Study Material

Chapter 1
The global capital market is a collection of institutions (central banks,
commercial banks, investment banks, not for
profit financial institutions like the IMF and World Bank) and securities
(bonds, mortgages, derivatives, loans, etc.),
which are all linked via a global networkthe Interbank Market.
(LIBOR The interbank market,
which must pass-through and exchange securities using currencies,
bases all of its pricing through the single most
widely quoted interest rate in the worldLIBOR)
This interbank market, in which securities of all
kinds are traded, is the critical pipeline system for the movement of capital.
The institutions of global finance are the central banks

Eurocurrencies are domestic currencies of one country

on deposit in a second country.

1) Eurocurrency deposits are an efficient

and convenient money market device for holding excess corporate liquidity; and
2) the Eurocurrency market is a major source of short-term bank loans to finance corporate
working
capital needs, including the financing of imports and exports.

The theorie of comparative advantage

the division of labor in productive activities, and subsequently international

trade of those goods, increased the quality of life for all citizens. Smith based his work
on the concept of absolute advantage, where every country should specialize in the
production
of that good it was uniquely suited for.

Instead, governments interfere with comparative

advantage for a variety of economic and political reasons, such as to achieve full
employment, economic development, national self-sufficiency in defense-related industries,
and protection of an agricultural sectors way of life. Government interference takes the
form
of tariffs, quotas, and other non-tariff restrictions.

Chapter 3
The Gold Standard, 18761913
Since the days of the pharaohs (about 3000 b.c.), gold has served as a medium of exchange
and
a store of value

Maintaining adequate
reserves of gold to back its currencys value was very important for a country under this
system.

The Impossible Trinity

If the ideal currency existed in todays world, it would possess three attributes (illustrated in
Exhibit 3.5), often referred to as the impossible trinity:
1. Exchange rate stability. The value of the currency would be fixed in relationship to
other major currencies, so traders and investors could be relatively certain of the
foreign exchange value of each currency in the present and into the near future.
2. Full financial integration. Complete freedom of monetary flows would be allowed,
so traders and investors could willingly and easily move funds from one country and
currency to another in response to perceived economic opportunities or risks.
3. Monetary independence. Domestic monetary and interest rate policies would be set
by each individual country to pursue desired national economic policies, especially as
they might relate to limiting inflation, combating recessions, and fostering prosperity
and full employment.
The seeds of the Global credit crisis of 2008 and at least
part of the European sovereign debt crisis of 20102012
were sown in the deregulation of the commercial and
investment banking sectors in the 1990s.
The flow of capital into the real estate sector in the
post-2000 period reflected changes in social and
economic forces in a number of major economies,
particularly that of the United States. These capital
flows drove asset values up, and combined with very
aggressive mortgage creation, lending, and securitization
practices, created a mountain of debt that
could not be serviced when these same asset values
collapsed.
Securitization allowed the re-packaging of different
combinations of credit-quality mortgages in order to
make them more attractive for resale to other financial
institutions; derivative construction increased the
liquidity in the market for these securities.
The SIV was an investment entity created to invest in
long-term and higher yielding assets such as speculative
grade bonds, mortgage-backed securities (MBSs) and
collateralized debt obligations (CDOs), while funding
itself through commercial paper (CP) issuances.
LIBOR plays a critical role in the interbank market
as the basis for all floating rate debt instruments of all
kinds. With the onset of the credit crisis in September
2008, LIBOR rates skyrocketed between major international
banks, indicating a growing fear of default in a
market historically considered the highest quality and
most liquid in the world.
The U.S. Congress passed the Troubled Asset Recovery
Plan (TARP), which authorized the use of up to $700
billion to bail out the riskiest banks. As a result of the
massive write-offs of failed mortgages, the banks suffered
weakened equity capital positions, making it
necessary for the private sector and the government to
inject new equity capital.
The eurozone sovereign debt crisis, born partially out
of the global credit crisis, is a complex combination of
failed sovereign state funding, global economic conditions,
and a single currency structure without all of the
attributes and capabilities of a single currency country.
Beginning with Greece in 2009 and 2010, followed by
Ireland and Portugal (and possibly Spain and Italy
in the coming years), members of the eurozone have
found themselves on the edge of sovereign default as
their euro-denominated debt far exceeded their debt
servicing capabilities.
Unlike traditional economic and financial structures,
the sovereign states of the eurozone do not have the
ability to individually print more money or use other
monetary policy approaches to debt repayment or currency
devaluation (to increase export competitiveness
and alleviate current account deficits).
Although Greece has been the recipient of several
bailout packages, and Ireland and Portugal have also
managed to get by to date, continuing deterioration
in economic growth has resulted in ever-larger fiscal
deficits, increased sovereign debt financing needs, and
deteriorating credit quality. The international financial
markets priced some sovereign debt on levels indicating
expected default.
The EU has yet to gain agreement and clarity on which
of a variety of strategies and approaches to take in
attempting to prevent sovereign default by a eurozone
member. It is also unclear if sovereign default would
necessarily result in the country, for example Greece,
leaving the single currency euro.

Chapter 6
The foreign exchange market provides the physical and institutional structure through which
the money of one country is exchanged for that of another country, the rate of exchange
between currencies is determined, and foreign exchange transactions are physically
completed.

Speculators and arbitragers seek to profit from trading in the market itself. They operate in
their own interest, without a need or obligation to serve clients or to ensure a continuous
market. Whereas dealers seek profit from the spread between bids and offers in addition to
what they might gain from changes in exchange rates, speculators seek all of their profit
from
exchange rate changes. Arbitragers try to profit from simultaneous exchange rate
differences
in different markets.
Spot Transactions
A spot transaction in the interbank market is the purchase of foreign exchange, with delivery
and payment between banks to take place, normally, on the second following business day.

Outright Forward Transactions

An outright forward transaction (usually called just forward) requires delivery at a future
value date of a specified amount of one currency for a specified amount of another currency.

Swap Transactions
A swap transaction in the interbank market is the simultaneous purchase and sale of a given
amount of foreign exchange for two different value dates. Both purchase and sale are
conducted
with the same counterparty. A common type of swap is a spot against forward. The dealer
buys a currency in the spot market and simultaneously sells the same amount back to the
same
bank in the forward market.
Currency Options
A foreign currency option is a contract that gives the option purchaser (the buyer) the right,
but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per
unit for a specified time period (until the maturity date). The most important phrase in this
definition is but not the obligation; this means that the owner of an option possesses a
valuable choice.

There are two basic types of options, calls and puts. A call is an option to buy foreign
currency, and a put is an option to sell foreign currency.
The buyer of an option is termed the holder, while the seller of an option is referred
to as the writer or grantor.
Foreign currency futures contracts are standardized
forward contracts. Unlike forward contracts, however,
trading occurs on the floor of an organized exchange
rather than between banks and customers. Futures also
require collateral and are normally settled through the
purchase of an offsetting position.
Corporate financial managers typically prefer foreign
currency forwards over futures out of simplicity of
use and position maintenance. Financial speculators
typically prefer foreign currency futures over forwards
because of the liquidity of the futures markets.
Foreign currency options are financial contracts that
give the holder the right, but not the obligation, to
buy (in the case of calls) or sell (in the case of puts)

a specified amount of foreign exchange at a predetermined

price on or before a specified maturity date.
The use of a currency option as a speculative device
for the buyer of an option arises from the fact that an
option gains in value as the underlying currency rises
(for calls) or falls (for puts). The amount of loss when
the underlying currency moves opposite to the desired
direction is limited to the option premium.
The use of a currency option as a speculative device
for the writer (seller) of an option arises from the
option premium. If the optioneither a put or call
expires out-of-the-money (valueless), the writer
of the option has earned, and retains, the entire
premium.

Speculation is an attempt to profit by trading on

expectations about prices in the future. In the foreign
exchange market, one speculates by taking a position
in a foreign currency and then closing that position
afterwards; a profit results only if the rate moves in
the direction that the speculator expected.
Currency option valuation, the determination of the
options premium, is a complex combination of the current
spot rate, the specific strike rate, the forward rate
(which itself is dependent on the current spot rate and
interest differentials), currency volatility, and time to
maturity.
The total value of an option is the sum of its intrinsic
value and time value. Intrinsic value depends on the
relationship between the options strike price and the
current spot rate at any single point in time, whereas
time value estimates how intrinsic value may change
for the betterprior to maturity.
The single largest interest rate risk of the nonfinancial
firm is debt-service. The debt structure of the MNE
will possess differing maturities of debt, different interest
rate structures (such as fixed versus floating-rate),
and different currencies of denomination.
The increasing volatility of world interest rates,
combined with the increasing use of short-term and
variable-
rate debt by firms worldwide, has led many
firms to actively manage their interest rate risks.
The primary sources of interest rate risk to a multinational
nonfinancial firm are short-term borrowing,
short-term investing, and long-term debt service.
The techniques and instruments used in interest rate
risk management in many ways resemble those used
in currency risk management. The primary instruments
used for interest rate risk management include forward
rate agreements (FRAs), forward swaps, interest rate
futures, and interest rate swaps.
The interest rate and currency swap markets allow
firms that have limited access to specific currencies and
interest rate structures to gain access at relatively low
costs. This in turn allows these firms to manage their
currency and interest rate risks more effectively.
A cross-currency interest rate swap allows a firm to
alter both the currency of denomination of cash flows
in debt service, but also to alter the fixed-to-floating or
floating-to-fixed interest rate structure.

Chapter 19