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    FIN/IBUS463

    InternationalFinance

    ProfessorRobinLumsdaine

    1 FIN/IBUS463: InternationalFinance

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    Todays overview

    Course Logistics

    Introduction

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    Course Logistics Description

    Textbook and other useful references

    Requirements and assessments

    Teaching philosophy Schedule

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    Course Description Introduction to global capital markets and

    financial management Challenging but useful

    Prerequisites:o FIN-365o Upper division standing

    o Quantitative comfort and facility

    Academic Integrity Code Bloomberg

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    Textbook and other useful references Main textbook: Geert Bekaert and Robert J. Hodrick, International

    Financial Management, Prentice Hall, (2011 2nd edition)

    Background references:o Alan C. Shapiro, Multinational Financial Management, 9th ed., Wiley,

    2008

    Other books that might be of interest (but are neither required norsupported in this class):o Bruno Solnik and Dennis McLeavey, International Investments, 5th ed.,

    Addison Wesley, 2004o Richard M. Levich, International Financial Markets: Prices and

    Policies, 2nd

    ed., McGraw-Hill Irwin, 2001o Piet Surcu , Theory into Practice, Princeton University Press, 2009

    Course readings: please do the readings in advance!

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    Requirements and Assessments Course grade

    Weekly homework: 5% Currency project: 35%, comprised of

    (a) Participation in class and on blackboard (10%),

    (b) Risk management spreadsheet and Bloomberg use(10%)

    (c) Group write-up, consisting of a group executivesummary (5%) and individual write-ups of eachcurrency (5%, for the part related to your currency),

    (d) Group presentation and handout (5%)

    Midterm (25%) and Final exam (35%)

    Please use name cardsFIN/IBUS463: InternationalFinance 6

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    Office hours and other appointments KSB T-43

    Mondays 4:00-5:30pm Tuesdays 4:30-6:00pm By appointment

    Bloomberg office hours (in Kogod mini-lab):Wednesdays, 8-9pm, January 20, 27, andFebruary 3, 10, and 17

    Important note: No office hours on Monday,March 14

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    Important dates Last day to drop course without penalty: Monday, January 25

    Early warning deadline: Monday, February 15

    Midterm: Wednesday, February 24, 8:55-11:35am

    Last day to drop course at all: Friday, March 4

    Last day to trade for the currency project: Friday, April 15 Currency write-ups and spreadsheets due: NO LATER THAN

    8:55am, Wednesday, April 20

    Currency project presentations: Wednesday, April 20

    Final examination: Wednesday,April 27, 8:55-11:35am(locationto be confirmed)

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    Currency Project Overview You are a manager in the corporate Treasury department of a dollar-

    based multinational (i.e., you need to primarily focus on exchange raterelative to dollar).

    You are responsible for actively managing the currency risk related toone of the firms subsidiaries in a foreign country.

    The other members in your group are your colleagues, responsible forother currencies (other subsidiaries)

    Your initial position is the equivalent of $100,000 cash in yourparticular foreign currency

    Keep daily running profit/loss tally (your P&L)

    Put into practice what we learn in class

    Individual and group components

    Minimum requirements: monitor daily, trade and post at least weekly

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    Currency project instructions (1)Your group should keep a blog on Blackboard in which together you moni tor yourrespective currencies and trades and help each other, that includes (but is not limi ted to)the following:

    1. Details of every trade you make, along with running profit/loss totals. What other tradeswere you considering and how would they have done if you had decided to implementthem instead?

    2. How are your forecasts and trades doing (e.g., are you on target to reach your forecastsor have you already reached them, have the currencies moved against you, what do you

    need to monitor). Are you happy with your trades and do you want to change them (and ifso, how). Provide justification for either choice

    3. As we progress in class, you will learn about more complex ways to express your view(i.e., trades you can do to capitalize on whether you think your currency is going toappreciate or depreciate, and ways to hedge to protect your exposure if you are wrong)

    4. What has happened in your country or the world that may have affected your currency(e.g,. Economic or political news, large changes in interest rates

    5. Remember to keep track of sources and Bloomberg screen shots this will help you withthe end-of-semester write-up.

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    Currency project instructions (2)1. Currency assignment: Assume you have $100,000 worth of your foreign

    currency (exact assignments and levels will be posted on Blackboard aftertodays class). This is a 100% long position.

    2. Forecast: Your starting day is Wednesday, January 13 (today) -- write down thestarting level of your currency (this will also be posted on Blackboard). Next,provide (via email to me, due no later than 5pm Friday, January 15)) an exactnumerical level that you expect your currency to be at on Friday, April 15, andindicate whether your forecast is an appreciation or depreciation relative to yourstarting point, as well as the percentage change that forecast represents (e.g.,EUR will depreciate from 1.33$/ to1.28 $/, a 3.9% depreciation). Note: DONOT choose stay the same.

    3. Initial trade direction: if your forecast suggests your currency will appreciate, youwant to have more of your currency than the dollar; otherwise, you will want tohave less. This should form the basis for your first trade. Given your firms

    business needs, it is unlikely you will want to be 100% long or 100% short at anytime.

    4. Describe in your blog what (e.g., specific economic or political events) you planto monitor to assess your currency and how you will evaluate your trade (e.g.,when will you decide to take a profit or cut your losses?).

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    Additional Currency Project Information Group Responsibilities

    o Get started now!o

    Bounce ideas off of colleagues/help each othero Plan strategies to try a variety of things and maximize learningo Set up a group spreadsheet to monitor your portfolio (that is, the aggregate of your

    currencies and trades)o Participate in discussion on blackboardo Contribute to and log trades in group blogo Work together but make individual trade decisions

    Individual Responsibilitieso Get started now!o Set up your individual spreadsheeto Form forecasts and trading rules for your currencyo

    Monitor and manage your specific currencyo Understand risks, key events affecting your currencyo Periodically update class on your activities

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    Things to consider about your currency

    How volatile is it?

    How might historical performance informyour views? How might things be different

    now? What are some of the macro events thatcould affect your currency?

    What are some of the global currency(e.g., dollar) considerations

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    Risk management basics Taking risk is not badfailure to manage risk

    is Common pitfalls:

    Poor decision-making, not enough thought

    upfront Overconfidence

    Lack of appropriate controls/governance

    Failure to balance upside/downside Excessive reliance on past performance/failure torecognize and react to changing environment

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    Questions?

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    Getting acquainted about me

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    Mathematics Economics

    Econometrics

    Time Series Econometrics

    Volatility Modeling Retirement Modeling

    Economics of Aging

    FinanceForecastingBanking

    My sabbatical:

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    My research

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    and

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    Introductionto

    Foreign

    Exchange

    MarketsandRisks

    ProfessorRobinLumsdaine

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    Introduction to International Finance

    1. Globalization

    Connectivity Integration

    2. Multinational Corporations

    Growth of international trade Efforts to promote free trade

    Cross-border production, labor mobility (e.g.,outsourcing, offshoring)

    Financial markets3. Privatization

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    Trade and Financial Openness

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    Copyright2009PearsonEducation,Inc. PublishingasPrenticeHall

    TO

    FO

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    Exhibit 1.1: Trade as percentage of GDP

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    Copyright2009PearsonEducation,Inc. PublishingasPrenticeHall

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    Financial Openness A country is financially open if:

    Note: financial openness appears to lagbehind trade openness

    Openness does not necessarily mean largetrade flows

    Deregulation also resulted in financial

    innovation Derivatives Securitizations

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    Multinational Corporations How MNCs enter foreign markets

    Goals of an MNC may differ in differentmarkets (e.g., shareholder maximization,stakeholder interests)

    Agency Theory and Corporate Governance

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    Why does foreign exchange matter?

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    What causes a currency crisis? Speculative attack

    Large devaluation

    Move to a floating system Economic upheaval

    Reasons why a speculative attack may occur Government policies inconsistent with peg Reserves become so low that central bank has to abandon the peg

    Devaluations are predictable Growing budget deficits Rapid money growth Rising wages/prices Inflation => rapid appreciation of local currency in real terms

    Current account deficit Self-fulfilling expectations Contagion

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    What does a currency crisis look like?

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    Foreign Exchange1. The Foreign Exchange Market

    2. Quoting Foreign Exchange Rates3. No Arbitrage Relationships

    4. Bid-Ask Spreads

    5. Appreciations and Depreciations6. Foreign Exchange Risk

    7. Forward Contracts

    8. Forward Premiums and Discounts9. Hedging Foreign Exchange Risk

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    The Foreign Exchange Market Largest financial market in the world Complex structure Interbank market: 80% of all transactions

    Typically large trades (>$1m) Competitive pricing

    Estimated daily trading volume $3.9tr (April 2010) Has grown dramatically (was $10-20bn in 1973, $2tr in2004)

    Generally very liquid Low transaction costs Average daily dollar volume in NYSE was $50bn in 2010

    Dealers (market makers) versus brokers (financialintermediaries)

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    Currencies of the World Exhibit 2.4 in BH gives 3-letter codes for many

    currencies (e.g., USD, EUR, GBP, JPY)

    Many also have particular symbols (e.g., $, , , ) Some countries have pegged currency (e.g.,

    Bahamas, Bermuda, Cuba to the $; Bulgaria,Macedonia to the )

    Others share common currency European Union (original): Austria, Belgium, Finland,

    France, Germany, Greece, Ireland, Italy, Luxembourg,Netherlands, Portugal, Spain

    Accessions: Andorra, Cyprus, Estonia, Latvia, Lithuania,Malta, Monaco, San Marino, Slovakia, Slovenia, VaticanCity

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    Quoting conventionsExchange rates describe the relative prices of monies in two

    countries. For ease of discussion, we will refer to onecountry as the reference country (most often this will be the

    US) and the other country as the foreign country but youmay encounter the opposite convention as well.

    Exchange rates may be quoted directly or indirectly

    Direct quotes refer to the amount of reference country currency ittakes to purchase one unit of the foreign countrys currency.

    Indirect quotes refer to the amount of foreign currency it takes topurchase one unit of the reference countrys currency

    Be careful to get the units right.

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    Direct Quotes examplesQ1: In the US, what is a direct quote for the British

    pound?

    A1:

    Q2: How many dollars would it take to purchase 1m?

    A2:

    Note: the amount is multiplied by the direct quote

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    Indirect Quotes examplesQ1: In the US, what is an indirect quote for the Japanese yen?

    A1:

    Q2: How many US dollars would it take to purchase 100m?

    A2:Note: the amount is divided by the indirect quote

    Q3: What is the direct price of the yen in the US?

    A3:

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    Reciprocal relationshipDirect and indirect quotes are reciprocals why must

    this be?

    If it werent the case, there would be arbitrage. Forexample:

    Suppose the (direct) dollar price of a British pound was$1.95/ but the indirect price was 1/$2.00

    Then the direct quote would indicate that I could getone British pound for $1.95 while the indirect quote

    would suggest it costs $2.00, a contradiction This would present an arbitrage opportunity, hence it

    does not happen

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    Market quoting conventionsSome currency pairs typically use direct quotes and

    others indirect quotes. Versus the dollar, the

    following are typically quoted with direct quotes(recent levels in parentheses):

    AUD (0.7042$/A$)

    NZD (0.6355$/NZD)

    EUR (1.1244$/) GBP (1.5318$/)

    Most other currency pairs are quoted indirectly versus thedollar, for example JPY (120.17/$), CAD (1.3274C$/$),

    CHF (0.9695CHF/$)Most currency pairs are quoted indirectly versus the euro

    (e.g., 0.7340/, 135.12/)

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    Currency Cross-Rates

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    Triangular ArbitrageWe can use the direct quote of one currency (currency A) and the

    indirect quote of another (currency B) that have the same referencecurrency to compute the exchange rate between the two. For

    example:

    If the dollar price of the euro is $1.45/ and the Japanese yen price ofthe dollar is 110.25/$, what is the Japanese yen price of the euro?

    Why must this be the price?

    If the direct price of / were higher than 159.86/, what would you do?

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    Spot Bid-Ask SpreadsThe forex market is an over-the-counter market in which

    traders quote prices at which they are willing to buyand sell currencies. What do we mean by Bid and Askprices in dollars/pound?

    The Bid price of $/ is the dollar price at which the dealerbuys pounds from the customer. The Ask price of $/is the dollar price at which the dealer sells pounds tothe customer. Ask>Bid.

    Spot forex markets are very liquid, and bid-ask spreadsare tiny. Suppose the bid rate is $1.4991/ and theask rate is $1.50/, the percentage bid-ask spread is

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    Appreciations and DepreciationsWhat does it mean when the euro

    appreciates relative to the dollar?

    What does it mean when the yen depreciatesrelative to the dollar?

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    Example: intraday

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    Example: BRL devaluation

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    How much did BRL depreciate?1/1/99: 1.21BRL/$ 1/29/99: 2.05BRL/$

    By the end of January 1999, one needed(2.05-1.21)/1.21*100 = 69% more BRL topurchase one dollar.

    The change in the dollar value of BRL was

    = -0.41

    or a 41% depreciation!

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    Homework problems/questions Ch 1: Modified problem 1: Go to the IMFs 2015 World Economic Outlook

    publication(http://www.imf.org/external/pubs/ft/weo/2015/01/pdf/text.pdf) and lookup the following information for the country corresponding to yourcurrency

    Real GDP: Table A2 on page 171 or Table A4 on pp. 174-176) Consumer Prices: Table A6 on page 178 or Table A7 on pp. 177-179) Current Account Balances: Table A11 on page 188 or Table A12 on pp. 189-191)

    Use this information to help you form an outlook for your currency (note:you may also need to consider the dollar and euro outlook as well) post a forecast to Blackboard before the beginning of the next class(September 10, 2015)

    Ch 2:

    Questions 4,5,7,8 Problems 1,3,5,6

    For next time: ch 3 readings from syllabus

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    ForwardRates,

    Risk

    Premia,

    HedgingTransactionsRisk

    ProfessorRobinLumsdaine

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    Todays overview Examples to review last class

    Forward Contracts Bloomberg session

    Hedging Foreign Exchange Risk Swaps

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    First exampleSuppose you have the followingexchange rates:

    Prices are: 99.95 in DKK, SEK, NOK 14.95 in Germany, Austria, Belgium 13.95 in Spain, Finland, Ireland

    Question: where would you choose topurchase the item if you were paying ineuros? What about if you were paying in $?

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    NOK/$ = 6.273 SEK/$ = 7.520 DKK/$ = 5.313

    NOK/ = 8.788 SEK/ = 10.539 DKK/ = 7.445

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    Second example Since the beginning of the year, there have been

    changes to the following exchange rates:

    Source: Bloomberg

    Question: How much (in percentage terms) hasthe dollar appreciated (or depreciated) versusboth the euro and the Argentine peso?

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    12/31/14 $/ = 1.2098 ARS/$ = 8.4655

    9/02/15 $/ = 1.1239 ARS/$ = 9.3099

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    Foreign Exchange RiskQ1: What is Foreign Exchange Risk?

    A1:

    Q2: How do you eliminate an FX exposure?

    A2:

    Q3: Suppose you have a known foreign currencycash inflow in 180 days. How could you hedge it?

    A3:

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    Attributes of Forward Contracts Price is agreed today for exchange in the

    future No money changes hands until the

    forward value date

    There is counterparty risk

    Prices are quoted in a bid-ask spread

    Spreads widen as the maturity increases

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    Forward Foreign Exchange Market OTC market less liquid than spot

    markets

    Most active contracts are 30, 60, 90, 180days (roughly 1, 2, 3, 6 months) but any

    horizon is possible Types of contracts

    Outright

    Swaps (>50% of market)

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    Forward value (settlement) dates end-end rule: if spot value date is on last

    day of month, use last day of next month

    (for 30-day contract)

    all other days use specified number ofcalendar days from today unless that fallson a weekend, in which case

    use next business day as long as that is stillwithin the same calendar month, or

    use previous business day if not

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    Forward Contracts ExampleYen Spot: 92.13/$30-day Forward: 92.11/$

    90 day Forward : 92.07/$180 day Forward : 92.00/$

    Q1: How many yen does it take to purchase $1million today?A1:

    Q2: How many yen does it take to purchase $1million in 180 days?

    A2:

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    Forward Premiums and DiscountsQ: When the forward rate of /$ is less than the spot

    rate (as in this example), is there a forward

    premium or discount on the dollar? Why?

    A:

    What is the annualized percentage forward premiumor discount on an N-day forward contract using a360-day year?

    100 x (360/N) x (forward spot)/spot

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    Forward Premium/Discount example100 x (360/N) x (forward spot)/spot

    Spot: 92.13/$90 day: 92.07/$

    Is there a forward premium or discount on theyen in terms of the dollar?

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    Forward Contracts ExampleEuro Spot: 1.4812$/30-day Forward: 1.4787$/

    90 day Forward : 1.4737$/180 day Forward : 1.4672$/

    Q1: How many euros does it take to purchase $1million today?A1:

    Q2: How many euros does it take to purchase $1million in 180 days?

    A2:

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    DXY

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    Forward Premiums/Discounts, Example

    Q1: When the forward rate of $/ is less than the spot rate, is there a forwardpremium or discount on the dollar?

    A1: There is a forward premium because it is more expensive to purchase dollarsin the forward market than in the spot market.

    Note: there is a forward discount on the euro

    Q2: What is the annualized percentage forward premium or discount on a 90-day

    forward contract using a 360-day year?

    A2: on euro,

    on the dollar,

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    Hedging FX Risk Example

    Q1: Suppose you are importing cheese from France. You will owe500,000 in 3 months. What is the nature of your FX risk?

    A1:

    Q2: What should you do to hedge?A2:

    Q3: If the 90-day forward rate is $1.50/, how many dollars willyou owe?

    A3:

    Q4: Why are you hedged?A4:

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    Hedging: Determining FX Risks How do you determine FX risk in general?

    If dollar cash flows increase with a weakening ofthe dollar, do you have foreign currency assets or

    liabilities?

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    Hedging FX Risks General Properties

    How do you hedge FX risk in general?

    If you have FX assets, you must acquire FX liabilitiesthat exactly match the cash flow characteristics of yourassets.

    If you have FX liabilities, you must acquire FX assetsthat exactly match the cash flow characteristics of yourliabilities.

    Generally, you must find a derivative instrument thathas the off-setting payoff to your underlying position.

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    Comparing Hedged and Unhedged Positions

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    Comparing Hedged and Unhedged Positions

    (Exhibit 3.4 in BH)

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    Copyright2011PearsonEducation,Inc. PublishingasPrenticeHall

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    To hedge or not to hedge?

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    Ex post versus ex ante

    Ex ante decision uses expected exchangerate (i.e., need a forecast)

    Need to consider cost of hedging

    Because ex post and ex ante can differ, nosuch thing as a perfect hedge

    Speculation or hedging?

    Other risks (e.g., counterparty)

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    Hedging and balance sheet

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    EX ANTE F(t,k) < Et [S(t+k)] F(t,k) > Et [S(t+k)]

    Foreign currency asset Should hedge

    Foreign currency liability Should hedge

    rates are expressed as domestic rates per unit of foreign currency(e.g., dollars per yen, dollars per euro)

    f(t,k) is the forward rate at time t for delivery at time t+k

    EX POST F(t,k) < S(t+k) F(t,k) > S(t+k)

    Foreign currency asset Cost of hedging Benefit of hedgingForeign currency liability Benefit of hedging Cost of hedging

    Copyright2009PearsonEducation,Inc. PublishingasPrenticeHall

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    An Intro to Swaps

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    Recall > 50% of FX transactions are

    swaps Four basic types (FX = foreign currency)

    Manage maturity structure of currencyexposure

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    How Swap Prices are Quoted

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    In basis points (bps)Example:

    Spot 30-day fwd/$104.30-40 80/85

    Q: Which is bid and which is ask?

    A: Add swap points if 1st # < 2nd #, else subtract

    Two things to remember:

    Bid is lower number Forward bid-ask spreads increase as time horizonincreases

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    Swap calculation example From the spot and swap rates, what is

    the bid and ask of the 30-day forwardSpot 30-day fwd

    $/1.4350-60 40/30

    Is the euro trading at a forward

    discount or premium?

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    Swap calculation example answer

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    Swap calculation example -- answer

    Since the 1st swap point number is above the 2nd,we need to subtract

    30-day forward bid: 1.4350 - .0040 = 1.4310$/

    30-day forward ask: 1.4360 - .0030 = 1.4330$/

    Check that bid is still < ask it is!

    Since the forward levels are below the spot, thereis a forward discount on the euro

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    Exhibit 3 7 from BHSpot exchange rates (bid/ask):104.30/104.35 /$

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    Exhibit 3.7 from BH

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    Copyright2011PearsonEducation,Inc. PublishingasPrenticeHall

    IBM Nomura

    1,042,000,000

    1,043,000,000

    Forward swap points: 20/15

    Relationship to Forward Premia and Discounts

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    Relationship to Forward Premia and Discounts

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    Recall that if forward rate is larger than spot rate,the reference currency (i.e., the denominator) is at

    a forward premium This will be the case when swap points are added,

    i.e., when first swap number is less than second

    Swapping into currency that is at a premiumgenerates a positive cash flow

    If swap points are subtracted, forward rate is lessthan spot rate and reference currency is at aforward discount; swap will generate a negativecash flow

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    Exchange rate distributions Hedging decisions depend on forecasts

    Historical information

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    Homework problems/questions Ch 3: Question 2 (2011)

    Problems 1,2,5 Also read Ch 3 appendix carefully!

    For next time: Review time value of money Read

    BH, Chapter 6, Interest Rate Parity, pp 178-198, 201-

    210 (skip Mexican Cetes for now) BH, Chapter 7, Speculation and Risk in the Foreign

    Exchange Market, entire chapter

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