international finance

International Finance

Lecture 6

World Financial Markets and Institutions

• International Banking and Money Market

• International Bond Market• International Equity Markets• Futures and Options on Foreign

Exchange• Currency and Interest Rate Swaps• International Portfolio Investment

Futures Contracts

• A futures contract specifies that a certain currency will be __________ for another at a specified time in the future at prices specified today.

• A futures contract is different from a forward contract:– Futures are standardized contracts trading on

organized exchanges with daily resettlement through a clearinghouse.

• Standardizing Features:– __________ Size– __________ Month– Daily __________

• ________ requirements (initial, maintenance margins)

Currency Futures Markets• The Chicago Mercantile Exchange (CME)

is by far the largest. • Others include:

– The Philadelphia Board of Trade (PBOT)

– The MidAmerica Commodities Exchange

– The Tokyo Financial Exchange– The London International Financial

Futures Exchange (LIFFE)

After Hours Trading

• __________ -hours trading on CME GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST.

• Singapore Exchange (SGX) offers contracts.• There are other markets, but none are close

to CME and SGX trading volume.

Daily Resettlement: An Example

• Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically you think

that the dollar will appreciate).

Currently __________. The 3-month forward price is __________.

Currency per U.S. $ equivalent U.S. $

Wed Th Wed ThJapan (yen) 0.007142857 0.007194245 140 1391-month forward 0.006993007 0.007042254 143 1423-months forward 0.006666667 0.006711409 150 1496-months forward 0.00625 0.006289308 160 159

Daily Resettlement

• Currently $1 = ¥140 and it appears that the dollar is strengthening.

• If you enter into a 3-month futures contract to sell ¥ at the rate of $1 = ¥150 you will make money if the yen depreciates. The contract size is ¥12,500,000

• You do not have to have ¥ now, either way you have committed yourself to sell ¥12,500,000 and receive in exchange ¥12,500,000 * 1/150 [$/ ¥] = $ _________

• Your initial margin is 4% of the contract value:

Daily Resettlement

• On Thursday the futures rate closes at $1 = ¥149, then your position’s value drops. Here’s why.

• Your have a short position in ¥. The mark-to-market profit/loss for short position is_______.

• That is, you have lost $ ________overnight• The $559.28 comes out of your $3,333.33 margin

account, leaving $2,774.05

Reading a Futures Quote Open Hi Lo Settle Change Lifetime

High Lifetime

Low Open

Interest

Sept .9282 .9325 .9276 .9309 +.0027 1.2085 .8636 74,639

Expiry month

Opening price

Highest price that day

Highest and lowest prices over the lifetime of the

contract.

Number of open contracts

Lowest price that day

Closing price

Daily Change

Currency Futures Trading: Example

• $CAN futures contract expiring on June 14 trades on CME at US$0.7761 on January 9. On the last trading day of the contract in June the spot rate is US$0.7570. The contract size is CAN$100,000.

1. What is the profit/loss for a trader who took a long position in the contract on January 9?

2. What is the profit/loss for a trader who took a short position in the contract on January 9?

Currency Futures Trading: Example

Eurodollar Interest Rate Futures

• Widely used futures contract for hedging short-term U.S. dollar interest rate risk.

• The underlying asset is a $1,000,000 90-day Eurodollar deposit—the contract is __________.

• Traded on the CME and the Singapore International Monetary Exchange.

• Eurodollar futures prices are stated as an index number of three-month LIBOR calculated as F = 100 – LIBOR.– For example, if the closing price F is 98.23, the

implied yield is 5.77 percent = __________• Hedging/speculation just like with forwards, except

standardized amounts and daily resettlement

Example• The size of a yen futures contract at CME is 12.5 million

yen. The initial margin is $2,025 per contract and the maintenance margin is $1,500. You decide to buy ten contracts with maturity on June 17, at the current futures price of $0.01056. Today is April 1 and the spot rate is $0.01041. Indicate cash flows on your position if the following prices are subsequently observed.

April 1 April 2 April 3 April 4 June 16 June 17

Spot, $/Y 0.01041 0.01039 0.01000 0.01150 0.01150 0.01100

Futures, $/Y 0.01056 0.01054 0.01013 0.01160 0.01151 0.01100

Example solvedApril 1 April 2 April 3 April 4 June 16 June 17

Spot, $/Y 0.01041 0.01039 0.01000 0.01150 0.01150 0.01100

Futures, $/Y 0.01056 0.01054 0.01013 0.01160 0.01151 0.01100

Gain/Loss

Margin before CF

CF from investor

Margin after CF

Example• It is 1 April now and current 3-month LIBOR is 6.25%.

Eurodollar futures contracts are traded on CME with size of $1 million at 93.280 with June delivery. The initial margin is $540 and the maintenance margin is $400. You are a corporate treasurer and you know your company will have to pay $10 million in cash for goods that will be delivered on June 17. You will sell the goods for profit, but you will not receive payment until September 17. Thus, you know you will have to borrow $10 million for 3 months in June.

1. What is the forward rate implicit in the Eurodollar futures price?

2. How to lock in 3-month borrowing rate for June 17 using Eurodollar futures?

3. On June 17, the Eurodollar futures is quoted at 91%, and the current Eurodollar rate is 9%. You close your position at that time. What are your cash flows?

Example solved1. Implicit rate = __________ = __________ Note that forward

rate 6.72% > spot 6.25%, term structure __________ sloping

2. You will have to borrow $10 million for 3 months as you know. Borrow = __________ instruments. Borrow in the future and lock in the % rate = __________. You __________ Eurodollar contracts.

3. Interest rates ____________________

Your profit from the short position in the futures contracts is ______________________________.

Your borrowing cost is _______________________

Your total borrowing CF = _______ _______ = $168,000. For 3 months borrowing you pay ________ __________ = 1.68% Convert this into per annum: __________________

Options Contracts

• An option gives the holder __________, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today.

• Call vs. Put options. Call/Put options gives the holder the right, to buy/sell a given quantity of some asset at some time in the future, at prices agreed upon today.

• European vs. American options. – European options can only be exercised __________

expiration date. American options can be exercised at any time up to and including the expiration date.

– Since this option to exercise early generally has value, American options are usually __________ than European options, other things equal.

Options Contracts

• In-the-money options

– Profitable to exercised __________• At the money options

– Profit = 0 if exercised __________• Out of the money options

– __________ if exercised under the option’s terms

• Intrinsic Value– In the money: The difference between the

exercise price of the option and the spot price of the __________ asset.

– Out of the money: __________

Currency Options Markets• Currency

– 20-hour trading day.

– __________ is much bigger than exchange volume.

– Trading is in six major currencies against the U.S. dollar.

– View standard specifications from PHLX

• Options on currency futures

– Options on a currency futures contract. Exercise of a currency futures option results in a long futures position for the ________of a call or the __________of a put.

– Exercise of a currency futures option results in a short futures position for the __________ of a call or the __________ of a put.

Basic Relationships at Expiry• At expiry, an American call option is worth the

same as a European option with the same characteristics.

• If the call is in-the-money, it is worth __________• If the call is out-of-the-money, it is __________.

• CaT = CeT = Max[ST - E, 0]• At expiry, an American put option is worth the same as a European option with the same characteristics.

• If the put is in-the-money, it is worth _______• If the put is out-of-the-money, it is _______.

• PaT = PeT = Max[E - ST, 0]

Basic Option Profit Profiles

Call. Long position (_____). If the call is in-the-money, it is worth ST – E. If the call is out-of-the-money, it is worthless and the buyer of the call loses his entire investment of c0.

Call. Short position (_____). If the call is in-the-money, the writer loses ST – E. If the call is out-of-the-money, the writer keeps the option premium.Put. Long position (______). If the put is in-the-money, it is worth E –ST. If the put is out-of-the-money, it is worthless and the buyer of the put loses his entire investment of p0.

Put. Short position (______). If the put is in-the-money, it is worth E –ST. If the put is out-of-the-money, it is worthless and the seller of the put keeps the option premium of p0.

American Option Pricing

• With an American option, you can do everything that you can do with a European option—this option to exercise early has value.

• CaT > CeT = Max[ST - E, 0]

• PaT > PeT = Max[E - ST, 0]

Market Value, Time Value and Intrinsic Value for an American Call

The black line shows the _________ at maturity (not profit) of a call option.

Note that even an out-of-the-money option has value—__________________.

Example• Calculate the payoff at expiration for a call option

on the euro in which the underlying is $0.90 at expiration, the option is on EUR 62,500, and the exercise price is

1. $0.752. $0.95

Example• Calculate the payoff at expiration for a put option

on the euro in which the underlying is $0.90 at expiration, the option is on EUR 62,500, and the exercise price is

1. $0.752. $0.95

Example• Calculate the payoff at expiration for a call option on

a currency futures contract in which the underlying is at $1.13676 at expiration, the futures contract is for CAN$1,000,000 and the exercise price is:

1. $1.130002. $1.14000

Example• Calculate the payoff at expiration for a put option on

a currency futures contract in which the underlying is at $1.13676 at expiration, the futures contract is for CAN$1,000,000 and the exercise price is:

1. $1.130002. $1.14000

Pricing currency options• Bounds on option prices are imposed by arbitrage

conditions (ignore in this course)• Exact pricing formulas (theoretical)

– Lattice models, for example binomial model (ignore for now)

– Pricing based on continuous time modeling and stochastic calculus (mathematics used in modeling heat transfers, flight dynamics, and semiconductors). No derivations here. More _________ than binomial.• Idea: model evolution of the underlying

asset’s price in ____________ time (i.e. not week-by-week) and calculate expected value of the option payoff.

Currency Option Pricing

Trr foreigndomesticeSF )(

00

Trt

domesticedNEdNFCall )]()([ 2100

,5.0)/ln( 2

01

T

TEFd

Tdd 12

Trt

domesticedNFdNEPut )]()([ 1020

r = the interest rate (foreign or domestic), T – time to expiration, yearsS – current exchange rate, E – exercise exchange rate, DC/FC

Example• Consider a 4-month European call option on GBP in the US.

The current exchange rate is $1.6000, the exercise price is $1.6000, the riskless rate in the US is 8% and in the UK is 11%. The volatility is 20%. What is the call price?

Example• Consider a 2-month European put option on GBP in the US.

The current exchange rate is $1.5800, the exercise price is $1.6000, the riskless rate in the US is 8% and in the UK is 11%. The volatility is 15%. What is the put price?

Put-call parity for currency options

TrTr foreigndomestic eSPuteECall 0

Option Value Determinants

Call Put1. Exchange rate 2. Exercise price 3. Interest rate at home 4. Interest rate in other country5. Variability in exchange rate6. Expiration date

The value of a call option C0 must fall within max (S0 – E, 0) < C0 < S0.

The precise position will depend on the above factors.

Empirical Tests • The European option pricing model works fairly

well in pricing American currency options.• It works best for ______________ and

_______________ options.• When options are in-the-money, the European

option pricing model tends to _____________ American options.

World Financial Markets and Institutions

• International Banking and Money Market

• International Bond Market• International Equity Markets• Futures and Options on Foreign

Exchange• Currency and Interest Rate Swaps• International Portfolio Investment

Preliminaries

• In Corp Fi we learn how to package debt and/or equity financing (_____________).

• Now assume that we have done so, i.e., the optimal capital structure is in place. For a MNC this is a _________________________ securities denominated in different currencies with some being ________________.

• Question: How a non-financial corporation can manage this complex exposure?

Risk exposures• MNE’s are exposed to a variety of risks:

– Interest rate– Currency– Business Cycle– Inflation– Commodity– Industry

• We have so far focused only on currency risk.

• Now extend to _____________________• Both asset and liability sides of a MNC is

exposed to it (think of ____________ and _____ that MNE’s hold on the _____________).

Risk exposures• Corporate floating-rate loans are the dominant

financing instrument• Two types of risks with loans:

– Credit risk:

– Re-pricing risk:

• Task is to measure the impact of the risks on the cost of debt and come up with suitable hedging strategy

Motivation for Swaps

• A UK firm wants to convert ______________ into ________________ to offset its revenues from US sales

• The UK firm’s alternatives include

–A ___________ in US dollars

–A ____________ that trades floating-rate £ debt for the fixed-rate $ debt of a U.S. company

Parallel Loan

Ford BritishPetroleum

Citigroup HSBC

BPUS FordUK

Parallel loans provided accessto new capital markets• Parallel loan: Borrow in ________________ and

then trade for the debt of a foreign counterparty

• Provided access to new capital markets– Legally _________________ on cross-border

currency transactions– Provided ___________________ for foreign

subsidiaries– May lower the firm’s _________________

Problems with parallel loans

• The foreign counterparty may have _______________

• Parallel loans ___________________ on the balance sheet

• Search costs can be _______

The swap contract

• Solution: Package the parallel loans into a single legal agreement called the ______________

– Reduced the default risk of parallel loans via the _______________ (if one party defaults, the other is automatically freed from its obligation)

– Swaps _____________________ on the balance sheet

– High swap volume led to ___________

Development of the swaps market• 1981

– ______________ engineers the first currency swap between the _____________ and _____

• Early 1980s – Customized, low-volume, high-margin deals

• Late 1980s and 1990s– Commercial and investment banks begin to

serve as swaps dealers – Swaps turn into a ___________, ____________,

_____________ business – Volume and liquidity grow

Swap Market• In 2001 the notional principal of:

Interest rate swaps was $58,897,000,000,000.Currency swaps was $3,942,000,000,000

• The most __________ currencies are:– US$, JPY, Euro, SFr, GBP

• A ___________ is a generic term to describe a financial institution that facilitates swaps between counterparties. It can serve as either a broker or a dealer.– A broker ___________ counterparties but does not

assume any of the risks of the swap.– A dealer ____________ to accept either side of a currency

swap, and thus may assume exchange rate risk.

Size of the Swap Market

Swaps

• A swap is an agreement to exchange cash flows at ___________________ according to certain specified rules (traded on OTC)

• Notional Principal• Counterparties: _________ and

________________ (market makers)

Swaps

• Interest Rate Swaps

• Currency Swaps

• Basket Swaps – swap a currency for a weighted basket of other currencies. The basket is chosen to _________________ of a MNC.

Interest rate swaps

• Interest rate swap

– Similar to a currency swap, but cash flows in a _____________ are exchanged

– A _________________ is paid during the life of the swap

– The __________________ is not usually swapped

An Example of a “Plain Vanilla” Interest Rate Swap

• An agreement by Microsoft to _________ ___________ & pay a _______________ every 6 months for 3 years on a notional principal of $100 million

• Next slide illustrates cash flows• Note that in practice Fixed Rates are

on __________ or __________ basis whereas Floating Rates are on _________ basis.

Cash Flows to Microsoft

---------Millions of Dollars---------

LIBOR FLOATING FIXED Net

Date Rate Cash Flow Cash Flow Cash Flow

Mar.5, 2008 4.2%

Sept. 5, 2008 4.8% +2.10 –2.50 –0.40

Mar.5, 2009 5.3% +2.40 –2.50 –0.10

Sept. 5, 2009 5.5% +2.65 –2.50 +0.15

Mar.5, 2010 5.6% +2.75 –2.50 +0.25

Sept. 5, 2010 5.9% +2.80 –2.50 +0.30

Mar.5, 2011 6.4% +2.95 –2.50 +0.45

Typical Uses of anInterest Rate Swap

• Converting a liability from– _______________________ – _______________________

• Converting an investment from – _____________________– _____________________

Banc One Swaps

• Backus, Telmer and Clapper (94) describe Banc One’s use of interest rate swaps.

• According to Bankers Magazine 1991, Banc One viewed itself as McDonald’s of retail banking :–80’s and 90’s saw its rapid growth through

acquisitions of banks all over US–Franchises were decentralized which led to

___________________________________ => _______________________________.

Banc One Swaps

• Backus, Telmer and Clapper (94) computed the exposure:

• 1% drop in interest rates in early 90’s would lead to ______________________

• Solution by Banc One:• ___________________________, mostly

______, with notional principal = $40 bil.

How does it work?

• Example:• If assets are ________ to R => financing

with fixed-rate debt __________________• This is because firm’s bottom line is

– _____________________ (long in a riskless security and short in a risky)

• What happens: _______ => _______ => ___________.

• Hedge by a swap: _____________ & ________________.

Back to Intel and Microsoft (MS) Transform a Liability

Intel MS

LIBOR+0.1%

5.2%

A Dealer is Involved

LIBOR+0.1%

5.2%Intel MS

The Comparative Advantage Argument

• AAACorp wants to borrow __________• BBBCorp wants to borrow __________• Swap Dealer will charge 4 basis points.

Fixed Floating

AAACorp 10.00% 6-month LIBOR + 0.30%

BBBCorp 11.20% 6-month LIBOR + 1.00%

The AAA-BBB Swap when a Financial Institution is Involved

AAA F.I. BBB10%

LIBOR+1%

The Comparative Advantage Argument

• We are not comparing ____________, rather _________________ from a single company’s point of view:– AAA Corp has a comparative advantage

in _________________ markets– BBB Corp has a comparative advantage

in ______________ markets

Criticism of the Comparative Advantage Argument

• The 10.0% and 11.2% rates available to AAA Corp and BBB Corp in fixed rate markets are _________________

• The LIBOR+0.3% and LIBOR+1% rates available in the floating rate market are _______________

• Floating Spread smaller than Fixed Spread may just reflect that _________________ of the BBB company ______________ than those of AAA

• BBB Corp’s fixed rate depends on the ___________________ it borrows at in the future

Another Example of an Interest Rate Swap

• Consider this example of a “plain vanilla” interest rate swap.

• Bank A is a AAA-rated international bank

located in _______. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. Two alternatives:– 5-year fixed-rate Eurodollar bonds at 10

percent.– It would make more sense for the bank to

issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.

Example of an Interest Rate Swap

• Firm B is a BBB-rated __________. It needs $10,000,000 to finance an investment with a five-year economic life. Two alternatives:– Issuing 5-year fixed-rate Eurodollar bonds at

11.75 percent.– Alternatively, firm B can raise the money by

issuing 5-year floating-rate notes at LIBOR + ½ percent.

– Firm B would prefer to borrow at a fixed rate.

• The borrowing opportunities of the two firms are:



LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8

¼

Swap

Bank

Company

B

10 ½%

LIBOR – ¼%LIBOR – 1/8%

10 3/8%

Bank

A

COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR

COMPANY B BANK A




10%

Swap

Bank

LIBOR – 1/8%

10 3/8%

Bank

A

COMPANY B BANK A




LIBOR+ ½%

Here’s what’s in it for B:

Swap

Bank

Company

B

10 ½%LIBOR – ¼%

The Quality Spread Differential

• The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank.– QSD = Fixed Differential – Floating Differential =

• There is no reason to presume that the gains will be shared ____________.

• In the above example, company B is less credit-worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

Example• Determine the upcoming payment in a plain vanilla interest

rate swap in which the notional principal is 70 million Euro. The end user makes semi-annual fixed 7% payments, and the dealer makes semi-annual floating payments at Euribor, which was 6.25% on the last settlement period. The floating payments are made on the basis of 180 days in the settlement period and 360 days in a year. The fixed payments are made on the basis 180 days in the settlement period and 365 days in a year. Payments are netted, determine which party pays and what amount.

Example• A US company enters into an interest rate swap with a

dealer. In this swap, the notional principal is $50 million and the company will pay a floating rate of LIBOR and receive a fixed rate of 5.75%. Interest is paid semiannually and the current LIBOR is 5.15%. The floating rate are made on the basis of 180/360 and the fixed rate payments are made on the basis of 180/365. Calculate the first payment and indicate which party pays.

Interest rate swap valuation• You can represent a swap as a bond portfolio or a

series of FRAs. We use bond portfolio representation.

• From the point of view of floating-rate payer, this is a long position in the fixed rate bond and short position in the floating rate bond.– ______________________

• From the point of view of fixed-rate payer, this is a long position in the floating rate bond and short position in the fixed rate bond.– ______________________

• Immediately after the interest payment, the floating rate bond is worth exactly the notional amount

Example• Consider a financial institution that pays LIBOR – 0.25% and

receives 10.50% p.a. (annual compounding) from a swap end user on a notional principal of $10 million. The swap has remaining life of 4 years. The fixed rates have fallen from 10.5% to 9% and the swap end user wants to get out of the deal. How much should the financial institution charge for the right to cancel the agreement?

An Example of a Currency Swap

• An agreement to pay 11% on a sterling principal of £10,000,000 & receive 8% on a US$ principal of $15,000,000 every year for 5 years

Exchange of Principal

• In an interest rate swap the principal is _____________

• In a currency swap the principal is __________ at the __________ and the ______ of the swap.

The Cash Flows IBM pays fixed 11% in sterling and receives 8% in USD

Year

Dollars Pounds$

------millions------

2001 –15.00 +10.002002 +1.20 –1.10

2003 +1.20 –1.10 2004 +1.20 –1.10

2005 +1.20 –1.10 2006 +16.20 -11.10

£

Typical Uses of a Currency Swap

• Conversion from a liability in one currency to a liability in another currency

• Conversion from an investment in one currency to an investment in another currency

Comparative Advantage Arguments for Currency Swaps• General Motors wants to ____________• Qantas wants to ______________• Dealer charges 10 basis points.

USD AUD

General Motors 5.0% 12.6%

Qantas 7.0% 13.0%

The Swap when a Dealer is Involved

GM QantasUSD 5%

AUD 13%

Swap Market Quotations

• Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs

• They also make a market in “plain vanilla” swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a ___________________.

Variations of Basic Currency and Interest Rate Swaps

• Currency Swaps– fixed for _______ – fixed for _______– floating for __________

• Interest Rate Swaps – __________for floating– _________ for floating

Risks of Interest Rate and Currency Swaps

• Interest Rate Risk– Interest rates might move against the

____________ after it has only gotten half of a swap on the books, or if it has an unhedged position.

• Basis Risk– If the floating rates of the two

counterparties are not pegged to the same ___________ (i.e. LIBOR)

• Exchange rate Risk

Swap Market Efficiency

• Swaps offer ______________________ and that has accounted for their existence and growth.

• Swaps assist in tailoring financing to the type desired by a particular borrower. – Since not all types of debt instruments are

available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more _____________ for their asset maturity structures.

Example• A US company can issue a US$-denominated bond but needs

to borrow in GBP. Consider a currency swap in which the US company pays a fixed rate in the foreign currency, GBP, and the counterparty pays a fixed rate in US$. The notional principals are $50 million and GBP 30 million, and the fixed rates are 5.6% in US$ and 6.25% in GBP. Both sets of payments are made on the basis of 30 days per month, 365 days per year, and the payments are made semi-annually.

• What are the following cash flows: (i) initial, (ii) semi-annual, (iii) final

Valuation of currency swaps• Currency swaps can be represented as bond

portfolios or a series of forwards. We use bond representation.

• From the point of view of foreign currency payer (domestic currency receiver), this is a long position in the domestic bond and short position in the foreign bond.– ________________________________________________

• From the point of view of domestic currency payer (foreign currency receiver), this is a long position in the foreign bond and short position in the domestic bond.– ________________________________________________

Example• In Japan term structure of interest rates is flat at 4% and in

the US it is 9%. A financial institution has entered into a currency swap in which it receives 5% p.a. in JPY and pays 8% p.a. in USD once a year. The principals are $10 million and JPY 1,200 million. The swap will last for another 3 years, and the current JPY/USD exchange rate is JPY 110. What is the value of this swap for the financial institution?

Swaptions

• An option to enter into swap• Types:

– Payer swaption • Gives the right to enter into a swap as a _________

rate payer and __________ rate receiver• Equivalent to ___________ option

– Receiver swaption• Gives the right to enter into a swap as a

__________ rate payer and ___________ rate receiver

• Equivalent to ___________ option

international finance

Documents

month futures contract

contract size

currency futures trading

forward contract

contract value

futures rate closes

exchange rate

trading day