Certified Finance

Specialist
M M Fakhrul Islam
Email: fakhrul@bimsedu.com

International Financial Management

Terminology used in International Finance
The cross-rate is an exchange rate between two currencies computed by reference to
a third currency, usually the US dollar
A Eurobond is an international bond that is denominated in a currency not native to the
country where it is issued
Eurocurrency is money deposited in a bank or financial firm outside of the country whose
currency is involved
Foreign bonds, unlike Eurobonds, are issued in a domestic market by a foreign entity and
are usually denominated in that countrys currency
Gilts, technically, are British and Irish government securities, although the term also
includes issues of local British authorities
The London Interbank Offer Rate (LIBOR) is the rate that most international banks charge
one another for loans of Eurodollars overnight in the London market

Foreign exchange transactions

A spot trade is an agreement to exchange currency on the spot, which actually
means that the transaction will be completed or settled within two business days.
A forward trade is an agreement to exchange currency at some time in the future.

Exchange rate risk

Exchange rate risk also called currency risk is the natural consequence of
international operations in a world where relative currency values move up and
down
A company may become exposed to foreign exchange risk or currency risk in
any of the following way:
As an exporter of goods or services
As an importer of goods or services
Through having an overseas subsidiary company
Through being the subsidiary of an overseas company
By borrowing in a foreign currency or lending a foreign currency

Three different types of exchange rate risk

Short-run exposure also called transaction exposure
The day-to-day fluctuations in exchange rates create short-run risks for international firms

Long-run exposure also known as economic exposure

the value of a foreign operation can fluctuate because of unanticipated changes in
relative economic conditions

Translation exposure
When the consolidated financial accounts are prepared for the group, the assets,
liabilities, and the profits of the subsidiary must be translated into the currency of the
parent company.

Interest rate risk

the risk of paying more interest on debt than necessary,
the risk of losses on interest-earning investments and
the risk of being unable to meet debt payment obligations

Hedging
The term immunisation is sometimes used as well
financial engineering
create a way by using available financial instruments to create new ones

derivative securities
financial asset that represents a claim to another financial asset.
Financial engineering frequently involves creating new derivative securities, or else
combining existing derivatives to accomplish specific hedging goals.

Hedging transaction exposures

Forward exchange contracts
Buy or sell in domestic currency
Matching receipts and payments
Leading and lagging
Matching assets and liabilities in a currency
Money market hedges
Currency options
Currency futures

Hedging economic exposure

Matching assets and liabilities.
Diversifying the supplier and customer base.
Diversifying operations world-wide.
Currency swaps

Hedging Translation exposures

Group borrowing in the currency of the foreign subsidiary
For example, the parent company could hedge the translation exposure by
borrowing in euros, possibly as much as the assets of the subsidiary. If the assets of
the subsidiary fall in value when translated into sterling, there would be a
corresponding fall in the sterling value of the company's debt liability.

Hedging with Forward contract

Agreement between two counterparties - a buyer and seller
The terms of the contract call for one party to deliver the goods to the other on a
certain date in the future, called the settlement date. The other party pays the
previously agreed-upon forward price and takes the goods.
delivery of the asset occurs at a later time, but the price is determined at the time of
purchase
Highly customised
All parties are exposed to counterparty default risk
Transactions take place in large, private and largely unregulated markets
Underlying assets can be a stocks, bonds, foreign currencies, commodities or some
combination
Forwards can be based on interest rates is known as a Forward Rate Agreement or FRA

Contd
buyer of a forward contract benefits if prices increase because the buyer will
have locked in a lower price
seller wins if prices fall because a higher selling price has been locked in
forward contract is a zero-sum game

Hedging with FRA

Forward contract on an interest rate for a short-term loan or deposit.
Not an actual short-term loan or deposit
an agreement about a rate of interest at a future date, but there is no
undertaking by either party to the agreement to either borrow or lend actual
money
The buyer of an FRA obtains a fixed rate of interest for payment, and can
therefore use an FRA to fix an interest rate on future borrowing.
The seller of an FRA obtains a fixed rate of interest to receive, and can therefore
use an FRA to fix an interest rate on a future deposit or future lending.
FRAs are very similar to swaps except that in a FRA a payment is only made once
at maturity. Instruments such as interest rate swap could be viewed as a chain of
FRAs.

Hedging with Futures contract

Futures are exchange-traded forward contract
A futures contract is exactly the same as a forward contract with one exception.
With a forward contract, the buyer and seller realise gains or losses only on the
settlement date.
With a futures contract, gains and losses are realised on a daily basis.

If we buy a futures contract on oil, then, if oil prices rise today, we have a profit
and the seller of the contract has a loss. The seller pays up, and we start again
tomorrow with neither party owing the other.
The daily resettlement feature found in futures contracts is called marking-tomarket.
Someone who has bought futures contracts is said to be 'long' in the futures or to
hold a long position
Someone who has sold futures contracts is said to be 'short' in the futures or to hold
a short position.

How Futures works?

The farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels
of grain to the buyer in June at a price of $4 per bushel.

By entering into this futures contract, the farmer and the bread maker secure a price that both parties
believe will be a fair price in June

Farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the
holder of the long (agreeing to buy)

Say the futures contracts for wheat increases to $5 per bushel the day after the above farmer and bread
maker enter into their futures contract of $4 per bushel. The farmer, as the holder of the short position, has
lost $1 per bushel because the selling price just increased from the future price at which he is obliged to
sell his wheat. The bread maker, as the long position, has profited by $1 per bushel because the price he is
obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.

On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X 5,000 bushels) and
the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels). As the market moves
every day, these kinds of adjustments are made accordingly.

Hedging using Options

Options
Right to purchase or sell

Call Option

Put Option

Right to buy

Right to sell

Contd
A person can buy an option, and becomes the option holder. The terms 'option buyer'
and 'option holder' effectively mean the same thing.
The purchase price of an option is called the option premium.
The premium for an option consists of two elements, intrinsic value and time
Together, intrinsic value and time value add up to the option premium.

value.

The intrinsic value of calls and puts can be summarised in the following formulae:
(a) The intrinsic value of a call option is the higher of (i) the current market price of the
underlying item minus the exercise price, and (ii) zero. An out-of-the-money call option
therefore has an intrinsic value of zero.
(b) The intrinsic value of a put option is the higher of (i) the exercise price minus the
current market price of the underlying item, and (ii) zero. An out-of-the money put option
therefore has an intrinsic value of zero.

Time value of an option

Value placed by the market on the possibility that the price of the underlying item
might move against the option writer in the time remaining until the option expires.
Time value reflects the possibility that an option will become in-the-money.

Contd
A person might hold a call option on 2,000 shares in ABC at a price of 500c per share.
This would give the holder the right, but not the obligation, to buy 2,000 shares in the
company, at a price of 500c.
The fixed purchase price for a call option and the fixed selling price for a put option are

known as the exercise price, strike price or strike rate for the option.
European-style options: right to exercise the option ONLY at the expiry date
American-style options: right to exercise the option at any time before the expiry date
Options offer a choice to the option holder between:
exercising the right to buy or sell at strike price, and
not exercising this right and allowing the option to lapse.

The option seller or option writer does not have any choice. The seller is obligated to do
so

Call Option example

Zico holds a call option on 2,000 shares of ABC at a strike price of 460c. The option
premium was 25c per share. Calculate the gain/loss for the option buyer and the
option writer if the share price at the expiry date for the option is:
(a) 445c
(b) 476c
(c) 500c

Solution
The option will not be exercised. The option writer will make a profit of 25c per
share ($500 in total), from the option premium. The option holder (Zico) loses this
amount, by paying the premium.
The option will be exercised by Zico, giving him a gain of (476 460)c, i.e. 16c per
share. However, the gain from exercising the option is more than offset by the cost
of the premium (25c per share), leaving the option writer with a net profit of 9c per
share, and the option buyer with a loss of the same amount. This is (2,000 9c)
$180 in total.
The option will be exercised by Zico, giving him a gain of (500 460)c, i.e. 40c per
share. This gives him a net gain, after deducting the premium of 25c per share, of
15c per share or ( 2,000 shares) $300 in total. The option writer suffers a net loss of
$300.

Put Option Example

Ms. Pessimist feels quite certain that BMI will fall from its current $160-per-share
price. She buys a put. Her put-option contract gives her the right to sell a share of
BMI stock at $150 one year from now.
If the price of BMI is $200 on the expiration date, she will tear up the put option contract
because it is worthless. That is, she will not want to sell stock worth $200 for the exercise
price of $150.
On the other hand, if BMI is selling for $100 on the expiration date, she will exercise the
option. In this case, she can buy a share of BMI in the market for $100 per share and turn
around and sell the share at the exercise price of $150. Her profit will be $50 ($150 $100). The value of the put option on the expiration date therefore will be $50.

More on Put
An investor who sells a put on common stock agrees to purchase shares of
common stock if the put holder should so request.
The seller loses on this deal if the stock price falls in the market below the exercise

price and the holder puts the stock to the seller.

For example, assume that the stock price is $40 and the exercise price is $50.
The holder of the put will exercise in this case. In other words, he will sell the underlying

stock at the exercise price of $50. This means that the seller of the put must buy the
underlying stock at the exercise price of $50. Because the stock is only worth $40, the
loss the Put seller here is $10 ($40 - $50).

Gain in Option
An in-the-money option has a strike price that is more favourable to the option
holder than the current market price of the underlying item. An option will be
exercised by its holder if it is in-the money when it can be exercised.
An on-the-money or at-the-money option has a strike price that is exactly equal to
the current market price of the underlying item.
An out-of-the-money option has a strike price that is less favourable to the option
holder than the current market price of the underlying item. If an option is out-ofthe-money on its exercise date/expiry date, it will not be exercised. The option
holder will prefer to let the option lapse and either buy the underlying item (call
option holder) or sell the underlying item (put option holder) at the market price,
rather than at the option strike price.

SWAP
Agreement between two counterparties to exchange the obligation to pay
streams of cash over a given period.
Swaps are over-the-counter instruments.

SWAPS

Interest rate
swaps

Currency
swaps

SWAP Example
Charlie owns a $1,000,000 investment that pays him LIBOR + 1% every month. As LIBOR
goes up and down, the payment Charlie receives changes.
Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month.
The payment she receives never changes.
Charlie decides that that he would rather lock in a constant payment and Sandy
decides that she'd rather take a chance on receiving higher payments. So Charlie and
Sandy agree to enter into an interest rate swap contract.
Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month
on a $1,000,000 principal amount (called the "notional principal" or "notional amount").
Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.

Scenario A: LIBOR = 0.25%

Charlie receives a monthly payment of
$12,500 from his investment ($1,000,000 x
(0.25% + 1%)). Sandy receives a monthly

payment of $15,000 from her investment

($1,000,000 x 1.5%).
Now, under the terms of the swap
agreement, Charlie owes Sandy $12,500
($1,000,000 x LIBOR+1%) , and she owes
him $15,000 ($1,000,000 x 1.5%). The two
transactions partially offset each other and

Sandy owes Charlie the difference: $2,500.

Scenario B: LIBOR = 1.0%

Now, with LIBOR at 1%, Charlie receives a
monthly payment of $20,000 from his
investment ($1,00,000 x (1% + 1%)). Sandy
still receives a monthly payment of $15,000

from her investment ($1,000,000 x 1.5%).

With LIBOR at 1%, Charlie is obligated
under the terms of the swap to pay Sandy
$20,000 ($1,000,000 x LIBOR+1%), and
Sandy still has to pay Charlie $15,000. The
two transactions partially offset each other
and now Charlie owes Sandy the
difference between swap interest
payments: $5,000.

Contd
We will focus on the simplest and most common type of interest rate swap, the socalled 'plain vanilla coupon swap' or 'generic' interest rate swap. In this type of
swap:
One party pays the other interest on a notional loan at a fixed rate of interest, and
The other party pays interest on the same notional loan amount, but at a floating rate of
interest.

Uses of SWAP
Interest rate swaps have several potential uses for a non-bank
company
To manage the mix of fixed and floating rate interest in the company's debt
mix. They can be used to switch fixed rate borrowing to effective floating rate
borrowing, or from floating rate borrowing to effective fixed rate borrowing.
To obtain fixed rate borrowing commitments when the company cannot

obtain debt finance at a fixed rate.

Possibly, to borrow at a cheaper fixed rate than by borrowing directly at a
fixed rate, or to borrow at a floating rate more cheaply than borrowing directly

at a floating rate. Using swaps to reduce borrowing costs is known as credit

arbitrage.

Contd
Currency swaps can provide a hedge against exchange rate movements for longer periods
than the forward market. Forward contracts are available for periods up to about two years
in liquid currencies, and less with other currencies. Currency swaps can also be useful when
using a currency for which no forward market is available.
With a currency swap, a company can obtain debt finance in another currency, and swap
the liability into its own currency.
Currency swaps can therefore be used by companies to restructure the currency base of
their liabilities. This may be important where the company is trading overseas and receiving
revenues in foreign currencies, but its borrowings are denominated in the currency of its
home country. Currency swaps therefore provide a means of reducing exchange rate
exposure.
At the same time as exchanging currency, the company might also be able to convert fixed
rate debt to floating rate or vice versa. Thus it may obtain some of the benefits of an interest
rate coupon swap in addition to achieving the other purposes of a currency swap. (These
swaps are called 'fixed-floating currency swaps'.)
A currency swap could be used to absorb excess liquidity in one currency which is not
needed immediately to create funds in another where there is a need.

SWAP: Maths
Brew has issued $20 million of fixed rate bonds, on which the interest rate is 8%,
and which have eight years remaining to maturity. It would like to switch from a
fixed rate to a floating rate interest commitment and arranges a five-year coupon
swap with a bank. The bank is prepared to pay fixed interest at 7.25% and receive
six-month LIBOR in return.
By arranging the swap, the company changes its fixed interest payments of 8%
per annum into a floating rate commitment of LIBOR plus 75 basis points (one
hundredth of a percentage point), as follows.
%
Bonds: pay fixed interest

(8.00)

Swap
Receive fixed interest
Pay floating rate
Overall cost

7.25
(LIBOR)
(LIBOR + 0.75)

Example 2: SWAP
Cord is too small to issue bonds, but would like to take on fixed rate borrowing of
$3 million. It therefore obtains a five-year loan of $3 million from its bank, on which
interest is payable at LIBOR plus 125 basis points. It also arranges a five-year swap
with a bank in which the company pays a fixed rate of 5.70% and receives LIBOR
in return.

Bank loan: pay floating rate interest

(LIBOR + 1.25)

Swap
Receive floating rate interest

LIBOR

Pay fixed rate

(5.70)

Overall cost

(6.95)

As a result of the swap, the overall borrowing cost is at a fixed rate of 6.95%, as above.