FINALS PREPERATION

Chapter 1: Key Issues in International Business Finance

KEY TAKEAWAY: Operating on an international scale brings many additional risks which must be dealt with in order to remain successful

Reasons Why Countries Print Their Own Money

i) It is a profitable endeavorii) National Prideiii) Remain control over one’s monetary policy

Main points

- Money does not have intrinsic value -> We must find other ways to value currencies- Governments in large part no longer control exchange rates -> Exchange Risk, from fluctuations,

must be understood- Prices Rise with GDP per Capita- Prices are Sticky and Exchange Rates Fluctuate -> Changes in exchange rate can have a

significant effect on a country’s competitiveness- Due to the above real exchange risk -> We must learn about currency forwards, futures, options

and swaps to mitigate these risks- Given that international operations involve more than one country -> A special type of credit risk

arises where no specific legal system has jurisdiction- Given this type of credit risks -> companies seek guarantees from financial institutions to offset

the risk- Political Risk -> Entails transfer risks which must be taken into account by companies- The main risks to be considered by a company operating internationally is real exchange,

credit and political risk -> The point of this book is understanding how to hedge these risks

Difference in the International Market:

Value Added = K(R-CoC)

Expanded Opportunity Set : More places to raise money which lowers Cost of Capital Market Imperfections: Taking advantage of differential tax rates, import restrictions, etc. FX and Political Risk : FX movements can impact a firm’s profitability and competitiveness.

Political risk includes such factors as expropriation of assets

Glossary

Credit Risk: The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation

Transfer Risk: The risk associated with the possibility of a currency not being able to be sent out of the country, usually due to central bank restrictions or a national debt rescheduling

Value at Risk: A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame.

Chapter 2: Institutional Background

Objective: Understand what money is and how it is traded in order to understand exchange rates (and related risks and hedging)

Key Takeaways

The balance of payments theory of exchange rate: holds that the price of foreign money in terms of domestic money is determined by the free forces of demand and supply on the foreign exchange market.

Under a floating rate exchange

If domestic exports a strong, the currency is likely to appreciate If foreign investment in domestic assets is strong, the currency is likely to appreciate Large Current account deficits, lead to positive Capital accounts/borrowing and indebtedness

Three Conditions for Money to be a Successful Least-Cost Medium of Exchange

i. It must be storable (should not evaporate or rot)ii. Stable purchasing poweriii. Easy to Handle

Takeaway: Today`s version of money is based on trust as opposed to intrinsic value. Thus, the value of money is uncertain, which created exchange rate risks

Money Supply = M1 = m * M0 = m * (D+G+RFX)

Where:

- M0: money base- M: money multiplier- D: Credit to the domestic private sector- G= Credit to the government- RFX = reserves of foreign exchange (including gold)

Ways that Central Banks Control the Money Supply

i) Intervention in the foreign exchange markets : Central banks can influence the monetary base by buying or selling forex

ii) Open-Market Policy: Central banks can influence the monetary base by restricting or expanding the amount of credit given to the government

iii) Reserve Requirements : Also the central bank can curb money supply by changing the reserve requirements on commercial banks (changing the upper bound of the money multiplier)

iv) Credit Control: The most direct way to control M1 is to impose limits on the amounts that private banks can lend

Takeaway: Governments have the most control over the supply of money, and hence has the power to change its value

Balance of Payments

- Sources (+): where the money was obtained for the international transaction- Uses (-): what we did with the money

i. Current Account: This entry records a country's net trade in goods and services, plus net earnings from rents, interest, profits, and dividends, and net transfer payments (such as pension funds and worker remittances) to and from the rest of the world during the period specified.

Y=C+ I+G+CA(R)

Where:Y= National Income/GDPC = Consumer SpendingI = Private Investment

G = Government SpendingCA = Exports – Imports

Current Account=S−I−¿)Where

S = Private After Tax SavingsG – T = Government Deficit

S = Y – (C-T)

If the current account is negative, the country is running a deficit, which must be financed by borrowed funds, thus the capital account will be positive

Takeaway: The current account will be in a deficit situation if private after tax savings is not enough to finance private investment and the government deficit

ii. Capital Account: A national account that shows the net change in asset ownership for a nation. The capital account is the net result of public and private international investments flowing in and out of a country.

Direct Investment – in which the investor exerts some explicit degree of control over the assets

Portfolio Investment – in which the investor has no control over the assets

Other Investment – consists of various short-term and long-term trade credits, cross-border loans, currency deposits, bank deposits and other A/R and A/P related to cross-border trade

The emergence of international money accounts has considerably weakened the link between the balance of payments and the exchange market –> because international transactions does not necessitate a currency exchange

Takeaway: While the BOP tells us whether a country’s asset portfolio is getting better or worse, the NII account tells us how good or how bad things actually are, in an absolute, cumulative sense

Exchange Rate Regimes

Fixed Exchange Rates: require similar inflation rates across countries, which in turn, requires similar economic policies

Examples

Bretton Woods Agreement:

- Both the GBP and the DEM were fixed to the USD- This created a synthetic upper and lower band for the DEM/GBP- Different inflation levels in the U.K (high) and Germany (low) led to the collapse of the

agreement- U.K was forced to sell USD in order to keep its currency artificially high, and Germany had to buy

USD in order to remain artificially low. This led to an undersupply and oversupply of USD for the U.K and Germany, respectively.

Glossary

Debasing: Reduce in quality or value Money Base (M0): A measure of the money supply which combines any liquid or cash assets

held within a central bank and the amount of physical currency circulating in the economy. M1: A measure of the money supply that includes all physical money, such as coins and

currency, as well as demand deposits, checking accounts and Negotiable Order of Withdrawal (NOW)

Money Multiplier: Ratio between M1 and M0 Bilateral: involving two parties, especially countries. Balance of Payments: The balance of payments, encompasses all transactions between a

country’s residents and its non-residents involving goods, services and income; financial claims on and liabilities to the rest of the world; and transfers such as gifts

Net International Investment Position: A nation’s stock of foreign assets minus its foreign liabilities. NIIP can also be defined as the value of overseas assets owned by a nation minus the value of domestic assets owned by foreigners. The NIIP can therefore be regarded as a nation’s balance sheet with the rest of the world at a specific point in time.

Chapter 3: Spot Markets for Foreign Currency

Objective: Understanding Spot Markets (ST )

The convention used in this book to quote exchange rates is defined by “per”. Meaning 1.2 CAD/USD translates into “1.2 CAD per USD dollar”

Furthermore the text uses a direct quotes where the base currency is the foreign currency, thus….HC/FC

Occurrence SpreadsHolidays, Weekends, Lunch Breaks IncreaseLow Volume IncreaseHigh Volatility Increase

Law of One Price

- If two securities operate in a frictionless market and produce the same cash flow, they should trade at the same price or else;

o Arbitrage opportunities exist until the prices become identical (if spreads don’t overlap, an arbitrage opportunity exists)

o Shopping around, investors purchase the lower priced asset until prices become identical

Law of Shaft: When calculating synthetic rates, the spread will always increase, benefitting the bank

In Class Example #1: Calculating Synthetic Rate Example

What are the synthetic bid & ask rates of AUD/GBP if:

2.4520-30 AUD/USD 1.3840-50 USD/GBP

- Step 1: Ensure that the rates are set up properly (base currencies must not repeat)- Shortcut: Multiply the ask by the ask, and the bid by the bid- Step 2: Calculate the Ask- Step 3: Determine how much USD you need to buy 1 GBP (base currency)

o Answer: 1.3850- Step 4: Determine how much AUD you will need to purchase 1.3850 USD

o Answer: (2.4530/1)*1.3850 =3.3974/1.3850 USD or 1GBP- Step 5: Calculate the Bid- Step 6: Determine how much USD you get when selling 1 GBP (base currency)

o Answer: 1.3840- Step 7: Determine how much AUD you will get from selling 1.3840 USD

o Answer: (2.4520/1)*1.3840 = 3.3936/1.3840 USD or 1 GBP- Step 8: Sanity check – is the bid below the ask?- Step 9: Look for an arbitrage opportunity – if spreads overlap there is no arbitrage opportunity

In Class Example #2: Triangular Arbitrage

1 USD = 2 AUD (Bank 1) 1 AUD = 20 BEF (Bank 1) 1 USD = 38 BEF (Bank 2)

Here, since I can tell that 1USD should be worth 40 BEF, I will not buy BEF at Bank 2….rather I will sell them there. I will take my 1 USD and sell it for 2 AUD, take my 2 AUD and exchange them for 40 BEF and take 38 of those BEF and exchange them for 1 USD and have 2 BEF left over. I have made an arbitrage profit of 2 BEF.

Purchasing Power of Parity

- The purchasing power of parity adds an extra layer on top of exchange rates, measuring not only the relative value of currencies, but comparing what each currency can purchase in its domestic country. This means that if currency A is “stronger” than currency B, this does not necessarily imply that the country with currency A is better off, if currency B purchases relatively more of a domestic homogeneous product (e.g. a soda) in comparison with currency A.

- Absolute Purchasing Power of Parity does not hold in reality (okay for commodities, CPP, because relatively small deviations and friction costs, however doesn’t hold at all for consumer goods)

PPPrate= ππ∗¿¿

π denotes price levels

Real Exchange Rate:

RER=S t∗π

¿

π

RER<1:ForeignCurrency isrelatively cheap

RER>1:ForeignCurrency isrelatively expensive

If RER = 1 -> APPP is said to hold

Takeaway: A country with a RER below 1 -> it is difficult to export because the domestic currency is relatively expensive

RPPP holds up well over the very long run but poorly for shorter time periods; and, The theory holds better for countries with relatively high rates of inflation and underdeveloped

capital markets.

Glossary

Cross Rate : The currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in. This phrase is also sometimes used to refer to currency quotes which do not involve the U.S. dollar, regardless of which country the quote is provided in.

Pip: One hundredth of a unit

Ch3: 2,3,5,6,9 and Applications:1,2,3,4,5

Chapter 4: Understanding Forward Exchange Rates

Objective: To use of spot, forward, home and foreign money markets in order to maneuver currency transactions

Any transaction in one of these markets can be replicated by a combination of the other three

Arbitrage Computations Diagram:

PV Home Currency

FV Home CurrencyDomestic Interest Rate

Spot Exchange Rate Forward Exchange Rate

Covered Interest Rate Parity Theorem

For there to be no arbitrage opportunities the following equation must hold:

F t ,T=St1+rt ,T1+rt ,T

¿

rt ,T Denotes domestic risk free return

Swap Rate ≅ r t ,T−rt ,T¿

Market Value of forward Purchase at F t0 ,T=Ft ,T−Ft 0 ,T

1+r t ,T

i.e. the present value of the new contract price – the old contract price

Expiration Value of forward contract with rate F t0 ,T=ST−F t0 ,T

Initial Value of a Forward Contract with rate F t ,T=Ft ,T−F t ,T

1+rt ,T = 0

In Class Example #1

A company has a known cash payment of SF 50 million to be made to a Swiss supplier in 100 days. the company wishes to fix or lock in the nominal dollar price of this payment using currently available rates. The spot rate available to the company is SF2.5/USD, the forward swap rate for maturity in 100 days is -0.035, and the company faces a dollar interest rate of 12% and a SF interest rate of 6%. Given this information, what is the smallest dollar price on its SF50 million that the co. can lock in with certainty? Explain the procedure the company will follow to obtain this price. Does the synthetic forward rate equal the quoted rate? Is an arbitrage opportunity available? Why or why not?

Glossary:

Swap rate: is the difference between the forward rate and spot rate % Swap Rate: swap rate divided by the spot rate ->Premium (+), Discount (-) and Par (=) Covered Interest Rate Parity Theorem: This term refers to a condition where the relationship

between interest rates and the spot and forward currency values of two countries are in equilibrium

Interest Rate Parity: A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

FV Foreign Currency

PV Foreign Currency

Foreign Interest Rate

Forward Contract: A customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. Unlike standard futures contracts, a forward contract can be customized to any commodity, amount and delivery date.

Futures Contract: A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange.

Chapter 5: Using Forwards for International Financial Management

Objective: Evaluate the Uses of Forward Contracts

Rule of Thumb (Law of Shaft):

- When the swap rate is at a premium, you add the larger number to the ask rate- When the swap rate is at a discount, you subtract the larger number from the bid rate- The spread is always larger on a futures contract than a spot rate, and increases with time to

maturity

Bt , T=∆V T

∆ST

Bt , T denotes contractual exposure

∆V Tdenotes change in cash flow

You may also net out all A/R’s and A/P’s on a monthly basis in order to hedge total exposure (page 165-166) Duration on page 172

Tax implications (page 181)

Glossary:

Perfect Hedge: Taking a position that exactly offsets the existing exposure Cross Hedge : The act of hedging ones position by taking an offsetting position in another good

with similar price movements. Credit Risk : The risk of default

Chapter 6: The Market for Currency Futures

Drawbacks of Using Futures as Opposed to Forwards

i. The contract size is fixed and is unlikely to exactly match the position to be hedgedii. The expiration dates of the futures contract rarely match those for the currency

inflows/outflows that the contract is meant to hedgeiii. The choice of underlying assets in the futures markets is limited, and the currency one

wishes to hedge may not have a futures contract

Types of Imperfect Hedges

a) Cross Hedges: when currencies don’t matchb) Delta Hedges: when maturities don’t matchc) Cross & Delta Hedges: when both currencies and maturities don’t match

Hedge Ratio:

MISSING HEDGE & DELTA RATIO FORMULA (page 221)

Glossary:

Right of Offset: the right of offset allows the bank to withhold its promised payment without being in breach of contract, should the customer default.

Marked to Market: A measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution's or a company's current financial situation.

Hedge Ratio: A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged. The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk.

Basis Risk: The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.

Margin: The amount of equity contributed by a customer as a percentage of the current market value of the securities held in a margin account.

Chapter 7: Markets for Currency Swaps

Low Default Risk:

- Right of Offset Clause- Companies are screened and those who are small must post initial margin- Credit Trigger Clause: stating that if the customer’s credit rating is revised downward, the

financial institution can terminate the swap and settle for the swap’s market value at the moment.

Valuing Interest Rate Swaps (Page 255)

Also do Excel Example: Worth of a Swap is the PV of Cash Inflows – PV of Cash Outflows

In Class Example: Interest Rate Swap

Interest Rate Swap

Company XXX wants a fixed rate loan (10 years) Company YYY wants a floating rate loan (10 years)

Company Fixed Rate Floating Rate

XXX 10 Libor + 2

YYY 6 Libor +1

4 1 ABS(3)

What is XXX comparatively better at?

They are only 1% worse at floating rate borrowing but 4% worse at fixed rate borrowing. Therefore they are COMPARATIVELY better at floating. That is the type they will initially borrow at but then swap into Fixed rate which they want.

What is YYY comparatively better at?

Fixed—They will borrow at fixed then swap into floating (which they want)

The total possible savings is: 3%, which is called the quality spread differential (QSD)

You are told that XXX will save 1 and YYY will save 2

Arrange the swap so that each saves what you stated above.

X borrows at floating (pays L+2) and agrees to get L from Y in exchange for 7%. That way X’s total cost is: L+2 – L + 7 = 9%. If they borrowed at a fixed rate on their own they would have paid 10%. They are saving 1%

Company Y borrows at 6% and agrees to pay (swap) L in exchange for getting 7%.

Total cost :6 + L – 7 = L – 1. If they borrowed on their own they would have paid L+1; they saved 2%.

The main benefit of Swaps: is to obtain debt financing in the swapped currency at an interest cost reduction brought about through comparative advantages each counterparty has in its national capital market, and the benefit of hedging long-run exchange rate exposure

Chapter 8: Currency Options (Skip: 8.3.1 – 8.3.4)

Option Value = Intrinsic Value + Time Value

Value Dead = Intrinsic Value= Value of the Option if it were to be Exercised

Key Upper & Lower Bounds

1) Options premia are non-negative : because there is a chance that the option will make money and have a minimum value of 0

2) American-style options are worth no less than European-style options: because they contain the right to exercise early

3) European-style call/put is worth more than the comparable forward purchase/sale : because it have a minimum value of 0, yet shares all of the same upside

4) An American style call/put is worth at least its intrinsic value : because time value is always positive

Buying a Foreign T-Bill = Buying a Call Buying a Domestic T-Bill = Buying a Put

Put Call Parity: The value of synthetic options should be the same as the directly trade options, or else there will be an arbitrage opportunity

C t−Pt=S t

1+r t , T¿ − X

1+r t , T

C tf−Pt

f=f t ,T−X

Delta: The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. Sometimes referred to as the "hedge ratio."

For example, with respect to call options, a delta of 0.7 means that for every $1 the underlying stock increases, the call option will increase by $0.70. Put option deltas, on the other hand, will be negative, because as the underlying security increases, the value of the option will decrease. So a put option with a delta of -0.7 will decrease by $0.70 for every $1 the underlying increases in price. As an in-the-money call option nears expiration, it will approach a delta of 1.00, and as an in-the-money put option nears expiration, it will approach a delta of -1.00.

Change∈the priceof a callChange∈the price of theunderlying asset

Gamma: The rate of change for delta with respect to the underlying asset's price. Gamma is an important measure of the convexity of a derivative's value, in relation to the underlying.

Change∈DeltaChange∈the priceof theunderlying asset

Theta: A measure of the rate of decline in the value of an option due to the passage of a day. Theta can also be referred to as the time decay on the value of an option. For example, if the strike price of an option is $1,150 and theta is 53.80, then in theory the value of the option will drop $53.80 per day.

Vega: The measurement of an option's sensitivity to changes in the volatility of the underlying asset. Vega represents the amount that an option contract's price changes in reaction to a 1% change in the volatility of the underlying asset.

Rho: How much does the value of the option change in response to changes in the domestic interest rate

Rho*: How much does the value of the option change in response to changes in the foreign interest rate

Call PutPrice Increases + -Strike Price Increases - +Interest Rate + -Foreign Interest Rate - +Time + +Volatility + +

DO IN CLASS PROBLEMS

Chapter 11: Do Forex Markets Themselves See What’s Coming?

Objective: Determine whether or not markets, measured by the forward rate, can predict changes in exchange rates.

s∗(r−r ¿)

¿0when (r−r¿)<0 (FCweak)

¿0when (r−r¿)>0 (FC strong)

Main Points:

- Economic models do not accurately forecast changes in exchange rates- Professionals rely heavily on technical analysis as well as fundamental analysis- There is empirical proof that the carry trade works- There is a forward bias , whereby investors have historically overestimated the change in the

spot rate

Nominal rate changes create big changes in R (Why?—sticky prices)

Forward Rate Bias: Forward rate bias is the tendency of currency markets to over-estimate changes in exchange rates: the actual movements tend to be smaller than the expectations as measured by forward rates

What might explain the forward bias?

1) Risky currencies provide higher returns2) Peso risk (big losses can wipe out 10 years of gains), Career Risk (no one fired for buying

IBM)

Example of Uncovered Interest Rate Parity: Assume that the interest rate in America is 10% and the interest rate in Canada is 15%. According to the uncovered interest rate parity, the Canadian dollar is expected to depreciate against the American dollar by approximately 5%. Put another way, to convince an investor to invest in Canada when its currency depreciates, the Canadian dollar interest rate would have to be about 5% higher than the American dollar interest rate.

For the most part Fundamental analysis/models do no better than the “no change” model

In Class Example #1 – Which Prediction is best?

St = 1.05 CAD/USD Ft,T = 1.10 CAD/USD Victoria forecast E(ST) = 1.09 CAD/USD Chin Forecast E(ST) = 1.20 CAD/USD Actual result ST = 1.11

Who did the better forecast?

o Victoria can argue that she was closer to the actual valueo Chin’s expectation allows her to make money, while Victoria’s does not. If she

expects 1.09 she will not buy the 1.10 forward.

Filter Rule: If a security’s price rises, it is likely to keep rising and vice versa. Thus, those using the filter rule set a given percentage, let’s say 1%, buy after the rise in price, as they expect the rise to continue.

Chapter 12: Should a Firm Hedge its Exchange Risk?

Assumptions:

i) Deviations from purchasing power parity are sufficiently large and persistent so as to expose firms to real exchange-rate risk

ii) It is difficult to predict exchange ratesiii) A forward contract has a zero-initial-value property (meaning that the investor does not

expect to make a profit by purchasing and selling the contract)

PV t= (ST−F t ,T )=0

Key Takeaway : Hedging Lowers the Risk Premium demanded by Investors and thus Increases Firm Value

Hedging only adds value if there is a useful interaction between the hedge’s cash flow and the other cash flows of the firm (investing, producing, marketing, servicing debt, etc.) This realizes itself primarily in the following fashion;

Reduction of Financial Distress Costs (both ex post and ex ante)

- A firm is said to be in financial distress when its income is not sufficient to cover its fixed expenses including financial obligations

- Outright bankruptcy is costly because of reorganization (Revenues: Loss of reputation, clientele, etc. & Costs: lawyers, courts, assessors, etc.) and liquidation costs (fire sale versus going concern value)

- Even before a firm actually goes bankrupt, the mere potential of future financial distress can affect the operations and the value of the firm significantly. Hence, if hedging reduces the volatility in a firm’s cash flow, and therefore the likelihood of the firm being in financial distress; hedging increases a firm’s value.

Examples:

- Firms which sell products requiring warranties and after sale services are evaluated by customers on the likelihood that they will survive the warranty period. Thus, the lower the likelihood of bankruptcy, the more attractive the firm becomes to customers, thus increasing revenues.

- Employees working at firms with a higher likelihood of bankruptcy will demand a wage premium. Thus, lowering the risk of financial failure, results in a smaller demanded wage premium.

- The greater the likelihood of bankruptcy, the greater the purchasing costs of the firm. Specifically, suppliers will either demand cash payment or charge a large interest on trade credit

- Loan covenants can trigger early repayment if the firm’s income falls below a stated level. This can translate into costs associated with refinancing, restrictions placed on management, negotiations, extra monitoring & reporting, etc.

Reduction of Agency Costs

Agency Costs: the costs that arise from the conflicts between shareholders and managers of the firm.

- Given that the wealth of managers is highly concentrated in the business itself they seek methods to hedge. However, for several reasons, it is costly and difficult to personally hedge and thus they seek to hedge within the business itself. If managers cannot hedge the businesses operations, they will seek higher compensation and may turn down risky projects with positive NPV’s. Thus, the presence of hedging instruments results in lower management compensation and improves decision making in line with shareholder interests; this increases the firm’s value.

- Equity holders are more risk-loving due to the fact that they effectively have a call option on the firm. However, bond holders are risk-averse because they do not benefit from large positive deviations in a firm’s cash flow as do equity holders; however, they succumb to the same consequences in the event of financial failure. Hence, if the firm can reduce cash flow volatility and increase bond holders’ confidence that the firm will not take unwarranted risks in order to increase shareholder value; the company will have a lower cost of debt.

Lower Expected Taxes

- If a company operates under a tax structure which sees the tax rate increase as income increases (convex), there is potential to lower the average tax burden.

- When earnings are negative, taxes are usually not proportionately negative- By spreading out your earnings and decreasing the likelihood of negative earnings, you can

effectively lower your average tax rate.

Homemade Hedging

....is ineffective because

i) Investors don`t have enough information to know the total exposureii) Investors will have to pay more in fees, because they are smaller in sizeiii) Investors likely don`t have access to the same hedging opportunities as the firm (e.g. large

forward contracts)

Less Noise in the Profit Figures

- Hedging stabilizes cash flows and reduces noise. This allows for better decision making on behalf of both company managers and investors.

- Investors prefer a less noisy set of results because this allows them get a clearer picture of how the company is doing and make more accurate predictions.

- Hedging results in less noise which increases decision making and shareholder interest

Chapter 13: Measuring Exposure to Exchange Rates

Exchange Risk: Uncertainty about the future spot rate. Possible measures of exchange risk include the standard deviation or the variance of the future spot rate exchange.

Exchange Exposure: a firm is said to be exposed to exchange risk if its financial position is affected by unexpected exchange-rate changes

Economic Exposure

Operating Exposure : the cash flow is from future operations as opposed to past contracts. Exposure to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm's market share/position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value

Contractual Exposure: contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency.

Hedging Operational Exposure (Can never be fully hedged)

Beta = Change∈the Firm’ sValue

Change∈Spot Rate

If the firm has positive Beta, you can hedge by shorting the spot rate

In Class Example #1: Beta Hedge

Two options for Britain’s Central Bank:

1) They can devalue the currency to BEF/GBP 55. Your cash flows will then be 1.8M GBP2) Alternatively, it can keep its currency at BEF/GBP 60. Your cash flows will be 1.55M GBP

What do you prefer? (REMEMBER TO TRANSLATE YOUR CASH FLOWS)

The first option, because your sales will be 99M vs. 93M for the second option

B = dV/dS

In this case: (93-99)/(60-55) = - 1.2M GBP

To hedge this exposure, you can go long 1.2M GBP

In Class Example #2: Beta Hedge w/ Probabilities

Freedonian Subsidiary Example on Page 468

(Boom Cash Flow * Spot Rate * Probability of Boom) + Bust Cash Flow * Spot Rate * Probability of Bust)

(Probability of Boom + Probability of Bust)

Result: 138−1081.2−0.8

=75 FDK→Hedge by goingshort 75 FDK

Accounting Exposure: When the domestic company files its financial statements, it has to translate revenue earned in foreign markets, back into the home currency

More Notes:

Market Imperfections, relates to costs such as bankruptcy (lawyers, liquidators) and trading fees (half of the bid-ask spread)

Modigliani-Miller theorem, as applied to the firm’s hedging decision, states that if shareholders (in perfect markets) can hedge the firm’s real exchange risk on their own, there is no value added for the firm to hedge.

Chapter 21: Putting It All Together – International Finance

Step 1: Calculate the NPV -> Present value of all future cash flows minus the initial outlay

Step 2: Calculate the Adjusted NPV -> NPV + Subsidies – Financing Costs

Tax Shield = Tax Rate * Interest Rate * Principal

Problems with WACC

- The weights used in calculating WACC are the market values, which we only know once we have completed the valuation -> This creates a chicken and egg problem

- WACC assumes that the entirety of a firms Tax Shield Gains, goes to the firm -> This is false because some of it may go to other entities

- The WACC only works for constant leverage- You should probably use different discount rates throughout the life of the project. The project

is riskier at the beginning. You undervalue the project by using a higher WACC for the later years.

Valuing International Projects

Step 1 (Brach Stage): Focus on cash flows from operations -> Treat all financial operations by assuming that the foreign venture is just an unincorporated branch of the parent

o Take out interest and royalties paid to otherso Don’t confuse left to right pocket transactions with out of pocket transactionso Don’t use inconsistent discount rateso Don’t expect tax credits will last forever

Step 2 (Unbundling Stage): The foreign venture is incorporated -> And the decision is made as to how the foreign entity will pay remittance

o Interest Paymentso Dividendso License Feeso Royalties

Remit by the amount that reduces taxes. You should look at what other companies are doing as to insure that the government will not block you.

In Class Example #1 (p.756): How Should Remittance Be paid and how much do we save?

TEK Canada pays no Taxes on Dividends Received, but 30% taxes on Royalties

TEK Brit pays 35% taxes (5% more than TEK Canada)

Thus by paying royalties TEK Brit’s revenues before they are taxed saves the firm 5% (35%-30%). Unfortunately, the government will not allow the firm to pay 100% of its revenue out in royalties. Thus, in this example after comparing with other companies, the firm decides to pay a royalty of 6%.

Total Savings = Royalty%∗Sales1+Discount Rate

∗% Saved

Step 3 (External Financing): Adjustments are made for the effects of external financing (e.g. issue costs and subsidies)

o Example 21. 13 (page 758)o The currency in which one borrows is irrelevant IF taxes do not discriminate between

interest and capital gains

In order to mitigate transfer risks should get insurance ->add present value of insurance premia to the risk-adjusted value of the transfer risk

In Class Example #2 (page 758): Where should a firm borrow, high or low tax environment?

High Tax Environment, given that the tax shield = tax rate * interest rate * Principal, however, we must also consider other taxes which may apply.

o Parent Firm is in Belgium

o Suppose tax rate = 16% in HK, 39% Belgium (Wrong: Borrow in Belgium because higher interest)

o Interest Payment of 100 HK

o 5% dividend tax in HK (meaning that if HK subsidiary pays a dividend to Belgium, HK government taxes 5% of that)

Must Calculate Effective Tax Rate

i) Interest Payment * HK Tax Rate = 100 * (1-0.16) = 84

ii) 84 * (1-Dividend Tax %) = 84 * (1-0.05) = 79.8

iii) 79.8 * (1-Belgium Tax Rate) = 79.8 * (1 – 39%) = 48.678

iv) 100 – 48.678 = 51.322

v) Effective HK Tax Rate = 51.322/100 = 51.322%

What currency should a firm borrow in, Low or High Interest Rate Countries?

Again, initially we would think that we should borrow in a high interest environment because of the above tax shield equation

However, the currency we borrow in DOES not matter, because assuming taxes do not differentiate between capital gains and interest income, the taxes on the capital gains or losses are exactly offset by the taxes on the difference between interest rates

Transfer Risks (in order of most likely to be blocked):

i. Intercompany transactions: (equity transfers, loans)—speed up payments for goodsii. Dividends (might want to include a domestic agency)

iii. Interest Payments and License Fees: (make payments to bank rather than parent) (what you can do is, instead of lending $100M to our subsidiary, we can instead lend $100M to

our bank, and borrow $100M from a local subsidiary in the emerging market—way of circumventing). Authorities do not want to screw with the financial system, so they’re unlikely to block this.

iv. Payments with nonfinancial label: Management fees, payments for trade or technical assistance (this includes consulting fees). Government might get suspicious if you suddenly start doing consulting fees. What you do is start planning now so you’re not starting these transactions as soon as the government blocks other types of payments.

Transfer price is the price at which related companies sell one another a product. For instance, a subsidiary is buying something from its parents company. It should pay the number that reduces the total amount of taxes that should be paid.

Transfer risk: is risk of getting capital out of country where you invested

Accounting for Transfer Risk in NPV/APV: check with private insurance companies (accurate, easy-to-measure figure for which data is publically available)

Learned from Doing the Questions

- The sum of the firm’s profits taken over time, without taking time value into account, is the same as the project’s cash flows

- The sum of a project’s investments and disinvestments, when accumulated over time is zero- Better to charge the entire investment to 1st year profit/loss- Only incremental overhead matters- Arm’s length profits is ill-defined, thus we don’t use it- You can’t just subtract costs from revenue because costs are incurred before revenue comes in.

Chapter 22: Joint Ventures

Joint Venture: A separate company used to conduct a business that is owned by two or more parent firms

In Class Example #1 - Calculating Shared Gains:

What if the total benefit from the project was 100M and Company A’s best alternative provided them with 20M and B’s best alternative provided them with 30M.

Remember that:

o A firm’s gain is equal to its NPV from the joint venture minus its next best alternative

a) Gain A = Xb) Gain B = 100 –Xc) X – 20 = (100 – X) – 30d) X = 90e) X = 45

Therefore:

Company A Gains 45M Company B Gains 55M

Questions:

If A faced a higher tax then B, should its share of the 100M go up or down? UpIf A had a gain in a subsidiary, would its share go up or down? Down

How the Questions are outlined (in addition to vocabulary):

Chapter 8: Options

Understand the key lower and upper bound characteristics of options (e.g. can’t trade lower than the value of a forward contract)

Know where the value of an option comes from (e.g. Option Value = Intrinsic Value + Time Value)

Understand qualitatively, the put-call parity theorem Know how to graph direct & synthetic options payoff Know how to read an options table Know how to spot an implicit option payoff structure Unsure if I need to do the quantitative stuff at the end of the application questions

Teacher: “A good part of the exam will likely be on options”

Focus of Final Exam

Ch.8

MC: 1,2,3

Additional Quiz: 5,6,

Applications: 1,2

Ch.11

MC 1,2

Ch.12

Valid, Invalid (All)

MC 1,2,3

Applications

4

Ch.13

Matching Questions: All

Operating Exposure (T/F All)

MC Attempt the MC, but I do not expect you to fully understand. But give them a go. Also attempt the application question

Ch. 21

Try all the quiz questions