International Finance

Theory into Practice

Piet Sercu

• Publisher: Princeton University Press
• Year: 2009
• ISBN:
  9781400833122
• Topic: Business
• Subtopic: Finance
• Index: Business

International Finance presents the corporate uses of international financial markets to upper undergraduate and graduate students of business finance and financial economics. Combining practical knowledge, up-to-date theories, and real-world applications, this textbook explores issues of valuation, funding, and risk management. International Finance shows how theoretical applications can be brought into managerial practice.
The text includes an extensive introduction followed by three main sections: currency markets; exchange risk, exposure, and risk management; and long-term international funding and direct investment. Each section begins with a short case study, and each of the sections' chapters concludes with a CFO summary, examining how a hypothetical chief financial officer might apply topics to a managerial setting. The book also contains end-of-chapter questions to help students grasp the material presented.
Focusing on international markets and multinational corporate finance, International Finance is the go-to resource for students seeking a complete understanding of the field.

• Rigorous focus on international financial markets and corporate finance concepts
• An up-to-date and practice-oriented approach
• Strong real-world examples and applications
• Comprehensive look at valuation, funding, and risk management
• Introductory case studies and "CFO summaries, " and end-of-chapter quiz questions
• Solutions to the quiz questions are available online

PART II

Currency Markets

About This Part

This part describes the currency market in its widest sense, that is, the exchange market plus all its satellites. In chapter 3, we describe spot markets. Forward markets, where price and quantity are contracted now but delivery and payment take place at a known future moment, are introduced in chapter 4, in a perfect-markets setting. Chapter 5 shows how and when to use contracts in reality: for arbitrage, taking into account costs; for hedging; for speculation; and for shopping around and structured finance applications including, especially, swaps. Currency futures and modern currency swaps, both of which are closely related to forward transactions, are discussed in chapters 6 and 7, respectively. Chapter 8 introduces currency options and explains how these options can be used to hedge against (or, alternatively, speculate on) foreign exchange risk. How one can price currency options is explained in chapter 9; we mostly use the so-called binomial approach but also link it to the famous Black-Merton-Scholes model.

At any instant, the market value of a forward, futures, or options contract depends on the prevailing spot rate (and, if the contract is not yet at the end of its life, also on the domestic and foreign interest rates). This dependence on the future spot rate means that these contracts can be used to hedge the exchange-rate risk to which the firm is exposed. The dependence of these contracts on the future spot rate also means that their current market values can be expressed, by relatively simple arbitrage arguments, as functions of the current spot rate and of the domestic and foreign interest rates. Throughout this part of the text, a unified approach based on arbitrage-free pricing is used to value these assets whose payoffs are dependent on the exchange rate.

Brabant Bus Company

Holland’s Brabant Bus Company NV (BBC) considers selling buses to the San Antonio Transit Authority (SATA) in the Caribbean. The proposed order is worth USD 12.5m (2.5m down and four annual payments of 2.5m each). This represents three months of production, so it is a sizable order by BBC’s standards. Given the spot exchange rate of EUR/USD 1.2000–1.2005 and a variable production cost of EUR 13.6m spread over three months, the contract provides a profit margin of [12.5m × 1.2 – 13.6m]/13.6m = 10%—“still a sound percentage, kind of” in the sales manager’s words. Also, the personnel manager sides with the sales manager: “BBC simply needs the deal to keep the factories going; laying off workers is something to be avoided at all reasonable costs,” he argues. “And in this instance, there is a 10% profit rather than a cost.”

The accounting department, however, raises the issue of exchange risk. BBC’s accounting policy is to mark-to-market all foreign currency balance-sheet items every quarter, on the basis of the current exchange rate. “This is the only sound procedure,” the accounting manager reminds his colleagues. “The current rate is close to the best possible forecast of the future rate, so there is no point in hiding one’s head in the sand and continuing to use historic exchange rates to value A/R or A/P.” Given this procedure, the fluctuations in the EUR value of the USD 10m A/R in the balance sheet would substantially influence the quarterly earnings. Next to this translation risk, there would also be a transaction risk: the actual realized value of the USD flows are rather uncertain.

The sales manager replies that a 10% profit margin is more than enough to absorb the transaction risk. “And hedging the exposure of the A/R is easy,” he continues. “It suffices to borrow USD 10m, amortized in four slices of USD 2.5m each, to offset the exposure of the A/R. At any reporting date, the exchange rate effects on the loan balance (a liability) and on the remaining A/R (an asset) will cancel out, thus leaving BBC unexposed.”

The finance manager, however, dislikes the USD-loan proposal. It is true that BBC needs a loan to finance the production outlays (EUR 13.6m). However, if BBC were to take up a USD loan, it would mean forgoing the attractive EUR financing provided by the Benelux Export Bank (BEB). (BEB is a fictitious Benelux joint-government agency that provides soft financing for, among others, long-term export contracts outside the EU. BEB loans are almost 2% cheaper than commercial bank loans, but BEB extends EUR loans only.) “It would be foolish to forgo this gorgeous interest subsidy,” the finance manager concludes, “so we cannot borrow USD. This means that we have to use forward contracts to hedge the transaction risk.” The sales manager disagrees. “This is too costly: the average forward rate that BBC can obtain is EUR/USD 1.117, which is 7% below the current spot rate. This would wipe out two thirds of the deal’s profit,” he snorts, “and swaps have the same effect. Finally, neither forward contracts nor swaps would eliminate the balance-sheet risk.”

But the finance manager has other worries too. While BBC has an excellent credit rating, the prospective customer is definitely less creditworthy, and the country San Antonio itself is rumored to be close to asking for a debt rescheduling. In fact, given the maturities and risks, not a single European bank is willing to guarantee SATA’s four payments for fees less than 5% upfront (calculated as a percentage of the cumulative receivable amount, USD 10m); that is, a bank guarantee would eliminate half of the profit. An alternative is credit insurance. In fact, BBC already has an overall credit insurance contract with BeneLloyds, and could obtain 90% insurance against commercial and political risk for an annual fee of 2% per annum, calculated on the beginning-of-period outstanding insured USD balance (the 100%, that is) and payable at the beginning of each year.

Issues

If the material is new to you, you probably already have questions about the nature of the instruments that were brought up: spot hedging via loans, forwards, options, and swaps. All these instruments are introduced in this part. (Other items, like credit insurance and letters of credit will come up in part III.) Here, then, is a list of calculations or issues you should be able to solve in a few minutes after working your way through this part. The necessary data are listed on the next page.

Q1. Discuss the sales manager’s suggestion to hedge the exposure by a 10m USD loan amortized in four equal payments.

• What is wrong with the proposal?

• How can you solve this problem using a USD loan?

(Hint. Even after reading the entire part, this question may be somewhat tricky; so if you don’t see the answer immediately, don’t worry—just move to the next question, which may in fact give you ideas about how to solve the present one.)

Q2. Ignore the subsidized loan for a moment, as well as the default risk. Suppose BBC wants to fully hedge all projected USD cash inflows. Should it

• borrow USD at 6.5% and convert spot, or

• hedge forward each payment, and borrow EUR at 3.45%, or

• swap the USD annuity into an EUR annuity, and again borrow EUR against this EUR income (at 3.45%)?

Q3. There manifestly is default risk, in this case. How would this risk change your answer to the previous question?

Q4. Some people may claim that a risky export proposal like the present one is like submitting a bid in an international tender—there is a substantial probability that the money will not come in. Therefore, these people may say, BBC should hedge using options rather than unconditional contracts like forward contracts or loans or swaps. What is your opinion?

Q5. The acceptance or rejection of the order is obviously an NPV problem. In computing the true NPV (before subsidies), should BBC

• convert the USD flows into EUR forward (o...