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CHAPTER 1:

FOREIGN EXCHANGE MARKET

1.1 Introduction

The world has become so small. Businessmen and individual can legitimately move from

one country to another. However with existence of comparative advantages and imperfect

market, investors, tourists and businessmen have induced trade internationally. The

foreign currencies are vital to enable those dealing internationally to execute their

international transactions. The foreign currency is made available through foreign

exchange market.

1.2 The FOREX Market Definition

The foreign exchange market is an international market in which national currencies are

traded. It is not an organized market trading place in the same sense as stock or

commodity exchanges are. That is there is no single, physical site where buy and sell

orders are executed. Rather it consist an enormous, highly sophisticated, and efficient

global communication system in which most transactions are communicated verbally by

two parties and executed by telephone or telex. In summary we can say that, the FOREX

Market is an electronically linked network of participants that facilitates trade by trading

in foreign exchange.

The principle purpose of the FOREX market it to finance international trade and other

forms of international operations that regularly needs firms to MAKE and RECEIVE

payments in different foreign currencies. A Foreign currency refers to the currency of

other countries. For instance for Tanzanian living in the United Republic of Tanzania, a

foreign currency is any currency other than a Tanzanian shilling.

The FOREX market is a worldwide market and thus is extremely large. The London

FOREX market is the largest foreign exchange market followed by New York and then

Tokyo. Other important foreign exchange centres are Zurich and Frankfurt . 90% of

foreign currency deals are executed in US $; approximately 60% spot, 35% forward, 5%

futures and options

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The FOREX market is highly competitive:

• There are many buyers and sellers

• The commodity is homogeneous

• Via computer systems there is near perfect information on prices charged

Since the market is highly competitive, the prices of currencies are determined by supply

and demand forces. Virtually no differences exist between one FOREX market (e.g.

London) and another (e.g. Tokyo).

1.3 Functions of Foreign Exchange Market

1.3.1 Transfer of Purchasing Power

An international transaction involves parties from different countries with different

currencies. Each party would like to trade in its own currency. Foreign currency market

permit transfers of purchasing power denominated in one currency to another. For

instance, if a Japanese exporter invoices in Japanese yen for Suzuki Escudo exported to

Tanzanian Importer, then Tanzanian importer should buy Japanese yen with Tanzania

shilling or any other acceptable currency.

1.3.2 Facilitating International Trade and Investment

International trade and investment would not be possible without the ability to buy and

sell foreign currencies. Currencies must be bought and sold to enable those who need

certain currencies to get them.

1.3.3 Provision of Credit

The foreign exchange market provides a third source of credit. This is made through

specialized instruments such as bankers` acceptances and letters of credit. These

documents enable to finance international trade before delivery of goods.

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1.3.4 Minimization of Foreign Exchange Risk

International dealings are subjected to foreign exchange risk. This risk is associated with

unexpected change that may have positive or negative impact on the international

transactions. A change in exchange rate is said to be positive if it leads to material gain

and it is said negative if it leads to material loss. Since it is difficult to predict the

direction of expected change in exchange rate, then traders are uncertain of their future

position. In this case they would like to reduce the uncertainty through hedging i.e. the

forex market provides such an opportunity.

1.4 Participants in the Foreign Exchange Market

Participants in foreign exchange market refer to the actors who make foreign exchange

market active. They buy and sell foreign currencies for different purposes. The following

are participants in the foreign exchange market:

1.4.1 Large Commercial Banks

They are considered as the dominant players (main dealers) in the market. The

commercial banks hold “inventories” of FOREX which consist of deposit balances in

other bank (denominated in different currencies). These deposits are used to meet

customer requests. The banks deal either directly with other banks or more usually

through foreign exchange brokers.

1.4.2 Individuals

Individuals and firms use foreign exchange market for various purposes. Some may use

foreign exchange market for international portfolio investment, some may use foreign

exchange for purpose of hedging foreign exchange risk, and others use foreign exchange

market to facilitate commercial transactions e.g. exportation, importation, tourism etc.

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1.4.3 Speculators, Hedgers and Arbitrages

Speculators – these are the persons attempting to profit by trading on expectations about

prices in the future. They speculate by taking an open (unhedged) position in a foreign

currency and then closing that position after the exchange rate has moved one step in the

expected direction.

Hedgers - a currency trader is hedging if he or she enters into a contract to protect

oneself from a downside loss. However by hedging the trader also forfeits the potential

for an upside gain. The hedging can be done by entering in a forward contract, where the

traders can fix the exchange rate to be used in the future when the transaction crystallizes.

Arbitragers - arbitrage, generally means buying a product when its price is low and then

reselling it after its price rises in order to make a riskless profit. Currency arbitrage means

buying a currency in one market (say New York) at a low price and reselling, moments

later, in another market at a higher price.

1.4.4 Central Banks and Treasuries

They use the market to acquire or spend their foreign exchange reserves so as to

influence the price at which their own currency is traded. Central bank can influence

prices by raising interest rate, thus leads the home currency to depreciate relative to

foreign currencies or it can decrease interest rate, hence strengthen the home currency

relative to foreign currencies.

For example the Bank of Tanzania (BOT) may intervene in the market either to stabilize

the volatility of exchange rate trends or to stop the depreciation of the TZS when it

believes the TZS moves too far from an economically realistic valuation.

1.4.5 Foreign Exchange Brokers

These are agents who facilitate trading between dealers without themselves becoming

principals in the transaction. Brokers are experts in matching demand and supplies of

foreign currencies among their clients. They possess a knowledge which enables them

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to find at any time a dealer who wants to buy or sell any currency. For this service, they

charge small commission

1.4.6 International Investors

Most of the daily currencies transactions are made by investors. These investors, be they

investment companies, insurance companies, banks or others, are dealing with foreign

currency transactions. Many of these companies are charged to manage the savings of

others. Pension plans and mutual funds in some developed countries buy and sell billions

of dollars worth of assets daily. Banks, in the temporary possession of the deposits of

others do the same (this is also the case in Tanzania). Insurance companies manage large

portfolios which act as their capital to be used to pay off claims on accidents, casualties

and deaths. More and more of these companies look internationally to make the most of

their investments. Evidence indicates that much of the currency exchanges are done by

international investors rather than importers and exporters.

1.5 Exchange Rates

An exchange rate is the price of a currency expressed in terms of another currency.

The most heavily traded currency is the US dollar which is also known as the vehicle

currency i.e. a currency that is widely used to denominate international transactions.

Therefore normally all currencies are quoted against the US dollar.

For example, the value of the TZS is quoted as TZS 1,200/$, or one dollar can be

exchanged in the foreign exchange market for TZS 1,200. Evidently an exchange rate is

interpreted as the amount of a currency required to purchase one unit of the other

currency.

In the exchange rate quotation, the home currency is called underlying currency and the

foreign currency known as reference currency. That is, for the exchange rate TZS

1,200/$, TZS is the underlying currency and $ is the reference currency.

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1.6 Quotations of Foreign Exchange Rates

There are two types of exchange rate quotations. These are direct quote and indirect

quote.

1.6.1 Direct Quotation

A direct quote expresses the number of units a home currency can buy one unit of foreign

currency. For instance, if the local currency is Tanzanian shilling and the foreign

currency is Norwegian Kroner (NOK). Then, the direct quote of Nok in Tanzania will be

TZS100/NOK.

Direct quotation can also be presented as:

• TZS /NOK 100

• TZS 100 = 1 NOK

• NOK : TZS 100

Worldwide, quotations normally follow the direct quotation except the US and UK, that

follow indirect quotation style. So around the world:

Country (Currency) Quotation

Brazil (Real) Real 2.6640/$

Japan (Yen) ¥117.68/$

Singapore (S$) S$173.40/$

Switzerland (Swiss Franc) SF1.6158/$

1.6.2 Indirect Quotation

Indirect quote states the number of units a foreign currency can buy one unit of local

currency. Indirect quote of the currency can be obtained by taking the reciprocal of direct

quote and vice versa. Using the above example, the indirect quote of NOK in Tanzania is

NOK 0.01/TZS. That is the reciprocal of TZS100/NOK. Indirect quotation for the NOK

can also be presented as:

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• NOK/ TZS 0.01

• NOK 0.01 = TZS 1

• TZS : NOK 0.01

1.7 Exchange Rate Systems/Regimes

The role played by national governments to a great extent defines the manner in which

exchange rates are determined. The following five exchange rate regimes are described

below:

1.7.1 Freely Fluctuating Exchange Rates

Under a pure freely fluctuating exchange regime currencies are allowed to float (i.e.

move upward or downward) freely with no government intervention in the market or

restrictions on who may change money. The foreign exchange market would closely

approximate the economic model of pure competition. That is the price of any national

currency would be determined by the interaction between the supply and demand for that

currency.

1.7.2 Managed Floating Rate Regime

The exchange rates here are allowed to float in response to demand and supply forces, but

not as free and complete as it would be under a pure freely fluctuating rate regime. The

government (through central banks) may occasionally intervene (this constitutes the

“managed” feature of the regime) in the FOREX market in order to influence (smoothen

the fluctuations) the rates of exchange. Since the actions of the government are

unpredictable, it follows that the managed floats (dirty-float) cause problems to exchange

forecasters.

1.7.3 Fixed Rate Systems

Government endeavour to maintain target exchange rate through the national monetary

authorities (i.e. central banks or treasury agencies) operations and economic policies.

Under a fixed exchange rate system the authorities are obliged to purchase their

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currencies when there is excess supply and sell the currency when there is excess

demand, in order to prevent the exchange rate from rising or falling above or below the

fixed par value.

Again in case of persistent balance of payment deficit or surplus, relatively large

devaluations or re-evaluations would occur. Predicting when devaluation will occur will

cause problems for forecasters.

1.7.4 Controlled Rate Regime

In such a regime, national governments directly affect exchange rates by imposing and

enforcing legal controls on private dealings in FOREX. The national governments use

their sovereign power to control the overall demand for, and/or supply of FOREX. Some

forms in which governments may exercise their powers include:

• Licensing requirement where residents have to apply to the exchange control

authorities for licenses to import goods and to acquire the exchange needed for those

goods;

• Residents may be required to obtain FOREX only from specified sources that have

been designed to operate as part of the exchange control mechanism;

• Similarly residents are required by law to sell all the FOREX to these official

agencies etc.

1.7.5 Pegged Currency

Currency linked to a major trading currency or a basket of currencies (currency blocs)

and keeps that relationship fixed. Many countries link the value of their currencies to the

US dollar.

1.8 The Bid and Offer Quotation

Quotations in the wholesale foreign exchange market are recorded indicating whether the

currency is for sale or purchase. So it is a two-way (pair wise) quotation.

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1.8.1 A Bid

A bid is the dealer’s buying rate. Putting it more precisely, a bid is the price (exchange

rate) in one currency at which a dealer will buy another currency.

1.8.2 An Offer

An offer (Ask) is the dealer’s selling rate. That is the exchange rate at which the dealer

will sell the other currency. Usually dealers buy (bid) at a lower price and offer (sell) at a

slightly higher price. In the foreign exchange markets, quotations are typically shown

with five significant digits.

Look at the quotations below:

BID OFFER

$1.0873/€ $1.0879/€

You can buy dollars from a bank or broker

at this rate

You can sell dollars to a bank or broker

at this rate

The above quotation implies that the bank is willing to purchase one euro for $1.0873

(and sell dollars) or to sell one euro for $1.0879 (and buy dollars). As you might have

noted these quotations are given by the bank or broker to you, a customer. In shorthand,

the bank normally quotes 873-879.

1.9 The Bid – Ask Spread

The representation of the quotation shown above is called the bid-offer spread, where

the first rate refers to the bid or buy price for the specified currency and the second rate

refers to the sell or offer price for that same currency. Banks do not charge commission

in the wholesale foreign exchange market. But they profit from purchase and sale of

foreign currency through the bid-offer spread.

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The transaction cost is measured by:

Spread = ( )

priceOffer

priceBidpriceOffer −x 100 =

( )∈

∈−∈/0873.1$

$1.0873/$1.0879/ x 100 = 0.055%

So, the % spread on the euro (the reference currency) quoted above equals 0.055%.

The width of the bid-offer spread reflects the breadth and depth of market trading as

well as the currency's underlying volatility. Currencies such as the US dollar, the euro,

and Japanese yen, which are traded globally in substantial volumes both in the spot and

forward markets, will tend to have comparatively narrower bid-offer spreads than less

well traded or more regional currencies. The underlying riskness of holding the currency

is also critical. Holders of a volatile currency have to be compensated for accepting the

risk of an asset whose value is potentially unpredictable and unstable. In general the bid –

offer spread depends on:

• The depth of trading and volume of trade

• Riskness of holding the currency

• Holding and administrative costs

1.10 Appreciation and Depreciation of a Currency

The values of currencies never become constant. Currencies tend to fluctuate in value.

That is a value of a currency may decrease or increase relative to the value of another

currency. The increase in value of a currency is called appreciation and the decrease in

value of a currency is called depreciation.

1.10.1 Currency Appreciation

A currency appreciates relative to another when its value rises in terms of the other. The

dollar appreciates with respect to the Tanzania shilling if the TZS/US$ exchange rate

rises.

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For instance, if in April, 2005 the value of a dollar against Tanzania shilling was

TZS1000/US$ and in May, 2005, the value of the same currency becomes Tsh1070/$.

Then it can be said the value of US$ has increased (appreciated) relative to TZS.

1.10.2 Currency Depreciation

A currency depreciates with respect to another when its value falls in terms of the other.

The dollar depreciates with respect to the Tanzania shilling if the TZS/US$ exchange rate

falls. Referring to the case above, the value of Tanzania shilling has depreciated in May.

This is because with one unit of US dollar you can get more of Tanzanian shillings

compared to the previous.

Generally it can be noted that when the TZS/US$ rate rises, then its reciprocal, the

US$/TZS rate falls. Since the US$/TZS rate represents the value of Tanzania shilling in

terms of dollars, this means that when the dollar appreciates with respect to the Tanzania

shilling, the Tanzania shilling must depreciate with respect to the dollar.

1.11 Currency Change

As seen above, the volatile behaviour of currency values lead to their appreciation and

depreciation against a target currency. The percentage change in the value of a currency

over some period of time is called the rate of change (i.e. appreciation or depreciation).

1.11.1 Periodic Rate of Change

The rate of Change which looks at how the currency has been changing over time is

called periodic rate of change and is determined by the following formula.

Rate of Change (%) = 100Pr

rate Previous rate Prevailing ×−rateevious

Illustration 1:

The price of $ at the beginning of May 1996 was (Yen) ¥105. At the end of April, 1998

the value of $ become ¥116. Determine the periodic rate of change and state of $

currency has appreciated or depreciated.

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Solution:

Using the above formula we have:

Rate of Change (%) = 100Pr

rate Previous rate Prevailing ×−rateevious

= %5.10100105

105 116 =×−

The calculation above represents the rate of change of the $ in terms of Yen. Since the

percentage change is positive, it means that the dollar has appreciated by 10.5% relative

to the Yen during the past years.

Illustration 2:

At the beginning of Jan 1997 the value of $ was £ 0.59 and at the beginning of Jan 1996,

the value of $ was £0.65. Determine the rate of change of $ and state whether the $ has

appreciated or depreciated.

Solution:

Using our formula we have:

Rate of Change (%) = 100Pr

rate Previous rate Prevailing ×−rateevious

= %2.910065.0

0.65 0.59 −=×−

We have calculated the change in the value of the $ in terms of the Pound, and since the

percentage change is negative; this means that the dollar has depreciated by 9.2% relative

to the pound during the past year.

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1.11.2 Annualised Rate of Change

When the length of the period varies, then for comparative purposes, a more robust

indicator is based on the annualised rate of change: this can also be obtained using the

following formula:

Annualised Rate of Change1 = ( )rateevious

rateevailing TPr

Pr1

- 1

Where T measures the period in years

Illustration 3

At the beginning of January 2000, the price of the $ was ¥102.355; what was the rate of

change in the $ currency if at the beginning of August 2001, it was worth ¥124.755?

Solution

Rate of Change [$] = 355.102

102.355 - 124.755 = 21.88%

Using the same figures, on an annualised basis the rate of change will be:

Annualised Rate of Change [$] =( )355.102

755.124 2012

- 1= 12.61%

The $ appreciated at an average annual rate of about 12.6% over the specified period. As

a measure of average change in the value of the $ over the specified period, the rate of

change provides no information on the variability around that rate or the variations of

that change. The exchange rate may fluctuate widely and occasionally show falls in its

value in spite of the overall upward trend. The figure below shows how currency change

conceals volatility.

1 Monthly rate of change = ( )rateevious

rateevailing DaysNoPr

Pr30

⋅- 1

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Figure 1: Currency Fluctuations

As it can be observed from the figure 1, the Yen/US$ exchange rate raised sharply

between December 1999 and March 2000, before it fell again sharply between March and

June, 2000. This variation between December, 1999 and June, 2000 can not precisely be

explained by the rate of change as calculated above. That is why we are saying the

exchange rate fluctuation has been concealed by the annual rate i.e. 12.6%.

It can also be observed that as a currency appreciates – the reciprocal currency do

depreciate. The rates of appreciation and depreciation measured by their respective

formula are not equal in absolute terms, although the difference becomes less significant

as rates tend to zero.

1.11.3 Factors Influencing the Exchange Rates

• The political stability of a country

• Government Intervention in the form of exchange control, that is when the exchange

rates are not influenced by the forces of demand and supply, but the government fixes

it at a certain rate

1.12 Spot and Forward Quotations

Exchange rate falls into two categories, spot and forward exchange rates. The exchange

rate that prevails at the market on the date when the transaction takes place is called spot

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rate; and the exchange rate that is fixed to day but is used in future date i.e. 30, 60, 90 or

180 days to effect transaction is called forward exchange rate.

The exchange rate existing in the market in the future date is called future spot rate. This

rate can be the same as spot rate if there is no any factor that may influence the changes

in spot exchange rates. It should be noted that future spot rates and forward rates are not

the same. Forward rates are predetermined and fixed at the date of entering the contract

while future spot rates are the actual rates that exist in the market.

1.13 Determination of Premium and Discount Amount

The forward exchange rate may be quoted as an outright rate or as a premium or discount

of the equivalent spot rate. Commercial customers are usually quoted the outright rate

(a.k.a. the actual price). In the interbank market, dealers quote the forward rate only as a

premium on, or discount from the spot rate.

A foreign currency is at premium (more expensive) when the forward rate is above the

spot rate and a discount (less expensive) otherwise.

For instance, if the three-month forward exchange rate is Sk/€ = 9.8385 and that spot rate

is Sk/€ = 9.8340, the euro quotes with a premium of 0.0045 Swedish kroner per euro.

The three-month forward and the spot rates of the euro in terms of (against the) Swedish

kroner are €/Sk = 0.101642 and 0.101688 respectively. The Swedish kroner, is at a

relative discount because the forward rate is less than the spot rate. This suggests that the

euro is “strong” relative to the Swedish kroner.

Knowing whether the forward rate is at premium or discount is easy. One can just

observe the movements of bid points and ask points or observe bid rate and ask rate. As

said previously, if ask in points is greater than bid in points, then the forward rate is at

premium and vice versa. However if outright ask rate is greater than outright bid rate,

then the forward rate is at premium. To know the actual amount or percentage of

premium the following formula is used.

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From the above example, one can obtain the forward rate by adding premiums to and

subtracting discounts from spot rates. However the forward discount or premium is

calculate as an annualized percentage.

The formula for determining the implied annualised premium / discount of the forward

contract for the reference currency is:

The annualized premium/discount =

×

−Monthsin Maturity

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rateSpot

rateSpotrateForward

Or

Premium/Discount (annualized) =

×

−Contract ain days of No

360

rateSpot

rateSpotrateForward

If the result is positive, then the forward rate is at premium and if it is negative, then the

forward rate is at discount

The annualized premium/discount = %183.03

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8340.9

8340.98385.9 =

×

−

Illustration 4

The spot rate of U.S dollar in Tanzania is sold at Tshs 990/= and six month forward, one

U.S dollar in Tanzania is sold at Tshs 999/=. Determine if the U.S dollar is sold at

premium or discount. Show computations.

Solution:

Forward premium/discount =

×

−contract ain days of No.

360

rateForward

rateForwardrateSpot

= %82.1180

360

990

990999 =

×

−

The U.S dollar is selling at premium of 1.82 percent.

The formula for determining the implied annualised premium / discount of the forward

contract for the underlying currency is:

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The annualized premium/discount =

×

−Monthsin Maturity

12

rateForward

rateForwardrateSpot

Or

Premium/Discount (annualized) =

×

−Contract ain days of No.

360

rateForward

rateForwardrateSpot

If the result is positive, then the forward rate is at premium and if it is negative, then the

forward rate is at discount.

1.14 Forward Differential

In the inter-bank foreign exchange market, traders quote the forward rate of the reference

currency as a differential from the respective spot rate. The foreign exchange quotes in

this wholesale market supply the forward differential as the bid-offer spread, from which

the forward outright rates can be calculated. This forward differential is also referred to

as the SWAP rate. There are two forms in which swap rates can be quoted.

These are:

• Point form

• Cent form

In calculating the forward outright rates, it is important to remember that the forward

spread is always greater than the spot spread because of the increased risk of having to

hold at some future date a specified amount of designated currency for the exchange.

1.15 Conversion of Swap Rates to Outright Rates: Point Form

A point is the last digit of a quotation to the right of the decimal point. In the financial

press the US dollar is usually quoted to four decimal points (others to two decimal points)

and therefore a point is equal to 1/10,000 or 0.0001. The points do not represent a

foreign exchange but rather the difference between the forward rate and the spot rate.

Note that the spot rate is never given on a point basis

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Illustration 5

River Side Motors is a very famous specialist in Garage services and Auto Spares. The

Managing Director imports genuine parts direct from Japan. His supplier has invoiced

him 100million Japanese yen for spare parts imported. He has been allowed to pay the

amount due over three instalments or pay the entire amount at once if he wishes. While

still scrutinizing on the payment plan of the amount due, he come across with the inter

bank market quotations.

Spot outright rate: Tshs 300.00/yen- Tshs 400.00/yen

One month forward: 10- 20

Three months forward: 50- 80

Six month forward is 90- 100

The managing director of River Side Motors is not familiar with the terms used in the

inter bank market, he asks you to use such information and advise him on the exchange

rates that will exist in each of the three periods above.

Solution

By observing the forward quotation in point above, we can know that the forward rates

are at premium. This is because the forward offer rate in points are grater than forward

bid rate in points. To get outright rate the points should be added to the outright spot

rates.

One month Three months Six months

Spot outright rate 300.00- 400.00 300.00- 400.00 300.00- 400.00 Add: Forward premiums 00.10 - 00.20 00. 50 - 00.80 00.90 - 01.00 Forward rates 300.10- 400.20 300.50-400.80 300.90-401.00

Note. If the forward rates in points could be in discount, then we should have deducted

from outright spot rate to get outright forward rate

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Derivation of the outright forward rates requires applying either of the following rules:

IF THEN

If the bid-offer spread on the forward is less than the

bid-offer spread on the spot, then the underlying

currency is at a forward premium.

Subtract the forward bid-offer spread from the outright

spot rates to derive the outright forward rates.

If the bid-offer spread on the forward is greater than

the bid-offer spread on the spot, then the underlying

currency is at a forward discount.

Add the forward bid-offer spread to the outright spot

rates to derive the outright forward rates.

Illustration 6

The trading screen presents the following rates:

Currency Contract Bid - Offer Rates Spread

Sf/€ Spot 1.4804 - 1.4814 10

3-month Forward 54 - 50 4

3-month Forward 1.4750 - 1.4764 14

Sk/€ Spot 9.8325 - 9.8355 30

3-month Forward 25 - 65 40

3-month Forward 9.8350 - 9.8420 70

Falling points (when the bid in points is larger than the offer in points) in a swap

quotation indicate that the underlying currency (Sf) is trading at a forward premium

against the reference currency (€). Falling Points Are Deducted From The Spot Rate

BID ASK

Spot: Sf/€ 1.4804 1.4814

Less: - 54 - 50

3-months forward 1.4750 1.4764

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Rising points (when the bid in points is smaller than the offer in points) in a swap

quotation indicate that the underlying currency (Sk) is trading at a forward discount

against the reference currency (€). RISING POINTS ARE ADDED TO THE SPOT

RATE!!

BID ASK

Spot: Sk/€ 9.8325 9.8355

Add: + 25 + 65

3-months forward 9.8350 9.8420

Finally, notice that the sum of the spreads on the spot rates and the bid-offer forward

contract equals the spread on the forward outright rate.

1.16 Conversion of Swap Rates to Outright Rates: Cent Form

Illustration 7

Consider the following quote:

Spot rate US$/£ 1.4815 – 1.4965

1-month forward 0.39 – 0.37 cents premium

The US$ in this case stands at a forward premium. In other words, the sterling is

weakening relative to the US$. To determine the outright forward quote from the

premium quote, simply add on the discount or take off the premium from the spot rate.

In general, the rule is:

• ADD a discount

• DEDUCT a premium

BID ASK

Spot US$/£ 1.4815 1.4965

DEDUCT - 0.0039 - 0.0037

One month forward 1.4776 1.4928

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1.17 Cross Rates

In some cases both currencies related to the transactions are not quoted in either of the

currency. However, the currencies are quoted against a single reference currency, mainly

the US $. Where one currency appears in two rates there is a third implied exchange rate

called the “cross exchange rate”. To find the exchange rate between the currencies we

should work out through the relationship to the third currency in which each currency is

quoted.

Illustration 8

In Dar-Es-Salaam on February 26th 2004, the following rates are quoted:

British [£] Tshs 2045/£ and

US [$] Tshs 1085/$

Calculate the implied rates for the two currencies in the two countries.

In UK the price of US dollar is:

$/1085

£/2045

Tshs

Tshs

= $1.8848/£

In New York the price of sterling pound is:

£/2045

1085/$Tshs

Tshs = £0.5306/$

Note that the currency symbols are dimensionally conformal in the formulas. The Tshs

symbol, which appears in both the numerator and the denominator, is cancelled out. The

denominator currency symbol becomes the underlying currency unit, the currency used to

purchase one unit of the reference currency.

Alternatively, the common currency can be expressed as reference currency and other

currencies as underlying currencies, then workout for cross rates. Using the above

example then the cross rates will be as follows

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In UK, the price of US dollar is:

Tsh/8620009216589.0$

97555/Tshs£0.0004889= $1.8848/£

In US the price of Sterling pound is:

97555/Tsh£0.0004889

589862/Tsh$0.0009216= £0.5306/$

Illustration 9

Mathew is a senior lecturer in International Finance at Mzumbe University Tanzania. On

July 2002, he imported an “International Finance Student Guide” from France. He is

planning to buy French franc to settle the debt, but he is not certain how much Tanzania

shilling will be given to buy one unit of French Franc. This uncertainty is due to the fact

that, Tanzania shilling is not quoted against French franc. After long conversation with

Mfalisayo, an import merchant trader, they realized that Both currencies are quoted

against U.S. dollar. The buying rate for the French franc is $0.15 and the Tanzania

shilling is selling at $0.00125. What will be the exchange rate between Tanzania shilling

and French franc?

Solution:

Because both currencies are quoted against U.S. dollar, then to get the exchange rate

between Tanzania shilling and French franc we should find the cross rate i.e. use the

relationship of third currency.

How to determining cross rates:

First express the common currency as reference currency and other currencies as

underlying currencies. That is how much each currency will buy one unit of U.S dollar

for this case?

Then, the direct quote of $0.15 is FF6.6667/$, and direct quote of $0.00125 is Tsh800/$.

23

Therefore, the cross rate will be 800/6.6667, that is Tsh119.9994/FF or (6.6667/800) FF

0.0083/Tsh

Illustration 10

The Tanzanian importer needs Zambian kwancha to pay a Zambian exporter for the

goods purchased from him. The amount to be paid is kwancha, 1,000 mil. Tanzanian

shilling is not quoted against Zambian kwacha, but both currencies are quoted against

U.S dollar. The trader contracted for spot rate basis. At that time the quotes against dollar

were Tshs 900/U.S$, and the kwacha 100/US$.

Required:

(a) What will be the exchange rate between Tanzanian shilling and Zambian kwacha?

(b) How much Tanzania shillings should be given to get 1,000mil kwacha to effect

payment to Zambian exporter?

Solution:

(a) the exchange rate Tanzanian shilling and Zambian kwacha

kwachaTshsKwacha

Tsh/9

$/100

$/900 =

or

TshkwachaTshs

Kwacha/111.0

$/900

$/100 =

(b) Tanzanian shillings to be paid to Zambian exporter will 9000mil (9x1000).

1.18 Approach For Determining Cross Rates:

It is easy to get confused when making cross-rate computations. The following points

need to be noted:

• All currencies should be quoted against the common currency. So a first thing to do,

is to make sure that you measure the cross-rate in the right direction by looking at the

symbols;

24

• The second thing to do is make sure that you maximize the bid – ask spread. To get

the bid cross-rate, which is the smaller rate, you put the smaller figure in the

numerator and the larger figure in the denominator.

1.18.1 The Tabular Approach

The main approach for determining cross rate is a tabular form. To be able to calculate

the cross rates it is important to ensure that the common currency has its prices given

directly in terms of both currencies, and then draw a cross against the exchange rates

BID ASK

Tshs/US$ 1000 1100

BID ASK

Kshs/US$ 100 110

• Produce exchange rate pairs

[Tshs 1000/US$]BID

[Kshs 110/US $]ASK

[Tshs 1100/US$]ASK

[Kshs 100/US$]BID

• Calculate the cross-rate such that the currency to be quoted directly forms the

denominator in the computation and identify the selling and buying rates

Illustration 11

Suppose that sterling is quoted at $1.7019-36, while the Deutch mark is quoted at

$0.6250-67. What is the direct quote for the pound in Frankfurt?

25

Solution

In this question the pound is not quoted against Deutch mark, but both currencies are

quoted against U.S dollar. In this case the cross rate should be found. However it should

be noted that the quotation given is for bid and offer. This is direct quote of pound in U.S

and direct quote of Deutch mark in U.S.

The direct quote of pound in Frankfurt can computed as follows:

Selling one currency means buying another currency. In this case, the relation between

selling price and buying price is considered. For direct quote, the rule is, sell high- buy

low.

Bid price = in U.S DM of price Selling

in U.S £ of price Buying

This implies that the pound is sold for dollar and the dollar obtained is converted into

DM. this gives, £/7157.2$0.6267/DM

$1.7019/£DM=

Offer price = in U.S DM of price Buying

in U.S £ of price Selling

= £/7258.2$0.6267/DM

$1.7036/£DM=

The direct quote of pound in Frankfurt is DM2.7157/₤- DM2.7258/₤

1.19 Forward Cross Rates

Forward cross rates are figured in much the same way as spot cross-rates. For instance,

suppose a customer wants to sell one-month forward lire (lit) against Dutch guider (Dfl)

delivery. The market rates (expressed in European terms of foreign currency units per

dollar) are

$: Lit spot 1,890.00- 1,892.00

One month forward 1,894.25-1,897.50

26

$:Dfl spot 3.582- 3.4600

One-month forward 3.4530- 3.4553

1.19.1 Computations of forward selling price of Lire against Guilders

Note that the $ is a common currency of Lire and Guilder.

Based on these rates, the forward cross rate for selling lire against guiders as follows:

Forward BID ASK

$: Lit 1,894.25 1,897.50

Forward BID ASK

$:Dfl 3.4530 3.4553

From the above presentation, the forward selling price for lire against guiders is lit

1,897.50/3.453 = lit 549.52 and the forward buying rate for lire against guiders is lit

1,894.25/3.4553 = Lit 548.22

1.19.2 Computation for spot selling and buying cross rate of Lire against Guilder

Based on these rates, the spot cross rate for selling lire against guiders as follows:

Spot BID ASK

$: Lit 1,890.00 1,892.00

Spot BID ASK

$:Dfl 3.582 3.4600

From the tabulation presentation, it can be seen that the spot selling rate is 1892/3.4582 =

547.11 and the spot buying rates Lit 1890.00/3.46

27

Therefore forward discount on selling Lire against Dfl delivery equals (F-S)/S which is

equal to 11.547

11.54752.549 −= 0.0044 or 0.0044x12 = 5.29% per annum

1.20 The Importance Of Cross-Exchange Rates

• Used to determine the exchange rates between currencies;

• Used to check if the opportunities for intermarket arbitrage exist.

1.21 Arbitrage in the Foreign Exchange Market

One of the most important implications deriving form the close communications of

buyers and sellers in the forex market is that there is almost instantaneous arbitrage

across currencies and financial centres (triangular arbitrage). This is possible only when

disequilibrium prevail in the forex markets

Arbitrage is the process of buying and selling equivalent or similar assets in order to

exploit price differentials for riskless guaranteed profits.

1.21.1 Cross-Currency Arbitrage

If the three linked rates do not match up then there are certain profit possibilities

(arbitrage). Suppose the rate in the market is £0.5000:1$ [i.e. $’s cheaper than they

should be!], what would be the arbitrage strategy?

To check for opportunity of profit, the arbitrageur compares the cross-rates and the actual

market quotations. If the two differ, then opportunities for profits do exist – simply by

selling the currencies. Triangular arbitrage involves the following steps:

(i) Exchange the first currency (the Undervalued currency) for the common currency

in the spot market at the spot exchange rate.

(ii) Convert the common currency into the second currency (the Overvalued

currency) in the spot at the spot exchange rate.

(iii) Exchange the second currency for the first currency in the spot market at the spot

exchange rate

28

Figure 2: The Cross-Currency Arbitrage Process

The amount at the end will be bigger than that at the beginning. The profit will be the

difference of the 1st currency at the beginning and at the end of the process. This is a risk

free profit because the arbitrageur knows right from the beginning the amount of profit to

be realized at the end of the arbitrage process. In addition, no original borrowing is

required. The process will continue until the market equilibrium is re-established, when

the spot rate equals the cross-rate. The increased supply of dollars would quickly

depreciate its rate against the pound to £0.5306/$ level.

Illustration 12

Suppose that the pound sterling is bid at $0.6251 in Frankfurt. At the same time, London

banks are offering pounds sterling at DM3.1650.

Solution:

First find the reciprocal of DM3.1650 which is equal to ₤0.3160/DM

1st currency UNDERVALUED

COMMON CURRENCY

2nd currency OVERVALUED

STEP 1 STEP 2

STEP 3

29

Cross rate will be = £/9784.1$31586.0

6251.0 =

In this case the intermarket arbitrage will be as follows.

• Sell dollar for Deutsche marks in Frankfurt

• Use the Deutsche mark to acquire pounds sterling in London

• Sell the pounds in York at the rate of $1.9784/₤

1.21.2 Financial Centre [Locational] Arbitrage

This type of arbitrage ensures that the exchange rate quoted in one country’s exchange

market will be the same as that quoted in other country’s financial centres. It eliminates

the possibilities of buying and selling currencies in the foreign exchange markets of two

or more countries so as to profit from price mismatches. This is because if the exchange

rate is $2/£ in, say, New York but only $1.98/£ in London, it would be profitable for

banks to buy pounds in London and simultaneously sell them in New York and make a

guaranteed profit of 2 cents per each pound bought and sold. This will lead to

depreciation of the dollar in London and appreciation of the same in New York.

Ultimately the rates in the different countries will equalise, and therefore arbitrage

transaction will conclude as parity is restored. In the figure below the arbitrageur made

$2 due to price mismatch in London and New York stock exchanges.

30

Figure 3: The Locational Arbitrage Process

Despite the above benefits, incidents of spatial arbitrage are extremely rare since most

currencies are quoted against a single reference currency, usually the US $, and traders

have employed automatic programmed arbitrage trading to exploit price differentials if

they ever appear.

1.22 Banks Dealing With Non- Bank Customers

In their dealing with non-bank customers, banks in most countries use a system of direct

quotation. A direct exchange rate quote gives the home currency price of a certain

quantity of the foreign currency quoted (usually 100 units, but only one unit in the case of

the U.S dollar or the pound sterling). For example, the price of foreign currency is

expressed in French francs (FF) in France and in Euro German. Thus, in France, the

Deutsche mark might be quoted at FF4 while, in German the franc would be quoted at

€0.25.

1.23 Selling and Buying Currency with Banks

When currency is indirectly quoted, that is the local currency is expressed in terms of

number of units of foreign currency which can buy one unit of local currency, the higher

London New York

$

£

Spot rate $1.98/£

Spot rate $2/£

198

100 100

200 200

Locational Arbitrage

Arbitrage profit = $200-$198=$2

31

figure will be the buying rate for the bank and the lower figure will be the bank’s selling

figure. The rate at which customers sell is the rate at which banks buys and verse versa.

Suppose the following quotation is given;

Kshs 0.1/Tsh – Kshs 0.08/tsh

Bank selling is Ksh0.1/Tsh and Bank buying price is Ksh 0.08/Tsh. That is to say the

bank will sell one Tshs for Kshs 0.1 and buy one Tshs for Kshs 0.08

Illustration 13

The following exchange rates are given.

US$ 1.4620-1.4785

Canada$ 2.0350-2.0560

Required:

(a) If a customer wanted to obtain Canadian $20,000 from his bank. How much the bank

would sell the currency?

(b) If a customer had Canadian $20,000 which he wanted to exchange for sterling. How

much the bank would sell the currency?

Solution:

The selling rate of bank will be Canadian $2.0350 and the buying rate will be

Canadian $ 2.0560

(a) The bank would sell the currency for, 20,000 = 9,828.01

2.0350

(b) The bank would buy the currency for, 20,000 = 9,727.63

2.0560

Note: the rule for banks selling and buying rates is that Sell low, buy high- bank

quotation rates

32

RFERENCE

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Review Questions

1. Answer the following questions on the basis that the euro/US $ exchange rate is

1.1168 – 1.1173

(i) What is the cost of buying €200,000?

(ii) How much would it cost to purchase US$ 4m?

(iii) How many dollars would be received from selling €800,000?

(iv) How many euros would be received from selling US$ 240,000?

2. Consider the tabulation below which comprises foreign exchange quotations given

by a bank to a customer. The figures given are for the US Dollar and Deutsche

Marks Against sterling pounds and the word ‘premium’ or ‘discount implies that the

foreign Currency quoted at the head of the column is at the premium or discount

respectively.

$ DM

Spot 1.6915-25 2.80-2.801\4

Premium Premium

1 month forward 1-0.90cents 21\2-21\4pfennings

2 months forward 1.60-1.50cents 41\2-41\4pfennings

3 month forward 2.10-2.10-2.00cents 51\2-51\4pfennings

Required

(i) At what rate will the bank buy spot dollars against sterling?

(ii) At what rate will the customer sell dollars one month forward against sterling?

33

(iii) At what rate will the customer buy Deutch Marks spot against sterling?

(iv) At what rate will the customer buy dollars two months forward against sterling?

(v) At what rate will the bank sell dollars two months forward against sterling?

(vi) At what rate will bank buy Deutch Marks three months forward against sterling?

(vii) At what rate will the bank buy dollars three months forward against sterling?

3. Describe the difference between the spot and forward currency markets.

4. Given below are spot and forward rates expressed in terms of US$ per unit of the DM

and £.

Rate DM £

Spot 0.5393 1.6030

30 – Days forward 0.5406 1.6006

60 – Days forward 0.5425 1.6000

90 – Days forward 0.5431 1.5945

180 – Days forward 0.5478 1.5859

Required:

(i) Is the 90 days forward DM at a discount or at a premium?

(ii) Is the 90-day forward contract in pound trading at a discount or at a premium?

(iii) Relative to the pound is the 180-day forward dollar quoted at a discount?

5. The following quotes are received for spot, one month, three month and six month

Swiss Francs (Sf) and pound sterling (£).

Spot One-month Three-month Six-month

£: $ 2.0015 – 30 19 -17 26 – 22 42 – 35

Sf: $ 0.6963 – 68 4 – 6 9 – 14 25 -38

Required:

Convert the above swap rates in outright rates.

6. The US $ appreciated by 20% against the Thai baht – the bath/$ prevailing rate is

30/$. By what percent did the baht depreciate against the dollar?

34

7. Determine the forward premium [discount] for the currency and maturity as specified

in each row of the following table of rates quoted as HuFI/$ [HuFI denotes Hungarian

Florint].

Currency spot rate forward rate Maturity

$ 247.785 267.25 12months

HuFI 247.785 252.805 3months

8. The euro is quoted as $/€ = 1.1610 – 1.1615, and the Swiss franc is quoted Sf/$ =

1.4100 – 1.4120. What is the implicit Sf/€ quotation?

9. The following exchange rates are available:

Dutch guilders (fl) per US dollar (US$) = 1.9025

Canadian dollar (C$) per US dollar (US$) = 1.2646

Dutch guilders (fl) per Canadian dollar (C$) = 1.5214

Are there any opportunities for market arbitrage? Show how Dutch investor with fl

1,000,000 can benefit from the possible arbitrage between the three markets.

10. Assuming no transaction costs, suppose: £1 = $2.4110 in New York; $ = FF 3.997 in

Paris, and FF1 = £0.1088 in London. How would you take profitable advantage of

these rates?

11. Here are some quotes of the Japanese Yen /US$ spot exchange rate given

simultaneously on the phone by three banks

Sokomoko 121.15 – 121.25

Nagayuki 121.30 – 121.35

Samakimoto 121.15 – 121.35

Are these quotes reasonable? Do you have an arbitrage opportunity?

35

PARITY RELATIONSHIP IN INTERNATIONAL FINANCE

2.1 Definition

Parity relationships in International finance are economic relationships which help to

explain the exchange rate movements. There are five Parity relationships in International

finance:

• The first one explains the impact of change of inflation to the change in exchange

rates between the countries. This is known as Purchasing Power Parity (PPP).

• The second parity relationship explains the impact of change in interest rates between

the countries to the change in exchange rates. This is called Interest rate parity (IRP).

• The third parity relationship is called Fisher effect (FE). This parity links nominal

interest rates to a real interest rates and inflation

• The fourth parity relationship is known as International Fisher Effect (IFE).

Essentially it links interest rates of different countries to exchange rate movements

• The last one is known as Expectations Hypothesis (EH). Provides a linkage between

forward rates to expected spot rates.

2.2 Purchasing Power Parity (PPP)

Purchasing power parity (PPP) is a theory of exchange rate determination and a way to

compare the average costs of goods and services between countries. According to this

parity theory, the value of a currency in one country is determined by the amount of

goods and services that can be purchased with a unit of the currency. This is called the

purchasing power of the currency.

If there is more than one currency, the exchange rate between currencies must provide the

same purchasing power for each currency. In other words, a unit of home currency should

have the same purchasing power worldwide. That’s to say if Tanzania shilling buys one

bottle of coca cola in Tanzania; it should buy the same volume of coca cola in any other

country. This relationship is called purchasing power parity.

In view of the above arguments, it can observed that where there is a cross country price

differences, the importers and exporters will be motivated to take advantages of such

price differences. That’s, importer will like to buy in a country where the price is lower

36

and sale where the price is higher. Moreover, the exporter will generally sell in a country

where the price for his/her product is higher. Eventually, their actions will induce

changes in the spot exchange rate.

In the country where the price for the products is lower, the demand will be higher, this

will entails for high demand of foreign currency to pay for goods purchased from other

countries. The higher demand for foreign currency will eventually lead to rise of

exchange rate and hence higher price for the goods. Similarly, in the country where the

price for goods is higher, will attract more supply. The effect of which would lead to fall

in price of goods and hence decrease in exchange rates.

Purchasing power parity attempts to explain changes in exchange rates as the result of

changes in the rate of inflation in different countries. The theory states that the exchange

rate of a currency depends on the purchasing power of the currency in its own, as

compared with the purchasing power of another currency in its own country.

For example, if the rate of exchange between Tanzania shilling and Kenya shilling is

Tsh10/Ksh and inflation is running at 4%p.a in Tanzania and 6% in Kenya, the Tsh

would strengthen against Ksh by factor( )( )06.01

04.01

++

that is 0.98 per annum After one year

the exchange rate would be 0.98 x 10 = Tsh 9.8/Ksh

Generally, PPP theory is based on an extension and variation of the "law of one price" as

applied to the aggregate economy. To explain the theory it is best, first, to review the idea

behind the law of one price.

2.3 The Law of One Price (LOP)

At its simplest level, the law of one price states that, in the situation where identical

product or service are sold in two different markets and where there are not transportation

costs cost of moving the products or service to the required place or differential taxes or

subsidies, the price for the products or services would be the same. Even though the

markets are of different countries, the price for the commodity would be the same in all

countries provided that there are no transport costs and differential taxes. Using this law

of one price, it is possible to determine the exchange rates between the currencies.

37

If the prices of identical commodity in the two countries are known, then we can work

out for exchange rate by taking the price of commodity in one country divided by the

price of a commodity in another country. For instance, If the price of Coca Cola in

Tanzania is Tsh250 per bottle and the price of coca Cola in Kenya is Ksh 25 per bottle,

then the exchange rate between currencies will be. Tsh250/Ksh25 = tsh10/Ksh.

Illustration 1

Consider the following information about movie video tapes sold in the US and Mexican

markets.

Price of videos in US market (P$v) $20

Price of videos in Mexican market (Ppv) p150

Spot exchange rate (Ep/$) 10 p/$

countryanothter in commodity same a of price a

by dividecountry onein commodity of Price rate Exchange LOP, the toAccording =

Therefore, the dollar price of videos sold in Mexico can be calculated by dividing the

video price in pesos by the spot exchange rate as shown,

per video 15$10

150

dollar and pesobetween rate Exchange

pesoin videoof Price market mexcoin sold videoof pricedollar The ===

To see why the peso price is divided by the exchange rate (rather than multiplied) notice

the conversion of units shown in the brackets. If the law of one price held, then the dollar

price in Mexico should match the price in the US. Since the dollar price of the video is

less than the dollar price in the US, the law of one price does not hold in this

circumstance.

2.4 What Would Happen If The Law Of One Price Does Not Hold?

The law of one price does not hold if there is different in prices on the same commodity

world wide. If this situation occurs, then there would be possibility for arbitration. That’s

38

traders would try to benefit from such price differences by buying from the country

where the price is lower and selling in the country where the price is higher. For

instance, as it can be seen above, while price of Video in US market is $20, the price in of

Video in Mexico market is $10. In this case there would be incentive to purchase the

Video from the country where its price is the lowest (That is from Mexico) and resell it in

the country where its price is the highest (In this case in US market).

An arbitrage opportunity arises whenever one can buy something at a low price in one

location and resell at a higher price and thus make a profit.

2.5 When Arbitrage Process Stops?

When the prices for the similar goods are the same in all the markets, then there would be

no incentive to buy from one market and resell in other market. The arbitration process

would stop when the prices for similar goods between the markets becomes equal. At a

long run this process of arbitrage will tend to produce the same price for the given

commodity in all countries by decreasing its price where the supply is high and increase

price where arbitragers purchase the commodity more. For example, using basic supply

and demand theory, the increase in demand for videos in Mexico would push the price of

videos up. The increase supply of videos on the US market would force the price down in

the US. In the end the price of videos in Mexico may rise to, say, 180 pesos while the

price of videos in the US may fall to $18. At these new prices the law of one price holds

since,

Where Ppv implies Price of videos in Mexican market and Ep/$ Spot exchange rate

2.6 Purchasing Power Parities and Exchange Rate Determination

The exchange rates in PPP can be determined in two alternatives. These alternatives are

commonly called as PPP versions. These are:

39

• Absolute version of purchasing power parity.

• Relative version of purchasing power parity.

2.6.1 Absolute Version Of Purchasing Power Parity

The purchasing power parity theory is really just the law of one price applied in the

aggregate, but, with a slight twist added. If it makes sense from the law of one price that

identical goods should sell for identical prices in different markets, then the law ought to

hold for all identical goods sold in both markets.

If this applies, then the cost of basket of goods let say in US would be CB$ and the cost of

basket of goods let say in Mexico would be CBp. whereby, CB$ represents the dollar

cost of purchasing all of the items in the market basket and CBp represents the Pesso cost

of purchasing all of the items in the market basket

Note here that, the basket is determined by surveying the quantity of different items

purchased by many different households and then determining on average how many

units of each item is purchased by the typical house hold. We can describe the market

basket easily as a collection or set of quantities let say Q1, Q2, Q3, ... Qn, where Q1 may be

quantity of coca cola, Q2 another items and so on. Each quantity has a price. Therefore

for the quantities survey may have a set of prices such as P1, P2, P3, .... Pn

Therefore, the cost of the market basket (CB), is found by summing the product of the

price and quantity for each item. That is, CB = P1Q1 + P2Q2 + P3Q3 + ... + PnQn or

This uses CB or CPI of different countries to determine the exchange rates. If the law of

one price holds for each individual item in the market basket, then it should hold for the

market baskets as well. This can be expressed quantitatively as,

40

Rewriting the right-hand side equation allows us to put the relationship in the form

commonly used to describe absolute purchasing power parity. Namely,

If this condition holds between two countries then we would say PPP is satisfied. The

condition says that the PPP exchange rate (pesos per dollars) will equal the ratio of the

costs of the two market baskets of goods denominated in local currency units. Note that

the reciprocal relationshipPCB

CB$PPP$/pE = is also valid.

2.6.2 Relative Version of PPP

There is an alternative version of the PPP theory called the "relative PPP theory." This

uses the inflation rate to determine the exchange rates. Since absolute PPP suggests that

the exchange rate may respond to inflation, we can imagine that the exchange rate would

change in a systematic way given that a continual change in the price level (inflation) is

occurring. In other words, the exchange rate between the home currency and any foreign

currency will adjust to reflect changes in the price levels of the countries. However, Price

level changes with change in inflation.

If the price level between countries is to be the same, then the change in inflation

between countries should be the same as well other wise the values of the currencies will

be different.

NB. If inflation is higher, then the value of currency will fall relative to other countries.

To equalise the values of currencies, then the value of currency in highly inflated country

should rise to the tune of differences in inflation rate.

Illustration 3

If inflation is 5% in Tanzania and 1% in Kenya, then in order to equalise the price of

goods in two countries, then the TSH value of Ksh must rise by about 4%. This also

41

implies that, Ksh is stronger by 4% while TSH is weaker by (5%- 1%), 4%. To make all

currencies equal value, then TSH value should rise by 4%

According to the power parity, exchange rate over the period is determined by relative

change in prices between countries over period of time. Any change in the differential

rate of inflation between the countries will tend to influence the change in exchange rate

between the countries.

Example: If rh and rf are the periodic rate of inflation in the country of the

underlying currency and in the country of reference currency respectively and e0 is the

value of one currency relative to one unit of another currency at the beginning of the

period, and et is the spot exchange rate in period t, then according to the relative version

of PPP,

et/ e0 = (1 + rh)t/ (1 + rf )

t

Where, rh inflation of underlying currency and rf inflation of reference currency.

• if et is not known and e0 is known, then we can use the relation to get spot exchange

rate at period t (et)

• therefore, et = (1 + rh)t x e0

(1 + rf )t

Illustration 4

If Tanzania and Kenya are running annual inflation of 5% and 3%, respectively, and the

initial exchange rate was Tsh10/Ksh. What would be the value of Kenya Shilling in three

years?

Solution:

The exchange rate at time t is given by

et = (1 + rh)t x e0

(1 + rf )t

42

Where, t = 3years; rh is inflation rate of underlying currency = 5%; rf is inflation

rate of reference currency =3%; e0 is spot exchange rate = Tsh 10/Ksh and et is

exchange rate at time t

Therefore, et = ( 1+ 0.05)3 x 10

(1 + 0.03)3

=Tsh 10.6/Ksh

The implication of relative PPP is that if the Tanzanian inflation rate exceeds the Kenyan

inflation rate, then the Ksh will appreciate by that differential over the same period.

That’s the Ksh will appreciate by (5%-3%) 2%

In summary, an increase in Tanzanian prices relative to the change in Kenyan prices

(i.e., more rapid inflation in Tanzania than in the Kenya) will cause the Kenya shilling to

appreciate and the Tanzania Shilling to depreciate according to the purchasing power

parity theory.

Illustration 5

Suppose the current price level in U.S is at 112 while the German price level is at Euro

107, relative to base price level of 100. If the initial value of the Euro was $0.48, then

according to PPP to how extent the dollar value of the Euro should rise?

Solution:

112 x 0.48 = $0.5024

107

The dollar value of the Euro should have risen to approximately $0.5024

The main justification for purchasing power parity is that if a county experiences

inflation rate higher than those of its main trading partners, and its exchange rate does not

change, its exports of goods and services will become less competitive with comparable

43

products produced elsewhere. Imports from abroad will also become more prices

competitive with higher priced domestic products.

2.7 Is It True That The Law Of One Price Normally Holds?

Of course, for many reasons the law of one price does not hold even between markets

within a country. The price of beer, gasoline and stereos will likely be different in New

York City than in Los Angeles. The price of these items will also be different in other

countries when converted at current exchange rates. The simple reason for the

discrepancies is that though this law assumes that there would be no transport costs, this

is not true, how the goods can move from one location of market to another?, for this

reason we see that there are costs to transport goods between locations that may differ

from country to country and this may lead to price variations between the markets for the

similar goods.

Generally, it can be said that the law of one price will hold if the price of the goods after

adjusting for the all the costs including transportation costs taxes are the same; and also

when all factors that can lead to the change in the price are the same.

2.8 Problems with the PPP Theory

The main problem with the PPP theory is that the PPP condition is rarely satisfied within

a country. There are quite a few reasons that can explain this and so, given the logic of

the theory, which makes sense, economists have been reluctant to discard the theory on

the basis of lack of supporting evidence. Below we consider some of the reasons PPP

may not hold.

2.8.1 Transportation Costs And Trade Restrictions

Since the PPP theory is derived from the law of one price, the same assumptions are

needed for both theories. The law of one price assumed that there are no transportation

costs and no differential taxes applied between the two markets. These means that there

can be no tariffs on imports or other types of restrictions on trade. Since transport costs

and trade restrictions do exist in the real world this would tend to drive prices for similar

goods apart. Transport costs should make a good cheaper in the exporting market and

44

more expensive in the importing market. Similarly, an import tariff would drive a wedge

between the prices of an identical good in two trading countries' markets, raising it in the

import market relative to the export market price. Thus the greater are transportation

costs and trade restrictions between countries, the less likely for the costs of market

baskets to be equalized.

2.8.2 Costs of Non-Tradable Inputs

Many items that are homogeneous, nevertheless sell for different prices because they

require a non-tradable input in the production process. As an example consider why the

price of a McDonald's Big Mac hamburger sold in downtown New York city is higher

than the price of the same product in the New York city suburbs. Because the rent for

restaurant space is much higher in the city centre, the restaurant will pass along its higher

costs in the form of higher prices. Substitute products in the city centre (other fast food

restaurants) will face the same high rental costs and thus will charge higher prices as

well. Because it would be impractical (i.e., costly) to produce the burgers at a cheaper

suburban location and then transport them for sale in the city, competition would not

drive the prices together in the two locations.

2.8.3 Perfect Information

The law of one price assumes that individuals have good, even perfect, information

about the prices of goods in other markets. Only with this knowledge will profit-seekers

begin to export goods to the high price market and import goods from the low priced

market. Consider a case in which there is imperfect information. Perhaps some price

deviations are known to traders but other deviations are not known. Or maybe only a

small group of traders know about a price discrepancy and that group is unable to achieve

the scale of trade needed to equalize the prices for that product. (Perhaps they face capital

constraints and can't borrow enough money to finance the scale of trade needed to

equalize prices). In either case, traders without information about price differences will

not respond to the profit opportunities and thus prices will not be equalized. Thus, the law

of one price may not hold for some products which would imply that PPP would not hold

either.

45

2.8.4 Other Market Participants

Notice that in the PPP equilibrium stories, it is the behaviour of profit-seeking importers

and exporters that forces the exchange rate to adjust to the PPP level. These activities

would be recorded on the current account of a country's balance of payments. Thus, it is

reasonable to say that the PPP theory is based on current account transactions. This

contrasts with the interest rate parity theory in which the behaviour of investors seeking

the highest rates of return on investments motivates adjustments in the exchange rate.

Since investors are trading assets, these transactions would appear on a country's capital

account of its balance of payments. Thus, the interest rate parity theory is based on

capital account transactions.

It is estimated that there are approximately $1 trillion dollars worth of currency

exchanged every day on international Forex markets. That's one-eighth US GDP, which

is the value of production in the US in an entire year! Plus, the $1 trillion estimate is

made by counting only one side of each currency trade. Thus, that's an enormous amount

of trade. If one considers the total amount of world trade each year and then divide by

365, one can get the average amount of goods and services traded daily. This number is

less than $100 billion dollars. This means that the amount of daily currency transactions

is more than ten times the amount of daily trade. This fact would seem to suggest that the

primary effect on the daily exchange rate must be caused by the actions of investors

rather than importers and exporters. Thus, the participation of other traders in the foreign

exchange market, who are motivated by other concerns, may lead the exchange rate to a

value that is not consistent with PPP.

2.9 The Interest Rate Parity Condition

Interest rate parity relates the exchange rate to the interest rates. This theory also holds

when the rate of return in deposit in one country is equal to the rate of return in deposit in

another country. Therefore, if currencies involved let say are dollars and Dutch mark,

46

then the Interest rate parity (IRP) holds when the rate of return on dollar deposits is just

equal to the expected rate of return on German deposits, i.e.,

Quantitatively this can be expressed as follows:

Note that the currency of a country, where investment is done, that’s a foreign country’s

currency should always expressed be as reference currency

This condition is often simplified by dropping for this case the final German interest term

and become

From that formula the theory of interest rate parity (IRP) states that the difference in the

national interest rates for securities of similar risk and maturity should be equal to, but

opposite in sign to, the forward rate discount or premium for the foreign currency, except

for transaction costs. Remember to get forward premium or discount, and then the right

hand side should be multiplied by 360/n days and 100

However, we need to be very carefully of this approximate version since would not give

an accurate representation of rates of return when interest rates in a country are high. The

most important thing is to use the first version other than approximate version.

In other words, it can be said that IRP holds when the deposit at home yield the same

return as depositing abroad. In this case the investor needs to invest abroad by converting

the home currency into foreign currency using spot rate and then deposit it. After earning

interest rate in foreign currency he will reconvert back the interest and principle amount

into home currency using forward rate or exchange rate existing at that date. If the result

47

is the same as the result of inverting at home then the IRP hold, but if not then IRP does

not hold. For this case he will invest where the return is higher. Quantitatively this can be

expressed in the following formula.

(1+ ih) = Spot rate (1+ if)

Forward rate

Where ih interest rate/investment rate at home and if in foreign country

In this case the currency of a country where investment is done,( a foreign country’s

currency should be expressed as underlying currency). That’s how much foreign currency

is equivalent to one unit of a home currency

Illustration 6

Consider the following data for interest rates and exchange rates in the US and Italy. Note

that Italian currency is in lira (L).

i$ 5.45% per year

iL 10.31% per year

e$/L96 1573 L/$

e$/L97 1540 L/$

Again imagine that the decision is to be made in 1996, looking forward into 1997.

However, we calculate this in hindsight after we know what the 1997 exchange is. Thus,

we plug in the 97 rate for the expected exchange rate and use the 96 rate as the current

spot rate.

Before calculating the rate of return it is necessary to convert the exchange rate to the lira

equivalent rather than the dollar equivalent. Thus,

and

Now, the ex-post (i.e. after the fact) rate of return on Italian deposits is given by,

48

This simplifies to

In this case an investor would have made money (in dollar terms) by purchasing the

Italian asset.

Now since RoR$ = 5.45% < RoRL = 12.69% the investor seeking the highest rate of

return should have deposited their money in the Italian account. While investing in US

will give an investor a total of $1.054 per each dollar invested, the investment or deposit

in Italy will give him a total of $1.1269 0r $ 1.127 for each dollar invested.

The computation above could also be worked out in other way round as follows:

(1+ i$) = Spot rate (1+ iL)

Forward rate

(1+0.0545) = 1573(1+0.1031)

1540

= 1.126737857

$1.0545 = $1.127

Since investing abroad gives the higher return, then the investor will invest his dollar

amount in Italy.

Illustration 7

Consider the following data for interest rates and exchange rates in the US and Germany.

i$ 5.45% per year

49

iDM 3.65% per year

e$/DM96 .6944 $/DM

e$/DM97 .6369 $/DM

We imagine that the decision is to be made in 1996, looking forward into 1997. However,

we calculate this in hindsight after we know what the 1997 exchange rate is. Thus, we

plug in the 97 rate for the expected exchange rate and use the 96 rate as the current spot

rate. Thus, the ex-post (i.e. after the fact) rate of return on German deposits is given by,

Which simplifies to

A negative rate of return means that the investor would have lost money (in dollar terms)

by purchasing the German asset.

Since RoR$ = 5.45% > RoRDM = - 4.93% the investor seeking the highest rate of return

should have deposited their money in the US account.

Or

We can express Dm as an underlying currency and compare the return that can be yielded

by each investment approach.

DM /e$96 =1/.6944 = Dm 1.4401/$ and

DM/ e$97 =1/.6369 = Dm1.5701/$

Therefore,

(1+ 0.0545) = 1.4401 (1+0.0365)

1.5701

$1.0545 = $0.9507

50

In this case the investor will invest in US other than in Germany

Illustration 8

Consider the following data for interest rates and exchange rates in the US and Japan.

i$ 5.45% per year

i¥ 0.55% per year

e$/¥96 105 ¥/$

e$/¥97 116 ¥/$

Again imagine that the decision is to be made in 1996, looking forward into 1997.

However, we calculate this in hindsight after we know what the 1997 exchange is. Thus,

we plug in the 97 rate for the expected exchange rate and use the 96 rate as the current

spot rate.

Before calculating the rate of return it is necessary to convert the exchange rate to the yen

equivalent rather than the dollar equivalent. Thus,

and

Now, the ex-post (i.e. after the fact) rate of return on Japanese deposits is given by,

Which simplifies to

A negative rate of return means that the investor would have lost money (in dollar terms)

by purchasing the Japanese asset.

Now since RoR$ = 5.45% > RoR¥ = -8.97% the investor seeking the highest rate of return

should have deposited their money in the US account.

51

Illustrations 9

Consider the following data for interest rates and exchange rates in the US and Italy. Note

that Italian currency is in lira (L).

i$ 5.45% per year

iL 10.31% per year

e$/L96 1573 L/$

e$/L97 1540 L/$

Again imagine that the decision is to be made in 1996, looking forward into 1997.

However, we calculate this in hindsight after we know what the 1997 exchange is. Thus,

we plug in the 97 rate for the expected exchange rate and use the 96 rate as the current

spot rate.

Before calculating the rate of return it is necessary to convert the exchange rate to the lira

equivalent rather than the dollar equivalent. Thus,

and

Now, the ex-post (i.e. after the fact) rate of return on Italian deposits is given by,

Which simplifies to

In this case an investor would have made money (in dollar terms) by purchasing the

Italian asset.

2.10 The Effect of Changes in Interest Rates on the Spot Exchange Rate

52

Suppose that the foreign exchange is initially in equilibrium such that Ksh = Tsh at the

exchange rate e1Tsh/Ksh. any increase in interest rate let say in Kenya, will raises the rate of

return on Kenyan assets, RoRKsh, than a comparable asset of another country. The

consequence of this will be raise the demand for Kenya shilling as the foreign investors

will likely to buy Kenya shillings with their currencies to invest in Kenya for the seek of

getting higher average return on Kenyan assets. Moreover it will also lower the supply of

Kshs by Kenyan investors who decide to invest at home rather than abroad.

Because the interest rate changes forcing the demand for the currency to increase while

decreasing the supply, the price (exchange rates) will also raise against other currency.

That’s the currency will appreciate against other currency and hence reducing the demand

for such currency. If this is possible the currency becomes now expensive to buy.

In this case the forward rate, using IRP is given by:

( )( ) rate spote

currency reference of i1

currency underlying of i 1 rate Foward x

++= . Where i’ s are an interest rates of

underlying currency and reference currency .This formula applies for single period only.

For multi-period, the forward rate using IRP is given as follows:

Forward rate = spot rate x (1+i of underlying currency)t

(1+i of reference currency)t

Illustration 11

Assume the spot rate between pound sterling and the U.S dollar is $ 1.40/£ and that the

12 months risk free interest rate (e.g on the government stocks) are U.S 5% and UK 8%.

a) Using IRP theory, what will be the 12 month forward rate?

b) What will happen to the value of Pound sterling against dollar as the result of the

higher interest rate in UK?

c) What would happen if interest rate parity did not hold and therefore the forward rate

only moves to, $ 1.36?

53

d) Take an investor who borrows $ 2,000. Calculate the risk free profit that could be

made by carrying out covered interest arbitrage.

Solution:

(a) The 12 month forward rate, as predicted by IRP will be.

Forward rate = spot rate x (1 + i$)/(1+iuk)

= 1.40 x 1.05/1.08

= $1.361/pound

(b) The higher UK interest rate will cause the pound sterling to weaken against the $

on the forward market (put another way. The $ will stand at a forward premium

against the pound sterling). IRP suggest that any gain that can be achieved from

the higher interest rates in UK will be countered by corresponding depreciation in

the value of the pound sterling on the forward market.

(c) If the interest rate parity did not hold and therefore the forward rate only moves

by $1.39/pound, the higher UK interest rates would make it possible to make a

profit by

• Raising a loan in $ at the low interest rate

• Selling the $ at the spot rate in order to buy Pound sterling

• Placing the pound sterling on deposit to earn the high interest rate

• Buy back the $ which will be needed in the 12 months in order to pay off the loan.

This can be done by using a forward contract which will fix the exchange rate for 13

months time thereby removing the exchange rate risk.

(d) An investor.

• Will raise loan $2,000

• Sell the $ at the spot rate and receive 2000/1.40 = Pound 1429

• Place the pound 1429 on deposit to accrue to pound 1429x1.08 = pound 1543

• Buy back $ using a forward contract in order to pay off the loan. Obtain $2,145 (1543

x 1.39) for £1543. Amount of $ loan plus interest, 2,000 x1, 05 = $2100. Risk free

profit will be $ 45 ( that’s $2145- $2100)

54

As a result of many people carrying out this transaction the $ will weaken on the spot

market (because of people selling $ and therefore increasing the supply of the $) and

strengthen on the forward market (because of people buying back $) causing the $ to

stand at a forward premium (over the spot rate) in terms of pound sterling, as predicted

by IRP.

2.11 Implied Forward Exchange rate using bid-ask spread

The interest rate parity relation only holds at a given point in time; one has to compare

interest rates and exchange rates quoted at the same point in time.

Illustration 12

Spot exchange rates are Tshs 2000.00/£- 10

One-year interest rates:

Tanzania 14%-15%

UK 10%-12%

Determine the implied bid- ask forward exchange rates

Solution:

The bid forward exchange rates can be calculated as:

Bid forward Tsh/£ = ( )( ) £/7143.20352000

12.01

14.01Tshx =

++

Ask forward Tsh/£ = ( )( ) £/9091.20902000

10.01

15.01Tshx =

++

Important tips to the students

• If you look at the Tsh/£ forward rate, the Tsh interest rate (underlying currency)

should be on a top, and the £ (reference currency) interest rate should be at the bottom

of the fraction

• to obtain the bid forward exchange rates, take the combination of bid and ask quotes (

for spot rate and for interest rates) that lead to the smallest quote for the forward

exchange rate

• To obtain the ask forward exchange rate, take the combination o bid and ask quote

(for the spot exchange rate and for the interest rates) that leads to the largest quotes

for the forward exchange rate

55

2.12 Covered Interest Arbitrage (CIA)

When the spot and forward exchange rates being in disequilibrium state, the investor will

take advantage of such disequilibrium by investing in whichever currency offers the

higher return on a covered basis. Since forward markets provide a way of eliminating

exchange rate uncertainty, arbitragers will arbitrage between various assets using forward

contracts to take care of the exchange risk. This kind of arbitrage called Covered Interest

Arbitrage (CIA). This is possible because when the market is not in equilibrium; arbitrage

profit (potential risk free) exists. In this situation, any arbitrager who happens to realise

will make use of this disequilibrium by investing in which ever currency offers the higher

return in covered basis.

Covered Interest arbitrage is the process of borrowing a currency where it is invested, and

selling this second currency forward against initial currency. Risk less profits are derived

from discrepancies between interest rate differentials and the percentage discount or

premium between the currencies involved in the forward transaction.

Illustration 13

For example, a crown is currency trading company. In 1999 it had $1,000,000 to invest i

alternative investment portfolio. The spot exchange rate between Dollar and yen is yen

106.00/$ for 1999 and six month. Six month forward rate in the same year was yen

103.50/$ and the interest rate in dollar market is 4% per annum. Show how CIA

transactions can be implemented.

Solution:

Opportunity for profitable covered Interest arbitrage will exist if IRP does not hold.

That’s if interest rate differential between countries is not equal to forward premium or

discount (but in opposite sign)

For IRP to hold, differential in interest rates between countries should be equal in amount

but in opposite direction for forward premium or discount. That’s IRP hold if,

56

h

hf

i

ii

s

sF

+−

=−1

Where, F implies forward rate, S spot rate, if interest rate foreign and ih interest rate

home. If there are differences between differential in interest rates between countries and

forward premium or discount, then IRP does not hold and the opportunity for arbitration

exists.

103.50/$-106.00/$

Steps

1) The company can convert $1,000,000 at the spot rate of yen 106.00 to get yen

106,000,000

2) Invest the proceeds, yen 106,000,000, in a Euroyen account for six months, earning

4% interest per annum

3) Simultaneously sell the proceeds (yen 108,120,000) forward for dollar at the 180 day

forward rate of yen 103.50/$. This action locks in gross dollar revenues of $1,044,638

4) Calculate the cost (opportunity cost) of funds used at the Eurodollar rate of 8% per

annum 0r 4% for six months, with principal and interest, totalling $1,040,000 profit

on CIA at the end.

2.13 The Fisher Effect

Because virtually all financial contracts are states in nominal terms, the real interest rate

must be adjusted to reflect expected inflation.

The Fisher Effect states that the nominal interest rates in each country are equal to the

required real rate of return plus compensation for expected inflation. The Fisher effect

states also that the nominal interest rate r is made up of two components:

• A real required rate of return

• Inflation premium or expected amount of inflation

57

The interest rates that are quoted in the financial press are nominal rates. That’s they are

expected as the rate of exchange between current and future dollars. What matters is the

real interest rate, that’s the rate after adjusting for inflation.

Because all financial contracts are stated in nominal terms, the real interest rate must be

adjusted to reflect expected inflation.

Formally, Fisher effect is,

1+Nominal rate = (1 + real rate)(1+Expected inflation rate)

Illustration 14

If the required real return is 3% and the expected inflation is 10%, then Fisher effect says

the nominal rate of return will be

1 + Nominal rate = (1+0.03)(1+0.1)

Nominal rate = 1.133-1 = 0.133 or 13.3%

The generalised version of the Fisher effect asserts that real return are equalised across

countries through arbitrage. Through arbitrage, if expected real returns were higher in one

currency than another, capital would flow from the second to the first currency. This

process of arbitrage would continue, in the absence of government intervention, until

expected real returns were equalised.

In equilibrium, then, with no government interference, it should follow that the nominal

interest rate differential will approximately equal the anticipated inflation rate

differential.

f

h

f

h

i

i

r

r

++=

++

1

1

1

1

In effect, the generalized version of the Fisher effect says that currencies with high rates

of inflation should bear higher interest rates those currencies with lower rates of inflation

58

2.14 The International Fisher Effect

The relationship between the percentage change in the spot exchange rate over time and

the differential between comparable interest rates in different national capital markets is

known as the international Fisher effect. This can be expressed as

£

£$

1

12

1 i

ii

S

SS

+−

=−

The international Fisher effect, tries to justify that investors must be rewarded or

penalised to offset the expected change in exchange rates

e\t = ( 1+ i of underlying currency )t x e0

( 1 + i of reference currency )t

Where e\t is the expected exchange rate in the period t

According to IFE, a rise in the inflation rate in one country relative to those of other

countries will be associated with.

• a fall in the value of currency in that country

• rise in interest rate relative to foreign interest rates

Why this situation?

This is because.

• Higher inflation leads to too much money in the circulation

• Too much money leads to high price for goods and also people will need much

money to buy one unit of good

• Too much inflation lower the value of home currency, hence to get one unit of foreign

currency become expensive, the import will decline and export will increase because

it becomes cheap to buy our goods by foreigner and expensive to buy foreign goods

• Too much home currency will be needed to convert to get foreign currency to pay for

import. In this case, the borrowings will increase, hence banks will rise the interest

rates

• The increase in interest rates will lead to increase in value of home currency. This is

because, the high interest rate will borrowings expensive, hence borrowings will

decrease and money in the circulation will decrease, hence rise the value of money.

59

NB: In effect, the IFE says that currencies with lower interest rates are expected to

appreciate relative to currencies with high interest rates

Illustration 15

In July, the one year interest rate is 4% on Swiss francs and 13% on U.S dollar.

a) If the current exchange rate is SF 1= $ 0.63, what is the expected future exchange rate

in one year?

b) If a change in expectations regarding future U.S inflation causes the expected future

spot rate to rise to $0.70, what should happen to the U.S interest?

Solution:

a) According to the international Fisher effect, the Spot exchange rate expected in one

year will be equal to $ 0.6845, that is ( )

( )04.1

63.013.1 x

if rus is the unknown U.S interest rate, and the Swiss Interest rate stayed at 4% ( because

there has been no change in expectations of Swiss inflation), then according to the

international Fisher effect, ( )

( ) %56.1563.0

04.17.0

63.0

7.0

04.01

1===

++ xrus

2.15 Relationship Between Forward Rates and Future Spot Rate

Normally both spot and forward rates are influenced by future events and these rates tend

to move in tandem (together), with the link between them based on interest differentials.

New information, such as change in interest rate differential is reflected almost

immediately in both spot and forward rates. However, spot and forward rates are

influence by future events where there is no government intervention in the market

Pressure from the forward market is usually transmitted to the spot market and vice versa.

Equilibrium is achieved when the forward differential equals the expected change in

exchange rate. At this point there is no longer any incentive to buy or sell the currency

forward

60

A formal statement of unbiased nature of the forward rate (UFR) is that forward rate

should reflect the expected future spot rate on date of settlement of the forward contract

f1 = -e1

Where:

e1 implies the expected exchange rate at time 1 (units of home currency per unit of

foreign currency)

f1 means the forward rate for settlement at time 1

This relationship can be expressed as follows

0

01

0

01

e

ee

e

ef −=

−

Where f1 forward rate, e1 expected exchange rate, e0 spot rate. It should however be noted

that the unbiased nature of the forward rates is an empirical, and not a theoretical issue

2.16 Forward Rate as an Unbiased Predictor of the Future Spot Rate

Some forecasters believe that for the major floating currencies, foreign exchange market

are efficient and forward exchange rates are unbiased predictor of future spot exchange

rates. When the forward rate is termed as unbiased predictor of the future spot rate, it

means the forward rate overestimates and underestimates the future spot rate with

relatively equal frequency and amount. The some of the errors equals to zero.

By being unbiased predictor does not mean the future spot rate will actually be equal to

what the forward rate predicts. The forward rate may in fact never actually equal the

future spot rate. The future spot rate may be greater or less than forward rate depending

with operating circumstances that may influence the change of exchange rates

2.17 Uncovered Interest Rate Parity (UIP)

The proceeds from foreign investment denominated in foreign currency are reconverted

into domestic currency at the spot exchange rate prevailing on the maturity date of the

investment rather than at the forward rate (pre- determined exchange rate).

As some times the prevailing exchange rate may be lower than spot rate, there is foreign

exchange risk that may lead to exchange rate loss to the firm

61

The Uncovered Interest parity equilibrium (UIP) can be explained in different conditional

relations as follows:

• ( ) ( )ii +=+ 1S

S1

e

. This relation tells us that gross domestic return is equal to

expected (uncovered) gross foreign return. The gross return is measured in terms of

the initial amount invested and the interest earned from the investment

• ( ) 11 −+= rs

si

e

. In other words, net domestic return is equal to expected (uncovered)

net foreign return. Net return here is the yield or interest rate earned.

• *).1(* iSii e +=− In other words, it can be said that interest rate differential between

countries is equal to the expected percentage change in the exchange rate adjusted for

by the factor that is equal to one plus the foreign interest rate.

• eSii =− * . This condition relation explain that the interest rate differential is equal to

the expected percentage change in the exchange rate

2.18 The Effect of Uncovered Arbitrage

2.18.1 Equilibrium (Arbitrage)

Under this situation, gross domestic return is equal to expected (uncovered) gross foreign

return. That’s( ) ( )*e

1S

S1 ii +=+ . In this question there would be not arbitration as the

investor may get the same return abroad as that can be obtained at home.

2.18.2 Outward Uncovered Arbitration

This is a situation that exists when gross domestic return is less gross expected foreign

return. That’s when( ) ( )*e

1S

S1 ii +<+ . In this case, investors would like to invest in the

foreign market

Outward Uncovered Arbitration work as follows

62

• Arbitragers borrows at the domestic interest rate, i

• They convert the borrowed funds at S, obtaining 1/S foreign currency units per unit of

the domestic currency. This amount is then invested at the foreign interest rate i*

• The foreign currency value of the invested amount at the end of the investment period

is (1/S)1+i*)

• This amount is reconverted into domestic currency at the spot exchange rate expected

to prevail on maturity, Se , to obtain Se/S(1+i*)

• The value of the loan plus interest per unit of the domestic currency is (1+i)

• Expected net profit per unit of the domestic currency borrowed (i.e. the expected

return on uncovered arbitrage) is the difference between the amounts expected to be

received at the end of the investment period and borrowed amount plus interest. This

equal to Se/S(1+i*)-(1+i). If Se/S(1+i*)-(1+i)>0, the investor expect to make profit

from that condition.

2.19 Inward Uncovered Arbitrage

This is the situation where the investor has to borrow foreign currency using foreign

interest rate and convert the amount borrowed into local currency and inverts at home

using local interest rate

This type of arbitrage work in the following way

• Arbitrages borrow at foreign interest rate i*

• Convert the borrowed funds at S, obtaining S domestic currency. Then this amount is

invested at the domestic interest rate, i

• The domestic currency value of the invested amount at the end of the investment

period will be S (1+i)

• The amount is reconverted into foreign currency at the expected spot rate to obtain

S/Se (1+i*)

• The value of the loan plus interest rate per unit of the domestic currency is (i+i*)

• The expected net profit per unit of the foreign currency borrowed (return on inward

uncovered arbitrage) is the difference between the amount obtained on transaction

including the initial amount and the total amount invested

63

RFERENCE

Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by

Palgrave MACMILLAN, UK

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Review Questions

1. Between 1999 and 2000, the rate of inflation in Tanzania was 6%, and the rate of

inflation in Kenya was 5%. In this connection the Kenya Shilling revalue from Tsh10

in 1999 to Tsh 12 in 2000.

Required

Determine the real exchange rate in 2000.

2. Now let’s consider an investor with $1,000,000 to invest and has comparable Swiss

Franc (SF) monetary investments. The spot exchange rate between Dollar and Swiss

franc is SF1.4800/$ and three month forward rate is SF1.4655/$. The interest rate in

dollar market is 8% per annum, and in Swiss franc money market is 4% per annum.

The investor can make use of the money on the following alternatives.

Required:

(a) Determine the rate of return in Swiss

(b) Where should the investor invest the money?

(c) What will be the total return if investment is done?

3. In February 2004 the US dollar - Mexican peso exchange rate was 11p/$. The price of

a hotel room in Mexico City was 1000 pesos. The price of a hotel room in New York

City was $200.

64

(a) Calculate the price of the Mexican hotel room in US dollars

(b) Calculate the price of the US hotel room in Mexican pesos.

(c) Suppose the exchange rate rises to 12 pesos per $. What does the exchange rate

change indicate has happened to the value of the US dollar? ... to the value of the

Mexican peso?

(d) Does the currency change benefit the US tourist travelling to Mexico City or the

Mexican tourist travelling to New York City? Explain why.

4. Consider the following data collected on February 9, 2004. The interest rate given is

for a one-year money market deposit. The spot exchange rate is the rate for February

9. The expected exchange rate is the one-year forward rate.

iC$ 2.5%

E$/C$ .7541 $/C$

Ee$/C$ .7468 $/C$

(a) Use both RoR formulae to calculate the expected rate of return on the Canadian

money market deposit and show that both formulae generate the same answer.

(Express each answer as a percentage.)

(b) What part of the rate of return arises only due to the interest earned on the deposit?

(Express the answer as a percentage.)

(c) What part of the rate of return arises from the percentage change in the value of the

principal due to the change in the exchange rate? (Express the answer as a

percentage.)

(d) What component of the rate of return arises from the percentage change in the value

of the interest payments due to the change in the exchange rate? (Again, express the

answer as a percentage.)

65

5. Consider the following data collected on February 9, 2004. The interest rate given is

for a one-year money market deposit. The spot exchange rate is the rate for February

9. The expected exchange rate is the one-year forward rate.

i£ 4.5%

E$/£ 1.8574 $/£

Ee$/£ 1.7956 $/£

(a) Use both RoR formulae to calculate the expected rate of return on the British

money market deposit and show that both formulae generate the same answer.

(Express each answer as a percentage.)

(b) What part of the rate of return arises only due to the interest earned on the

deposit? (Express the answer as a percentage.)

© What part of the rate of return arises from the percentage change in the value of

the principal due to the change in the exchange rate? (Express the answer as a

percentage.)

(d) What component of the rate of return arises from the percentage change in the

value of the interest payments due to the change in the exchange rate? (Again,

express the answer as a percentage.)

6. Assume that an investor has 1000,000 sterling pounds to invest for a period of one

year. The exchange rate quotation for the US dollar is $1.610000 spot and $1.530949

for 13 months forward. Twelvemonths interest rates are 8 15/16 for Eurodollar

deposit and 14 9/16 for Euro sterling deposits.

Required

a) Show whether opportunity for profit covered interest arbitrage exist

b) State whether interest rate parity hold

c) Show how the investor can avoid foreign exchange risk

66

7. The United State and German are running annual inflation rates of 5% and 3%

respectively. The initial exchange is DM 1 = $0.75. Calculate the value of the DM in

three years (Assume the PPP holds)

67

CHAPTER 3

EFFICIENCY MARKETS AND EXCHANGE RATE FORECASTING

3.1 Introduction

Foreign exchange market consists of various participants and cheaply available

information that can easier be accessed by each participant in the market. In this market,

new information are accessible by each participants and the activities involved in this

market cause prices to rapidly adjust to available information.

From the points of view of the above, Efficiency market can be defied as a market in

which information is widely and cheaply available to investors and that all relevant and

ascertainable information is already reflected in the prices. In this condition it is not

possible to make abnormal profit.

Additionally, Efficiency market can also be said to be the market in which prices reflect

all available information so that excess risk-adjusted are not possible. That’s to say a

market is efficient if transaction prices fully reflect in an unbiased way all relevant

information available to market participants at the time the transaction takes place.

3.2 Characteristics Of Efficient Market

• Information is readily available and every participant can easier access to such

information

• Information arrives in the market in a random manner in such a way that it is not

easier to predict the kind of information that will come

3.3 Implication of the efficient market definition

The implications of the market efficient definition are as follows:

• It is not possible to predict price movements from available information because this

information is already reflected in prices.

• Since the arrival of information is random and given that new information is reflected

in prices very quickly, the period-to-period changes in prices tend to be random

68

• It is not possible to earn abnormal (higher) returns through active trading as compared

to what can be obtained from a passive buy and- hold strategy.

• It is not possible to earn profit through speculation and arbitrage where the market is

efficient. This is because no one can charge different prices for different customers as

each participant is well informed of the prices in the market

3.4 Assumptions Underlying Efficiency Foreign Exchange Market

The efficiency foreign exchange market assumes that:

• All relevant information is quickly reflected in both the spot and forward exchange

markets. This will enable the information to be available to a sufficient number of

investors

• Transaction costs are low

• No individual participant is of sufficient wealth that can in any sense dominate the

market.

• Instruments denominated in different currencies are perfect substitutes for one

another.

3.5 Implications of the Efficient Markets Assumptions

a) Financial Management Functions

If the assumptions hold, then a company’s true financial position will be reflected in its

prices. If a company markets good financial decision this will be reflected in an increase

in its prices

b) New Issue

Many firms issue shares when share prices are generally high, but if the market is

efficient, the new issue can be made regardless of the share price levels in the Market

Investment Analysis

For the efficient market assumption to hold, it is necessary to analyse and attempt to

interpret the information available, so as we can make viable decision about the

69

investments. The existence of an efficient market does not guarantee the viability of

various investments.

3.6 Levels Of Efficiency

The levels of efficiency of the market are defined with reference to the contents of the

underlying information set. In this context, there are three levels of market efficiency:

a) Weak Efficiency

In this level of market efficiency, current price reflects all the information contained in

the past behaviour of prices. This proves to be week efficient because it excludes the

effect of other relevant variables. As current prices already reflect all past price changes

and any other information, there can be no relationship between past changes and future

price changes. So if the foreign exchange market is weakly efficient, it means that past

market data cannot be of any use in predicting future prices behaviour.

b) Semi- Strong Efficiency

The set of past information prices behaviour and other all publicly available information

are reflected in the current prices. Here publicly available information refers to variables

that affect exchange rates, economic and otherwise. E.g economic news as released by

the authorities is publicly available since it is reported by a media as soon as it is

released. In most case, the information which is publicly available includes those relating

to inflation, unemployment, the balance of payment, the money supply, public debt etc.

The implication is that, any attempt to act on new information by investors once it is

publicly released, can not derive above-average profits because the price already reflects

the effects of the new public information

c) Strong Efficiency

It is said a market is strong efficiency if Prices reflect all available information including

private, public, insider information and otherwise. In side information can be obtained

from officials working in the reserve Banks by having talks privately with them. If the

foreign exchange market is strong efficient, then no group has a monopolistic access to

70

information and no group should be able to consistently earn above average profits. In

other words it can be said that no insider and private information can help to predict the

future behaviour of exchange rates or to make abnormal profits

3.7 Market Efficiency and Trading Rules

With Market efficiency there is no possibility for an active trading strategy to produce

superior profit than what can be obtained from a passive buy hold strategy. The reason is

no matter what, strategy can be made; will not influence the price to differ from the

prices charged by other participants for the similar security.

Market efficiency is governed by two basic types of rules. These are

• Filter rules. A currency is bought when it appreciates by certain percent from its most

depression and sold when it depreciates by certain percent from its most recent peak.

• Moving Average rules. It is the simple average of the daily values of the last of days.

A moving average rule depends on the behaviour of one or two moving averages in

relation to the actual exchange rate and to each other. Under moving average rules,

the most recent observed information is more relevant to the future behaviour than

that conveyed by old observation

3.8 Basic concepts of foreign exchange market efficiency

a) Spot Market Efficiency

This implies that spot exchange rates move in a random and unpredictable way, reflecting

the random arrival of new information. This means that one can not make profit by

speculating in the foreign exchange by buying and selling currencies actively

b) Forward Market Efficiency

Where spot and future information are embodied in the forward rate, the foreign

exchange market is said to be efficiency. The forward rate performs this function because

represents the collective knowledge of many well- informed profit- seeking traders and

also because it revises quickly as new information becomes available

71

c) Cross Sectional Efficiency

In this market two or variables that can influence the price behaviour in the market

operate. The market is said to be cross sectional efficiency if the variables congregate.

Two variables are said to congregate (work together) if they are linked by a long-run

relationship such that they cannot draft too far apart

3.9 Exchange Rate Forecasting

Forecasting is a formal process of generating expectations which used as an input in the

decision making process. Exchange rate forecasting is an important element in decision-

making process of international business firms. This is attributed by the fact that the

quality of an MNC’s corporate decisions depends on the accuracy of exchange rate

projection. Forecasting exchange rate is important because it has an influence on the

operations of an MNC. However, exchange rate forecasting is crucial because the future

or forward exchange ate is not certain.

3.10 Reasons for need of exchange rate forecasting

Among other reasons the following are some of reasons for forecasting needs of the

Multinational Firms

a) Hedging Decision

A firm’s hedge decision may be determined by its forecasts of foreign currency value.

Firms engage in many international transactions in which case their expected cash flows

are vulnerable to risks associated to exchange rate fluctuations. Firms need to protect

themselves against such risks. This can be done through hedging. However, this largely

depends on the expected exchange rates. For instance, the decision whether or not to

hedge a foreign exchange exposure resulting from payables or receivables depends on the

spot exchange rate expected to prevail when the payables and receivables are due

b) Short Term Financing Decision

The firms financing decision involves the choice of the currency to serve as the

denomination of a bond issue. The firms will borrow in a currency which exhibit a low

72

interest rate, and which weaken in value relative to home currency over the financing

period. This will enable the firm to pay back the loan with fewer home currencies when

convention is done. This financial decision will also be influenced by exchange rate

forecasts of any currencies available for financing.

c) Short- Term Investment Decision

The choice of the currency for short-term investment depends on the rate of return on

assets denominated and whether or not it is expected to appreciate over the investment

horizon. The multinational firms would invest their excess cash in currency which exhibit

a high interest rate and which strengthen in value over the home currency over the

investment period. This will enable more home currency be received at the end of the

period if foreign currency received is converted to home currency. To be able to

determine where the excess cash available is to be invested, exchange rate forecasts of

the currencies are necessary.

d) Capital Budgeting Decision

To decide on whether to invest or not, future cash flow for the inspired investment

should be determined. This future cash flow forecast would depend on future currency

value which is determined by forecasting exchange rates.

e) Pricing Decision

Exchange rate forecasting is important for international business firms selling their

products in foreign currencies. If a particular domestic currency price is chosen, for

example, to implement a market penetration objective, then exchange rate forecasting is

essential.

f) Strategic Planning

Exchange rate forecasting is also important for strategic planning, such as the choice of

the production location and the foreign market

g) Macroeconomic Condition

The forecasting process provides an extensive discussion of macroeconomic conditions in

each country.

73

h) Central Bank Intervention

Exchange rate forecasting is needed by central banks and economic decision- making

authorities. If central bank or if exchange rate exhibits that the currency will go in an

desired direction, the central will intervene the foreign exchange market rate converge on

the desired path

i) Options speculation

A long call or short put position will be taken if the underlying currency is expected to

appreciate, while a short call or long put position will be taken if the currency is expected

to depreciate. There is need therefore to forecast the level of underlying exchange rate.

j) Spot-Forward Speculation

If it is expected that the spot rate in future will be higher than the forward rate on the

maturity date, a speculator will buy forward and sell spot upon delivery. However, if the

forecasts reveal that the spot exchange rate will be lower than the forward rate, then the

speculator will sell forward and buy spot. The information about the exchange rates will

be obtained through forecasts and the foreign exchange forecasts is needed for that

purpose.

3.11 Exchange Rates Forecasting Models

To be able to forecast exchange rates, different forecasting techniques are critical

important. There are several forecasting techniques. However, three major techniques are

used. These are:

• Econometric Forecasting Model

• Time Series forecasting model

• Technical Analysis and forecasting

3.11.1 Econometric Forecasting Model

This method is based on some economic theory and estimates. Econometric models are

classified into single equation model and multi-equation econometric modules. For a

single equation model, the exchange rate depends on one or more variables. One variable

74

being independent and others explanatory variables. For multi-equation econometric

modules exchange rate depend on more variable.

3.11.2 Time Series Forecasting Model

This model is based entirely on the past history of the exchange rate. The level of the

exchange rate is assumed to depend on its past levels e.g. which implies that there is no

underlying economic theory. The function relationship is normally specified in a linear

form, i.e. )...( 2,1 ntttt SSSfS −−−=

3.11.3 Technical Analysis And Forecasting

This model focuses on past price and volume movements, ignoring economic and

political factors. Technical analysis utilises the exchange rates past history to forecast its

future level, but these models tend to be less formal and less rigorous (precise). It is a

market based technique. The rationales for technical analysis are:

• Market value is determined by the interaction of supply and demand

• Supply and demand are governed by numerous factors, both rational and irrational

• Changes in trend are caused by shifts in supply and demand

• History tends to repeat itself. Therefore past patterns of behaviour will recur in the

future and can thus be used for predictive purpose.

The main method of technical analysis is Chartism; this encompasses the use of bar

charts or trend analysis (various mathematic computations)

Under Chartism method, historical data are plotted on a chart. The technical analysis

relies on the study of historical data by plotting them on a chart. For this reason, this

method is also known as charting. This method uses three major types of charts. These

are:

• Line charts- A plot against time, normally of daily closing exchange rates

• Bar charts- it plots the high and low closing exchange rates for each day

75

• Point and figures charts. These charts are used to highlight major market trends. They

do not show small exchange rate movements and they are not time-related to the

extent that initially they look very confusing

3.12 Exchange Rate Patterns

Exchange rate movements may reveal different patterns. The following are the patterns

which exchange rates can reveal:

Trend lines and Trading Ranges - A trend may be upward, downward or sideways.

Upward trend is a situation where the chart shows series of ascending bottom. Down

ward trend is a situation where a chart is characterized by a series of descending tops.

The market is said to be in a trading range when the market moves sideways that’s when

the tops and bottoms are at the same level. The trend in this case will be recognised by

drawing trend lines connecting the tops and bottoms

Flags- These are continuation patterns. In this case the poles are the continuation of a

previous trend. A flag occurs when major trends are interrupted. When this takes place,

some market participants wait for the move to continue, while others get in hoping that

the trend will proceed. The increase in buying will increase pressure and consequently

upward trend will continue

Triangles- This can be ascending, or descending. An ascending triangle occurs when

buyers come into the market at progressively higher levels while sellers get out at the

same level. The buyers in this case will lead the exchange rate to rise as the pressure for

buying will increase. Consequently, will be a continuation of the trend.

3.13 Composite Forecasting

Composite forecasting is based on two or more forecasts that are derived independently.

The basis idea behind composite forecasting is that the forecasting accuracy can be

increased by pooling different forecasts and deriving some sort of an average. In this case

the simple average of two forecasts is taken. For instance, T is a forecast based on time

series and P is a forecast based on the PPP, therefore the composite forecast based on

simple average will be as follows:

76

20

PTS

+=

However, this formula can be modified by incorporating weighted average and hence

find econometric forecasting. For this case, if weighted average is given by 1W and W2

respectively, then the composite forecasting based on econometric forecasting will be

given by:

SWSWSc

21

^

+=

Reference

Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by

Palgrave MACMILLAN, UK

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

77

Review Questions

1. Discuss different models that can be used in exchange rate forecasting and state their

differences

2. Why Exchange rate forecasting important for the MNC and for other participant in

the Foreign exchange market?

3. Exchange rate movements may reveal different patterns identify and explain different

exchange rate patterns that can be demonstrated by exchange rate movements.

4. Discuss the differences between Outward and Inward covered arbitrage and state how

an investor can make use of each of the two to realise gain.

5. What it meant by market efficiency and Discuss different levels of market efficiency

6. Brother Nyundo has forecasted the following inflation rates in two different countries.

Zimbabwe 10% and Tanzania 5%. The prevailing exchange rate at the time of

forecast was Tsh50/Z$. Using the PPP forecast the exchange rate after one year that

will prevail after two years

7. Mr Seven is much specialised in exchange rate forecasting using inflation rates

between countries. He has been provided the following information by the United

Republic of Kenge. It has been revealed that the inflation rate in Zawe country will

ran to 5% in 2006 and 8% in Kowa Country. Additionally the information reveals that

in Zawe the inflation rate will be 10% in 2007 and 9% in Kowa. If the today’s

exchange rate between the currencies of these two countries is K10/Z. Determine

exchange rate that will exist in 2007.

78

CHAPTER 4

FINANCIAL DERIVATIVES

4.1 Introduction

Business environment is changing quickly, resulting in more and more sophisticated

financing instruments being used to provide better return on invested capital. Moreover

as the results of globalization, businesses have become borderless in their operations. As

such the risks have increased. Significant amount of money is currently used by

organizations to buy and sell term contracts, and benefit from opportunities resulting

from exchange rates and interest rate variations between countries. In other words it can

be said that financial derivatives are important instruments for increasing shareholders

wealth. More importantly, financial derivatives are increasingly used as tools for hedging

risks of price fluctuations and managing rate of cost of capital.

4.2 Definition of Financial Derivatives

Financial derivatives are commonly known as financial instruments. Are contracts that

give rise to a financial asset of one entity and financial liability or equity instrument of

another entity.

• Financial assets will or are likely to lead to a company receiving cash in the future

• Financial liabilities will, or are likely to , lead to a company paying out cash in the

future

• An equity instrument evidences a residual interest in the assets of the company after

deducting all its liabilities

Derivatives provide an opportunity for contracts to those who have specific expectations

about future currency movement. Derivatives are contracts which give the right, and

sometimes the obligation, to buy or sell a quantity of the underlying asset, or benefit in

another way from a rise or fall in the value of the underlying asset. These rights are assets

which have values and can be purchased or sold in the specific market.

4.3 Types of Financial Derivatives

There are many types of financial derivatives, however, this manuals covers only the

following derivatives:

79

• Currency future contracts

• Forward contracts

• Options contacts

4.3.1 Currency Futures Contracts

The markets providing an opportunity for speculating on the future value of a foreign

currency is known as currency futures market. With currency future market, traders

hedge against price fluctuations of a currency.

The transactions in the currency future markets are known as currency future contracts.

These are contracts for the delivery of a specified quantity of currency at an agreed price

or exchange rate at a named future date. It involves purchase of currency to be delivered

at a specified future date at a price agreed at the moment.

Currency futures contracts act as a means of hedging or insuring against serious

fluctuations in price. Some times the speculator can purchase currency future contract in

order to benefit from currency future movement.

Futures are contracts specifying a standard volume of a particular currency to be

exchanged on a specific settlement future date or set the size of each contract, the units of

price quotation, minimum price fluctuations, the grade and the place for delivery.

The economic purpose of doing so is to enable trading firms to fix in advance exchange

rates or prices which will be used in future to effect the transaction. In other words,

Currency future allows one to lock in the price to be paid for a given currency at a future

date. For instance, for agricultural commodities, the type or grade is fixed in the future

contract (e.g wheat of a particular quality or variety). The futures exchange sets the

minimum contract size (e.g. Y bushels of wheat), delivery dates (e.g. March, may, June

for wheat)

For instance, if a speculator expects the NOK to appreciate in the future, he might

purchase a futures contract that will lock in the price at which they can buy NOK at a

specified settlement date. On the settlement date, they can purchase their pounds at the

rate specified by the future contract, and then sell these NOK at the spot rate. If the spot

80

rate has appreciated by this time in accordance with their expectations, they will profit

from this strategy

The speculator will speculate in the following ways.

• If speculator expects a currency to depreciate relative to other currency, the

speculator will want to sell now the currency which is expected to depreciate in future

and buy it back after it has depreciated using strong currency enabling him to get

much of that currency again

• If the expectation is for an appreciation, the speculator will want to buy the currency

now and sell it later when it is stronger relative to other currencies.

Illustration 1

A trader may contract to buy NOK 200,000 at future contract at rate of NOK10/£. In this

case, the trader in a settlement date will pay £20,000 (that is NOK200,000/10) to obtain

NOK 200,000. If at settlement date, the spot rate is NOK 5/£, that’s the price existing in

the future date, then the trader will sell NOK at price of NOK 5/£ and get £40,000 (that

is, 200,000/5).The profit to the trader will then be £20,000 (that is 40,000-20,000)

4.3.1.1 Gain in the future contracts

The gain or loss to the firm from the currency future contract is dependent of the price of

purchasing futures versus selling futures. If the selling future is greater than purchasing

future contract, then the firm will get profit. The price of a future contract changes over

time to reflect the markets anticipation of the future spot rate.

By holding futures contracts, the firm does not have to worry about the changing spot rate

of the currency over time because future contracts lock in the price to be paid for a given

currency at a future point in time.

4.3.1.2 Margins and Marking to Market

Futures are traded on a regulated exchange. In this market there is no direct transaction

between seller and buyer. The clearing house becomes a formal counterparty to every

transaction.

81

Since future contracts (unlike forward contracts) are traded on an exchange, there needs

to be some standardization of the contracts and price quotes. Also, to minimize default

risk, a clearing house and some collateral are required to compensate a trader if another

trader defaults (this is taken care of with the margin requirement). For this purpose

certain percentage of the total value of the contract is paid to provide financial protection

in case one of the counterparties to the futures contracts defaults. The amount paid is

called initial margins. It is collateral that must be posted to transact in a futures or

options contract, in order to ensure the clearing house against credit risk.

It is important to understand that the initial margin is not a payment for the future

contract. It is a good faith deposit to ensure that the terms of the future contract are

honoured.

4.3.1.3 Marking to market

To enable the clearing house to maintain the initial margin and protect it from falling

below the maintenance value, normally it operates a system of daily marking to the

market. This refers to the act of revaluing securities to current market values (and taking

account of accruals of interest on bonds).

Futures price fluctuate every day and even every instant. Therefore, all contract positions

are marked to market at the end of every day. if the price movements induce a gain on the

position, the customer immediately receives cash in the amount of gain. However, if there

is a loss, the customer must cover the loss. Normally as soon as a customer’s account

falls below the maintenance margin, the customer receives a margin call to reconstitute a

margin. If this is not done immediately, the broker will close the position on the market.

This will involve terminating the contract, which will amount the loss of the initial

margin by one of the party who defaults the contract.

Marking to the market work as:

• Counterparty’s profits or losses are established as a result of that day’s price change

82

• The counterparty that makes a loss, his/her margin account is debited. This action will

require him to inject more cash, on the following day to cover the loss below the

threshold amount- called the maintenance margin

• Failure to pay the daily loss causes a default and the contract is closed to protect the

clearing house from possibility of further losses

The profit that occur due to daily credits and debits to members account (marking-to-

market) are known as the variation margin

Illustration 2

Assume the initial margin is $2600 per contract and the maintenance margin is $1,600.

Assume that you buy one March contract on February 1999 at $0.7049/SF and you

deposit, in cash, an initial margin of $2,600. Listed below are the future quotations

(settlement price) observed on three successive days:

Feb. 19 0.7049

Feb .20 0.7009

Feb. 21 0.6949

Feb. 22 0.7089

Note the one contract is equivalent to SF125,000

Determine the cash flows associated with these price fluctuations

Solution

You bought a contract to sell SF. that means you will like to sell when SF appreciates so

as you get more $ for each SF sold.

On Feb. 20 you lose 0.0040 dollars per franc or $500 per contract (that’s 0.7009-0.7049).

The loss is debited from your initial deposit. This makes your margin to fall to $2100

(that’s 2600-500). But this is still above your maintenance margin of $1,600.

For that reason, you do not need to reconstitute the margin

On February 21, you lose 0.0060 dollar per franc, that is (0.6949-0.7049) or $750 per

contract. In this case, your margin is now $ 1350 that’s (2100-750). Because $1350 is

83

below the maintenance margin, you will require to constitute the initial margin up to

2,600 by transferring $1250 to your margin account.

Feb. 22 you gain 0.0140 dollars per franc, or $1750 per contract. You can use the $1750

as you like since your initial margin is intact at $2,600

Note:

The result on Feb 22, is that you have net gain of $500, that’s:

The Gain in Feb.22 per contract $1750

Less:

Loss in Feb.19 $500

Loss in Fe. 20 $750 (12500)

Net gain $500 per contract

Now let us say you decided in Feb. 22 to sell back the contract, your margin deposit of

$2,600 would be given back to you and also the gain of $500 will be users

Illustration 3

Suppose you purchase one US T-Bond futures contract at noon on day 1 when the current

future price Fo= $98 (per $100 nominal) and one contract is for $100,000 nominal. Let us

act as clearing house and define ‘one tick’ as a change in F of 1 unit

The tick value of a change in F of 1 point is therefore (1/100x 100,000), which is equal to

$1000. The initial margin we take as $5000 and the maintenance margin is $4000. That is

when you purchase the contract at $98 you deposit your initial margin of $5000

Suppose that by the end of day 1 the futures prices falls dramatically, from Fo = $98 to

F1 = $94. The futures price at the close of day 2 falls to F2 = $93.50. On day 3, the

investor reverses his position and closes out at F3 = 98.50 (makes an increase of 5 points.

Solution:

In day one the investor has a loss of $4000 since at the end of day 1 she can now only

sell her futures contract for $94,000 (94 x1000) in stead for $98,000 (98 x 1000). Now

84

the balance at the end of day 1 of $1000 is below the maintenance margin. Hence the next

morning, the investor must immediately pay a variation margin of $4000 (so that the

balance in the margin account at the beginning of day 2 is back to $5000)

In year two there is additional loss of $500, (that’s 93.5-94,)x1000, which brings the

balance in the margin to $4500, (5000-500). Since the long has previously paid in

$5000+ $4000 then the net profit over three day 3 is $ 500, (98.5-98)x1000, which is

equal to the change in the future prices (F3-Fo) grossed up by the tick value.

4.3.1.4 The Basis

A futures price approaches the spot price at delivery. The difference between the two is

called the basis. The basis is often expressed as a percentage of the spot price.

Thefore, the basis is given by:

Future- Spot Price

Future

Table 1: Differences between Forward and Future Contracts

Forward Contracts Future Contracts

Customized contracts in terms of size and

delivery

Standardised contracts in terms of size

and delivery

Private contracts between two parties Standardised contracts between customer

and clearing house

Impossible to reverse a contract Contract may be freely traded in the

market

Profit or loss on a position is realized only

on the delivery date

All contracts are marked to market;

profits and losses are realised

immediately.

Margins are set once, on the day of the

initial transaction

Margins must be maintained to reflect

price movements

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4.3.1.5 Hedging with Futures

Hedging the risk of an individual asset is easy if futures contracts on that specific asset

exist. In some cases, future contracts do not exist in some assets. Here arises then a

question of which futures contracts should be used and in what amount? This being the

case, a hedging strategy needs to be designed.

Classification hedge contracts can generally be classified as a cash hedge or an

anticipatory hedge. A cash hedge is the hedging of an existing position in the spot (cash)

market. It involves selling future contracts to cover a cash position and also it is known as

short hedge. Anticipatory hedge involves buying future contract in anticipation of a cash

purchase. This is also known as long hedge because the investor is long in future

contract.

Illustration 4

One a Swiss portfolio Manager expects to receive $1million in his account in a week

from a client who purchased goods on credit from him. He plan that this cash flow will be

invested in short term Euro deposits. The current interest rate in Euro market is 10%, but

the manager worries that that rate will drop before he receives the money a invest.

Therefore, he decides to lock this interest rat by buying one Eurodollar future contract.

One week later, the three-month interest rate drops to 9% and the Eurodollar futures price

is 91. One week later, the manager receives the money as expected and invests. Show

how the manager realised profit from this transaction.

Solution:

Note first that, the future contract was bought at 90. this is because short term futures

contracts are quoted as 100-the annual interest rates (even for three months deposits)

This is a profit on future contract

Therefore, the profit per unit equals to the future price variation divided by four

(quarterly interest rate) times principal amount. That is

( )500,2$000,1000$

4

%90%91 =−x

.

86

This is a profit on deposit (investment). The cash was deposited at 9%, this also gives a

return of $1000000 x 9% x 1/4 = $22,500.

Total profit will be 22,500+ 2,500= $25,000

If the investment was made before interest rate drops, that when it was 10% interest, then

the investor would have gained $25,000. That’s (10%x 1000,000)/4. But because he

invested at 9%, there is a loss of $2,500. Now since he purchased future contract, the

profit gained on future contract compensate the loss of $2500.

4.3.1.6 Cross Hedging

Unfortunately, futures contracts exist for only a few assets; the chance of matching a

future contract is very small. In this case a cross hedge has to be constructed in order to

hedge the volatility of a specific security in a portfolio.

A cross hedge means that the futures contract used is different from the initial asset to be

hedged. For example, a U.K gilt (long term government bond) contract can be used to

hedge a specific British Corporate bond. Clearly, the price of the selected futures contract

will be closely related with the price of the initial asset

4.3.1.7 Hedging Ratio

The success of hedging strategy depends on the proper hedging ration, because price

movements of the asset and of the futures often differ in magnitude (see an example of

how portfolio manager succeeded to hedge the drop of 10% interest rate).

The hedge ratio here is defined as the ratio of the principal (face value) of the futures

contracts used to hedge relative to the principal (face value) of the cash asset position.

The hedge ratio if given by:

Hedger ratio = Number of contracts x Size of Contract x spot price/Market value of asset

position

= V

SxSizexN

87

Where;

• N is the number of future contracts used to hedge

• Size is the quantity of assets (e.g 125,000 Euros) or the face value of securities (e.g,

$1000,000 worth of Treasury bonds or $1000,000 worth of Eurodollars)

• S is the spot price of the asset

• V is the market value of the cash asset position

Illustration 5

If an investor holds 1,000 ounces of gold (spot price $400 per once) and decides to short

ten contracts of 100 ounce (futures price $413 per ounce0, the hedge ratio is equal to:

h = V

SxSizexN =

1400000

40010010 =xx

Illustration 6

An investor would sell $400,000 worth of gold futures or approximately 9.69 contracts.

The price of the ounce is $400. The contract size is 100

Required

Determine the hedge ratio.

Solution:

The hedge ratio =969.0

400000

40010069.9 =xx

4.3.1.8 Minimum Variance Approach

Because of cross-hedge and basis risks, it is usually impossible to build a perfect hedge.

Therefore, a minimum variability in the value of hedged portfolio is determined.

Investors would like to minimise the variance of the return on the hedged portfolio.

The optimal hedge ratio is equal to the covariance of the asset, or portfolio, return to be

hedged with the return on the futures divided by the variance of the futures:

h= бPF/ б2F

88

This optimal hedge ration can also be estimated as the slope coefficient of the regression

of the asset, or portfolio, return on the future return

Rp = hRF

where,

Rp is the return on the asset or portfolio, RF is the return on the futures, and a is constant

term.

marketspaot on lossprofit /

contract futureon lossProfit/ efficiency Hedge =

4.3.1.9 Pricing Foreign Currency Futures

Foreign currency futures contracts can be valued using two equivalent instruments. These

are risk less domestic debt and risk less foreign debt

If an investor has an amount in dollars he converts these dollars into pounds and invests

in risk less debt e.g treasury bills. The investor will convert back the earnings plus

principal amount into dollar. To guarantees the exchange rate he will do so with a future

contract

Future sterling rate = ( )[ ][ ] rate

(£)1

($)1xSpot

R

R

++

Illustration 7

Assume Euro sterling interest rate R(£)= 11%; Eurodollar interest rate R($) = 6%;

30-day Euro sterling interest rate = 0.11x30/365; 30-day Eurodollar interest rate =

0.06x30/365; Sterling spot rate $1.50%. What is the 30-days sterling future rate?

Solution

So the 30-day sterling futures rate is

( )[ ][ ] $1.4941.50

)3036511.0(1

)365/3006.0(1 =+

+x

x

x

4.3.1.10 Closing Out A Futures Position

In practice most traders close out their position before the expiration of the future

contract. They therefore make a gain or loss depending on the difference between the

initial future price and the futures price at which they close the contract. In other words it

89

can be said the gain or loss to the firm from its previous futures position depends on the

purchasing futures versus selling futures. A currency futures contract decided before

settlement date can be closed out if the firms no longer want to hold such position. That is

closing out position involves shorting the contract before maturity date. This can be done

by selling out the contact at the price existing at that particular date.

Illustration 8

A British trader has imported goods valued $4,000,000 from one of the famous exporting

Company in USA. The transaction took place on April 1, 2001, and it was agreed to

effect the payment on 10th May 2001. The company wishes to protect itself from adverse

movements in the spot rate that might occur before the payment is due. Assume that the

standardized size of a dollar/sterling future contract is £25,000

The following information also pertains to the transaction.

Spot rate $1.6149\£

June futures $1.6000\£

Required

Show how the company can protect itself against exchange rate risk using future

contracts.

Solution:

The hedging future contracts will be as follows.

On I April the company should sell 100 June sterling futures contracts at a price of

$1.600/£ ( £25,000x 1.600x No of contract = $4000,000). The contracts are sold because

sterling needs to be sold in order to acquire dollars. The importer would need

(4,000,000\1.600) which is equivalent to £2,500,000 to buy $ 4,000,000.

If on 10th May the spot rate is $1.5850\£ and the June futures is $1.5720\£, therefore,

The actual payment for goods on May 10th will be made by exchanging sterling pounds

into dollar on the spot market.

The company will close out the futures contracts at the market price prevailing at that

time. Therefore to get $4,000,000 at May spot rate the importer will need £2,523,659.

That’s $4,000,000\1.5850. If the settlement would be immediately, that’s on April 1, the

importer would have incurred £2,476,933 for $4,000,000. This means $4,000,000\1.6149

90

This will result to loss on spot market of £46,726 , (2,523,659-2,476,933)

In order to protect against possible loss on exchange rate movement, the importer sell

sterling pound to get enough money to buy dollar (close out a future position). This

enabled him to get the profit which offset the loss on spot market.

Therefore, the profit on future contract would be 4,000,000\1.5720- 4,000,000\1.600 =

£44,529. This profit on future contract can be offset to loss on spot market. In this case

the overall net loss will be £46,726-£44,529, which is equal to £2197 loss. This loss is

due to appreciation of dollar against sterling pound or hedge efficiency of £ 95.3%.

%3.95£46,726

£44,529

marketspaot on ssprofit /lo

contract futureon sProfit/los efficiency Hedge ===

4.3.1.11 Selling currency futures

Currency futures are often sold by speculators who expect that the spot rate of a currency

will be less than the rate for which they would be obligated to sell it. By selling a futures

contract, the firm is locking in the price at which it will be able to sell the currency as of

settlement date. This can be appropriate if the firm expects this currency to depreciate

against its home currency.

For example;

Assume a speculator wants to purchase 125,000 marks in the spot market and sell it in

future contract. A mark futures contract specifies a price of $0.54 per mark. The spot rate

is expected to be $0.50 on the settlement date.

If the expectations are correct:

• The speculator will be able to purchase 125,000 marks for $62,500 in the spot market.

That’s 125,000 x 0.5

• The speculator will then sell their mark at $0.54 par mark as specified by the futures

contract, and receive $67,500. The gain is $5000. That’s the difference between the

purchase price and selling price of future contract.

91

4.3.1.12 Straddle and Tick

A straddle position is where an equal number of the same currency futures contracts are

simultaneously bought and sold. Short-term interest rate futures prices are quoted as 100

minus the rate of interest on the instrument involved. Thus an interest rate of 10% would

be priced at 90.0 for one future contract

Tick size is a minimum price fluctuation. Tick is Units in which price movements are

usually measured. It is a smallest permissible price fluctuation of a security. On most

contracts a tick is 1/100 of a 1% or 0.01 per cent (This is also referred to as a basis point).

Illustration 9

An investor has a $ 1,000,000 floating rate bond yielding 9% and is worried about

interest rate fluctuations during the next 3-months. He /she want to use 3-month

Eurodollar interest rate future contract to protect against interest rate changes. Assume

the interest rate fall to 9%. At what price the investor will sell the future contract, and

what will the yields from the bond?

Solution:

The investor will sell futures contracts at 100-9= 91 and the Profit will be equal to

0.01/100 x $1000,000 x 3/12 = $25 per tick

• For 100 tick, profit is 25x100 = $2500

• Bond yield will be equal to 9/100x3/12x1, 000,000+ 2,500 (Profit from the contract)

= $22,500 +2500= $25,000

Effective yield = %1003

12

00,000,1

000,25$xx

=10%

If interest rates rise to 11% the investor sells futures at a loss. From the above example,

the losses will be (89-90) = loss of 100 ticks at $25 per tick which is equal to $2,500.This

loss will be reduced from interest earned on investment:

92

Here interest earned on investment = $27,500 000,000,1$12

3

100

11 =xx

Less loss on interest rate 2,500

$25,000

Effective Yield: %10%1003

12

000,000,1

000,25$ =xx

Tick value - This is the monetary value of one Tick. It is calculated as the minimum

price movement (Tick size) multiplied by the contract size. Therefore, given the contract

size and Tick size, then the Tick value can be obtained as follows:

Tick value = contract size x Tick size. For instance, if three month sterling contract size is

£500,000 on LIFFE future contract, what would be the Tick value per contract?

Solution:

Normally Tick size is given by 0.01% or 0.01/100 = 0.0001. Therefore, for the three

month contract, the Tick value will be equal to 500,000x0.0001x 3/12 =£12.50

Illustration 10

NESTA plc is a company operating in the USA which imports goods from NECTA plc in

UK. NESTA plc is due to pay £650,000 to NECTA plc on 20 February 2002. It is now 12

November 2001. The following futures contracts (contract size £62,500) are available on

the Philadelphia exchange:

Expiry Current futures rate

December 1.4900$/£

March 1.4960$/£

Required

Illustrate how NESTA plc can use futures contracts to reduce the transaction risk if, on 20

February, the spot rate is 1.5030$/£ and March futures are trading at 1.5120$/£. The spot

rate on 12 November is 1.4850$/£. Calculate the “hedge efficiency”

93

Solution:

Step 1: Choose the appropriate futures contract.

In this case, it will be the March contract. The December futures contract will expire

before the exposure period (i.e. 12 November to 20 February) is over. It is normally

advisable to select the futures contract that will expire soonest after the end of the

exposure period

Step 2: Determine the number of contracts:

£650,000/£62,500 = 10.4 or approximated to 10 contracts. This implies that, NESTA plc

will buy 10 March contracts now (12 November) at 1.4960$/£ and sell 10 contracts on 20

February for 1.5120$/£, thus making a profit from the futures trading that will largely,

but not totally, negate the ‘loss’ from the spot market (i.e. the fact that sterling has

strengthened between 12 November and 20 February from 1.4850$/£ marking NESTA

plc’s imports from the UK more expensive if payment is to be made in £s)

Step 3: Determine the spot/loss from the futures contracts trade.

(a) Calculate the ‘tick’ movement

1.5120- 1.4960 = 0.0160 (i.e. 160 ticks, remember, one tick = 0.0001)

(b) Calculate ‘tick’ value per contract

£62,500x0.0001= $6.25

(c) Calculate the profit:

10contracts x160 x $6.25 = $10,000

Step 4. Calculate the overall cost and hedge efficiency

On 20 February, NESTA plc will exchange $ for £. £650,000 will cost on the spot

market:

94

£650,000 x 1.5030 = $976,950 (Note: With futures trading you still exchange at the

prevailing spot rate-unlike a forward contract)

The net cost to NESTA is therefore, $976,950- $10,000 = $966,950

The spot on 12 November was 1.4859$/£. So £650,000 would have cost $965,250, and

the loss on the spot market is $976,950-965,250 = $11,700

The hedge efficiency is therefore the futures contract profit divided by the spot market

loss.

%5.85100700,11

000,10$ =x

The efficiency is due to;

Rounding the contract to 10 from 10.4

Basis risk- The fact that the movement on the futures prices has not exactly equalled the

movement on the spot rate

4.3.2 Spot And Forward Markets

The transactions in the foreign exchange market can be dealt in the spot or forward

market. These forms of market forms the bases through which the exchange rate is to be

quoted.

4.3.2.1 Spot Market

A spot market involves purchases or sells of foreign currencies with the delivery and

payment between banks to take place, normally on the second following business day. It

requires immediately payment and delivery of foreign currencies. In the spot market, the

currency is sold or bought at its spot rate. The transactions in the spot market is known as

spot transactions and the rate at which the transactions are effected in the spot market is

known as spot rate

95

4.3.2.2 Forward Market

Forward contract requires the delivery of a specified amount of foreign currency for a

specified amount of another currency at a future value date. One buys forward contract

for exchange of one currency for another at a specified future date and at agreed

exchange rate. Although the exchange rate is fixed at the time of agreement, the payment

and delivery of foreign currency is effected in the future date. The transactions dealt in

the forward market are called forward transactions and rate at which forward transactions

will be dealt is known as forward rate. The forward exchange rate is the rate today for

exchanging one currency for another at a specified future date. Traders/firms can use

forward market to protect themselves against foreign exchange fluctuations.

4.3.2.3 The Forward Exchange Market

It is possible for agents in the exchange market to agree today to exchange currencies at

some specified time in the future. The exchange rate, which is fixed at the time when the

contract is entered into, defined by the specified amount of one currency in exchange for

the other currency, is referred to as the forward rate. The forward contracts, most

commonly for deeply traded currencies such as €, $, £ and ¥, are typically for a month,

two, three, six and twelve months. However, most foreign exchange traders are

agreeable to tailoring the maturity of the forward contract to the needs of the customer.

The forward market for less well-traded and exotic currencies often does not exist and

may have to be simulated.

96

Example

4.3.2.4 The Participants in the Forward Market

The major participants in the forward market are:

• Arbitrageurs – the act of arbitrage is to exploit price differences on the same

instrument or similar assets. So they use forward contracts to earn risk-free profits by

taking advantage of differences in interest rates among countries.

• Hedgers – enter into forward transactions to protect assets and liabilities denominated

in foreign currencies against exchange rate fluctuations.

• Speculators – engage in buying and selling forward with a view to obtaining profit on

exchange rate fluctuations. They accept high risk in anticipation of high reward.

A US company buys textile from England with payment of £1,000,000 due in 90

days. The importer, thus, is shorter of pounds – that is it owes pounds for future

delivery. Suppose the present price of the pound is $1.71. Over the next 90 days,

however, the pound might rise against the dollar, raising the dollar cost of the

textiles. The importer can guard against this exchange risk by immediately

negotiating a 90 day forward contract with a bank at a price of, say, £1 = $1.72.

According to the forward contract, in 90 days the bank will give the importer

£1,000,000 (which it will use to pay for its textile order), and the importer will

give the bank $1.72 million, which is the dollar equivalent to £1million at the

forward rate of $1.72

In technical terms the importer is offsetting a short position in pounds by going

long in the forward market – that is buying pounds for future delivery.

97

4.3.2.5 Forward Contracts

Forward contracts refer to the contracts between two parties to deliver certain amount of

currency or a product at future date at fixed prices. The exchange rate or price to be used

at the maturity date is fixed at the date of agreement. In forward contracts each part is

obliged to complete a deal as agreed.

For instance, if X enter into forward contract to buy $1000,000 in 30th June for

Tsh1070/$ from Y bank, then at 30th June, X will pay Tshs 107,000,0000.00 to Y bank

and Y bank give $1000,000 to X. doing so the contract will be concluded and closed.

4.3.2.6 Calculating Forward Rates

A forward contract on a given currency or commodity call for future delivery of a given

amount of currency or commodity at a fixed time and price. Forward contracts uses

forward exchange rates which is fixed at the date of agreement. Normally, forward rates

are quoted on the basis of the prevailing spot rate and the interest rate differential for the

currencies in question.

According to the IRP, the return from investing a given sum of money in the domestic

capital market will be the same as that produced by:

• Converting the sum into foreign currency at the prevailing spot rates

• Investing this in the foreign capital market at the going rate of interest; and

• Contracting to convert the gross proceeds from this investment back into the

domestic currency at the prevailing forward rate

Using this theory, then forward rate can be defined as follows:

( )( )t

f

t

r++=

1

r1sF h

0t0,

where: F0,1 is the forward exchange rate. That’s the rate quoted to day for delivery of

foreign currency at the end of the period

S0 is the spot rate of exchange

rh is the interest rate of underlying currency annualized

rf is the interest rate of reference currency

t Time period (expiry date of the period)

98

Illustration 11

It is estimated that in three months to come the Interest rate in Tanzania will be 8% and

that of U.K be 4%. If the spot rate is Tsh2000/£, what would be the exchange rates in

three months?

3

3 04.01

08.012000f

++=

2239.76/£Tsh f 3 =

Using relative purchasing power parity theory, the forward rate can also be computed.

According to the power parity, any change in the differential rate of inflation between the

countries will tend to influence the change in exchange rate between the countries. Where

the spot rate between the currencies is known and where there is change in inflation rates

over the periods, then the spot exchange rate will change. The future spot rate is called

forward exchange rate and it is determined using the following formula

( )( )t

f

t

r++=

1

r1sF h

0t0,

Where rh refer to inflation underlying and r f refers to inflation reference and t refer to

time period

Illustration 12

If Tanzania and Kenya are running annual inflation of 5% and 3%, respectively, and the

initial exchange rate was Tsh10/Ksh. What would be the value of Kenya Shilling in three

years?

Solution:

The forward exchange rate at the their year will be

( )( )3

3

0,303.01

0.05110F

++= = Tsh 10.6/Ksh

99

4.3.2.7 Speculating In The Spot Market

To speculate in spot market, the speculator should believe that, the foreign currency will

appreciate in value. For example A speculator in Holland is willing to risk money on his

own option about future currency prices. The speculator may speculate in the spot rate,

forward rate, or options markets.

The German mark is currently quoted as follows:

Spot rate $0.5851\DM

Six month forward rate $0.5760\DM

The speculator has $100,000 with which to speculate, and he believes in six months the

spot rate for the mark will be $0.6000\DM. Therefore the speculator will speculate

$100,000 as follows:

1. Use the amount to buy mark at spot rate $0.5851\DM. He will get

($100,000\ $0.5851) DM170, 910.96.

2. Hold DM170, 910.96 indefinitely. Although the mark is expected to rise to the target

value in six months, the speculator is not committed to that time horizon.

3. Sell DM170, 910.96 at the new spot rate of $0.6000\DM, receiving $102,546.57.

(DM170910.96 x $0.6000\DM )

Profit for the speculator will be ($102,546.57 - $100,000), = $2,546.57 for committing

$100,000 for six month.

4.3.2.8 Speculating in the Forward market

To speculate in the forward market speculator should believe that the spot rate at some

future date will differ from the present forward rate. If this situation is believed to happen

in the future date then speculator will sign the forward contract using forward rate.

Using an example above, the following steps will be taken by the speculator speculating

in the forward market.

1. To day buy DM173,611.11 forward six months at the forward quote of $0.5760\DM.

2. In six months, fulfil the forward contract, receiving DM173,611.11 at $0.5760\DM

for a cost of $100,000

100

3. Simultaneously sell the DM173,611.11 in the spot market, receiving $104,166.67,

(DM173,611.11 x $0.6000\DM)

4. The speculator will make profit of $4,116.67, ($104,166.67- $100,000)

The profit of $4,116.67 is for six month forward rate, the situation could be different if in

six month the value of Mark has devalued to zero. In this case, the speculator could get a

loss of $100,000 the whole amount invested.

4.3.2.9 Benefits of Forward Exchange Hedge

Your organization can receive the following benefits from forward exchange hedge:

• Reduced earnings volatility

• Improved cash flow forecasting

• Maintained or improved corporate credit ratings

• Defined risk management and hedge methodologies (regulatory and internal risk

management compliance)

• Improved currency exposure forecasting and measurement capabilities

4.3.2.10 The Challenge

An effective hedging program does not attempt to eliminate all risk. Rather, it attempts to

transform unacceptable risks into an acceptable form. The key challenge for the corporate

risk manager is to determine the risks the company is willing to bear and the ones it

wishes to transform by hedging. The goal of any hedging program should be to help the

corporation achieve the optimal risk profile that balances the benefits of protection

against the costs of hedging

4.3.3 Options Contracts

Currency option is a contract giving the option holder the right, but not the obligation, to

buy or sell a given amount of foreign currency on or before specified future date at a

specified price called strike or exercise price and in an amount called contract size which

is fixed in advance. For the privilege of having a choice of whether or not to exercise the

option, the upfront called premium/price has to be paid.

101

4.3.3.1 Types Of Options

There are two types of options. That’s Call option and put option.

• A call is an option to buy foreign currency or an asset. The buyer of an option is

termed the holder of put option. The owner of a currency call option is granted the

right to buy a specific currency at a specific period of time. However, the holder of

call option has a choice as to whether or not to exercise the option and buy the asset at

a fixed price, at a certain time in the future. The buyer of call option will buy only the

underlying asset when it is profitable to do so. If it is not profitable then the hold of

call option will leave it lapse at the maturity date. That leave the right unused.

• A put is an option to sell foreign currency or an asset. The seller of a put is called

writer or grantor. The seller here can sell only the underlying asset when it is

profitable to do so, otherwise will leave the option lapse un- excised

4.3.3.2 Options Quotations and Prices

Every option has three price elements.

• The exercise or strike price. This is the exchange rate at which the foreign currency

can be purchased or sold. It is a price at which the owner is allowed option is allowed

to buy or sell the currency/ underlying asset. This price is fixed at the time the

contract is signed

• The premium. This is the cost or value of the option itself. Is the amount initially paid

by the owner of the option for the right to purchase or sell the currency/underlying

asset. This is non-refundable money. That’s whether the hold of option excises it or

not, the money is not refunded back. It is a cost of acquiring a right to soothing.

• The underlying or actual spot exchange rate in the market. This is the actual

prevailing market price of the assets in question. That’s the price of an asset existing

at the maturity date of the option.

4.3.3.3 Determinants of Currency Option Prices

Option prices depend on the number of factors. The following are some factors that

determine the option prices:

102

• The time to expiry of option. The longer the period to expiry the more expensive the

option will be as there is a greater chance that exchange rates will move in favour of

the option buyer

• The striking price or exercise price. The more favourable the striking price to buyer

of the option, the higher will be the option price

• Current spot and forward market rates for the period of the option

• The expected volatility during the life of the of the currency in which the option is

being purchased

• Whether an American or European option is to be purchased

• Current interest rates that could be earned on the option premium

4.3.3.4 When The Option Can Or Not Be Exercised?

As it has been said, the holder of option is not obliged to use his/her right at the maturity

date. That’s he/she may use it if and only if by doing so it is profitable. In other words the

option will not be excised if the price is not favourable to the holder of the option

A call option can be exercised if the strike price is lower than prevailing market price. If

this situation prevails, then the holder will be able to buy an asset from the seller at lower

price and resale it in the market at higher price. Under this situation, the price is

favourable to the holder of the call option and by exercising it he/she will get profit. In

case the prevailing market price of the asset is lower than the strike price, the holder of

option will not get any profit by buying and reselling the asset. This is because the buying

price will be higher than the price he may sale in the market. For this matter the call

option will be left to lapse un-excised.

So it can be summarized that the call option can be exercised when strike price less than

Underlying market price of an asset (K<S)

A put option can be excised if its strike price is higher than the underlying market price.

In this case it implies that the put option holder will be able to sale at higher price than

the real value of underling asset. However, if the strike price is lower than the prevailing

market price, then the holder will not excise it, as by excising it will lead to big loss.

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Moreover, it can be summarized in this case that the put option can be excised when

strike price greater than Underlying market price of an asset (K>S)

4.3.3.5 The Impact of Deciding Not To Excise an Option

The holder of call option or put option will excise the options when it is favourable to

them, otherwise they will leave the options lapse un-exercised. There is an impact on

deciding not to excise the option when the price is not favourable. The impact here is

that, because the cost called premium is paid at the time of acquiring the option, then by

letting the option un-excised means incurring loss equal to the premium paid. It should be

noted that this loss is smaller than the loss that could be incurred by excising the option

when the price is not favourable to the holder of the option

Illustration 13

Assume the strike price of an option to buy 100 Tanzanian Government bond is Tsh

30,000.00. The buy of the option pays a premium of Tsh5, 000.00 per contact. It is agreed

that the maturity date of the contract in July 2005. If the end of July 2005 the value of the

bond is Tsh28, 000.00, will the buyer excise its right? What would be the impact of any

decision that may be arrived?

Solution:

Since this is a call option giving the holder to buy the bond at the end of July, the holder

will not buy the bond because the buying price is greater than the value of the bond or the

price he/she may re-sale the bond in the market. For this reason the holder will lave it

lapse. The impact of this decision will be losing only Tsh5, 000.00 per contact.

However, if the holder exercises it, then he will get a loss equal to:

( )( )

contractper 7,000.00Tsh

500030,000-Tsh28,000

premium price strike-price marke

−=+=

+

As can be observed above, the loss of excising is greater than the loss of deciding not to

exercise

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4.3.3.6 Options Styles

There are two styles of options. One is called American style and another known as

European style.

• American style of option can be exercised at any time up to the expiration date. The

holder of it does not need to wait until the maturity date to exercise it. He can exercise

at any time provided that it pays to do so.

• European style of option is one which can not be exercised until the maturity date.

That’s the day of expiration. That is to say even though the holder may find it

profitable to exercise before the expiration date, can not do so.

Note, however that European and American options can be sold to another market

participant at any time (but one who buys European option has to wait until maturity

date)

Illustration 14

In May, 2005 a trader purchased an option to buy £1000, 000 at the end of August, 2005.

The premium paid for such option is $20,000. The agreed excise price is $1,500,000. The

movement of prices thought the period have been as follows.

May $1.5/£

June $1.6/£

July $1.7/£

August $1.6/£

Required:

Assume it is an American option, should the trader wait until the maturity date? What is

the impact of such decision? If the option is a European one, what would be the profit or

loss to the trader?

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Solution:

• If the call option was an American one, then the holder of it could exercise it at any

time until the date of expiration provided that it pays to do so. Since it was agreed to

buy £1000, 000 for $1,500,000, it means that the strike price per contract was

£/5.1$000,1000£

00,500,1$ = . This also implies that the number of contacts is 1000,000

Because July market price is greater than the exercise price of $1.5/£ the holder will buy

the option in July and resale it at higher price of $1.7/£ per contract. And get a profit of

1.7-(1.5+0.02) per contract. This equals to 0.18 x 1000, 000 = $180,000

• If the option is a European one, then the holder has aright to exercise it until the

expiration date. For this case he/she will wait until August when the market price is

$1.6/£. The holder will buy £1000, 000 at $1.5 per contract and resale it in the market

at $1.6 per contract.

Therefore,

Effective cost will be: = Contract size x exercise price

= £1000, 000 x 1.5

= $1,500,000.00

The Premium cost = contract size x premium cost per contract

= £1000, 000 x 0.02

= $20,000

Total cost = Effective cost + Premium cost

= $1,500,000+ 20,000

= 1,520,000.00

Total Revenue = Market price/ market value of an asset x contract size

= £1.6 x1000, 000

= $1,600,000

Profit or loss = Revenue- Total cost

=$1,600,000-1,520,000

= $80,000

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or

The profit /loss can be obtained as 1,600,000- (1,500,000+ 20,000) = $80,000

4.3.3.7 Positions in Options

It should now be clear that there are two sides of the market for calls and puts. The two

parties to each option contract are classified as follows:

• Long call and Short call

• Long put and short Put

4.3.3.7.1 Long call (buy) and Short call (sell)

Long call means buying a call option and short call means writing or selling a call option.

Thus where there is a buyer of option, there should be a seller of such option. While the

buyer gets right to buy it but not obliged to do so, the seller of it has no option other than

meaning the promise unless the buyer decides not to exercise the right. The writer of put

option has no option to go away from the contract because by receiving the premium

from the buyer grantees that he will sell the underlying asset as agreed. So it is binding

contract to the writer but not to the buyer

From this reasoning it can also be seen that, while the buyer of put option is getting profit

from the transaction, the writer gets loss and the reverse is true. However, the buyer of

the call option limits downside risk to a call premium he pays, but can benefit from any

upside potential

Illustration 15

The Managing Director of NICO plc in January 2005 purchased a European call option

on the shares of BINGO Ltd. One stock contract is a contract to buy or sell 10,000 shares.

Managing Director of NICO paid a premium of $300 per share. It was agreed that NICO

plc would be allowed to buy the shares at the end of agreed period for $800 per share.

The expiry date of the contract is March. At the end of March, the market price of

BINGO shares was $850 per share

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Solution:

Given;

K (strike price) = $800 per share; C (premium or cost of option) = $300 per share; ST

(market price of option at time T) = $850 per share

But the holder of call option will exercise it if and only if ST>K. since $850> $800, then

the Managing Director of NICO will buy the option at $800 and resale it in the market at

$850

The breakeven point for NICO would be equal to K+C, that’s $800+$300= 830 per share

or $8,300,000 for 10,000 shares

The profit of the transaction will be;

Net profit = S-(K-C) or S- Breakeven point

= $850- (800+300)

=$200 per share

Therefore, for 10,000 shares the total net profit would be $ 2000, 000

The case of writer would be different from the buyer. The net profit of the writer of a call

option is given by K+C-ST , where by K is the selling price of option to the buyer and C

is the premium received on transaction (it is also a revenue to the writer), S is the cost or

value of the asset being sold at the agreed period

Using an example above, the writer here will get a loss of $200 per share, making a total

loss of $2000,000 for 10,000 shares. That is ( 800+300-850) x10,000

Illustration 16

Assume the market price of shares of BINGO Ltd in illustration two, becomes $600 at the

end of March instead of $850. What would happen to the net profit of both buyer and

writer of a call option?

Given,

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S = $600; K=$800 and C=$30

Since S<K, then the managing director of NICO will not buy the shares of BINGO. He

will let his right lapse unused and get a minimum of loss equal to the premium paid.

That’s a loss equal to $300 per share. For 10,000 shares makes a total loss of $3,000,000.

However, if the managing Director of NICO make unwise decision and decides to buy

the shares of BINGO at $800. He will make a loss equal to 600-(800+300) =$500 per

share, thus $5000, 000 for 10,000 shares. This loss is greater than if the option is not

exercised.

In this case the writer will benefit in all scenarios. If the Managing Director decides not

to exercise, then the writer of call option (BINGO Ltd) will get a profit of $300 per share,

that’s the amount equal to premium received. This is equal to $3,000,000 profit for

10,000 shares. If the option is exercised, then the writer will get a profit equal to the loss

incurred by the buyer for exercising his write. That’s the total of $5,000,000 profit will be

obtained

4.3.3.7.2 Long and Short Put

Long put means buying put option and short put selling put option. The buyer of a put

option granted by the seller of put option that he will sell him the asset at the maturity

date. For the assurance he gets from the seller, pays an amount of money called premium.

This money is revenue to the seller of a put option but an expense or cost to the buyer of

the put option. It should be noted here that while it is legal binding to the seller of put

option that he has to fulfil the promise, it is not obligation to the buyer. The buyer may

decide to walk away from the contract if find that the market price at the expiration date

is not paying. By doing so he will be losing only the premium paid.

A speculator who expects that a certain currency will depreciate, he could purchase that

currency put options, which would entitle him to sell that currency at specified strike

price. The buyer of the put option will buy it with intention to sell the underlying

currency at the exercise price when the market price of such currency drops. The buyer of

the put option will get profit if the spot price is lower than the strike price. At any

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exchange rate above the strike price, the buyer of the put would not exercise the option,

and if the trend continue, that’s is the strike price continue being lower than any exchange

rate, the buyer will retain the option even until the expiry date and lose the amount i,e the

premium paid on option. Generally, it can be seen that while the seller is getting profit the

buyer of put option is getting loss and that when the seller is getting loss the buyer is

getting profit. The minimum profit of the buyer is premium received on contract and the

minimum loss of the seller is premium paid on contract

Illustration 17

The following information relates to Wasukuma put option transaction for the period of

2005.

Strike price £0.585\$

Spot price £0.575\$

Premium £0.005\$

Required:

1. Compute the break even price for the buyer of the put

2. Compute the profit of the buyer of the put.

Solution:

Breakeven price = K-C (premium)

£0.5850\$ - £0.005\$

= £0.5800\$

If ST>K then the speculator will not exercise the put, he will let it expire worthless and

lose the put premium of £0.005/$

Now since K<ST, then the speculator will not exercise the put option. If decides to

exercise then he will get a loss equal to £0.015 per dollar

Net lo = Strike price – (Spot Rate + premium)

= £0.5850\$–( £0.595\$ + £0.005\$)

= -£0.015/$

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4.3.3.8 In, Out and At The Money

• A call option is said to be in-the-money if Current Spot Price is greater than strike

price (S> K) and a put option is in-the-money if K>S

• A call or put option is At-the-Money when current spot price is equal to strike price

(S=K )

• A call option is Out-of-the-money when current spot price is less than strike price (S<

K) and a put option is out-of –the money if K<S

4.3.3.9 Types of Option trading strategies

Option trading can be made in various strategies. The following are the type of options

trading strategies.

Naked Options A currency option is naked when the buyer or seller does not hold

an offsetting position in the contracted currency (or currencies)

Covered Options A currency option is covered when the writer holds an offsetting

position in the contracted currency (covered option buying)

Option spreads An option spread involves the simultaneous purchase and sale of

two options of the same type but with different exercise prices or terms until maturity

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Reference

Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by

Palgrave MACMILLAN, UK

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review Questions

1. An American investor believes that the dollar will depreciate and buys one call option

on the euro at an exercise price of 110 cents per euro. The option premium is 1 cent

per euro, or $625 per contract of 62, 500 euros (Philadelphia):

a. For what range of exchange rates should the investor exercise the call option at

expiration?

b. For what range of exchange rates will the investor realize a net profit, taking the

original cost into account?

c. If the investor had purchased a put with the same exercise price and premium,

instead of a call, how would you answer the previous two questions?

2. Willem Koopmans is considering a different call option on German mark than what

he bought previously. He can also buy an August call option with a strike price of

59.0 cents per Deutschemark. The premium for this option is 0.30 cents per

Deutschemark.

Required:

a. what is a breakeven price for Koopmans

b. What would Koopmans expect as the profit or loss on this call option if by August

the spot exchange rate is $0.6000/DM?

3. Willem Koopmans is considering a different call option on German mark than what

he bought previously. He can also buy a September put option with a strike price of

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58.5 cents per deutschmarks.. The premium for this option is much higher 0.99 cents

per deutschemark.

Required:

a. what is a breakeven price for Koopmans

b. What would Koopmans expect as the profit or loss on this put option if the spot

exchange rate is $0.5700/DM?

4. Which options are in the money and which are out of the money if the spot price is

$800?

Type of security Exercise price call put

T-Bond $700 55.5 17.5

K-Nipel $750 28 40

5. Explain briefly what is meant by foreign currency options and give examples of the

advantages and disadvantages of exchange traded foreign currency options to

financial manager

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CHAPTER 5

FOREIGN EXCHANGE EXPOSURE MEASUREMENT AND RISK

MANAGEMENT

5.1 Introduction

As a result of globalization, businesses nowadays operate worldwide. This has also led to

increase in international transactions. As many businesses engage in international

transactions, they become vulnerable to various market risks.

5.2 Exposure and Risks

The vulnerability to market risk is known as risk exposure. For a specific risk at which a

firm if vulnerable, let says foreign currency fluctuation, the exposure is known as foreign

currency exposure. The principal market risks that businesses face in connection to

international transactions is are:

• Foreign exchange-rates, generating translation and transaction gains and losses.

• Interest rate and other risks related to financial assets and liabilities.

• Equity price risks relating to the equity securities we hold of certain of our

collaboration partners.

Foreign exchange risk is a risk that results from exchange rate fluctuations. It is a result

of foreign currency exposures. It is a risk because exchange rates are always changing

and that the direction of the exchange rates movement is normally uncertain as it is

difficult to predict with certainty. In most cases, foreign exchange volatility exposes

multinational corporations which typically have investments, assets, funding, cash

inflows and outflows denominated in various foreign currencies to significant foreign

exchange risk.

Foreign exchange rate risk frequently leads to earnings volatility and cash flow

uncertainty. It represents the risk that a company’s performance will be affected by

exchange rate movements. It reflects uncertainty about the future cash flows since the

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firms can not accurately predict future net cash flows due to potential exchange rate

fluctuations

As such, its management is vital not for seek of reducing it only but also to be our self in

the piece of mind. Here we say risk need to be reduced not eliminated because risks can

not be totally eliminated. If foreign exchange exposure remains unmanaged, the impacts

may be severe to the businesses’ earnings and expected cash flows if risk materialises

5.3 Foreign Exchange Exposure Measurement

Refers to the determination of the extent to which foreign operations are at risk from

exchange rate changes. It indicates the degree to which foreign operation has an impact

on the firms operations. Measuring the exposure of a firm to the risk of losses from

changes in the exchange rate is an important issue since this exposure is often the basis

for the decision on whether such risk should be avoided, neutralized or carried

There are three ways of measuring Foreign currency vulnerability ( exposures), namely:

• Transaction exposure

• Economic exposure

• Translation exposure

5.3.1 Transaction Exposure

Transaction exposure represents the change in the value of outstanding financial

obligations incurred prior to a change in exchange rates but due to be settled until after

the exchange rate has changed. Transaction exposure arises out from various types of

transactions that require settlement to be made in future in terms of a foreign currency.

Because cash is received or paid later, the exchange rate may not be the same as that

prevailed at the date when transaction took place. For this reason the value of cash flows

denominated in various foreign currencies will be affected by exchange rate movement.

The change in value of expected revenue or financial obligation due to change in

exchange rate may lead to gains or losses.

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If the value of expected cash inflow after the change in exchange rate is higher than the

value of expected cash inflow before the change in exchange rate, then there would be

gain resulting from exchange rate movement and verse versa. If the value of cash outflow

after the change in exchange rate is higher than the value of cash outflow before the

change in exchange rate, then there would be a loss resulting from exchange rate

movement and the verse versa.

Illustration 1

Winome Wood Works Ltd, a Tanzanian Company sells wooded furniture to Waningu Ltd

a Kenyan Company for Ksh70, 000,000.00. It is agreed that payment to be made 60 days

from the date of invoice. The exchange rate (spot) at the date of transaction was Ksh

0.1/Tsh. During the day of settlement the value of Tanzania shilling was Ksh 0.125/Tsh

Because a Tanzanian firm will converted Ksh it Tsh after receiving the payment from

Waningu Company, so it will get an equivalent to Tsh560,000,000.00, that is

000,000,70125.0

1 × . But if this was paid at spot, then Winome could have received, Tsh

700,000,000, that is 000,000,701.0

1 × . In this case exposure arises because Winome will

receive something other than Tsh 700,000,000. What it receives after the change in

exchange rate is small than what it could receive if the payment could be done at spot.

5.3.1.1 Causes (Sources) of Transaction Exposure

Transaction exposure arises from many ways. The following are the basic causes of

transaction exposure:

• Purchasing good/services on credit whose price is denominated in foreign currency

• Selling goods/services on credit whose price is denominated in foreign currency

• Borrowing or lending and when repayment is to be made in foreign currency

• Acquiring assets or liabilities denominated in foreign currency

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5.3.1.2 Management of Transaction Exposure/Risk

As we have said before, foreign exchange risk may cause severe impacts to the

businesses if materialises. To be in the piece of mind, businesses need to manage such

risks. Managing here refers to reduction of the expected risks by using different strategies

such as hedging. There are various Techniques by which transaction exposure can be

managed or protected against. The use of derivatives is very common. However, other

techniques such as leading and lagging, and sharing risks can be used.

a) Currency Risk Sharing

This is done through contractual agreement between the seller and the buyer to split or

share the impacts of exchange rate movements on payments between them. This

technique is mostly used by those companies who are involved in long -term trade

contracts

b) Internal Asset And Liability Management

Internal asset liability management refers to the manipulation of foreign currency assets

and liabilities in order to reduce foreign exchange exposure. It is mostly associated with

the management of transaction exposure, where a company might try to equalize the

value of assets and liabilities in a particular foreign currency to leave a zero currency

exposure, but it may also be used as part of transaction exposure management.

The possible manipulation of assets and liabilities might include:

• Borrowing or investing in foreign currencies in an opposing manner to expected

export/import transaction cash flows

• Moving funds from countries where currencies are expected to depreciate in value

into relatively hard currency countries

• Collecting in debts as quickly as possible in a depreciating-prone currency, and

reducing financial investments in such currencies

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• Deciding to purchase goods from a country to which export sales are made, the

purchase price being met by proceeds from the export sales.

c) The Currency of Invoice

The transaction exposure can be avoided if exports and imports are denominated in the

home currency other than in the foreign currency. In this case the expected cash receipts

from export is not needed to be converted into other currency because it is already in a

home currency and that the there is no need to find a foreign currency to pay for the debt

as it is denominated in our home currency

d) Leading and Lagging

Firm can reduce transaction exposure by accelerating or decelerating the timing of

payments. These techniques are known as leading and lagging. To lead is pay early,

that’s payment an obligation in advance of the due date. A firm can lead payments if it is

anticipated that the home currency will drop in value and much of it will be needed to

buy foreign currency to settle the foreign debt.

To lag is to pay debt obligation late, and this is done if it is expected that the home

currency will appreciate and less of it will be needed to buy foreign currency to pay for

the debt. However, leading and lagging techniques are constrained by the exchange

control regulations of individual countries. It is important that when deciding for the

hedging strategy, firms take this into account.

5.3.2 Economic Exposure

The degree to which a firm’s present value of future cash flows can be influenced by

exchange rate fluctuations is referred to as economic exposure to exchange rates.

Economic exposure is also called, operating exposure, competitive exposure, or strategic

exposure. Economic exposure measures the change in the present value of the firm

resulting from any change in the future operating cash flows of the firm caused by an

unexpected change in exchange rates.

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The change in value depends on the effects of the exchange rate change of future sales

volume, price, or costs. Economic exposure exists because of unexpected changes in

future cash flows. Planning for operating exposure is a total management responsibility

because it involves the interaction of strategies in finance, marketing, purchasing, and

production.

The exchange rate fluctuations may lead to appreciation or depreciation of currencies.

The appreciation or depreciation of currency will affect the overall future sales volume,

prices or costs. If the local currency appreciates:

• The future sales volume will tend to decrease

• Cash inflows from exports denominated in local currency would likely be reduced as

a result of appreciation in local currency. This is because foreign importer would need

more of their own currency to pay for those goods.

• However exports dynamited in the foreign currency would likely reduce cash inflows

5.3.2.1 Managing Economic Exposure

The efficient management of both operating and transaction exposure is to anticipate and

influence the effect of unexpected changes in exchange rates on a firm’s future cash

flows, rather than merely hoping for the best. Though economic exposure is very difficult

to measure precisely, companies must be able to respond quickly to significant economic

exposure effects. There are different ways that can be used to manage economic

exposure. The techniques are categorised into diversification, marketing management of

economic exposure, changing of operational policies and, production management of

economic exposure

a) Diversifying Operations

This involves diversifying location facilities and raw materials sources. If the firms’

operation is diversified internationally, management will be positioned both to recognise

disequilibrium when it occurs and react competitively. Although the disequilibrium of

PPP may have been unpredictable, management can often recognise its symptoms as

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soon as they occur. For instance a firm may notes a change in competitive costs in the

firms’ own plant located n different countries. It might also observe changed profit

margin or sales volume in one area compared to another, depending on price and income

elasticity’s of demand and competitive reactions

Recognising a temporary change in world wide competitive conditions permits

management to take changes in operating strategies, e.g. shift of sourcing of raw material,

components, or finished products.

Even if management does not actively distort normal operations when exchange rates

change, the firm should experience some beneficial portfolio effects. The variability of its

cash flows is probably reduced by international diversification of its production,

sourcing, and sales because exchange rate changes under disequilibrium conditions are

likely to increase the firm’s competitiveness in some markets while reducing it in others.

b) Diversifying Financing

If a firm diversifies its financing sources, it will be positioned to take advantage of

temporary deviations from the international fisher effect. If interest rate differential do

not equal expected changes in exchange rates, opportunities to lower a firm’s cost of

capital will exist.

c) Changing Operational Policies

Operating and transaction exposures can be partially managed by adopting policies that

deviate from normal domestic oriented policies but have the virtue of reducing foreign

exchange exposure.

Three of operating policies commonly employed to managed operating and transaction

exposure. These are:

• Leads .

Firms can reduce both operating and transaction exposure by accelerating the timing of

payments that must be made or received in foreign currencies. To lead is to pay early.

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Firm pays early if hoping that the foreign currency will appreciate and much of home

currency will be needed to pay the foreign denominated currency debt

• Lags

The firm will lag payment (decelerate) if hopes that the home currency will appreciate

and less of home currency will be needed to acquire foreign currency to pay for the

foreign currency denominated debt

• Sharing The Risk Through Currency Clause

An alternative arrangement for managing long term cash flow exposure between firms

with continuing buyer supplier relationship is risk sharing. Risk sharing is a contractual

arrangement in which the buyer and seller agree to share or split currency movement

impacts on payments between them.

5.3.2.2 Marketing Management of Economic Exposure

a) Market selection

Deciding of international markets the company wishes to operate in, and whether

opportunities in the selected markets will achieve the objectives of the company. The

market strategy can be adjusted if the change in exchange rate continues

b) Pricing Strategy

The Company may decide to put the price of its home currency fixed or reducing. Each

decision has an impact on the markets for its products. If a company let say Tanzanian

company keep TSH price fixed relative to other currency, it can loose the market share

but protecting profits. However, if the company reduces TSH prices, it can sustain the

market share currently held but decrease its profits.

c) Promotion Strategy

Companies will wish to change their promotional strategy with exchange rate changes.

For instance, if an exporter faces difficulties in getting market abroad due to the strong

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position of the home currency, the exporter may educe advertisement expenditure, or

change production image through different advertisement media and slogans

5.3.2.3 Production Management of Economic Exposure

This can involve varying of various factors that are affected by economic exposure. The

following factors are involved:

a) Plant Location

This involves selection of foreign branch to locate a plant. The location to be selected is

that which will give the cost advantage and the maximum unit profitability. This will also

involves determining the longevity of which the location selected will continue giving the

cost advantage to the firm

b) Shifting Production Among Plants

The companies will change the location of production to the countries whose currencies

have been devalued. In other words, it can be said that MNC can avoid risks by shifting

of production in line with changing elative production costs.

5.3.3 Translation Exposure

In preparing consolidated financial statements, foreign subsidiaries accounts have to be

reproduced in terms of the parent company’s currency. This act may lead to translation

exposure. That is to say, translation exposure (a.k.a Accounting Exposure) arises because

foreign currency financial statements of foreign affiliates must be translated in the parents

reporting currencies if the parent is to prepare consolidated financial statements

The process of changing the amount from foreign currency to home currency is

commonly referred to as translation. Students normally confuse and refer this as the same

as conversion, actually it is not. Translation is simply a change in monetary expression

and not a physical exchange of one currency for another as it is in conversion.

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Although the main purpose of translation is to prepare consolidated statements, translated

statements are also used by management to assess the performance of foreign affiliates.

Translation exposure is dependent on.

• The degree of foreign involvement by foreign subsidiaries. The greater the percentage

of a business conducted by its foreign subsidiaries, the larger will be the percentage

of a given financial statement item that is susceptible to translation exposure

• The location of foreign subsidiary. This can influence the degree of translation

exposure since the financial items of each subsidiary are typically measured by that

country’s home currency

• The accounting method used. Accounting procedure used to translate when

consolidating financial statement data an greatly affect the accounting exposure

5.3.3.1 Methods For Translating Foreign Transaction

It is beyond the scope of this manual to discuss the details of the methods of translating

the financial statements of companies having foreign operations or foreign subsidiaries.

This topic is covered in financial accounting. So the authors presume that students

reading this manual are knowledgeable and fully conversant with the whole mechanism

regarding the methods of translation.

However, it is worth mentioning at this juncture that the following accounting standards

are now operational and should be adhered to when translating the financial statements of

Multinational Corporations. These are:

• International Accounting Standard (IAS) 21 -The Effects of Changes in Foreign

Exchange Rates

• International Accounting Standard (IAS) 27 - Consolidated and Separate Financial

Statements

• International Financial Reporting Standard (IFRS) 3 - Business Combinations

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5.4 Use of Derivatives To Reduce Transaction Risks

The use of financial derives to manage foreign exchange risk is done through hedging.

This involves employing contractual hedges such as forward market, money market,

future market and options market. Sometimes these derivatives are called hedge tools

A well-designed hedging program reduces both risks and costs. Hedging frees up

resources and allows management to focus on the aspects of the business in which it has a

competitive advantage by minimizing the risks that are not central to the basic business.

Ultimately, hedging increases shareholder value by reducing the cost of capital and

stabilizing earnings. To be able to know how derivatives can reduce transaction exposure

it is better to use quantitative illustration as follows.

Illustration 2

Winome Wood Works Ltd, a Tanzanian Company sells wooded furniture to Waningu Ltd

a Kenyan Company on 30th April for Ksh70, 000,000.00. It is agreed that payment to be

made 90 days effectively from the date of invoice, that’s in July. Economists have

anticipated that the Tanzanian economy is likely to boom in the future and this will call

for value of Tanzanian shilling to appreciate. The financial time indicates the following

quotes which are the same as those provided in the BOT newsletter.

Spot exchange rate Tsh10/Ksh

Three moths forward rate Tsh8/Kth

Three months borrowing interest rate in Kenya 2.5% and investment rate is 2% for three

months

Three months borrowing rate is 2% and investment rate 1.5% in Tanzania

July put option in the over the counter (bank) for Ksh70, 000,000, strike price Tsh 7.5

and premium is 2%

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Required:

Show how Winome can use forward market hedge, money market hedge and option

market hedge to protect against transaction exposure.

Solution:

a) Using Forward Market Hedge

Forward market cover involves taking a contract to exchange two currencies at an agreed

future date at a predetermined rate of exchange. The forward contract requires a future

source of funds to fulfil the contract. It is a legally binding contract which must be

fulfilled. A hedge can be open or uncovered. This occurs when funds for the forward

exchange contract are not already available or due later. These funds need to be

purchased on the spot market at some future date.

Using the above case, should Winome wish to hedge transaction exposure in the forward

market, he will do so by selling the currency denominated receivable forward, that’s Ksh

70,000,000, at fixed forward exchange rate of Tsh 8/Ksh. Three months later, Winome

will receive Ksh 70,000,000 and exchange it against forward rate. He will receive Tsh

560,000,000.00. Could the exchange late at the end of July have been let say Tsh12/Ksh,

Winome could yet receive Tsh560, 000,000. But if the receivable was un-hedged then

Winome could have received Tsh840, 000,000.00. By hedging forward he is assured of

the amount he is going to receive in terms of home currency hence eliminating the risk of

adverse exchange rate fluctuation

b) Using Money Market Hedge

This involves a contract and a source of fund to fulfil a contract like in forward market

hedge. In this case, Winome need to borrow in one currency and exchange the amount

borrowed in another currency. It is important that the amount to be borrowed should not

exceed the account receivable. For that matter to know how much to borrow, it is

important to note that the interest rate on borrowing plus principal amount should be

equal to account receivable. Using the borrowing interest rate in Kenya of 2.5% for three

months, then Winome will borrow:

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1.025P= Ksh70, 000,000.00

P= 1.025

000Ksh70,000,= Ksh68292682.93

This borrowed amount will be converted into TSH using spot rate and get Tsh

682,926,829.3. This amount will be used for various purposes, mainly for running of the

business, or if the firm has idle liquidity, then the amount can be reinvested and generate

more income

At the end of July Winome will pay Ksh 1,707,317.07 as interest plus Ksh68, 292,682.93

principal amounts. In total Winome will pay Ksh 70,000,000. The source of this sum will

be the account receivable he is going to receive from Waningu

c) Using Option Hedge

For an account receivable, put option is an appropriate type of option to be used. This

option gives the holder a right to sell a foreign currency after receiving it at a specified

exchange rate called strike price.

The size of option is Ksh 70,000,000

Spot rate Tsh10/Ksh

Strike price Tsh 7.5

Premium = 20%x10 = Tsh2 per contract

Winome will buy a put option and pay a premium of 2x70, 000,000 = Tsh140, 000,000

At the end of July he will receive Ksh 70,000,000 and either deliver it against put option,

receiving Tsh 525,00,000; or sell Ksh70,000,000 in the market if prevailing spot rate is

greater than Tsh7.5/Ksh. This is possible because it is not obligation for Winome to sell

Ksh70, 000,000 against put option. He will do so only if it is profitable.

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5.4.1 Hedging Accounts Payable

Account payables are the financial obligations of a firm. The firm enter in such obligation

and payments are made in later days. If the obligations are denominated in the foreign

currency, there is a risk that in future the transaction may lead to financial gain or loss

due exchange rate fluctuation. For this reason, firms can reduce/manage this anticipated

risk through hedging

Hedging account payable may be different from hedging account receivable in some

circumstances. However the approach in using forward market will be the same. The

different will be in using money market hedge and option hedge. While put option is used

to hedge account receivable against risk, call option is used to hedge account payable

against risk. Moreover, while local currencies is needed to be converted into denominated

foreign currency debt and be invested there to earn interest for account payable hedge, for

account receivable hedge, certain amount of foreign debt is borrowed immediately for

specific uses and the debt is used to refund the loan

Illustration 3

Wambao Wood Works Ltd, a Tanzanian Company purchased building materials furniture

from Waningu Ltd a Kenyan Company on 30th April for Ksh70, 000,000.00. It is agreed

that payment to be made 90 days effectively from the date of invoice, that’s in July. The

following information relates also to the transaction.

Spot exchange rate Tsh10/Ksh

Three moths forward rate Tsh8/Kth

Three months borrowing interest rate in Kenya 2.5% and investment rate is 2% for three

months

Three months borrowing rate is 2% and investment rate 1.5% in Tanzania

July call option in the over the counter (bank) for Ksh70, 000,000, strike price Tsh 7.5

and premium is 2%

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Required:

Show how Wambao can use forward market hedge, money market hedge and option

market hedge to protect against transaction exposure.

a) Using Forward Contract Hedge

In this case Winome will need KSH to pay for the goods purchased on credit. Should

Winome wish to hedge transaction exposure in the forward market, he will do so by

buying the currency denominated account payable forward, that’s Ksh 70,000,000, at

fixed forward exchange rate of Tsh 8/Ksh at total TSH 560,000,000.00. Three months

later, Winome will receive Ksh 70,000,000 against Tsh 560,000,000.00 and pay the debt.

Exchange it against forward rate. He will receive Tsh 560,000,000.00. Could the

exchange late at the end of July have been let say Tsh12/Ksh, Winome could yet pay

Tsh560, 000,000 and receive Ksh 70,000,000. However, if the account payable was un-

hedged then Winome could have paid Tsh840, 000,000.00 for Ksh 70,000,000.00. By

hedging forward he is assured of the amount he is going to pay in terms of home currency

for the foreign currency needed and hence eliminating the risk of adverse exchange rate

fluctuation

b) Using Money Market Hedge

This technique works different in account payable management from that of account

receivable management. It can be defined as the process of borrowing in the money

markets, converting the funds borrowed at the spot rate into the currency in which

payment is due, and investing in the second country. The total receipts, i.e. principal plus

interest from foreign currency investment are then used to make payment for the goods.

In this case, Winome need to borrow TSH and exchange the amount borrowed at spot

rate so as to get foreign currency for this case KHS and invest it there at Kenyan interest

rate for 90 days. The interest and principle at the end of 90 days will be used to pay Ksh

70,000,000 debt.

128

To know how much to invest in Kenya, it is important to note that the interest amount on

investment plus principal amount should exactly be equal to account payable. This can

easier be determined by discounting Ksh70, 000,000.00 using investment interest rate in

Kenya for 90 days. Using the investment interest rate in Kenya of 2% for three months,

then Winome will need Kenya Shilling equal to:

P= 1.02

000Ksh70,000,= Ksh 68,627,450.98

To get Ksh 68,627,450.98 now Winome will need to borrow TSH68, 627, 4509.8 and

convert it at the spot rate Tsh10/Ksh.

c) Using Option Hedge

For hedging an account payable, call option is an appropriate type of option to be used.

This option gives the holder a right to buy a foreign currency at a specified exchange rate

called strike price. The currency so bought will be used to pay the debt

The size of option is Ksh 70,000,000

Spot rate Tsh10/Ksh

Strike price Tsh 7.50

Premium = 20%x10 = Tsh2 per contract

Winome will buy a call option and pay a premium of 2x70, 000,000 = Tsh140, 000,000

If the spot rate in 90 days is less than Tsh8/Ksh, the option will would be allowed to

expire but if is greater than Tsh7.5/Ksh then the call option will be exercised. The total

cost of call option hedge if exercised will be as falls:

Exercise call option 70,000,000x7.5= Tsh 525, 000,000

Add premium paid 2x 70,000,000 = 140,000,000

Total maximum expenses for call option Tshs 665,000,000

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Therefore, Winome will pay TSH 665,000,000 and receive Ksh 70,000,000. This will be

used to pay the debt.

Illustration 4

Suppose an importer of BMWs is expecting a shipment in 60 days. Suppose that upon

arrival the importer must pay DM150,000. The current spot exchange rate is 1.5 DM/$

thus if the payment were made today it would cost $100,000. Suppose further that the

importer is fearful of a $ depreciation. He doesn't currently have the $100,000 but expects

to earn more than enough in sales over the next two months. If the $ falls in value to, say,

1.4 DM/$ in 60 days time, how much would cost the importer in dollars to purchase the

BMW shipment?

A. The shipment would still cost DM150,000. To find out how much this is in dollars

take DM150,000/ 1.4 DM/$ = $107,143. Note this is more than $7000 more for the cars

simply because the $ value changed.

One way the importer could protect himself against this potential loss is to purchase a

forward contract to buy DM for $ in 60 days. The exchange rate on the forward contract

will likely be different from the current spot exchange rate. In part its value will reflect

market expectations about the degree to which currency values will change in the next

two months. Suppose the current 60-day forward exchange rate is 1.48 DM/$ reflecting

the expectation that the $ value will fall. If the importer purchases a 60-day contract to

buy DM150,000 it will cost him (150,000/1.48) = $101,351. Although this is higher than

what it would cost if the exchange were made today, the importer does not have the cash

available to make the trade today, and the forward contract would protect the importer

from even an even greater $-depreciation.

Reference

Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

130

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by

Palgrave MACMILLAN, UK

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review Questions

1. For instance, a Tanzanian company expect to receive 10mil Kenya shilling three

month from now. The present price of Kenya shilling is Tshs 10.00. Over the three

months the price of Kenya shilling is expected to be Tshs 12.00. In this case, the

Tanzanian company will enter into forward contract with bank to sell Kenya shilling

at exchange rate of Tshs 12.00 per Kenya shilling. At maturity date, the bank will

receive, 10mil Kenya shilling and deliver Tshs 12mil to the Company.

a. What would happen if the actual spot rate at the end of three month would

have been Tsh 20.00/Ksh?

b. The Tanzanian company would still get Tsh12mil and deliver 10mil Kenya

shilling. The forward rate would be used as agreed by the parties.

c. What would happen if there was no agreement between the parties?

In this case, the company would receive 20mil Tanzania shilling in exchange of

10mil Kenya shilling. Actual spot rate would be used.

2. It is now approaching a farming season in most parts of Tanzania. The tractors are

highly demanded particularly in Southern highlands regions. To meet this increasing

demand of tractors, a Tanzanian importer known as Masilingi has just contracted to

buy Massey Ferguson Tractors from UK on 90 days’ credit, at a price of £1,000,000

(payable in £). Exchange rates published by bank of Tanzania show that on 1st

September, 2005 were Tshs 2000 – 2005/£ and that the exchange rates on 30th

November will be Tshs1999- 2000/£. Further information reveals the following

Borrowing rates Lending rates

UK 14% 10%

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TZ 7% 4%

Masilingi is very experienced importer and is also knowledgeable on how to

manage exchange rate exposures. Given the exchange rates provided by the Bank

of Tanzania, he decided hedge through leading payment so that to minimize the

amount of TSHS that will be needed to by £1000,000

Required:

How much cash he will require now in order to make payment? If decide to

borrow the amount what will be the total cost after three months?

3. Exchange traded foreign currency option prices in London for dollar/sterling

contracts are shown below:

Sterling (£12,500) contracts

Calls Puts

Exercise Price September December September December

1.90 5.55 7.95 0.42 1.95

1.95 2.75 3.85 4.15 3.80

2.00 0.25 1.00 9.40 -

2.05 - 0.20 - -

Option price are in cents per £. The currency spot exchange rate is $1.9405-$1.9425/£.

Required

Assume that you work for a US company that has exported goods to the UK and is due to

receive a payment of £1,625,000 in three months’ time. It is now the end of June.

Calculate and explain whether your company should hedge its sterling exposure on the

foreign currency option market if the company’s treasury believes the spot rate in

3month’s time will be:

$1.8950-$1.8970/£

$2.0240-$2.0260/£

4. Explain what is meant by the terms foreign exchange translation exposure,

transactions exposure and economic exposure. What is the significance of these

different types of exposure to financial manager

5. Discuss different methods that can be used to protect against transaction risk

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6. Widambe is a Tanzania importer of used tractors from UK. The company has

contracted to purchase 30 tractors at a price of £1800. Three months’ credit is allowed

before payment is due. Widambe currently has no surplus cash, but can not borrow

short term at 2% above bank base rate or invest short term at 2% below base rate in

either the U.K or Tanzania

Exchange rates:

Tsh/£

Spot 2000-2020

1 month forward 50-40 premium

3 months forward 60-50 premium

(The premium relates to TSH)

Current bank base rates

Tanzania 10%p.a

UK 5% P.a

Required

(a) Explain and illustrate three policies that Widambe might adopt with respect to

the foreign exchange exposure of this transaction. Recommend which policy

the company should adopt. Assume that interest rates will not change during

the next three month

(b) If the UK supplier were to offer 2.5% discount on the purchase price for

payment within one month, evaluate whether you would alter your

recommendation in (i) above

(c) If annual inflation levels are currently at 2% in UK and 6% in Tanzania, and

the levels move during the next year to 3% in UK and 9% in Tanzania, what

effect are these in inflation like on the relative value of the UK and TSH

(d) Discuss the advantages and disadvantages to a company of invoicing an

export sale in a foreign currency.

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CHAPTER 6

INTEREST RATE RISK MANAGEMENT

6.1 Introduction

Interest rate volatility has increased significantly in the international capital market.

Firms both small and larger have become very sensitive to interest rate movements.

Interest risks have significant impact on the expected interest revenue or payments of the

firm. The risk arises because net interest income is likely to be different from the interest

liabilities. As such firms need to manage the risks that may occur as the result of interest

rate changes. Various techniques can be used to manage interest rate risk. Swap is one of

the hedging techniques.

6.2 SWAPS

A swap is defined as an agreement between two (or more) parties to exchange cash flows

related to specific underlying obligations. In other words it can be said that a swap is an

exchange of one stream of future cash flows for another stream of future cash flows with

different characteristics. For instance, one can agree to swap payments of fixed rate

interest on an agreed sum for a fixed period for payments on a floating rate basis.

There are two basic types of swaps:

• Interest rate swaps

• Currency swap

6.2.1 Interest Rate Swap

An interest rate swap is a contract between two parties to exchange one stream of interest

rate payments for another. It involves the exchange of interest rate streams, not an

exchange of principal. Interest rate swaps are conducted in a single currency.

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Illustration 1

Lupembe plc prefers to raise a £4 million capital through issuing debt security which has

fixed interest rate. Because the company is currently facing poor credit rating than used

to be, the managing director Mwakitwange considers a debenture issue to be out of the

question and the best fixed interest rate loan it can secure given the present reputation is

at 12.5% p.a. Lupembe can also borrow the variable rate of LIBOR (London Inter-Bank

Offered Rate)+0.5%. Lwasenga Plc is also a famous company managed by Mharuka. The

manager is indenting to borrow £4million to expand the business operation in

Scandinavia countries. The manager prefers to raise capital through floating rate (variable

rate) loan LIBOR. However, he can also borrow by issuing debenture at a fixed rate of

11%.

The managers of the two companies arrange a swap to fulfil their desires. Lupembe plc

agrees to pay Lwasenga a fixed interest rate of 113/4 on £4 million and Lwasenga agrees

to pay Lupembe an interest of LIBOR (variable) on the same amount of loan.

Required:

Show how the two companies can implement swap transaction and determine the savings

that can be achieved.

Solution:

If the companies arrange the swap, the following steps must be taken.

• Lupembe plc borrows £4 million at variable rate of LIBOR + 0.5%

• Lwasenga borrow £4 million at the fixed rate of 11%

• Lupembe plc agrees to pay Lwasenga a fixed interest rate of 113/4% on £4 million

and Lwasenga agrees to pay Lupembe an interest of LIBOR (variable) on the same

amount of loan.

The net financing to each party of the swap transaction will be as follows:

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Lupembe plc

Interest payable on borrowing (variable rate loan) LIBOR + 0.5%

Interest received from Lwasenga LIBOR

Total cost 0.5%

Interest payment to Lwasenga (paid on behalf of Lwasenga) 11.75%

Net cost 121/4 (fixed)

Lwasenga plc

Interest on borrowing (payable on fixed loan) 11%

Less: Interest received from Lupembe 113/4

Total cost (¾)

Add: Interest payment to Lwasenga LIBOR

Net cost (variable) LIBOR-3/4%

Savings for each party

Lupembe if there would be no swap arrangement could have paid an interest on fixed

loan at 12.5%, now with swap arrangements pays an interest on loan at 121/4%. This

leads a saving of ¼%, that’s (12.5%- 12.25%)

However, Lwasenga could have paid LIBOR on variable loan if no swap arrangement.

With swap arrangement pays on LIBOR-3/4, making a saving of ¾% that’s LIBOR-

(LIBOR-3/4)

Illustration 2

Chakwale plc can borrow for six months at a fixed interest rate of 10% and at a floating

rate of LIBOR + 3/8%. Pakwale plc has a lower credit rating and can only borrow at a

fixed interest rate of 11.5% and a floating rate of LIBO + 1%

136

Required:

Evaluate, showing relevant swap transactions, whether it is possible for both companies

to benefit from a six-month interest rate swap on loans of £10 million.

Solution:

Chakwale Pakwale Relative advantage

Fixed rate 10% 11.5% 1.5%

Floating rate LIBOR+3/8% LIBOR +1% 5/8%

Differences (gain by Chakwale) 0.875%

If the gain is shared equally, then Pakwale is cost of 11.5% that has to be paid to

Chakwale on behalf will be reduce by that share of gain which is 0.875/2= 0.4375%.

Therefore, Pakwale will pay fixed rate on behalf of Chakwale at 11.0625% (11.5-0.4375)

In this case Chakwale has relative advantage in both floating and fixed rates; however it

will borrow in fixed rate, which offer it greater relative advantages And Pakwale will

borrow at floating rate.

Swap transaction will be as follows:

• Chakwale borrow fixed rate at 10%

• Pakwale borrows variable interest rate at LIBOR + 1%

• Chakwale pays Pakwale floating rate interest at LIBOR +1

• Pakwale pays Chakwale fixed rate interest at 11.0625%

137

Chakwale

Interest paid on loan (fixed)

Interest received (paid by Pakwale on its behalf)

Interest gained

Interest paid on Swap

Overall cost

(10%)

11.0625%

1.0625%

LIBOR+1%

LIBOR – 0.0625

Average saving 0.4375%. An arbitrage saving of 0.4375% on £10 million for six months

is £21,875 for each company

Pakwale

Interest paid on loan

Interest received (paid by Chakwale on behalf)

Net cost

Interest paid

Overall cost

LIBOR + 1%

LIBOR + 1%

0%

11.0625%

11.0625%

Arbitrage saving 0.4375%

Illustration 3

International Oil plc is interested in raising £100 million in order to carry out further oil

exploitation. International oil is an AA-rated company and, as such can borrow for six

months at a fixed rate of 12% or a floating rate of LIBOR +30 basis points

London property Ltd has a lower credit rating, and wishes to raise a similar sum for

investment in the housing market. London property can only borrow at a fixed interest

rate of 14% and a floating rate of LIBOR + 80 basis points. Security Pacific Bank has

been recommended as the best continuous swap managers and the keenest on prices. For

arranging a swap, a fee of £50,000 is payable by each party.

Required:

Show how the parties can benefit from the swap arrangement?

138

Solution:

First determine the comparative advantages

International Oil London Property Comparative advantage

Fixed rate 12% 14% 2%

Floating rate LIBOR + 0.3% LIBOR + 0.8% 0.5%

From above computation, it can be observed that International Oil is better to borrow at

the fixed rate and London Property to borrow at a floating rate. However, it can be

observed that International Oil has relative comparative advantage in both floating and

fixed rates. The difference of comparative advantage is a net gain that can be enjoyed by

International Oil from the swap. This is equal to 1.5% that’s (2%-0.5%). Now if this gain

is shared equally, then each company would benefit at 0.75%, that’s 1.5/2= 0.75%

In this case London Property would require to pay a fixed rate less of a gain, that’s 14%-

0.75 = 13.25% on behalf of International Oil

Therefore, the swap transaction will be as follows:

International Oil borrows at the fixed rate of 12%

London Property borrows at the floating rate of LIBOR + 80 basis points

International Oil pays London LIBOR + 80 basis points

London Property pays International Oil fixed rate of 13.25%

Interest paid on borrowing

Interest received on swap

Net cost or benefit

Paid in swap

Overall cost(paid in swap-net benefit)

International Oil

(12%)

13.25%

1.25%

LIBOR +0.8%

LIBOR -0.45%

London Property

(LIBOR + 0.8%)

LIBOR + 0.8%

0%

13.25%

13.25%

139

In other words, the overall cost for International Oil would be equal to amount that is

required to be paid on floating if no swap arrangement less benefit that can be arrived on

swap arrangement. For this case, overall cost o would be equal to LIBOR + 0.3% - 0.75%

This gives the cost to LIBOR-0.45%. Similarly, for London property, the overall cost if

borrows fixed cost on swap will be equal to cost without swap less gain on swap. That’s

14%- 0.75% = 13.25%

Savings from undertaking swap can be calculated as follows:

Overall cost after swap – cost that could be paid if swap could not be taken

For International Oil

Saving = LIBOR -0.45 %-( LIBOR+0.3%)

=LIBOR – 0.45%-LIBOR-0.3%

= -0.75%, that’s the cost is reduced by 0.75%, which in other words can be said to

be the benefit realised from the swap transaction.

For London Property

Saving = 13.25 %-14%

= -0.75%, that’s the cost is reduced by 0.75%, which in other words can be

denoted as the benefit realised from the swap transaction

Illustration 4

Consider XYZ plc, a manufacturing firm which wants to raise $100 million a 5-year

fixed rate dollar funding to finance an expansion project. Its credit rating is not very high,

say BBB. It finds that it will have to pay 2% over 5-year treasury notes which are

currently yielding 9%. In the floating rate market it can issue 5-year FRNs at a margin of

0.75% over the prime rate. On the other hand, ABC inc., a large bank looking for floating

rate funding finds that it will have to pay prime rate while in the fixed rate market it can

raise 5-year funds at 50 base points (bp) or 0.50% above T-notes due to its AAA rating

140

for the loan of $100 million. Thus the spread demanded by the market between an AAA

and a BBB credit is 150%bp in the fixed rate segment while it is only 75 bp in the

floating rate segment. This differential is known as quality spread differential (QSD).

Required:

Show the swap transaction can be implemented and determine the benefits that can be

derived from the transaction.

Solution:

The requirements and access of the two parties are summarised below:

XYZ ABC

Requirement Fixed Rate $ Floating Rate $ Differences

Cost Fixed $ 11% 9.5% 1.5%

Cost Floating $ Prime + 0.75% Prime 0.75%

Benefit on swap is equal to different in differences 1.5%-0.75% = 0.75%

From the above, the bank ABC has an absolute advantage over the XYZ plc in both the

markets but the company has comparative advantage in the floating rate market. Both can

achieve cost saving by each borrowing in the market where it has a comparative

advantage and then doing a fixed-to-floating interest rate swap

Therefore, the terms of the swap arranged by a swap bank can be as follows:

• ABC borrows $100 million at 9.5% s.a fixed. XYZ borrows $100 million floating at

prime + 0.75

• ABC pays the swap bank (Prime – 0.25%) on $100 million every six months. The

swap bank passes this on to XYZ. And then XYZ pays the swap bank 9.75% s.a

(that’s 9.5 plus the profit element of 0.25 or cost attributable to swap bank) 0n $100

million. The swap bank pays ABC 9.5% (That’s retain part of profit element paid by

XYZ of 0.25 attributable to swap bank)

141

Note that the profits realised of 0.75% is shared equally to the three parties of the

transaction. That’s XYZ, ABC and Swap bank. Each gets 25%, that’s 0.75%/3

Therefore, the overall cost for XYZ on borrowing fixed late and arranging swap would

be; Cost that could be paid if no swaps less benefit on swap. That’s 11% -0.25 = 10.75%

The overall cost for ABC for borrowing floating and arranging swap with XYZ through

swap bank would be equal to cost of floating if no swap less benefit on swap. That’s to

say Prime-0.25%

6.2.2 Currency Swap

A currency swap is a contract between two parties to exchange payments denominated in

one currency for payments denominated in another.

In a currency swap, the two payment streams being exchanged are denominated in two

different currencies. Usually, an exchange of principal amounts at the beginning and a re-

exchange at termination are also a feature of a currency swap.

Currency swap can be fixed-to-fixed currency swap , floating to floating swap or a fixed-

to floating currency swap

A typical fixed-to-fixed currency swap works as follows:

One party raises a fixed rate liability in currency X say US$ while the other raises fixed

rate funding in currency Y say TSH. The principal amounts are exchanged, where first

party gets TSH and the second party takes US$. However, the first party markets periodic

TSH payment and the second party markets a periodic payment of US$ against interest

rate in each respective country. At the maturity, the principal

The floating –to-floating currency swap will have both payments at floating rate but in

different currencies

A fixed-to-floating currency swap is a combination of a fixed-to-fixed currency swap and

a fixed-to- floating interest rate swap. In this type of swap, one payment stream is at fixed

rate in currency X while the other is at a floating rate in currency Y

142

Illustration 5

Kalumanzila plc, a UK company, wishes to hedge a one-year foreign exchange risk on an

investment in Chile. The company has been offered a currency swap by a Chilean bank as

a possible alternative to conventional hedging. The foreign investment is for 800 million

escudos and is expected to yield an after-tax return of 35% for the year. The bank has

offered a currency swap at the rate of 22 escudos/£, with the bank making interest

payments of 4% to the UK company in pounds.

The current spot rates are:

28.000escoudos/£

1.51600US dollars/£

18.46965/US$

Interest rates are:

Borrowing Lending

UK 15% 12%

Chile N/A 25%

Show how the company can use of currency swap to hedge against risk

Possible scenarios

• Do not hedge. If no hedge is done, the investment will require 800 million escudos at

28escoudo/£. This will give a total of £28,571,429. If the loan is financed through UK

borrowing, the interest cost will be:

£28,571,429 at 15%= £4,285,714

• Currency swap: If the currency swap is used, the amount of pound required to get

escudo 800 million will be: 800million at 22 escudos/£ = £36,363,636

If financed by UK borrowing the interest cost is: £36,363,636 at 15% = £5,454,545

143

Interest received is: £36,363,636 at 4% = £ 1,454,545

Total cost £4,000,000 that’s (£5,454,545-£ 1,454,545). This is a gain over not hedging of

£285,714

6.2.3 Benefits Of Swaps

Swaps offer many potential benefits to companies including:

• The ability to obtain cheaper fiancé than would be possible by borrowing directly in

the relevant market

• The opportunity to restructure the company’s capital profile without physically

redeeming debt or raising new debt. For example, the proportion of debt on which

fixed and floating rate interest is paid can be altered without incurring expensive

transactions costs associated with redemption or new issues

• Access to markets in which it is impossible to borrow directly. For instance,

companies with relatively low credit rating might not be able to borrow directly in

some fixed rate markets, but can arrange fixed rate debt servicing through swaps.

• Used in long term hedging. swaps can be arranged for periods of up to 10years

• Hedging against foreign exchange risk. Currency swaps are especially useful in less

developed countries with volatile exchanges rates and exchange controls.

6.3 Interest Rate Movement

As in foreign exchange exposure management, the firm cannot undertake informed

management or hedge strategies without forming expectation about the direction and

volatility of interest rate movements. Normally forecasting of interest rate begins with the

markets own implied forecast the series or strip of forward interest rates.

Forward interest rates, also called forward spot rates, are interest rates for specified time

periods beginning at future dates

144

6.3.1 Selection of the Appropriate Tool or Technique

Once management has formed expectations about future interest rate level, it must choose

the appropriate instrument or technique for managing the exposure. Various techniques

can be used. The following are some of techniques:

• Forward rate agreement (FRA)

• Interest rate Caps

• Interest Rate Floor

• Interest Rate Collar

Interest rate caps, Interest rate floor and Interest rate collar are interest rate options that

traded or written over the counter.

6.3.1.1 Forward Rate Agreement (FRA)

A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest

rate payments on a notional principal.

• These contracts are settled in cash.

• The buyer of an FRA obtains the right to effectively lock in an interest for a desired

term that begins at a future date.

• In case of increase in interest rate expenses, the seller of the FRA will pay the buyer

increased interest expense on a nominal sum (notional principal) of money if interest

rates rise above the agreed rate

Forward rate agreements are purchased when a firm intends to borrow in the future or

faces a variable rate interest payment in the future, but expects interest rates to rise.

However, a firm planning to invest funds at a future date, but fearing a fall in market

interest rates, can purchase a FRA to lock in an investment rate that will be used in

future.

145

Illustration 6

Assume the agreed rate is 7.5% per annum on $, 2000,000, with 91 days in the three-

month period. Three months from now, at the beginning of the FRA period, the actual

three-month rate is 9%. Because the actual rate of 9% is above the agreed rate of 7.5%,

the firm that purchased the FRA (the holder) will receive from the seller of the FRA the

difference in the interest expenses. Therefore, the seller will repay:

Repayment amount = P( )

−36001

nxrr t

$2,000,000x (( ) 33.583,7$360

91075.009.0 =

− x

Where P= the principle amount

1r = the current interest rate

0r = the spot interest rate

Because the differential cash flow of the FRA is settled at the beginning of the three

month period (and not at the end of as in a normal interest payment), the cash flow must

be discounted back the three months of the FRA period. The actual rate of 9% is used as

the discounting factor

65.414,7$

360

91900.01

33.583,7$ =

+ x

. Therefore, the actual payment to the buyer FRA is

therefore $7,414.65

The impact on the firms borrowing costs can be seen by isolating the various actual

interest and FRA cash flows. The interest expense, independent of the FRA, payable at

the end of the six-month period is

00.500,45$360

919.0000,2000$ =

xx

146

Therefore, net payment would be $37,916.67 that’s:

Interest payment on borrowing $45,500.00

Less interest received on compensation $ 7,583.33

Net payment $37,916.67

The firm locked in borrowing rate by entering forward rate of 7.5% per annum,

$37,196.67 on $2,000,000

6.3.1.2 Interest Rate Caps

It is an option to fix a ceiling or maximum short-term interest rate payment. The buyer of

the Cap will receive a cash payment as a compensation for the raise of market interest

above the agreed rate (strike rate). The amount to be received as compensation is equal to

the difference between the actual market interest rates and the Cap strike rate on the

notional principal (the amount of loan or amount hedged).

For the right the buyer receives from the seller of the Interest Rate Cap, the buyer pays an

upfront amount called premium. The premium here is stated as annual percentage

consistent with that of the strike rate

The cap is excised if and only if the market interest rate on the predetermined date is

greater than the strike rate. In this situation the buyer will be compensated the differences

by the seller of the cap.

The buyer of the Cap will be pay Interest on the principal amount using the market

interest rate, and if that rate is higher than the strike rate, then he/she will be compensated

by the difference amount.

The interest payment is computed as follows:

Interest payment =

360

nxrp

Where,

147

P is notional principal

r is market interest rate

n is number of days in a contract

Received cap cash Flow: That’s amount to be compensated in case the market interest

rate is higher than strike interest rate is given by:

Received Cap Cash Flow = ( )

−36001

nxrrP

Whereby,

P = notional principal

1r = market interest rate

0r = Strike Interest Cap

n = number of days in a contract

6.3.1.2.1 Cap Premium Payment

It is normally paid at the date of the transaction. It is a single lump sum payment which is

paid at the beginning of the contract. This payment should also be annualised in order to

determine the total cost of the capped payment. This amount is added to the Interest cap

amount paid. The annualised cap premium is determined as follows:

( )

+−

=

trxrr

esentPeriod

1

11

Value Pr Payment

Where,

Present value is the current loan amount

t is the number of periods

148

r is the rate of interest per period

Illustration 7

Makauki is a famous dealer in Political Science books. He normally buys the books from

US and sells them in Tanzania where the demand has proved to be very high as the

education system in a country is encouraging political Science education. The numbers of

secondary schools have increased drastically and Makauki has projected the drastic

increase in demand for the books. Kamanyola, her marketing advisor has advised him to

increase the order for the books. To meet this order, Makauki borrows $10,000,000 and

buys Interest rate Cap to protect against interest rate fluctuation risk. That’s decides to

lock the interest rate that he will pay on the loan.

The bank ha provided the following information to the customer:

Maturity: 3 Years

Strike rate 10%

Reference rate: 3-mont U.S dollar LIBOR

Total Periods: 12 (4 periods per year for 3 years)

Premium: 10basis point (or 0.1%)

Fixed borrowing rate: 12%

Further information reveals that, the three month LIBOR rate (reference rate) will rise

above the strike rate to 12%

Required:

Determine the total cost of the cap that will be incurred by Makauki.

149

Solution

The value of this type of cap option comprises of the three elements of values. These

values need to be determined so as to reach to a total cost or value of the cap. The

following are elements of values:

The actual Interest rate payments on the loan. This is the obligation of the buyer of the

cap. In any case, the buyer is responsible to pay interest on the notional principal basing

on the market interest rate.

Therefore, for the three months period of actual 90 days:

Interest payment =

360

nrxp

= 360

90 x0.12 x 000,000,10$

= $300,000

Since the three month LIBOR rate has risen above the cap rate on the rest date, the cap is

activated and the buyer of the cap receives a cash payment from the seller equal to the

difference between the actual three-month LOBOR rate and the cap rate (strike rate).

Therefore,

The received cap cash Flow = ( )

−36001

nxrrP

= ( )

360

900.1-0.12 x 000,000,10$ x

= $50,000

So, Makauki will receive a compensation of $50,000 from the seller of the interest cap.

This will reduce the amount of interest paid on loan.

150

6.3.1.2.2 Amortized Cap Premium Payment

The upfront amount paid for the right and protection received from the seller of the cap

should be amortized over the 12 reset periods.

Therefore, quarterly premium will be equal to:

( )

+−

=

trxrr

esentPeriod

1

11

Value Pr Payment

=

( )

+−

1203.01 03.0

1

03.0

1

0.1%

x

= 38.2333.33

%1.0

−

= 95.9

001.0

=0.01% on quarterly bases and 0.04% on annually basis

The premium amount will then be $1000 per quarter

Note. Borrowing rate is 12% per year, for a quarter will be 3%, (12/4)

Therefore, the total or All-in-cost will determined as follows:

Cap component Annualised interest cost Quarterly cash payment

1 Interest payment outflow 12% $300,000

2 Cap cash payment inflow (12%-10%)= 2% -$50,000

3 Cap Premium payment 0.04% $1000

Total or All-in-cost 10.04 $250,000

151

Effective cost = $300,000- 50,000

= $250,000

6.3.1.3 Interest Rate Floor Valuation

Interest rate floor is equivalent to put option on an interest rate. A floor guarantees the

buyer of the floor option a minimum interest rate to be received for a specified

reinvestment period or series of periods. An investor who have money to invest and fears

that the interest rate on investment in future will drop, then he/she may purchase floor.

This will guarantee the investor the minimum effective rate investment.

It should be understood that, normally investors would prefer to invest when interest rate

is higher. A such in case at the maturity date the actual market rate is less than the strike

rate, then the buyer will be compensated by the seller (writer) the differences in form of

cash settlement.

Illustration 8

Mdotta & Kitove plc is a famous gambler in Tanzania. It is recently the company has

received enormous amount to the tune of US$10,000,000 resulting from its gambling

activities. The managing director of the company Mr. Mikosi had no plan before of how

the money if the company win a gamble would be used. Mr Mikosi approaches the

experienced investor Mr. Bahati to seek for the advice. Thank Mr. Bahati is not selfish,

he advised Mr. Mikosi to invest the money in a very paying investment portfolio. They

agreed, but the fear remains of the expected drop of interest rate on investment. This was

decided to buy an interest rate floor. The following information also pattern to the this

hedging strategy.

Maturity: 2 Years

Strike rate 10%

Reference rate: 6-month U.S dollar LIBOR

Total Periods: 4 (2 periods per year for 2 years)

152

Floor Premium: 10 basis point (or 0.1%)

Fixed borrowing rate: 12%

Further information reveals that, at end of the three month LIBOR rate (reference rate)

dropped below the strike rate to 5%

Required:

Determine the total yield of the floor option

Solution:

Interest payment/Yield =

360

nxrp

Where;

P = $10,000,000

r = 5%

n = 180

Interest payment/Yield = 360

180 x0.05 x 000,000,10$

=$250,000

Floor cash payment inflow

The received cap cash Flow = ( )

−36001

nxrrP

= ( )

360

1800.05-0.1 x 000,000,10$ x

= $250,000

153

Amortized Floor Premium payment

:

Periodic payment

( )

+−

=

trxrr

esent

1

11

Value Pr

=

( )

+−

406.01 60.0

1

06.0

1

0.1%

x

= 20.1367.16

%1.0

−

= 47.3

001.0

= 0.029% on semi annual basis and 0.058% on annual basis

Premium paid semi annual will be $2,900

Therefore, the total Yield of the floor will determined as follows:

Floor component Annualised interest cost Semi annual cash Flow

1 Interest payment inflow 5% $250,000

2 Floor cash payment inflow (10%-5%)= 5% $250,000

3 Floor Premium payment outflow 0.058% -$2,900

Total Yield or All-in-Yield 10.04 $497,100

6.3.1.4 Interest Rate Collars

This is a simultaneous purchase (sale) of a cap and sale (purchase) of a floor. By

simultaneous buying and selling of the cap and floor enables investors to earn premium

154

from sale of one side to cover in part or in full the premium expenses of purchasing the

other of the collar. If the two premiums are equal, the position is usually called a zero

premium collar. This hedging strategy allows investors to retain some of the benefits of

declining rates while removing the unpleasantness of paying an up-front option premium

for the cap.

An interest rate collar is an arrangement under which a corporate user Buys an interest

rate cap from bank, and sells an interest rate floor to the bank

6.4 Swaptions

A swaption gives the firm the right but not obligation to enter into swap on a

predetermined notional principle at some defined future date at a specified strike rate.

The holder of swaption will exercise it when the rate rise above the strike rate, otherwise,

the holder may leave it unexercised and take advantage of lower rate environment

If swaption is valuable, buyer may require seller to enter into an interest rate swap in

which,

• Buyer pays fixed rate (and receives floating rate)

• Buyer pays floating rate (and receives fixed rate

6.4.1 Uses of Swaptions

Swaptions are used mostly in tender scenarios where:

• The tender will be awarded at some future date

• Investor will have to borrow larger amounts of funds for a larger period of time

• To protect against future rate movement

155

Reference

Bruno, S (2000), International Investments, Wesley Longman. Inc US , 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

Demirag, I and Goddard, S (1994), Financial Management for International Business.

McGraw-Hill International UK

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by

Palgrave MACMILLAN, UK

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

156

Review Question

1. William Copson has just purchased the following interest rate cap agreement which

he believe is the best hedging strategy for his loan portfolio of $ 250,000,000.

Maturity: 2 Years

Strike rate 10%

Reference rate: 6-month U.S dollar LIBOR

Total Periods: 4 (2 periods per year for 2 years)

Floor Premium: 10 basis point (or 0.1%)

Fixed borrowing rate: 10%

Further information reveals that, at end of the three month LIBOR rate (reference

rate) rose to 15%

Required:

Determine annualised interest cost and semi-annual cash payment by filling the

following table

Cap component annualised interest cost semi-annual cash payment

Interest rate outflow % $

Cap cash payment inflow % $

Cap premium payment outflow % $

Total Cost or All-in cost % $

2. The Kampaboy is highly in need of fund to establish a wooded furniture workshop.

The money needed amounts to Tsh 1,000,000,000, that he think may be borrowed fro

the bank in 90 days. The Kampaboy can access the floating market at the interest

bank plus 3%. The loan will have a maturity of 180 days, at which time all of the

interest and principal will be repaid. To hedge the uncertainty of future rate,

Kampaboy purchases a cap at 15% for a premium of 20 basis points. The current

inter-bank borrowing rate is 10%

Required

Determine the amount Kampaboy will payback for both future interbank rates of 8%

and 12%.

157

3. The PACHA is a building company specialised in road and complex building

construction. By the nature of its activities and the volume deals it wins, the company

is required by law, to hold a minimum percentage of its assets in highly liquid interest

deposit of 360 days maturity or less. Because of the recent continuing decline in the

market interest rates, PACHA has purchased a floor agreement for the entirely of its

money market portfolio of $ 36, billion. The following information relates also to this

heading strategy

Maturity: 2 Years

Strike rate 6%

Reference rate: 6-month U.S dollar LIBOR

Total Periods: 4 (2 periods per year for 2 years)

Floor Premium: 105 basis point

Fixed borrowing rate: 10%

Further information reveals that, at end of the three month LIBOR rate (reference

rate) dropped to 5%

Required:

Determine annualised interest yield and semi-annual cash Flows by filling the

following table

Floor component Annualised interest yield semi-annual cash Flow

Interest rate Payment inflow % $

Floor cash payment inflow % $

Floor premium outflow % $

Total Yield or All-in Yield % $

4. AIKA Company limited has taken on a floating loan to fiancé new project. The

financing bank is worried about the impact on the project performance if inter-bank

rate raise above 8%. At the same time the bank is ready to forgo the benefit of 3

months inter-bank rate falling below 5%. CRDB Bank is ready to write AIKA

company a cap at a premium cost of 4% flat for a period of 5 years. AIKA company

sales a 5% 5 years floor on 3 month inter-bank rate at a premium of 2%

158

Required

What would be the adjusted inter-bank rate in the above question. What is the

effective price of a collar?

5. Mapatano Company is tendering for the $ 60 million contract for a 3 years project on

which it is budgeted interest cost must not exceed 7%. The current 3-year swap rate is

6%. The contract will be awarded in three months time. Mapatano buys a three year

7% payer’s swaption which is execrable in 3 months time at a premium of 0.35% flat

Required

With example illustrate what would happen to Mapatano if the company wins the

tender or loose the tender.

6. Makwesa the managing director of Concern limited company intends to reduce the

interest expenses of the company on $600 million floating rate loan based on a 3

months inter-bank rate for a year at a level of 12%. The loan next re-fixed on 30th

June 2002. The Santego bank writes an interest cap at a premium of 15basis point to

Makwesa.

Required

What would happen to the concern’s position if the inter-bank rate re-fixed at a level

above or below 12% on 30th June 2005?

7. Winome and PACHA Corporations both seek funding at the lowest possible cost.

They face the following rate structure:

Winome PACHA

Credit rating AA BB

Cost of fixed-rate borrowing 10.0% 13.0%

Cost of floating-rate borrowing LIBOR+ 0.5% LIBOR+1.0%

Required:

a. In what type of borrowing does Winome have a comparative advantage?

b. In what type of borrowing does PACHA have a comparative advantage? Why?

c. If a swap were arranged, what is the maximum savings that could be divided between

the two parties?

159

d. Illustrate a transaction that would generate such a savings divided equally between

the two firms

8. Lankee plc would like to borrow floating-rate dollars, which it can do at

LIBOR+0.5%. It can also borrow fixed-rate Sterling pound at 6%. Sokomoko plc has

a strong preference for fixed-rated sterling pound debt, which will cost it 7%.

Sokomoko could borrow floating dollars at LIBOR + 1%

Required

State the possible range of savings to Lankee plc from engaging in a combined

interest and currency swap with Sokomoko.

160

CHAPTER 7

MULTINATIONAL CAPITAL BUDGETING

7.1 Introduction

The globalisation process has enabled most of large $2,900making direct foreign

investment is not an easier task; critical evaluation of multinational project proposals

requires to be made before the fund is committed. This process is called Multinational

capital budgeting analysis. Through this process, MNCs would be able to decide whether

or not to invest. Thus Capital budgeting is necessary for all long term projects that

deserve consideration. Multinational capital budgeting focuses on the cash inflows and

cash outflows associated with prospective long term investment project. Cash inflows

are expected revenues that are generated by a projects and cash outflows are expected

expenses for running a projects including initial capital investment.

7.2 Evaluation of MN Projects for capital budgeting

The evaluation of MN projects is similar to the evaluation of a domestic one. NPV or

IRR can be used for evaluation. The project which yields positive NPV or higher required

rate of return is selected. However, to be able to evaluate a project or an investment,

various steps need to be followed. The following are the basic steps in Multinational

capital budgeting.

• Identify the initial capital invested or put at risk

• Estimate cash flows to be derived from the project overtime including an estimate of

the terminal or salvage value of the investment

• Identify the appropriate discounting rate for determining the present value of the

expected cash flows

• Apply traditional capital budgeting decision criteria. Such as NPV, IRR, or modified

internal rate of return (MIRR) to determine the acceptability of, or priority ranking of,

potential projects.

161

7.3 Data Needed for Multinational Capital Budgeting:

Capital budgeting requires various inputs. Those inputs have influence on the net

expected cash flows and on the decision criteria (such as NPV/IRR) of the projects. For

that reason they need to be incorporated in the budgeting processes so that to arrive at

correct net cash flow and decision criteria. The following are the most important data in

the capital budgeting:

• Cash flows i.e. revenues (both Price per unit and Quantities); Costs, including

variable costs and fixed costs; and initial investment

• The duration of a project or project life time (the time period a project is expected to

take to be accomplished)

• Salvage Value. The value of a project remaining after the end of the project. This can

be value of plants and other equipments. If these salvages are disposed off, then adds

to the cash inflow of the project. However, salvage value is not taxable, and does not

form part of the revenue subject to withhold tax. Therefore it is added to after tax

profit of the project for the parent perspective.

• Depreciation. This refers to the allocation of the cost of an asset to expense in the

periods in which services are received from the asset. This is non-cash item, but it is

included in the expense list to arrive at after tax earnings of subsidiary. When the

subsidiary remit fund to the parent company, this element of depreciation is added

back to after tax earnings of subsidiary to get net cash flow to be remitted to

subsidiary.

• Taxes. This is a tax imposed by parent company’s government on revenue received

from subsidiary company. Where there is an agreement that the tax should not be

double taxed, then it will be charged by host government or parent company’s

government but not both. The rate of tax should be known and taken into account

when making capital budgeting for multinational projects

• Exchange Rates. Exchange rates never stable and this has significant impact to the

expected cash flows of a project. When a subsidiary transfer fund to the parent

162

company, it has to convert it into the reporting currency of the parent company using

the prevailing exchange rates for each year in case the company did not hedge the

expected cash flows

• Required Rate of Return (k). This is the rate of return at which the project requires in

order to be carried out. It is the rate which project needs to be compensated for the

inverted capital. It reflects the rate of revenue generated which find its way to the

project. Once the relevant cash flows of a proposed project are estimated, they can be

discounted at the project’s required rate of return.

• Restrictions to cash Outflows. This refers to the host government imposing restriction

from the subsidiary remitting all the revenue earned there to the parent company’s

country. The host government restrict transfers of all revenue through imposing

certain percentage as withhold tax on revenue generated. Normally withhold revenue

is deducted from subsidiary total cash inflow before convention to the parent

company reporting currency is done.

7.4 Should Capital Budget Base on Subsidiary or Parent Perspective?

The decision of whether to invest or not particularly in multinational projects is very

difficult. The decision whether capital budgeting for multinational projects be conducted

from the view point of the subsidiary or parent should be made. Mangers face dilemma in

this matter. The dilemma arises because each approach produces different results. A

project can be profitable from the subsidiary perspective but not from the parent

perspective

Illustration 1

PACHA is UK Firm’s Subsidiary in US. The following information pattern relates to the

PACHA subsidiary.

Initial investment $ 480,000

Annual cash $ 350,000

Corporate tax:-

US None

163

UK 25%

Required rate of return 18%

Exchange rate:

Year 0 Year 1 Year 2

₤0.50\ $ ₤0.52\ $ ₤0.54\ $

Compute NPV in both subsidiary and parent perspectives

Solution:

From the Subsidiary Perspective (Decentralised approach)

Year 0 Year 1 Year 2

Annual cash flows -480,000 350,000 350,000

Discounting factor 1 0.8475 0.7182

PV of cash flows -480,000 296610 251365

Therefore NPV = -480,000+296610+251365

= $67975.

It is positive NPV; hence accept the project basing on subsidiary perspectives

From the Parent Perspective (Centralised approach)

• In this case, the currency should be translated or converted into the currency used by

parent Company.

• Subsidiary will withhold tax. So cash flow remitted should be deducted withhold tax.

The amount remitted will be converted into parent Currency to get cash flows.

• Compute PV of Cash flows

• Compute NPV. Note! the discounting factor will be as in case one above

164

Year 0 Year 1 Year 2

Cash flows

Less: with hold tax 10%

Remitted fund in $

Convert into ₤:

Cash flow in ₤

Discounting Factors

PV

NPV

-480,000

-

- 480,000

₤0.50\ $

-240,000

1.0000

-240,000

350,000

(35,000)

315,000

₤0.52\ $

163,800

0.8475

104110

350,000

(35,000)

315,000

₤0.54\ $

170,100

0.7182

91622

-£44268

The NPV to subsidiary Company is positive, but the NPV to Parent Company is negative,

hence the project will not be accepted because it does not add cash flow to the Parent

company.

7.5 Cash flows Difference between the Parent and the Subsidiary

There are various factors that may lead the after tax cash inflow of subsidiary to differ

from those of parent Company. The following factors are fundamental:

7.5.1 Tax Differentials

If the parent’s government imposes a high tax rate on the remitted funds, the project may

be feasible from the subsidiary’s point of view, but not from the parent’s point of view.

Under such situation, the parent should not consider financing a project even though it

appears feasible from the subsidiary’s perspectives.

7.5.2 Restricted Remittances

Some country may restrict a certain percentage of subsidiary earnings from being sent to

the parent company. Since the parent may never have access to such funds, the project is

not attractive to parent.

165

7.5.3 Excessive Remittances

If parent charge high administrative fee to subsidiary, the subsidiary may appear to have

law earnings and parents may appear to have high earnings due to administrative charge

being cost or expenses to subsidiary and revenue to parents. Considering the parent view

point the project will be accepted, but if we base on subsidiary point of view, there is

danger of rejecting the project.

7.5.4 Exchange Rate Movement

Where earnings are remitted to the parent, they are normally converted from the

subsidiary’s local currency to the parent’s currency. The amount of funds received by the

parent is therefore influenced by the existing exchange rate.

Because of such differences in NPVs between parents and subsidiary, greater care in this

point is needed as there is possibility of rejecting a project thinking that it is not profitable

while not or accepting non-profit making projects.

To avoid some confusion in multinational capital budgeting, an overseas capital project

may be looked at from at least two standpoints.

• Incremental project cash flows. This is concerned with foreign currency cash flows.

• Incremental parent cash flows. This means cash flows which may find their way back

to the parent.

That is to say, a foreign project should be judged on its net present value from the view

point of funds that can be freely remitted to the parent. The capital budgeting should be

made in view of parent other than in subsidiary, because the parent is one which finances

the project, and also because subsidiary is subset of parent company. The cash flows to

the parent is important because it helps the parent Company:

• For paying dividends to the stockholders

• For reinvestment else where in the world

• For repayment of corporate debt act

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7.6 The Use of Risk Free Rate Of Interest In Capital Budgeting

In case there is a risk free rate of interest, then for capital budgeting purposes:

• The expected change in spot rates should be determined.

• The expected change will be used to estimate the future spot rate

• The expected change is considered as annual rate of depreciation or inflation in parent

currency.

To determine the spot rate in each following year, use the following formula

( )( ) )(e ratespot present 1

1)(e ratespot Expected 0t ×

++= t

f

t

h

i

i

Illustration 2

UK Company establishing a Subsidiary in US

Post tax nominal cash flows are:

Year 0 Year 1 Year 2 Year 3 Year 4

Cash flows in $ - 5,000 1200 1900 25000 2500

Current Spot rate $2\₤

Risk free rate of interest:-

UK 8%

US 10%

Expected rate of inflation in US 4%

Parent Company’s required rate of return 17%

Required:

Evaluate the project by:

Discounting cash flows in ₤ using nominal rate of discount in ₤

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Solution:

Discounting cash flow in ₤ sterling using nominal rate of discount

• Estimate future spot rate using the above following formula

Where by:-

if = 8%

ih = 10%

Then future spot rate will be:-

Year Future Spot Rate

Year 0 2.00 = 2.0000

Year 1 ( )( ) 00.2

1.1

08.1x = 1.9636

Year 2 ( )( )

00.2 1.1

08.12

2

x = 1.9279

Year 3 ( )( )

00.2 1.1

08.13

3

x ) = 1.8929

Year 4 ( )( )

00.2 1.1

08.14

4

x = 1.8585

• Compute discounting factors for each year and apply them for determining PV for

each year

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Year 0 Year 1 Year 2 Year 3 Year 4

Cash flow $ -5000 1200 1900 2500 2500

Spot rate $/£ 2.000 1.9036 1.92.79 1.8929 1.8585

Cash flow £ -2500 611 986 1321 1345

Discounting factor 1.000 0.8547 0.7305 0.6244 0.5337

PV of cash flow -2500 522 720 823 717

NPV = -2500 + 522 +720 +823 + 717

= £ 285 at 17%

7.7 The International Capital Budgeting Complications

Capital budgeting for foreign projects involves many complexities that do not exist in

domestic projects. These are:-

• Project cash flows and parent cash flows differ. Each of these two types of flows

contributes to a different view of value

• Parent cash flows often depend on the form of financing. Thus cash flows cannot be

clearly separated from financing decision, as is done in domestic capital budgeting.

• Part of the parent input is via equipment. This can be difficult to treat at the level of

incremental cash flows

• Exchange rates are not expected to be constant throughout the project life.

• Different rates of tax apply in the country of the project and in the parent’s country

• Royalties and management fees are involved

• Full remittances of cash flows arising from a project are restricted in terms of

payment to the parent.

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7.8 The Cost of Capital For The Foreign Investments

The central question concerning MNC is whether the required rate of return of foreign

projects should be higher, lower, or the same as that for domestic projects

7.8.1 Cost of Capital

For a given investment, the cost of capital is the minimum risk-adjusted return required

by shareholders of the firm for undertaking that investment.

The required rate of return is met only if the net present value of future project cash

flows, using the project’s cost of capital as the discount rate, is positive.

The value of the firm will increase if the investment generates sufficient funds to repay

suppliers of capital. This is possible if the firm generates positive NPV of the future cash

flow of the project

7.8.2 The Cost of Equity

The minimum rate of return necessary to attract investors to buy or retain the firms stocks

is called the cost of equity. The rate required here should cover all time value and the risk

associated to the capital supplied.

Therefore it can be said that the required return equals a basic yield covering the time

value of money plus a premium for risk.

The cost of equity is the rate used to capitalise total cash flows. As such it can be said that

the cost of equity is the weighted average of the required rates of the return on the firm’s

individual activities.

7.8.3 Approaches to Determine the Cost of Equity

Two approaches can be used:

7.8.3.1 CAPM

This model is based on the modern capital market theory. According to this theory, an

equilibrium relationship exists between an asset’s required return and its associated risks.

170

Capital Asset Pricing Model is given by )(ri fmif rrBr −+=

Where;

ri = equilibrium expected return for asset i

rf = rate of return on a risk free asset

rm = expected return on the market portfolio consisting of risk assets

CAPM is based on the notion that intelligent risk-averse shareholders will seek to

diversify their risks, and as a consequence, the only risk that will be rewarded with a risk

premium will be systematic risk

Note that the risk premium associated with a particular asset i is assumed to be equal to ß

(rm-rf), where Bi is the systematic or risk that can not be diversified

ß measure the return the correlation between returns on a particular asset and returns on

the market portfolio. The (rm-rf) is called market risk premium

7.8.3.2 Gordon Model Approach

Another approach of determining cost of equity is called Gordon modal. This model

discounts the expected future dividends.

Therefore according to this modal,

Po = gk

DIV

e −1

this can be simplified as g

p

DVKe +=

0

1

Where Ke = company’s cost of equity capital

DV1 = expected dividend in year 1

P0 = current stock price

g = average expected annual dividend growth rate

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7.8.4 Weighted Average Cost of Capital For Foreign Projects

The required rate of return on equity for a particular investment assumes that the financial

structure and risk of the project is similar to that for the firm as a whole.

To get the WACC for the parent and project as a whole, the cost of equity capital Ke is

combined with the cost of debt KD. Because interest is tax deductible, then the after tax

cost of debt is used for this case.

Therefore WACC for the project and for the parent is calculated as follows

)1()1(0 tLiKLK de −+−=

Where;

L is the parent’s debt ratio. That’s debt/asset.

Note! This cost of capital is then used as discounting rate in evaluating the specific

foreign investment

If the net present value of those cash flows-discounted at the weighted average cost of

capital is positive, the investment should be undertaken, if negative, the investment

should be rejected.

It should be understood that that Ke is the required return on the firm’s stock given the

particular debt ration selected

Reference

Bruno, S (2000), International Investments, Wesley Longman. Inc US, 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

Demirag, I and Goddard, S (1994), Financial Management for International Business.

McGraw-Hill International UK

172

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by

Palgrave MACMILLAN, UK

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review Questions

1. Identify and discuss the complications in Multinational capital budgeting?

2. What factors should be considered in Multinational capital budgeting?

3. Should Multinationals budget the capital investment on the basis of parent or

subsidiary perspectives? Why? Explain. What are differences between the two

approaches?

4. Discuss to approaches that can be used to determine cost of equity for the

Multinationals

5. MARPOL, a UK Company establishing a Subsidiary company called SECURCO in

US. The projected pre-tax cash flows to be generated by the subsidiary company are

as follows:

Year 0 1 2 3 4

Cash flows in $ - 5,000 1200 1900 2500 2500

MARPOL Company is very famous in UK and its long lasting reputation in security

services has enabled it demand higher required rate of return on its investments. For that

reason, the required rate of return on MARPOL stocks is 17%. To evaluate the projects, it

was agreed that the company will be using the required rate of return of the parent

company only.

173

The Financial Times of UK has provided the following data, which may assist the

investors in evaluating the multinational projects for capital budgeting purposes:

Current Spot rate $2/₤

Risk free rate of interest:-

US 8%

UK 10%

It is a practise for the host country to charge a withhold tax of 2% and parent

company’s country charges a corporate tax of 30%

Required:

Evaluate the project using NPV decision criteria and state if the project should be

accepted or not

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CHAPTER 8

STRATEGIC ISSUES IN DIRECT FOREIGN INVESTMENT

8.1 Introduction

MNCS are increasingly attracted to do business beyond their domestics markets. The

main reason for this is said to be the growth of the international trade and the increase of

world economic interdependent. As such Foreign Direct Investment (FDI) has become an

important source of private capital for developing countries. Direct foreign investment

leads to private international capital flows, which are vital for national economic

development efforts’. It is important because it represents additional investment and

hence provides employment. This is good from the host government point of view.

8.2 What is Foreign Direct Investment

The IMF defines FDI as "an investment that is made to acquire a lasting interest in an

enterprise operating in an economy other than that of the investor, the investor's purpose

being to have an effective voice in the management of the enterprise.

• Distinguishing Foreign Aid and Direct Investment…

• The concept of Control

• The concern about control

8.3 Managerial Decision in DFI

Three main managerial decisions that need to be considered before investment can be

made:

• Whether to export its finished goods,

• Whether to invest abroad. If the decision is to invest abroad, then decision should be

made on where to invest and how to invest

• . Whether the overseas operations be structured as a branch or subsidiary etc

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8.4 Motives Behind Overseas Investment Decisions

In drawing up its strategic plan, a coy may Identify Direct foreign investment as a means

of fulfilling its strategic objectives. There are several possible motives for a corporation

becoming more internationalized. These are

8.4.1 Production Efficiency Motives

MNC often attempt to set up production in a location or countries where factors of

Production (Raw materials, Labour) are cheaper. In addition to that fully benefits from

economies of scale may be achieved by expanding production in other countries. By

doing this the corporation may increase its earnings and shareholders wealth due to the

economies of scale.

8.4.2 Demand – Led Motives

When the MNC has reached a stage where growth is limited in their home country, then

it can attract new sources of demand. This may be also due to the intense competition for

the product they sell. Thus a possible solution is to consider foreign markets where there

is potential demand.

8.4.3 Profit Motive

Inter markets where excessive profits are possible .If excessive earnings can be realized

in other market MNC may also decide to sell in that market or invest in that market.

8.4.4 Raw Materials

A county or MNC may develop the product in the country where the raw materials can be

found for export or further processing and sale in the host country e.g oil, mining wtc..

This may lead to reduction of transportation cost of material.

8.4.5 Knowledge Motives

MNC may establish overseas plants or acquire existing overseas plants to learn about the

technology or managerial expertise of foreign countries. This technology is then used to

improve their production process at all subsidiary plants around the world.

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8.4.6 To Avoid Tardifs

Same countries impose tariffs to frustrate imports. A MNC might establish a base in that

country in order to avoid being subject to the Tariffs. The IMF defines FDI as “as

investment that is made to acquire a lasting interest in an enterprise operating in an

economy other than that of the Investor, the investor’s purpose being to have an effective

voice in the Management of the Enterprise.

8.4.7 Exploit Monopolistic Advantages

Some county may posses an advantage over other countries in the market. However even

within a given country some firm may posses an advantage over other firms in these

market eg, if a particular firm possesses advanced technology and has exploited this

advantage successfully in local markets it may attempt to exploit it internally as well.

8.4.8 Diversification Motives

The reason why firms conduct international business is international diversification. This

also helps to reduce risk.

8.4.9 Reaction to Currency Fluctuations

When a foreign currency is perceived by a firm undervalued the firm may consider direct

foreign investment in their country.

8.4.10 React To Trade Restrictions

If there are trade restrictions in home country, a county may think of going

internationally. Export to new market where there are no trade restrictions if restrictions

are tightened in existing export market.

8.4.11 Political Safety Motives

A MNC coy established in a politically unstable country would be attracted to acquire or

establish new operations in countries that are considered to be politically stable i.e.

countries that are whitely to interfere with private enterprises. However a MNC establish

a subsidiary in markets where the government does not control the price of products.

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8.5 Designing A Global Expansion Strategy

The world market has become very competitive. Some firms are very strong and pose

greater competition and barrier to entry in the market. However, firms need to keep on

systematically pursuing policies and investments that are congruent with worldwide

survival and growth. This approach involves five interrelated elements. These elements

are:

8.5.1 Awareness of Investments Which Are Likely To Be Most Profitable

The firm need to be aware of these investments and capitalise on. By doing that the firms

may enhance the differential advantage possessed by the firm; that is, an investment

strategy should focus explicitly on building competitive advantage

8.5.2 Continual Audit of The Entry Model

Firms must continue auditing the effectiveness of current entry models, bearing in mind

that a market’s sales potential is at least partially a function of the entry strategy. As

knowledge about a foreign market increases or sales potential grows, the optimal market

penetration strategy will likely change.

8.5.3 Make a Systematic Investment Analysis

It is important that investment analysis requires the use of appropriate evaluation criteria.

This is important because it will lead the firms to make right investment decision that

may give the firm high return. Nevertheless, despite the importance of using appropriate

evaluation criteria, most firms use the rule of thumb in selecting projects to undertake.

Analytical techniques are used as a rough screening device or as a final check off before

project approval. The use of rules of thumb may be dangerous, as sometimes may lead to

select unprofitable projects.

8.5.4 Estimate the Longevity of Particular Form of Competitive Advantage

If a firm have certain competitive advantage and wants to enter in multinational market to

befit such competitive advantage, it is important to estimate how long the firm will

continue enjoying such competitive advantage. If the competitive advantage of a form is

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easier replicated, by both local and foreign competitors, it is likely that the firm will not

take long to apply the same concept, process to their operations. The resulting

competition will erode profits to a point where the MNC can no longer justify its

existence in the market. For this reason, the firms’ competitive advantage should be

constantly monitored and maintained to ensure the existence of an effective barrier to

entry into the market. Should these entry barrier break down, the firm must be able to

react quickly and either reconstruct them or build new ones.

8.5.5 Forms of Entity for International Operations

Different forms of expansion overseas are available to meet various strategic objectives.

These include:

8.5.5.1 Export From the Home Country

A coy may decide not to establish any permanent set-up in the foreign country,

Government instead to export its goods directly from home country. Exporting is a safer

way to break into anew market since there is less to lose if the strategy fails. The initial

cost of producing at home and exporting is low relative to establish a subsidiary

Advantages

• Immediate returns

• Low risk

• Low capital needs and start-up costs.

• High learning Possibilities.

Disadvantages

• Little knowledge of local market gained.

• Slow response to market charges.

• It is difficult for customers to contact the company,

• Sales could be frustrated by the imposition of tariffs barriers on imports

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.

8.5.5.2 Set-up an Overseas Subsidiary

This demonstrates buyer-term commitment to operations in the foreign country. There

may be tax advantages since home country taxation will not be incurred until profits are

remitted home are there may be opportunities to set transfer prices to reduce worldwide

tax liabilities. The disadvantage is that there will be legal costs associated with setting up

the coy and on going costs in resourcing it.

8.5.5.3 Mergers and Acquisition

This is a situation where by one coy acquires/purchase another company or two

companies of similar size merges to form one big coy A firm might take over or merge

with established firms abroad. This provides a means of purchasing market information

market share and distribution channels. If a speed of entry into overseas market is a high

priority, then acquisition may be preferred to start up. ho

Advantages

• Quicker way to establish presence in a host country.

• Economies of scale and scope.

• Reduction of forex exposure.

• Knowledge exploitation.

• May be a cost-effective way to capture valuable technology or underutilized assets.

Disadvantages

• Cultural differences (nationality, customs)

• The price paid by the acquirer way be to high.

• Unfavourable host country political reactions.

180

8.5.5.4 Joint Venture

A Joint venture between a MNC and a host country partner is a viable strategy if, and

only if, one finds the right local partner. In this method, each partner is operating in its

own country, but each one send goods to his/her partners’ country to be traded there

under the supervision of the partners in respective country.

Advantages

• The existing Management has a detailed knowledge of the overseas market.

• The overseas government may treat the venture more favourably than if it was all

overseas owned and so grants way be available.

• Enables ventures to pool their expertise and are less risky.

• Access to local capital markets due to the local partner’s reputation.

• Access to local loans, government approval and tax ancestries.

• Use of established distribution networks, trained labours, raw materials Suppliers and

local Government.

Disadvantages

• They can take up large amounts of Management time with few returns.

• Disagreement about future cause of action on matters such as dividend policy,

remuneration, marketing strategy, transfer of technology etc.

8.5.5.5 Strategic alliances

One form cross-border strategic alliance is where two firms exchange a share of

ownership with each other.

181

8.5.5.6 Licensing agreement

Licensing is a popular for non multinational firm to profit from foreign markets without

the need to commit sizable fund .Such agreements permits a foreign firm to manufacture

the company’s products in return for loyalty payments. They are cheap, low-risky way of

rapidly expanding into foreign markets. The problems with this may be

• Poor quantity the goods produced by the inclusive, which may damage the value of

brand.

• The cash them from licensing compared to exporting

• The possibility that the foreign coy may use the knowledge it has learnt to compete

against the home coy after the expiration of the licensing period.

8.6 Theories of Foreign Direct Investment

Certain theorists have attempted to address limitation of International Trade Theories

under the rubric/rules of FDI. It has long been recognized that all MNCs are oligopolies

and that multimodality and oligopoly are linked via the notion of imperfection. The

imperfection is also related to product and factor markets or financial markets.

8.6.1 The Market imperfection Theory (MIT)

The ability of a firm to transfer its competitive advantage (built at home market) abroad

depends and binding product or factor market imperfection.

The theory states that firms constantly seek market opportunities and their decision to

invest overseas is explained as a strategy to capitalize on certain capabilities not shared

by competitions in foreign countries.

The perfect market theory dictates that firms produce homogeneous products and enjoy

the same level of access to FOPs. However the reality of imperfect competition, which is

reflected in Industrial organization theory porter determine that firms gain different types

of competitive advantage and each to verging degrees.

182

Market imperfections occur naturally, but they are usually caused by policies of the firms

and government in developing country tax-breaks, tariff protection from later entrants

etc.

Nevertheless, MIT does not explain why foreign production is considered the most

desirable means of harnessing the firms’ advantage.

8.6.2 International Production Theory (IPT) Location-Specific Factors

IPT suggests that the propensity of a firm to initiate foreign production will depend on

the specific attractions of its home country compared with resource implications and

advantages of locating in another country.

Not only resource differentials and Advantages but also Foreign Government actions may

significantly influence the piece need attract ness and entry conditions for firm.

8.6.3 Internalization Theory

Competitive advantage and market imperfections are necessary but not sufficient to

guarantee direct foreign investment. For FDI to occur, competitive advantage must be

firm –specific, not easily copied, and in a form that allows them to be transferred to

foreign subsidiaries. Internalization concerns extending the direct operations of the firm

and bringing under common ownership and control the activities conducted by

intermediate markets (form of vertical integration) that link the firm to customers. Firms

will gain in creating their own internal markets such that transactions can be carried out

at a lower cost within the firm. The key ingredient for maintaining a firm-specific

company Advantage is the possession of proprietary informational and control of human

capital (could competence) who can generate new information through expertise in

research, management and Technology.

8.6.4 Follow-the-leader Theory

This is mostly applicable in small number of Producer oligopolistic industries where

when one competitor undertakes a foreign direct investment, others follow with defensive

183

direct investments. The followers are competed by a desire to deny any company

Advantages, e.g. benefits occurs of scale to others.

8.7 Strategies of Multinational Enterprises

An understanding of the strategies followed by MNCs in defending and exploiting the

barriers to entry created by product and fact market imperfections is crucial to any

systematic evaluation of investment opportunities. Such an understanding would:

• Suggest those projects that are most compatible with a firms international expansion

• Help to uncover new and potentially profitable projects

Some MNCs rely on product innovation, other on product differentiation, and others on

cartels and collusion to protect themselves from competitive threats.

The following are categories of multinationals:

8.7.1 Innovative- Based Multinationals

These Multinationals have high innovative ability and they normally create barrier to

entry by continually introducing new products and differentiating existing ones. They

normally spend large amounts of money on research and development and have a high

ratio of technical factory personnel. Their products are designed to fill a need of both

local and abroad markets.

8.7.2 The Mature Multinationals

These are larger firms that have been in the industry for quite a long time. They produce

the products at large scale hence benefiting from economies of scale. These firms use

economies of scale technique as a barrier for multinational entry by other firms. The

existence of economies of scale means that there are inherent cost advantages to being

larger. The more significant these economies of scale are, the greater will be the cost

disadvantage faced by a new entrant to the market.

Some companies such as Coca-Cola , take advantage of enormous advertisement

expenditures and highly developed marketing skills to differentiate their products and

184

keep out potential competitors that are wary of the high marketing costs o new product

introduction. By selling in foreign markets, these firms can exploit the premium

associated with their strong brand names

8.8 Investment Concerns - International or Domestic

8.8.1 Rate of return

The percentage change in the value of an asset over some period of time is referred to as

the rate of return. Investors purchase assets as a way of saving for the future. Anytime

an asset is purchased the purchaser is forgoing current consumption for future

consumption. In order to make such a transaction worthwhile the investors hopes

(sometimes expects) to have more money for future consumption than the amount they

give up in the present. Thus investors would like to have as high a rate of return on their

investments as possible.

Illustration 1

Suppose a Picasso painting is purchased in 1996 for $500,000. One year later the painting

is resold for $600,000. The rate of return is calculated as,

Example 2: $1000 is placed is a savings account for 1 year at an annual interest rate of

10%. The interest earned after one year is $1000 x 0.10 = $100. Thus the value of the

account after 1 year is $1100. The rate of return is,

This means that the rate of return on a domestic interest bearing account is merely the

interest rate.

185

8.8.2 Risk

The second primary concern of an investor is the riskness of the assets. Generally, the

greater the expected rate of return, the greater the risk. Invest in an oil wildcat endeavour

and you might get a 1000% return on your investment ... if you strike oil. The chances of

doing so are likely to be very low however. Thus, a key concern of investors is how to

manage the tradeoffs between risk and return.

8.8.3 Liquidity

Liquidity essentially means the speed with which assets can be converted to cash.

Insurance companies need to have assets which are fairly liquid in the event that they

need to pay out a large number of claims. Banks have to stand ready to make payout to

depositors etc.

Reference

Bruno, S (2000), International Investments, Wesley Longman. Inc US, 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

Demirag, I and Goddard, S (1994), Financial Management for International Business.

McGraw-Hill International UK

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by

Palgrave MACMILLAN, UK

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

186

Review Questions

1. Discuss different categories of Multinationals

2. Discuss the major Investment Concerns of Internationals when considering

investing abroad

3. Discuss different theories that explain Foreign Direct Investment

4. Identify and explain different forms of Entity for International Operations

5. The world market has become very competitive. Some firms are very strong and

pose greater competition and barrier to entry in the market. However, firms need

to keep on systematically pursuing policies and investments that are congruent

with worldwide survival and growth. For the firm need to be aware of different

factors before it decide to enter into foreign market. identify and discuss the that’s

that the multinational firms need to take into the account when considering to

enter into the foreign market.

6. Foreign Direct Investment (FDI) is an important source of private capital for

developing countries. Direct foreign investment leads to private international

capital flows, which are vital for national economic development efforts. It is

important because it represents additional investment and hence provides

employment. This is good from the host government point of view. While the

governments of many nations are increasing strategies to encourage international

investors, international investors too are increasing pumping their fund to new

investment portfolios in foreign countries. The motives behind this are not known

by most of the citizens of the host countries.

Required:

As you are learned brother or sister in direct foreign investment issues, you are

requested to prepare a brief presentation slides highlighting the motives for direct

foreign investment

187

TOPIC 9

PORTFOLIO THEORY AND INTERNATIONAL DIVERSIFICATION

9.1 Introduction

One approach in dealing with uncertainty in project returns is to increase the required rate

of return on risky projects. This is the approach normally taken by investors. For

example, if they are comparing equity investments in a food retailing company against a

similar investment in a computer electronics company, investors would usually demand

higher returns from the electronics investment to reflect its higher risk. However, this

approach is not as simple as it sounds. That is why investors seldom hold securities in

isolation. They attempt to reduce their risks by “not putting all their eggs into one

basket” and therefore hold a portfolio of securities.

Portfolio theory therefore is concerned with establishing guidelines for building up a

portfolio of stocks and shares, or portfolio of investment projects. A portfolio describes

the collection of various different investments that make up on investors’ total

investments. It is a combination of two or more security or assets. A risk adverse investor

would hold a well diversified portfolio, instead of a single or a few securities, in order to

reduce risk.

9.2 Portfolio Diversification

The principle behind the use of portfolio theory is that by diversifying between various

investments one is potentially able to affect the total degree of risk involved. The theory

argues that an investor selects from among an efficient group of portfolio that gives a

higher return for the same level of risk. A procedure of diversifying investments allows

the investor to reduce the risk associated with the portfolio. Therefore International

diversification is identified as a method for reducing MNC’S risks. It also saves as

corporate motives for increasing international business.

188

9.3 Choice of Optimal International portfolio

The basic principles of portfolio selection are that investors try to increase the expected

return on their portfolio and reduce the standard deviation of that return. A portfolio that

gives the highest expected return for a given SD, or the lowest SD for a given expected

return is known as an efficient portfolio. To work out which portfolios are efficient, an

investor must be able to state the expected return and SD of each stock and the degree of

correlation between each pair of stocks. Once the optimal portfolio is identified, investors

allocate their wealth between the optimal portfolio and the risk free asset to achieve the

desired combination of risk and return

9.4 Assumptions Underlying Optimal International Portfolio

• Investors can lend or borrow at the risk free interest of return

• Investors are not allowed to sell stocks short, that’s investors cannot hold stocks in

negative amounts

• Investors diversify internationally by investing in national stock market indices,

rather than individual stocks

• Investors use their respective domestic currencies to measure returns

9.5 The benefits of Portfolio Diversification

A portfolio is simply a combination of investments. If an investor divides his fund in more

than one investment, then it is possible than any misfortune in one investment may be to

some extent offset by the performance of another investment.

This can be demonstrated in the following graphs. Assume we have two companies, A and

B, where when A does well B does badly and vice versa.

189

Both investment A and investment B show fluctuating returns over time. They both have

roughly the same amount of variability. There fortunes are inversely correlated. If both

investments are held, the resulting portfolio will generate a greater average [absolute]

return than with either one alone but a greatly reduced risk, because the ‘ups’ of A cancel

the ‘downs’ of B and vice versa.

Illustrating the same effect numerically, consider the following two traders with different

returns due to changes in weather:

Investment A returns

Investment B returns

Time

Time

Rate of return

Rate of return

Rate of return (Average of A and B)

Portfolio return

Time

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State Sun Rain Average Risk

Probability 0.5 0.5

Contribution: Ice creams 200 20 110 High

Contribution: Umbrellas 20 200 110 High

Both businesses seem to be profitable but the traders are unhappy about the risk involved.

Also they never talk to each other because when one is happy, the other is miserable and

vice versa. Lucky enough the two traders have been persuaded to pool their resources

together such that each holds half their stock. When it is sunny they both make [0.5 x

200] + [0.5 x 20] = 110, and when it rains they both make [0.5 x 20] + [0.5 x 200] = 110.

State Sun Rain Average Risk

Probability 0.5 0.5

Contribution: 110 110 110 Zero

Now both are happy all the time because each has as much money as before but it is

earned risk-free.

9.6 Correlation

Correlation is a statistical measure of how strong the connection is between two

variables. In portfolio theory the two variables are returns of two investments

The extent, to which risk is reduced by combining the investments, however depends on

how highly the individual securities included in the portfolio are correlated. The less

highly correlated the individual securities are, the less risky the portfolio becomes.

9.6.1 Positive Correlation

When there is positive correlation between investments, then investment does well ( or

badly) is likely to affect even the other to perform likewise. That’s the circumstances that

influence one stock to perform badly or well will likely influence other stocks in the

portfolio to behave the same.

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Consider a portfolio consisting of two stocks. If returns to these stocks are highly

positively correlated so they move up and down together, the possibility of risk reduction

by holding these stocks is minimal. In other hand high positive correlation means that

both investments tend to show increases [or decreases] in return at the same time.

9.6.2 No correlation

If returns to the two stocks are not correlated with each other, risk reduction is very

substantial, and as a result, the portfolio will be much less risky than either of the two

stocks. In this case, the performance of one investment will be independent of how one

performs. If you hold shares in company A selling Cement and others in company B

selling soft drinks, it is likely that there would be no relationship between the companies

returns

9.6.3 Negative correlated

If one investment does well the other will do badly, and vice-versa. Thus if you hold

shares in one company making let say umbrellas and others which sells ice-cream, the

weather will affect the companies differently. So it can be said that if returns of two

stocks are highly negative correlated then, as returns on one stock increase, returns on

another stock decrease.

9.7 Estimating the Return and Risk of International Diversification

It is generally known that, an investor may reduce investment risk by holding risky assets

in a portfolio. As long as the asset returns are not perfectly positively correlated, risk

reduction can be achieved because some of the fluctuations of the assets returns will

affect each other.

9.7.1 Expected return on Portfolio

Individual stocks have expected returns. The stocks here can be domestic and foreign

stocks. Then the weighted average of the expected stocks forming the portfolio is called

expected returns of the portfolio. The estimation of the benefits of international

diversification follows the same basic rules of a two-asset portfolio with weights or

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proportions of capital investment W1 and W2 respectively, and where W1 +W2 = 1. .

Let rwd randr be the expected returns on the domestic and rest-of-the-world portfolios

respectively. Therefore, the expected portfolio return can be estimated as follows

rp = rwd wrwr +

Where, W1 and W2 are proportions of funds invested in security d (domestic) and rw (rest

of the world)

9.7.2 The Portfolio Risk

The risk of portfolio investment represents the deviation of actual return and expected

return. That’s the actual return from investment may be different from the expected

returns. A wise investor will want to avoid too much risk, and hope that the actual returns

from his portfolio are more or less the same as what he has been expecting them to be.

Hence the estimation of risk of a portfolio is important.

As in the case of stocks expected returns, stocks have different expected risks. Hence

because stocks are combined to form a portfolio, then the expected risks of individual

stocks should be combined to get expected risk of portfolio. The risk of portfolio is

measured by the standard deviation of expected returns of portfolio. Let rwd randr be

the expected returns on the domestic and rest-of-the-world portfolios respectively; p the

correlation coefficient between the two markets or stocks and rwd andσσ be the

expected risks (SD) of returns on the domestic and rest-of-the-world portfolios.

Therefore, the portfolio standard deviation [Risk] is give by:

rwdrwdrwd pwwww σσσσσ ,2122

222

12 2++=

Illustration 1

Assume you have equally invested your portfolio in Mzumbeland and UK stocks. The

standard deviations are 18.2% and 34.4% in Mzumbeland and the UK respectively. The

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correlation coefficient between the two markets is 0.33. What is the standard deviation of

the internationally diversified portfolio?

rwdrwd 4.342.1833.05.05.02)4.34(5.0)2.18(5.0 22222 ×××××++=σ

= 21.95%

The risk is significantly below the risk of the UK.

Illustration 2

Assume that the expected return of risk assets 1 and 2 are 14% and 18% respectively.

Their SD is 15% and 20% respectively. The correlation coefficient is 0.5. If an investor

invests 0.4 in asset 1 and 0.6 in asset 2;

a. What will be the expected return of the investment portfolio?

b. What is the risk/SD of the investment portfolio?

Solution:

(a) Er p = 0.4x0.14 + 0.6x0.18

=16.4%

(b) =2σ ( ) ( ) ( ) ( )( )( )( )( )2.015.05.06.04.022.06.015.0)4.0( 2222 ++

= 0.159 or 15.9%

As long the correlation coefficient is smaller than 1.0, some of the fluctuations of the

asset returns will offset each other, resulting in risk reduction. The lower the correlation

coefficient, the greater the opportunity for risk diversification

9.8 The Risk and Return of Portfolios with associated probabilities

The risk of an investment can be measured by the standard deviation of its expected

return. If possible returns are R1, R2… Rn, with associated probabilities P1, P2… Pn,

then the standard deviation is calculated as:

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( ) ii PRR2

−∑=σ Where iR = return if event i occurs, Pi = probability of event i

occurring and R = the average return, ii PR∑

Normally the portfolio has an expected return which is equal to the weighted average of

the two investment returns, but its risk, as measured by the standard deviation, is lower

than either of the two original investments.

9.9 Covariance and Correlation

The effects of diversification occur when security returns are not perfectly correlated.

One way of computing the correlation coefficient is to first compute the covariance.

9.9.1 Covariance

Covariance is a measure of degree of co-movement between two variables, which is

defined as:

( )( )yyxxpCov YX −−∑=,

Where x and y are corresponding returns from investments X and Y arising with

probability p.

- Cov(X, Y) > 0 => X and Y move in the same direction [positive correlation but the

strength is not quantified]

- Cov(X, Y) < 0 => X and Y move in the opposite direction

The covariance of Return provides a measure of the extent to which returns on two

assets/securities are correlated or otherwise.

9.9.2 Correlation coefficient

The correlation coefficient (r) is a standardised measure of the linear relationship between

two variables. The correlation coefficient is the ratio of the covariance to the product of

the two standard deviations. Correlation coefficient always lies in the range from -1 to 1.

a positive correlation coefficient indicates that the returns from two securities generally

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move in the same direction, while a negative correlation coefficient implies that they

generally move in the opposite direction

Correlation, yx

YXYX

Cov

σσρ ,

, =

9.10 Formulae for the Two –Security Portfolio

In general, the risk of a two security portfolio will depend on

• The risk of the constituent investments in isolation

• The correlation between them

• The proportion in which the investments are mixed

Let α =proportion of asset X

β =proportion of asset Y; β = 1 - α

Portfolio return: YXR βα +=

Portfolio risk: ( ) ( ) ( ) ( )YXCovYVarXVarRVar p ,222 αββα ++=

Illustration 3

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Assume 90% of the funds are placed in ‘A’; calculate the portfolio expected return and

standard deviation.

9.10 General rule in portfolio theory:

Portfolio returns are a weighted average of the expected returns on the individual

investment.

BUT…

Portfolio standard deviation is less than the weighted average risk of the individual

investments, except for perfectly positively correlated investments.

9.11 Risk/Return Nature of International Investments

The local currency return on a foreign investment depends on the following:

• Foreign currency return

• Currency change [i.e. gains/loss]

Accordingly, the currency change brings into mind the question of exchange risk. It is

this prospect of exchange rate fluctuation that makes investors to have preference for

home country investments rather than foreign investments. Thus investors would like to

be rewarded or compensated for takings such risk. The local currency rate of return

required by investors can be approximated as:

gRR Fh +=

Where =fR

foreign currency return and g = currency change

The standard deviation of the local currency return, hσ = is given as

hσ = gfgfgf ,22 2 βσσσσ ++

Where 2fσ = the variance of the foreign currency return

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2gσ

= the variance of the change in the exchange rate

gf ,β = the correlation between the foreign currency return and the exchange rate change

From the above equation, it can be observed that the foreign exchange risk associated

with a foreign investment depends on the standard deviation of the foreign exchange rate

fluctuation and the covariance between the exchange rate fluctuation and the foreign

currency return on the investment. This implies that, exchange risk could lower the risk

of investing across borders. However this can only be possible when there is sufficient

large negative correlation between the exchange rate fluctuation and the foreign currency

return.

9.12 The Benefits of International Diversification

The major attraction for investing internationally is that international investment focus

provides more opportunities than domestic focus. Because, for instance, if you want to

invest in products with huge worldwide markets [e.g. in electronics industry], you will

find that most of the highly successful companies are based abroad. With this view

therefore, given the growth and availability of international investments, there are high

chances that investors may gain a better risk-return trade-off by focusing on international

diversification rather than entirely focusing at home investments alone.

By risk-return trade-off we mean that investors should be able to get higher returns for

the same level of risk or less risk for the same level of expected returns.

As it is well known that diversifying across industries leads to lower level of risk for a

given level of expected return [especially when there is a negative correlation].

Similarly, through international diversification, with different cyclical economic

fluctuations – investors should be able to reduce significantly the risks of their returns,

rather than by adding more domestic investments to a portfolio. This should be true

following the basic rule of portfolio diversification that the more investments you hold

the more stable the returns and more diffuse are the risks.

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9.13 The Expected Return on an International Portfolio and the Portfolio Risk

One way to estimate the benefits of international diversification is to consider the

expected return and deviation of return for a portfolio consisting of a fraction, w1,

invested in domestic country and the remaining fraction, w2, invested in foreign stocks.

Define E(Rd) and E(Rf) to be the expected returns on the domestic country and local

country. The expected return E(Rp) can be calculated as:

E(Rp) = W1(Rd) + W2(Rf)

Portfolio standard deviation = fdfdffdd wwww βσσσσ 22222 ++

9.14 Barriers to International Diversification

The benefit to international diversification will be limited to the extent that there are

barriers to investing overseas. Such barriers include

• Legal restrictions. This exists in some markets, limiting the ownership of securities by

foreigners investors

• Foreign exchange regulations. This may prohibit international investments or make it

more expensive

• Double taxation of income from foreign investment may deter investors

• There are likely to be higher information and transaction costs associated with

investing in foreign securities. Lack of adequate information can significantly

increase the perceived risk ness of foreign securities, giving investors an added

incentive to keep their money at home

• Lack of liquidity. The ability to buy and sell securities efficiently is major obstacle

• Lack of readily accessible and comparable information on potential foreign securities

acquisitions. Lack of adequate information can significantly increase the perceived

risk ness of foreign investments, particularly for the less-developed capital markets

• Currency controls

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• Exchange rate fluctuations [risk]

• Differing tax regulations e.g. withholding taxes

9.15 Limitations of portfolio Theory

Forecasting returns and the correlations betweens returns will be hazardous in practice

• It is a single period model. Measuring risk as the standard deviation as the expected

returns is not the only component of risk, there are other costs such as the risk of

bankruptcy etc.

• Risk is assessed in terms of the total risk of individual investments, but in practice

much of this risk will be diversified away when the investment is added to an already

well diversified portfolio

• Different shareholders will have different attitudes to risk, hence the concept of a

single set of shareholders is unrealistic etc

• Portfolio theory is not a practical method of project appraisal for financial managers.

However, it is usefully introduces managers to the concept of risk reduction through

diversification, and it leads on to the capital asset pricing model which is more useful

in practice.

9.16 Capital and Asset Pricing Model (CAPM)

This model describes the relationship between risk and expected rate of return. The

premise of this model is that risks can be reduced i.e. eliminate the unsystematic risk, by

diversification, but there are some risk that remain un eliminated.

The CAPM model is a theoretical model, derived from portfolio theory. It estimates the

expected return on individual security and it can be expressed as follows:

Rj = Rf + jβ (Rm-Rf)

Where: jβ = the beta coefficient for security j

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Rj = the expected return of security j

Rf = the expected return of risk free investment

Rm = the expected return on the market as a whole

The difference between expected return on the market as a whole and expected return of

risk free investment (Rm-Rf) is called excess return. It is also known as market risk

premium. Capital assets pricing model make use of the principle that return on shares in

the market as a whole are expected to be higher than the returns on the risk free

investment

9.16.1 Measuring Foreign Market Risk

Foreign market beta (ß) measures the market risk. It is an index of systematic risk. It

measures the sensitivity of stock’s returns on the market portfolio. The beta may be

derived from Capital Asset Pricing Model (CAPM) or calculated relative to the domestic

market.

The beta of a portfolio is simply a weighted average of the individual stock betas in the

portfolio with the weights being the proportion of the total portfolio market value

represented by each stock. However, the beta of a foreign market (individual security)

may be obtained by dividing the covariance of returns on the foreign market (f) with

returns for the domestic market (market as a whole) by the variance of returns for the

domestic market (d).

Bf = ( )( )dVar

fdCov ,

The beta factor of the domestic market (d) is 1.0. Market risk makes market returns

volatile and the beta factor is a yardstick against which the risk of other investments can

be measured.

• A foreign market of beta = 1, tends to have returns which move in line with the

domestic market.

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• A foreign market beta greater than 1.0 tends to show amplified return movements e.g.

Kenya has a beta of 1.55, so when the Tanzanian return rises say by 10%, the returns

of Kenya will tend to rise by 15.5%

• A foreign market beta less that 1.0, will vary less that the domestic market

Alternatively, the foreign market beta can be calculated from a pair of data representing

returns from the domestic market and those of the foreign market. In that situations, the

following formula will apply:

( )( )22 dnd

dfndBf −

−=

Where Bf = the foreign market beta

d = return from the domestic market

f = return from the foreign market

n = number of pairs of data from d and f

9.16.2 Assumption of CAPM

• Investors are well informed

• Transaction costs are low

• There are negligible restrictions as investment

• No investors is large enough to affect the market price of stock

9.16.3 Uses of CAPM

• To identify the appropriate required rate of return on a given asset. This required rate

of return can be used as discount rate in investment appraised decisions

• To determine the appropriate current price of an asset given its riskness

• To evaluate the performance of a portfolio

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9.16.4 Limitations of the CAPM

• In practice the market portfolio cannot be observed. It is therefore usual practice to

use the returns on a broad-based market index. Such an index is by definition, an

approximation to the true market portfolio

• The beta coefficient in practice cannot be an unambiguous measure of risk since the

value calculated for the beta depends upon the index which is used to represent the

market portfolio

• Empirical evidence suggests that in its basic form CAPM overstates the required rate

of return on high beta securities and understates the required rate of return on low

beta stock.

• It is a single period model capable of appraising investment projects lasting for a

single period. Many projects would, however, last for several years

9.17 Measuring Total Return From Foreign Investments

To ensure the return associated with investing in securities issued in different markets

and denominated in a variety of currencies we assume that the US$ is our domestic

currency. However, any currency can be used for this purpose. In general, the total dollar

return on an investment can be decomposed into three elements

• Dividend/Interest Income

• Capital gain(Loses)

• Currency Gain (losses)

9.17.1 Return from Foreign Bond Investment

The one period total Tshs return on a foreign bond investment (RTshs) can be computed as

follows:

Total domestic currency return = Total local Currency Return x Currency gain (Loss)

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( ) ( ) 1110

01 −+

+−+= g

B

CBBRd

Where B0 = Local currency (LC) bond price at time 0

B1 = Local Currency bond Price at time 1

C= Local Currency Coupon Income

g = percentage change in dollar value of the local currency

9.17.2 Measuring total Returns from Foreign stock Investment

The one-period total Tshs return on a foreign stock investment (RTshs) can be calculated

as follows:

Total domestic currency return = total local Currency Return x Currency gain (Loss)

( ) 1110

01 −+

+−+= gP

DIVPPRd

Where;

P0 = Local Currency Stock Price at time 0

P1 = Local Currency stock price at time 1

Div = Local currency dividend income

Reference

Bruno, S (2000), International Investments, Wesley Longman. Inc US, 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

Demirag, I and Goddard, S (1994), Financial Management for International Business.

McGraw-Hill International UK

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

204

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by

Palgrave MACMILLAN, UK

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review Questions

1. The initial price of Tanzania Government bond is 95/=, the coupon income is 8/= and

the end of the period bond price is 97/=. Assume that the Tanzanian shilling

appreciates by 3% against the U.S dollar during the period. What is the total dollar

return on Tanzanian Government bond?

2. ABC is a Tanzanian based company. At the beginning of the year 2000 the

company’s share price was 50/=, the dividend income was 1/=. The end of the period

stock price is 48/=. During the year the Tanzania shilling depreciated by 5% against

the U.S dollar. Calculate the dollar return on the ABC Company’s share.

3. During the first half of the 1990, the Swiss Government bonds yielded a local

currency return of -1.6%. However the Swiss Franc rose by 8% against the dollar

over this six- month period. Corresponding figures for France were 1.8% and 2.6%.

Which bond earned higher U.S dollar return? What was the return?

4. During the year Toyota motors Company shares went from yen 9000 to yen 11200,

while paying a dividend of yen 60. At the same time, the exchange rate went from

yen145/$ to Yen 120/$. What was the total dollar return, in percent, on Toyota stock

for the year?

5. During the year the British Government Bond went from £102 to £106, while paying

a coupon of £9. at the same time, the exchange rate went from $1.76 to $1.62. What

was the total dollar return, in % on the British government bond for the year?

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6. Here are some data on the stock market returns and exchange rate changes during

2000 for some of the world’s stock markets

Country Return in local currency Currency units per U.S Dollar % 31/12/1999 31/12/2000 Australia 14.5 1.41 1.17 Tanzania 25.0 800 900 Canada 10.9 1.29 1.20 Germany 27.9 1.68 1.85

Required:

Determine the dollar return on each of these markets

7. A Tanzanian Portfolio Manager is considering the benefits of increasing his

diversification by investing overseas. He can purchase shares in individual country

funds with the following characteristics:

Tanzania (%) United kingdom(%) Spain (%) Expected return 15 12 5 Standard deviation 10 9 4 Correlation with Tanzania 1.0 0.33 0.06

Required:

(a) What is the expected return and standard deviation of return of a portfolio with 25%

invested in the united Kingdom and 75% in Tanzania

(b) What is the expected return and standard deviation of return of a portfolio with 25%

invested in the Spain and 75% in Tanzania

(c) What is the expected return and standard deviation of a portfolio with 50% invested

in the United Kingdom and 50% in Tanzania

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8. Given the following information

Country Correlation with Tanzania market

Standard deviation of Return

Tanzania 1.00 18.2

Canada 0.60 21.9

UK 0.33 34.4

Required:

(a) calculate the foreign market betas relative to the Tanzania market

(b) Calculate the risk of an internationally diversified portfolio that is equally in Tanzania

and in each of the individual foreign country markets. State in each case whether the

risk of the internationally diversified portfolio is considerably below or above the risk

of the Tanzania portfolio

9. A portfolio manger has decided to invest a total of Tsh.2million on Tanzanian and

Kenyan portfolios. The expected returns are 12% on the Tanzanian portfolio and 20%

on the Kenyan Portfolio.

Required:

a. What is the expected return of an international portfolio with 40% invested in the

Tanzania portfolio and 60% invested in the Kenyan portfolio?

b. How much should be invested in Kenya portfolio for the international portfolio to

yield an expected rate of return of 15%

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10. A Tanzanian portfolio manager has gathered the following information on three

different stock exchanges

DSM LONDON NAIROBI NEW YORK

Expected return 12% 8% 9% 10%

Standard deviation 9% 8.1% 15.3% 7%

Market beta relative to DSM stock Exchange

- 0.9 1.7 0

Required:

(a) Determine whether return from each of the individual foreign markets are positively

or negatively correlated with those of the DSE and state in each case whether the

benefit of international portfolio diversification in the form of risk reduction can be

attained

(b) Determine the risk of an internationally diversified portfolio which is 75% invested in

the DSE and 25% in each of the three foreign markets.

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CHAPTER 10

DESIGNING A GLOBAL FINANCIAL STRATEGY

10.1 Introduction

Multinational Corporation need enough funds global operations of their activities. Due to

the nature of the funds the MNC need, making global financial strategy is important.

Therefore, designing global financial strategy involves choosing among alternative

sources of funds to fiancé foreign affiliates. However, availability of different sources of

funds is important factor for Multinational Corporation in selecting an appropriate

strategy for financing (MNC).

10.2 Variables In Evaluating Global Financial Strategy

Designing global financial strategy is not an easier task; many variables that may affect

the cost of the funding strategy being selected should be taken together into

consideration. The following are key variables that need to be considered when selecting

the global financial strategy:

• Firm’s capital structure (mixture of the firms capital)

• Taxes

• Exchange risk

• Diversification of fund sources

• The freedom to move funds across borders

• Variety of government credit and capital control

• Political risk implication

10.3 Objectives of Financing International Operations

The financing of international operations can be separated into three objectives

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• Minimize expected after tax – Tax financing costs

• Reduce the Riskness of operating cash flows

• Achieve on Appropriate worldwide Financial structure

10.3.1 Minimize Expected After Tax Financing Costs

Multinational Corporation prefers to select financing strategies that are priced at below-

market rates. Due to the competition that exists in the world markets for funds, firms are

likely find difficult to obtain bargain–priced funds.

The choice among the sources of funds ideally involves simultaneously minimizing the

cost of external funds after adjusting for foreign exchange risk and taxes. Therefore, it is

important that selection among the sources of funds for financing should take into

account of the cost associated and the effect of these sources on the firm’s operating risks

and ensuring that managerial motivation in the foreign affiliates is geared toward

minimizing the firms consolidated worldwide cost of capital, rather than the foreign

affiliate’s cost of capital

Many firms consider debt financing to be less expensive than equity financing because

interest expense is tax deductible, where dividend are paid out of after tax income.

However, firms may choose internal sources in order to minimise worldwide taxes and

political risks.

Moreover, it is most important that the funding strategy selected must reconcile a variety

of potentially conflicting objectives, such as minimising expected financing costs,

reducing economic exposure, providing protection from currency control and other forms

of political risk

10.3.2 Reducing Operating Risks

After taking advantage of the opportunities available to lower its risk-adjusted financing

costs, the firm should arrange its additional financing in such a way that the risk exposure

of the company is kept at manageable levels. The risks we refer here are those arising

from currency fluctuations, political instability, and changing access to funds. To the

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extent that a particular element of risk contributes materially to the firm’s total risk,

management will want to lay off that risk as long the cost of doing so is not too great.

10.3.2.1 Exchange Risk.

The risk arising from foreign currency fluctuation is referred to as exchange risk. If this

arises, may adversely affect the expected cash flows. For example the firm may be

obliged to pay more debt denominated in foreign currency. If financing opportunities in

various currencies are fairly priced, firms can structure their liabilities so as to reduce

their exposure to foreign exchange risk at no added cost to shareholders. Firms may inter

contractual agreement such as forward contracts and futures with the aim of offsetting

unanticipated changes in the dollar value of its cash flows with identical changes in the

dollar cost of servicing liabilities

10.3.2.2 Political Risks

Global financing is associated with many risks. Political risk is among the risks that faces

MNC when finance their operation globally. Political risk here associates to exchange

control, currency inconvertibility, and transfer restrictions. Firms need to use financing

strategy to reduce such risks. This involves mechanisms to avoid or at least educe the

impact of certain risk itself. For instance, firms may reduce currency inconvertibility by

arranging their affiliates financing. The strategy for reducing this kind of risk may

involve investing parent’s funds as debt rather than equity, arranging back-to-back and

parallel loans and using local financing

Another approach that may help to reduce political risk is financing foreign operation

with funds from the host and other government, international development agencies,

overseas banks

10.3.3 Changing access to funds

Effective Multinational firms operational is vital for competition and confidence building

to the customers and stakeholders. However, this depends in part on its ability to secure

continual access to funds as reasonable cost and without onerous restrictions. If firms

have continual access to funds, it can be able to meet temporary shortfalls of cash and

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also take advantage of profitable investment opportunities without having to sell off

assets or otherwise disrupt operations. Though this may be possible, but firm’s always

fear that during some future period of monetary stringency, fund suppliers may reduce

the quantity of credit available to them while their competitors retain access to funds in a

broader range of markets. In such conditions of uneven credit allocation, the market

shares of their own business would be at risk because the scale of their operations would

be limited by the scale of available finance

Therefore, firms need to ensure adequate and reliable access of funds. For this purposes,

firms may maintain unused debt capacity and liquid assets. It can also diversify its fund

sources and indirectly buy insurance through excess borrowing. Having these extra

financial resources signals competitors, customers as well as other stakeholders that the

firm is financially healthy and has staying power; and that temporary setbacks will not

become permanent ones

Diversification of Fund sources – a key element of any MNC’s global financial strategy

should be to gain access to a broad range of fund sources to lessen its dependence on any

one financial market. The benefit to diversification of fund sources is that the firm

broadens its sources of economic and financial information.

Excess borrowing – most firms have lines of credit with a number of banks that give

them the right to borrow up to an agreed-upon credit limit. Unused balances carry a

commitment fee, normally on the order of 0.5% per annum. Some firms are willing to

borrow funds that they do not require (and then place them on deposit) in order to

maintain their credit limit in the event of tight money situation. In effect, they are buying

insurance against the possibility of being squeezed out of the money market. The measure

of the cost of this policy is the difference between the borrowing rate and the deposit rate,

multiplied by the average amount of borrowed funds placed on deposit

10.3.4 Establishing a Worldwide Capital Structure

The capital structure problem for multinational enterprise is to determine the mix of debt

and equity for the parent entity and for all consolidated and unconsolidated subsidiaries

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that maximises shareholder wealth. To be able to determine the financing mix, the

knowledge of cost and benefit of each source of fund is important.

Once a decision has been made regarding the appropriate mix of debt and equity for the

entire corporation, question about individual operations can be raised. How should MNCs

arrange the capital structures of their foreign affiliates? And what factors are relevant in

making this decision? Specifically, the problem is whether foreign subsidiary capital

structure should:

• Conform to capital structure of the parent company

• Reflect the capitalization norms in each foreign country

• Vary to take advantage of opportunities to minimise the MNC’s cost of capital

Disregarding public and government relations and legal requirements for the moment, the

parent company could finance its foreign affiliates by raising funds in its own country

and investing these funds as equity. The overseas operations would then have a zero debt

ratio (debt/total assets). Alternatively, the parent could hold only one dollar of share

capital in each affiliate and require all to borrow on their own, with or without

guarantees; in this case, affiliate debt ratio will approach 100%. Or the parent can itself

borrow and lend monies as intracorporate advances.

A subsidiary with a capital structure similar to its parent may forgo profitable

opportunities to lower its cost of funds

Reference

Bruno, S (2000), International Investments, Wesley Longman. Inc US, 4th ed.

Cuthbertson, K and Nitzsche, D (1996).Investments Spot and Derivatives markets, John,

Wesley and Sons, Inc, USA

Demirag, I and Goddard, S (1994), Financial Management for International Business.

McGraw-Hill International UK

Eiteman, S,M(1995), Multinational Business Finance. Wesley Publishing, Inc, U.S. 7th

ed.

213

Valdez, S (2003), An Introduction to Global Financial Markets, 4th ed. Published by

Palgrave MACMILLAN, UK

Strategic Financial Management, ACCA Text book, Exams Paper 3.7, 2000-2003

Sounders, A (2004), Financial Markets and Institutions, a modern perspective, 2end

Review questions

1. Discuss various sources of long –term financing available to Multinational

Corporation for raising capital

2. Discuss the objectives of Financing International Operations

3. Designing global financial strategy is not an easier task; many variables that may

affect the cost of the funding strategy being selected should be taken together into

consideration. Discuss the key variables that need to be considered when selecting

the global financial strategy:

4. Effective Multinational firms operational is vital for competition and confidence

building to the customers and stakeholders. However, this depends in part on its

ability to secure continual access to funds as reasonable cost and without onerous

restrictions. Discuss various techniques firms may use to ensure continual access

of fund for the operations.