International Finance

Syllabus
Cairo University Spring Semester,2011
Faculty of Econ. & Political Sciences International Finance
Post Graduate Program Thursday: 3 – 6 PM
_____________________________________________________________________
Text:
Alan Shapiro, Multinational Financial Management, John Wiley &
Sons, 7th ed,2003.
Course Outline:
Part (I) : Environment of Int”l Financial Management.
1- Introduction :Multinational Enterprise& Multinat’l Financial
Management. Ch. (1)
2- The Determination of Exchange Rate. Ch. (2)
3- The International Monetary System. Ch. (4)
4- The Balance of Payments (BOP). Ch. (5)
5- Country Risk Analysis. Ch. (6)
Part (II) : Foreign Exchange & Derivatives Markets.
5- The Foreign Exchange (Forex) Market. Ch. (7)
6- Currency Futures& Options Markets. Ch. (8)
7- Swaps & Inerest Rate Derivatives. Ch. (9)
 International Finance
Syllabus (Cont’d)
Cairo University Spring Semester,2011
Faculty of Econ. & Political Sciences International Finance
Post Graduate Program Thursday: 3 – 6 PM

Part (III) : Finance The Multinational Corporation.

8- International Financing & National Capital Markets. Ch. (12)
9-The Euromarkets. Ch. (13)

Part (IV) : Multinational Working Capital Management.

10- Financing Foreign Trade. Ch. (18)
Course Objective:
The Course is tailored toward help post-graduate students
understand the conceptual framework within which the key
international financial decisions of multinational institutions
are analyzed and taken.

Grading System:
1- Class Participation. 30%
- Attending at least 10 classes 10%
- Group Project. 20%
a- Select A Topic. 3%
b- Project Outline presentation. 7%
c- Project Presentation. 10 %
3- Final Exam. (In-class) 70%
Total Grade 100%
Part I: Environment of International
Financial Management

Chapter (1) Introduction:

Multinational Enterprise & Multinational
Financial Management
 Ch.1 : MNCs Classification:
Based on type of the products.

Classification of Companies: base on how they produce &

market their products
1- International Cos. (INCs.)
2- Multinational Cos. (MNCs.)
3-Transnational Cos. (TNCs.)
MNC. Is a co. engaged in producing and selling goods &
services in more than one country. It ordinarily consists of a
parent co. located in the home country. and at least five or
six foreign subsidiaries, typically with a high degree of
strategic interaction among the units. Some MNCs have
upward of 100 foreign subsidiaries scattered a round the
world.The U.N. estimates that at least 35,000 co. a round
the world can be classified as MNCs.
 MNCs Classification: Based on Motives for
Expansion
1- Raw-Material Seekers.
They are the earliest form of MNCs. :They are exploring
raw materials such as oil , minerals .
Ex. Britch petroleum, Exxon Mobile, Texaco.Total
2- Market seekers:
Looking for wide markets measured by per capita
income & number of population
3- Cost Minimizers :
They will locate their business in countries having cost
competitive , brain –power advantages. They are the
most recent form of MNCs as Intel Microsoft
 MNCs Classification:
Based on Motives for Expansion

The behavioral Definition of the MNC.

• MNCs marketing management seeks global market
segment to penetrate & MNCs financial management
raise capital in the international capital market .The MNCs
is committed to seeking out, undertaking, and
integrating manufacturing, marketing ,R&D, and
financing opportunities on a a global basis.
• MNCs.is characterized by the state of mined than by
the size and worldwide dispersion of its assets
The integration of the worldwide operations are
flexibility, adaptability.
• Another critical aspect of competitiveness is focus;
means figuring out and building on what the does best.
 The Global Manager

The Global Manager: is a key to international competitiveness,

that is, the ability of the management to adjust to changes
and volatility at an ever faster rate. He should know:
1- how to get detailed, Accurate ,and received on timely fashion
knowledge of their operations.
2- how to design & make the products that match the
international consumers’ tastes.
3- where the raw materials and parts come from, how to get
their.
4- where the funds come from and what their cost.
5- the political and economic choices facing the key nations
and those choices will affect the outcomes of their decisions
 Politician & labor Union Concern About global
Competition

1-Politician & Labor Union: they denounce selling

a country’s assets to foreign direct investors b\c
it reduces the country. sovereignty,
However, foreign-owned cos. Account for 20%
and 50% in both Germany and Canada and
neither of the two countries have experienced
the slightest loss of sovereignty in addition it
improves productivity, efficiency , and the
standard of living.
 Politician & labor Union Concern About
global Competition (Cont,d)
A- From the Providing Countries views:
1- Investing abroad means depriving the country from creating
more jobs and reduces exports. While it creates more
exports and jobs abroad.
To the contrary, such investment abroad tends to increase
the home country export of components and services and
create more and higher- paying jobs.
Investing in the developing countries will increases its GDP
and per capita income ,hence, improves the standard of
living, therefore their demand for goods and services from
the rich countries will increase its exports, employment,and
support the high-paying jobs
 Politician & labor Union Concern About
global Competition (Cont,d)
B- Recipient Countries Views:
1- The argument that the poor countries drain jobs
from rich countries and depress wages. This
was a major theme of 1999’s “”Battle in Seattle”
and Doha unfinished round over reductions in
trade barriers sponsored by WTO are examples
of such an argument.
Indeed, the growth in trade and FDI since World
War II has raised the wealth and living standards
of millions in developed cos. While lifting
hundreds of millions of people around the world
out of abject poverty, e.g., Asian tigers ,China,
India, and Brazil.
Politician & labor Union Concern About
global Competition (Cont,d)
Countries that fail to invest in their physical
and human intellectual infrastructure are
likely to lose entrepreneurs and jobs to
Countries that do invest in both. In short,
economic integration is forcing government
sector as well as private sector to compete
rigorously
 Multinational Financial Management Theory &
Practice
MNCs. Financial Objective :
Their objective is to maximize shareholder wealth as
measured by the share price and coupon. This means the
companies’ management must effectively manage the
assets under their control. This is because :
1- Shareholders are the legal owners of the corporation and
management has to act in their best interests. Although other
stakeholders in the company do have rights but they are not
coequal. Allowing other stakeholders coequal control over
capital supplied by the shareholders is equivalent to allowing
one group to risk someone else’s capital . This undoubtedly
will produce numerous inefficiencies.
 MNCs. Financial Objective (Cont’d )

2-Companies maximizing shareholders wealth

provide the best defense against a hostile
takeover, Also they find it easier to attract equity
capital for future expansions.
3-Companies that maximize shareholders wealth
will have more money to distribute to all
stakeholders
 Criticisms of the MNCs.

One of the major criticism directed towards the

MNCs’ behavior Is summarized as looking at
them like an octopus with tentacles extended,
squeezing the nations of the world to satisfy the
insatiable appetite of its center.
Defense:
By linking activities globally, the world output can be
maximized. According to this view, greater profits from
overseas activities are the fair and just reward for
providing the world with new products, technology , and
the know-how.
 Criticisms of the MNCs.

Example: GM. Subsidiary in Australia was founded in1926

with and initial equity investment of A$ 3.5 million. The
earning were reinvested until 1954, at which time the 1 st
dividend (A$ 9.2 million) was paid to GM’s parent company in
Detroit. This amount seemed reasonable to GM. management,
Considering the 28 years of foregoing dividend , but the
Australian press and politicians denounced a dividend equal to
more than 260% of GM. Original equity investment They
considered it as an economic exploitation by imperialism.
 Differences b/w Domestic & Multinational Cos.

Both they have two basic functions:

- Financing decision, involving generating funds from internal
and external sources at the lowest cost possible in long-run.
- Investment decision, concerned with the allocation of funds
over time so as to maximize shareholders wealth.

But MNCs. have different themes:

I- MNCs. Managements face different problems that have no
domestic counterparts. These problems include:
1-Exchang rate risks 2-Inflation risks
3-Differences in tax rates 4-Multiple financial markets
5-Political Risks
 Differences b/w Domestic & Multinational
Cos. (cont’d)
II-The ability of MNCs. To move people, money, and material in
a global basis enables it to be more than the sum of its
parts , b/c:
1- Can access segmented capital markets to lower its overall
cost capital
2- shift profits to lower its taxes
3- take advantage of international diversification of market
and production sites to reduce economic and country
risks.
III-It increases the bargaining power when they
negotiate investment agreements and operating
conditions with foreign governments and labor
unions
 Some Basic International Finance Concepts

1- Financial Economics: A discipline that emphasizes the

use of economic analysis to understand the basic
workings of financial markets particularly the
measurement and pricing of risk and the intertemporal
allocation of funds. In this regard three concepts are of a
particular importance in developing a theoretical
foundation for international finance:
2- Arbitrage : the purchase of assets or commodities in one
market for an immediate resale in another market to get
the prices differences until the market imperfections
disappear and insures market efficiency, , such as tax
arbitrage ,securities arbitrage , forex arbitrage. Arbitrage
involve almost no risk.
 Some Basic International Finance Concepts
(Cont’d)
2-Market Efficiency: Is the one in which the prices of traded assets
readily incorporate new information ( complete ,accurate, and flow in an
orderly fashion with ability to analyze and swiftly make the proper
decisions) – lacking this mechanism will lead to crisis e.g., the Asian crisis
mid of 1997 and the global financial crisis September 2008.
3- Capital Asset Pricing Model (CAPM): refers to the way in which
financial assets are valued with their anticipated risks and returns. Finding
a relationship (assumed to be negative) b/w the risk of a financial asset
(measured by return variability - Systematic or Unsystematic) and the
required return of an asset is the core of this model or more general The
Arbitrage Pricing Model (APM)
Risk Classification
1- Unsystematic (Diversifiable risk con be eliminated by assets
diversification)
2- Systematic (non-diversifiable) risk by definition can not be eliminated ,
thus the investor should be compensated with the fare premium of
bearing such a risk
However total risk should be compensated for. Also, total cost could be
minimized by diversification assets portfolio and geographical portfolio
 1st Homework Assignment

1- a. What are the various categories of multinational firms?

b. What is the motivation for international expansion

of firms within each category?

2- a. How does foreign competition limit the prices that domestic

companies can charge and the wages and benefits that
workers can demand ?
b. What political solutions that can help Cos. and unions avoid
the limitations imposed by foreign competition?
c. Who pays for these political solutions? Explain.

3- a. What factors appear to underlie both the Asian crisis and the
global financial crisis?
b. What lessons can we learn from this crisis?
 1st Homework Assignment (Cont’d)

4 - What is an efficient market?

5. a. What is CAPM.?
b. What is the basic message of the CAPM.?
c. How might a MNC. Use the CAPM.?
6- A memorandum by US Labor Secretary to the US
president suggested that the gov’t. analyze U.S.
companies that invest overseas rather than at
home. According to him, this kind of investment hurts
exports and destroy well-paying jobs. Comment on this
argument.
7- a. Are MNCs riskier than purely domestic firms?
b. What data would you need to address this question?
c. Is there any reason to believe that MNCs may be less
risky than purely domestic firms ?Explain.
 Ch.(2):The Determination of Exchange
Rates
Some Basic Concepts:
1-Currency Appreciation or Depreciation :
is a decrease or increase in the market value of a floating
currency, one whose value is set by the market forces
(demand & supply).
2-Currency Devaluation or Revaluation:
is a decrease or increase in the par value of a pegged
currency, one whose value is set by the government.
 Setting the Equilibrium Spot Exchange
Rate
• The spot exchange rate :
is the price of one country’s currency in terms of
another country’s currency (reference currency)
which is traded for immediate delivery.
• The forward exchange rate :
is the price at which a foreign exchange currency is
quoted and delivered at a specific future date .
 Setting the Equilibrium Spot Exchange
Rate (Cont’d)
The equilibrium Exchange Rate
- Demand for the euro by the Americans:
- To import German’s
* goods , services ,and assets E=$
S
- Supply of the euro received
by the American e0
(euro 1=$1.4)
- To export American’s
* goods , services ,and assets
D

o Q euro
Q0
 Setting the Equilibrium Spot Exchange
Rate (Cont’d)
• Factors that affect the Equilibrium Exchange Rate
(Current Events)
1- Relative Inflation Rates:
If inflation in US > Inflation in Germany , E=$ S1
then the American are likely to demand S
more of the Germans products (demand e1
more of the euro) Also the Germans are
likely to switch to (euro 1=$1.4 ) e0
substitute their imports
D1
from US products to Germans domestically
D
Produced goods and services. Therefore
the supply of the euro in US will decrease O Q euro
The resultant : an appreciation of the exchange Q0 Q1
rate of the euro vis a– vis the US $
• Factors that affect the Equilibrium Exchange
Rate (Cont’d)
Class Exercise

2- Relative Interest Rates

3- Relative Economic Growth Rates
4- Political & Economic Risk E=$
S

(euro 1=$1.4) e0

o Q euro
Q0
 Calculating Exchange Rate Changes

• The % of Appreciation or Depreciation

= (New exchange rate - Old exchange rate) / Old exchange rate
= (e1 - eo) / e0
Ex.1 The US dollar value of the euro was determined at € 1 = $ 1.6500 in year 2008.Now,

in year 2011 the exchange rate of euro is € 1= $ 1.4000. Determine whether the
value of the euro is appreciating or depreciating ? calculate it in percentage.
Alternatively, determine whether the value of the $ is appreciating or depreciating
? Calculate it in percentage .

Ex. 2 The exchange rate of the dollar ($) vis the Egyptian pound was equal $ 1 = LE
5.5000 in 2010. Now the exchange rate is $ 1 = LE 6.0000 in 2011. Determine
whether the value of the LE is appreciating or depreciating ? calculate it in
percentage. Alternatively, determine whether the value of the $ is appreciating or
depreciating ? Calculate it in percentage .
 Calculating Exchange Rate Changes (Cont’d)
Answers
Ex.1
1-The exchange rate of the euro is appreciating.
% of the appreciation = (1.4000–1.6500) / 1.6500 = - 0.1515 or 15.15 %
during the 2008 -2011 period.
2- The exchange rate of the $ is depreciating .
% of the depreciation = (1.6500 – 1.4000 ) / 1.4000 = 0.1786 or 17.86 %
during the 2008 -2011 period.
Ex.2
1-The exchange rate of the $ is appreciating.
% of the appreciation = (6.0000 – 5.5000 ) / 5.5000 = 0.0909 or 9.09 %
during the 2010 -2011 period.
2- The exchange rate of the LE is Depreciating .
% of the depreciation = (5.5000 – 6.0000 ) / 6.0000 = - 0.0833 or – 8. 33 %
during the 2010 -2011 period.
 Expectations & The Asset Market Model of
Exchange Rates

• Exchange Rate of a currency as a financial asset depend also

on conceivable (future) economic, political, And social factors.
• The Asset Market Model :Currencies As Financial Assets:
An exchange rate is simply the relative price of two financial
assets (like stocks, bonds, gold, or real estate) Unlike
products of goods & services, financial assets prices are
influenced little by the current events. Accordingly the
exchange rate of a currency just balances the relative supply
of, and demand for, assets denominated in this currency.
Consequently, shifts in preferences can lead to massive shifts
in currency values.
- US. $ Exchange rate case before 1960s. And after 1960s.
 Expectations & The Asset Market Model
of Exchange Rates (Cont’d)
1-The sounder the economic & political policies the more
valuable the nation’s currency will be, conversely, the more
uncertain a nations future economic & political policies, the
riskier its assets will be, and the more depressed and
volatile its currency’s value.
2-Central bank reputations & Independency.
If the C.B is conducting a sound monetary policy targeting
price stability, therefore reducing the risk of holding
currencies (fiat money) as a financial assets.
Ex. The Bundesbank (German’s central bank) before the
European Monetary Union) & The US Federal Reserve
System , and the Swiss bank are good examples of highly
reputable and independent central banks, while the central
banks of Spain, New zealand, and Italy are the opposite.
 Expectations & The Asset Market Model
of Exchange Rates (Cont’d)
• Currency Board ( The case of Argentina)
Under this system, there is no central bank. Instead the
currency board issues notes & coins that are convertible
on demand at a fixed rate into a foreign reserve
currency. Its reserves covers 100% or slightly more of its
notes & coins in circulation.
• The currency board has no discretionary monetary
policy (this reflect independency in conducting the
monetary policy.
• Home work Assignment
Solve the problems in page 76:
problems: 1, 4 ,and 5.
Case Study (Argentine, the 7th largest world
economy )

- Cavello,
the minister of economic announced the
Convertibility Act in 1990..the dollarization of the
monetary system but it needs a sound econ. policies

- The central bank was replaced by the currency board &

the Austral (Argentina money was 100% covered by gold
& $ and pegged to the US dollar .this reduced inflation
rate from 2,300 % in 1990 to 170 % in 1991 and 4 % in
1994. No seignorage.

-1990 the exchange rate was set at Austral 10,000 =$

1(1990) then changed to Peso 1 = $ 1(1993)
 Case Study (Argentine, the 7th largest world
economy )

- Since 1994 Argentine economy has suffered a series of

external shocks (Mexico – 94, Asian crisis-97, Russian
and Brazilian crisis-98/99) and Global financial crisis and
internal problems of sovereign huge budget deficit -,high
rate of unemployment ,and stagnation.

- 2001 Cavello devalued the Peso 1=$ 0.5 or Euro 0.5.

- 2002 ,the country experienced economic & political chaos

(5 presidents in 2 weeks and a moratorium of its 132
billion public debt .
- The peso depreciated by 50 %
 Currency Board
The currency board (CB) have been adopted by countries such as Hong Kong
(1983), Argentina (1991),Estonia (1992), Lithuania (1994) and Bulgaria (1997)
Advantages:
1- Speculative attacks against a currency do not occur in a currency
board system because you are credibly committed to fixed
exchange rates.
2- Currency boards are good for the stability of the banking and
financial system
3- Fixed exchange rate regimes, and CBs in particular, work better
than more flexible exchange rate regimes
4- Currency board are good for countries exporting world
commodities priced in foreign currency because such countries
cannot use the exchange rate to affect their real exchange rate
 Currency Board

Advantages (Cont’d) :
5-Currency boards are better than monetary unions
6-Currency boards avoid destabilizing international capital
flows.
7-Currency boards prevent real appreciations and loss of
competitiveness
8-Currency boards cannot collapse because the monetary
base is fully backed by the foreign reserves of the country
9-Currency boards leads to lower inflation rates than flexible
exchange rates
10-Currency boards lead to more fiscal discipline than flexible
exchange rate regimes
 Homework Assignment
- Solve the problems in page 76:
problems: 1, 4 ,and 5.
- “Dollarization by it self is no guarantee of
economic success, it is not a substitute of for
good economic policies” . comment
 Ch.(3)
The International Monetary System
3.1 Alternative Exchange rate systems
The International Monetary System:
It is the set of policies, institutions, practices,
regulations, and mechanism designed and
enforced by the International Monetary Fund
(IMF) to determine the exchange rate of a
currency with another.
 Ch.(3)
The International Monetary System
The current exchange rate system (the high hybrid
system) :
1- Free float system (clean float system)
The equilibrium exchange rate is determined by the free
interaction b/w demand & supply of which both of them
affected by current and future events mentioned earlier.
- Volatility increases uncertainty, therefore this system is
good for economies adopting sound and credible
economic policies.
- 36 Countries Including 2 Arab countries; Somalia, Yemen
 1- Free float system (clean float system)

S3 (2003)
Ex
S1 (2001) Ex

S4 (2004)
3
3
1
1
2
2
4
4
D1 (2001)
D2 (2002
o o year
Q
2001 2002 2003 2004
The equilibrium exchange rate of the euro vis-à-vis the US $ (e1) is determine
freely by the intersection b/w demand(D1) for & supply of the foreign currency
(euro) in 2001, and experience a depreciation when D1 for the euro decreases to D2
in 2002 and then appreciate when S1 of the euro decreases to S3 in 2003 . Finally, it
depreciates when the S of the euro increases to S4 in 2004.
 The International Monetary System
(Cont’d)
2- Managed float system (Dirty float system)
The central bank intervene to smooth out exchange rate
fluctuations. (62 Countries including 5 Arab Cos. Algeria,
Egypt ,Mauritania ,Sudan ,Tunisia
Classification: based on the central bank intervention
approach in his reliance on market forces.
a- Smoothing out daily fluctuations (Crawling peg):
with an aim to bring about long-term currency depreciation or
appreciation. i.e., the Brazilian real and Russian ruble are
allowed to depreciate monthly by about 0.6 and 0.5
respectively against the $ - the Polish zloty depreciated
monthly by 1% against a basket of currencies.
 The International Monetary System
(Cont’d)
b- Leaning against the wind.
- Designed to moderate or prevent abrupt short and
medium-term fluctuations brought about by a random
events whose effects are expected to be temporary .
- This policy is questionable ,whether the gov’t. is capable
of distinguish b/w temporary and fundamental events.
c- Unofficial pegging.
- This strategy resist fundamental upward or downward
exchange rate movements for reasons clearly unrelated
to exchange rate forces.
- Japan historically resisted revaluation of the yen for fear
of its effect on its exports
 The International Monetary System
(Cont’d)
3- Target-zone arrangement.
- Countries adjust their national economic policies to
maintain their exchange rates within a specific
margin around agreed-upon fixed central
exchange rate .
- This system existed for the major European
currencies participating in EMS which led the euro
currency.
 The International Monetary System
(Cont’d)
4- Fixed rate system
- Such as the Bretton Woods system , gov’t. are
committed to maintain target exchange rates (par
value). Each central bank has to intervene in the
market whenever its exchange rate threaten to
deviate from its stated par value by more than
agreed margin (one percent)
- The resulting coordination of monetary policies
ensures that all member countries have the same
inflation rate. Therefore ,the monetary policy will
be a subordinate to the exchange rate policy (like
Currency Board system)
 The International Monetary System
(Cont’d)
5- Currency Peg
a- Pegged to the US dollars (32 countries, including11 Arab
countries-the gulf cos., Syria, Djibouti, Iraq, Jordan, Lebanon
b- Pegged to the euro. (26 countries, including ERM II, CFA)
c- Pegged to other currencies ( 6 countries)
d- Pegged to currency basket (7 countries-including Libya,
Morocco)
6 – Use foreign currency with no local currency.
(24 countries including 7& they are adopting the US
dollars currency & 12 they use the euro and belong to
the euro area. (The recent number of countries is 41)
 The International Monetary System
(Cont’d)

6- Exchange Arrangements with No Separate Legal Tender

The currency of another country circulates as the sole
legal tender (formal dollarization), or the member
belongs to a monetary or currency union in which the
same legal tender is shared by the members of the
union. Adopting such regimes implies the complete
surrender of the monetary authorities' independent
control over domestic monetary policy.
 3.2 A Brief History of the International Monetary
System
The Gold Standard (1834-1914) - Fixed exchange rate
system
I- Gold coins standard.
II- Gold bouillon standard

Conditions
1- Determining a Fixed rate b/w each country currency and a

specific weight of gold .i.e., one ounce of gold = ₤ 4.2474

and =$ 20.67. ₤(1) = $ 4.8665
2- Full convertibility into gold
3- Free export and import of gold
 3.2 A Brief History of the International
Monetary System
III- Gold Exchange Standard (1925-1931)
The gold standard broke down during World War
(I),1914 and was briefly reinstated from 1925 to
1931.Under this standard, the US and England
could hold only gold reserves, but other nations
could hold both gold and $ or pounds as
reserves. In 1931, England departed from gold
in the face of massive gold and capital outflows.
 A Brief History of the International Monetary System
(Cont’d)

The break down of the International Monetary System (1931

-1944)
England devaluated the pound, 25 other nations devaluated their
currencies to maintain trade competitiveness. This beggar-thy-neighbor
devaluation led to a trade war which led to trade protection policies.

The Bretton Woods (The US $ Standard) Monetary System (1945 -1971)

Under this system the rules are:
1- Each gov’t. pledged to maintain a fixed ,or pegged exchange rate for its
currency vis-à-vis the US.$ or gold (1 ounce of gold = US $ 35). The ex.
rate of each currency is allowed to fluctuate only within a range of +/- 1%
around its par value.
 A Brief History of the International Monetary
System (Cont’d)

3- US. $ are always convertible to gold at the above par

value.

2- To maintain the ex..rate par value central banks

intervene in the forex market by buying & selling the US.
$. The IMF stands ready to provide the necessary forex.
to members when experiencing a short-term deficit.
Devaluation is necessary when the deficit is a long-term.

The system, provided discipline in econ. Policies.

Reduced uncertainty.
 A Brief History of the International Monetary System
(Cont’d)

The Post-Bretton Woods System (1971 – Present)

- US. authorities terminated the $ convertibility in 1971.
- US. authorities devaluated its currency.
- US. Authorities adopted a free float system.
- The IMF is setting an International econ. Coordination mechanism
(G-8 )
The European Monetary System (EMS) & The monetary Union(1979)
- ECU was created.
- Maastricht Treaty (1992)
1- Conversion Criterion:
- Gov’t debt not to exceed 60 % of the nation’s GDP.
- Gov’t. budget deficit not to exceed 3 % of the nation’s GDP.
- Inflation not to exceed 1.5 % above the average rate of the
three lowest-inflation nations.
 A Brief History of the International Monetary
System (Cont’d)

- Long-term interest rate ≤ 2 % higher than the

average (i) in the three lowest-inflation nations.
- launching the euro. In Jan. 1999 as a unit of account,
then in June 2001 as a parallel currency, finally in
Jan. 2002 as a single European currency

• The establishment of the European Central Bank

 Ch.3- Home Work Assignment
1. a. What are the five basic mechanism for establishing exchange rates?
b. How does each work?
c. What costs and benefits are associated with each mechanism?
d. Have each rate movements under the current system of managed
floating been excessive ? Explain.
2. Suppose nations attempt to pursue independent monetary policies. How
well exchange rates behave?
3. The experience of fixed exchange-rate systems and target- zones
arrangements have not been entirely satisfactory.
a. What lessons can economists draw from the breakdown of the
Bretton Woods system?
b. What lessons can economists draw from the exchange rate
experience of EMS.
4. How did the EMS limit the econ. Ability of each member nation to set its
interest rate to be different from Germany’s?
 Ch.3- Home Work Assignment (Cont’d)

Problems
1. By some estimates, $ 185 billion to $ 260 billion in
currency is held outside the US.
a. What is the value to the US. Of the signorage associated with
these overseas dollars?
b. Who in US. realizes this seigniorage?
 Ch. 5
The BALANCE OF PAYMENT (BOP)
1-Definition & Categories
• Definition
Is an accounting statement (T account) that
summarizes all the intern’l econ. transactions
b/w residents of a home country and residents of
all other countries .
• Currency inflow are recorded as credits (receipts)
with (+) sign.
• Currency outflow are recorded as debits (payments)
with(-) sign .
 The BALANCE OF PAYMENT (BOP)- Cont’d

• BOP Categories .
I- Current account :
Records flows of goods, services, and transfers
II- Capital account :
Records flows of public and private investment and lending
activities.
III- Official reserve account :
measures changes in holdings of gold and foreign currencies
(reserve assets) by official monetary institutions .
 I- Current account
Main Items
Credit Debit

1-Trade Account EX Goods IM goods

2-Trade in Services EX Services IM services

Ex. Tourism, transportation,

traveling, .. etc
3- Investment income. Receipts Payments

Ex. Return on deposits

,securities and FDI
4- Unilateral Transfers (official) Foreign aids Nat’l aids
(private) nat’l remittance foreign remittance
 II- Capital account
Main Items: Credit Debit

5- Private investments FDI NDI

FI in Portfolio NI in Portfolio

6- Official lending
Borrowing Lending

7- Debit Repayments
Receipts Payments
 III- Official reserve account
Main Items Credit (+) Debit (-)
8- Official reserve account :
Changes in the foreign
Decrease Increase
reserve holdings by the
monetary institutions.
9- Statistical discrepancy XXX XXX
( Error & Omission)

Overall BOP (in accounting sense)

Current A/C + Capital A/C +Official Reserve A/C = BOP = 0
BOP (in economic sense)
Items: all excluding item # 8 surplus credit > debit
or deficit credit < debit
 2-The Macroeconomic Accounting
Identities
1- Nat’l Account Equilibrium
• Nat’l Income = Consumption (C) + Savings (S) ….(1)
• Nat’l Spending = Consumption (C) + Investment (I)..(2)
• Nat’l Income – Nat’l Spending = S - I …………….(3)
2- The link b/w Current & Capital Accounts
d. Nat’l Income – Domestic Spending = Export …….(4)
e. Nat’l Spending - Domestic Spending = Import …….. (5)
f. Nat’l Income - Nat’l Spending = Export – Import …. (6)
g. S - I = X - M (Net Foreign Investment) ….(7)
Conclusions :
When S > I then X > M means Current A/C surplus =
Deficit in the Capital A/C and / or Official Reserve A/C
 2-The Macroeconomic Accounting
Identities (Cont’d)
3- Gov’t. Budget (Spending – Taxes) & Current
A/C
a- Nat’l Income = Private (C) + Priv.S + Taxes ……1
b- Nat’l Spending = Priv. (C) + Priv. I + Gov’t. Spending …2
c- Nat’l Income - Nat’l Spending = Priv. S – Priv. I + Gov’t.
Savings ………………3
D- Current A/C (X – M) = Priv. S Gap +Gov’t. Savings …4
 3- Coping With The Current A/C Deficit

A country with a current a/c deficit suggests:

1. Currency Devaluation 2. Protectionism

1. Currency Devaluation:
A current a/c deficit (X<M) therefore devalue the
currency will:
- make X cheaper – foreigner will demand more X
- make M expensive – Nat’l will demand less M
the current a/c deficit will be corrected.
 3- Coping With The Current A/C Deficit
(Cont’d)
• The US. experience does not support theory
of currency devaluation .
The overall changes in the $ value explain less than
4%of the variation in US. Current a/c balance as % of
GDP over the period.
Two explanations:
1- Lagged effects
2- J-Curve Theory
 2- J-Curve Theory
-During the early 80s US. Attractive investment climate &
political and economic turmoil elsewhere. $ value
appreciates and the Capital account surplus with current
account deficit . 4 yrs later the trade a/c improved. Why ?
• In the short-run:

Net ∆ in trade a/c

Currency depreciation –
Currency depreciation
worsen the trade a/c b/c
Price effect dominate
the volume effect on M 0
Time
• In the long-run:
• the adjustment
in both the monetary & fiscal
policy could bring a positive impact on the trade a/c.
 Classwork

1-How would each of the following transactions show up on the US.

balance of payments account?
a. Payment of $50 m. in social security to US citizens living in Costa
Rica.
b. Sale overseas of $12.5 Elvis Presley CDs.
c. Tuition receipts of $ 3 b. received by American universities from
foreign students.
d. Payments of $ 1 m. to US consultants by a Mexican company.
e. Sale of a $100 m. Eurobond issue in London by IBM.
f. Investment of $25 m. by Ford to build a parts plant in Argentina .
g. Payment of $45 m. in dividends to US. Citizens from foreign
companies.
Homework :
- Answer Qs. 2, 5 ,and 8 page 194
- Solve problems, 2,3,4,and 5 Page 195.
 Mid-Term Take home exam

Q.1 “The exchange rate risks is one of the major

challenges faced by the MNCs” explain this statement in
light of the econ. Literature presented in Ch.1 & 2 .
Q.2 “The Gulf co-operation Council (GCC) members is
planning to reach a Gulf monetary Union with one
currency (Gulf Dinar) by 2010” Discuss the challenges
that will be faced by these countries in light of the
literature presented in Ch. 2 related to the EMS
experience.
 II-The Foreign Exchange & Derivatives Markets
Ch. 7- The foreign Exchange Market
1- Organization of The Forex Market
The Forex Market: Is arrangements to trade one currency with
Another, mainly electronically.
Interbank Market :Is a wholesale market in which major banks trade
with one another. Account for 95 % of the foreign exchange transactions
denominated by about 20 major bank.
Classification:
Spot market: currencies are traded for immediate delivery; i.e., within 2
business days after the transaction has been concluded. account for about
40% of the market
Forward market: contracts are made to trade currencies for future
delivery. Account for 9%
The remaining 51% of the market consists of swap transactions ; a
backage of a spot & a forward contract.
 1- Organization of The Forex Market
(cont’d)
Forex. Trading Systems: Conducted by Telephone , Telex,
or the SWIFT (Society for Worldwide Inter-bank Financial
Telecommunications)
Trade in goods & services represent only 5% of the
total transactions.
Capital transactions represent 95% of the total
-The market Spreads in a number of leading financial centers ;London
($637b), New York($351b), Tokyo($149b), Singapore($140b), Frankfurt
($100b), Zurich($85b), Hong Kong($80b), Paris($75b), Amsterdam, Toronto,
Milan and other cities.
-Total Transactions:1.5 Trillion / day in 1999 compared to 0.26 trillion / day in
1986 and 0.01 trillion / day in1973.
-About 60% of the total Transaction is in US dollar
 2-Spot Market Quotations:

- Based on using the US dollar as the international central currency

among banks (inter-bank quotations).

American terms: Numbers of European terms: Numbers of foreign

US.$ per unit of foreign currency currency units per US.$

- Based on trading all currencies b/w banks & non-bank customers.

Direct Quotations: Inside any country Indirect Quotations: outside any

expressed in the number of domestic country expressed in the number of
currency units per one unit of a foreign foreign currency units per one unit of the
currency country domestic currency
 2-Spot Market Quotations (Cont’d)

• Forex Transaction Cost:

Dealers are not charging commission, but they earn from the spread b/w
buy (bid) less and sell (ask) high to coverits transaction cost which depends
on:
1- market maturity
2- currency risk
3- profit margin for tied-up in the business.
Ex. € 1 = $ 1.3724-38 . This means the dealer buy (bid) at a price of
€ 1 = $ 1.3724 and sell the euro at (ask) price of € 1 = $ 1.3738
With a spread of 14 pips
Ask price – Bid price

Spread percent = Ask price × 100 =

= 0.0014/ 1.3738 × 100 = 0.102 %

Ex $ 1 = ₤e 5.6724-923 Then spread % ={ (5.6923-5.6724) / 5.6923} × 100=0.35%
 2-Spot Market Quotations (Cont’d)

Cross Rates:
In Egypt $ 1 = ₤e 5.6724-923 and the € 1= $ 1.3612-28. or
$ 1 = € 0.7338- 46 What is the
direct quote for the US $ in Egypt.
Answer:
Bid rate for the euro. In Egypt € 1 = $ 1.3612 × ₤e 5.6724 = ₤e 7.7213
Ask rate for the euro in Egypt € 1 = ₤e 5.6923 × $ 1.3646 = 7.7677
Currency Arbitrage New York Start $ 1 million
Finish with $
sell $ 1 million in
Sell ₤ for Frankfurt at €=$ 1.3620
$ divided by $ 1.3620

₤= € 1.7500 €734214.39
London Sell € for Frankfurt
 2-Spot Market Quotations (Cont’d)

Payment Settlement:
The value date for a spot transactions :the date on which the monies
must be paid to the parties involved . It is the 2nd working day after the
date in which the transactions is concluded.
Exch. Risk: the position bankers and agent are taking when they
exposing themselves to exchange cross border transactions .It will be
spelled out in a wider spread in the Bid – Ask quote .
The Mechanics of Spot Transactions:
1- Receiving and accepting a verbal quote from the trader US
Bank .
2- Asking the importer to specify 2 a/c :
a. An a/c with a US bank to debt the equivalent $ amount at agreed
exch. Rate US $ =
b. the hong kong supplier’s a/c to be credited by the one million HK $
 The Mechanics of Spot Transactions:

3- Forward a dealing slip containing the relevant

information to the settlement dept. in the same day.
4-contract note includes the amount of the foreign exch.
And the conformation of the payments instructions will
be sent to the importer. Also the settlement dept. will
then cable bank’s correspondent or branch in hong kong
requesting the transfer of HK $ 1,000,000 from its
nostro a/c ( working balance maintained by the bank’s
correspondent or branch to facilitate delivery and receipt
of currencies) to the account specified by the importer.
5- On the value date , the US bank will debt the importer’s
a/c and the exporter will have his a/c credited by the
Hong kong bank’s correspondent or branch
 The Mechanics of Spot Transactions:

6- Settlement risk (Herstatt risk)

• It is a kind of credit risk that a bank will deliver currency in one
side of a foreign deal only to find that its counterparty has not
any money in return.
• In the case of the Deutsche Herstatt bank b/c of different time
zones ,there may be a delay, when the German regulator shut
down the bank after it had received the deutsche marks but
before it had delivered the dollars to its counterparty banks in
New York
• now a global clearing bank that would operate 24 hours a day
will settle both sides of foreign exchange trades
simultaneously as long as the banks’ accounts had sufficient
funds.
 3- The Forward Market

• It carries 2 types of risks:

1- Credit risk like the spot transactions but for longer
periods of time
2- Exchange risks due to its fluctuations
• A forward contract b/w a bank and a customer (could be
another bank) calls for a delivery, at fixed future date , of
a specific amount of one currency against dollar
payment at agreed upon exchange rate.
• Active forward markets exist for the euro, sterling pound,
the Canadian dollars, yen ,and the Swiss franc.
• Forward contracts for the currencies of the developing
countries are either limited or nonexisted.
 Example

US co. buys textiles from England with payments of ₤ 1

million due in 90 days. Thus the US. importer is short in
pound. Suppose the spot price of the pound is $ 1.99
During the next 90 days, the pound might rise against
the dollars ,raising the dollar cost of the textiles. The
importer can hedge against this exchange rate risk by
immediately negotiating a 90-day forward contract with a
bank at a price of, say ₤1=$ 2.00.
According to the contract, in 90 days the bank will give the
importer ₤1 million to pay for the textiles and the importer
will give the bank $ 2.00 million
 Example (Cont’d)
Hedging a future payment with a a Forward contract
1.95 1.96 1.97 1.98 1.99 2.00 2.o1 2.02

Forward contract
gain
Payment cost
In $ million

Forward contract
losses

(forward rate)

1.95 1.96 1.97 1.98 1.99 2.00 2.01 2.02 2.03 2.04 2.05
$ value of pounds in 90 days
 Forward Quotations

1- Outright rate : The actual quotation-for commercial

customers
2- Swap rate : may be expressed by inter-bank dealers in 2
ways :- forward premium:If the forward rate is above the spot rate
. - forward discount :If the forward rate is below the spot rate
.Spot 30-dy 90-dy 180-dy
₤:$ 1.9855-60 4-6 9-14 25-35
SFr:$ 0.6963 19-17 26-22 42-35
The outright equivalent
Maturity Bid Ask Spread (%) Bid Ask Spread (%)
Spot $1.9775 1.9860 $0.6963 0.6968 0.072
30-dy 1.9759 1.9866 $0.6967 0.6974 0.100
90-dy 1.9764 1.9874 $0.6972 0.6982 0.143
180-dy 1.9880 1.9895 $0.6988 0.7006 0.257
 Forward Quotations
Forward rate – spot rate 360
Forward premium or = ×
discount annualized
Spot rate F. Contract
no. of dys.

Cross Rates : suppose a customer wants to sell 30-day forward ₤ against €

delivery.The market rates (expressed in European terms of foreign currency units per $)
are as follows:
₤:$ 1.8900-1.8920 Spot
1.8942-1.8975 30-day forward
€ :$ 1.3600-1.3615 Spot
1.3550-1.3580 30-day forward
The forward cross rate for selling ₤ against (buy) € is found as follows: forward ₤
are sold for $- ₤:$ 1.8975 & the $ to be received and simultaneously sold for 30
day forward € at a rate of € :$ 1.3550 .
Thus forward selling (ask) price ₤ against € = 1.8975 / 1.3550 =
Similarly, the forward buying (bid) rate for ₤ against € is 1.8942 /1.3580 =
The spot selling (ask) rate ₤ 1.8920 / 1.3600 = , Hence
‘the forward premium annualized =( - )/ × 360 / 30 = %
 Ch.(8)- Currency Options-Futures
An option: is a financial instrument that gives the holder the right
but not the obligation to sell (put) or buy (call) another financial
instrument at a set price and expiration date.
Type of options:
1- American option: can be exercised at any time up to the expiration date.
2- European option: can be exercised only at maturity.
Option description
1- In-the-money option: is one that will be profitable when exercised at the
current exchange rate. (Strike price < Spot rate)
2- Out-of-the-money option: is one that would not be profitable to exercise
at the current exchange rate. (Strike price > Spot rate)
3- At-the-money option :is one whose exercise price is the same as the
spot exchange rate. (Strike price = Spot rate)

Exercised (strike) price :is one that the option is exercised.

 2- Currency Options (Cont’d)
Profit from buying a call option (Contract size: € 62.500 Exercise: $ 0.94/
€-option premium: $0.02 / € (1,250 /contract) - Expiration date 60 days)

Profit Exercise price

Potential unlimited profit

Spot price of
0 0.90 0.92 0.94 0.96 0.98 1.00 1.02
euro at
Limited Loss expiration

-1,250 Call premium Break-even price

Out-of-the-money At-the-money In-the-money

Inflow: spot sale of the euro

Outflow
Call Premium
 2- Currency Options (Cont’d)

Profit from buying a put option (Contract Size: € 62.500 Exercise : $

0.94/€ Option premium: $0.02 / € (1,250 /contract) - Expiration date 60 days)

2500 Break-even price Exercise price

Potential
profit up to
Profit $38,750 Potential unlimited profit

0 0.88 0.90 0.92 0.94 0.96 0.98 1.00 1.02

Limited Loss Limited loss Spot price of
euro at
expiration
Put premium

Out-of-the-money At-the-money In-the-money

Inflow: spot sale of the euro
Outflow
Call Premium
Exercise of option
 2- Currency Options (Cont’d)

Profit from selling a put option (Contract size:€ 62.500-Exercise price : $ 0.94/ €
- Option premium: $0.02 / € ($1,250 /contract) - Expiration date 60 days)
Break-even price
Put premium

Exercise price

1,250
Profit limited to put
premium $1,250

0 0.88 0.90 0.92 0.94 0.96 0.98 1.00 1.02

Potential loss
up to $38.750
2500
Out-of-the-money At-the-money In-the-money

Inflow: spot sale of the euro

Outflow
Call Premium
Exercise of option
Profit
 2- Currency Options (Cont’d)

Currency Option Pricing & Valuation

Total value Intrinsic value Time Value

The amount by which The amount by which the price of its the option is
in-the-money contract exceeds its intrinsic value

Call option = S –X , where S is the current Positively Affected by an

spot price and x is the exercise Increase in:
price - Time to expiration (usually)
- Volatility
- domestic/foreign (i)
differential
Put option = X –S intrinsic value is zero Positively Affected by an
if S –X < 0 increase in :
- Time to expiration (usually)
- Volatility
- domestic/foreign (i)
differential
2- Currency Options (Cont’d)
 Currency Futures Contracts

Currency Futures Contract : It is a contract for a specific quantities of a

given currencies ; the exchange rate is fixed at the time the contract is
entered into , and the delivery date is set by the board of directors of
the IMM (International Monetary Market – a division of the Chicago
Mercantile Exchange opened in 1972)
Currency Futures Contract Now Available in the following
currencies :-
Euro , yen , Australian dollar , British pound , Canadian dollar ,Swiss franc ,
New Zealand dollars , Russian ruble , Brazilian real , South African rand ,
Mexican peso .
A number of cross – rate contracts are available (Eruo/JY , AD/SF)
Contract sizes are standardized by amount of foreign currency :
₤ 62,500 , C$100,000 , SFr125,000 , AD100,000 ,
JY 12,500,000 , MP 500,000 , € 125,000 .
 Currency Futures Contracts (Cont,d)
Contract Specifications for Foreign Currency Futures
Aust $ ₤ C$ € JY Mex.P SFr
Contract Size 100,000 62,500 100,000 125,500 12,500,000 500,000 125,000
Performance
bond requirs.(Margin requrs.)
Initial : $1,485 $1,350 $608 $2,025 $2,025 $3,125 $1,485
Maintenance: $1,100 $1,000 $450 $1,500 $1,500 $2,500 $1.075
Min.Price: $0.0001 $0.0002 $0.0001 $0.0001 $0.000001 $000025 $0.0001
Change: 1 pt. 2 pt. 1 pt. 1 pt. 1 pt. 1 pt.

Value of 1 Pt.: $10.00 $6.25 $10.00 $12.50 $12.50 $12.50 $12.50

Month traded : ---------March, June, Sept. , Dec.---------------------
Trading hours.: ----------7:20 A.M. – 2:00 P.M. (central Time) -------------
Last day of trading: The 2nd business day immediately preceding the the 3rd
Wed. of the delivery month
 Currency Futures Contracts (Cont,d)
EX: On Tuesday morning , an investor takes a long Position in
a Swiss franc futures contract that matures on Thursday
afternoon. The agreed-on price is $0.75 for SFr 125,000. To
begin, the investor must deposit into his account a
performance bond of $ 1,485. At the close of trading on
Tuesday, the futures price has risen to $0.755 . B/c of daily
settlement, three thing occur. First, the investor receives his
cash profit of $625 (125,000 × 0.005). Second, the existing
FC with the price of $0.75 is cancelled . Third, the investor
receives a new FC with the prevailing price of $0.755.Thus
the value of the FC is set to zero at the end of each trading
day.
 Currency Futures Contracts (Cont,d)
EX: On Tuesday morning , an investor takes a long Position in
a Swiss franc futures contract that matures on Thursday
afternoon. The agreed-on price is $0.75 for SFr 125,000. To
begin, the investor must deposit into his account a
performance bond of $ 1,485. At the close of trading on
Tuesday, the futures price has risen to $0.755 . B/c of daily
settlement, three thing occur. First, the investor receives his
cash profit of $625 (125,000 × 0.005). Second, the existing
FC with the price of $0.75 is cancelled . Third, the investor
receives a new FC with the prevailing price of $0.755.Thus
the value of the FC is set to zero at the end of each trading
day.
 Currency Futures Contracts (Cont,d)
At Wednesday close, the price has declined to $0.743. The
investor must pay the $1,500 loss (125,000 × 0.012) to
the other side ot the contract and trade in the old
contract for a new one with a a price of S0.743. At
Thursday close, the price drops to $0.74, and the
contract matures. The investor pa$375 loss to the other
side and takes delivery of the Siss francs, paying the
prevailing price of $0.74. The investor has had a net loss
on the contract of $1,250 ($625 -1,500 - $375) before
paying his commission.
 Currency Futures Contracts (Cont,d)
Time Action Cash Flow
Tuesday morning Investor buys SFr FC None
that matures in 2 days.
Price is $0.75.
Tuesday close FC price rises to $0.755 Investor receives
position is marked to market 125,000 × (0.755-
0.75)=$625
Wednesday close FC price drops to $0.743.Investor pays
position is marked to market 125,000 × (0.755 -
0.743)=$15,00
Thursday close FC price drops to $0.74 . (1) Investor pays
(1)FC is marked to market 125,000 × (0.743 – 0.74)=
$375
(2)Inestor takes delivery (2) Investor pays
of SFr125,000 125,000 × 0.74 =$92,500
Net loss on the FC =$1,250
 Forward Contract Vs. Futures Contract
Forward Contract Futures Contract
1-Trading: - Among individuals - By brokers face to face on a By
telephone nor telex trading floor

2- Regulation: - Self-regulating - IMM is regulated by the Comd. Futs.

Trad. Commission (CFTC).
3- Frequency
of Delivery - 90% of all FCs. Are - Less than 1% of IMM FCs are
settled by actual by delivery.
delivery.
4- Size of Contract:
- Individually tailored - Standardized in terms of
much larger than the currency amount
the FCs.
5- Delivery Date:
- Banks offer it any date - on a few specific dates
6- Settlement: - on the date agreed on b/w – Made daily via the Exchs.
the bank and the customer Clearing House. Gains on position
values may be withdrawn / losses
are collected daily . The practice
is known as marking to market
 Forward Contract Vs. Futures Contract
Forward Contract Futures Contract

7- Quotes : - In European terms - American terms

8- Transaction Costs:
- Bid – ask (spread) basis - Brokerage fees for buy
and sell orders
9-Margins: - Not required - Required
10- Credit Risk: -Borne by each party - The ECH becomes the
of the contract opposite side to each
FCs, thereby reducing
credit risk substantially.
 CH. (9) :Interest rate &currency
swaps
Objectives: to arrange complex, innovative financing that
reduce borrowing (funding) costs and increase control over
(hedge against) interest rate risk and foreign currency
exposure.
Interest Rate Swaps: It is an agreement b/w two parties to
exchange US $ interest payments for specific maturity on
an agreed upon notional amount .
Notional principal: it is a reference amount against which the
interest is calculated. No principal ever changes hands.
Maturities range from less than a year to more than 15
years, however, most transactions fall within a two-year to
10-year period.
 CH. (9) :Interest rate &currency
swaps
Objectives: to arrange complex, innovative financing that
reduce borrowing (funding) costs and increase control over
(hedge against) interest rate risk and foreign currency
exposure.
Interest Rate Swaps: It is an agreement b/w two parties to
exchange US $ interest payments for specific maturity on
an agreed upon notional amount .
Notional principal: it is a reference amount against which the
interest is calculated. No principal ever changes hands.
Maturities range from less than a year to more than 15
years, however, most transactions fall within a two-year to
10-year period.
 Interest rate &currency swaps (cont’d)
Types of interest swaps: The two main types are:
1- Coupon Swap: one party pays a fixed rate calculated at the time of
trade as a spread to a particular Treasury bond, and the other side pays
a floating interest payments that resets periodically throughout the life of
the deal against a designated index
2- Basis Swap: two parties exchange floating interest payments based
on different reference rates .
(LIBOR) The most important reference rate in swaps & other financial
transactions is Landon Inter-bank offered Rate (LIBOR) : that is the
average interest rate offered by a specific group of multinational banks in
London for US $ deposits of a stated maturity and is used as a base
index for setting rates for many floating rate financial instruments.
Eurocurrency : is a $ or other freely convertible currency deposited in a
bank outside its currency of origin .
Ex. A dollar on deposit in London banks is a Eurodollar.
Eurobond is a bond sold outside the country in whose currency it is
denominated; a $ bond sold in Paris by IBM would be a Eurobond
Eurobond can carry either : 1- Fixed rates 2- Floating rates
 The Classic Swap Transactions
Ex: Two counterparties A and B both require $ 100
million for 5-year period. To reduce their financing
risks, counterparty A would like to borrow at a fixed
rate, whereas counterparty B would prefer to borrow
at a floating rate. Suppose that A is a company with
a BBB rating and B is a AAA-rated bank. Although A
has a good access to banks or other sources of
floating-rate funds for its operations, it has difficulty
raising fixed-rate funds from bonds issues in the
capital markets at a price it finds attractive. By
contrast, B can borrow at the finest rates in either
market. The cost ton each party of accessing either
the fixed-rate or the floating-rate market for a new 5-
year debt issue is as follows:
 The Classic Swap Transactions

Borrower Fixed-rate available Floating-rate available

Counter party A 8.5% 6-month LIBOR + 0.5%

Counter party B 7.0% 6-month LIBOR

Difference 1.5% 0.5%

Credit quality difference b/w a AAA-rated party B a BBB-rated party A is

worth 150 basis points, the other determines that this difference is worth
only 50 basis points, Through an interest rate swap, both parties can
take advantage of the 100 basis points spread differential. How could
they reduce cost of finance by taking advantage of this differential.
A will take out a $100 million. 5-year floating-rate Eurodollar loan from a
syndicate of a banks at an interest rate of LIBOR +0.5%. At the same
time, B will issue a $100 million , 5-year Eurobond carrying a fixed rate
of 7% .
 The Classic Swap Transactions
Entering into a swap
A & B will enter into an interest rate swap with Big-bank taking b/c they
exploit the different comparative advantage of credit quality across
financial markets
Counterparty A will agrees that it will pay Big-bank 7.35% for 5-year,
with payments calculated by multiplying that by $100 million notional
principal amount. In return for the payment, Big-bank agrees to pay
A 6-month LIBOR over 5 years, with reset dates matching the rest
dates on its floating rate loan. Through the swap, A has managed to
turn a floating rate loan into a a fixed-rate loan costing 7.85%. In a
similar fashion B enters into a swap with Big-bank whereby it agrees
to pay 6-month LIBOR to Big-bank on a notional principal amount of
$100 million for 5 years in exchange for receiving payments of
7.25%. Thus has swapped a fixed-rate loan for a floating rate loan
carrying an effective cost of LIBOR – 0.25.
 The Classic Swap Transactions
Entering into a swap
A & B will enter into an interest rate swap with Big-bank taking b/c they
exploit the different comparative advantage of credit quality across
financial markets
Counterparty A will agrees that it will pay Big-bank 7.35% for 5-year,
with payments calculated by multiplying that by $100 million notional
principal amount. In return for the payment, Big-bank agrees to pay
A 6-month LIBOR over 5 years, with reset dates matching the rest
dates on its floating rate loan. Through the swap, A has managed to
turn a floating rate loan into a a fixed-rate loan costing 7.85%. In a
similar fashion B enters into a swap with Big-bank whereby it agrees
to pay 6-month LIBOR to Big-bank on a notional principal amount of
$100 million for 5 years in exchange for receiving payments of
7.25%. Thus has swapped a fixed-rate loan for a floating rate loan
carrying an effective cost of LIBOR – 0.25.
 The Classic Swap Transactions
Why would Big-bank enter into such Financial swap ?
Answer :Big-bank aims at achieving some profits, by
putting
together both transaction:
Receive (from A) 7.35%
Pay (to B) 7.25%
Receive (from B) LIBOR
Pay (to A) LIBOR
Net 10 basis points

Big-bank thus receives compensation equal to $100,000 annually for

the next 5 years on $100 million swap transaction
 The Classic Swap Transactions
Classic Swap Structure (Risk reducing potential of interest swap)

7.35% 7.25%
Counterparty Counterparty
A LIBOR Big-bank LIBOR B

Net profit
7.35%
LIBOR+ 0.5% -7.25% 7%
+ LIBOR
- LIBOR

0.10%

Floating-rate $100 million loan $100million Eurobond

lender loan
5-year maturity 5-year maturity
Net cost Net cost
7.35% 7.25%
+ LIBOR+0.5% + LIBOR
- LIBOR LIBOR
-7.85% 7.0 %
 Cost Saving Associated with Swap

Cost reducing potential of interest swap

Normal Funding Cost After Difference
Party Cost Swap

Counterparty A 8.5% 7.85% 0.65%

Counterparty B LIBOR LIBOR – 0.25% 0.25%
Big-bank -- -- 0.10%

Total 100

In this example, (A) lowers its fixed-rate costs by 65 basis points,

(B) lowers its floating-rate costs by 25 basis points, and the Big-
bank receives 10 basis points for arranging the transaction bearing
the credit risk of the counterparties.
 Cost Saving Associated with Swap

Would financial arbitrage process expect to eliminate

any such cost savings opportunities associated with a
mispricing of credit quality?
The Answer is no, if the credit market is efficient.
Therefore, many players in the swaps market believe
that such perceived credit risk continue to exist. The
explosive growth in the swaps market supports this
belief.
AIso, this tremendous growth trend, may also indicate
the presence of other factors, such as differences and
risk aversion of lenders across markets, that are more
likely to persist
 Cost Saving Associated with Swap

Would financial arbitrage process expect to eliminate

any such cost savings opportunities associated with a
mispricing of credit quality?
The Answer is no, if the credit market is efficient.
Therefore, many players in the swaps market believe
that such perceived credit risk continue to exist. The
explosive growth in the swaps market supports this
belief.
AIso, this tremendous growth trend, may also indicate
the presence of other factors, such as differences and
risk aversion of lenders across markets, that are more
likely to persist
 Currency Swaps
Currency Swaps :It is an exchange of debt-service obligations denominated
in one currency for the service on an agreed upon principal amount of debt
denominated in another currency to help manage both interest rate and
exchange rate risk.
Ex. Suppose that Dow Chemical is looking to hedge some of its euro exposure
by borrowing in euro. At the same time, French tire manufacturer Michelin is
seeking $ to finance additional investment in the US market. Both want the
equivalent of $200 million in fixed-rate financing for 10 years. Dow can issue
$-denominated debt at a coupon rate of 7.5% or euro-denominated at a
coupon rate of 8.25%. Equivalent rates for Michelin are 7.7% in dollars and
8.1% in euros. Given that both companies have similar credit ratings, it is
clear that the best way for them to borrow in the other’s currency is to issue
debt in their own currencies and then swap the proceeds and future debt-
service payments.
Assume a current spot rate of € 1.1/ $ . Michelin would issue € 220 million
in 8.1% debt and Dow Chemical would float a bond issue of $200
million at 7.5%. The coupon payments on these bond issues are:
17,820,000 (0.081 × € 220,000,000) and $15,000,000
(0.075×$200,000,000), respectively, giving rise to the following debt
service payments.
 Currency Swaps
Year Michelin Dow Chemical
1-10 € 17,820,000 $15,000,000
10 € 220,000,000 $200,000,000
After swapping the proceeds at time zero (now), Dow Chemical
winds up with € 220 million in euro debt and Michelin has $200
million in debt to service. In subsequent years, they would exchange
coupon payments and the principal amount at repayment. The cash
inflows and outflows for both parties are summarized in the following
table. The net result is that the swap enables Dow to borrow fixed-
rate euros indirectly at 8.1%, saving 15 basis points relative to its
8.25% cost of borrowing euros directly, and Michelin can borrow
dollars at 7.5,saving 20 basis points relative to its direct cost of
7.7%.
 Currency Swaps
Ex: A fixed-for-fixed Euro –US dollar Currency Swap

Fixed-rate US $ debt Fixed-rate euro debt

€ 17.820 million- year

$15 million-1-10 -years

€ 220 million – year

$200 million- year 10
$200 million – time o

€ 220 million-time 0

1- 10
$200 million- year 10

10
$15.0 million-1-10
-years

$200 million – time o

Dow Chemical
Michelin
€ 220 million-time 0

Cost of borrowing € 17.820 million- year 1- 10 Cost of borrowing

euro 8.1% instead US $ - 7.5% instead
of 8.25% Of 7.7%
€ 220 million – year 10
Final :
Exam design:
Part I- Essay Qs – 3/2
Part II- Problems 4/3
Each for 9 marks
eslsca19@yahoogroups.com
moismail@tedata.net.eg
Use old edition – need to determine Chs.& Qs. And
Problems. Downloaded by Friday, June 1st .