Models


    We will go over two popular well-known (& old!) models that produce mechanical rules –i.e., produce
    objective signals:

    IFM-LN.109
    ⋄ Moving Averages (MA)
    ⋄ Filters

    (1) MA model: The goal of MA models is to smooth the erratic daily swings of FX to signal major trends.
    We will use the simple moving average (SMA).
    An SMA is the unweighted mean of the previous Q data points:
     SMA = (St + St-1 + St-2 + ... + St-(Q-1))/Q

    The double MA system uses two MA: Long-run MA (Q large, say 120 days) and Short-run MA (Q small,
    say 30 days). LRMA will always lag a SRMA (LRMA gives smaller weights to recent St).

    Every time there is a crossing, a qualitative forecast is generated.


    When SRMA crosses LRMA from below  Forecast: FC to appreciate
    When SRMA crosses LRMA from above  Forecast: FC to depreciate.

    The double MA system uses the two MAs to forecast changes in St and generate trading signals.

    St
    (USD/GBP)

    Buy GBP LRMA


    SRMA

    time
    Sell GBP

    Buy FC signal: When SRMA crosses LRMA from below.


    Sell FC signal: When SRMA crosses LRMA from above.

    Example: St (USD/GBP) Double MA (red=30 days; green=150 days).

    IFM-LN.110
    Buy GBP

    Sell GBP

    (2) Filter models: The filter, X, is a percentage that helps a trader forecasts a trend.
    Simple Intuition:
    When St reaches a peak  Sell FC
    When St reaches a trough  Buy FC

    Key: Identifying the peak or trough. We use the filter to do it:


    When St moves X% above (below) its most recent peak (trough), we have a trading signal.

    Example: X = 1%, St (CHF/USD)

    IFM-LN.111
    St = 1.47114 CHF/USD

    Trough
    Peak

    Sell USD
    Peak = 1.486 CHF/USD (X = CHF .01486)  When St crosses 1.47114 CHF/USD, Sell USD

    Trough = 1.349 CHF/USD (X = CHF .01349)  When St crosses 1.36249 CHF/USD, Buy USD ¶

    • TA: Newer Models


    In both models, the TA practitioner needs to select a parameter (Q and X). This fact can make two TA
    practitioners using the same model, but different parameters, to generate different signals.

    To solve this problem, there are several newer TA methods that use more complicated mathematical
    formulas to determine when to buy/sell, without the subjectivity of selecting a parameter.
    Clements (2010, Technical Analysis in FX Markets) describes four of these methods: Relative
    strength indicator (RSI), Exponentially weighted moving average (EWMA), Moving average
    convergence divergence (MACD) and (iv) Rate of change (ROC).

    • TA: Summary
    ⋄ TA models monitor the derivative (slope) of a time series graph.
    ⋄ Signals are generated when the slope varies significantly.

    • TA: Evidence
    - Against TA
    ⋄ Random walk model: It is a very good forecasting model.
    ⋄ Many economists have a negative view of TA: TA runs against market efficiency (EM Hypothesis).

    - For TA:
    ⋄ Lo (2004) suggests that markets are adaptive efficient (AMH, adaptive market hypothesis): It may take
    time, but eventually, the market learns and profits should disappear.
     Some TA methods may be profitable for a while.
    ⋄ The marketplace is full of TA newsletters and TA consultants (somebody finds them valuable & buys

    IFM-LN.112
    them).
    ⋄ A survey of FX traders by Cheung and Chinn (2001) found that 30% of the traders are best classified
    as technical analysts.

    - Academic research:
    ⋄ Related to filter models in the FX market. Sweeney (1986, Journal of Finance): Simple filter rules
    generated excess returns (1973-1980). A 1% filter rule had a return of 2.8%, while a buy-and-hold
    strategy had a 1.6% return.
    ⋄ TA in FX market: In general, in-sample results tend to be good –i.e., profitable–, but in terms of
    forecasting –i.e., out-of-sample performance– the results are weak. LeBaron (1999) speculates that
    the apparent success of TA in the FX market is influenced by the periods where there is CB
    intervention.
    ⋄ Ohlson (2004) finds that the profitability of TA strategies in the FX market have significantly
    declined over time, with about zero profits by the 1990s.
    ⋄ Park and Irwin (2007, Journal of Economic Surveys) survey the TA recent literature in different
    markets. They report that out of 92 modern academic papers, 58 found that TA strategies are profitable.
    Park and Irwin point out problems with most studies: data snooping, ex-post selection of trading rules,
    difficulties in the estimation of risk and transaction costs.

    IFM-LN.113
    CHAPTER 9 – BRIEF ASSESMENT

    You work in Austin for a local investment bank. You have available quarterly inflation rate (I), interest rate (i),
    and growth rate (y) data for the U.S. and Europe from 2016:1 to 2016:4. The USD/EUR in 2016:1 was equal
    to 1.0821 USD/EUR, which you believe is an equilibrium exchange rate. Your job is to do quarterly forecasts
    of the USD/EUR exchange rate for 2017:1. The investment bank uses the following ad-hoc model:

    st+1 = St+1/St -1 = .75 (Id,t+1 - If,t+1) + .25 (yd,t+1 - yf,t+1) (M1).

    This model is based on the monetary approach. You have the following data:
    Year yUS – yEUR IUS-IEUR iUS-iEUR St (EUR/USD)
    2016.1 0.17% 0.4473% -0.5012% 1.0821
    2016.2 0.24% 0.6976% -0.0593% 1.1453
    2016.3 0.31% -0.1308% 0.6773% 1.1183
    2016.4 0.57% -0.3403% 0.8381% 1.0962

    To forecast income growth rates differentials (yt) your firm uses the following regression model (estimated
    regression is attached below):
    yUS,t - yEUR,t = α + β (yUS,t-1 - yEUR,t-1) + t.

    To forecast inflation rates (I) your firm uses a RW model.

    (A) Use the ad-hoc model (M1) to forecasts the USD/EUR exchange rate for the period 2017:1.
    (B) Use the forward rate to forecast the USD/EUR exchange rate for the period 2017:1.
    (C) Use StPPP (long-run PPP, starting with St=2016.1) to forecast the USD/EUR exchange rate for the period
    2016:4.
    (D) Use the random walk to forecast the USD/EUR exchange rate for the period 2017:1.

    SUMMARY OUTPUT

    Regression Statistics
    Multiple R 0.196241
    R Square 0.03851
    Adjusted R
    Square 0.032185
    Standard Error 1.143971
    Observations 154

    ANOVA
    df SS MS F Significance F
    Regression 1 7.967219 7.967219 6.088029 0.01472
    Residual 152 198.9178 1.30867
    Total 153 206.885

    Standard
    Coefficients Error t Stat P-value Lower 95%
    Intercept -0.03019 0.092218 -0.32737 0.743839 -0.21238
    X Variable 1 0.19537 0.079181 2.467393 0.01472 0.038933

    IFM-LN.114
    CHAPTER 9 - BONUS COVERAGE: TAYLOR RULE
    According to the Taylor rule, the CB raises the target for the short-term interest rate, it, if:
    (1) Inflation, It, raises above its desired level
    (2) Output, yt, is above “potential” output

    The target level of inflation is positive (deflation is thought to be worse than positive inflation for the economy)
    The target level of the output deviation is 0, since output cannot permanently exceed “potential output.”

    John Taylor (1993) assumed the following reaction function by the CB:

    it = It + φ ( It - It* )+ γ y-gapt + r* (Equation BC.1)

    where y-gapt is the output gap –a percent deviation of actual real GDP from an estimate of its potential level-, and
    r* is the equilibrium level or the real interest rate, which Taylor assumes equal to 2%. The coefficients φ and γ are
    weights, which can be estimated (though, Taylor assumes them equal to .5).

    Let It* and r* in equation BC.1 be combined into one constant term, μ = r* - φ It*. Then,

    it = μ + λ It + γ y-gapt,

    where λ = 1 + φ.

    For many countries, whose CB monitors St closely, the Taylor rule is expanded to include the real exchange rate,
    Rt:

    it = μ + λ It + γ y-gapt + δ Rt

    Estimating this equation for the US and a foreign country can give us a forecast for the interest rate differential,
    which can be used to forecast exchange rates.

    IFM-LN.115
    Chapter 10 - Measuring FX Exposure – Part 1
    At the firm level, currency risk is called FX exposure. Recall that currency risk describes how the
    value of an asset/liability fluctuates due to changes in St.

    From Kellogg’s 2014 Annual Report


    Almost everyone knows Kellogg, but the general public may not be aware that they do more than
    cereal. Kellogg is the world's largest cereal company; second largest producer of cookies and
    crackers; a major producer of snacks; and a major North American frozen foods company.

    “Our operations face significant foreign currency exchange rate exposure and currency restrictions
    which could negatively impact our operating results.

    We hold assets and incur liabilities, earn revenue and pay expenses in a variety of currencies other
    than the U.S. dollar, including the euro, British pound, Australian dollar, Canadian dollar, Mexican
    peso, Venezuelan bolivar fuerte and Russian ruble. Because our consolidated financial statements are
    presented in U.S. dollars, we must translate our assets, liabilities, revenue and expenses into U.S.
    dollars at then-applicable exchange rates. Consequently, changes in the value of the U.S. dollar may
    unpredictably and negatively affect the value of these items in our consolidated financial statements,
    even if their value has not changed in their original currency”

    Three areas of FX exposure:


    (1) Transaction exposure: Risk of transactions denominated in FX. The transaction should have a
    settlement or maturity date, T (today, 60 days, 90 days, 1 year, etc.).
    (2) Economic exposure: Degree to which a firm's expected cash flows are affected by unexpected
    changes in St.
    (3) Translation exposure: Accounting-based changes in a firm's consolidated statements that result from
    a change in St.

    Example: The different FX exposures.


    A. Transaction exposure.
    Swiss Cruises, a Swiss firm, sells cruise packages to U.S. customers priced in USD. SC also has
    several U.S. suppliers that price in USD.

    B. Economic exposure.
    SC has the majority of its costs denominated in CHF. Almost 50% of its revenue is in USD. The CHF
    appreciates against the USD. SC cannot increase the USD prices of its cruise packages (competitive
    business). SC’s net CHF cash flows will be affected.

    C. Translation exposure.
    SC has inventories in USD and a USD loan from a U.S. bank of equal USD amounts. These balance
    sheet items will be translated to CHF. Due to Swiss accounting rules, different exchange rates are used
    to translate USD inventories and the USD loan to CHF. Thus, an accounting gain/loss will be
    generated. ¶

    Q: How can FX changes affect the firm?

    IFM-LN.116
    • Transaction Exposure
    Short-term CFs: Existing contractual obligations

    • Economic Exposure
    Future CFs: Erosion of competitive position

    • Translation Exposure
    Revaluation of balance sheet (book value vs market value)

    Q #1: How do we measure these FX exposures?


    Q #2: How do we use these measures to manage FX exposures?

    10.1 Measuring TE
    TE is easy to identify and measure, especially in the short-run, when firms can forecast future CF with
    high accuracy.

    TE represents today’s value of a future, certain transaction denominated in FC translated to the DC:
    TE = Value of transaction denominated in FC x St

    Example: Swiss Cruises has sold cruise packages to a U.S. wholesaler for USD 2.5 million. Payment
    is due in 30 days.
    St = 1.45 CHF/USD.
    TE = USD 2.5 M x 1.45 CHF/USD = USD 3.625 M. ¶

    MNCs measure Net TE. If a subsidiary has CF>0 in EUR and another subsidiary has CF<0 in EUR,
    net TE might be very low.

    Example: Swiss Cruises.


    SC has sold cruise packages to a U.S. wholesaler for USD 2.5 million.
    SC has bought fuel oil for USD 1.5 million.
    Both cash flows are going to occur in T=30 days.
    St = 1.45 CHF/USD.

    TEEUR (in USD): (USD 2,500,000 - USD 1,500,000) x 1.45 CHF/USD = CHF 1,450,000. ¶

    An MNC, like GE or MSFT, has many transactions denominated in FC, say EUR, GBP, JPY, MXN,
    etc. Since all net TEs by currencies are translated to DC, TE is easy to aggregate in a single number,
    the company’s overall NTE:
    NTE = TEEUR + TEGBP + TEJPY + TEMXN + ...

    Usually, companies aggregate and report the overall NTE by maturity date, say “less than 90 days,”
    and “more than 90 days.”

    MNCs measure Net TE. If a subsidiary has CF>0 in EUR and another subsidiary has CF<0 in EUR,
    NTE might be very low.

    IFM-LN.117
    If we believe in the RW model, this is what we expect to happen at time T. Now, we know St will
    likely change at time T. We want to know how TE will be affected by changes in St. That is, we want
    to measure the FX risk involved with the transaction.

    To do this, we need to say something about the variability (volatility) of St.

    • Range Estimates of Transaction Exposure


    Exchange rates are volatile, difficult to forecast. A range estimate of NTE will provide a more useful
    number for risk managers. The smaller the range, the lower the sensitivity of the NTE => The lower
    the FX risk.

    Three popular methods for estimating a range for transaction exposure:


    (1) Ad-hoc Rule: Usually, assume a change in ef,t, for example  0.10.
    (2) Simulation/Sensitivity Analysis: We look at empirical distribution (ED) of St, simulating St+T.
    (3) Assuming a statistical distribution for St.

    1. Ad-hoc Rule
    Based on past experiences, a firm assumes that St can change (in either direction) by a fixed
    percentage. Then, it calculates the range of NTE under the assumed percentage.

    Example: SC wants to estimates the sensitivity of NTE to changes in the St. They use the 10% rule
    (ef,t =  0.10). (Recall: receivable USD 1 M due in 30 days.)
     if St changes by 10%, then NTE changes by CHF 145,000. ¶

    Note: This example presents a range for NTE. NTE  [USD 1.305M, USD 1.595 M]. The wider the
    range, the riskier an exposure is.

    The  percentage used depends on the volatility of the portfolio of currencies in NTE:
    Higher volatility in the currencies in the portfolio  A higher  percentage.

    2. Simulation/Sensitivity Analysis
    Goal: Measure the sensitivity of TE to different exchange rates.

    There are different ways to approach sensitivity analysis. Popular approaches: Look at the empirical
    distribution (ED), do a simulation.

    Examples: Sensitivity of TE to extreme forecasts of St.


    Sensitivity of TE to randomly simulated thousands of St. Then, draw a histogram to

    analyze the empirical distribution of TE.

    Example ED-I: Using the ED for SC’s Net TE (CHF/USD) over one month.
    Statistics for the Empirical Distribution (ED) of monthly ef,t over the past 27 years (1990-2017), for 325 ef’s:

    IFM-LN.118
    Minimun -0.12260
    0.25 -0.02066
    Median -0.00086
    0.75 0.00192
    Maximun 0.12570
    Average () -0.000886
    Standard Deviation () 0.03151
     Extremes: 15.09% (on September 2011) and –12.26% (on December 2008).

    (A) Best case scenario: largest appreciation of USD: 0.1509


    NTE: USD 1M x 1.45 CHF/USD x (1 + 0.12570) = CHF 1,632,265.

    (B) Worst case scenario: largest depreciation of USD: -0.1162


    NTE: USD 1M x 1.45 CHF/USD x (1 + (-0.12260)) = CHF 1,272,230.

    Based on these extremes, we estimate a range for TE


     TE  [CHF 1,272,230, CHF 1,632,265]

    Practical Application: If SC is counting on the USD 1M to cover CHF expenses, from a risk management
    perspective, the expenses to cover should not exceed CHF 1,281,510. ¶

    Note: Some firms may feel that this range, based on extremes, is too conservative. After all, the probability
    of the worst case scenario to happen is very low (only once in 248 months!). Under more likely scenarios,
    we may be able to cover more expenses with the lower bound.

    Simulating TE from Empirical Distribution


    A different range can be constructed through sampling from the ED. Typical simulation:

    (i) Randomly draw one scenarios from the ED -say, ef,t=Jun 1999.
    (ii) Calculate quantity of interest using simulated scenario -say, TE = USD 1M x St (1+ ef,t=Jun 1999).
    (iii) Repeat (i)-(ii) R times. This is your simulated distribution. Analyze it as usual (calculate mean, SD, (1-
    α)% C.I., etc.)

    Example ED-II: Simulation for SC’s Net TE (CHF/USD) over one month.
    Based on the ED, we will draw R = 1,000 ef,t realizations (past monthly ef,t.). Then, we calculate 1,000 TE
    for each scenario drawn. Steps:
    (i) Randomly draw ef,t = esim,1 from ED: Observation 19: ef,t = 0.0034.
    (ii) Calculate Ssim,1: St+30 = 1.45 CHF/USD x (1 + .0034) = 1.4549
    (iii) Calculate TEsim,1: TE = USD 1M x St+30 = 1,454,937.57
    (iv) Repeat (i)-(iii) 1,000 times. Plot the 1,000 TEs in a histogram. (This is your simulated TE distribution.)

    IFM-LN.119
    Lookup Random Draw Draw e_sim
    cell ef,t with Randbetween with Vlookup S_sim TE(sim)
    1
    2 0.0025 19 0.0034 1.4549 1,454,937.57
    3 -0.0027 147 -0.0104 1.4349 1,434,895.83
    4 0.0001 99 0.0125 1.4682 1,468,189.96
    5 -0.0443 203 -0.0584 1.3653 1,365,272.92
    6 -0.0017 82 -0.0727 1.3446 1,344,597.25
    7 -0.0031 4 0.0001 1.4502 1,450,168.79
    8 -0.0227 67 -0.0226 1.4172 1,417,218.22
    9 -0.0099 136 0.0095 1.4638 1,463,838.02
    10 0.0098 232 0.0191 1.4777 1,477,749.46

    Note: You can find this example in my homepage: www.bauer.uh.edu/rsusmel/4386/chfusd-sim.xls

    TE: Simulated Distribution (in CHF M)


    300
    250
    200
    150
    100
    50
    0
    More
    1.2815
    1.3074
    1.3332
    1.3590
    1.3848
    1.4106
    1.4365
    1.4623
    1.4881
    1.5139
    1.5397
    1.5656
    1.5914
    1.6172
    1.6430

    Based on this simulated distribution, we can estimate a 95% range (leaving 2.5% observations to the left and
    2.5% observations to the right)
     TE  [CHF 1.356775 M, CHF 1.52688 M]

    Practical Application: If SC expects to cover expenses with this USD inflow, the maximum amount in CHF
    to cover, using this 95% CI, should be CHF 1,356,775. ¶

    IFM-LN.120
    3. Assuming a Distribution
    Confidence intervals (CI) based on a distribution provide a range for TE. We will assume a normal
    distribution to construct a CI.

    Example: A firm can assume that St changes (ef,t) follow a normal distribution and based on this distribution
    construct a (1-)% confidence interval. Then, a 95% (=.05) CI is given by
    [  1.96 ]. (Instead of 1.96, you can use 2.) ¶

    Example: CI range based on a Normal distribution.


    Swiss Cruises believes that CHF/USD monthly changes (ef,t) follow a normal distribution. SC estimates the
    mean and the variance from the empirical distribution from past 20 years.
     = Monthly mean -0.000886 ≈ -0.09%
    2 = Monthly variance = 0.000992 (  = 0.03151, or 3.15%)
    ef,t ~ N(-0.00152, 0.031512).

    SC decides to construct a 95% CI for ef,t. Then, a 95% confidence interval is given by:
    [-0.000886  1.96*0.03151] = [-0.06365; 0.06087].

    Thus, ef,t is expected to be between -0.06365 and 0.006087 (with 95% confidence).

    Based on this range for ef,t, we derive bounds for the net TE:
    (A) Upper bound
    NTE: USD 1M x 1.45 CHF/USD x (1 + 06087) = CHF 1,538,267.

    (B) Lower bound


    NTE: USD 1M x 1.45 CHF/USD x (1 - 0.06365) = CHF 1,359,164.

     TE  [CHF 1.3592 M, CHF 1.5383 M]

    Interpretation of CI: If we have 100 transactions, with the same terms, we expect that in 95 of those
    transactions the TE will lie within the estimated 95% confidence interval.

    Note 1: VaR interpretation (VaR measures the worst case scenario within a one-sided CI):

    CHF 1,359,164 is the minimum revenue to be received by SC in the next 30 days, within a 97.5% CI.
    Notation: VaR(97.5%) = CHF 1,359,164..

    If SC expects to cover expenses with this USD inflow, the maximum amount in CHF to cover, within
    a 97.5% CI, should be CHF 1,359,164..

    The VaR is often expressed as a potential loss, relative to today’s value of the cash flow at risk (or
    expected value, using the RWM!). In this case, we call it VaR(mean):
    VaR(mean) = CHF 1,359,164.- CHF 1,450,000 = CHF -90,836.

    IFM-LN.121
    VaR(97.5%):
    Minimun revenue
    within a 97.5% C.I.

    2.5%
    CHF -90,836

    CHF 1.359M
    TE: CHF 1.45M

    Note 2: For a given data set, using logarithmic (geometric) returns, it is easy to extend the results to
    different maturities. Suppose we are interested in building a 95% C.I. for TE in q months, using data
    based on frequency n (say, n=1 month). Approximation formulas for mean and SD:
    q-mo mean = n-mo mean x q/n
    q-mo SD = n-mo SD x √ q/n)

    Suppose, in the above example, the maturity of the cash flows is extended to 3 months. Using the monthly
    data, we create a 95% C.I. for 3-mo TE. Then, q=3 and n=1:
    3-mo mean = -0.000886 x 3 = -0.00266
    3-mo SD = 0.03151 x √3 = 0.05458

    95% C.I. for ef,t: [-0.00266  1.96*0.05458] = [-0.10963; 0.10431]

    (A) Upper bound


    NTE: USD 1M x 1.45 CHF/USD x (1 + 0.10431) = CHF 1,601,254.

    (B) Lower bound


    NTE: USD 1M x 1.45 CHF/USD x (1 - 0.10963) = CHF 1,290,960. ¶

     Real World Example: Transaction Exposure: The Case of Kellogg


    The Kellogg Company is the world’s largest cereal company; second largest producer of cookies and
    crackers; and a major producer of snacks and frozen foods. The principal markets for these products
    include the U.S. and the Europe. Kellogg’s operations are managed in two major divisions –U.S. and
    International- with International further delineated into Europe, Latin America, Canada, Australia, and
    Asia. Operating profits for fiscal year 2014 were USD 1,024 million on sales of USD 14.58 billion.

    IFM-LN.122
    Primary exposures include the USD versus the EUR, GBP, MXN, AUD, CAD, VEF, and RUB, and
    in the case of inter-subsidiary transactions, the British pound versus the euro.

    The total notional amount of foreign currency derivative instruments at year-end 2014 was USD 764
    million, representing a settlement receivable of USD 23 million. The total notional amount of foreign
    currency derivative instruments at year-end 2013 was USD 517 million, representing a settlement
    obligation of USD 1 million. All of these derivatives were hedges of anticipated transactions,
    translational exposure, or existing assets or liabilities, and mature within 18 months. Assuming an
    unfavorable 10% change in year-end exchange rates, the settlement receivable would have become a
    settlement obligation of USD 53 million at year-end 2014 and the settlement obligation at year-end
    2013 would have increased by approximately USD 52 million.
    Source: Kellogg Annual Report 2014. 

    IFM-LN.123
    CHAPTER 10 - BONUS COVERAGE I: Value-at-Risk (VaR)
     VaR provides a number, which measures the market risk exposure of a portfolio of a firm over a given length
    of time. VaR measures the maximum expected loss in a given time interval, within a (one-sided) confidence
    interval. (This is what we call before VaR(mean).)

    Note: To calculate the VaR of a portfolio, we need to specify a time interval and the significance level for the
    confidence interval.

    Interpretation of VaR: VaR of a FX portfolio.


    Time interval: 1 day
    Level of significance (): 5% (zα=1.645, 95% C.I.)
    VaR of FX portfolio: USD 10,000.

    This VaR amount (USD 10,000) represents the potential loss of the FX portfolio in about one every twenty
    days within a 95% one-sided C.I.

    Banks report the VaR for their trading desk. They use =.01% ((zα=2.33, 99% C.I.) and T=10 days. Regulators
    use the reported VaR to calculate capital requirements (capital charge). Say,
    Capital charge = VaR x k, k>3.

    Example: Microsoft uses a VaR computation, within a 97.5% confidence interval, to estimate the maximum
    potential 20-day loss in the fair value of its foreign currency denominated investments and account receivables,
    interest-sensitive investments and equity securities. At the end of June 2001, Microsoft calculated a VaR of
    negligible for foreign currency instruments, USD 363 million for interest sensitive instruments, and USD 520
    million for equity investments. ¶

    IFM-LN.124
    CHAPTER 10 - BONUS COVERAGE II: The Normal Distribution
    Suppose the random variable X has a probability distribution function (pdf) given by:

    fX(x) = [1/(22)1/2] exp{-(x-)2/(22)} - < x < ,

    where  and 2 are any number such that -<<, and 0<2<. Then X is said to follow a normal distribution.
    We will use the following notation: X ~ N(,2). The pdf has the following bell shape:

    If Z follows a standard normal distribution then Z ~ N(0,1), that is the green function in the above graph. Using
    the formula of the pdf normal distribution, tables for the cdf of the standard normal distribution have been
    tabulated.

    1.B.1 Useful Results of the Normal Distribution

    Let X ~ N(,2). Then,

    (i) E[X] =  (the mean, , is also the mode and the median)
    (ii) Var(X) = E[(X-)2] = 2
    (iii) The shape of the pdf is a symmetric bell-shaped curve centered on the mean.
    (iv) Let Z = (X-)/. Then, Z  N(0,1).
    (v) If  and ß are any numbers with  < ß, then

    P[< X < ß] = P[(-)/ < Z < (ß-)/] = FZ[(ß-)/] - FZ[(-)/],

    where FZ represents the cdf of Z.

    Example: Let X be the annual stock returns (in percentage points) in the U.S. Assume that X ~ N(11.44,16.222).
    (The mean and variance of X have been obtained from annualizing the 1980-1990 U.S. weekly mean return
    and variance.) Suppose you are the manager of a portfolio that tracks the U.S. Index. You want to find the
    probability that your portfolio's return (X) is lower than -30% next year (i.e., a market crash).

    IFM-LN.125
    P[X < -30]= P[Z < (-30-11.44)/16.22]= P[Z < -2.55]= FZ[-2.55]= 1 - FZ[2.55]= 1 - .9878 = .0122.

    That is, the probability that next year stock return is lower than 30% is 1.22%. ¶

    Example: Go back to the previous example. Now, suppose you want to determine a minimum return, say %,
    with probability .95. That is, you want to find the probability that your portfolio's return exceeds a level  with
    probability .05. That is,

    .95 = P[X > ] = P[Z > (-11.44)/16.22] = 1 - FZ[(-11.44)/16.22].

    From the Normal Table, we obtain that if FZ(z) = .05, z = -1.645.

    Then, (-11.44)/16.22 = -1.645   = 11.44 - 1.645 (16.22) = -15.323.

    That is, there is a 95% probability that next year's portfolio return will be bigger than -15.323%. ¶

    Using the above properties, it is very easy to construct confidence intervals for the random variable X, which
    is normally distributed with mean  and variance 2. The key to construct confidence intervals is to select an
    appropriate z value, such that

    X [  zα/2 ] with a probability (1-).

    For a 99% confidence interval (i.e, =.01) z is equal to 2.58.


    For a 98% confidence interval (i.e, =.02) z is equal to 2.33.
    For a 95% confidence interval (i.e, =.05) z is equal to 1.96 (2).
    For a 90% confidence interval (i.e, =.10) z is equal to 1.645.

    IFM-LN.126
    Chapter 10 - Measuring FX Exposure – Part 2
    Three areas of FX exposure
    - Transaction exposure: associated with specific transactions (in FC).
    - Economic exposure: associated with futures cash flows –true exposure for owners.
    - Translation exposure: associated with a firm's consolidated statements.

    TE is simply to calculate: Value in DC of a specific transaction denominated in FC.

    We can measure TE, and analyze the sensitivity of TE to changes in St.


    Use a statistical distribution or a simulation.
    The less sensitive TE is to St, the lower the need to pay attention to changes in St.

    MNCs have measures for NTE for: - A single transaction


    - All transactions (Netting + taking into account co-
    movements of transactions. A portfolio approach)

    The portfolio approach incorporates correlations.

    Recall that the co-movement between two random variables can be measured by the correlation
    coefficient. The correlation between the random variables X and Y is given by:

    Corr(X,Y) = XY = XY/(YY).

    Interpretation of the correlation coefficient (xy [-1,1]):


    - If xy = 1, X changes by 10%, Y also changes by 10%.
    - If xy = 0, X changes by 10%, Y is not affected --(linearly) independent.
    - If xy = -1, X changes by 10%, Y also changes by -10%.

    Note: Currencies from developed countries tend to move together -i.e., positive correlations. But, there
    are periods where the correlations can be quite negative.

    IFM-LN.127
    • MNC take into account the correlations among the major currencies to calculate NTE
     Portfolio Approach.

    A U.S. MNC: Subsidiary A with CF(in EUR)>0


    Subsidiary A with CF(in GBP)<0
    GBP,EUR is very high and positive.
    Net TE might be very low for this MNC.

    Hedging decisions: Not made transaction by transaction. Rather, they are made based on the exposure
    of the portfolio.

    Example: Swiss Cruises.


    Net TE (in USD): USD 1 million. Payment: 30 days.
    Loan repayment: CAD 1.50 million. Payment: 30 days.
    St = 1.47 CAD/USD.
    CAD,USD = .924 (1990-2001)
    Swiss Cruises considers the Net TE (overall) to be close to zero. ¶

    Note: As seen in the previous graphs, currencies tend to move together, but not always. Correlations
    vary a lot across currencies. In general, regional currencies are highly correlated. From 2000-2007,
    the GBP and EUR had an average correlation of .71, while the GBP and the MXN had an average
    correlation of -.01. Correlations also vary over time.

    Correlation: GBP/US D and MXN/US D

    1
    4-year Correlation

    0.5

    0
    1985 1990 1995 2000 2005
    -0.5

    -1

    • Sensitivity Analysis for Portfolio Approach


    Do a simulation. That is, assume different scenarios (pay attention to the correlations!)

    Example: IBM has the following CFs in the next 90 days


    Outflows Inflows St Net Inflows
    GBP 100,000 25,000 1.60 USD/GBP (75,000)
    EUR 80,000 200,000 1.05 USD/EUR 120,000

    NTE (in USD) = EUR 120,000 * 1.05 USD/EUR + (GBP 75,000) * 1.60 USD/GBP =
    = USD 6,000 (this is our baseline case)

    IFM-LN.128
    Situation 1: Assume GBP,EUR = 1. (The correlation between the EUR and the GBP is high.)
    Scenario (i): EUR appreciates by 10% against the USD (ef,EUR=.10)

    Since GBP,EUR = 1, St = 1.05 USD/EUR * (1+.10) = 1.155 USD/EUR


    St = 1.60 USD/GBP * (1+.10) = 1.76 USD/GBP

    NTE (in USD) = EUR 120,000*1.155 USD/EUR+(GBP 75,000)*1.76 USD/GBP =


    = USD 6,600. (10% change = USD 600)

    Scenario (ii): EUR depreciates by 10% against the USD (ef,EUR=-.10)

    Since GBP,EUR = 1, St = 1.05 USD/EUR * (1-.10) = 0.945 USD/EUR


    St = 1.60 USD/GBP * (1-.10) = 1.44 USD/GBP

    NTE (in USD) = EUR 120,000*1.155 USD/EUR+(GBP 75,000)*1.76 USD/GBP =


    = USD 5,400. (-10% change = USD -600)

    Now, we can specify a range for NTE NTE  [USD 5,400, USD 6,600]

    Note: The NTE change is exactly the same as the change in St. If a firm has matching inflows and
    outflows in different currencies –i.e., the NTE is equal to zero-, then changes in St do not affect NTE.
    That’s very good.

    Of course, we will draw more than 2 scenarios, say 10,000 draws for ef,EUR and then draw a histogram
    with the 10,000 NTEs. Finally, we can draw a (1-α)% Confidence interval.

    Situation 2: Suppose the GBP,EUR = -1 (NOT a realistic assumption!)


    Scenario (i): EUR appreciates by 10% against the USD (ef,EUR=.10)

    Since GBP,EUR = -1, St = 1.05 USD/EUR * (1+.10) = 1.155 USD/EUR


    St = 1.60 USD/GBP * (1-.10) = 1.44 USD/GBP

    NTE (in USD) = EUR 120,000*1.155 USD/EUR+(GBP 75,000)*1.44 USD/GBP =


    = USD 30,600. (410% change = USD 24,600)

    Scenario (ii): EUR depreciates by 10% against the USD (ef,EUR=-.10)

    Since GBP,EUR = -1, St = 1.05 USD/EUR * (1-.10) = 0.945 USD/EUR


    St = 1.60 USD/GBP * (1+.10) = 1.76 USD/GBP

    NTE (in USD) = EUR 120,000*0.945 USD/EUR+(GBP 75,000)*1.76 USD/GBP =


    = (USD 18,600). (-410% change = USD -24,600)

    Now, we have a range for NTE  NTE  [(USD 18,600), USD 30,600]

    IFM-LN.129
    Note: The NTE has ballooned. A 10% change in exchange rates produces a dramatic increase in the
    NTE range. Having non-matching exposures in different currencies with negative correlation is very
    dangerous.

    Again, we will draw more than 2 scenarios, say 10,000 and then draw a histogram with the 10,000
    NTEs. Finally, we can draw a (1-α)% Confidence interval.

    In both situations, given the high correlations, IBM only draws one variable (ef,EUR). For the other
    situations, where the correlation is not very high, IBM will draw from the empirical distribution (ED).
    In this case, IBM will randomly draw pairs together –say, ef,EUR & ef,GBP- and then calculate NTE’s
    for each draw. ¶

    Alternatively, IBM can assume a distribution (say, bivariate normal) with a given correlation
    (estimated from the data) and, then, draw many scenarios for the St’s to generate an empirical
    distribution for the NTE. From this simulated distribution, IBM will get a range –and a VaR- for the
    NTE.

    Real World: Walt Disney Company’s VALUE AT RISK (VaR)


    According to Disney’s 2006 Annual Report:
    The Company utilizes a VaR model to estimate the maximum potential one-day loss in the fair value of its
    interest rate, foreign exchange and market sensitive equity financial instruments. The VaR model estimates
    were made assuming normal market conditions and a 95% confidence level. Various modeling techniques can
    be used in a VaR computation. The Company’s computations are based on the interrelationships between
    movements in various interest rates, currencies and equity prices (a variance/co-variance technique) These
    interrelationships were determined by observing interest rate, foreign currency, and equity market changes
    over the preceding quarter for the calculation of VaR amounts at fiscal 2006 year end.

    The estimated maximum potential one-day loss in fair value, calculated using the VAR model, is as follows
    (unaudited ,in millions):

    Interest Rate Currency Equity


    Sensitive Sensitive Sensitive
    Financial Financial Financial Combined
    (in millions) Instruments Instruments Instruments Portfolio
    VaR (year end 05) USD 22 USD 10 USD 1 USD 21
    Average VaR USD 19 USD 13 USD 0 USD 22
    Highest VaR USD 22 USD 15 USD 1 USD 24
    Lowest VaR USD 18 USD 10 USD 0 USD 18

    10.2 Measuring Economic Exposure


    EE: Risk associated with a change in the NPV of a firm's expected cash flows, due to an unexpected
    change in St.

    Q: How can we measure the degree to which CFs are affected by unexpected ef,t?
    A: Remember Random Walk. All changes in St are unexpected.

    IFM-LN.130
    Example: On February 2, 2015, Owens-Illionis (OI), the giant U.S. manufacturer of glass containers,
    reported its fourth-quarter results. OI reported that sales declined 9% year over year to USD 1.6 billion
    due to a stronger USD that adversely impacted sales by 6%. OI forecasted that, in 2015, earnings will
    be negatively impacted by the strong USD. The strong USD is expected to reduce translated sales by
    nearly 10%. This is economic exposure. ¶

    • The degree to which a firm is subject to EE depends on:


    - The type and structure of the firm
    - The industry structure in which the firm operates.

    In general, importing and exporting firms face a higher EE than purely domestic firms do.

    Industry structure is also very important. In general, monopolistic firms will face lower EE than firms
    that operate in competitive markets will.

    Example: Suppose a U.S. firm face almost no competition in the domestic market. This U.S. firm is
    able to transfer to its prices almost any increase of its costs due to changes in St. Thus, this firm faces
    no EE, since its CFs are unaffected by changes in St. ¶

    But, the degree of EE for a firm is an empirical question.

    • Economic exposure is: - Subjective.


    - Difficult to measure.

    Idea: To measure EE we need to relate future cash flows to changes in St.

    1. A Measure Based on Accounting Data


    It requires to estimate the net cash flows of the firm (EAT or EBT) under several FX scenarios. (Easy
    with an excel spreadsheet.)

    Example: IBM HK provides the following info:


    Sales and cost of goods are dependent on St
    St = 7 HKD/USD St = 7.70 HKD/USD
    Sales (in HKD) 300M 400M
    Cost of goods (in HKD) 150M 200M
    Gross profits (in HKD) 150M 200M

    Interest expense (in HKD) 20M 20M


    EBT (in HKD) 130M 180M

    EBT (in USD) at St = 7 HKD/USD: USD 130M/7 HKD/USD = USD 18.57M


    EBT (in USD) at St = 7.7 HKD/USD: USD 180M/7.70 HKD/USD = USD 23.38M

    IFM-LN.131
    A 10% depreciation of the HKD, increases the HKD cash flows from HKD 130M to HKD 180M, and
    the USD cash flows from USD 18.57M to USD 23.38 or a 25.9%.

    Q: Is EE significant?
    A: We can calculate the elasticity of CF to changes in St.
    For example, in USD, a 10% depreciation of the HKD produces a change of 25.9% in EBT, for a 2.59
    elasticity. It looks quite significant. But you should note that the change in exposure is USD 4.81M. This
    amount might not be very significant for IBM! A judgment call maybe needed here. ¶

    2. An Easy Measure of EE Based on Financial Data


    Sometimes, accounting data are not very relevant, since it measure the past. EE deals with futures cash
    flows. If available, changes in stock prices –i.e., returns- should be used –recall that stock prices measure
    discounted future cash flows.

    • We want to measure the correlation between CF and ef,t.


    ⇒ we can use the correlation coefficient between CF and ef,t.

    Example: Kellogg’s and DIS’s EE.


    Using monthly stock returns for Kellogg’s (Kret) and monthly changes in St (USD/TWC) from 1/1990-
    2/2015, we estimate ρK,e (correlation between Krett and ef,t) = 0.175. TWC represents a Trade Weighted
    Basket of Major Currencies. It looks small, but away from zero. We do the same exercise for Walt Disney
    (DIS), obtaining ρDIS,e = 0.070, small and close to zero. ¶

    Interesting result: Correlations between returns and changes in exchange rates are time-varying. Recessions
    and crises affect the relation. Below, we calculate the 12-month rolling correlation between the S&P returns
    and percentage changes in the USD/TWC, ef,t:

    After the financial crisis of 2007-2008, there is a higher correlation between stock returns and changes in
    exchanges rates. The average correlation is 0.29, which does not seem to be representative.

    IFM-LN.132
    It is better to run a regression on CF against unexpected ef,t, it gives us a test.

    Steps:
    (1) Collect data on CF and St (available from the firm's past).
    (2) Estimate the regression: CFt =  + ß ef,t + t,
     ß measures the sensitivity of CF to changes in ef,t.
     the higher ß, the greater the impact of ef,t on CF.
     the higher R2, the greater the explanatory power of ef,t.
    (3) Test for EE  H0 (no EE): β = 0
    H1 (no EE): β ≠ 0
    (That is, evaluation of regression: t-statistic of ß and R2.)

    Note: One thing to do: Replace CFt by stock returns. A better measure.
    Stock returns measure changes in discounted future cash flows.

    Example: Kellogg’s EE.


    Now, using the data from the previous example, we run the regression: Krett =  + ß ef,t + t,

    R2 = 0.03066
    Standard Error = 0.05821
    Observations = 303
    Coefficients Standard Error t Stat P-value
    Intercept (α) 0.006123 0.003344 1.831073 0.068078
    ef,t (β) 0.511863 0.16588 3.085745 0.002219

    We reject H0, since |tβ = 3.09| > 1.96 (significantly different than zero).
    Note, however, that the R2 is low! (The variability of ef explains 3% of the variability of Kellogg’s returns.)

    Example: DIS’s EE.


    Now, using the DIS data, we run the regression: IBMrett =  + ß ef,t + t,

    R2 = 0.00387
    Standard Error = 0.07389
    Observations = 303
    Coefficients Standard Error t Stat P-value
    Intercept (α) 0.010746 0.004245 2.531386 0.01187
    ef,t (β) 0.255634 0.210576 1.213973 0.22571

    We cannot reject H0, since |tβ =-1.21| < 1.96 (not significantly different than zero).
    The R2 is extremely low. (The variability of ef explains less than 0.4% of the variability of DIS’s returns.) ¶

    • Sometimes the impact of St is not felt immediately by a firm.


     contracts and short-run costs (short-term adjustment difficult).

    IFM-LN.133
    Example: For an exporting U.S. company a sudden appreciation of the USD increases CF in the short term.
    But, later, the export contract will be renegotiated.

    Run a modified regression: CFt =  + β0 ef,t + ß1 ef,t -1 + ß2 ef,t -2 + ß3 ef,t -3 + …+ ßQ ef,t-Q + t.
     Sum of the β’s measures the sensitivity of CF to changes in St (ef,t). ¶

    Practical issue: number of lags (Q in the modified regression)?


    Usual practice: include at most two years of information.

    Example: Kellogg runs the following regression to estimate EE with lags (t-stats in parenthesis):
    CFt = .006 + .478 ef,t + .264 ef,t -1 + .180 ef,t -2. R2= .045.
    (1.90) (2.87) (1.97) (1.08)

    K's CF (in USD) sensitivity to ef,t is 0.742 (=.478+. 264).


     a 1% depreciation of the USD increases CF (in USD) by 0.742%. ¶

    • Note on regressions to measure EE


    Changes in St (et,t) is not the only variable affecting a company’s stock returns. A company grows, adds
    assets, then higher sales and EPS are expected. Also, the economy and the stock market grow over time.
    We need to be careful and “control” for these other variables, to isolate the effect of ef,t.

    A multivariate regression will probably be more informative, where we can include other independent
    (“control”) variables (income growth, inflation, sales growth, assets growth, etc.), not just ef,t as
    determinants of the change in CFs (or stock returns).

    We can also borrow from the investments literature and use the three popular Fama-French factors (Market,
    Size (SMB), Book-to-Market (HML)) as controls. Then, we can run a regression to check if a company
    faces EE:

    Stock Returnt = α + β ef,t + δ1 Market Returnt + δ2 HMLt + δ3 SMBt + εt

    Example: Using the Fama-French Factors to compute Kellogg’s EE.


    Now, using the data from the previous example, we run the regression:
    Krett =  + β ef,t + δ1 Market Returnt + δ2 HMLt + δ3 SMBt + εt

    R2 = 0.0903
    Standard Error = 0.05676
    Observations = 302
    Coefficients Standard Error t Stat P-value
    Intercept 0.003981 0.003307 1.203665 0.229678
    Market (Rm-Rf) 0.003152 0.000821 3.842074 0.000149
    Size (SMB) -0.00061 0.001145 -0.52906 0.59716
    B-M (HML) 0.00191 0.000888 2.150606 0.032314
    ef,t (β) 0.300494 0.170147 1.766091 0.078408

    Note: You can find this, the previous (K and IBM) and other (DIS) examples in my homepage:

    IFM-LN.134
    www.bauer.uh.edu/rsusmel/4386/kellogg-euro.xls

    A higher R2 is mainly due to the market factor. But, looking at EE, once we control for other factors (the FF
    factors), we cannot reject H0, since |tβ = 1.77| < 1.96 (not significantly different than zero); that is, at the 5%,
    we cannot reject the null hypothesis of no economic exposure. ¶

    Evidence: The above regressions have been done repeatedly for firms around the world. (Without the FF
    factors, we have already done it for DIS and with the FF factors, we have already done it for Kellogg.) On
    average, for large firms (MNCs) EE is small –i.e., β is small- and not significant at the 5% level. See recent
    paper by Ivanova (2014).

     Real World Example: Economic Exposure - The Case of Ericsson


    Ericsson is very dependent on the behavior of the SEK and on economic conditions in Sweden.
    Around 40% of all employees and 25% of total production is located in Sweden, but Sweden accounts
    for just 3% of all sales. With this substantial cost base in SEK, for example, an appreciation of the
    SEK against the major currencies will have a negative impact on Ericsson’s cash flows. As a matter
    of fact, during the year 2000, the depreciation of the EUR against the SEK had a negative impact on
    Ericsson compared to Ericsson’s competitors with costs denominated in EUR. Usually, Ericsson does
    not hedge economic exposure. Source: Ericsson Annual Report 2000. 

    IFM-LN.135
    Chapter 10 - Measuring FX Exposure – Part 3
    Review from Chapter 10 – Parts 1 & 2:
    - TE is easy to calculate: Value in USD of specific transaction or portfolio of transactions.
    ⋄ Correlations are very important.

    - EE more difficult to measure. More subjective.


    ⋄ Accounting-based measures need to simulate EAT under different St.
    ⋄ Finance-based measures need CFt & ef,t. Use returns, not CFt. Run a regression.

    - Testing for EE: Use a linear regression model.


    ⋄ Stock Returnst =  + β ef,t + t
    H0 (No EE):  = 0
    H1 (EE):   0.

    Evidence: For large companies (MNCs, Fortune 500),  is not significantly different than zero. We
    cannot reject Ho: No EE.

     In this class, we will cover the last FX exposure: Translation exposure.

    10. 3 Translation Exposure


    Translation exposure: Risk from consolidating assets and liabilities measured in foreign currencies with
    those in the reporting currency.

    Assets and liabilities in a FC must be restated in terms of a DC. This translation follows rules set up by
    a parent firm's government or an accounting association –in the U.S., FASB.

    Problem: The translation involves complex rules that sometimes reflect a compromise between
    historical and current exchange rates.

    - Historical rates may be used for some equity accounts, fixed assets, inventories.
    - Current exchange rates are used for current assets, liabilities, expenses and income.

    Every item translated at historical rates is not exposed to changes in St.


    Note: Different exchange rates are used, imbalances will occur.

    Key issue: What to do with the resulting imbalance? It is taken to either current income or equity
    reserves.

    Measuring Translation Exposure

    There are several methods to translate foreign currency accounts into the reporting currency. Two
    methods that predominate:
    ⋄ Temporal method (monetary/nonmonetary method)

    IFM-LN.136
    ⋄ Current rate method

    Terminology:
    Monetary: there is a date attached to the asset or liability.
    Three exchange rates can be used:
    S0: Historical exchange rate.
    St: Current exchange rate at the date of balance.
    SAVERAGE: Average exchange rate for the period.

    FASB #8 - Temporal Method (1976-1982)


    - Translate nonmonetary assets at S0, assets and liabilities use St
    - Translate most income statements items at the SAVERAGE
    - Translate shareholder equity at S0
    - Bookkeeping exchange gains or losses are passed to the Income statement

    FASB #52 - Current Rate Method (since 12/15/1982)


    - Translate most amounts at St
    - Income statement items are translated at S0 or SAVERAGE
    - Translate shareholder equity at S0
    - Exchange gains or losses are not reflected in income statement rather accumulate in an adjustment
    account in stockholders' equity: Cumulative translation adjustment (CTA).
    - Distinguished between functional currency (usually local currency) and reporting currency (currency
    the parent firm uses to prepare own financial statements)

    - Exceptions to FASB #52


    1. Subsidiaries who mostly deal with parent, functional currency: USD => translate using temporal
    method.
    2. Subsidiaries in hyperinflationary countries (100%+ over 3 years), functional currency: USD =>
    translate using temporal method.

    IFM-LN.137
    Example: IBM Hong Kong has the following balance sheet.

    IBM Hong Kong Balance Sheet in millions of HKD


    Balance CR Temporal
    accounts exposure exposure
    Assets
    Cash 300 300 300
    Accounts receivable 850 850 850
    Inventory 400 400 N.ex.
    Net fixed plant and equip. 1,000 1,000 N.ex.
    Total assets 2,550
    Total exposed assets 2,550 1,150

    Liabilities and Capital


    Accounts payable 200 200 200
    Notes payable 300 300 300
    Long-term debt 900 900 900
    Shareholder's equity 1,150 N.ex. N.ex.
    Total liabilities and capital 2,550
    Total exposed liabilities 1,400 1,400

    Net exposed assets 1,150 -250

    At St = .128 USD/HKD, IBM’s exposure (in USD):


    Current rate method: HKD 1,150,000,000 x .128 USD/HKD = USD 147,200,000
    Temporal method: HKD -250,000,000 x .128 USD/HKD = USD -32,000,000 ¶

    Real World Example: Translation Exposure - The Case of Ericsson


    Ericsson has many subsidiaries outside Sweden.

    For most of the subsidiaries, the local currency is the currency in which the companies
    operate => local currency is the functional (business) currency.
    Financial statements are translated to SEK using the current rate method.
    For some subsidiaries (“integrated companies”), having very close relations with the Swedish
    operations => SEK is the functional currency
    Financial statements are translated using the temporal method.

    Translation exposure in foreign subsidiaries is hedged:


     Monetary net in companies translated using the temporal method (translation effects in investment
    affecting the income statement) is hedged to 100%.
     Equity in companies translated using the current rate method (translation effects reported directly in
    stockholders’ equity in the balance sheet) is hedged selectively up to 20% of the total equity.

    The translation differences reported in equity, during the year 2000, were SEK 2.0 billion, mainly due
    to a weaker SEK. Source: Ericsson Annual Report 2000.

    IFM-LN.138
    CHAPTER 10 – BRIEF ASSESMENT

    1. It is March 3, 2017. Malone, a U.S. company, exports mining equipment to South Africa. Malone expects to
    receive a payment of ZAR 500 million in August 3, 2017 (ZAR=South African Rand).

    (A) Calculate TE
    (B) Use the information given in the attached Excel output (based on 15 years of 5-mo changes) to calculate:
    i) The VaR associated with Malone’s open position (use a 97.5% C.I.).
    ii) The VaR-mean (97.5%). Interpret this number.
    iii) The worst case scenario for Malone.

    The information below is based on monthly percentage changes from 2001:9 to 2016:12.
    5-mo % change ZAR/USD

    Mean 3.117%
    Standard Error 0.854%
    Median 1.803%
    Mode #N/A
    Standard Deviation 9.355%
    Sample Variance 0.875
    Kurtosis 143.329
    Skewness 48.399
    Range 61.127%
    Minimum -22.970%
    Maximum 38.157%
    Sum 374.077
    Count 183

    2. You work for Vandelay Industries, U.S. MNC. Vandelay gives you the following projections for next year:
    Currency Total inflows Total outflows Current Exchange rate
    GBP GBP 25,000 GBP 40,000 1.40 USD/GBP
    KUD KUD 600,000 KUD 400,000 0.40 USD/KUD (KUD=Kuwaiti Dinar)

    (A) What is Vandelay's net transaction exposure (NTE)?


    (B) Suppose the GBP and the KUD are perfectly and positively correlated (=1). The USD/GBP exchange rate
    increases to 1.68 USD/GBP. What is the change in net transaction exposure for Vandelay?
    (C) Suppose the GBP and the KUD have zero correlation (=0). The USD/GBP exchange rate increases to 1.68
    USD/GBP. What is the change in (expected) net transaction exposure for Vandelay?

    IFM-LN.139
    3. HM Sweden provides the following info:
    Sales and cost of goods are dependent on St (SEK/USD, SEK=Swedish Kroner). All numbers are in
    millon kroners.
    St = 7 SEK/USD St = 6.3 SEK/USD
    Sales (in SEK) 400 550
    Cost of goods (in SEK) 150 200
    Gross profits (in SEK) 250 350

    Depreciation (in SEK) 50 50


    Interest expense (in SEK) 20 20
    Taxes (in SEK) 70 110

    A. Calculate the elasticity of free CF (measured as EAT+Depreciation) to changes in St.


    B. Interpret the elasticity.

    4. You want to test if MSFT faces EE. You collect data from January, 1990 to April 2017, for a total of 328
    observations. You run two regressions, using monthly data:
    returnst =  + ß ef,t + t,
    and
    returnst =  + ß ef,t + δ1 (Rmarket,t-Rf) + δ2 HMLt + δ3 SMBt + εt.

    Using the excel output (shown below) test if MSFT has faced EE during your sample.

    R Square 0.011907

    Coefficients SE t Stat
    Intercept 0.018569 0.005069 3.662978
    ef,t 0.499677 0.2521 1.982063

    R Square 0.327083

    Coefficients SE t Stat
    Intercept 0.011673 0.004262 2.739086
    Rmarket,t-Rf 1.250846 0.105388 11.86891
    HML -0.16682 0.134013 -1.24478
    SMB -1.53667 0.593604 -2.58871
    ef,t -0.28523 0.2186 -1.30478

    IFM-LN.140
    Chapter 11 - Managing TE – Part 1
    We have two ways to manage TE (to hedge FX exposure):
    - Using Internal Methods (special contracts/organization/restructure)
    - Using External Methods (market tools)
    ⋄ Forwards/Futures
    ⋄ Options
    ⋄ Money Market (same as IRP)

    11.1 Internal Methods


    ⋄ Risk Shifting: Pricing in DC (no FX risk, but no flexibility to accommodate clients).

    Example: Boeing exports planes to TAM Airlines, a Brazilian company. The transaction is priced (&
    settled) in USD. Boeing faces no FX risk from this transaction; TAM takes all the FX risk. ¶

    ⋄ Risk Sharing: Two parties can agree -using a customized hedge contract- to share the FX risk involved
    in the transaction.

    Example: Levi’s buys cotton for USD 1 million from Nakatami Cotton (NC). Payment in JPY.
    Risk sharing agreement:
    • If St[98 JPY/USD, 140 JPY/USD]  transaction unchanged. (Levi’s pays USD 1M to NC)
    The range where the transaction is unchanged is called neutral zone.
    • If St < 98 JPY/USD or St > 140 JPY/USD  both companies share the risk equally, by setting a
    different exchange rate to settle the transaction.

    Suppose that when Levi’s has to pay NC, St = 180 JPY/USD.


    The St used in settling the transaction is 160 JPY/USD (=180 - 40/2).
     Levi’s's final cost = JPY 160 million = USD 888,889 < USD 1M. ¶

    ⋄ Leading and Lagging (L&L): Accelerating or decelerating the timing of FC payments:


     leading or lagging the movement of funds.

    L&L is done between the parent company and its subsidiaries or between two subsidiaries.

    Example: Managing TE with L&L.


    Parent company: IBM (US company).
    Subsidiaries: Mexico, Brazil, and Hong Kong. (IBM Mexico and IBM owe payables to IBM HK.)
    Situation: IBM Hong Kong's exposure, due to payables in FC, is too large.

    IBM orders IBM Mexico and IBM Brazil to accelerate (lead) its payments to IBM HK. ¶

    ⋄ Natural hedging: Natural hedges are created by payment obligations and/or receivables that have, at
    least, partially offsetting foreign currency risk.

    IFM-LN.141
    Example: A U.S. company imports machine parts from Germany priced in euros. This transaction
    exposure is partially offset by sales of machines to Spain, also priced in euros. ¶

    In situations where natural hedges exist, companies should only consider hedging the net transaction
    exposure, not the individual transaction.

    11.2 External Methods


    Use market instruments to hedge TE exposure:
    ⋄ Forwards/Futures
    ⋄ Options
    ⋄ Money Market (same as IRP, without covering step)

    We will go over two cases: (1) Receivables in FC


    (2) Payables in FC

    Example 1: CASE I - Receivables in FC


    MSFT exports Windows to Switzerland for CHF 3M Payment due in 90 days.
    St = 0.60 USD/CHF
    TE(in USD) = CHF 3M * 0.60 USD/CHF = USD 1.8M

    To manage TE, MSFT considers the following tools: forwards/futures, options, Money market
    instruments (used to replicate IRPT). MSFT also considers keeping the position open –i.e., no
    hedging.

    Hedging Tools- Futures/Forwards/Options/Money Market Hedge/Do Nothing

    Data:
    Interest USD = 5% - 5.125%
    Interest CHF = 4% - 4.25%
    Ft,90-day = .650 USD/CHF - .651 USD/CHF
    Put (Xp = 0.64 USD/CHF; pp = USD .059-.060)
    Call (Xc = 0.63 USD/CHF; pc = USD .019-.020)
    T = 90 days
    Possible scenarios for St+90 (distribution for St+90 based on the ED)
    St+90 (USD/CHF) Probability
    0.58 .10
    0.62 .10
    0.65 .50
    0.68 .30

    1. Forward Hedge – Sell Forward CHF


    Sell CHF forward at Ft,90-day = .65 USD/CHF
    Amount to be received in 90 days = CHF 3M * 0.65 USD/CHF = USD 1.95M

    Note: No uncertainty. MSFT will receive USD 1.95M, regardless of St+90.

    IFM-LN.142
    2. MMH (Replication of IRP) – borrow FC, convert to DC, deposit in domestic bank
    Today, we do the following: (1) Borrow CHF at 4.25%
    (2) Convert to USD at 0.60 USD/CHF
    (3) Deposit in US Bank at 5%
    MMH Calculations:
    Amount to be borrowed = CHF3M/(1+.0425*90/360) = CHF 2.9684M
    CHF 2.9684M * 0.60 USD/CHF = USD 1.781M = amt to be deposited in US Bank
    Amount to be received in 90 days = USD 1.781M (1+.05*90/360) = USD 1.8032M
    Note: There is no uncertainty about how many USD MSFT will receive for CHF 3M.

    Compare FH vs MMH: MSFT should select the FH. MMH is dominated by FH.

    3. Option Hedge -Buy CHF puts: Xp = 0.64 USD/CHF, pp = USD .06/CHF


    Floor = 0.64 USD/CHF * CHF 3M = USD 1.92 M - Total premium cost
    Premium cost = CHF 3M * USD .06/CHF = USD .18M
    Opportunity Cost (OC) = USD .18M*.05*.25=USD .0025M

    Total premium cost = Premium cost + OC = USD .1825M

    Scenarios
    St+90 (USD/CHF) Probability Exercise? Amount received (Net of cost, in USD)
    0.58 .20 Yes 1.92M - .1825M = 1.7375M
    0.62 .20 Yes 1.92M - .1825M = 1.7375M
    0.65 .50 No 1.95M - .1825M = 1.7675M
    0.68 .30 No 2.04M - .1825M = 1.8575M

    E[Amount to be received in 90 days] = (1.7375)*.2 + (1.7675)*.5 + (1.8575)*.3 = 1.7885M

    Notes:
    1. An option establishes a worst case scenario. In this case, MSFT establishes a floor, a minimum
    amount to be received: USD 1.92M (or net USD 1.7375).
    2. The opportunity cost (OC) is included to make a fair comparison with FH and MMH, which require
    no upfront payment. (OC=Time value of money!)

    Compare FH vs OH: FH seems to be better; but preferences matter. A risk taker may like the 30%
    chance of doing better with the OH.

    4. No Hedge (Leave position open, that is, do nothing and wait 90 days)

    Scenarios
    St+90 (USD/CHF) Probability Amount received (Net of cost)
    0.58 .10 USD 1.74M
    0.62 .10 USD 1.86M
    0.65 .50 USD 1.95M
    0.68 .30 USD 2.04M

    IFM-LN.143
    E[Amount to be received in 90 days] = USD 1.947M

    Compare FH vs NH: NH seems to be better. But, preferences matter (a very conservative manager
    might not like the 20% chance of the NH doing worse than the FH).

    Graph 11.1: General CF Diagram for all Strategies

    Payoff Diagram for MSFT

    Net Amount
    Received in No Hedge
    Put

    t+90

    Forw ard
    USD 1.83M

    USD 1.7375M

    .63 .64 .671 St+90

    In general, the preference of one alternative over another will depend on the probability
    distribution of St+90. If the probability of St+90>.63 USD/CHF is very low, then the forward hedge
    dominates.

    Q: Where do the probabilities come from? We can estimate them using the empirical distribution
    (ED).

    Example 2: CASE II - Payables in FC


    MSFT has payable in GBP for GBP 10M in 180 days.
    St = 1.60 USD/GBP
    TE(in USD) = USD 16M
    MSFT decides to manage this TE with the following tools:
    Hedging Tools: Futures/Forwards/Options/Money Market Hedge/Do Nothing

    Data:
    Interest USD = 5% - 5.25%
    Interest GBP = 6% - 6.5%
    Ft,180-day = 1.578 - 1.580 USD/GBP
    Put (Xp = 1.64 USD/GBP; pp = USD .05)
    Call (Xc = 1.58 USD/GBP; pc = USD .03)
    Distribution for St+90
    St+90 (USD/GBP) Probability
    1.55 .30

    IFM-LN.144
    1.59 .60
    1.63 .10

    Which alternative is best? The hedge that delivers the least USD amount

    1. FH – Buy forward GBP


    Amount to be paid in 180 days = GBP 10M * 1.580 USD/GBP = USD 15.8M

    2. MMH – Borrow DC, convert to FC, deposit in foreign bank


    Today, we do the following: (1) Borrow USD at 5.25%
    (2) Convert to GBP at 1.60 USD/GBP
    (3) Deposit in UK Bank at 6%
    MMH Calculations (we go backwards):
    Amount to deposit = 10M/[1+(.06*180/360)] = GBP 9.708M
    Amount to borrow = GBP 9.708M * 1.60 USD/GBP = USD 15.533M
    Amount to repay = USD 15.533 *(1+.0525*180/360) = USD 15.94M

    Compare FH vs MMH: FH is better

    3. Option Hedge – Buy GBP calls: Xc= 1.58 USD/GBP, pc = USD .03/GBP
    Cap = GBP 10M * 1.58 USD/GBP = USD 15.8M
    Total premium cost = Total premium + OC = 10M*USD .03/GBP*(1+.05*.5) = USD .31M

    Scenarios
    St+90 (USD/GBP) Probability Exercise? Amount paid (Net of cost, in USD)
    1.55 .30 No USD 15.5M + .31M = USD 15.81M
    1.59 .60 Yes USD 15.8M + .31M = USD 16.11M
    1.63 .10 Yes USD 15.8M + .31M = USD 16.11M

    E[Amount to be paid in 180 days] = USD 16.02M

    Compare FH vs OH: FH is better always. (Preferences do not matter.)

    Note: Again, the option establishes a worst case scenario. In this case, MSFT establishes a cap, a
    maximum amount to be paid: USD 15.8M (or net USD 16.11M).

    4. No Hedge –leave position open; that is, do nothing and wait.


    E[Amt] = GBP 10M [1.55(.3)+1.59(.6)+1.63(.1)] = USD 15.82M

    Compare FH vs OH: FH is the most likely choice; but preferences matter.

     Summary of Strategies

    IFM-LN.145
    Receivables in FC Payables in FC
    Forward Hedge (FH) Sell FC at Ft,T Buy FC at Ft,T
    Money Market Hedge (MMH) Borrow FC at iFC, Borrow DC at iDC,
    Convert to DC at St, Convert to FC at St,
    Deposit DC at iDC Deposit FC at iFC
    Option Hedge (OH) Buy FC puts; pay pp Buy FC calls; pay pc

    11.2.1 Options hedging (with different X)


    With options it is possible to play with different strike prices –different insurance coverage.

    Key Intuition: The more the option is out of the money, the cheaper it is.
    The higher the cost, the better the coverage.

    Example: Revisit MSFT payables situation: MSFT has to pay GBP 10M in 180 days.
    Notation: Xj = Strike Price (j = call; put)
    pj = Option premium (j = call; put)
    St = 1.60 USD/GBP
    Options available:
    Xc = 1.56 USD/GBP, pc = USD .08, T=180 days (call)
    Xc = 1.58 USD/GBP, pc = USD .07, T=180 days (call)
    Xc = 1.63 USD/GBP, pc = USD .05, T=180 days (call)
    Xc = 1.65 USD/GBP, pc = USD .04, T=180 days (call)
    Xp = 1.58 USD/GBP, pp = USD .055, T=180 days (put)
    Xp = 1.61 USD/GBP, pp = USD .095, T=180 days (put)

    1. Out-of-the-Money (St < X)


    Alternative 1: Call used: Xc = 1.63 USD/GBP, pc = USD .05
    Cost = Total premium = GBP 10M * USD .05/GBP = USD 500K
    Cap = worst amount to be paid = 1.63 USD/GBP * GBP 10M = USD 16.3M
    (Net cap = USD 16.8)
    Alternative 2: Call (Xc =1.65 USD/GBP, pc = USD .04)
    Cost = GBP 10M * USD .005/GBP = USD 400K
    Cap = 1.65USD/GBP * GBP 10M = USD 16.5M  Net cap = USD 16.9M

    Note: The tradeoff is very clear: The higher the cost, the better the coverage.

    2. (Closest At-the-money) In-the-money (St  X)


    Call used: Xc = 1.58 USD/GBP, pc = USD .07
    Cost = Total premium = USD 700K
    Cap = USD 15.8M  Net cap = USD 16.5M

    Compare to Out-of-the-money: Advantage: Lower cap.

    IFM-LN.146
    Disadvantage: Its cost.

    Companies do not like to pay high premiums. Many firms finance the expense of an option by
    selling another option. A typical strategy: A collar (form a portfolio with one put and one call:
    Long one option, short the other).

    3. Collar (buy one call, sell one put. In general, both are OTM)
    Buy Call (Xc = 1.63 USD/GBP, pc = USD .05);
    Sell Put (Xp = 1.58 USD/GBP, pp = USD .055)
    Collar’s premium = USD .05 - USD .055 = USD -0.005 (negative!)

    Cost = GBP 10M*USD (-.005/GBP) = USD -50K


    Cap = 1.63 USD/GBP * GBP 10M = USD 16.3M
    Floor = Best case scenario = 1.57 USD/GBP*GBP 10M = USD 15.7M
     Net cap = USD 16.25; Net floor = USD 15.65M

    Notes:
    ⋄ With a collar you get a lower cost (advantage), but you give up the upside of the option
    (disadvantage)  there is always a trade-off!
    ⋄ Zero cost insurance is possible  sell enough options to cover the premium of the option you
    are buying.

    IFM-LN.147
    CHAPTER 11 - BONUS COVERAGE: Getting probabilities from the Empirical Distribution
    Firms will use probability distributions to make hedging decisions. These probability distributions can
    be obtained using the empirical distribution, a simulation, or by assuming a given distribution. For
    example, a firm can assume that changes in exchange rates follow a normal distribution. Here, we present
    an example on how to use the empirical distribution.

    Example: We want to get probabilities associated with different exchange rates. Let’s take the
    historical monthly USD/AUD exchange rates 1976:1-2017:1. First, we transform the data to
    changes (ef,t). Excel produces a histogram, with bins and frequency. Below we show the bins for
    ef,t frequency and relative frequency. We calculate St+30 = St * (1+ef,t). Today, St =0.7992
    USD/AUD.

    ef,t (USD/AUD) Frequency Rel frequency St =.7992*(1+ef,t)


    ‐0.17761  1  0.002049  0.657257 
    ‐0.16533  1  0.002049  0.667066 
    ‐0.15306  0  0  0.676874 
    ‐0.14079  0  0  0.686682 
    ‐0.12852  0  0  0.69649 
    ‐0.11624  1  0.002049  0.706298 
    ‐0.10397  1  0.002049  0.716106 
    ‐0.0917  2  0.004098  0.725914 
    ‐0.07943  4  0.008197  0.735722 
    ‐0.06715  4  0.008197  0.745531 
    ‐0.05488  6  0.012295  0.755339 
    ‐0.04261  12  0.02459  0.765147 
    ‐0.03034  29  0.059426  0.774955 
    ‐0.01806  56  0.114754  0.784763 
    ‐0.00579  86  0.17623  0.794571 
    0.006481  91  0.186475  0.804379 
    0.018753  82  0.168033  0.814187 
    0.031025  54  0.110656  0.823996 
    0.043298  29  0.059426  0.833804 
    0.05557  18  0.036885  0.843612 
    0.067843  8  0.016393  0.85342 
    0.080115  3  0.006148  0.863228 
    More  5  0.010246  0.871128 

    IFM-LN.148
    You can plot the histogram to get the above empirical distributions.

    IFM-LN.149
    Chapter 11 - Managing TE – Part 2
    Hedging with Options gives us more instruments to choose from  different strike prices (X):
    1. Out of the money (cheaper)
    2. In the money (more expensive)

    • Review: Reading Newspaper Quotes


    Typical Newspaper Quote

    PHILADELPHIA OPTIONS (PHLX is the exchange)


    Wednesday, March 21, 2007 (Trading Date)
    Calls Puts => (Contracts traded)
    Vol. Last Vol. Last => (Vol.=Volume, Last=Premium)
    Australian Dollar 79.92 => (St=.7992 USD/AUD)
    10,000 Australian Dollars-cents per unit. => (AUD 10,000=Size, prices in
    78 June 9 3.37 20 1.49 USD cents)
    79 April 20 1.79 16 0.88
    80 May 15 1.96 8 2.05
    80 June 11 2.29 9 2.52
    82 June 1 1.38 2 3.61
    ↑ ↑ ↑ ↑
    X=Srike T=Maturity Call Premium Put Premium
    Price

    Example: Payable AUD 100M in Mid-June


    St= .7992 USD/AUD

    Xcall-June = .78 USD/AUD, P = USD .0337


    Xput-June = .78 USD/AUD, P = USD .0149
    Xcall-June = .80 USD/AUD. P = USD .0229
    Xput-June = .80 USD/AUD. P = USD .0252
    Xcall-June = .82 USD/AUD, P = USD .0138
    Xput-June = .82 USD/AUD. P = USD .0361

    1. Out-of-the-money: Xcall-June = 0.82 USD/AUD (or Xcall-June = .80 USD/AUD, almost ATM)
     Xcall-June = 0.82 USD/AUD, Premium = USD .0138
    Cost = Total premium = AUD 100M * USD .0138/AUD = USD 1.38M
    Cap = AUD 100M x 0.82 USD/AUD = USD 82M (Net cap = USD 83.38M)

     Xcall-June = 0.80 USD/AUD, Premium = USD .0229 (almost ATM)


    Cost = Total premium = AUD 100M * USD .0229/AUD = USD 2.29M
    Cap = AUD 100M x 0.82 USD/AUD = USD 80M (Net cap = USD 82.29M)

    2. In the Money: Xcall-June = 0.78 USD/AUD, Premium = USD .0337


    Cost = Total premium = USD 3.37M

    IFM-LN.150
    Cap = USD 78M (Net cap = USD 81.37M)

    Note: The higher the cost, the lower the cap established for the AUD 100M (payables). ¶

    Example: Receivables AUD 20M


    1. Out-of-the-money: Xput-June = 0.78 USD/AUD
    Cost = Total premium = AUD 20M * USD .0149/AUD = USD 298K
    Floor = 0.78 USD/AUD x AUD 20M = USD 15.6M (Net Floor = USD 15.302M)

    2. In the money: Xput-June = 0.82 USD/AUD, (or Xput-June =.80 USD/AUD –ATM)
     Xput-June = 0.82 USD/AUD
    Cost = Total premium = AUD 20M * USD .0361/AUD = USD 722K
    Floor = 0.82 USD/AUD * AUD 20M = USD 16.4M (Net Floor = USD 15.678M)

     Xput-June = 0.80 USD/AUD (ATM option)


    Cost = Total premium = USD 504K
    Floor = USD 16M (Net Floor = USD 15.496M)

    Note: The higher the cost, the higher the floor for the AUD 20M (receivables). ¶

    Lesson from these 2 examples:


    1) Options offer the typical insurance trade-off: Better coverage (lower cap, higher floor) =>
    Higher cost (higher premium)
    2) Insurance is expensive. For example, for the Xput-June = 0.80 USD/AUD case, it costs USD
    .504M to insure USD 15.496M (a 3.2% premium).

    Q: Is it possible to lower the cost of insurance lower?


    A: With a Collar (buy put, sell call/buy call, sell put).

    Example: Buy Xput-June = 0.78 USD/AUD (P = USD .0149)


    Sell Xcall-June = 0.82 USD/AUD (P = USD .0138)

    Cost = 20M x [USD .0149 - USD .0138] = 22K (very close to zero!)
    Floor = USD 15.6M (Net Floor = USD 15.578M)
    Cap = 20M x 0.82 USD/AUD = USD 16.4M (Net Cap = Best case scenario = USD 16.378M)

    A collar is cheaper, but it limits the upside of the option.


    Note: zero (or almost zero) cost insurance is possible! ¶

    IFM-LN.151
    Real World: Walt Disney Company
    According to Disney’s 2006 Annual Report:
    The Company utilizes option strategies and forward contracts that provide for the sale of foreign currencies
    to hedge probable, but not firmly committed transactions. The Company also uses forward contracts to hedge
    foreign currency assets and liabilities. The principal foreign currencies hedged are the AUD, GBP, JPY and
    CAD. Cross-currency swaps are used to effectively convert foreign currency denominated borrowings to
    USD denominated borrowings. By policy, the Company maintains hedge coverage between minimum and
    maximum percentages of its forecasted foreign exchange exposures generally for periods not to exceed five
    years. The gains and losses on these contracts offset changes in the value of the related exposures.

    IFM-LN.152
    CHAPTER 11 – BRIEF ASSESMENT

    1. It is March 3, 2017. Malone, a U.S. company, exports mining equipment to South Africa. Malone
    expects to receive a payment of ZAR 500 million in August 3, 2017 (ZAR=South African Rand).
    Malone decides to hedge this exposure using an August forward contract, which expires on August 3,
    2012. The 1-month, 3-month and 5-month South African interest rates are 8.5%, 8.7% and 9%, while
    the 1-month, 3-month and 5-month U.S. interest rates are 0.3%, 0.5% and 0.8%, respectively. On
    March 3, the spot exchange rate is 15.62 ZAR/USD and the August 3 forward trades at 16.15
    ZAR/USD. A Bank offers Malone OTC options with expiration August 3 with the following prices
    (in USD cents –i.e., 6.3 USD cents=USD 0.063):
    ZAR August 6.3 p (put) 0.07
    ZAR August 6.3 0.24

    (A) Calculate the amount to be received on August 3, using a forward hedge.


    (B) Calculate the amount to be received on August 3, using the PHLX option.

    2. MSFT has a payable in GBP. Details:


    Amount = GBP 10M
    T= 180 days.
    St = 1.35 USD/GBP
    TE (in USD) = USD 13.5M
    MSFT decides to manage this TE with the following tools:
    Hedging Tools: Futures/Forwards/Options/Money Market Hedge/Do Nothing

    Data:
    Interest USD = 2% - 2.25%
    Interest GBP = 3% - 3.5%
    Ft,180-day = 1.341 - 1.344 USD/GBP
    Put (Xp = 1.34 USD/GBP; pp = USD .03)
    Call (Xc = 1.38 USD/GBP; pc = USD .02)
    Distribution for St+90
    St+90 (USD/GBP) Probability
    1.33 .30
    1.37 .60
    1.42 .10

    Which alternative is best?

    3. A U.S. company has AUD 20M receivables in mid-June 2007. Using the PHLX quotes, reported
    below, construct the following hedges (calculating total premium cost and worst case scenario):
    (A) OTM
    (B) ITM
    (C) Collar (using out-of-the money options)

    IFM-LN.153
    PHILADELPHIA OPTIONS
    Wednesday, March 21, 2007
    Calls Puts
    Vol. Last Vol. Last
    Australian Dollar 79.92
    10,000 Australian Dollars-cents per unit.
    78 June 9 3.37 20 1.49
    79 April 20 1.79 16 0.88
    80 May 15 1.96 8 2.05
    80 June 11 2.29 9 2.52
    82 June 1 1.38 2 3.61

    IFM-LN.154
    Chapter 12 – Managing Economic Exposure (EE)
    Review from Chapter 10.
    -EE: It measures how future CFs are affected by percentage changes in St (ef).
    - Measures: 1) Accounting measures (simulate EAT under different exchange rates)
    2) Regressions using CFs or stock market returns.

    Q: Is EE significant –i.e., should we do something about it?


    A) Use a regression. Measure an elasticity and make a judgment call.

    If we determine that EE is significant, then a firm should try to manage it.

    EE measures how changes in FX rates affect CFs. It is easy to see that importers benefit from a
    strong domestic currency (the cost of buying foreign goods decreases as St decreases); while
    exporters benefit from a weak domestic currency (domestic exports become to foreign buyers as St
    increases). But, not only importers and exporters face economic exposure, many purely domestic
    firms are exposed too.

    Example: As the USD becomes stronger, more U.S. tourism goes to visit the active volcano Arenal,
    in Costa Rica. Restaurants in Cost Rica buy and sell everything in CRC (CRC = Costa Rican Colón),
    thus having no direct EE. But, as U.S. tourism increases (decreases) in Arenal, the cash flows of
    restaurants in Arenal will also increase (decrease). Thus, even smaller Costa Rican restaurants
    (called sodas) face EE. In this case, they behave like an exporter. ¶

    12.1 Understanding Economic Exposure


    Let’s look at the simplified cash flow of an MNC’s subsidiary, which exports its production, Q, at
    the international price, P, denominated in foreign currency (FC):

    Revenue: Price in FC x Quantity = PQ


    Cost: Variable + Fixed = α PQ + Fixed Costs (α: proportion of PQ as VC, 0<α< 1)
    Gross profits: (1- α) PQ – Fixed Costs
    EBT = [(1- α) PQ – Fixed Costs] - IE (IE: Interest Expense)
    EAT = [(1- α) PQ – Fixed Costs - IE] (1-t) (t: tax rate)

    Costs & IE have, potentially, two components: a FC & a DC. Say, for VC: αFC & αDC; and for
    IE=IEDC+IEFC. Usually, Fixed Costs are in DC, not sensitive to FC.

    EE: How changes in St affect CFs of the firm (say, EAT)? Let’s take a first derivative:
    EAT  PQ IE FC 
     (1   FC )   (1  t )
    S t  S t S t 

    where we assume the DC components of VC and IE are independent of the FC part.

    If the derivative is 0, EAT is not affected by changes in St. That is, there is no EE. For example, if
    αFC=1 & IEFC=0, EAT is not sensitive to changes in St. Obviously, αFC=1 is not a very interesting
    case! But, as αFC→1, EE decreases. That is,

    IFM-LN.155
    the better the FC match, between Revenue and Cost, the smaller the EE.

    The degree to which P and Q affect EE depends on the type and structure of the firm and the industry
    structure in which the firm operates. In general, importing and exporting firms face a higher degree
    of EE than purely domestic firms do.

    Also, in general, monopolistic firms face lower EE than firms in competitive markets (monopolistic
    firms can increase prices in response to changes in St.).

    Note: The amount exposed is not total revenue in FC, but the difference between Revenue in FC
    and Cost in FC. If Revenue in FC > Cost in FC, selective hedging of receivables –i.e., no full hedging
    of receivables in FC- may work well to reduce short-term EE.

    Example: Foreign Auto Exporters


    During the last semester of 2014, the USD appreciated against the major currencies (13% against
    the EUR, and 15% against the JPY). Because of the expected loose monetary policies from the ECB
    and the Bank of Japan, the strong USD was expected to continue in 2015. According to earnings
    forecasts, reported by the WSJ, Germany’s three large car manufacturers were expected to increase
    their (unhedged) earning by EUR 12 billion (USD 14.2 B).

    On the other hand, according to Nissan Motor Co.’s Chief Executive Carlos Ghosn, Nissan was
    planning to make more vehicles for the U.S. market in Japan in 2015, but the profit impact was
    expected to be “marginal,” because it makes so many of its vehicles in North America.
    Source: Wall Street Journal, Jan 12, 2015. ¶

    Example: H&M vs. Zara


    In late June 2015, Sweden’s Hennes & Mauritz, the world’s second-biggest fashion retailer,
    warned it expects the strong USD to translate into rising sourcing costs throughout the year after it
    hurt second-quarter profits.

    H&M, which buys the bulk of its clothes in Asia on USD contracts while selling most of them in
    Europe, is more exposed to the strong USD than bigger rival Inditex, the Zara owner which
    produces more garments in house and sources most of them in or near Europe.

    And it is harder for the budget brand to pass on costs by raising prices as it faces growing
    competition from discounters like Primark and Forever 21, which pose less of a threat to mid-
    market brand Zara.
    Source: Reuters, July 2015. ¶

    As both examples show, a better match => lower EE. Zara has a better match between FC
    receivables and FC costs than H&M, and, thus, lower EE. Similar situation applies to Nissan relative
    to the big three German automakers. Moreover, according to Nissan’s executive Ghosn, Nissan has
    a very good match in USD, creating a very low EE.

    IFM-LN.156
    12.2 Managing Economic Exposure
    Q: How can a firm get a good match? Play with αFC to establish a manageable EE. For example, if
    FC and IE are small relative to variable, then, the bigger αFC, the smaller the exposed CF EAT to
    changes in St.

    When a firm restructures operations (shift expenses to FC, by increasing αFC) to reduce EE, we say
    a firm is doing an operational hedge.

    Note: In math terms, EE measures a first derivative: δEAT/ δSt.

    Case Study 1: Laker Airways (Skytrain) (1977-1982)

    Skytrain: Low cost carrier, no-reservation, no-


    frills, from LON to NY (1977): GBP 59 one-way
    ticket ( 1/3 of the competition). Huge success.
    Rapid expansion, financed with debt.

    Situation: UK airline expands rapidly: Laker buys


    airplanes from MD (a DC10-10 in the picture),
    financing in USD.

    • Cost structure
    As most major airlines before Airbus, Laker Airways had three major categories of costs:
    (i) fuel, typically paid for in USD
    (ii) operating costs incurred in GBP (administrative expenses and salaries), but with a non-negligible
    USD cost component (advertising and booking in the U.S.)
    (iii) financing costs from the purchase of U.S.-made aircraft, denominated in USD.

    • Revenue structure
    Sale of transatlantic airfare (probably, evenly divided between GBP and USD), plus other GBP
    denominated revenue.

    Currency mismatch (gap):


    Revenues Payables
    mainly GBP, USD mainly USD, GBP

    Q: How did St affect CFs?


    1977-1981: USD depreciates against the GBP (from 1.71 USD/GBP to 2.12 USD/GBP).
    1981-1982: USD strong appreciation against the GBP (reaching 1.60 USD/GBP).
     1982: Laker Airlines files for bankruptcy.

    Solutions to Laker Airlines problem (economic exposure):


    - More sales in US
    - Borrow in GBP

    IFM-LN.157
    - Transfer cost out to GBP/Shift expenses to GBP (increasing αFC/reduce αDC
    - Diversification (always a good risk management technique)

    Q: Why operational hedging?


    Financial hedging –i.e., with FX derivative instruments- is inexpensive, but tends to be short-term,
    liquid only for short-term maturities. Operational hedging is more expensive (increasing αFC by
    building a plant, expansion of offices, etc.) but a long-term instrument.

    Moreover, financial hedging only covers FX risk (St through P), but not the risk associated with
    sales in the foreign country (Q-risk). For example, if the foreign country enters into a recession, Q
    will go down, but not necessarily St. An operational hedge will work better to cover Q-risk.

    Idea: To avoid EE, we would like to have constant CFs at different exchange rates (CFs: Free CFs,
    EAT). A firm can restructure operations to reduce EE.

    Typical operational hedges: Move production abroad (build/expand a plant), buy more inputs
    abroad.

    Example: A U.S. firm exports to the Australia. Two different FX scenarios:


    (1) St = 1.00 USD/AUD
    Sales in US USD 11M
    in Aus AUD 15M
    Cost of goods in US USD 5M
    in Aus AUD 8M
    (2) St = 1.10 USD/AUD
    Sales in US USD 12M
    in Aus AUD 18M
    Cost of goods in US USD 5.5M
    in Aus AUD 10M

    Taxes: US 30%
    Aus 40%
    Interest: US USD 4M
    Aus AUD 1M

    CFs under the Different Scenarios (in USD)


    St=1 USD/AUD St=1.1 USD/AUD
    Sales 11M+15M=26M 12M+19.8M=31.8M
    CGS 5M+8M= 13M 5.5M+11M=16.5M
    Gross profit 5M+7M=13M 5.5M+11M=15.3M

    Int 5M+1M=6M 5M+1.1M=6.1M


    EBT 6M 9.2M

    Tax 0.3M+2.4M=2.7M 0.45M+3.08M=3.53M

    IFM-LN.158
    EAT 4.3M 5.67M

    Q: Is the change in EAT significant?


    Let’s calculate the CF-exchange rate elasticity: Change in EAT(%)/ef,t = .3186/.1= 3.186
    => A 1% depreciation of the USD, EAT increases by 3.2% (probably, very significant!). That is, this
    company benefits by an appreciation of the AUD against the USD. The firm faces economic exposure.

    How can a U.S. exporting firm avoid (or reduce) economic exposure? (Short answer: Match!)
    1. Increase US sales
    2. Borrow more in AUD (increase outflows in AUD)
    3. Increase purchases of inputs from Australia (increase CGS in AUD)

    Note: A U.S. importing firm can reduce EE by taking the reverse steps.

    Diversification always helps to reduce economic exposure. By diversifying a company takes a portfolio
    approach to inflows and outflows denominated in different currencies.

    Example: In the previous (baseline) example, we’ll play with scenarios (one at a time).
    (A) US firm increases US sales by 25% (unrealistic!)
    EAT(St=1 USD/AUD) = USD 6.225M
    EAT(St=1.1 USD/AUD )= USD 7.77M
     a 1% depreciation of the USD, EAT increases by only 2.48%.

    (B) US firm borrows only in AUD: AUD 6M


    EAT(St=1 USD/AUD) = USD 4.8M
    EAT(St=1.1 USD/AUD) = USD 5.87M
     a 1% depreciation of the USD, EAT increases by 2.23%.

    (C) US firm increases Australian purchases by 30% (decreasing US purchases by 30%)


    EAT(St=1 USD/AUD) = USD 3.91M
    EAT(St=1.1 USD/AUD) = USD 4.845M
     a 1% depreciation of the USD, EAT increases by 2.39%.

    (D) US firm does (A), (B) and (C) together


    EAT(St=1 USD/AUD) = USD 6.335M
    EAT(St=1.1 USD/AUD) = USD 7.145M
     a 1% depreciation of the USD, EAT increases by 1.28%.

    Note: You can find this example (and play with different values) in my homepage:
    www.bauer.uh.edu/rsusmel/4386/ee-example.xls ¶

    Remark: Some firms will always be exposed. For example, U.S. small firms that only do business
    in the U.S. and import parts from abroad (say, a store selling Chinese food and goods in Houston’s
    Chinatown) do not have a lot of opportunities to reduce EE. For them, a strong USD is good for

    IFM-LN.159
    their CFs; while a weak USD is not. Large firms have more leeway in adjusting their business
    structure to reduce EE.

    Case Study 2: Walt Disney Co.


    Four divisions (in 2006): Entertainment, Consumer Products, Theme Parks
    and Resorts, and Media Networks.

    S06 = 108.113 TWC/USD (TWC = Trade-weighted currency)


    Price06 = USD 30.90

    Inflows (2006 Revenue USD 34.3B, Operating income: USD 6.49B, EPS: USD 2.06):
    - Media (ABC, ESPN, Disney Channel, A&E. Low). Revenue 14.75B, OI: 3.61B
    - Parks & Resorts (Disney Cruise Line & 10 parks: Euro Disney, Tokyo Disney + HK park, U.S.
    (30% from abroad). Medium). Revenue 9.95B, OI: 1.53B
    - Studios (Disney, Pixar, Touchstone. 50+% from abroad. High). Revenue USD 7.2B, OI: 0.73B
    - Consumer products (Licensing, Publishing, Disney store (Europe). Medium) Revenue
    USD 2.4B, OI: 0.62B
    Outflows - 80% in USD

    S06 = 108.113 TWC/USD (TWC = Trade-weighted currency index)


    Price06 = USD 30.90

    UPDATE (2006-2013):
    - DIS bought Marvel for USD 4B in 2009 and Lucasfilm for USD 4B in 2012.
    - DIS introduced a new division: Interactive Media (Kaboosee.com, BabyZone.com, Playdom
    (social gaming), etc.)
    - DIS ordered two new cruises with 50% more capacity each in 2011.
    - Shangai theme park to be opened in 2016.

    Economic Exposure? Yes. Probably: Medium

    • Note: To check our intuition, we can calculate a pseudo-elasticity to check EE. We need data.
    Let’s use 2013 data:

    Inflows (2013 Revenue USD 45.04B, Operating income: USD 10.72B, EPS: USD 3.38):
    S 13 = 101.923 TWC/USD (USD depreciated by 5.73% against the TWC)
    Price13 = USD 65.30.

    Summary:

    IFM-LN.160
    2006 (in USD) 2013 (in USD)
    Revenue Operating Revenue Operating
    Income Income
    Media 14.75B 3.61B 20.35B 6.82B
    Parks & Resorts 9.95B 1.53B 14.09B 2.22B
    Studios 7.2B 0.73B 5.98B 0.66B
    Consumer Products 2.4B 0.62B 3.56B 1.11B
    Interactive Media 1.06B -0.09B
    Total 34.3B 6.49B 45.04B 10.72B

    13-06 Change in Revenue = USD 10.74B (31.31%)


    13-06 Change in OI = USD 4.23B (65.18%)
    13-06 DIS Stock Return = 111.32%
    13-06 ef,t = - 0.05725 (or 5.73% depreciation of the USD)

    CF-elasticity = % Change in OI / % Change in St = .6518/-.05725 = -11.385

    If stock market numbers are more trusted than accounting numbers, recalculate pseudo-elasticity =
    DIS Stock Return/ef,t = 1.1132/-.05725 = -19.445

    According to these elasticities, DIS behaves like a net exporter, a depreciation of the USD
    increases cash flows.

    • Managing Disney’s EC
    1. increase expenses in FC
    a. make movies elsewhere
    b. move production abroad
    c. Borrow abroad
    2. Diversify revenue stream
    a. Build more parks abroad
    b. New businesses

    • Let’s revisit the measurement Disney’s EE.


    Q: Is the pseudo-elasticity informative? Is St the only variable changing from 2006 to 2013?
    A: No! DIS added assets, then more revenue and OI are expected. Also the economy and the stock
    market grew during these dates. We need to be careful with these numbers. We need to “control”
    for these changes, to isolate the effect of ef,t.

    A multivariate regression will probably be more informative, where we can include other
    independent (“control”) variables (income growth, inflation, sales growth, assets growth, etc.), not
    just ef,t as determinants of the change in OI (or DIS stock return).

    We can also borrow from the investments literature and use the popular 3 Fama-French factors
    (Market, Size, Book-to-Market) as controls. Say:

    IFM-LN.161
    DIS Stock Returnt = α + β ef,t + θ Assetst + δ FF Factorst + ... + εt

    Example: Disney’s EE.


    Using Disney’s monthly excess returns from the past 30 years (1984:Jan, 2014:Sep), we run a regression
    against ef,t (using USD/TWC) and the Fama-French factors (Market, SMB, HML):

    R2 = 0.20409
    Standard Error = 8.0665
    Observations = 369

    Standard
    Coefficients Error t Stat P-value
    Intercept 1.2865 0.43149 2.9815 0.0031
    ef,t 0.4002 0.24512 1.6329 0.1034
    Market - rf 0.2223 0.09912 2.2428 0.0255
    SMB 0.1787 0.14391 1.2423 0.2149
    HML 0.5013 0.15226 3.2924 0.0011

    After controlling for other factors that affect Disney’s excess returns, we cannot reject H0, since |tβ =-
    1.63| < 1.96 (at 5% level, no EE).

    Q: Why is economic exposure not showing up? Disney has been diversifying and taking a lot of the
    measures discussed above to reduce economic exposure for many years. It seems to be working. ¶

     EE: Evidence
    Using a regression like the one above for Disney, Ivanova (2014) estimates the EE for 1,231 U.S.
    firms. She finds that the mean β is 0.57 (a 1% USD depreciation increases returns by 0.57%).
    However, only 40% of the EE are statistically significant at the 5% level. In general, large firms have
    lower exposures (average β is 0.063).

    He and Ng (1998) and Doukas et al. (2003) find that only 25% of Japanese firms have significant EE.

    Interesting result: Ivanova reports that 52% of the EEs come from U.S. firms that have no international
    transactions (a higher St “protects” these domestic firms).

    12.3 Should a Firm Hedge?


    There are two views with respect to hedging at the firm level:
    - Based on the Modigliani-Miller Theorem (MMT). It states that hedging adds nothing to the
    value of a firm.
    - Exploits some of the basic assumptions underlying the MMT. This second view analyzes
    specific situations where hedging might add value to a firm.

    1. MMT: Hedging is Irrelevant


    When we value a firm, the financing source of those good investments is irrelevant. Different
    mechanisms of financing determine how the CFs are divided among the different classes of investors
    (shareholders or bondholders).

    IFM-LN.162
    The MMT depends on a set of assumptions about financial markets. These assumptions basically
    require that a firm operates in perfect markets (i.e., no transaction costs, no distortions, etc.).

    Implications for hedging: If the methods of financing and the character of financial risks do not matter,
    managing them is not important, and, thus, should not add any value to a firm. On the contrary, since
    hedging is not free, hedging might reduce the value of a firm.

    Modigliani and Miller also show that if investors want to reduce the financial risks associated to
    holding shares in a firm, they can diversify their portfolios by themselves.

    2. Hedging Adds Value


    The assumptions behind the MMT are routinely violated and, then the MMT does not hold. Under
    these circumstances, hedging adds value to a firm. The added value of hedging is still open to
    discussion.

    2.1 Investors might not be able to replicate an optimal hedge


    Investors might not be big enough to have access to optimal hedges. Or investors might not have
    enough information about CFs, denominated in different currencies, of the firm.

    2.2 Hedging as a tool to reduce the risk of bankruptcy


    If CFs are very volatile, a firm might be faced with the problem of needing cash to meet its debt
    obligations. Thus, firms, like MNCs, with good access to credit markets have no need to hedge.
    (Surprisingly, U.S. largest corporations are the biggest hedgers.)

    2.3 Hedging as a tool to reduce investment uncertainty


    Firms should hedge to ensure they always have sufficient cash flows to fund their planned

     Who Hedges? And How?


    U.S. Evidence
    A 1998 Wharton U.S. survey on hedging reported the following main findings:
    - Size matters: 83% of big firms hedge, while on 12% of small firms hedge.
    - Industry matters: primary product firms (68%) and manufacturers (48%) hedge more than service
    firms (42%).
    - Hedge only a fraction of the total FX exposure. The average firm hedges less than 50% of the
    perceived FX exposure. This practice is called selective hedging.
    - Short-dated hedges: 82% of firms use FX derivatives with a maturity of 90 days or less.
    - Standard options most popular. Firms use standard European-style or American-style options much
    more than such exotic options as average rate, basket, or barrier options.
    - Speculation: 32 % of firms that use FX derivatives reported that their market view of exchange rates
    leads them to “actively take positions” at least occasionally.

    More Results:
    - For equity markets, FX hedging in the long run does not significantly improve returns –see Statman
    and Fisher (2003), Thomas (1988).

    IFM-LN.163
    - For equity markets, FX hedging does not increase well-diversified portfolio returns, nor always
    reduces risk. MSCI Barra Research Paper No. 2009-12.
    - For bond markets, fully FX hedging is the best policy for risk-minimizing investor. Schmittmann
    (2010), IMF Working Paper 10/151.
    - For the gold industry, firms engaging in selective hedging do not add to their performance. Brown,
    et al. (2006) "Are firms successful at selective hedging?" Journal of Business, 79, 2925-2949.
    - For the gold industry, firms engaging in selective hedging are closer to financial distress. Adam et
    al. (2012) “Why do Firms engage in selective hedging?” SFB 649 Working Paper, Humboldt
    University.

    Canadian Evidence
    The Bank of Canada conducts an annual survey of FX hedging. The main findings from the 2011
    survey are:
    • Companies hedge approximately 50% of their FX risk.
    • Usually, hedging is for maturities of six months or less.
    • Use of FX options is relatively low, mainly because of accounting rules and restrictions imposed by
    treasury mandate, rules or policies.
    • Growing tendency for banks to pass down the cost of credit (credit valuation adjustment) to their
    clients.
    • Exporters were reluctant to hedge because they were anticipating that the CAD would depreciate.
    On the other hand, importers increased both their hedging ratio and duration.

    Australian Evidence
    The National Bank of Australia also conducts a survey, every four years since 2001, to gauge
    Australia’s aggregate foreign currency exposure.
    • The banking sector hedges all of its net FC liability exposure, while other financial corporations
    hedge only part of their net FC exposure.
    • Overall, financial sector liabilities in FC (bonds, loans and deposits) had a hedge ratio of 60%, while
    assets in FC had a hedge ratio of 30%.
    • 80% of FC denominated debt security liabilities was hedged using derivatives, reflecting a hedge
    ratio of 84% for short-term debt liabilities and 77% for long-term debt securities.
    • Non-financial corporations hedged close to 30% of FC denominated liabilities, while there was
    almost no hedging of FC denominated assets.

    IFM-LN.164
    CHAPTER 12 – BRIEF ASSESMENT

    1. Padres Company does business in the U.S. and Australia. In attempting to assess its economic exposure, it
    compiled the following information:
    • Its U.S. sales are somewhat affect by the Australia dollar's value because it faces competition from Australian
    exporters. It forecasts the U.S. sales based on the following exchange rate scenarios:
    St (USD/AUD) Revenue from U.S. (in million)
    .70 USD 180
    .85 USD 250

    • Its AUD revenues on sales to Australian residents invoiced in AUD are expected to be AUD 400,000,000.
    • Its anticipated cost of goods sold is estimated at USD 60 million from the purchase of U.S. material and AUD
    100 million from the purchase of Australian materials.
    • Fixed operating expenses are USD 20 million.
    • Variable operating expenses are estimated at 15 percent of total sales (including Australian sales, translated to
    a USD amount).
    • Interest expense is estimated at AUD 30 million on existing Australian loans, and USD 20 million on existing
    USD loans.
     Income tax is paid at the U.S. effective tax rate of 27%.

    A. Create a forecasted income statement for Padres under each of the two exchange rate scenarios.
    B. Explain how Padres' projected earnings before taxes are affected by possible exchange rate movements.
    C. Explain how Padres can restructure its operations to reduce the sensitivity of its earnings to exchange rate
    movements, without reducing its volume of business in Australia.

    2. In the previous exercise, calculate the CF-elasticity under the following scenarios (one at a time):
    (A) Padres Co. increases US sales by 25% (unrealistic!)
    (B) Padres Co. only in AUD:
    (C) Padres Co. increases Australian purchases by 30% (decreasing US purchases by 30%)
    (D) Padres Co. does (A), (B) and (C) together.

    3. Below, we report GE’s net income (in millions, USD) and earnings per share, EPS, along the
    USD/TWC exchange rate for the period 2012-2016. (Whole income statement on my homepage:
    http://www.bauer.uh.edu/rsusmel/4386/ GE_Income_Statement.csv). Does GE face EE?

    2016 2015 2014 2013 2012


    Net income (in M) 8,175 -6,126- 15,233 13,057 13,641
    EPS 0.89 -0.61 1.5 1.27 1.29
    USD/TWC 1.044244 1.05869 1.114673 1.308284 1.361726

    IFM-LN.165
    CHAPTER 12 - BONUS COVERAGE: Brief Laker Airways Story
    After a legendary six-year battle won in the courts, Freddie Laker
    obtained a permit for his Laker Airways, established in 1966, to
    operate the Laker Skytrain service on both sides of the Atlantic,
    using two DC-10 planes. The Skytrain was a no-reservation, low
    cost air service, which revolutionized the air transport industry.
    It was the first low-cost transatlantic operation. Skytrain flew
    from New York to London and back for USD 236 (USD 400 less
    than the going rate). Breakfast was USD 1.25 extra.

    On September 26, 1977, the first Skytrain flight departed London


    for New York, and subsequently went on to carry over 50,000
    passengers before the end of the year with each flight over 80
    percent full. The success was such that the Skytrain service was
    expanded to include a London to Los Angeles service in 1978, London to Miami in 1980 and London to Tampa in
    1981.

    During this time of expansion, the USD was weak against the GBP, and U.S. trips were relatively cheap for U.K.
    residents. Freddie Laker was able to expand the Skytrain concept by buying more DC-10s, financing them in USD.
    Thus, Skytrain's debt payments were in USD, while Skytrain's revenues were primarily in GBP.

    Although popular with the public, Laker Airways became embroiled in price wars with more powerful companies.
    (Rumors and stories of collusion against Laker Airways are still told today.) The start of the Reagan presidency,
    with a consistent USD appreciation against European currencies, did not help Laker Airways’ fortunes. On February
    5, 1982, Laker Airways was forced to file for bankruptcy, owing GBP 270 million.

    Thousands of pounds poured into a “Save Laker” fund, set up by members of the public sympathetic to the flamboyant
    tycoon. The “Save Laker” fund collected over GPB 1 million in donations. But it was too little too late. Within weeks
    Sir Freddie was attempting to re-launch an airliner by transferring the Laker Airways licenses to a new company. The
    Civil Aviation Authority officially blocked his efforts in May after objections from other airlines and the public.

    Freddie Laker retired to Florida, then the Bahamas. He died in Miami aged 83 on 10 February 2006.

    Richard Branson, founder of Virgin Atlantic, credited Freddie Laker for some of the success of Virgin Atlantic.
    “Perhaps his best advice was to make sure that I took British Airways to court before they bankrupted us — not after,
    as he (Laker) did.”

    Taken From “A brief history of price-fixing,” by Simon Calder


    The Independent (London), Jun 24, 2006

    In the bad old days when airlines were run by, and for the benefit of governments and civil servants,
    colluding on fares was not illegal - it was compulsory. National airlines cosily agreed fares between
    themselves. Indeed, when the inspectors called on airlines, it was to uncover evidence of cutting fares,
    rather than artificially inflating them. Airlines from Laker Airways to British Caledonian were fined for the
    heinous practice of lowering their prices to allow more people to fly. Indeed, it was one such raid at
    Gatwick that prompted the late, great Sir Freddie Laker to start his Skytrain enterprise.

    IFM-LN.166
    One day in 1970, Laker was summoned to the airport because Civil Aviation Authority staff were
    interrogating his passengers. His airline was involved in "affinity group charters", which at the time
    represented the only way for an ordinary working man or woman to travel the Atlantic. The big airlines had
    the scheduled business sewn up, and governments had imposed such a stranglehold on charters that only
    genuine clubs and societies were allowed on board transatlantic flights at reasonable rates. You can guess
    the result: all sorts of spurious associations were created to circumvent the stifling regulations. Everyone
    knew somebody who knew a dodgy agency that dabbled in cheap transatlantic air fares, and issued
    specious membership cards to the "Left Hand Club" to go with the tickets. Which made these flights prime
    targets for government inspectors seeking to stop people traveling - as happened to a Laker Airways
    departure from Gatwick to New York in 1970.

    Sir Freddie later told me he was more appalled by the fact that they were "chucking old women off the
    aeroplanes" than by the hefty fine that he had to pay for the temerity of trying to take people across the
    Atlantic at an affordable price.

    That episode led directly to the creation of the Laker Skytrain, which was allowed to cut prices and
    transform travelers' lives.

    IFM-LN.167
    Chapter 13 - DFI
    In this chapter we start the second of the course. In the first part, we have concentrated on issues
    related to FX Rates. From now on, we will study issues related to a company dealing in an
    international environment.

    The first topic involves Direct Foreign Investment (DFI), a decision a firm makes to invest in a
    foreign country. The chapter is motivated through a firm’s evaluation of two alternatives:
    - A domestic firm can produce at home and export production.
    - A domestic firm can also invest to produce abroad (& do a DFI).

    Note: Depending on the author/organization DFI can also be called Foreign Direct investment (FDI).

    DFI
    Definition: It is a controlling ownership in a business enterprise in one country by an entity based in
    another country.

    DFI is different from investing in foreign stocks, which is a more passive investment.

    The World Bank/OECD defines DFI as the net inflows of investment to acquire a lasting management
    interest (10% or more of voting stock) in an enterprise operating in an economy other than that of the
    investor. DFIs can be done through mergers & acquisitions, setting up a subsidiary, a joint venture,
    etc.

    From the point of view of national accounts, DFI is calculated as the sum of equity capital,
    reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of
    payments.

    According to the World Bank, the total DFI in 2013 was USD 1.65 trillion (7.3% growth with respect
    to 2012), with China getting the biggest part (USD 347.8 billion), followed by the U.S. (USD 235.9
    billion), Brazil (USD 80.8 billion) and Hong Kong (USD 70.7 billion).

    13.1. Why DFI instead of exports?


    DFI requires capital, sometimes a lot of capital, and, thus, DFI decisions are difficult to reverse. So,
    why choose DFI over the simpler exports?
    A: ⋄ Avoid tariffs and quotas
    ⋄ Access to cheap inputs
    ⋄ Reduce transportation costs & trade frictions
    ⋄ Local management
    ⋄ Take advantage of government subsidies
    ⋄ Access to new technology
    ⋄ Access to local expertise (including: local contacts, dealing with red tape, etc.)
    ⋄ Reduce economic exposure

    IFM-LN.168
    ⋄ Diversification
    ⋄ Real option (an investment today helps to make investments elsewhere later).

    Q: What is the main disadvantage of a DFI?


    A: A DFI usually requires a large investment, which is not easy to revert. There is a higher risk
    relative to exports, where the decision to export can easily be changed. To penetrate a new market and
    limit risk, licensing agreements and joint ventures (a “limited DFI”) are used by MNCs.

    13.2 Diversification through DFI


    MNCs have many DFI projects. Since all investments have risks, they will select the project that will
    improve the company’s risk-reward profile (think of a company as a portfolio of projects). We will
    evaluate projects according to risk-adjusted performance measures (RAPM).

    We need to know how to calculate E[r] and Var[r] for a portfolio. Suppose X and Y are two
    investments, then the return on the portfolio of the two investments (X+Y):
    E[rx+y] = wx *E[rx] + (1- wx)*E[ry]
    Var[rx+y] = σ2x+y = wx2(σx2) + wy2 (σy2) + 2 wx wy x,y σx σy

    We need given this information, we can evaluate the risk-reward profile of the portfolio using the
    Sharpe Ratio (SR), also called reward-to-variability ratio (RVAR), defined as:
    SR = Reward-to-variability ratio = E[ri - rr]/ σi = RVAR

    But, total volatility (σ) may not be the appropriate measure of risk for a portfolio. Another measure of
    a portfolio’s risk is . To calculate the  of the X+Y portfolio, you should remember that the beta of a
    portfolio is the weighted sum of the betas of the individual assets:
    x+y = wx *x + (1- wx)*y

    Now, we can define another RAPM, the Treynor Ratio (TR), or reward-to-volatility ratio (RVOL):
    Treynor Ratio = TR = Reward-to-volatility ratio = E[ri - rf]/ ßi = RVOL

    Note: SR uses total risk (σ), this measure is appropriate when total risk matters –i.e., when most of an
    investor's wealth is invested in asset i. When the asset i is only a small part of a diversified portfolio,
    measuring risk by total volatility is inappropriate. TR emphasizes systematic risk, the appropriate
    measure of risk, according to the CAPM.

    Example: A US company E[r] = 13%; SD[r] = 12% (recall SD = σ), =.90


    Two potential DFIs: Colombia and Brazil
    (1) Colombia: E[rc] = 18%; SD[rc] = 25%, c = .60
    (2) Brazil: E[rb] =23%; SD[rb] =30%, b = .30
    rf = 3%
    ExistPort, Col = 0.40
    EP,Brazil = 0.05
    wCol = .30,  (1- wcol) = wEP = .70
    wBrazil = .35,  (1- wBrazil) = wEP = .65

    IFM-LN.169
    The US company evaluates the Projects according to SR and TR.

    We need to calculate for each project E[r], σ =SD[r], :


    E[rEP+Col], Var[rEP+Col], EP+Col
    E[rEP+Brazil], Var[EP+Brazil], EP+Brazil

    Recall: The higher the SR or RVOL, the better the project

    Calculate the SR for both countries (we’ll work with excess returns, directly):

    1. Colombia
    E[rEP+Col - rf] = wEP*E[rEP - rf] + (1- wEP)*E[rcol - rf]
    = .70*.10 + .30*.15 = 0.115

    σEP+Col = (σ2EP+Col)1/2
    σ2EP+Col = wEP2(σEP2) + wCol2(σCol2) + 2 wEP wCol EP,Col σEP σCol
    = (.70)2*(.12)2 + (.30)2*(.25)2 + 2*.70*.30*0.40*.12*.25 = 0.0177210
     σEP+Col = (0.017721000)1/2 = 0.1331

    EP+Col = wEP *EP + wCol*Col


    = .70*.90 + .30*.60 = 0.81
    SREP+Col = E[rEP+Col - rr]/ σEP+Col = .115/.1331 = 0.8640
    TREP+Col = E[rEP+Col - rr]/ βEP+Col = .115/.81 = 0.14198

    Interpretation of SR: An additional unit of total risk (1%) increases returns by .864%
    Interpretation of TR: An additional unit of systematic risk increases returns by .142%

    2. Brazil
    E[rEP+Brazil - rf] = 0.135
    σEP+Brazil = 0.1339
    EP+Brazil = 0.69
    SREP+Brazil = 0.135/0.1339 = 1.0082
    TREP+Brazil =.135/.69 = 0.19565

    Interpretation of SR: An additional unit of total risk increases returns by 1.0082%

    Under both measures, Brazilian project is superior.

    Now, compare existing portfolio of the company with the Brazilian project
    SREP = (.13-.03)/.12 = .833
    TREP = (.13-.03)/.90 = .111

    Using both measures, the company should diversify internationally through DFI in Brazil Why?
    Because it improves the risk-reward profile for the company.

    IFM-LN.170
    Note: There is another RAPM - Jensen’s alpha measure
    It estimates a constant (α) on a CAPM-like regression. You regress the excess returns on a portfolio
    against the excess market returns (and/or Fama-French factors.) The Jensen’s alpha measure is often
    used to rank mutual funds.

    13.3. Aside: Diversification and International Investments


    Recall the Efficient Frontier:

    E[r] US + International

    US only

    Risk ()

    When you go international, you improve the tradeoff and move the frontier up, in the northwest
    direction.

    Key: The correlation of the project that we are considering to add to our existing portfolio should be
    low to achieve a significant movement in the efficient frontier.

    • Risk-Return in international investments

    Table 13.1 reports the USD mean annual returns on MSCI equity indexes from 11 developed
    markets, along with the World and EAFE Indexes (based on monthly data, 1970-2017 period).Over
    the past 47 years, Hong Kong and Singapore show the best returns in Developed Markets, but we
    need to take into consideration the risk taken by an investor. Using the Sharpe ratio (with a 4.74%
    risk-free rate) to measure the risk-return trade-off, Switzerland and Japan have the best
    performances over the past 47 years.

    IFM-LN.171
    Table 13.1: MSCI Index USD Annual Returns: (1970-2017)

    Market Return Standard Dev Sharpe Ratio


    U.S. 8.19 15.04 0.2295
    Canada 8.22 19.35 0.1801
    France 9.02 22.17 0.1927
    Germany 9.37 21.67 0.2135
    Italy 5.08 25.38 0.0315
    Switzerland 10.44 17.83 0.3193
    U.K. 7.77 21.44 0.1411
    Japan 9.94 20.74 0.2506
    Hong Kong 16.80 33.72 0.3578
    Singapore 12.26 27.79 0.2705
    Australia 7.68 23.79 0.1233

    World 7.70 14.58 0.2026


    EAFE 8.00 16.78 0.1945

    We can use the above numbers to compute the equity risk premium. If we consider that the average
    U.S. T-bill rate during the 1970-2017 period was 4.74%, the realized equity risk premium for the
    U.S. is 3.45% (= 8.19 - 4.74). There is no agreement on what the equity risk premium should be; in
    general, the reported numbers for the U.S. market are between 3% and 8%, which place our 3.45%
    estimate on the lower side of the range.

    Since stock returns are calculated with error (even for large portfolios, like the above indexes),
    using a long data set is important: the longer the data set, the smaller the sampling error and, thus,
    the more precise the estimation. Dimson, Marsh and Staunton (2011) used data from 1900-2010 to
    report for mainly 19 developed markets. For example, they calculated mean annual return (standard
    deviation in parenthesis) for the U.S., Switzerland and Italy are 7.2% (19.8%), 5.1% (18.9%), and
    9.8% (32%), respectively. The numbers are a bit different from the ones reported in Table 13.1,
    though within the usual estimation error.

    For emerging markets, the estimation error is considerable, given that quality data, following
    international standards, started to be collected in 1988 (Brazil, Greece, Ireland, Malaysia, Mexico,
    Thailand, etc), and for Russia, India and China, considered then the major "frontier markets," data
    started to be collected in 1993 (along with Israel, Pakistan, Poland, South Africa, etc). In Table 13.2,
    we report annual USD returns, standard deviation and Sharpe Ratio (using the U.S. T-bill average rate
    in the period, 2.43%) for the period 1993-2017 for some emerging markets, two emerging market
    indexes (EM-Asia and EM-Latin America), and, for reference purposes the U.S., World and EAFE
    Indexes.

    In general, we observe the typical emerging market behavior: high returns and high volatility. In terms
    of Sharpe ratios, in Table 13.2, the U.S. market provided the best trade-off, closely followed only by
    the Russian market.

    IFM-LN.172
    Table 13.2: MSCI Index USD Annual Returns: (1970-2017)

    Market Return Standard Sharpe


    Deviation Ratio
    Brazil 16.58 37.54 0.3768
    China 5.40 33.25 0.0785
    Greece -0.18 35.46 -0.0736
    India 12.05 28.99 0.3318
    Malaysia 6.54 27.82 0.1477
    Mexico 10.00 27.75 0.2728
    Pakistan 6.79 34.91 0.1248
    Poland 18.62 44.78 0.3615
    Russia 22.65 50.09 0.4035
    South Africa 11.30 26.30 0.3373

    EM-Asia 7.24 24.13 0.1990


    EM-Latin America 10.65 27.68 0.2969
    U.S. 8.72 14.25 0.4409
    World 7.06 14.44 0.3207
    EAFE 5.48 16.06 0.1899

    We see a big dispersion in expected returns (and risk!) in international markets, which cannot be
    explained by the usual World CAPM. Several papers have been proposed to explain these differences,
    among them:
    ⋄ Global economic risks Ferson and Harvey (1994).
    ⋄ Inflation risk Chaieb and Errunza (2007).
    ⋄ Liquidity risk Karolyi, Lee, and van Dijk (2012), Malkhozov, et al. (2014).
    ⋄ Momentum and a global cash-flow-to-price factor Hou, Karolyi, and Kho (2011).
    ⋄ Investment restrictions Karolyi and Wu (2014).
    ⋄ Currency risk Dumas and Solnik (1995).

    There is also an international version of the 3-factor Fama-French model, extended by Fama and
    French (1998, 2012), which finds that only two factors matter in their model: world (say, a global
    equity benchmark) and value (HML).

    • Empirical facts related to international investments


    Empirical fact 1: Low Correlations (first reported by Gruber (1970).) Correlations in international
    equity markets tend to be moderate to low. This fact puzzles economists. Table 13.3 reports return
    correlations for several international market indexes.

    Correlations between neighboring markets tend to be higher: Correlation between the U.S. and
    Canada is 0.74; the U.S. and Japan is 0.36. (Data: 1970-2015).

    IFM-LN.173
    Average correlation between the US and international markets is around .40.

    Table 13.3: MSCI Index Returns: Correlation Matrix (1970-2015)*

    A. European Markets
    MARKET Bel Den France Gerrn Italy Neth Spain Swed Switz U.K. World
    Belgium 1.00 0.59 0.72 0.70 0.54 0.75 0.56 0.55 0.68 0.59 0.69
    Denmark 1.00 0.53 0.59 0.48 0.62 0.51 0.54 0.55 0.49 0.61
    France 1.00 0.73 0.59 0.73 0.59 0.57 0.68 0.63 0.73
    Germany 1.00 0.56 0.78 0.58 0.64 0.71 0.54 0.71
    Italy 1.00 0.55 0.57 0.50 0.50 0.57 0.57
    Netherlands 1.00 0.59 0.63 0.75 0.69 0.81
    Spain 1.00 0.57 0.50 0.47 0.62
    Sweden 1.00 0.57 0.52 0.69
    Switzerland 1.00 0.62 0.72
    U.K. 1.00 0.73
    World 1.00

    B. Pacific Markets
    MARKET Australia HK Japan Korea Singap Taiwan U.S. World
    Australia 1.00 0.32 0.37 0.50 0.51 0.33 0.56 0.65
    Hong Kong 1.00 0.34 0.40 0.57 0.41 0.39 0.48
    Japan 1.00 0.48 0.39 0.24 0.36 0.67
    Korea* 1.00 0.46 0.33 0.45 0.53
    Singapore 1.00 0.45 0.53 0.60
    Taiwan* 1.00 0.35 0.38

    C. North American Markets


    MARKET Canada U.S. Mexico World EAFE EM-LA EM-ASIA
    Canada 1.00 0.74 0.54 0.77 0.62 0.60 0.65
    U.S. 1.00 0.58 0.88 0.62 0.57 0.61
    Mexico * 1.00 0.56 0.49 0.72 0.52

    Notes:
    *: The sample for South Korea, Taiwan, Mexico, the EM-Latin America and the EM-Asia indexes start in January
    1988.

    Empirical fact 2: Correlations are time-varying


    Correlations change over time. In general, during bad global times, correlations go up:
     When you need diversification, you tend not to have it!

    In the graph below, we plot the US-Japan rolling monthly correlations from 1970:Jan -2015:Feb.
    There is a lot of movement for the correlation coefficient (average correlation close to 0.35).

    IFM-LN.174
    Time Varying (Rolling) Correlations: US-Japan
    1

    0.5

    0
    07/01/71
    04/01/73
    01/01/75
    10/01/76
    07/01/78
    04/01/80
    01/01/82
    10/01/83
    07/01/85
    04/01/87
    01/01/89
    10/01/90
    07/01/92
    04/01/94
    01/01/96
    10/01/97
    07/01/99
    04/01/01
    01/01/03
    10/01/04
    07/01/06
    04/01/08
    01/01/10
    10/01/11
    07/01/13
    -0.5

    Empirical Fact 3: Risk Reduction (from Solnik, B. (1974), “Why Not Diversify Internationally?”
    Financial Analyst Journal, 20, 48-54).

    Figure 13.2: Effect of International Investment on Risk

    Portfolio risk (%)

    US only

    US + World

    27.0

    11.7

    Number of assets

    Solnik’s observes that past 12 stocks, the risk in a portfolio levels off, around .27. For international
    stocks, the risk levels off at .11

    Empirical Fact 4: Returns Increase (from P. Jorion and S. J. Khoury (1996), Financial Risk
    Management: Domestic and International Dimensions, published by Blackwell.)

    Portfolios with international stocks have outperformed domestic portfolios in the past years. About
    1% difference (1978-1993).

    Recent Past (1988:Jan-2017:May): The case of emerging markets (see Graph 13.1 below).
    Three portfolios:
    - A US purely domestic portfolio, with 7.76% annualized return.

    IFM-LN.175
    -A 90% US, 10% EM portfolio, with 8.01% annualized return (or extra 85% over 29.5 years).
    - A 70% US, 30% EM portfolio, with 8.55% annualized return (or extra 239% over 29.5 years!).

    Graph 13.1: The Case for Emerging Markets (1988-2017)

    1400
    USA
    1200
    10% EM
    1000
    30% EM
    800

    600

    400

    200

    0
    12/31/1987

    10/30/1998
    11/30/1999
    12/29/2000

    10/31/2011
    11/30/2012
    12/31/2013
    1/31/1989
    2/28/1990
    3/29/1991
    4/30/1992
    5/31/1993
    6/30/1994
    7/31/1995
    8/30/1996
    9/30/1997

    1/31/2002
    2/28/2003
    3/31/2004
    4/29/2005
    5/31/2006
    6/29/2007
    7/31/2008
    8/31/2009
    9/30/2010

    1/30/2015
    2/29/2016
    3/31/2017
    Q: Free lunch?
    A: In the equity markets: Yes! Higher return (1% more), lower risks (2% less).

    IFM-LN.176
    Q: Does hedging FX risk affect the risk-return of a exposed portfolio?
    Unhedged international portfolios add an additional risk to a portfolio: FX. Unhedged international
    portfolios have higher volatility, but if we look at the long-term risk-adjusted performance of hedged
    and unhedged international portfolios we get similar results. During periods of USD appreciation,
    hedging adds to returns, but during periods of USD depreciation the opposite occurs. On average,
    Sharpe ratios are very similar. See Graph below taken from Oey (2015, Morningstar research note).

    Q: How to take advantage of facts 3 and 4?


    A: True diversification: invest internationally.

    Empirical Fact 5: Investors do not diversify enough internationally (first discussed by French and
    Poterba (1991, American Economic Review).
    ⋄ A 2002 report by UBS on the proportion of foreign bonds and foreign equities in the total equity and
    bond portfolio of local residents for several OECD countries:
    - Most internationally diversified investors: Netherlands (62%), Japan (27%) and the U.K. (25%).
    - U.S. ranks at the bottom of list: only 12% of internationally diversified investors.
    ⋄ 2010 data put the proportions of the U.K. at 50% and of the U.S. at 28%, an improvement.

    ⋄ Does home bias hurt your portfolio? Yes!


    In 2004, the Kansas City Fed estimates that:

    IFM-LN.177
    (a) With the actual 12% share of foreign equity investments, the mean return and SD for the US
    equity portfolio were 10.30% and 14.47%.
    (b) Increasing to 41% the share of foreign equity investments increases the mean return to 10.44%
    and decreases the SD to 13.78% for the U.S. equity portfolio.
     Sharpe Ratio up  US equity portfolio is inefficient!

    (From Meirelles Aurélio (2006) “Going Global: The Changing Pattern of U.S. Investment Abroad,”
    Kansas City Federal Reserve, Quarter III.)

    ⋄ Popular measure for Equity Home Bias (EHB) –only equity, not bonds and other assets:
    EHBi =1 - Share of Foreign Equity in Country i Equity Holding
    Share of Foreign Equity in World Market Portfolio

    EHB has been decreasing over time, from Coeurdacier and Rey (2013):

    For bonds, the BHB (Bond Home Bias) also shows a similar pattern over time:

    IFM-LN.178
    Europe the more diversified region.

    Emerging markets have very low EHB. For example, Brazil = .98, China = .99.

    Institutional Investors also have a home bias (maybe driven by domestic investors’ tastes?). Data
    from 2013:

    ⋄ Aside Question: What should drive your exposure?


    - Global GDP?
    - Market capitalization?

    IFM-LN.179
    Puzzle: Home Bias (Investors tend to ignore the benefits of international diversification.)

    ⋄ Proposed explanations for home bias and low correlations:


    (1) Real exchange rate risk (local assets show a better correlation with the domestic consumption
    basket).
    (2) Information costs/frictions (locals may have better information about local assets).
    (3) Controls to the free flow of capital.
    (4) Currency & country/political risk.
    (5) Behavioral biases (investors trust more the local information/signals; cognitive bias).

    IFM-LN.180
    (6) Indirect exposure through local assets (local firms may be already exposed to international
    markets)

    IFM-LN.181
    CHAPTER 13 – BRIEF ASSESMENT

    1. Cammy Inc., a U.S. firm, plans to invest in a new project that will be located either in Ecuador or
    in Colombia. Assume the U.S. risk free rate is 3%. You have the following data on expected returns,
    volatility, correlations, and weights for each project:

    Cammy Ecuador Colombia


    Expected return 10% 20% 30%
    Standard deviation 15% 25% 50%
    Correlation with existing Cammy’s portfolio 1.00 .35 .11
    Weight on overall portfolio - .20 .10
    Beta .90 1.10 1.40

    A. Based on the Sharpe Ratio, which project would you recommend to Cammy?
    B. Based on the Treynor Ratio, which project would you recommend to Cammy?
    C. Is Cammy, under both criteria, better off without adding any project?

    2. Two traders, working for a bank, dealing in different markets.

    Trader I position (FX futures):


    Annualized profits: USD 12 million.
    Position: USD 41 million.
    Volatility (σ): 15% annualized
    Trader II position (FX spot):
    Annualized profits: USD 23 million.
    Position: USD 68 million.
    Volatility (σ): 25% annualized

    Use the RAROC (see Bonus material) measure to determine which trader provides the bank a better
    risk-return trade-off.

    IFM-LN.182
    CHAPTER 13 - BONUS COVERAGE: Another RAPM: RAROC
    Bankers Trust created a modification of RVAR to evaluate the performance of its managers, the so-called risk-
    adjusted return on capital (RAROC) system.

    RAROC adjusts returns taking into account the capital at risk, which is defined as the amount of capital needed
    to cover 99 percent of the maximum expected loss over a year. The one-year horizon is used for all RAROC
    comparisons, regardless of the actual holding period. All traders can be compared using the same measure.

    Example: Two traders, working for a bank, dealing in different markets.


    Trader I position (Mexican bonds):
    Annualized profits: USD 3.3 million.
    Position: USD 45 million.
    Volatility (σ): 21% annualized
    Trader II position (Spot exchange rates):
    Annualized profits: USD 3 million.
    Position: USD 58 million.
    Volatility (σ): 14% annualized

    1) Calculate the worst possible loss in a 99% Confidence Interval –i.e., VaR(99%).
    Using a normal distribution: The 1% lower tail of the distribution lies 2.33σ below the mean.

    Mexican bonds: 2.33 x 0.21 x USD 45,000,000 = USD 22,018,500.


    Spot FX: 2.33 x 0.14 x USD 58,000,000 = USD 18,919,600.

    2) Calculate RAROC:
    Mexican bonds: RAROC = USD 3,300,000/USD 22,018,500 = .1499.
    Spot FX: RAROC = USD 3,000,000/USD 18,919,600 = .1586.

    Conclusion: Once adjusted for risk, Trader II provided a better return.¶

    • SUMMARY: RAPM - Pros and Cons


    - RVOL and Jensen’s alpha:
    - Pros: They take systematic risk into account. Appropriate to evaluate diversified portfolios.
    Comparisons are fair if portfolios have the same systematic risk, which is not true in general.
    - Cons: They use the CAPM => Usual CAPM’s problems apply.

    - RVAR
    -Pros: It takes unsystematic risk into account =>can be used to compare undiversified portfolios.
    Free of CAPM’s problems.
    - Cons: Not appropriate when portfolios are well diversified.
    SD is sensible to upward movements, something irrelevant to Risk Management.
    - RAROC
    - Pros: It takes into account only left-tail risk.
    - Cons: Calculation of VaR is more of an art than a science.

    IFM-LN.183
    Chapter 14 - Multinational Capital Budgeting
    MNCs receive project proposals from foreign subsidiaries. In general, they have several
    competing ones.

    14.1. How to Evaluate the Desirability of Projects?


    A: NPV. The evaluation of MNC’s project is similar to the evaluation of a domestic one.

    Simple definitions:
    EBIT = Revenue – Cost of goods – Selling and general administrative expenses – Depreciation
    NOPLAT (Net operating profit less adjusted taxes) = EBIT * (1-t) – t: corporate tax rate
    Gross CF = GCF = NOPLAT + Depreciation
    FCF (Free Cash Flows) = GCF – CAPEX – ∆NWC – NWC: Net Working Capital

    A typical evaluation of a project will discount future FCF, using a constant appropriate –i.e.,
    reflecting the risk of the CFs- discount rate. An evaluation may also add a project’s benefits not
    reflected in CFs (subsidies, additional tax advantages, etc.) and any associated value from real
    options (option to expand, delay or cancel).

    • Data Needed for Multinational Capital Budgeting:


    1. CFs (Revenues[P & Q] and Costs[VC & FC])
    2. Initial Outlay (I.O. or CF0)
    3. Maturity (T)
    4. Salvage Value (SVT)
    5. Depreciation
    6. Taxes (local and foreign, withholding, tax credits, etc.)
    7. Exchange Rates (St)
    8. Required Rate of Return (k)
    9. Restrictions to Capital Outflows

    In general, CFs are difficult to estimate. A point estimate (a single estimated number) is usually
    submitted by the subsidiary. The Parent will attempt to adjust for CFs uncertainty. Usually, this is
    done through the discount rate, k: Higher CF’s uncertainty, higher k.

    • International Taxation: Tax Neutrality


    DFIs are subject to foreign and/or local taxes. All countries attempt to eliminate double taxation to
    achieve tax neutrality:
     Tax neutrality: No tax penalties associated with international business.

    Two approaches to achieve tax neutrality:


    (1) Capital import neutrality (CIN), based on territorial income.
    (2) Capital export neutrality (CEN), based on worldwide income.

    (1) CIN Approach (most European countries, Canada, Hong Kong, Singapore)
    - No penalty or advantage attached to the fact that capital is foreign-owned
    - Foreign capital competes on an equal basis with domestic capital.

    IFM-LN.184
    - Local tax authorities exempt foreign-source income from local taxes.
     For MNCs: Exclusion of foreign branch profits from U.S. taxable income (exclusion method).

    (2) CEN Approach (U.S., Brazil, South Korea, Israel, India, Mexico)
    - No tax incentive for firms to export capital to a low tax foreign country.
    - Overall tax is the same whether the capital remains in the country or not.
    - Local authorities "gross up" the after-tax income with all foreign taxes; then apply the home-
    country tax rules to that income, and give credit for foreign taxes paid.
     For MNCs: Inclusion of "pre-tax" foreign branch profits in U.S. taxable income (gross-up
    income). A tax credit is given for foreign paid taxes (credit method).

    • Typical Problem: Agency Problem - Subsidiary vs. Parent


    The subsidiary will want to undertake projects (prestige of subsidiary in host country, local
    political pressure, incentives for local revenue, etc), whereas the Parent only cares about
    Profitability. Subsidiary can misstate Revenues, Costs, and Salvage Value.

    Example: Project in Hong Kong (Data provided in HKD)


     T= 4 years
     CF0= HKD 70M
    Price for Product = HKD 20 Year 1 Quantity = 1.00M
    25 Year 2 0.95M
    30 Year 3 0.90M
    35 Year 4 0.85M
     VC = HKD 5/unit
     FC = HKD 3M
     Depreciation = 10% of initial outlay (HKD 7M/year)
     Taxes: HKD 17%, US 35% (CEN system: Gross-up, credit for foreign taxes)
    Withholding tax=10%
     St = 7 HKD/USD (use RW to forecast future St’s)
     SV4 = HKD 25M
     k = 15%

    1. Subsidiary’s NPV (in HKD including local taxes)


    Year 1 Year 2 Year 3 Year 4
    Revenues 20M 23.75M 27M 29.75M
    Cost 5M 4.75M 4.5M 4.25M
    3M 3M 3M 3M
    Gross Profit 12M 16M 19.5M 22.5M
    Dep. 7M 7M 7M 7M
    EBT 5M 9M 12.5M 15.5M
    Taxes .85M 1.53M 2.125M 2.635M
    EAT 4.15M 7.47M 10.375M 12.865M
    Free CFs 11.15M 14.47M 17.375M 19.865M
    Free CF +SV 11.15M 14.47M 17.375M 44.865M

    IFM-LN.185
    NPV (in HKD) = -70M + 11.15M/1.15 + 14.47M/1.152 + 17.375M/1.153 + +
    44.865M/1.154 = - HKD 12.2869M <0

    Note: If SV4 is changed to HKD 80M, then NPV = 19.16M  Subsidiary would accept the
    project. (This is likely to happen: the subsidiary will never submit a project to the parent
    company with a NPV<0.) Thus, SV is very important!

    2. MNC’s NPV (in USD, including all taxes)


    Year 1 Year 2 Year 3 Year 4
    CFs to be remitted HKD 11.15 14.47 17.375 19.865+25
    St = 7 HKD/USD
    CFs in USD 1.59M 2.067M 2.48M 2.84M+3.57M
    Withholding .159M .2067M .248M .284M
    CFs remitted 1.431M 1.86M 2.3M 2.56M+3.57M

    (US Tax) (.6M) (.8M) (.975M) (1.125M)


    Tax Credit .281M .425M .552M .660M
    Net Tax .319M .375M .423M .465M
    EAT 1.114M 1.486M 1.811M 2.09M+3.57M

    NPV = - USD 10M + 6.5195M = - USD 3.48M < 0  No to the project.

    A subsidiary will never submit a project like this (they want to undertake the project.) A
    subsidiary will inflate some numbers, for example, SVT.

    If SVT=4 = HKD 80M, then

    NPV(USD M) = 10 – {1.114/1.15 +1.486/1.152 +1.811/1.153 +(2.095+80/7)/1.154}


    = USD 1.01181 M > 0  Yes.

    Note: Computation of US Tax, using the credit method:


    Year 1 Year 2 Year 3 Year 4
    Gross-up 12.0 16.0 19.5 22.5
    US-tax 4.20 5.60 6.83 7.88
    Foreign Tax credit 1.97 2.98 3.86 4.62
    Net US tax (in HKD M) 2.235 2.623 2.963 3.254

    US-tax (in USD M) 0.600 0.800 0.975 1.125


    Foreign Tax credit (in USD M) 0.281 0.425 0.552 0.660
    Net US tax (in USD M) 0.319 0.375 0.423 0.465

    Remark: Not all the countries collect taxes like in the U.S., based on worldwide income. ¶

    14.2. Adjusting Projects for Uncertainty

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    MNCs use different techniques to adjust for uncertainty in the estimated CFs submitted by the
    subsidiaries.

    • Adjusting discount rate, k


    In general, CF’s uncertainty is incorporated in the evaluation process through the discount rate, k:
    The higher the uncertainty, the higher k. In general, k incorporates economic and political
    uncertainty in the local country. But k is a point estimate, an average risk. Using an average risk
    may cost an MNC: it may wrongly reject (accept) projects that have a below (above) average risk

    Sometimes, it is better not to work with a point estimate for k, but with a range instead. In this
    case, an MNC may construct a range for k, say {kLB, kUB}, to create a range for {NPV(kLB),
    NPV(kUB)}.

    Example: A range for NPV based on {kLB, kUB} for the HK project.
    Suppose the Parent decides to build a range for NPVs based on {kLB=.135, kUB=.165} (using SV4 =
    HKD 80M to get NPV>0):
     Range for NPV: {USD 0.535M; USD 1.519M}.

    The lower end of the range is positive (under the higher kUB=.165). This is good for the project. ¶

    • Sensitivity Analysis/Simulation
    In addition to adjusting k, an MNC may use sensitivity analysis for CFs to derive an expected
    value for the CFs, and then an E[NPV]. You may remember that calculating an E[CF] is not the
    same as adjusting for risk (recall the St. Petersburg paradox).

    Sensitivity analysis when CF uncertainty is introduced by the subsidiaries can be very informative to
    evaluate proposals from subsidiaries. Recall the agency problem: Subsidiaries may not be
    forthcoming about true profitability of projects.

    1) Sensitivity Analysis of the impact of Revenues and Costs on the NPV of project
    ⋄ Play with different scenarios/Simulation
    Steps: a. Assign a probability to each scenario/Simulate from a distribution
    b. Get an NPV for each scenario.
    c. Calculate a weighted average (weight=probability) NPV => E[NPV]
    d. If possible, use a risk-reward measure (a RAPM), say a Sharpe Ratio.
    ⋄ Breakeven Analysis (same as what we do below for SV).

    Note: Decisions
    A Parent can base a decision using some risk-reward rule. For example, a firm may look at the SR
    (using E[NPV] and SD[NPV]), the range –i.e., the difference between best and worst case
    scenarios-, establishing some ad-hoc tolerable level for the probability of negative NPV, etc.
    Experience tends to play an important role in an MNC’s decisions.

    Example: Scenarios for CFs and E[NPV] & SD[NPV] for HK project

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    We create different scenarios for the CFs=Gross Profits (as a percentage of the CFs submitted by
    the subsidiary).
    % of CFs Probability NPV (in M)
    0.60 0.01 -0.77918
    0.64 0.025 -0.60009
    0.68 0.05 -0.42099
    0.72 0.075 -0.24189
    0.76 0.09 -0.06279
    0.80 0.1 0.116313
    0.84 0.125 0.295412
    0.88 0.15 0.474512
    0.92 0.15 0.653611
    0.96 0.125 0.832711
    1 0.1 1.01181

    E[NPV] 0.35541
    SD[NPV] 0.64477
    Prob[NPV<0] 0.25

    • Descriptive Stats
    E[NPV] = USD 0.355411 M
    SD[NPV] = USD 0.644769 M
    Prob[NPV<0] = 0.25
    SR= E[NPV]/SD[NPV] = 0.551221
    95% C.I. (Normal) = {USD -0.90834M; USD 1.61916M} ¶

    • Decision
    Rule: Among the projects with E[NPV]>0, The Parent will compare the SRs (or CIs) for different
    projects and select the project with the higher SR (or the CI with the smallest negative part). ¶

    2) Sensitivity Analysis of the impact of SV on NPV


    ⋄ Try different scenarios with different values for SV (same as above for CFs). For example:

    IFM-LN.188
    % of SVs (in HKD) Probability NPV (in M)
    0.60 (=HKD 48) 0.05 -1.60192
    0.64 (=HKD 51.2) 0.065 -1.34055
    0.68 (=HKD 54.4) 0.085 -1.07917
    0.72 (=HKD 57.6) 0.1 -0.8178
    0.76 (=HKD 60.8) 0.125 -0.55643
    0.80 (=HKD 64) 0.15 -0.29505
    0.84 (=HKD 67.2) 0.125 -0.03368
    0.88 (=HKD 70.4) 0.1 0.227692
    0.92 (=HKD 73.6) 0.085 0.489064
    0.96 (=HKD 76.8) 0.065 0.750437
    1.00 (=HKD 80) 0.05 1.01181

    E[NPV] -0.29505
    SD[NPV] 0.866876
    Prob[NPV<0] 0.70

    ⋄ Breakeven Analysis: Calculate SVBE, such that NPV(SVBE) = 0.
    => SVBE = {IO - Σt CFt/(1+k)t}*(1+k)T

    The higher SVBE, the more dependent the project is on an uncertain CF. To make the NPV>0, we
    need SVT > SVBE. (Not good!)
    Q: Is the SVT reasonable? SVBE helps to answer this question.

    Example: Calculate SVBE for HK project.


    SVBE = {10M - {1.114M/1.15 + 1.486M/1.152 + 1.811M/1.153 + 2.09M/1.154}*1.154
    = USD 10.21583 (or HKD 71.51075M)

    Check:
    NPV(USD M) = 10 – {1.114/1.15 + 1.486/1.152 + 1.811/1.153 + (2.09+51.51075/7)/1.154}= 0

    A parent company compares the SVBE with the reported SV value:

    SVBE = HKD 71.51075M < SV4 = HKD 80M. (Too big!)

    Note: You can find the whole set of examples regarding the HK project (and play with different
    values) in my homepage: www.bauer.uh.edu/rsusmel/4386/npv-int2.xls ¶

    Remark: If SVBE is negative, it is good for the evaluation of the project. Its profitability does not
    depend at all on an uncertain –and difficult to estimate- future CF.

    • Judgment call
    We presented several techniques that can be used by an MNC to measure and evaluate a project’s
    risk. But, in practice there is a lot of subjective judgment. MNCs also incorporate their own and/or
    a consultant’s experience to make a decision. Introducing a judgment call in the process is

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    acceptable, given that in building scenarios, changing k, assuming distributions, experience also
    plays a very important role.

    Example: Ad-hoc decision


    Rule: The Parent not only requires E[NPV]>0, but as an additional control for risk that the
    probability of NPV<0 be lower than 30%. In the HK example, the probability of a negative NPV
    is 25%, which would be acceptable under this ad-hoc risk-reward rule.

    Note: This ad-hoc rule double counts risk, since NPV is calculated using risk-adjusted discount
    rates! ¶

    14.3. Real Options View


    The original HK project (with SV = HKD 25M) has an NPV<0. Under the usual view, a company will
    reject this project. But, an MNC company may undertake a negative NPV project if there maybe future
    benefits to the company associated with the project. For example, an expansion, development of
    contacts, power to influence future political events, etc.

    An MNC may view a DFI as an option –a real option. The initial investment is a sunk cost needed to
    have the option to expand later, similar to an option premium, p:
    p = NPVInitial Investment < 0

    The MNC will have some targets for the initial investments (revenue, market share, etc.) that will play
    the role of a strike price, X:
    If Realized Target > X  Expand (exercise real option).

    Finally, the MNC undertakes project if


    E[NPV] = NPVInitial Investment + Option Value of Expansion

    Think of a real option as a two-phase project:


    1) First phase: Test the Market
    2) If test is successful: Expand

    Example: Suppose Malouf Coffee is considering expanding to Mexico by opening two stores: a
    small one and a big one. If the expansion is done simultaneously, the upfront investment is 230.
    There is a 70% probability of failure. The associated CFs under failure and success are 60 and
    140, respectively, for the small store; and double the CFs under both scenarios for the big store.

    Alternatively, Malouf Coffee can do the expansion in two phases, with an Initial Investment = 100
    & Expansion Investment (the big store) = 70 if X (CFs) > 120 (k=.15) and the following CFs:

    IFM-LN.190
    Suppose P1 = .70 & P2 = .50.
    The numbers reflect the fact that Malouf Coffee can double the CFs in the second phase at a lower
    investment cost (70), taking advantage of the initial investment and successfully learning about the
    business. Learning (better marketing, distribution, Mexican contacts, etc) also appears in the form
    of a lower the probability for the bad outcome (120). Then:

    E[NPV] = -100 + (.70)*60/1.15 + (.30)*{(140-70)/1.15 + [120*.50 + 280*.50]/1.152}


    = 0.1512 > 0.
     Malouf Coffee expands to Mexico.

    Notice that ex-ante, the NPV of opening one store in Mexico is negative:
    E[NPV] = -100 + [(.70)*60 + (.30)*140]/1.15 = -26.9565 <0.

    But, Malouf Coffee decides to do the initial NPV<0 investment because it allows Malouf Coffee
    to learn about the Mexican market.

    Clearly, if Malouf Coffee does not use the option approach and evaluates the expansion in Mexico
    under the scenario of opening the stores simultaneously, we get:
    E[NPV] = {-(100+130) + [(.70)*(60+120) + (.30)*(140+280)]/1.15} = -10.86957< 0.
     Malouf Coffee does not expand to Mexico.

    Note: The valuation is higher when the real option is introduced. The option has value! ¶

    The value of the real option comes from the fact that the firm learns from observing the CFs in the
    real world during the testing phase and, then, adapts the behavior (expand, delay, or close the
    project) accordingly. It is an attempt to limit the downside.

    Technical Note: The discount rate in the second-phase should be lower!

    In general, it is not easy to determine P1 & P2 and future CFs. It is difficult to do NPV analysis, as
    done in the above example. Option valuation methods are used to get an idea of the value of the
    option to expand.

    Many MNCs went to China in the early 1990s with negative NPV projects. Years later, many of them
    substantially expanded their initial investment (BMW, Nike, Starbucks), while many others closed the
    projects and left the market (Home Depot, Mattel).

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    CHAPTER 14 – BRIEF ASSESMENT

    1. Dennis Corporation, a U.S.-based MNC, has a subsidiary in Nicaragua that manages coffee fields.
    The subsidiary believes it could also enter into the sugar export business. The following data has been
    compiled for the analysis (in córdobas (NIO), Nicaragua’s currency):
    • Initial outlay: NIO 60 million
    • Life of the project: 3 years
    • Revenue per year: NIO 40 million
    • Cost of Goods per year: NIO 10 million
    • Interest expense per year: NIO 2 million
    • Depreciation: 10% of initial outlay
    • Salvage value: NIO 15 million
    • Exchange rate: 25 NIO/USD
    • Forecasted exchange rates:
    Et[St+1]=24 NIO/USD; Et[St+1]=22 NIO/USD; Et[St+1]=20 NIO/USD.
    • The Nicaraguan government imposes a 20% tax on profits.
    • The Nicaraguan government also imposes a 10% withholding tax on funds remitted to the U.S. parent
    house (excluding salvage value).
    • The U.S. government imposes a 10% tax on remitted funds, excluding salvage value. Tax credit is
    allowed.
    • All the cash flows will be remitted to the parent company.
    • The required rate of return is 12%.

    i.- What is the evaluation of the project for Dennis Corporation's Nicaraguan subsidiary?
    ii.- What is the evaluation of the project for Dennis Corporation?
    iii. Calculate SVBE.
    iv.- Would you recommend the project to Dennis Corporation?

    2. Following the previous exercise, what happened to the evaluation of the project if:
    (A) Dennis decides to increase required rate of return to 15%.
    (B) Dennis decides to decrease SV to NIO 5 million
    (C) Dennis decides to use the RW model to forecast exchange rates.
    (D) Dennis adds NIO 10 million to the net present value, as the value of the option to expand.
    (E) Dennis believes there are four scenarios regarding annual revenue:
    - 50% probability annual revenue will be as stated by subsidiary –i.e., NIO 40 million.
    - 25% probability annual revenue will be 10% lower.
    - 15% probability annual revenue will be 20% lower.
    - 10% probability annual revenue will be 30% lower.

    3. Suppose Fox Sports is considering buying the soccer league TV rights of Panamá, El Salvador,
    Guatemala, Nicaragua and Honduras. The success of the investments depends on the number of
    subscribers. If the number is “high”, the total expected 5-year return (in USD) is 40% for Fox
    Sports per market; if the number is “low,” the total expected 5-year return (in USD) is -20% for
    Fox Sports per market. Suppose, the probability of a high number of subscribers is 60%. To simplify

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    suppose the upfront initial investment per market is USD 100. Evaluate the investment under 2
    situations (a & b below), using a discount rate of 14%:
    a.- Fox Sports decides to test one market, say Panama. If successful in test market, Fox Sports
    will enter the other (& assume Fox Sports now knows it will be successful in all the other
    markets).
    b.- Fox Sports decides to buy all TV rights simultaneously.
    c.- Explain why the results are different.

    IFM-LN.193
    Chapter 16 - Country Risk (CR)
    Review from Chapter 14
    - MNCs make decisions on DFI projects on the basis of NPVs.
    - MNCs use discount rates to establish NPV for projects
    - the higher the discount rate, the lower the chances of a project to have a NPV>0.

    Q: Where do discount rates come from?


    A: For projects abroad, a key element is Country risk (CR)

    In this chapter, we will study country risk and how it impacts projects.

    16.1 Country Risk: Introduction


    CR reflects the (potentially) negative impact of a country’s economic and political situation on an
    MNC’s, a lender’s or an investor’s CFs.

    Country Risk
    Definition: Country risk (CR) is the risk attached to a borrower or an investment by virtue of its
    location in a particular country.

    Note: CR is different than FX risk. CR risk can be zero and FX can be huge for a given country.
    The reverse, though unusual, can also happen.

    • Q: What are the determinants of CR?


    We look for variables that have a negative effect (reduce and/or disrupt) on the CFs of a lender/investor.
    We consider variables that have the potential to produce expropriations, change in regulations/taxes,
    exchange rate/banking crisis, revolutions, wars, etc. A good economy, sound institutions (independent
    branches of government) tend to be good indicators for CR.

    In general, we tend to put the determinants of CR in groups. For example:


    - Economic variables, such as GDP growth, government deficit, debt, trade balance, St, etc.
    - Political variables, such as orientation of government, potential for change in regulations/policies, etc.
    - Legal variables, such as quality of court system, protections of investors/creditors, etc.
    - Social variables that can contribute to the stability of a country, such as poverty, corruption, etc.

    Global factors also matter. For example, if the world economy is doing well, it is likely that the economy
    of a particular country is doing well, reducing country risk.

    • Q: Why does country risk analysis matter?


    A: Look at the 2014 Ukraine crisis and the 2011 Greek crisis. Look at the Argentine debt default on
    Dec. 2001. Value of Russian, Ukrainian, Greek and Argentine assets went down significantly after
    those crises. Banks, MNCs, bondholders, and investors realize the relevance of country risk analysis.

    Sovereign debt crises are not rare. See graph below from Reinhart and Rogoff (2011), which does not
    even include the debt defaults/restructures of Ecuador (2008), Iceland (2008) and Greece (2011).

    IFM-LN.194
    • Credit and Interest Rate Risk for Bonds: Brief Review
    Bonds are subject to two types of risk:
    1) Interest rate risk: The risk associated to changes in interest rates.
    2) Credit/default risk: The risk associated to the probability of default combined with the
    probability of not receiving principal and interest in arrears after default.

    Credit rating agencies describe (measure) the credit risk with a credit rating (a letter grade).
    Credit ratings are usually estimated using financial characteristics of firms, such as the interest
    coverage ratio and the leverage ratio.

    Note: It is not entirely clear what a credit rating means. Some economists (myself included) say it
    is a measure of the probability of default over a specified horizon. Other economists say it is a
    measure of expected loss.

    Rule: Regardless of the interpretation of a rating, the higher the grade, the lower the yield of the bond
    (measured as a spread over risk-free rate; where the risk-free rate is the yield of government bonds).

    16.2 Construction of a Country Risk Grade (Score)


    CR is associated with credit (default) risk, which is influenced by political risk and economic risk.

    • Measuring CR
    CR is, in general, reported as a grade: A very good, C bad.

    Same credit rating rule applies: The higher the grade for a country, the lower the discount rate used to
    evaluate projects in that country.

    We will associate CR with a spread over a risk-free rate (in the U.S. or USD debt segment: US

    IFM-LN.195
    Treasuries). That is, CR influences the interest on the debt issued by a government of a country. Many
    times the spread is called sovereign default spread or, just, country risk (CR).

    Example: Setting yields for Mexico (actually, the Mexican government)


    The Mexican government wants to borrow in USD for 3 years.
    Yields on Mexican government debt = US Treasuries + spread (risk premium, a function of CR)
    Mexico’s grade: BBB (a spread of 140 bps (1.40%) over US Treasuries).
    3-yr US Treasuries yield = 3%.
    YieldMex (USD) = 3% + 1.40% = 4.40% (sovereign default spread: 1.40%)

    If the Mexican government wants to borrow in MXN, we have to introduce the expected change in St
    (measured as an annualized ef,t). Using linearized IFE (with MXN as the DC):
    YieldMex (MXN) ≈ YieldMex (USD) + E[ef,t]. ¶

    • There are two approaches to measure CR (and get a grade):


    (1) Qualitative – collect data, get an opinion from “experts,” form a “consensus” grade.
    (2) Quantitative – collect data, process the data with a computer model, get a grade.

    (1) Qualitative Approach: Talk to experts (politicians, union members, economists, etc) to form a
    consensus opinion about the risk of a country. The consensus opinion becomes the grade. This process
    is “subjective.”

    (2) Quantitative Approach: Start with some quantifiable factors that affect CR. Use a formula to
    determine numerical scores for each factor. Calculate a weighted average of the factors’ numerical
    scores. This weighted average determines the final grade. This process is (or seems more) “objective.”

    We will emphasize the Quantitative Approach.

    16.3 Quantitative Approach – Getting a CR Grade: Risk Rating Method (Check list)
    The Check list approach provides a weighted average of grades for four major aspects of a country:
    i. Economic Indicators (EI) (financial condition)
    ii. Debt management (DM) (ability to repay debt)
    iii. Political factors (PF) (political stability)
    iv. Structural factors (SF) (socioeconomic conditions)

    The scores (between 0 and 100) for each factor are a function of “fundamental data”. For example, the
    economic indicator’s grade depends on GDP per capita, GDP growth, inflation, interest rates, etc. Debt
    management’s grade depends on growth of money, trade balance, foreign and domestic debt, fiscal
    balance, etc.

    A formula is used to compute the scores for each factor and the final score is computed as a weighted
    average of the four scores. For example, for Country J:

    Score(EICountry J) = α1 GDP per capitaj + α2 GDP growthj + α3 Inflationj + α4 interest ratesj + ....
    Final Score for Country J = wEI Score(EIj) + wDM Score(DMj) + wPF Score(PFj) + wSF Score(SFj)

    IFM-LN.196
    Note: The weights should be positive and should up to 1 –i.e., wEI + wDM + wPF + wSF = 1.

    Once a final score is determined a Table, like Table 16.1 is used to translate the final score into a rating,
    given by a letter grade. For example if Final Score of Country J is 83, we will give it a AA rating.

    • Q: Where are the weights and the formulae for the grades coming from?
    This method seems more “objective,” because it is based on hard economic data, but weights and
    formulas might be “subjective.” It is more an art, than an exact science.

    A regression can be used to determine the factors and the coefficients (estimates of αi’s) used in the
    formulas.

    • The model can deliver different forecasts: Short-term, Medium-term, and Long-term. The weights and
    grades can change depending on your horizon.
    For example:
    (a) Short-term: More weight to debt management and political factors.
    (b) Long-term: More weight to economic indicators and structural factor.

    • Each model assigns a score between 0 and 100.


    Each grade is associated with a spread in basis points (bps) over base rate, usually the risk free rate.
    The following Table presents a standard conversion table. (Suppose for 1-year maturities.)

    TABLE 16.1
    Conversion Table of a Country's Grade into a Rating and Spreads over US Treasuries
    Overall grade Rating Interpretation Spread (in bps) Average
    91-100 AAA Excellent 10-70 50
    81-90 AA 50-100 70
    71-80 A 80-130 100
    61-70 BBB Average risk 110-220 160
    51-60 BB 190-300 240
    41-50 B 270-410 350
    31-40 CCC Excessive risk 360-490 450
    21-30 CC 450-700 570
    10-20 C 700+ 800
    0-10 D In Default (debt in arrears)

    Notes:
    ⋄ A rating of BBB or better is considered “investment grade.”
    ⋄ A rating of BB or less is considered “junk” (also called “high-yield,” “speculative grade”). In the U.S.,
    the usual spread of junk debt is between 400 to 600 bps over 1-yr T-bills. Range is very wide: Spreads
    can go over 2600 bps.
    ⋄ This Table is for short-maturities. As time to maturity increases, the spread (in bps) also increases.
    ⋄ Spreads are not constant over time, global and credit market conditions matter. We pointed out above
    that global factors matter. If developed markets are doing well, in general we tend to see that liquidity
    and appetite for risk in credit markets increases. These two factors will drive down spreads.

    IFM-LN.197
    ⋄ This Table gives spreads over T-bills, in USD. If we are interested in converting the YTM in USD
    into a YTM in the local currency, we use IFE combined with relative PPP to estimate E[ef]. That is,
    using the linearized version of both formulas, we get:

    YTMD (in local currency) YTMD (in USD) + (ID – IUS).

    Example: Suppose country DX wants to borrow short-term & medium-term in USD. Bertoni Bank
    evaluates the country risk of country DX.

    Short-term Horizon Medium-term Horizon


    Factor Weight Grade Weight Grade
    Economic .3 80 24 .3 70 21
    Debt management .3 90 27 .2 70 14
    Political .3 67 12 .2 50 15
    Structural .1 75 15 .3 60 12
    Total 78.6 63
    Short-term ranking: A
    Medium-term ranking: BBB

    That is, the short-term debt of country DX will get a spread in the 80-130 bps range, say 93 bps over US
    Treasuries; while the medium-term debt will get a higher spread, say 178 bps.

    Suppose the short-term US Treasuries yield 3% (s.a.). Then, the short-term debt of country DX yields
    YTMDX (in USD) = 3% (s.a.) + 0.93% (s.a.) = 3.93% (s.a.).

    Based on the past 10 years, the expected inflation in country DX is 5% and in the U.S. is 2%, then
    YTMDX (in DX currency) = 3.93% + 3% = 6.93% .¶

    Remark: The observed spread, the sovereign default spread, –i.e., the difference between the US
    Treasuries yield and another government debt yield (in USD)– is a good proxy for CR. The CDS
    (Credit Default Swap) market allows investors to buy insurance against CR. The insurance premium
    paid (say, 1.60% per year) is also a good indicator for CR! (Both indicators should be similar!)

    Example: Weights and Factors in Practice (Euromoney) – March 2014


    The British magazine Euromoney produces semi-annual country risk analysis of 189 countries using a
    panel of more than 400 experts. Euromoney rates nine categories with a score (0 to 100).
    • Factors and weights:
    Economic performance: GDP growth - 25% weight
    Political Risk - 25% weight
    Debt indicators: Debt/GDP -10% weight
    Debt in default or rescheduled -10% weight
    Credit rating: Moody’s or S&P’s or Fitch IBCA’s rating -10% weight
    Short-term credit market access - 5% weight
    Access to bank finance: Commercial bank credit - 5% weight
    Access to Capital markets - 5% weight

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    Discount default factor: Spread over US Treasury bills: - 5% weight

    Based on the weighted average for each country, each country is placed on a Tier (Tier 1=AAA, Tier
    5=C). A world country risk weighted average is also calculated: 42.86 (B rating or Tier 4)

    • Measures to reduce CR
    ⋄ A cap on the total amount invested in a particular country
    ⋄ Diversification
    ⋄ Credit/Political Risk Derivatives

    Diversification and Country Risk


    Taken From “Profits in a Time of War,” The Economist, Sep 20, 2014.

    An excessive concentration on one country is a classic mistake. After China’s revolution in 1949
    HSBC, then a purely Asian bank, lost half its business. Iran’s nationalisation in 1951 of the Anglo-
    Iranian Oil Company’s assets devastated the firm, a precursor of BP.

    There are modern echoes of these episodes. Repsol, a Spanish oil firm, fell in love with Argentina,
    leaving it vulnerable when YPF, the firm it bought there, was nationalised in 2012. First Quantum,
    of Canada, had made a third of its profits from a mine that the Democratic Republic of Congo
    nationalised in 2009. But as they have expanded over the past two decades, multinationals have
    spread themselves more. Only a dozen big, global, listed firms have over a tenth of their sales in
    Russia. BP is the country’s largest foreign investor but gets only about 10% of its value from its
    stake in Rosneft, an oil giant. McDonald’s Moscow outlets, once a symbol of détente, are

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    temporarily shut, victims of a diplomatic tit-for-tat. Even so, the burger giant makes less than 5% of
    its profits in Russia.

    This picture is true in other hotspots. Telefonica, a Spanish firm, and Procter & Gamble (P&G),
    together have billions of dollars trapped in Venezuela, which has introduced capital controls. But it
    represents less than 5% of their sales. Ben van Beurden, the boss of Royal Dutch Shell, recently said
    diversification is “the only way to inoculate yourself”.

    • Review of CR
    ⋄ Pros
    - It is simple (many factors simplify to a letter)
    - It allows cross-country and across time comparison.
    ⋄ Cons
    - It is too simple.
    - In practice, ratings tend to converge (herding).
    - Not a lot of predictive power.

    The last point –i.e., the lack of predictive power– is a major criticism. For example, a month before
    the 1997 Asia crisis, South Korea was rated as Italy and Sweden. Then, Fitch went from rating Korea
    as AA- (investment grade) to B- (junk) in one month. Other rating agencies replicated the same
    dramatic sudden change in Korea’s CR rating.

    Similar sudden downgrades occurred during the 2009-2012 European debt crisis with Greece,
    Cyprus, Ireland, Italy, Portugal, and Spain.

    Given the lack of predictive power of CR, a single indicator may not be enough to capture the overall
    risk of a country. There are other indexes that may be help to signal the true riskiness of a country –
    i.e., indicators that can be correlated with the underlying true country risk. For example, FDI
    confidence index (produced by A.T. Kearny), Global competitiveness index (GCI) (produced by
    World Economic Forum), Index of economic freedom (produced by the Heritage Foundation and
    the Wall Street Journal), Opacity index (produced by PWC and The Milken Institute), etc.

    Examples of CR Ratings:
    1) From A.M. Best, 2014 (http://www.ambest.com/ratings/countryrisk.asp):
    A.M. Best uses country risk analysis to determine how the factors outside an insurer's control affect its ability
    to meet its obligations to its policyholders. These analyses include, amongst others, the assessment of local
    accounting rules, government policies and regulation, economic growth and social stability. A.M. Best has a
    five-tier scale and assigns a Country Risk Tier I-V based on each country's level of risk (I-lowest risk, V-
    highest risk).

    Australia, Austria, Canada, England, Luxembourg, Singapore, Sweden, Switzerland, UK, USA Tier I
    Belgium, Bermuda, Cayman Islands, HK, Italy, Macau, New Zealand, Singapore, Spain, South
    Tier II
    Korea, Taiwan
    Bahrain, China, Cyprus, Kuwait, Malaysia, Malta, Poland, Qatar, T&T, South Africa, Ukraine Tier III

    IFM-LN.200
    Brunei, India, Indonesia, Jordan, Kazakhstan, Morocco, Panama, Russia, Tunisia, Turkey Tier IV
    Dominican Republic, Ghana, Jamaica, Kenya, Lebanon, Libya, Nigeria, Pakistan, Ukraine Tier V

    2) From Coface, November 2014 (http://www.trading-safely.com):


    Coface is France's export credit underwriter, offering insurance against the risk that when you sell
    something to a foreign company, they won't pay their bills (for whatever reason, from bankruptcy to
    international war).

    Country Rating Definition of Rating


    Canada, HK, Japan, A1 The steady political and economic environment has positive effects on an
    Sweden, Switzerland, already good payment record of companies. Very weak default
    Taiwan, USA probability.
    Australia, Chile, A2 Default probability is still weak even in the case when one country's
    Malaysia, New politic/al and economic environment or the payment record of companies
    Zealand, Sou. Korea, is not as good as A1-rated countries.
    Thailand, U.K.
    Belgium, China, A3 Adverse political or economic circumstances may lead to a worsening
    France, Ireland, payment record that is already lower than the previous categories, although
    Netherlands, T&T the probability of a payment default is still low.
    Brazil, Costa Rica, A4 An already patchy payment record could be further worsened by a
    India, Mexico, Spain, deteriorating political and economic environment. Nevertheless, the
    Sou Africa, Thailand probability of a default is still acceptable.
    Dominican Rep., B An unsteady political and economic environment is likely to affect further
    Gabon, Kazakhstan, an already poor payment record.
    Kenya, Italy, Turkey
    Argentina, Lebanon, C A very unsteady political and economic environment could deteriorate an
    Ghana, Greece, Togo, already bad payment record.
    Uganda
    Cambodia, Cuba, D The high risk profile of a country's economic and political environment will
    Haiti, Pakistan, further worsen further a generally very bad payment record.
    Sudan, Yemen

    Example: Spread on government European bonds – Nov 11, 2014.


    Base Rate: German government bonds
     Higher observed spreads, higher CR.

    IFM-LN.201
    From MTS Indices: http://www.mtsindices.com/european-bond-spreads. ¶

    IFM-LN.202
    CHAPTER 16 – BRIEF ASSESMENT

    1. Suppose the Brazilian government wants to borrow in USD for 7 years. You want to set the YTM in
    USD and in BRL. You have the following data:
    Brazil’s grade: BB (associated with a spread of 280 bps (2.80%) over US Treasuries).
    7-yr US Treasuries yield = 2.5%.
    E[IUS] = 2%
    E[IBR] = 6%

    2. Suppose Colombia wants to borrow for 3-yers (medium-term) in USD. Given the information below
    determine the YTM for Colombian debt. (Use Table 16.1 and a linear interpolation method to set the
    spread).
    Medium-term Horizon
    Factor Weight Grade
    Economic .30 90
    Debt management .25 90
    Political .25 70
    Structural .20 60

    3-year US Treasuries yield: 2.1%.

    3. What is the effect on Colombia’s YTMs of the following events?


    (A) Commodity prices, say coffee prices, decrease.
    (B) The Colombian government runs an unexpectedly large government deficit.
    (C) Colombian economy grows more than expected.
    (D) The US Fed increases interest rates.

    IFM-LN.203
    Chapter 17 – The Cost of Capital in an International Context
    Review from Chapter 16
    - Country Risk affects discount rates
    - Different countries will have different risk free rates (kf).
    - High CR, high risk-free rate kf.

    Q: How do MNCs set discount rates for projects in foreign countries?

    In this chapter, we study the determination of the cost of capital for international projects. The cost
    of capital is the cost of a MNC’s funds for a project/investment. In equilibrium, it also represents
    the required return on a project/investment.

    We will use the WACC to calculate an MNC’s cost of capital of projects, which can be used as the
    discount rate for those projects.

    17.1 Brief Review: Capital Structure


    A firm can raise new capital by:
    ⋄ Issuing new equity (E) –a firm gives away ownership and has to pay dividends
    ⋄ Issuing debt (D) –a firm borrows and has to pay interest payments.

    The firm can also use retained earnings for new investments, which we will consider E.
    (According to the pecking order theory, retained earnings are the first source of funds for a
    company.)

    Recall that the investment decision (NPV evaluation based on CFs and risk of project) is separate
    from the financing decision (selection of E and D).

    • Trade-off Theory of Capital Structure


    Firms will use the E and D mix that minimizes the cost of capital, kc. There is a U-shape relation
    between cost of capital and the amount of debt relative to the total value of the firm (V=E+D).

    Trade-off: Debt has its (tax) advantages, but also its disadvantages (bankruptcy). E and D need to
    be combined optimally.

    Before the optimal Debt Ratio, (D/V)*, the tax advantages dominate and decrease the cost of
    capital; after (D/V)*, the increased probability of bankruptcy dominates and increases the cost of
    capital.

    IFM-LN.204
    Cost of
    Capital
    (kc)

    (D/V)* Debt Ratio (D/V)

    The capital structure that a firm desires is called their target structure. It should be close to
    (D/V)*.

    • Target Debt-Equity Ratio in Practice


    Suppose that GE’s target debt-equity ratio is 70%-30%. It is unlikely that GE will raise funds with
    a 70-30 debt-equity split for every project. For example, for a Brazilian project, GE may use a 60-
    40 D/E split. The target (D/V)* reflects an average; it is not a hard target for each project. That is,
    for other projects GE will use D/E in order to compensate and be close to the target debt-equity
    ratio.

    It is expensive to issue shares for each project. It is common for companies to finance
    projects using retained earnings first (the easiest and cheapest form of E) and then use
    debt for the remaining part −following the Pecking order theory.

    17.2 Measuring the Cost of Capital


    The cost of capital (discount rate) used should reflect both the riskiness and the type of cash flows
    under consideration. If the cash flows are cash flows due to E (D), then the appropriate cost of
    capital is the cost of equity, ke (cost of debt, kd). In general, firms use both E & D to finance
    projects.

    We will use weighted average cost of capital (WACC).

    WACC: kc = D/(E+D) kd (1-t) + E/(E+D) ke

    • Cost of debt (kd)


    The cost of debt of a project (kd): The interest a firm has to pay to borrow from a bank or the bond
    market to fund a project. Sometimes kd is called pre-tax cost of debt.

    It is easy to determine for a firm: A firm calls a bank/investment bank to find out the interest rate it
    has to pay to borrow capital.

    It is also easy to determine for companies that borrow from debt markets, which are rated. If the
    company is not rated or most of the debt is old bank debt, it is more difficult to calculate a current

    IFM-LN.205
    kd. In these cases, we benchmark kd with similar companies (similar size, similar industry, similar
    D/V, etc.)

    Q: How does a bank set the interest rate for a given firm?
    A: Base rate (say, a risk free rate like T-bills, kf) + spread (reflecting the risk of the
    company/project, which includes CR). We will see this in Chapter 18.

    Note: Interest payments are tax deductible => After-tax cost of debt = kd*(1-t)

    • Cost of equity (ke)


    The cost of equity of a project (ke): The required (expected) return on equity a firm has to pay to
    investors. This is an equilibrium result. A model is needed to determine required rates of return on
    equity. We can use the CAPM or other risk-return models, for example a multifactor model, with
    the 3- or 5-Fama-French factors. (Recall that only undiversifiable risk is priced in expected
    returns.)

    We will use the CAPM, which produces a required rate of return on equity, to value the cost of
    equity:
    ke = kf +  (kM – kf)
    kf: Risk-free rate (ideally, the rate on a zero coupon government bond matching the time horizon
    of the investment). In practice, short-term government security rates, say 90-day T-bill rates.
    kM: Expected return on a market portfolio (in practice, the long-run return on a well-diversified
    market index).
    (kM – kf): Risk premium, what investors demand for investing in an average risk investment,
    relative to the risk-free rate. In practice, the difference between the above calculated kM & kf.
    : Systematic risk of the project/firm = Cov(ke,kM)/Var(kM). In practice, a coefficient estimated by a
    regression against excess market returns or risk premium, (kM – kf)).

    : Systematic Risk of the project/firm = Cov(ke,kM)/Var(kM) (in practice, a coefficient estimated


    by a regression against excess market returns or risk premium, (kM – kf), using 5 years of data).

    Q: Which CAPM: World or Domestic?


    A: The (kM – kf) and  used depends on the view that a company has regarding capital markets. If
    capital markets are integrated (or if the shareholders are world-wide diversified) the appropriate
    equity risk premium should reflect a world benchmark (say, MSCI World Index), (kM – kf)W. But,
    if markets are segmented (or if the shareholders hold domestic portfolios), then the appropriate
    equity risk premium should be based on a domestic benchmark (say, the Bovespa Index for
    Brazilian companies), (kM – kf)D. The risk-free rate should also be adjusted accordingly. Then,

    - World CAPM: ke = ke,W = kf ,W + W (kM – kf)W


    - Domestic CAPM: ke = ke,D = kf,D + D (kM – kf)D

    The difference between these two models can be significant. According to Bruner et al. (2008), on
    average, there is a 5.55% absolute difference for emerging markets and a 3.58% absolute
    difference for developed markets. The betas (W and D) tend to be different too: the average
    absolute difference is 0.44 for emerging markets and 0.21 for developed markets.

    IFM-LN.206
    Given that the evidence for integrated capital markets is weak, especially for emerging markets;
    we tend to think of financial markets as partially integrated. Then, a weighted average can be used
    to calculate ke, where the weights can be ad-hoc or represent some measure of integration, say,
    based on international trade or international investments of a country as a proportion of GDP:

    - Partially Integrated CAPM: ke = wD ke,D + (1- wD) ke,W

    In general, we tend to find that World CAPM produces low expected returns. The Fama-French 3-
    factor model tends to produce higher (and more realistic) expected returns. Many ad-hoc
    adjustments are used in the private sector.

    Notes:
    ⋄ Dividends are not tax deductible. There is an advantage to using debt!
    ⋄ Time-consistency with kf . The same maturity should be used for ke and kd. That is, if you use
    long-term bonds to calculate kd , you should also use long-term data to calculate ke.
    ⋄ In Chapter 16 we discussed country risk. For practical purposes, many emerging market
    government bonds may not be considered risk-free. Thus, the government bond rate includes a
    default spread, which, in theory, should be subtracted to get kf.
    ⋄ If the company is publicly traded, getting  is simple:  is estimated by the slope of a regression
    against a market index. If the company is not publicly traded, we need to benchmark . That is, we
    use the s of publicly traded similar companies.
    ⋄ There are many issues associated with the estimation of : choice of index, noisy data,
    adjustment by leverage, mean reversion, etc. We will not get into these issues.

    Issues:
    Q: Real or Nominal? If the CFs are nominal (the usual situation), then ke should be calculated in
    nominal terms.
    Q: Which kf to use? Local or Foreign? The kf that reflects the risk of the cash flows. If the CFs are
    in MXN, then kf should be a Mexican treasury rate (for example, CETES).
    Q: Which maturity for kf to use? The maturity that reflects the duration of the cash flows. In
    practice, the duration of the project is matched to the maturity of kf (potentially a problem for
    many emerging markets where there is no long-term debt market).
    Q: Which  to use? The  of the company or the  of the project?  should reflect the systematic
    risk of the project.

    Example: GE wants to do an investment in Brazil.


    Equity investment: BRL 100M
    Debt issue: BRL 150
    Value of Brazil investment = D + E = BRL 250 (⟹ 60-40 D/E split)
    Brazilian Tax Rate = t = 34% (25% corporate rate + 9% social contribution on net profits)
    Cost of capital of project = kc = ?

    • Cost of debt (kd)


    GE decides to use a domestic CAPM, with the following data.
    GE can borrow in Brazil at 60 bps over Brazilian Treasuries (kf)

    IFM-LN.207
    kf = 11.90% (3-year Brazil government bond yield)
    kd (for GE) = .1190 + .0060 = .1250 (12.50%)

    • Cost of equity (ke)


    Similar projects in Brazil have a beta of 1.1 (GE-Brazil = 1.1)
    Return of the Brazilian market (BOVESPA) in the past 20 years: 14% (kM = 14%)
    ke = kf +  (kM – kf) = .1190 + 1.1 * (.14 - .1190) = 0.1421 (14.21%)

    • Cost of Capital –WACC- (ke)


    kc = D/(E+D) kd (1-t) + E/(E+D) ke
    kc = (.60) x .1250 x (.66) + (.40) x .1421 = .10634 (10.634%)

    This is the discount rate that GE should use to discount the cash flows of the Brazilian project.
    That is, GE will require a 10.634% rate of return on the investment in Brazil. ¶

    Remark: Every time the cost of capital increases, the NPV of projects goes down.
    Anything that affects kc, it will also affect the profitability (NPV) of a project.

    Application: Argentina defaults in some of its debt. Argentine country risk increases, kf,Arg goes
    up and kc,Arg also goes up. Then, NPV projects in Argentina can become negative NPV projects:
    ⟹MNCs may suddenly abandon Argentine projects.

    Estimating the Equity Risk Premiun (kM – kf):


    Risk premiums are estimated with error. To deal with this issue, we use as many years as possible
    to build the long-run average. Remember that using averages comes with an associated standard
    error: More data (T) ⟹ lower S.E. -i.e., more precision. This may be a problem for emerging
    markets, where there is limited reliable return data.

    Example: Suppose we have 2 markets: a Developed Market (DM) with T=100 annual observation
    and an annualized standard deviation (SD) equal to 15%; & an Emerging Market (EM) with T=50
    and SD=30%.
    We can calculate the S.E. for both markets. Recall that S.E. = SD/sqrt(T).
    S.E.DM = .15/sqrt(100) = .015 (or 1.5%)
    S.E.EM = .30/sqrt(50) = .0424 (or 4.24%).

    Note: A 95% C.I. for the EM around 0% goes from [-8.5% to 8.5%]. Not very precise! ¶

    But, note that even with more than 100 years of data for developed markets there is no consensus
    on how to estimate the equity risk premium (ERP) and what the estimate should be.

    Duarte and Rosa (2015) list over 20 different approaches to estimate the ERP in the U.S. Using
    data from 1960 to 2013, Duarte and Rosa (2015) report estimates from -0.4% to 13.1%, with a
    5.7% average for all model. A wide range!

    Table 17.1 presents ERP estimates in international markets, translated to USD, using monthly data
    from 1970 to 2017. The estimates range from 0.8% (Italy) to 12.06% (Hong Kong), with a 2.95%

    IFM-LN.208
    world average. Again, a wide range.

    Table 17.1: MSCI Index USD Equity Returns and ERP: (1970-2017)

    Market Equity Standard ERP


    Return Deviation
    U.S. 8.19 15.04 0.0345
    Canada 8.22 19.35 0.0349
    France 9.02 22.17 0.0427
    Germany 9.37 21.67 0.0462
    Italy 5.08 25.38 0.0079
    Switzerland 10.44 17.83 0.0567
    U.K. 7.77 21.44 0.0302
    Japan 9.94 20.74 0.0520
    Hong Kong 16.80 33.72 0.1206
    Singapore 12.26 27.79 0.0752
    Australia 7.68 23.79 0.0293

    World 7.70 14.58 0.0295


    EAFE 8.00 16.78 0.0326

    For a market with limited return history, say Country J, it is sometimes easier to adjust the ERP
    from a well-established market, say, the U.S., to estimate that market’s (kM – kf)J. There are several
    ways to do this adjustment. These approaches are mainly intuitive, with simplicity in mind (taken
    from Damodaran (2012)):

    ⋄ Country Risk Approach: The U.S. market risk premium is increased by country risk (CRJ, the
    sovereign default spread of the bond issued by Country J):
    (kM – kf)J = (kM – kf)US + CRJ (⟹ no distinction between bond and equity risk!)

    ⋄ Relative Equity Market Approach: The U.S. market risk premium is modified by the volatility of
    the Country J’s equity market, σJ, relative to the volatility of the U.S equity market, σUS:
    (kM – kf)J = (kM – kf)US * σJ/ σUS (⟹ problem: σJ is also an indicator of liquidity!)

    ⋄ Mixed Approach: The U.S. market risk premium is increased by combining Country J’s CR,
    equity market volatility and bond market volatility. We expect equity spreads to be higher than debt
    spread. Then, we need to adjust the CR upward. One way to do this is to use the relative volatility
    of Country J’s equity market to the volatility of Country J’s bond market, σJ,bond:
    (kM – kf)J = (kM – kf)US + CRJ * σJ/ σJ,bond.

    Notes:
    ⋄ We may have very different numbers from these three approaches. Judgement calls/adjustments
    may be needed.
    ⋄ Following the idea of CR from bond markets, a country equity risk premium (CER) can be easily
    derived for Country J: CERJ = (kM – kf)J - (kM – kf)US.
    ⋄ We construct a market risk premium for Country J based on USD rates. To convert this premium

    IFM-LN.209
    into a local currency premium, we can use IFE combined with relative PPP to estimate E[ef]. That is,
    using the linearized version of both formulas, we get:
    (kM – kf)J (in local currency) (kM – kf)J + (IJ – IUS).

    Example: Suppose the limited returns history of Brazil’s equity markets makes GE’s risk manager
    uncomfortable. She wants to adjust (kM – kf)Brazil using different methods, using the U.S. market as a
    benchmark: the relative equity market approach and the mixed approach. GE uses the following
    data:
    (kM – kf)US = 3.45% (from Table 17.1)
    σUS = 15.2% (⟹ SE: .152/sqrt(45) = 0.02265 (or 2.27%), not very precise!)
    σBrazil = 34.3% (based on past 15 years)
    σBrazil,bond = 23.1% (based on past 15 years)
    CRBrazil = kf,Brazil (in USD) - kf,US = 2.80%
    E[IBrazil] = 7.5%
    E[IUS] = 3%

    ⋄ Relative Equity Market Approach:


    (kM – kf)Brazil = .0345 * .373/.152 = 0.08466
    (kM – kf)Brazil (in BRL) 0.08466 + (0.075-0.03) = 0.08466 + 0.045 = 0.1297

    ⋄ Mixed Approach:
    (kM – kf)Brazil = .0345 + .028 *.373/.231 = 0.07971
    (kM – kf)Brazil (in BRL) 0.07971 + 0.045 = 0.12471.

    Note: We can calculate CERBrazil from any of these approaches. For example, using the Mixed
    Approach:
    CERBrazil = 0.07971 - .0345 = 0.04521 (in USD!) ¶

    CER as a factor in the estimation of ke:


    Q: How sensitive are companies to CER? There are different ways to incorporate CER into ke.
    (They are all CAPM extensions, delivering two-factor models.)

    ⋄ Beta as a Measure of Exposure:


    We assume that CER exposure is proportional to the  of the company/project. That is, the
    sensitivity to CER is treated in the same way as the sensitivity to market risk. (This is the implicit
    assumption of the CAPM used above). Then,
    ke,J = kf,US +  (kM – kf)J = kf,US +  [(kM – kf)US + CERJ].

    ⋄ Using different weights for CER Exposure (“lambda approach”):


    We can allow each project/company to have its own sensitivity to CER. This sensitivity is called
    lambda, λ. Similar to , λ is scaled around 1 (λ=1, average exposure).
    ke,J = kf,US +  (kM – kf)US + λ CERJ.

    There is no consensus on how to estimate λ. The easier way to do this: Estimate λ using the
    proportion of revenue generated by the company/project in the country relative to the rest of the
    companies in the country. (It is possible to adjust this estimate by where the production facilities are

    IFM-LN.210
    located, by a company’s risk-management, etc.). A regression (say, returns against a CR indicator)
    can also be used to estimate λ.

    ⋄ Equal CER Exposure:


    A popular alternative method to estimate ke is to estimate ke as a U.S. company/project and, then,
    add CER. Very simple method that treats all companies/projects as equally exposed to CER:
    ke,J = kf,US +  (kM – kf)US + CERJ.

    Example: Suppose that GE’s risk manager wants to re-estimate ke using the lambda approach. She
    uses the following additional data:
    kf,US = 4.74% (using 1970-2017 average U.S T-bill rates)
    CERBrazil = 0.04521 (using the Mixed Approach)
    Revenue from Brazil: 50%
    Exports contribution to Brazil’s GDP: 13% ⟹ average revenue for a typical Brazilian firm: 87%
    λGE-Brazil = .50/.87 = 0.5747
    ke,Brazil = kf,US +  (kM – kf)US + λGE-Brazil CERBrazil = .0474 + 1.1*(0.0345) + .5747*(0.04521) =
    0.1113

    If we want to express the cost of capital into BRL, we proceed as usual (linearized IFE+PPP):
    ke,Brazil (in BRL) = 0.1113 + .045 = 0.1563 (15.63%). ¶

    17.3 Determinants of the Cost of Capital for MNCs


    Intuition: Economic factors that make the CFs of a firm more stable reduce the kc.
    1) Size of firm (larger firms get better rates from creditors and have lower s)
    2) Access to international markets (better access, more chances of finding lower rates)
    3) Diversification (more diversification, more stable CFs, lower rates. Also, s closer to M)
    4) Fixed costs (the higher the proportion of fixed costs, the higher the )
    5) Type of firm (cyclical companies have higher s)
    6) FX exposure (more exposure, less stable CFs, worse rates)
    7) Exposure to CR (again, more exposure to CR, less stable CFs, worse rates).

    Example: Calculating the Cost of Capital (Nov 2014)


    General Electric (GE): Huge, internationally diversified company
    Walt Disney (DIS): Large, moderate degree of international diversification
    The GAP (GPS): Medium cap, low international diversification.
    Data:
    T = Medium-term, say 5 -years
    US Treasuries (kf): 1.70% (5-year T-bill rate, from Bloomberg)
    S&P 500 return (kM): 8.15% (39 years: 1976-2014)
    tax rate (t): 27.9% (effective U.S. tax rate, according to World Bank)
    Recall: kc = D/(E+D) kd (1-t) + E/(E+D) ke

    E D Rating Spread  kd ke WACC


    GE 109B 260B AA- 87 1.58 2.57 11.89 4.82
    DIS 46B 15B A+ 55 1.50 2.25 11.38 8.98

    IFM-LN.211
    GPS 2.9B 1.4B BBB- 154 1.31 3.24 10.15 7.60

    For comparison, before the financial crisis, in Nov 2006, we got the following numbers:
    US Treasuries (kf): 4.25%
    S&P 500 return (km): 9.02% (1976-2006)
    tax rate (t): 25%

    E D Rating Spread  kd ke WACC


    GE 111B 410B AAA 92 0.65 5.17 7.35 4.62
    DIS 31B 13B A- 140 0.93 5.65 8.69 7.37
    GPS 5B 0.5B BBB- 213 0.91 6.38 8.59 8.24

    Note: kd went down and s increased from 2006 to 2014. We see simple results at work:
    ⋄ Lower interest rates ⟹ lower WACC
    ⋄ Higher betas ⟹ higher WACC. ¶

    Example: Country risk matter.


    According to The Economist (Sep 20, 2014), Western oil firms operating in Kurdish-run Iraq in mid-
    2014, after ISIS seized the city of Mosul, increased the assumed cost of capital from 12.5% to 15%. ¶

    IFM-LN.212
    CHAPTER 17 – BRIEF ASSESMENT

    1. Padres Co. wants to do an investment in the Dominican Republic (DR). Padres Co. uses the
    WACC to determine the cost of capital (and the CAPM to determine the cost of equity). Using the
    following information, set kc.
    Equity investment: DOP 200M (DOP = DR peso)
    Debt issue: DOP 150M
    DR tax rate = t = 25%
    Cost of project = kc = ?
    kf = 6.5%
    Padres’ spread over DR’s kf = 2.52%
    similar project-DR = 1.1)
    Return of DR’s stock market = 14% (kM = 14%)

    2. Suppose you do not trust the DR’s kM estimate. You decide to use an average of the estimates provided
    by the relative equity market approach and the mixed approach. You have the following data:
    (kM – kf)US = 3.65%
    σUS = 15.2%
    σDR= 42.5%
    σDR,bond = 28%
    CRDR = 4.20%
    E[IDR] = 4%
    E[IUS] = 2%

    Compute the new estimate of kc.

    3. Now, Padres Co. wants to re-estimate ke using the lambda approach. Padres Co. has the
    following additional data:
    kf,US = 2.5%
    Revenue from DR: 20%
    Exports contribution to DR’s GDP: 15%.

    Using your results from exercise 2, compute the new estimate of ke.

    4. What is the effect on Padres Co.’s estimated DR’s cost of capital under the following events?
    (A) DR risk-free rate decreases?
    (B) Padres Co.’s investment in DR becomes more diversified
    (C) Padres Co.’s CFs become less predictable
    (D) DR decides to decrease the corporate tax rate.

    IFM-LN.213
    CHAPTER 17 - BONUS COVERAGE: Cost of Debt – GE Data (Nov 2014)
    From Morningstar we can get Debt, Equity, bond yields & rating, and beta. For example:
    (http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=GE&Country=usa):

    IFM-LN.214
    CHAPTER 17 - BONUS COVERAGE: Cost of Debt (2011)
    Intel Plans First Non-Convertible Bonds in 24 Years to Fund Stock Buybacks
    By Sapna Maheshwari – (Bloomberg) - Sep 14, 2011 2:07 PM CT

    Intel’s USD 1.5 billion of five-year notes may yield 110 basis points more than similar-maturity Treasuries,
    the USD 2 billion of 10-year notes may pay a spread of 135 basis points and the USD 1.5 billion of 30-year
    bonds may offer 160 basis points more than benchmarks, said the person with knowledge of the transaction
    who declined to be identified because terms aren’t set.

    Intel is graded A1 by Moody’s Investors Service and A+ by Standard & Poor’s, Bloomberg data show.

    The average A rated bond pays a 217 basis-point spread and the average AA graded company debenture
    offers a 187 basis-point spread, Bank of America Merrill Lynch index data show, indicating strong demand
    for Intel’s offering.

    CHAPTER 17 – BONUS: ISSUING BOND DEBT - GOOGLE


    Google debuts in high-grade bond market with $3 billion deal
    On Monday May 16, 2011, 1:04 pm EDT

    BRADENTON/NEW YORK, May 16 (IFR) - Google Inc hit the U.S. bond market on Monday with its high
    grade market debut, announcing a $3 billion sale of 3-year, 5-year and 10-year notes that will take advantage
    of low borrowing rates.

    Proceeds of the SEC-registered deal will be used to repay commercial paper and for general corporate
    purposes, the company said in a statement. Citigroup, Goldman Sachs and JP Morgan are joint lead managers
    on the deal, which garnered an Aa2 rating from Moody's Investors Service, the third-highest rating in the
    agency's scale.

    Google is one of the few large-cap technology companies to actually have debt on its balance sheet -- albeit at
    about $2 billion of commercial paper, a tiny sum compared to its $169 billion market cap.

    The company is the latest in a spate of new or rare technology company borrowers coming to the corporate
    bond market this year, as they look to take advantage of low interest rates and realize that having some debt
    makes sense.

    "We are seeing some of the large cap tech companies deciding that having debt on the balance sheets is an
    appropriate way of having a capital structure and running a company, which is relatively new to them," said
    one banker.

    "Generally most of these large cap tech companies have only used the debt markets to finance their
    acquisitions. They typically don't use the debt markets for anything else."

    Now, with rates so low and their own industries having reached a level of maturity, many are using the debt
    markets as a way of returning value to shareholders, at a time when they have large levels of cash trapped
    overseas.

    Microsoft, for instance, raised funds in the bond market in February in part to buy back shares, while Google
    is improving its debt profile by extending the maturity of its debt. Both have large levels of cash overseas.

    IFM-LN.215
    Cisco Systems in March sold $4 billion of three-year fixed and floating rate notes and six-year bonds; eBay
    in October last year sold $1.5 billion of three, five and 10 year notes.

    Google is planning to sell $1 billion of 3-year notes, that launched at 33 basis points over comparable
    Treasuries. The company will sell $1 billion of 5-year notes at 43 basis points over Treasuries and $1 billion
    of 10-year notes at 58 basis points over Treasuries. That compares with market "whispers" that put the 3-year
    in the mid 30s, the 5-year in the high 40s and the 10-year in the mid 60s. Pricing is expected later on Monday.

    At the guidance stage, sources heard book size on the deal was already up to $8-$9 billion, with sources
    originally hearing there was little chance of an increase.

    Google may grab the lowest coupon levels seen so far this year. The 2011 coupon to beat in 3-years is 1.25
    percent, with both IBM and Colgate-Palmolive pricing deals with a 1.25 percent coupon. The 2011 coupon to
    beat in 5-years is 2.50 percent set by Microsoft on Feb 3. The 2011 coupon to beat in 10-years is 3.85
    percent, set by Berkshire Hathaway's Pacificorp last week.

    While at the lowest levels seen since December 2010, benchmark Treasury rates are still not in a spot which
    would allow any all-time low coupon records to be hit, with the all-time low coupon record in 3-years at 0.75
    percent, in 5 years at 1.375 percent and in 10-years at 2.95 percent.

    Google's strong debt protections measures are backed up by its almost $11 billion of operating profit and $7
    billion of free cash flow for fiscal 2011, ended March, according to Moody's Senior Vice President Richard
    Lane. The company also has nearly $37 billion in cash balances, he said. "These strengths, combined with
    solid business execution, will drive strong profitability, significant free cash flow generation, and ample
    financial flexibility," Lane said.

    However, the company is facing challenges from well-funded rivals, including Microsoft, rated Aaa, and
    Apple, which is not rated, along with private companies such as Facebook, he said. "An additional rating
    constraint considers the still developing nature of Internet technologies, usage, and behavioral patterns, all of
    which pose challenges to constantly invest and innovate," he said.

    (Reporting by IFR senior analysts Andrea Johnson and Danielle Robinson; Additional reporting by Reuters
    reporter Jennifer Saba; Editing by Ciara Linnane.)

    IFM-LN.216
    Chapter 18 - Long term financing – Part 1: Bonds
    Review from Chapter 17
    Cost of capital
    kc = (D/V) kd + (E/V) ke
    V=E+D
    kc = cost of capital = required rate of return = discount rate.

    In this chapter we answer the following question: How do we determine the cost of debt? Or how
    do investment banks determine the price (coupon) of a bond?

    We will focus on two long term financial instruments: bonds and swaps.

    18.1 Bond Market


    The bond market (debt, credit, or fixed income market) is the financial market where participants
    buy and sell debt securities, usually bonds. Governments and agencies, Corporations,
    Municipalities & individuals (mortgages) are the main participants.

    Size of the world bond market (2012 debt outstanding): USD 100 trillion, or 140% of World GDP
    (size of world equity markets capitalization USD 53 trillion).
    - U.S. bond market debt: USD 33 trillion (33%).
    - Japan bond market debt: USD 14 trillion (14%).

    Organization:
    - Decentralized, OTC market, with brokers and dealers.
    - Small issues may be traded in exchanges.
    - Daily trading volume in the U.S.: USD 822 billion (in 2012)
    - Government debt dominates the market (50% of market).
    - Non-financial corporations make up 12% of market (61% by U.S. corporations).
    - Used to indicate the shape of the yield curve.

    Note: The bond market is a public debt market, strictly regulated by a local body –in the U.S., the
    S.E.C. There is a private debt market: bank debt, private placements, and special debt vehicles (in
    the U.S., the popular Rule 144A debt).

    • The World Bond Market: Segments


    - Domestic: A domestic firm issues local debt in local currency (70% of World Bond Mkt). For
    example, Apple, the U.S. tech giant, issues USD bonds in the U.S. market.
    - Foreign: A foreign firm issues local debt in the local currency. Regulated like a domestic issue.
    For example, Apple issues AUD bonds in the Australian market.
    - Euro-yyy bond: A firm issues debt in a currency (yyy) different than the local currency where the
    bond is issued/trades. Domestic investors (from the firm’s home country) are not the target of the
    issue. For example, Apple issues EUR bonds in the U.K market.

    The Foreign + Eurobond Markets form the International Bond Market (30% of World Bond Mkt).

    IFM-LN.217
    According to Henderson et al. (2006), 20% of corporate bonds are issued in the international bond
    market (from 1990-2001, USD 4.2 trillion). BTW, it is a high number relative to the 6% of public
    equity offering issued by corporations outside the home country.

    Main currencies in the International Market (in Sep 2013): EUR (44% of issues), USD (37%), and
    GBP (9%). The majority of the issues are straight (fixed rate) bonds (71%).

    • Eurobond Market
    Characteristics:
    - Unregulated
    - Bearer bonds (you hold them, you own them)
    - AAA or governments borrow in Eurobond market
    - Fastest way to raise funds for reputable borrowers
    - Very creative market, with lots of instruments (straight bonds, FRN, dual zero-coupon
    bonds, currency bonds, convertibles, bonds with warrants, etc.)
    - Most common bonds: Straight bonds (market share around 70%)

    Coupon payments for straight bonds are annual (YTM should be in p.a. basis).
    Coupon payments for floating bonds are semi-annual (YTM should be in s.a. basis).

    18.2 Brief Review


    There is a huge variety of bonds, loosely divided in straight or fixed rate, floating rate, and equity-
    related. In the international bond market, the majority of the issues are straight (fixed rate) bonds,
    with 71% of the market, while floating rate bonds have 26% of the market.

    1.A Straight or Fixed Income Bonds


    A fixed income bond is a financial instrument with specific interest payments on specified dates
    over a period of years. On the last specified date, or maturity, the payment includes a repayment of
    principal. The interest rate or coupon is expressed as a percentage of the issue amount and is fixed at
    launch.

    Example: Straight bond.


    In January 2004, the Brazilian Companhia Vale do Rio Doce (CVRD) issued straight coupon
    Eurobonds, with the following terms:

    Amount: USD 500 million.


    Maturity: January 2034 (30 years).
    Issue price: 100 (or 100%)
    Coupon: 8.25% payable annually
    YTM: 8.35% (Brazil’s government bonds traded at YTM 9.02%)

    IFM-LN.218
    Note: CVRD, which is the world's largest iron ore miner, was initially planning to sell USD 300
    million worth of the bonds, but ended up placing USD 500 million thanks to strong demand that
    surpassed USD1 billion. ¶

    1.B. Floating Rate Notes (FRNs)


    FRNs are similar in structure to straight bonds but for the interest base and interest rate calculations.
    The coupon rate is reset at specified regular intervals, normally 3 months, 6 months, or one year. The
    coupon comprises a money market rate (e.g., LIBOR) plus a margin, which reflects the
    creditworthiness of the issuer.

    Example: FRNs ("floaters").


    In January 2004, Mexico issued a USD Eurobond, with the following terms:

    Amount: USD 1,000 million.


    Maturity: January 2009 (5 years).
    Issue price: 99.965
    Coupon: 6-mo LIBOR + 70 bps payable semiannually.

    At the time the notes were offered, 6-mo LIBOR was 3.64 percent. So for the first six months Mexico
    paid an interest at an annual rate of 4.64% (=3.64% + .70%)

    Afterward, at the end of each six-month period, the interest rates on the bonds are updated to reflect
    the current 6-mo LIBOR rate for dollars. ¶

    2. Q: How are bonds priced?


    Bonds typically trade in 1,000 increments of a given currency (say, USD or EUR) and are priced
    as a percentage of par values (100%). The price of a bond is determined by computing the NPV of
    all future cash flows generated by the bond discounted at an appropriate interest rate –i.e., YTM.
    There is a one-to-one relation between the price of a bond (P) and the YTM of a bond.

    P = C1/(1+YTM) + C2/(1+YTM)2 + C3/(1+YTM)3 + ... + CT/(1+YTM)T,

    Ct = Cash flows the bond pays at time t. (CT = couponT + Face ValueT )

    Once you know the YTM, you know the price –given that you know the coupon payments.

    Interesting mathematical fact: If C = YTM  P = 100 (par or 100%)

    Example: A straight Eurodollar bond matures in 1 year.


    C = 10%
    FV1 = USD 100
    P = 95 (USD 95).
    YTMBond = ?
    P = C+FV1  95 = 110 / (1+YTM).
    1+YTM
    YTM = 110/95 - 1  YTM = .1578947. ¶

    IFM-LN.219
    18.3 Setting the YTM -i.e., the price- of a (Euro)bond
    We have three main cases:
    (1) Established company with a history of borrowing (say, GE, IBM);
    (2) Established company with no history of borrowing (until 2010: MSFT, Google);
    (3) New company.

    1. Established company with history of borrowing


    Example: IBM wants to borrow USD 100M in the next 10 days => Eurobonds
    YTMIBM=?
    - Look at competitors (by industry and credit rating).
    - Look at secondary market (the best way).

    IBM has outstanding bonds trading in the secondary market. YTMIBM-outsanding = 5.45%
    Then, YTMIBM-new debt = 5.45%. ¶

    2. Established company with no history of borrowing


    - Analyze the company.
    - Look at competitors and industry benchmarks  set a range, say YTM  [2.55%, 4.10%].
    - Based on your analysis, pick a YTM in the range.

    3. New company
    Now, if a MNC is new to the Eurobond market, setting the YTM is more complicated.
    - Look at competitors and industry benchmarks.
    - Analyze the new company (or new industry, if needed) and potential market.
    - Determine potential demand. Book building for the new bond (phone calls, lots of
    research).

    The YTM is determined by:


    YTM = Base Rate (kf) + Spread (Risk of Company)
    kf = risk free rate = government bond (of similar maturity)
    Spread = Risk of company = this is what the investment bank has to determine (in bps)

    In general, the spread is related to a risk rating (S&P, Moody’s). If a company is in a given risk
    category, there’s a corresponding risk spread.

    Example: Space Tourism (or an internet company in 1994, or railroads in the 1800s!)
    New company, no similar borrower in the market.
    The investment banker determines that the YTM spread is in the range 140 bps to 210 bps over
    U.S. Treasuries (kf).
    Aggressive spread: 140bps ( risk of not selling enough bonds –i.e., overpricing risk).
    Conservative spread: 210 bps ( risk of overselling bond issue –i.e., underpricing risk!).
    The investment banker decides on setting the Yield spread at 145 bps.

    The lead manager is able to formulate a pricing scheme:

    IFM-LN.220
    U.S. Treasury: 5.915% s.a. (semiannual)
    ST spread: 1.45% s.a.
    ST yield: 7.365% s.a. ( p.a. = (1 + 0.07365/2)2 - 1)

    Technical detail:
    Straight Eurobonds pay annual coupons. YTMST = (1+0.07365/2)2 = 7.501% p.a. (annual)
    At inception, the bond sells at par  P = 100 (if P=100  C=YTM).
    Then, CST = YTM = 7.50 %. ¶

    IFM-LN.221
    CHAPTER 18 – BONUS: ISSUING BOND DEBT - PETROBRAS
    Brazil's Petrobras breaks drought in LatAm market
    Reuters January 9, 2017
    By Paul Kilby

    NEW YORK, Jan 9 (IFR) - Brazil's Petrobras opened the Latin American primary markets on
    Monday with the region's first cross-border bond sale of the year.

    Petrobras is approaching investors with five and 10-year bonds to finance an up to US$2bn
    tender as part of the debt-laden company's efforts to term out upcoming maturities.

    At initial price thoughts of 6.5% area on the five-year and 7.75% area on the 10, bankers are
    calculating starting new issue premiums at anywhere between 50bp and 75bp.

    That calculation depends in part on how much weight to give the high dollar price on the
    existing 8.375% 2021s and 8.75% 2026s, which according to one banker were trading last week
    around 109 and 110.50, or yields of 5.95% and 7.18%.

    "The dollar price is worth something but not worth 25bp," said one, arguing that investors like
    Petrobras bonds for their high liquidity.

    "Liquidity means more than the high dollar price."

    But other market participants disagreed. "I would say that fair value is close to 5.75% on the five
    year," another banker said. "The high dollar price matters a lot for this."

    Either way, Petrobras is starting with a generous premium to get investors on board, much as
    Mexican state-controlled oil company Pemex did in December, when it amassed an over USD
    30bn order book after initially offering lavish NICs.

    "Petrobras isn't in a position these days where it can skin every last basis point on their deals,"
    said the first banker.

    The company has been struggling to regain its footing following a corruption scandal that has
    had a broad impact on Brazil's political and business classes.

    New management has been shedding assets and undergoing liability management exercise in an
    effort to deleverage and improve the company's credit standing.

    While Petrobras fell short of its 2015-2016 divestment target to raise USD 15.1bn, investors
    largely feel the company is heading in the right direction, and it is still seen as cheap to the
    sovereign.

    In the tender, Petrobras is targeting USD-denominated 3% 2019s, floating-rate 2019s, 7.875%


    2019s, 5.75% 2020s, 4.875% 2020s and floating-rate 2020s.

    IFM-LN.222
    If holders tender by the early bird date of January 23, they will receive a purchase price of
    100.625, 101.625, 110.50, 104.875, 102.75 and 101.625, respectively.

    Petrobras is also offering to buy back euro-denominated 3.25% 2019s at 105.125 if holders
    tender by the early bird date.

    The bond is set to price on Monday. Bradesco, Citigroup, HSBC, Itau and Morgan Stanley are
    acting as leads. Expected ratings on the SEC-registered notes are B2/B+ (stable/negative).

    (Reporting by Paul Kilby; Editing by Marc Carnegie)

    CHAPTER 18 - BONUS COVERAGE: BOND SPREADS (2014)


    REUTERS CORPORATE BOND SPREAD TABLES

    Reuters Corporate Spreads for Industrials - 03/28/2014


    Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr
    Aaa/AAA 5 8 12 18 28 42 65
    Aa1/AA+ 10 18 25 34 42 54 77
    Aa2/AA 14 29 38 50 57 65 89
    Aa3/AA- 19 34 43 54 61 69 92
    A1/A+ 23 39 47 58 65 72 95
    A2/A 24 39 49 61 69 77 103
    A3/A- 32 49 59 72 80 89 117
    Baa1/BBB+ 38 61 75 92 103 115 151
    Baa2/BBB 47 75 89 107 119 132 170
    Baa3/BBB- 83 108 122 140 152 165 204
    Ba1/BB+ 157 182 198 217 232 248 286
    Ba2/BB 231 256 274 295 312 330 367
    Ba3/BB- 305 330 350 372 392 413 449
    B1/B+ 378 404 426 450 472 495 530
    B2/B 452 478 502 527 552 578 612
    B3/B- 526 552 578 604 632 660 693
    Caa/CCC+ 600 626 653 682 712 743 775
    US Treasuries 0.13 0.45 0.93 1.74 2.31 2.73 3.55

    Spread values represent basis points (bps) over a US Treasury security of the same maturity, or the
    closest matching maturity.

    IFM-LN.223
    CHAPTER 18 - BONUS: BOND MATH -Bond Prices and Yields
    Before reviewing the basics of bond mathematics, we will introduce some notation:

    P = current market value of a bond = present value of the bond.


    FV = face value or future value at a certain date, usually maturity.
    r = internal rate of return (yield-to-maturity) of a bond.
    T = number of years to final maturity.
    C = coupon rate of the bond.

    A.1. Yield-to-maturity
    The theoretical value of a bond is determined by computing the present value of all future cash flows generated
    by the bond discounted at an appropriate interest rate. Conversely, one may calculate the internal rate of return,
    or yield-to-maturity (YTM), of a bond on the basis of its current market price and its promised payments. The
    YTM is also referred as yield. The YTM measures the expected total return on the overall investment. No other
    financial instrument has such an easily observed or intuitively understandable expected return.

    Example: A straight Eurodollar bond has a coupon payment of 5%. The market price of the Eurodollar bond is
    P = 103.91. Maturity is one year from now. The Eurodollar bond has a yield-to-maturity r, given by

    P = C+ FV1  103.91 = 100 / (1+r).


    1+r
    Hence,

    103.91(1+r) = 105  (1+r)=105/103.91  r = .0104898. ¶

    Similarly, one may compute the yield-to-maturity of zero-coupon bonds maturing in T years using the formula:

    P = FVT ,
    (1+r)T

    where r is expressed as a yearly interest rate. The term 1/(1+r)T is the discount factor for year T. The YTM is
    defined as the interest rate at which P dollars should be invested in order to realize FT dollars T years from now:

    P(1+r)T = FVT.

    Example: A two-year zero-coupon Eurodollar bond paying FV2 = USD 100 is currently selling at a price P =
    USD 85.20, has a YTM, r, given by

    85.20 = 100/(1+r)2,  r = (100/85.20)1/2 - 1,  r = 0.08338. ¶

    The YTM should not be confused with the current yield or dividend yield. The current yield on a bond is the
    ratio of the coupon bond to its current price.

    Example: A bond with a price of 90 and a coupon of 10 percent has a current yield of:
    10/90 = .1111 = 11.11%. ¶

    A.2. Yield curves

    IFM-LN.224
    Similar bonds -i.e., bonds with similar characteristics: risks, coupons, maturities- should have the same
    return. Suppose we have bonds with similar characteristics but with the only exception of maturity.
    Graphing the yields to maturity on similar bonds with different maturities allows us to draw a yield curve. As
    illustrated below in Figure 18.1, the YTM of two zero-coupon bonds in the same currency but with
    different maturities is usually different.

    Figure 18.1: Example of a Yield Curve from zero-coupon bonds

    YTM

    1 2 3 4 5 6 7 8 9 10 Maturity (years)

    The yield curve shows the YTM computed on a given date as a function of the maturity of the bonds. Therefore,
    the graph should have on the horizontal or x-axis years to maturity and on the vertical or y-axis the YTM. It
    provides an estimate of the current term structure of interest rates. To be meaningful a yield curve must be
    drawn from bonds with identical characteristics, except for their maturity. In the graph, two zero-coupon bonds
    are represented as two points on the yield curve.

    A yield curve is a best fit average of the individual yields, so the individual bond yields may well lie above or
    below the line when it is drawn. This gives an indication as to whether a particular bond has a relatively high
    or low yield in relation to its market. Points above the curve may be considered as high-yielding (cheap), and
    those below as low-yielding (dear).

    The normal slope of the curve when the market is in equilibrium is positive, that is, yields rise as maturity
    lengthens. Under these conditions, investors are receiving higher remuneration for forgoing immediate
    consumption and for the increased risks associated with longer-term investments.

    The slope of the curve is important: the curve becomes steeper when the market expects a general rise in interest
    rates, and therefore traders sell longer dated bonds, forcing the price down and the yield up.

    A flat curve arises when investors are indifferent to maturity risk, that is, short-term and long-term interest rates
    are very similar.

    An uncommon yield curve arises where the yield curve has one or more humps of relative high yields, with
    lower yields on either side. Usually, there is a technical explanation for such a curve, such as oversupply of
    issues in a particular maturity band, for example a major issue by a government.

    The so-called Treasury yield curve is constructed from on-the-run Treasury issues. These are the most recently
    auctioned Treasury securities: 3-month, 6-month, 1-year, 2-year, 4-year, 5-year, 10-year, and 30-year.

    IFM-LN.225
    The first three issues are Treasury bills, which are issued at discount and pay no coupon. That is, these Treasury
    bills are zero-coupon securities. In contrast, the five other issues are coupon bonds. In fact, there are no zero-
    coupon securities issued by the U.S. Department of the Treasury with a maturity greater than one year.
    Consequently, the Treasury yield curve is a combination of zero-coupon securities and coupon securities.

    There are, in fact, zero-coupon Treasury securities with a maturity greater than one year that are created by
    government dealer firms. These securities are called stripped Treasury securities. All stripped Treasury
    securities are created by dealer firms under a Treasury Department program called STRIP (Separate Trading of
    Registered Interest and Principal Securities).

    A.3. Valuing a bond with coupons


    The theoretical value of a bond with coupons may be considered the present value of a stream of cash flows
    (coupons and principal payments). The cash flows occur at different times and they should be discounted at the
    interest rate corresponding to their date of disbursement. In essence, a coupon-paying bond is a combination of
    bonds with different maturities.

    Example: A five-year EUR 1,000 bond with an annual coupon of EUR 80 is a combination of five bonds. Each
    bond has a nominal value of EUR 80 and a maturity of one to five years, and a bond with a nominal value of
    EUR 1,000 and a maturity of five-years. ¶

    The YTM, r, of a T-year coupon-paying bond is given by

    P = C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + ... + CT/(1+r)T,

    where Ci is the coupon payment, including final reimbursement, at date i=T.

     Price of a bond = f(Coupon, YTM, T)

    The formula for the price of a bond shows that the bond's price is a function of the maturity of the coupon rate
    and of the YTM. Other factors being constant, the higher the coupon rate, the higher the value of the bond.
    Other factors being constant, the higher the YTM, the lower the price of the bond. 

    Coupons may be paid semiannually or quarterly, and a valuation may be made at any time during the coupon
    period. This calls for the more general valuation formula to determine YTM:

    P = C1 t1/(1+p)t1 + C2 t2/(1+p)t2 + C3 t3/(1+p)t3 + ... + CT tT/(1+p)tT,

    where p is the daily yield, i.e., (1+p)365 = (1+r), and t1, t2,.., tT are the dates on which the cash flows occur,
    expressed in number of days from the current date. Cash flows include all payments.

    The majority of U.S. domestic bonds pay interest twice a year. In this case, the above formula simplifies to:

    P = C1/(1+r/2)1 + C2/(1+r/2)2 + C3/(1+r/2)3 + ... + CT/(1+r/2)T,

    where r is the annual YTM of the bond.

    Example: Annual v. Semiannual coupon bonds


    A. Annual coupon bond.

    IFM-LN.226
    An 8% annual coupon bond with a face value of USD 1,000 and with 5 years remaining to maturity has a YTM
    of 10%, the current price P is:

    P = 80/(1.10) + 80/(1.10)2 + 80/(1.10)3 + 80/(1.10)4 + 1,080/(1.10)5 = 924.18 (or 92.418%)

    Note: the YTM of 10% is higher than the current yield of USD 80/USD 924.18 = 8.66%.

    B. Semiannual coupon bond.


    An 8% semi-annual coupon bond with a face value of USD 1,000 and with 5 years remaining to maturity has a
    YTM of 10%, the current price P is:

    P= 40/(1.05) + 40/(1.05)2 + 40/(1.05)3 + 40/(1.05)4 + 40/(1.05)5 + 40/(1.05)6 +


    + 40/(1.05)7 + 40/(1.05)8 + 40/(1.05)9 + 1040/(1.05)10 = 922.78.

    Note: The YTM on the semiannual coupon bond is higher than the YTM on the annual bond. The annualized
    YTM on the semiannual yield is (1 +.10/2)2 - 1 = .1025, or 10.25%. ¶

    A.4. Implied forward exchange rates


    How do we compare exchange rate movements and YTM differentials? A higher yield in one currency is often
    compensated, ex post, by a depreciation in this currency, and in turn, an offsetting currency loss on the bond. It
    is important to know how much currency movement will exactly compensate the yield differential.

    Consider a one-year T-bill with an interest rate rd,1 in domestic currency, and rf,1 in foreign currency. The current
    exchange rate is St, expressed as the domestic currency value of one unit of a foreign currency. Using the IRPT
    (interest rate parity theorem), derived in Chapter 7, it is possible to calculate the forward exchange rate, Ft,1 that
    makes an investor indifferent between the two investments:

    1 + rd,1 = (1 + rf,1) Ft,1/St.

    The implied offsetting currency depreciation is given by

    S1 = p = (Ft,1 - St)/St = (rd,1 - rf,1)/(1 + rf,1).

    You should notice that the implied offsetting change in St was called, in Chapter 7, foreign currency premium
    (p).

    Example: The USD one-year interest rate is rd,1=5.468%, the EUR interest rate is rf,1=4.120%, and the exchange
    rate is St=1.10 USD/EUR. The forward exchange rate is equal to:

    Ft,1 = St(1+rd,1)/(1 + rf,1) = 1.10 USD/EUR (1.05468)/(1.0412) = 1.1142 USD/EUR.

    The foreign currency premium (or implied offsetting currency movement) is therefore equal to:

    S1 = p = (1.1142 - 1.10)/(1.10) = 0.01295 (or 1.295%).

    Thus, a 1.295% appreciation of the EUR will exactly compensate the yield advantage of the USD investment.

    IFM-LN.227
    Similarly, we can calculate implied forward exchange rates on two-year zero-coupon bonds as well as on bonds
    of longer maturity.

    The implied forward exchange rate for a t-year bond is given by:

    Ft,T/St = [(1 + rd,T)/(1 + rf,T)]T.

    The implied currency appreciation or depreciation over the t-year period is equal to

    ST = [(1 + rd,T)/(1 + rf,T)]T - 1.

    Example: We are given two hypothetical term structures (five first years). Suppose that S0= 1.10 USD/EUR.
    With this information we calculate the implied forward exchange rates in Table 18.1

    Table 18.1: Implied Forward Exchange Rates and Currency Depreciation

    Maturity (T) 1 2 3 4 5
    EUR Yield (%) 4.120 4.322 4.544 4.678 4.792
    USD Yield (%) 5.468 5.618 5.645 5.658 5.850

    Ft,T (USD/EUR) 1.1142 1.1275 1.1351 1.1418 1.1567

    ST (%) 1.295 2.500 3.193 3.798 5.151

    For the above calculations, we assume that the yield curves are for zero-coupon bonds. The formulas are slightly
    more complicated if we use yield curves for coupon bonds, because we must assume that the coupons are
    reinvested each year or semester until final maturity.

    IFM-LN.228
    Chapter 18 - Long term financing – Part 2: Swaps
    This chapter introduces a new debt instrument, a swap, which is very flexible and allows
    companies to change the profile of CFs.

    Definition: Swap
    A swap represents a periodic exchange of CFs between 2 parties. In general, one of the parties is a
    swap dealer (in general, a bank). Each payment to the counterparty is called a “leg.”

    Typical exchange of CFs between 2 counterparties:

    leg
    A B (SD)

    leg

    A usual swap contract has to specify:


    ⋄ Frequency of the payments (f)
    ⋄ Duration of the swap (T)
    ⋄ How the legs (payments) are calculated. (In general, one leg is a fixed payment and the other leg
    is a floating (market price) payment. The fixed payment is based on a fixed rate called the coupon
    of the swap).

    There are different types of swaps. They differ in how the payments (legs) are indexed. For
    example, if the legs are denominated in different currencies: currency swap.

    • Market Organization
    - Most swaps are tailor-made contracts.
    ⋄ Swaps trade in an OTC type environment.
    ⋄ Swap specialists fill the role of broker and/or market maker.
    ⋄ Brokers/market makers are usually large banks.
    ⋄ Prices are quoted with respect to a standard, or generic, swap.
    ⋄ Reference interest rates are inter banking offered rates (IBOR): USD LIBOR, JPY LIBOR,
    Euribor (EUR IBOR), etc.

    - All-in-cost: price of the swap (quoted as the rate the fixed-rate side will pay to the floating-rate
    side)

    - It is quoted on a semiannual basis (s.a.):


    ⋄ absolute level ("9% fixed against six-month LIBOR flat")
    ⋄ bp spread over the U.S. Treasury yield curve ("the Treasury yield + 57 bps against 6-mo
    LIBOR flat," where "LIBOR flat" = LIBOR is quoted without a premium or discount).

    - It is a big market, with a USD 425 trillion of outstanding notional amounts (in December 2014).

    • Q: Why use a swap?

    IFM-LN.229
    A: To change the profile of cash flows.

    Example: IBM pays bondholders of a Eurobond in EUR

    EUR
    IBM Bondholders

    Situation: Payments in EUR. IBM wants to pay in USD


    Solution: A currency swap

    USD
    IBM Swap Dealer

    EUR

    Net result: IBM pays USD:

    EUR EUR
    Swap Dealer IBM Bondholders
    10.9
    USD

    • Swap Dealers
    The SD is an intermediary, usually a large financial institution. They make a living of the bid-ask
    spread, usually paid as a premium/discount over one of the legs. Usually, SDs attempt to match
    the sides –i.e., find a counterparty to any swap they enter (with opposite direction). In the previous
    example:

    EUR+spread/2 EUR spread/2


    Counterparty Swap Dealer IBM
    10.9
    USD USD

    Thus, the SD does not face interest rate/currency risk. It only faces credit risk (this is why, only
    companies with good reputations enter into the swap market).

    If a swap dealer matches the two sides of a swap is called back-to-back transaction (or “matched
    book” transaction). But, if a counterparty to a swap cannot be quickly found, the SD enters a swap
    and then hedges the interest rate risk using interest rate derivatives, while waiting for a counter
    party to appear. This practice is called warehousing swaps.

    In practice it is difficult to find a perfect counterparty to a swap, with the same amounts and
    maturity needs. In this case, the swap dealer also faces mismatch risk. SDs also warehouse the
    unhedged portions of swaps.

    IFM-LN.230
    18.4 Five Types of Swaps
    • Interest rate swap (Plain vanilla)
    One party (A) pays a fixed interest rate. The other (B) pays a floating market rate.
    The floating interest rate is set every period according to market conditions. Usually, one of the
    parties is a bank (SD).
    Example: A pays 5% to swap dealer; SD pays floating rate (LIBOR) to A.
    Frequency = f: Semi-Annual (s.a.)
    Duration = T: 4 years
    Notional Principal: USD 100M
    Legs = Fixed: 5%; Variable: 6-mo LIBOR.

    Every 6 months, A pays USD 2.5M and receives 6-mo LIBOR.

    USD 2.5 M
    A Swap Dealer

    USD 100M*(LIBOR/2)

    Today, suppose 6-mo LIBOR = 6%. In 6 months, SD pays USD 3M. Net difference is USD
    0.5M. Only the net payment will be exchanged. ¶

    Note: Recall the SD is an intermediary. The SD will try to find a counterparty to the swap, but
    with opposite direction. For example:

    USD 2.5M USD 2.45M


    A Swap Dealer Bondholders
    10.9

    USD 100M*(LIBOR/2) USD 100M*(LIBOR/2)

    In this situation, the SD does not face interest rate risk. It only faces credit. ¶

    Day count convention (on short-term rates): In the example, the first floating payment is listed as
    6%. But, since it is a money market rate, the 6-month LIBOR should be quoted on an actual/360
    basis. Assuming 183 days between payments the actual payment should be
    USD 100M x (0.06) x (183/360) = USD 3.05M
    The fixed-rate side is also adjusted. Payments may not be equal at each date.

    Remark: In interest rate swaps, the notional principals are never exchanged (only the net changes
    hands).

    A popular variation to the plain vanilla swap is the basis swap, where the two legs are indexed to
    floating interest rates. For example, Party A pays 6-mo LIBOR, while the SD pays 12-mo LIBOR.

    • Currency Swaps (also called Cross-Currency Swaps, XCCY)


    Both legs are denominated in different currencies. There are different possibilities here:

    IFM-LN.231
    1. Fixed-Fixed
    Example: IBM pays 4% in USD and receives 5% in EUR.
    f = Semi-Annual
    T = 3 years
    Notional Principals: USD 200M, EUR 210M
    Legs = Fixed USD: 4%; Fixed EUR: 5.25%.

    Every 6 months, IBM pays USD 4M and receives EUR 5.25M

    USD 4M (4% s.a.)


    IBM Swap Dealer

    EUR 5.25M (5% s.a.)

    2. Fixed-Floating (also called Circus swap)


    Example: IBM pays LIBOR in USD and receives 5% in EUR. ¶

    3. Floating-Floating (also called XCCY basis swap, if initial exchange of notionals occurs)
    Example: IBM pays LIBOR in USD and receives LIBOR in EUR. ¶

    The difference between the two floating rates in a currency swap is called the basis swap
    spread. The USD LIBOR is usually one of the rates. It is quoted USD LIBOR vs. FC LIBOR
    spread or premium (positive or negative).

    If the XCCY spread is negative, banks are willing to receive lower interest rate payments on
    funds lent in non-USD currencies, in exchange for USD. The XCCY spread is taken as an
    indicator of funding conditions.

    Note: Unlike interest rate swaps, in currency swaps the notional principal can be exchanged. This makes a
    currency swap more like an exchange of bonds.

    Example: Back to the IBM USD/EUR fixed-for-fixed swap. The swap involves three sets of cash
    flows:

    At inception, IBM receives USD 200 million and the swap dealer receives EUR 210 million:

    USD 200M
    IBM Swap Dealer

    EUR 210M

    Then, there are the semi-annual interest payments:

    IFM-LN.232
    USD 4M
    IBM Swap Dealer

    EUR 5.25M

    Finally, at the end of the swap, the principals are repaid:

    USD 200M
    IBM Swap Dealer

    EUR 210M

    Notes: Since at the end both parties are simply returning the notional principals they exchanged at
    inception, the exchange rate at the end is the same as the initial rate. There is no FX risk involved in
    the repayments of principals. ¶

    • Commodity Swap
    One party (A) pays a fixed commodity price. The other (B) pays a variable commodity price.
    Example: Coffee Commodity Swap
    Situation: Maxwell House (MH) buys 100M lbs of coffee every 6 months. MH receives 100M
    lbs of coffee and pays the market price for the coffee. MH decides to use a swap to fix the
    price of coffee.
    Terms: MH pays a fixed price and receives from a SD a variable market price.
    f = Semi-Annual
    T = 5 years
    Notional Principal = 100M lbs of coffee
    Legs = Fixed: 2.5 USD/lb; Variable: Robusta Coffee NY cash price.

    Every 6 month, MH pays USD 250M to the SD and receives market price*100M lbs.

    USD 250M
    MH SD

    100M pounds x (Robusta Coffee NY price)

    Suppose Robusta Coffee NY price = 2.2 USD/lb. MH pays: USD 30M (net). ¶

    • Equity Swaps
    One party (A) pays a fixed amount, usually calculated as a fixed interest rate. The other (B) pays a
    variable amount based on the performance of an equity index –S&P 500 or Nikkei 225.
    Example: A Mutual Fund pays LIBOR in GBP and receives the returns of the FTSE 100 (in
    GBP).
    f = Semi-Annual
    T = 3 years
    Notional Principals: GBP 100M

    IFM-LN.233
    Legs = Floating Rate: 6-mo LIBOR; Equity Variable: 6-mo return on FTSE.

    Every 6 months, the Mutual Fund pays a fixed amount (GBP 100M x 6-mo LIBOR/2) and
    receives a floating amount (GBP 100M x 6-mo return on the FTSE 100).

    GBP 100M x (6-mo LIBOR/2)


    Mutual Fund SD
    GBP 100M x (6-mo return on FTSE)

    If the return on the FTSE is negative, the Mutual Fund pays the SD. ¶

    • Credit Default Swaps (CDS)


    One party (A) buys protection against specific risks associated with credit events –i.e., defaults,
    bankruptcy or credit rating downgrades. It is said that Party A buys a CDS or protection –i.e.,
    “sells” risk or “short credit exposure- and the counterparty, usually a Swap Dealer, sells a CDS or
    protection –i.e., “buys” risk or credit exposure.

    Cash flows:
    - The protection buyer pays a periodic fee (the spread) to the protection seller.
    - The protection seller pays a set amount if there is a credit event (usually, default).

    Example: Bertoni Bank buys protection against a borrower’s default.


    f = Quarterly
    T = 5 years
    Notional Principal: USD 10M (same as loan)
    Credit Event: Default
    Spread (or Premium) = 160 bps.

    Diagram of CFs:

    IFM-LN.234
    Payment calculation: (0.0160 / 4) x USD 10M = USD 40,000 (every quarter as a premium
    for protection against company default). ¶

    Remark: In Chapter 17 we mentioned that CDS spreads are a very good indicator of country risk.

    • Market size per segment: Outstanding amount & Value (in December 2014)
    ⋄ Interest rate swap: USD 381.0 trillion & USD 13.9 trillion.
    ⋄ Currency swaps: USD 24.2 trillion & USD 1.3 trillion.
    ⋄ Equity swaps & Forwards: USD 2.4 trillion & USD 0.19 trillion.
    ⋄ Commodity swaps & Forwards: USD 1.4 trillion & 0.3 trillion.
    ⋄ Credit default swaps: USD 16.4 trillion & 0.59 trillion.

    18.5 Valuation of a Swap


    The value of a swap is equal to the difference of the NPV of the CFs exchanged.

    V = Value of Swap = NPV(Receivables) - NPV(Payables) (denominated in same currency)

    At inception (T=0), the value of a swap to both parties should be 0 (or very close to 0). This would
    be a “fair” valuation. But, as time goes by, interest rates and exchange rates will change and, thus,
    V will change too.

    Example: IBM’s fixed-fixed currency swap.


    Value of Swap(IBM) = VIBM = NPV(Receivables in EUR)*(St) - NPV(Payables in USD)

    Situation: 2 years have passed. Payments left = 2 (T=1 year)


    f : Semi-Annual
    T: 1 year
    Notional Principals: USD 200M, EUR 210M
    Coupons: 4% USD (USD 4M), 5% EUR (EUR 5.25M)
    St = 1.05 USD/EUR
    Discount rates: In USD: 6 mo= 5%, 1 yr=5.1%
    In EUR: 6 mo= 6%, 1 yr=6.2%
    Notional principals are repaid at the end of swap.

    VIBM = [EUR 5.25M/(1.03) + EUR 215.25M/(1.031)2]*1.05 USD/EUR -


    - [USD 4M/(1.025) + USD 204M/(1.0255)2] = USD 20,094,054

    If IBM wants to liquidate the swap, IBM has to receive USD 20,094,054 to sell the swap.¶

    Note: You can think of currency swaps as a collection of forward currency contracts. IBM
    exchanges USD 4M for EUR 5.25M for 2 years  implicit St = .762 USD/EUR.
    At T=3, IBM exchanges USD 204M for EUR 215.25 M  implicit S3 = .94 USD/EUR

    IFM-LN.235
    • Remark: Credit Risk
    Credit risk in the swap market: Potential loss to a counterparty of the present value of a swap position
    if the swap party defaults.

    IBM has credit risk exposure from the currency swap only in years when the value of swap is positive
    (in this example, always). In the previous example, if St = 0.95 USD/EUR then,

    VIBM (1st-year) = [EUR 5.25M/(1.03)*.95 USD/EUR] - [USD 4M/(1.025)] = USD .94M


    VIBM (2nd-year) =USD-1.61M.  SD would face credit risk in year 2.

    A CDS can be used to deal with this risk.

    IFM-LN.236
    Chapter 18 - Long term financing – Part 2: Swaps (continuation)
    Review from Chapter 18 – Part 2: Swaps
    - Four types of swaps, similar in structure, but different in how the legs are indexed.
    1. Interest Rate Swap
    2. Currency Swap
    3. Equity Swap
    4. Commodity Swap.

    - Value of Swap: NPV(Receivables) – NPV(Payables)


    Q: Why does the value of the currency swap change?
    A: The value is a function of the coupons and the exchange rate. When these variables change, the
    value of the swap also changes.

    For example, going back to the IBM currency swap, the value is a function of the exchange rate
    (USD/EUR), and interest rates (iEUR and iUSD):
    VIBM = f(couponEUR, couponUSD, St, iEUR, iUSD, T)
    Only the exchange rate and interest rates constantly and randomly change.

    Comparative statics-VIBM (IBM pays USD, receives EUR):


    If St falls (USD appreciates)  VIBM falls.
    If iUSD falls  VIBM falls
    If iEUR goes up  VIBM falls.

    The opposite happens for the Swap Dealer.

    Note: You can think of currency swaps as a collection of forward currency contracts. IBM
    exchanges USD 4M for EUR 5.25M for 2 years  implicit St = .762 USD/EUR
    At T=3, IBM exchanges USD 204M for EUR 215.25M  implicit S3 = .94 USD/EUR

    18.5.1 Decomposition into Forward Contracts


    We can decompose the currency swap into a series of forward contracts. Then, we can value the
    currency swap as the sum of the values of the series of forward contracts.

    Example: IBM entered into a 3-year currency swap, which has one year left. The swap terms, current
    exchange rate and discount rates are given below:
    T: 1 year
    Notional Principals: USD 200M, EUR 210M
    Coupons: 4% USD (USD 4M), 5% EUR (EUR 5.25M)
    St = 1.05 USD/EUR
    Discount rates: In USD: 6 mo= 5%, 1 yr=5.1%
    In EUR: 6 mo= 6%, 1 yr=6.2%

    Then, the swap sets the following implicit forward FX rates:


    2 semi-annual exchanges: EUR 5.25M = USD 4M  St+j= .762 USD/EUR

    IFM-LN.237
    At maturity, final exchange: EUR 210M = USD 200M  S2= .9524 USD/EUR. ¶

    • Each of the currency exchanges in a swap represents a implicit (swap) forward contract. We can value
    the implicit swap forward rate relative to the forward rate determined by IRPT, Ft,T.:
    Ft,Tj = St (1 + id,Tj x Tj/360)/(1 + if,Tj x Tj/360).

    Suppose in the swap, we are long the FC (say, IBM is long EUR). Then, the PV, using id as the discount
    rate, of each annual payment j is:
    (Ft,j – Swap forward rate at time j) x Amount of FC/(1+id)j

    Example (continuation): We calculate IBM’s value of the exchange of principals at T=1 year
    (ValueIBM,Principal).
    Ft,T=12-mo = 1.05 USD/EUR * (1+.051/2)2/(1+.062)2 = 1.038827 USD/EUR
    Swap forward rate = USD 200M/EUR 210M = 0.952381 USD/EUR.

    ValueIBM,Principals = (1.038827 USD/EUR – 0.952381 USD/EUR) * 210M /(1+.051/2)2 =


    = USD 17.2621M

    IBM would be willing to sell the exchange of principals for USD 17.2621M.

    Note: We can do the same for each exchange of CFs. ¶

    • Alternatively, we can value the CFs in terms of forward DC.

    Notation:
    Tj: time of the jth settlement date
    iTj: interest rate (appropriate to discount the CFs) applicable to time Tj
    Ft,Tj: forward exchange rate applicable to time Tj.

    • IBM’s NPV of the forward contract corresponding to the exchange of payments at Tj:
    (EUR 5.25M x Ft,Tj – USD 4M)/(1+iUSD,Tj )Tj

    • Similarly, IBM’s NPV of the forward contract corresponding to the exchange of principals at T
    (maturity):
    (EUR 215.25M x Ft,T – USD 204M)/(1+iUSD,T)T.

     The value of a currency swap can be calculated from the term structure of forward rates and the term
    structure of domestic interest rates (yield curve).

    Example (continuation): Reconsider IBM’s example with two payments left. Using IRPT, the 6-mo, and
    12-mo forward exchange rates are:
    Ft,6-mo = 1.05 USD/EUR x (1+.05/2) /(1+.06/2) = 1.0449029 USD/EUR
    Ft,12-mo = 1.05 USD/EUR x (1+.051/2)2/(1+.062/2)2 = 1.038827 USD/EUR

    IFM-LN.238
    • The exchange of interest payments involves receiving EUR 5.25M and paying USD 4M. Thus, the values
    of the CFs in terms of forward USD are (in millions):

    (EUR 5.25 x 1.0449029 USD/EUR - USD 4)/(1+.05/2) = USD 1.4495027


    (EUR 5.25 x 1.038827 USD/EUR - USD 4)/(1+.051/2)2 = USD 1.3824395

    • Final exchange of principals: IBM receives EUR 210M and pays USD 200M. The value of the forward
    contract is (in millions):

    (EUR 210 x 1.038827 USD/EUR – USD 200)/(1+.051/2)2 = USD 17.262119

    • The total value of the swap (in USD M) is:

    1.4495027 + 1.3824395 + 17.262119 = 20.094061 (check value from last class!)

     IBM would be willing to sell this swap for USD 20,094,061. ¶

    18.6 Financial Engineering


    Financial engineers combine different financial instruments to solve problems for firms. In this
    section, we present one example of combination of swaps. We combine swaps to deal with a
    typical situation for non-US commodity markets participants: Commodity prices are set in USD.

    Problem: Two sources of uncertainty: commodity price risk and FX risk.


    Solution: Use swaps to fix the price of the commodity in terms of the domestic currency.

    Example: Mexican Oil Producer – PEMEX (Petróleos Mexicanos)


    Pemex sells 100M barrels every six months in the Oil Market.

    100M barrels
    PEMEX Oil Market

    Avg. oil price (USD)

    The price for oil is set in USD. Not in MXN. This creates transaction/economic exposure.

    1. Commodity price risk – use a commodity swap

    Avg. oil price (USD)


    PEMEX Swap Dealer

    Fixed oil price (USD)

    2. Exchange rate risk – use a currency swap

    Fixed (USD)
    PEMEX Swap Dealer

    IFM-LN.239
    Fixed (MXN)

    With two swaps, PEMEX has fixed the price of oil in terms of MXN.

    Swap Details
    ⋄ Commodity swap
    Dealer pays 25 USD/barrel against market price for 2 years.
    Notional = 100M Barrels
    Duration: 2 years
    Frequency: semiannual

    ⋄ Currency swap (fixed by fixed)


    SD pays 6.5% in MXN against 5% in USD.
    St = .105 USD/MXN
    iUSD = 5%
    iMEX = 6.5%
    Duration: 2 years
    Frequency: semiannual

    * We need to find out the fixed price of oil in terms of MXN

    1. Commodity Swap (Notional = 100M Barrels)

    Avg. oil price (USD)


    PEMEX Swap Dealer

    USD 2.5 Billion


    2. Currency Swap

    USD 2.5 Billion


    PEMEX Swap Dealer

    MXN ?

    Calculations for the SD MXN payments:


    (1) Need to determine the Notionals of Swap
    Notional of USD part = USD 2.5B/.025 = USD 100B
    (2) Determine MXN payment. (Recall that at inception the Value of the Swap is zero.)
    NPV (USD payments) = USD 100B
    NPV (MXN payments) = USD100B/.105 USD/MXN = MXN 952.38B
     SD’s MXN payment = MXN 952.38B (.0325) = MXN 30.952381B

    Note: The price of oil in MXN for 2 years has been fixed:
    Pt = MXN 30,9524M/100M barrels = 309.52 MXN/Barrel. ¶

    IFM-LN.240
    IFM-LN.241
    CHAPTER 18 – BRIEF ASSESMENT

    1. Green Lion, an Irish design company, wants to refinance debt amounting to USD 200 million.
    An investment bank suggests issuing a straight bond, with annual coupon payments. The
    investment bank has the following data available:

    Irish government bond yields: 4-year 5.75 % (p.a.)


    U.S. Treasury government bond yield: 4-year 1.85 % (s.a.)
    German government bond yield: 4-year 2.25 % (s.a.)
    Green Lion Euro-Eur bond yield (outstanding debt): German government bonds + 345 bps (s.a.)

    Given the current tight market conditions, an investment bank suggests: a 5-year full-coupon USD
    Eurobond and an issue price of 100% (P=100).

    (A) Following usual market practices, set the coupon and the yield of the new Green Lion bond.
    (B) A year from now, there is a big debt crisis in Europe. What would the effect of this crisis be on
    the value of the bond? Briefly explain your logic.
    (C) Two years from now, the Irish government has a budget surplus. What would the effect of this
    budget surplus be on the value of the bond? Briefly explain your logic.
    (D) Three years from now, Green Lion wants to buy back the bond. If the yield to maturity for
    similar bonds is 8% and St = 1.20 USD/EUR, how much does Green Lion have to pay (in EUR)
    for the bond buyback?

    2. The annual Chinese yuan (CNY) interest rate is 5% (s.a.), while the annual USD interest rate is 1%
    (s.a.). Padres Co., a U.S. firm, entered into a currency swap with a swap dealer, where Padres pays
    3% semi-annually in USD and receives 4% semi-annually in CNY. The notional principals in the two
    currencies are USD 6 million and CNY 26 million. The swap will last for another two years. The
    exchange rate is 0.16 USD/CNY. For simplicity, assume the term structure in Chinese and in the U.S.
    is flat.

    A. Draw a diagram showing the semi-annual swap cash flows (in CNY and in USD).
    B. Value this currency swap for Padres Co.
    C. A year from now, the exchange rate is 0.13 USD/CNY. Assuming that nothing else has changed,
    use the forward contract decomposition approach to calculate the new value of the swap for Padres
    Co.

    3. Metales Inc, a Mexican company, imports 100 tons of copper per quarter. The company wants to
    set the price of copper in terms of MXN. Combine swaps to achieve this goal. Draw a diagram.

    IFM-LN.242
    Chapter 20 – Short-term Financing
    • Sources of short-term financing
    - Commercial Paper/Bank Notes
    - Bank Debt
    Cost of debt: call a bank. Example for a US MNC  iUSD = 5%
    Banks set cost of borrowing: Base Rate + Spread (reflecting risk)

    • MNCs can borrow anywhere. If an MNC borrows abroad faces FX Risk (needs to pay attention
    to ef,t).

    • Determination of the Cost of Borrowing


    For a US MNC, the effective borrowing cost (in USD) has two elements:
    - Cost of borrowing = quoted interest rate = i
    - But, when borrowing abroad, borrowers should also consider ef,t.
    ⇒We are back to IFE.

    For a US MNC, the effective borrowing cost (in USD):


    Rb,FC (in USD) = (1+ iFC x T/360)(1+ ef,t ) – 1

    As we know, ef,t is unknown and difficult to forecast. Let’s assume we know/estimate E[ef]. Then,
    Rb,FC (in USD) is an expectation, the expected effective borrowing cost => E[Rb,FC].

    20.1 MNCs: Evaluation of Borrowing Choices


    MNCs can borrow in almost all countries. Q: Where should a MNC borrow? Where it is cheaper.
    MNCs will compare effective borrowing costs (translated to the domestic currency of the MNC,
    say USD).

    Example: BHP Billiton, Australia’s mining giant, can borrow at home or abroad, say China.
    Data:
    iAUD = 7%
    iCNY = 10%
    E[ef,t] = - 1% (CNY expected to depreciate 1% against AUD next quarter)
    T = 90 day loan (T/360=90/360=1/4)

    Rb,AUD = iAUD = 7% x 90/360 = .0175 (or 1.75%)


    E[Rb,CNY (AUD)] = (1+ iCNYx90/360)x(1+ E[ef,t]) – 1 = (1+.1/4)x(1-.01) = .01475 (1.475%)
     BHP should borrow abroad –i.e., in CNY. It faces a lower expected borrowing cost. ¶

    MNCs can borrow anywhere. MNCs can also have portfolios of borrowings.
    Why? For diversification purposes: It reduces the risk of interest rates increasing in one place
    (revolving credit).

    Example: Petrobras choices: Home (Brazil) or Abroad (single currency or portfolio of currencies)
    Data:

    IFM-LN.243
    iBRL = 9.1%
    iNZD = 9% E[ef,t] = 2%
    iJPY = 2% E[ef,t] = 6.8%
    Portfolio: wJPY=.8, wNZD=.2
    For simplicity assume T=1 year (=> T/360=1).

    Where should Petrobras borrow?


    1. Home: RBRL = 9.1%
    2. New Zealand: E[RNZD] = 11.18%
    3. Japan: E[RJPY] = 8.936%
    4. Portfolio: E[RPort] = .80*(8.936) + .20*(11.18) = 9.3848%
     Petrobras should borrow in Japan. ¶

    Problem: We have assumed that we know the expected change in St -i.e., E[ef,t]. But, we have not
    said anything about the precision of the expectation, that is, we have ignored the FX risk of each
    currency. In general, we work with a probability distribution. It gives us an idea of risk, since we
    will see a realization from the distribution, not the expectation.

    Example: Now, we introduce probability distributions for ef.


    Data:
    iBRL = 9.1%
    iNZD = 9%
    iJPY = 2%

    NZD
    ef,t+90 Probability RNZD
    .01 .5 (1+.09)*(1.01)-1=10.09%
    .03 .5 (1+.09)*(1.03)-1=12.27%

    JPY
    ef,t+90 Probability RJPY
    .02 .4 (1+.02)*(1.02) -1=4.04%
    .10 .6 (1+.02)*(1.10)-1=12.2%

    Where should Petrobras borrow?


    1 Home: Rb,BRL = 9%
    2. NZ : E[Rb,NZD] = .5*(.1009) + .5*(.1227) = 11.18%
    3. Japan: E[Rb,JPY] = .4*(.0404) + .6*(.122) = 8.936%

    NZDef,t+90 JPYef,t+90 Joint Prob(Ind) Effective borrowing cost (BRL)


    .01 .02 .5*.4=.2 .8*(.0404) +.2*(.1009) = .0525
    .01 .10 .5*.6=.3 .8*(.1227) +.2*(.1009) = .1178
    .03 .02 .5*.4=.2 .8*(.0404) +.2*(.1227) = .0566
    .03 .10 .5*.6=.3 .8*(.122) +.2*(.1227) = .1221
     E[Rb,port]= .09379

    IFM-LN.244
    Now, it is likely Petrobras will borrow in Brazil; but not so clear, preferences matter. ¶

    Note: We have paid no attention to the variability of interest rates. Variability in borrowing costs
    was only introduced through the distribution of ef,t. But interest rates do change and it may be very
    important to an MNC. For example, if an MNC selects a revolving debt, it should consider the
    variability of the rates. In this chapter, we are considering this exercise as a one shot game.

    IFM-LN.245
    Chapter 21 – Short-term Investing
    The usual instruments for short-term investments are:
    - Bank deposits & CDs
    - Short-term bills/paper/notes

    Idea: MNCs with excess cash for a short term period (7 days, 15 days, a month)
    MNCs will try to invest in the country that offers the highest return, once exchange rate effects are
    considered. We are back to the context of the IFE.

    MNCs have many choices for investing


     Home  return(USD) = deposit interest rate (US)
     Abroad
    - Single country  return (GBP) = deposit rate (UK)
    - Portfolio of currencies  return (portfolio)

    Exactly like in Chapter 20, when investing abroad, MNCs should also consider ef. Since we do not
    know ef, we work with E[ef,t]. That is, for a US MNC, the (expected) effective yield/return (in
    USD) is:
    E[RUSDFC ] = (1+ RFC x T/360) (1 + E[ef,t ]) – 1 (yield in DC=USD).

    21.1 MNCs: Evaluation of Investing Choices


    Similar idea to Chapter 20: MNCs will maximize rates of return. Again, we will pay no attention
    to the variability of returns. This chapter ignores the risk/return relation.

    Example: MSFT can invest at home, the U.K., and Mexico It has excess cash for 30 days
    Data:
    RUSD = 6%
    RGBP = 5% E[ef,t] = 0.7%
    RMXP = 12% E[ef,t] = -1%
    T = 1 month  T/360=1/12.
    MSFT will translate the foreign return into an effective USD return, RUSDFC.

    1. Home
    RUSD = .06 x 30/360 = 0.005 (or 0.50%)
    2. Abroad
    UK: E[RGBPUSD] = (1+.05/12)(1.007)-1 = .011196 (or 1.12%)
    Mexico: E[RMXPUSD] = (1+.12/12)*(1-.01) -1 = -.0001 (or -0.01%)

    In terms of expected returns, MSFT should invest in the U.K. ¶

    • Using the distribution of ef (realistic case)


    We assume we know E[ef]. The precision of E[ef,t] is given by the distribution of ef. This
    distribution will tell us something about the risk.

    IFM-LN.246
    Example: IBM has excess cash for 1 year (T/360=1)
    Data:
    RUSD = 4%
    RGBP = 5%
    REUR = 3%

    ef,t, Distribution Prob


    GBP -.04 .5
    0 .5
    EUR .01 .3
    .05 .7
    1. Home
    RIBMUSD = 4%

    2. Abroad (GBP)
    Distribution Prob RUSDGBP
    -.04 .5 (1+.05)*(1-.04) -1 = .008
    0.00 .5 (1+.05)*(1+0) – 1 = 1.05
    USD
    E[R GBP] = .029

    3. Abroad (EUR)
    Distribution Prob RUSDEUR
    .01 .3 (1+.03)*(1+.01) - 1 = .0403
    .05 .7 (1+.03)*(1+.05) - 1 = .0815
    USD
    E[R EUR] = .043*(.30) + .0815*(.70) = 6.914%

    4. Abroad (Portfolio: wGBP=.4 & wEUR=.6) – Assume independence between GBP and EUR.
    Distribution Prob RUSDPort
    GBP EUR
    -.04 .01 .15 .4(.008) + .6(.0403) = .02738
    -.04 .05 .35 .4(.008) + .6(.0815) = .05210
    0.0 .01 .15 .4(.05) + .6(.0403) = .04410
    0.0 .05 .35 .4(.05) + .6(.0815) = .06890
    E[RUSDPOR] = 0.053084

    The portfolio somewhat reduces the risk (a more compact distribution), relative to the two
    individual abroad choices. But, it still looks better to invest in EUR. ¶

    IFM-LN.247
    CHAPTERS 20 & 21 – BRIEF ASSESMENT

    1. Cammy Co., a U.S. firm, needs funding for the next 90 days. It’s planning to borrow 80% from a Swiss
    bank and the remaining 20% from a Brazilian bank. The forecasts of the appreciation (against the USD) of the
    Swiss franc (CHF) and the Brazilian real (BRL) for the next three months are as follows:

    Currency Possible ef Probability


    CHF 0% .50
    CHF 2% .50

    BRL 4% .80
    BRL 8% .20

    The three-month borrowing rates are: 2% in CHF, 6% in BRL, and 2% in USD. Calculate the effective cost of
    funds of the overall portfolio. Would you advise Cammy Corp. to borrow abroad or at home? (Justify your
    answer, considering borrowing in CHF deposit only, BRL only, in the above mentioned 80-20 portfolio of
    currencies, and in USD only.)

    2. Baggy Co., a U.S. firm, has excess cash for the next 30 days. It can invest 60% from a Swedish bank and
    the remaining 40% from a Dominican Republic bank. The forecasts of the appreciation (against the USD) of
    the Swedish kroner (SEK) and the Dominican peso (DOP) for the next month are as follows:

    Currency Possible ef Probability


    SEK -1% .30
    SEK 0% .70

    DOP 1% .60
    DOP 2% .40

    The 1-mo deposit rates are:1% in SEK, 7% in DOP, and 2% in USD. Calculate the effective yield of the overall
    portfolio. Would you advise Baggy Corp. to deposit abroad or at home? (Justify your answer, considering
    placing the excess funds in SEK deposit only, DOP only, in the above mentioned 60-40 portfolio, and in USD
    only.)

    IFM-LN.248
    BONUS COVERAGE: Eurocurrency Futures
    ● Eurocurrency time deposit
    Euro-zzz: The currency of denomination of the zzz financial instrument is not the official currency of
    the country where the zzz instrument is traded.

    Example: a Mexican firm deposits USD not in the U.S. but with a bank outside the U.S., for example
    in Mexico or in Switzerland. This deposit qualifies as a Eurodollar deposit. ¶

    Rate paid on Eurocurrency deposits: London Interbank Offered Rate (LIBOR).

    • Eurodeposits tend to be short-term: 1 or 7 days; or 1, 3, or 6 months.


    Typical Eurodeposit instruments:
    Time deposit: non-negotiable, registered instrument, fixed maturity.
    Certificate of deposit: negotiable and often bearer.

    Note I: Eurocurrency deposits are direct obligations of the commercial banks accepting the deposits and
    are not guaranteed by any government. Although they represent low-risk investments, Eurodollar
    deposits are not risk-free

    Note II: Eurodeposits serve as a benchmark interest rate for international corporate funding.

    • Eurocurrency time deposits are the underlying asset in Eurodollar currency futures.

    A. Eurocurrency futures contract


    A Eurocurrency futures contract calls for the delivery of a 3-mo Eurocurrency time deposit at a given
    interest rate (LIBOR).

    A trader can go long (a promise to make a future 3-mo deposit) securing a yield for a future 3-mo deposit.
    A trader can go short (a promise to take a future 3-mo. loan) securing a borrowing rate for a future 3-mo
    loan.

    The Eurodollar futures contract should reflect the market expectation for the future value of LIBOR for
    a 3-mo deposit.

    • Q: How does a Eurocurrency futures work?


    A: Think of a futures contract on a time deposit (TD), where the expiration day, T1, of the futures
    precedes the maturity date T2 of the TD.

    Typically, T2-T1: 3-months.

    Such a futures contract locks you in a 3-mo. interest rate at time T1.

    IFM-LN.249
    3 months

    Today T1 T2

    Cash deposit Cash payout

    Example: In June you agree to buy in mid-Sep a TD that expires in mid-Dec.


    Value of the TD (you receive in mid-Dec) = USD 100.
    Price you pay in mid-Sep = USD 99.
     3-mo return on mid-Dec (100-99)/99 = 1.01% (or 4.04% annually.)

    • Eurocurrency futures work in the same way as the TD futures:


    “A Eurocurrency futures represents a futures contract on a Eurocurrency TD having a principal value of
    USD 1,000,000 with a 3-mo maturity.”

    - Eurocurrency futures are traded at exchanges around the world.


    Each market has its own reset rate: LIBOR, PIBOR, FIBOR, etc.

    - Eurodollar futures price is based on 3-mo. LIBOR.

    - Eurodollar deposits have a face value of USD 1,000,000.

    - Delivery dates: March, June, September and December.


    Delivery is only "in cash," -i.e., no physical delivery:

    “Eurocurrency futures are cash settled on the last day of trading based to the British Banker's Association
    Interest Settlement Rate.”

    - The (forward) interest rate on a 3-mo. CD is quoted at an annual rate.


    Eurocurrency futures price is quoted as:
    100 - (the interest rate of a 3-mo. euro-USD deposit for forward delivery).

    Example: if the interest rate on the forward 3-mo. deposit is 6.43%, the Eurocurrency futures price is
    93.57. ¶

    Note: If interest rates go up, the Eurocurrency futures price goes down, the short side gains.

    • Minimum Tick: USD 25.


    Since the face value of the Eurodollar contract is USD 1,000,000
     one basis point has a value of USD 100 for a 360-day deposit.
    For a three-month deposit, the value of one basis point is USD 25.

    Example: Eurodollar futuresNov 20: 93.57


    Eurodollar futuresNov 21: 93.55
     Short side gains USD 50 = 2 x USD 25. ¶

    IFM-LN.250
    • Q: How is the future 3-mo. LIBOR calculate?
    A: Eurodollar futures reflect market expectations of forward 3-month rates. An implied forward rate
    indicates approximately where short-term rates may be expected to be sometime in the future.

    Example: 3-month LIBOR spot rate = 5.4400%


    6-month LIBOR spot rate = 5.8763%
    3-month forward rate = f = ?

    (1 + .058763 x 182/360) = (1 +.0544 x 91/360) x (1 +f x 91/360)

    1.029708/ (1.013751) = 1.015740 = (1 + f x 91/360)  f = 0.062270 (6.227%)

    IFM-LN.251
    Example: The WSJ on October 24, 1994 quotes the following Eurodollar contracts:

    EURODOLLAR (CME) - $ 1 million; pts of 100%


    Yield Open
    Open High Low Settle Chg Settle Chg Interest
    Dec 94.00 94.03 93.97 94.00 .... 6.00 .... 447,913
    Mr95 93.56 93.60 93.53 93.57 + .01 6.43 - .01 402,624
    June 93.11 93.15 93.07 93.12 + .01 6.88 - .01 302,119
    Sept 92.77 92.80 92.73 92.77 .... 7.23 .... 243,103
    Dec 92.45 92.49 92.42 92.46 .... 7.54 .... 176,045
    Mr96 92.38 92.41 92.34 92.38 .... 7.62 .... 152,827
    June 92.26 92.28 92.24 92.25 - .01 7.75 + .01 124,984
    Sept 92.16 92.18 92.12 92.15 - .01 7.85 + .01 117,214
    Dec 92.04 92.06 92.01 92.03 - .01 7.97 + .01 95,555
    Mr97 92.05 92.06 92.01 92.04 - .01 7.96 + .01 83,127
    June 91.98 92.01 91.95 91.97 - .01 8.03 + .01 69.593
    Sept 91.92 91.94 91.89 91.91 - .01 8.09 + .01 55,103
    Dec 91.81 91.82 91.77 91.79 - .01 8.21 + .01 53,103
    Mr98 91.83 91.84 91.79 91.81 - .01 8.19 + .01 43,738
    June 91.77 91.78 91.73 91.75 - .01 8.25 + .01 37,785
    Sept 91.71 91.73 91.67 91.69 - .01 8.31 + .01 26,751
    Dec 91.60 91.61 91.56 91.58 - .01 8.42 + .01 24,137
    Mr99 91.62 91.63 91.58 91.60 - .01 8.40 + .01 21,890
    June 91.56 91.57 91.52 91.54 - .01 8.46 + .01 15,989
    Sept 91.50 91.51 91.46 91.48 - .01 8.52 + .01 10,263
    Dec 91.40 91.41 91.36 91.37 - .01 8.63 + .01 7,354
    Mr00 91.44 91.44 91.40 91.41 - .01 8.59 + .01 7,536
    June 91.39 91.40 91.35 91.36 - .01 8.64 + .01 4,971
    Sept 91.34 91.35 91.30 91.31 - .01 8.69 + .01 7,691
    Dec 91.23 91.24 91.19 91.21 .... 8.79 .... 6,897
    Mr01 91.28 91.28 91.24 91.26 .... 8.74 .... 7,312
    June 91.24 91.24 91.20 91.22 .... 8.78 .... 5,582
    Sept 91.21 91.20 91.17 91.19 .... 8.81 .... 5,040
    Dec .... .... .... 91.09 .... 8.91 .... 3,845
    Mr02 91.13 91.13 91.13 91.14 .... 8.86 .... 2,689
    June .... .... .... 91.10 .... 8.90 .... 2,704
    Sept 91.06 91.06 91.06 91.08 .... 8.92 .... 2,016
    Dec 90.97 90.97 90.97 91.00 .... 9.00 .... 1,341
    Mr03 91.01 91.03 91.01 91.04 .... 8.96 .... 1,589
    June 90.97 90.97 90.97 91.00 .... 9.00 .... 1,367
    Sept 90.85 90.98 90.95 90.98 .... 9.02 .... 1,354
    Dec 90.85 90.88 90.85 90.89 - .01 9.11 + .01 1,227
    Est vol 437,328; vol Thur 615,913; open int 2,576,727. +17,451.

    IFM-LN.252
    A.1 Terminology
    Amount: A Eurodollar futures contract involves a face amount of USD 1 million. To hedge USD 10
    million, we need 10 futures contracts.

    Duration: Duration measures the time at which cash flows take place.
    • For money market instruments, CFs generally take place at the maturity of the instrument.

    A 6-mo. deposit has approximately twice the duration of a 3-mo. deposit.


    Value of 1 bp for 6-mo. is approximately USD 50.

    Hedge a USD 1 million six-month deposit beginning in March with:


    (1) 2 March Eurodollar futures (stack hedge).
    (2) 1 March Eurodollar futures and 1 June Eurodollar futures (strip hedge).

    Slope: Eurodollar contracts may be used to hedge other interest rate assets and liabilities. The rates on
    these instruments are not expected to change 1-for-1 with Eurodollar interest rates.

    • Let f be the interest rate in an Eurodollar futures contract, then

    slope = Δ underlying interest rate / Δ f. (think of delta = change)

    • If the rate of change of T-bill rates with respect to Eurodollar rates is .9 (slope = .9), then we only need
    nine Eurodollar futures to hedge USD 10 million of three-month T-bill.

    • FA: face amount of the underlying asset to be hedged


    DA: duration of the underlying asset to be hedged.
    n: number n of Eurodollar futures needed to hedge underlying position

    n = (FA/1,000,000) x (DA/90) x slope.

    Example: To hedge USD 10 million of 270-day commercial paper with a slope of .935 would require
    approximately twenty-eight contracts.

    Margin: Eurodollar futures require an initial margin. In September, this was typically USD 800 per
    contract; maintenance margin was USD 600.

    ● Q: Who uses Eurocurrency futures?


    A: Speculators and Hedgers.

    • Hedging
    Short-term interest rates futures can be used to hedge interest rate risk:

    - You can lock future investment yields (Long Hedge).


    - You can lock future borrowing costs (Short Hedge)

    IFM-LN.253
    A.2 Eurodollar Strip Yield Curve and the IMM Swap
    • Successive Eurodollar futures give rise to a strip yield curve.

    March future involves a 3-mo. rate: begins in March and ends in June.

    June future involves a 3-mo. rate: begins in June and ends in September.
     This strip yield curve is called Eurostrip.

    Note: If we compound the interest rates for four successive Eurodollar futures contracts, we define a
    one-year rate implied from four 3-mo. rates.

    • A CME swap involves a trade whereby one party receives one-year fixed interest and makes floating
    payments of the three-months LIBOR.

    CME swap payments dates: same as Eurodollar futures expiration dates.

    Example: On August 15, a trader does a Sep-Sep swap.


    Floating-rate payer makes payments on the third Wed. in Dec, and on the third Wed. of the following
    Mar, June, and Sep.

    Fixed-rate payer makes a single payment on the third Wed. in Sep.¶

    Note: Arbitrage ensures that the one-year fixed rate of interest in the CME swap is similar to the one-
    year rate constructed from the Eurostrip.

    Application: Pricing Short-Dated Swaps


    • Swap coupons are routinely priced off the Eurostrip.

    Key to pricing swaps: The swap coupon is set to equate the present values of the fixed-rate side and the
    floating-rate side of the swap. Eurodollar futures contracts allow you to do that.

    • The estimation of the fair mid-rate is complicated a bit by:


    (a) the convention is to quote swap coupons for generic swaps on a semiannual bond basis, and
    (b) the floating side, if pegged to LIBOR, is usually quoted money market basis (for consistency,
    we will assume that the swap coupon is quoted bond basis).

    Notation: If the swap is to have a tenor of m months (m/12 years) and is to be priced off 3-mo Eurodollar
    futures, then pricing will require n sequential futures series, where n=m/3 or equivalently, m=3n.

    Example: If the swap is a six-month swap (m=6), then we will need two future Eurodollar contracts.

    • Procedure to price a swap coupon involves three steps:

    IFM-LN.254
    i. Calculate the implied effective annual LIBOR for the full duration (full-tenor) of the swap from
    the Eurodollar strip.
    n
    A(t) 
    r 0,3n =  [1 + r 3(t -1),3t ] - 1,  = 360/A(t)
    t=1 360

    ii. Convert the full-tenor LIBOR, which is quoted on money market basis, to its fixed-rate
    equivalent FRE0,3n, which is stated as an annual effective annual rate (annual bond basis).
    FRE0,3n = r0,3n x (365/360).

    iii. Restate the fixed-rate equivalent on the same payment frequency as the floating side of the swap.
    The result is the swap coupon SC. This adjustment is given by
    SC = [(1 + FRE0,3n)1/k - 1] x k, k=frequency of payments.

    Example: It's October 24, 1994. Housemann Bank wants to price a one-year fixed-for-floating interest
    rate swap against 3-mo LIBOR starting on December 94.

    Fixed rate will be paid quarterly (quoted quarterly bond basis).

    TABLE 21.A
    Eurodollar Futures, Settlement Prices (October 24, 1994)
    Implied Number of
    Price 3-mo. LIBOR Notation Days Covered
    Dec 94 94.00 6.00 0x3 90
    Mar 95 93.57 6.43 3x6 92
    Jun 95 93.12 6.88 6x9 92
    Sep 95 92.77 7.23 9 x 12 91
    Dec 95 92.46 7.56 12 x 15 91

    Housemann Bank wants to find the fixed rate that has the same present value as four successive 3-mo.
    LIBOR payments.

    (1) Calculate implied LIBOR rate using (i).


    Swap is for twelve months, n=4.

    f0,12 = [(1+.06x(90/360)) x (1+.0643x(92/360)) x (1+.0688x(92/360))x(1+.0723x(91/360))]360/365 - 1 = =


    .06760814 (money market basis).

    (2) Convert this money market rate to its effective equivalent stated on an annual bond basis.

    FRE0,12 = .06760814 x (365/360) = .068547144.

    (3) Coupon payments are quarterly, k=4. Restate this effective annual rate on an equivalent quarterly
    bond basis.

    SC = [(1.068547144)1/4 - 1] x 4 = .0668524 (quarterly bond basis)

    IFM-LN.255
     The swap coupon mid-rate is 6.68524%. ¶

    Example: Go back to the previous Example. .


    Now, Housemann Bank wants to price a one-year swap with semiannual fixed-rate payments against 6-
    month LIBOR.

    The swap coupon mid-rate is calculated to be:

    SC = [(1.068547144)1/2 - 1] x 2 = .06741108 (semiannual bond basis). ¶

    Note: A dealer can quote swaps having tenors out to the limit of the liquidity of Eurodollar futures on
    any payment frequency desired.

    IFM-LN.256

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