International Finance Questions - Assignment Example

a] The main characteristics of interest rate, currency, and credit default swaps Interest rate swaps refer to an agreement entered into by two parties. One party undertakes to make interest payment to another party according to the terms of the agreement on scheduled dates in future. Each party agrees to pay fixed or floating interest rate denominated in a particular currency to the other party. Interest rate is multiplied by the principle amount to obtain the amount of cash flow to be exchanged. Interest rate swaps is concerned with interests payment streams only on designated notional amounts on regular basis for a specific period of time. Interest rate swaps are over the counter (private) transactions; and they are highly liquid financial derivatives that can be used by hedgers to manage both their fixed and floating assets and liabilities. A party that pay fixed rate is referred to as the payer and the receiving party is called the receiver. For example, X agrees to pay fixed rate of interest under specified time intervals to W and in return, X receives variable or floating interest on notional principle from W. The types of currency swaps include fixed for floating swap for same currency, fixed for floating rate for different currencies, floating for floating swap for same currency, floating for floating rate for different currencies and fixed for fixed rate swap for different currencies. Currency swap refers to a foreign-exchange currency agreement entered into by two parties in relation to principle alone or with interest for payment of a specified loan sum in one currency for an equivalent principle and interest of a specified loan sum in another currency (Shamah, 2003). Payments are made periodically and at maturity or termination of the contract, the principle amounts are re-exchanged. Currency swaps are over the counter financial instruments. Foreign currency swaps are long term because they involve high costs associated with finding counterparty. Currency swap are further divided into two. Principle only currency swap and principle plus interest currency swap. Principle only currency swap is appropriate for contract that are up to ten years and involves exchange of principle with another party in a specific time in future at a rate agreed at the present. It is used to secure cheap loan and reduce exposure to exchange rate fluctuations. Principal plus interest currency swap considers both principal and interest payments. In currency swap, principal is exchanged on national amounts at market rates, often using the same rate for the transfer at inception and at maturity. Credit default swaps refers to contracts between two parties, where one who buys credit default swap, pays a seller and receives a payoff if loan is defaulted. Credit default swaps can be compared to Insurance because the buyer pay a premium, which make the party to receive specific sum of money if events specified in the contract matures (occur). However unlike in insurance, the buyer can make a profit from the contract and covers assets that the buyer does not have direct exposure. [b] Evaluate the usefulness of these swaps for issuers of and investors in debt. First, swaps are flexible. Swaps are over the counter transactions. This means that the terms and conditions such as maturity dates and the amount involved is decided upon by the two counterparties at their convenience. It also allows parties involved to freely exploit their comparative advantage in their respective markets. Secondly, the cost of transaction is lower in swaps. The transaction is over the counter meaning that, there are no brokerage fees which could have been charged by a clearing house. In addition, the transaction is based on comparative advantage of both parties. Therefore, both parties are able to obtain funds at cheaper rates Third, swaps minimize risks associated with foreign exchange, interest rates changes as well as changes in credit facilities following occurrence of an event. If a company issues fixed bond rates and expects interest rates to decline at a future date in response to economic changes, the company will have to exchange fixed rate obligation with floating rate obligation to benefit from falling rates. The company will have to enter an agreement to pay interest rate at changing rates and receive interest rates from the other party at fixed rate. Fixed rate paid is compensated by the other counterparty. Fourth, swaps are used to correct Asset- Liability mismatch. For example, a financial institution acquires fixed rate bearing asset and a floating rate interest bearing liability. If interest rates go up, financial institution will pay more interests. But interest receipts will not increase because the rate is fixed. Consequently, asset mismatch emerges. The bank can swap fixed interest rate with floating interest rate. Therefore, fixed rate interest received by a bank is matched with payment of fixed rate to the other counterparty. The receipts of floating interest rates from swap counterparty are matched with payment of floating interest rate on the liabilities. This reduces or eliminates losses that may have been caused by increasing floating interest rate on liabilities. 2. Appraising the view that a company should not incur debt denominated in foreign currency, as this will not generally lower their expected cost of debt, measured in their domestic currency. Increase in risks and losses incurred in debt denominated in foreign currency is influenced by a number of factors and not just the mere mention of debt incurred in foreign currencies. Therefore, every investor should assess the factors carefully and determine the cost of different alternatives before making a decision to borrow. A company should not fear incurring debts denominated in foreign currencies. This is because an investor can reduce cost of transactions and make more profits. First, if other countries have a lot of liquid assets as compared to home country, then the cost (interest rates) of obtaining debt in foreign currencies is much lower than in domestic market. In addition, the rate of return in foreign locations with a lot of liquid assets is lower as compared with countries with a lot of illiquid assets. Secondly, tax rates in foreign countries could be higher than in domestic markets. Therefore, a firm incur debt in foreign currencies and invest them in domestic market to benefit from tax shields. Thirdly, obtaining debt in foreign currencies depend majorly on the volume of international operations. Firms that have high volumes of international trade borrow foreign currency and hedge corresponding exposures to reduce cost of transactions. Fourth, capital market segmentation also influences the cost of debts in both domestic and foreign markets. Firm’s credit rating, liquidity level, size and profitability determine whether it is favourable for a firm to borrow using foreign currencies or no. Segmented capital markets demands that an investor chooses a foreign currency debt to minimize expected costs. Segmentation is evident through legal barriers on capital control, information asymmetric ownership restrictions and security law. Foreign investors spend more time and financial resources in obtaining investment information across different countries, where the information is asymmetric. Fifth, size of the firms determines whether to borrow in foreign currency denominations or not. Most firms with foreign subsidiaries are exposed to significant exchange rate fluctuation due to increase in foreign trade. Such firms must have a risk management team, which require fixed cost of setting up computerised systems and train or hire personnel in foreign exchange management. Cost of running a risk management department is lower as compared to smaller firms. Large firms can benefit from economies of scale. Sixth, if the firm is highly liquid and profitable, it cannot borrow using foreign denominations because firms with high liquid assets or profitability have little incentive to hedge because they are exposed to very low probability of financial distress. 3. [a] Briefly explain the meaning of “securitization” and “structured finance products”. Comment on the supposed advantages of these processes and products. Securitization refers to an act of pooling contractual debt instruments (auto credits, house mortgages, student loans, credit card debts obligations or commercial mortgages into saleable financial instruments such as bonds, collateralised mortgage obligation (CMOs) or any other security, which are sold to investors. Investors receive part of their invested principle and earned interest in regular basis. Securitized financial instruments include mortgage backed securities and asset-backed securities. Securitization and structure finance enables financial institutions to raise funds without diluting control and ownership of the firms. Securitization and structure finance are cheaper sources of finance. Loans and bonds can be prohibitively expensive, especially when the credit rating of the company is low. With securitization a company with BB rating, which has AAA worthy cash flow can borrow at AAA rates. Securitization and structure finance reduce asset liability mismatch. If a good structure of contractual obligations is chosen, securitization can be a perfect source of funds, which can eliminate exposure to terms and conditions such as duration and pricing of debt. It also allows banks and other financial institutions to develop a self-financed asset book. Financial institutions may have a limit as to how much loans they can borrow by existing laws or regulation in the industry that dictates achievement of a specific capital requirement. With securitization and structure finance, they may be less or no such stringent conditions. Securitization transfer risk away from financial institutions to other parties. This is applicable for highly risk averse firms. In addition, it provides a chance for investors to diversify their investment portfolios. It also uses off-balance sheet instruments meaning that the transactions does not affect company’s balance sheet. [b] Evaluate the view that securitization and structured finance played a major role in creating the recent international banking crisis. Securitization of mortgage contractual obligations caused the recent international baking crisis. This is because credit rating agencies provided over optimistic rating in the securities and financial institutions used mortgage backed securities to transfer credit risk to others. 4. The one year U.K. rate of interest is 5% and the equivalent U.S. rate of interest is 10%. The current spot exchange rate is $2 = ?. The forward exchange rate after one year would be as follows; Interest rate parity links up future and spot market currency to differential interest rate of two countries. Foreign exchange rate = spot rate? ((1 + U.S. rate of interest) ? (1+ U.K. rate of interest)) ?n =2? (1 .1 ? 1.05) ?1 =2 ? 1.047619 =2.095238 I one year’s time, $2.095238 will be equivalent to 1? Where, N= 1 [b] Suppose the one year forward exchange rate was $2.05 = ?. Arbitrage is a profit earned by an investor when he or she purchases an asset at lower price and sells it at a higher price. Difference between The percentage differences between spot and futures exchange rate may be greater or less than the percentage difference of the respective rates of interest. According to the above example forward exchange rate difference is given as follows. The forward exchange rate after one year minus spot forward exchange rate ($2.095238 - $2.05= $0.045238) is $0.045238. The value $0.045238 is the forward exchange rate differences that will create arbitrage opportunity. The arbitrageur (investor) will choose to buy currency in the market and sell in forward contracts to earn additional $0.045238 for every currency traded. [c] Usefulness of the covered interest rate parity condition Covered Interest Rate Parity (CIP), which is also called Interest Parity Condition, refers to an equilibrium condition between interest rates and forward and spot currency values of two countries. Investors would always invest in countries with higher interest rates and borrow from countries with lower interest. The covered Interest Rate Parity is achieved automatically when investors seeking excess riskless returns invest their funds in profitable areas until arbitrage opportunity disappears and parity is restored. Consequently, interest rate arbitrage does not exist between two currencies of different countries because interest rates between currencies of two countries are equal. This means that if an investor invests specific United Stated Dollars in the United States deposits and same United States Dollars in foreign currency , the return will be equal as long as the investment is protected using a forward on foreign currency. For example, if United States currency is trading at par with Canadian currency, but the interest rate in United States is 4 percent and that of Canada is 6 percent. With all factors kept constant, it will make sense for a company to borrow in United States Dollars, and convert them in the spot market to Canadian Dollars and invest in Canada. However, in order to repay the loan principle and interest in United States Dollar, the borrowing company must enter into a forward contract to exchange Canadian Dollar to United States Dollar. If forward rate that convert Canadian Dollars into United State Dollars eradicates all the profit from the transaction, then the covered interest rate parity condition is met. This means that interest rate parity is covered. 5. Forward, futures and options markets and products may all be used for managing price risks and exposures. The factors a user may consider, in choosing which market to use for this purpose. There are a number of factors that influence use of a specific market when hedging financial risks. Cost of transaction is the biggest determinant of the choice of markets. Swaps are cheaper because it is an over the counter transaction, which may not involve brokerage fees as compared to futures that are traded in a clearing house. The second factor is ease of exit or liquidity. Swap markets are hard to exit as compared to futures. This is because swaps are customised and not standard as compared to the futures. It is easier for counterparties to terminate futures by entering an off-setting contract. Counterparty default or credit risk is the third factor to consider. Futures are more secure than swaps because under futures, the clearing house shoulders the credit risk on behalf of the partners. The fourth factor to consider is flexibility. Futures are standardized as compared to forward contracts and each future contract has a stated amount and maturity period. Futures also require sufficient trading volumes, without which futures cannot be provided. Futures required parties to a contract to make initial deposit (margin) to the clearing house. On the other hand, firms that require flexibility can choose swaps market because their terms are tailor made to meet specific requirements of each party. With swaps it is easier to match maturity with the position that is being hedged. Furthermore, swaps can be entered into anywhere. Fifth, time scale is an important factor in choosing a particular market to hedge risks. For example, currency swaps are more appropriate for hedging foreign debt risk because foreign currency debt payment are long time and can be predicted. Forward contracts are appropriate for short term and unpredictable transactions. Bibliography Shamah, S 2003, A foreign exchange primer, John Wiley and Sons, West Sussex. Read More