INSTRUCTION: Answer the questions given.

QUESTION 1

a) Foreign direct investment (FDI) has always affected the exchange rates of countries.
Movements in foreign direct investment flows into and out of emerging markets
contribute to exchange rate volatility.

Describe in detail, one concrete historical example of this phenomenon in the last 15
years.

Foreign direct investment (FDI) is famous for rapidly boosting developing country’s economy. In

relatively short time, FDI boost can make a country after 2008 melt down to break record levels of

demand drivers – wages, jobs, credits and confidence, in less than a year. For example Brazil's real

GDP surpassed the pre-crisis production during 2H09, while most developed economies are still

below pre-crisis levels. Real GDP grew at an annualized pace of more than 9% in 2H09 and

quickened its pace to 11.3% during 1Q10. This is the effect of FDI.

When it comes to exchange rates, FDI definitely plays big role. What happen is, when FDI comes in it

creates a lot of production, creates jobs, increases wages, increases domestic demand and exports,

imports also will go up and so on. Most of the time FDI buys real assets such as land, buildings,

machineries and manufacturing plants. These definitely help improve economic outlook of the

country. However, when everything is rosy there must be something stink. Overly dependent on FDI

is a disease, because after a while the exchange rates will appreciate, soon inflation will go up.

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One country example close to FDI phenomenon is Argentina. The country was experiencing

hyperinflation (200% - 5000%!) and to curb that the government pegged peso to US dollar. At that

time peso was pegged at 10, 000 per USD. On top of that, the government also allowed conversion of

peso to dollar on one-to-one basis. People scrambling to exchange and keep dollar instead. Because

of that, the government has to keep buying dollar and hold large amount peso. That remedied the

situation, because inflation dropped soon after that and value of peso preserved and the rakyat is

having a good time for several years. Later FDI inflows to the country increased manifolds where

jobs were created, lands being acquired, MNCs being set up and economic confidence boosted up.

Argentina became the darling of FDI. They privatized a number of utilities companies in the name of

competitiveness and efficiencies.

However, this has forced the government to keep buying dollars to balance the circulation of dollars

in the market and they have been extending dollars for relatively low interest. To some extent the

government of Argentina has accumulated substantial foreign debt in the process. The big hit came

when Brazil devalued its real currency in 1999. For many investors and FDI they see this as a big

opportunity because they now can get the same thing in Argentina at much cheaper cost or more in

Brazil. It triggers massive capital flight away from Argentina and domestic consumption spiraling

downward. Later people rushed to the bank and convert peso to dollar and send them abroad to the

point when bank runs out of money. This massive withdrawal forced the government to impose

capital control however it was too late.

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The rakyat was not happy and it worsens when they took it on the street. They were riots, property

destruction and hostile demonstrations. They took it to the foreign banks, Europeans and Westerns

corporations and privatized utilities organizations. This problem haunts Argentina for a few years

until the government decided to devalue the currency in 2002. Devaluation angered some peso

holders and saving accounts holders because it shrinks the currency value over night. Later peso

was left free float and since imports were severely damage, peso suffered huge depreciation which

later triggered another problem; inflation.

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b) What were the main causes of Asian financial crisis of 1997? What lessons were learned
and what steps were eventually taken to normalize the economy of this region?

There are many literatures on this and after careful reading on some; there is one dominant

reason to how the crisis started – attack on Thai baht. Thailand was on economic boom

period during pre-crisis, whereby the capital inflows was huge, (but debt was high in 1998

(approximately $35 billion)), very accommodating economic policy and high private

consumption in the economy. Because of all these factors, Thai baht was stronger and the

stock markets seemed to perform “too well”.

For some reasons, the speculators beginning to dump Thai baht (many felt baht being

overvalued as domestic currency) after intense speculation and stock market plunged a few

months after that. Since Thai baht has been giving “special attention” to US dollar in its

foreign exchange, more dollars were needed to neutralize the capital flight away from

Thailand. Bank of Thailand spent nearly 90% of its reserves to buy foreign currencies (in

particular US dollar) to defend baht, but it soon learns it doesn’t have enough money to do

that. That event triggered loud alarm to regional investors and FDI “donors”. Recession

began. Foreign investors and businesses pulled out and retreated to home base or other

countries. No less than US dollars 108 billion left the region within first six months of the

crisis. The herd behavior of local speculators did aggravate the situation in the stock market

but had little to do with the chaos in currency trading. This problem spread across the region

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including Indonesia, Hong Kong, Korea, Taiwan, Singapore – Malaysia included. Nonetheless,

Taiwan and Singapore were the least affected with major structural problems caused by the

crisis compare with other mentioned countries.

Now more than 13 years after the 1997 crisis, these are some valuable lessons for all

developing countries:

a) It is important to pay attention to economic fundamentals such as inflation,

deficit/surplus of BoT, exchange rate policy and banking policy.

b) Regulation of financial institutions is a must and curbs any high risk lending and creation
of credit. The stringent and more difficult measures are better for them.

c) Political stability is pivotal in making sure action plan during the crisis get implemented
and monitored. Lackadaisical attitude is a sure way to systemic failure.

d) Be wary with overly accommodative economic policy towards foreign funds, they can
bring it in therefore they can also take it out.

e) Management of foreign funds and terms need to be carefully scrutinized such as bilateral
or free trade agreements i.e. quantity vs. quality.

f) Do not fix exchange rate to US dollar because when dollar appreciates you will have
difficulties to do business with other currencies and export becomes expensive. Besides
it hurts current account deficits.

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Some useful steps were taken by various countries to normalize their economy. The net
effect of these measures helps to normalize regional economic outlook.

a) Impose capital control to curb capital flight away from the country. This step taken by
Malaysia, Thailand and Indonesia.

b) Seek to understand the prescription by other party such as IMF before fully subscribe to
their measures because they usually come with a catch or two. Malaysia did implement
IMF-like measures without having to officially subscribe (modelling) and found out it
won’t work in the long run.

c) Accumulate high level of foreign exchange reserves as safety net during crisis. As of Jan
2011, Malaysia has accumulated $108 billion, Thailand $173 billion, Indonesia $95
billion, Korea $295 billion and Taiwan $387 billion. In 1997, Taiwan foreign reserves are
3 times more than its external debt – which totally opposite for the rest of crisis stricken
countries! ☺

d) Look into fiscal areas to change such as interest rate policy, exchange rate policy, and
government spending and public expenditures.

e) Find ways to boost domestic economy through higher domestic private consumption
such as entrepreneurs and small medium enterprises. Creation of SME industries can
help generate the much desired economic activity and contribute to government taxes in
medium run. Malaysia (created SME “Satu Daerah Satu Industri for agriculture) and
Thailand (created One Village One Product to promote small scale industry in rural area)

f) Have positive (surpluses) in current account balance. When the current account runs of
deficit, the country has to borrow a lot of money from abroad which further deteriorate
the economy. During the 1997/98 crisis, one country that literally saved and insulated
from the crisis was Taiwan. While Taiwan also spent billions of dollars to defend New
Taiwan dollar (NT$), it has enough money to do so without borrowing.

[10 marks]

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QUESTION 2

Options and Futures are used in risk management when it involves international trade. For,
example, MAS and AirAsia hedges their air fuel purchase. Elaborate on the differences between
foreign currency options and futures. When is Options and Futures be most appropriately used?

It is a form of derivative securities that derive from currency values. Currency Options and Futures

are used as risk management tool in international trade and finance. Businesses are exposed to

volatile and unpredictable foreign exchange risks. Foreign exchange risk refers to the risk faced due

to fluctuating exchange rates. For example, a Malaysian trader who exports palm oil to India for

future payments in Rupees is faced with the risk of Rupees depreciating against the Ringgit when

the payment is made. This is because if Rupee depreciates, a lesser amount of Ringgit will be

received when the Rupees are exchanged for Ringgit. Therefore, what originally seemed a profitable

venture could turn out to be a loss due to exchange rate fluctuations. Such risks are quite common in

international trade and finance.

First let’s define what is currency options and futures.

Currency Futures

Currency Futures contracts are standardized contracts, with fixed, standardized contract sizes and

volume and fixed expiration dates. It is similar to forward contracts in terms of the mechanics

requirements but has some differences especially with the way its being traded. They are commonly

used by MNCs or any business that trade in overseas market - to hedge their foreign currency

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positions.

The participants of futures market are both hedgers and speculators. Hedgers usually has business

or personal interest in the underlying currency and using futures as risk management tool eg

minimize, eliminate or control currency risk. They could be MNCs, banks, importers or exporters. On

the other hand, speculators are hoping to capitalize on the exchange rate movements.

Currency Futures is based on daily settlements and dealing with an exchange i.e. clearing house; just

like stock market. It is a liquid securities and before the expiry of the contract you can neutralize the

position by making an opposite transaction.

Example of transaction:

Assuming TMY Sdn Bhd just won a development project in Japan worth Yen 10,000,000. The

payment will be paid upon project completion. Currently Yen is valued at RM 0.10 per Yen, and since

the payment is in a few months time and to minimize foreign exchange fluctuation risk, TMY Sdn

Bhd can hedge by selling Yen futures against Yen depreciation. Assuming the Yen rate is RM 0.10 per

Yen, the size of the contract is RM 1,000,000. After few months, Yen depreciates to RM 0.07, TMY

Sdn Bhd can quickly buy futures at this new rate ie spot price. So now, in a perfect hedging market

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TMY Sdn Bhd transactions looks like this:

-- (RM 0.10 – RM 0.07) x 10,000,000 = RM 300,000 (gained from futures)

-- RM 0.07 x 10,000,000 = RM 700,000 (gained from spot market)
total cash flow: RM 1,000,000 (still maintaining desired cash flow)

For currency futures, the participants need to pay a deposit. At any one time, they deposit must be

able to sustain any open position. Else, margin call will be executed ie. to top up the account.

Currency Options

Currency Options is not a standardize contract. It is customized between two parties – a buyer and a

seller. It is similar to futures, but without the obligation of contract delivery. The buyer has the

option to forego the contract – only to pay premium. While the buyer of option enjoys a right but not

obligation, the seller of the option nevertheless has an obligation in the event the buyer exercises

the given right.

There are two types of options:

• Call options – gives the buyer the right to buy a specified currency at a specified
exchange rate, at or before a specified date.

• Put options – gives the buyer the right to sell a specified currency at a specified
exchange rate, at or before a specified date.

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The participants of the options are similar to forwards and futures. The settlement is only when the

contract expires i.e. at the end of the contract.

Assuming a merchant buys a June RM0.10 Yen call option for RM0.01. This means that the merchant

has the right to buy Yen for RM0.10 per Yen anytime till the contract expires in June. The merchant

pays a premium of RM0.01 for this right. The RM0.10 is called the strike price or the exercise price.

If Yen appreciates over RM0.10 anytime before expiry, then he may exercise his right and buy it for

RM0.10 per Yen. If however Yen were to depreciate below RM0.10 then he may just let the contract

expire without taking any action since he is not obligated to buy it at RM0.10. If he needs physical

Yen, just buy it from the spot market which is now at lower rate. In hedging using options, calls are

used if the risk is an upward trend in price and puts are used if the risk in a downward trend in

price.

Differences between Currency Futures and Options

1. Contract Obligation Futures come with an obligation to get the contract delivered by the time

it expires, unless you are a speculator. Options don’t have this feature but the buyer has the right to

own or abandon (sell) if they want to.

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2. Cashflow  Futures are tracked on daily basis (marked-to-market) and hedgers are required to

pay the variations at the end of trading day. This can cause cash burden to some. Options on the

other hand is neither initial margin nor daily variation margin since the position is not marked to

market. This could potentially provide significant cash flow relief to traders. (American and

European Options are slightly different in Options exercise)

3. Flexibility  Since market is an unpredictable beast, Futures can be disadvantageous because in

between the market may give you some profits or vice versa, you got them spot. Nonetheless, the

net profits/losses can only offset (most of the time) by the end of the contract expiry. Options give

the flexibility to ‘abandon’ unfavourable contract; the only lost is to pay the premium. If transaction

is huge, Options would be the better bet.

4. Price of Premium  Because of the flexibility it provides, Options is generally more expensive

compares to Futures.

So, coming back to MAS and AirAsia air fuel hedging question which one is more useful? My opinion

is Options. The reason being is because Options allow flexibility of timing and also looking at the

magnitude of oil purchase; I need something with less risk especially with higher probability when

the market can go against my position. With this very volatile movement crude oil price, this

uncertainty that be managed better with using Options.

[7 marks]

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QUESTION 3

Derivatives is a ‘zero-sum’ game. If someone gains, someone else has to lose. Why would anyone
write an option, knowing that the gain from receiving the option premium is fixed but the loss if
the underlying price goes in the other direction can be extremely huge?

Yes, derivatives is a zero-sum game. Everyone says that and everyone is derivatives should already

know that. It is by design that derivatives has to side of the coin which is Short and Long. A position

is Short when selling, and Long when buying. This is applicable to most derivatives instruments

such as Futures and Options. This mechanism allows them to equalize their position and hedge

against the risk they expose themselves to; of course for profits.

For example in Currency Options, when a seller is obligated to sell his position and make a loss. In

the real world, he will also have another buy position of the same currency to equalize it. Therefore,

he is the same person who losses and wins at the same time. The trick is how many positions do you

need to have? Because in every transaction, there is always premium to pay, even though the

contract is abandoned.

Derivatives is a tricky instrument because it derives its value on top of something else ie underlying

assets such as commodities, currencies or debts! In fact, the very reason on 1998 SEA financial crisis

was mostly because of derivatives made of currency and debts securities. A lot of call options were

transacted at that time (some say by trillions of US dollars). Suddenly, these so called investors want

their money back and massive capital flight away from the country. Look at what happened, it was a

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zero sum game and it is still the same played during recent 2008 financial crisis. This time on

mortgage-backed securities. In some material I read, the author quipped, “One party’s loss is equal to

its counterparty’s gain and therefore the transaction as a whole is a zero-sum game. Right? Well, if

that’s true, then why has almost everyone who has traded derivatives lost money over the last year?”

Generally derivatives are used for the following purpose:

i) To transfer risk from one person (party) to another  usually derivatives are value derived

from underlying assets such as loans, mortgage or currency. Derivatives later offered to other party

for cash. Since the bank needs cash to run its operation and invest in other assets class, derivatives

is a popular way to obtain those hard cash.

ii) Providing insurance  For example in commodity business when a farmer is guaranteed for his

payment for his crops even before planting, happy with the price he will get he is more motivated to

produce those crops. This future anticipation can be securitize and sell as derivatives.

iii) Frees up cash  Derivatives frees up cash that is trapped in the system because of obligation

possessed by the assets class. Being higher risk therefore derivatives are not for faint-heart and

those who can tolerate greater risk for advanced cash.

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Overall derivates are not as bad as many would have thought or read. You will find in early 90s

derivatives are the savior of our economy and many investment managers are strong proponent of

these form of securities. Nevertheless more than ten years later in the advent of year 2008 financial

crisis, derivatives are the sole culprit of all these mess. Personally, derivatives are just tools and

financial instruments that can help boost the economy if used with empathy and compassion. Some

people got cranky and unduly “irrational exuberance” by how much money the system can generate.

"Most, probably, of our decisions to do something positive, the full consequences of which will be
drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous
urge to action rather than inaction, and not as the outcome of a weighted average of quantitative
benefits multiplied by quantitative probabilities."
John Maynard Keynes, The General Theory of Employment Interest and Money, 1936

[8 marks]

END OF QUESTION

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REFERENCES

1. Jeff Madura, “International Corporate Finance 10th Edition”, South-Western Cengage

Learning, 2010

2. Mahathir Mohamad, “Reflections on Asia”, Pelanduk Publications, 2002

3. Alan Greenspan, “The Age of Turbulence – Adventures In a New World”, The Penguin
Press, 2007

4. Joseph E. Stiglitz, “Making Globalization Work”, Penguin Books, 2006

5. Yi-Chi-Chen, “Asian Crisis Project – Country Report on Taiwan”, University of Washington,

1998

6. Francesco Caramazza and Jahangir Aziz, “Fixed or Flexible? Getting the Exchange Rate
Right in the 1990s”, International Monetary Fund, Economic Issues No. 13, 1998

7. Zubair Hassan, “The 1997-98 Financial Crisis in Malaysia:Causes, Response and Results”,
Islamic Economic Studies, Volume 9, No. 2, 2002

8. Chalongphob Sussangkarn, “Economic Crisis and Recovery in Thailand: The Role of IMF”,
Thailand Development Research Institute, 1999

9. Eshan Karunatilleka, “The Asian Economic Crisis”, House of Commons Library, Research
Paper 99/14, 1999

10. Professor Mark J. Perry, “Currency Futures and Options”, Chapter 7 International Finance,
BUS, 2000

11. Ahamed Kameel Mydin Meera, “Hedging Foreign Exchange with Forwards, Futures,
Options and the Gold Dinar: A Comparison Note”, International Islamic University
Malaysia, 2002

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