1. Describe the differences between foreign bonds and Eurobonds.

Also
discuss why Eurobonds make

up the lions share of the international bond market.

Answer: The two segments of the international bond market are: foreign bonds and
Eurobonds. A foreign bond issue is one offered by a foreign borrower to investors in
a national capital market and denominated in that nations currency. A Eurobond
issue is one denominated in a particular currency, but sold to investors in national
capital markets other than the country which issues the denominating currency.
Eurobonds make up over 80 percent of the international bond market. The two
major reasons for this stem from the fact that the U.S. dollar is the currency most
frequently sought in international bond financing. First, Eurodollar bonds can be
brought to market more quickly than Yankee bonds because they are not offered to
U.S. investors and thus do not have to meet the strict SEC registration
requirements. Second, Eurobonds are typically bearer bonds that provide anonymity
to the owner and thus allow a means for evading taxes on the interest received.
Because of this feature, investors are generally willing to accept a lower yield on
Eurodollar bonds in comparison to registered Yankee bonds of comparable terms,
where ownership is recorded. For borrowers the lower yield means a lower cost of
debt service.

2. Briefly define each of the major types of international bond market

instruments, noting their

distinguishing characteristics.

Answer: The major types of international bond instruments and their distinguishing
characteristics are as follows:

Straight fixed-rate bond issues have a designated maturity date at which the
principal of the bond

issue is promised to be repaid. During the life of the bond, fixed coupon payments
that are some

percentage rate of the face value are paid as interest to the bondholders. This is the
major international

bond type. Straight fixed-rate Eurobonds are typically bearer bonds and pay coupon
interest annually.

Floating-rate notes (FRNs) are typically medium-term bonds with their coupon
payments indexed
to some reference rate. Common reference rates are either three-month or six-
month U.S. dollar LIBOR.

Coupon payments on FRNs are usually quarterly or semi-annual, and in a accord

with the reference rate.

A convertible bond issue allows the investor to exchange the bond for a pre-
determined number of

equity shares of the issuer. The floor value of a convertible bond is its straight fixed-
rate bond value.

Convertibles usually sell at a premium above the larger of their straight debt value
and their conversion

value. Additionally, investors are usually willing to accept a lower coupon rate of
interest than the

comparable straight fixed coupon bond rate because they find the call feature
attractive. Bonds with

equity warrants can be viewed as a straight fixed-rate bond with the addition of a
call option (or warrant) feature. The warrant entitles the bondholder to purchase a
certain number of equity shares in the issuer at a pre-stated price over a pre-
determined period of time.

Zero coupon bonds are sold at a discount from face value and do not pay any
coupon interest over

their life. At maturity the investor receives the full face value. Another form of zero
coupon bonds are

stripped bonds. A stripped bond is a zero coupon bond that results from stripping
the coupons and

principal from a coupon bond. The result is a series of zero coupon bonds
represented by the individual

coupon and principal payments.

A dual-currency bond is a straight fixed-rate bond which is issued in one currency

and pays coupon

interest in that same currency. At maturity, the principal is repaid in a second

currency. Coupon interest

is frequently at a higher rate than comparable straight fixed-rate bonds. The

amount of the dollar
principal repayment at maturity is set at inception; frequently, the amount allows
for some appreciation in the exchange rate of the stronger currency. From the
investors perspective, a dual currency bond

includes a long-term forward contract.

Composite currency bonds are denominated in a currency basket, such as SDRs

or ECUs, instead

of a single currency. They are frequently called currency cocktail bonds. They are
typically straight

fixed-rate bonds. The currency composite is a portfolio of currencies: when some

currencies are

depreciating others may be appreciating, thus yielding lower variability overall.

Explain the following three concepts of purchasing power parity (PPP):

a. The law of one price.

b. Absolute PPP.

c. Relative PPP.

Answer:

a. The law of one price (LOP) refers to the international arbitrage condition for the
standard consumption basket. LOP requires that the consumption basket should be
selling for the same price in a given currency across countries.

b. Absolute PPP holds that the price level in a country is equal to the price level in
another country
times the exchange rate between the two countries.

c. Relative PPP holds that the rate of exchange rate change between a pair of
countries is about equal

to the difference in inflation rates of the two countries.

11. Evaluate the usefulness of relative PPP in predicting movements in

foreign exchange rates on:

a. Short-term basis (for example, three months)

b. Long-term basis (for example, six years)

Answer.

a. PPP is not useful for predicting exchange rates on the short-term basis mainly
because international commodity arbitrage is a time-consuming process.

b. PPP is more useful for predicting exchange rates on the long-term basis.

1. a. What is purchasing power parity?

ANSWER. In its absolute version, purchasing power parity states that price levels
should be equal worldwide when expressed in a common currency. In other words, a
unit of home currency (HC) should have the same purchasing power around the
world. The relative version of purchasing power parity, which is used more
commonly now, states that the exchange rate between the home currency and any
foreign currency will adjust to reflect changes in the price levels of the two
countries. For example, if inflation is 5% in the United States and 1% in Japan, then
the dollar value of the Japanese yen must rise by about 4% to equalize the dollar
price of goods in the two countries.

b. What are some reasons for deviations from purchasing power parity?

ANSWER. PPP might not hold because:

The price indices used to measure PPP may use different weights or different
goods and services.

Arbitrage may be too costly, because of tariffs and other trade barriers and high
transportation costs, or too risky, because prices could change during the time that
an item is in transit between countries.
 Since some goods and services used in the indices are not traded, there could be
price discrepancies

between countries.

Relative price changes could lead to exchange rate changes even in the absence
of an inflation differential.

Government intervention could lead to a disequilibrium exchange rate.

c. Under what circumstances can purchasing power parity be applied?

ANSWER. The relative version of purchasing power parity holds up best in two
circumstances: (a) over long periods of time among countries with a moderate
inflation differential since the general trend in the price level ratio will tend to
dominate the effects of relative price changes, and (b) in the short run during
periods of hyperinflation since with high inflation changes in the general level of
prices quickly swamp the effects of relative price changes.

2. One proposal to stabilize the international monetary system involves

setting exchange rates at their purchasing power parity rates. Once
exchange rates are correctly aligned (according to PPP), each nation
would adjust its monetary policy so as to maintain them. What problems
might arise from using the PPP rate as a guide to the equilibrium
exchange rate?

ANSWER. The proposal to adjust monetary policy so as to maintain purchasing

power parity assumes that the PPP rate is the equilibrium rate. This assumption
ignores the many shortcomings of PPP as a theory of exchange rate determination.
Deviations from PPP have prevailed throughout the history of floating rate regimes.
Thus there is good reason to believe that PPP provides a poor proxy for the
equilibrium exchange rate at any point in time. If the PPP benchmark is used as a
proxy for the equilibrium exchange rate when there are equilibrium departures from
PPP, this guideline will interfere with long-run equilibration in the foreign exchange
market. Here is the basic problem: Domestic and foreign goods are not perfect
substitutes, and hence issues of spatial arbitrage and the law of one price are
irrelevant. Imagine that at the PPP exchange rate U.S. firms can't find buyers for
their goods, while Japanese firms work overtime to meet the demand for their
goods. Something will have to give, probably the real exchange rate. When a
country opens new markets, introduces new products, or experiences a favorable or
unfavorable price shock for its traditional exports, the real exchange rate will
change. Monetary policy that stabilizes a disequilibrium exchange rate is clearly
inappropriate.
What causes the deviations from the purchasing power parity?

PPP can be violated if there are barriers to international trade or if people in

different countries have

different consumption taste. PPP is the law of one price applied to a standard
consumption basket.

5. Discuss the implications of the deviations from the purchasing power

parity for countries competitive positions in the world market.

Answer: If exchange rate changes satisfy PPP, competitive positions of countries will
remain unaffected

following exchange rate changes. Otherwise, exchange rate changes will affect
relative competitiveness

of countries. If a countrys currency appreciates (depreciates) by more than is

warranted by PPP, that will hurt (strengthen) the countrys competitive position in
the world market.

PROBLEMS

1. Suppose that the treasurer of IBM has an extra cash reserve of

$100,000,000 to invest for six months. The six-month interest rate is 8
percent per annum in the United States and 7 percent per annum in
Germany. Currently, the spot exchange rate is 1.01 per dollar and the six-
month forward exchange rate is 0.99 per dollar. The treasurer of IBM
does not wish to bear any exchange risk. Where should he/she invest to
maximize the return?

Solution: The market conditions are summarized as follows:

I$ = 4%; i = 3.5%; S = 1.01/$; F = 0.99/$.

If $100,000,000 is invested in the U.S., the maturity value in six months will be

$104,000,000 = $100,000,000 (1 + .04).

Alternatively, $100,000,000 can be converted into euros and invested at the

German interest rate, with the euro maturity value sold forward. In this case the
dollar maturity value will be

$105,590,909 = ($100,000,000 x 1.01)(1 + .035)(1/0.99)

Clearly, it is better to invest $100,000,000 in Germany with exchange risk hedging.

2. While you were visiting London, you purchased a Jaguar for 35,000,
payable in three months. You

have enough cash at your bank in New York City, which pays 0.35%
interest per month, compounding

monthly, to pay for the car. Currently, the spot exchange rate is $1.45/
and the three-month forward

exchange rate is $1.40/. In London, the money market interest rate is

2.0% for a three-month investment.

There are two alternative ways of paying for your Jaguar.

(a) Keep the funds at your bank in the U.S. and buy 35,000 forward.

(b) Buy a certain pound amount spot today and invest the amount in the
U.K. for three months so that the maturity value becomes equal to
35,000.

Evaluate each payment method. Which method would you prefer? Why?

Solution: The problem situation is summarized as follows:

A/P = 35,000 payable in three months

iNY = 0.35%/month, compounding monthly

iLD = 2.0% for three months S = $1.45/; F = $1.40/.

Option a:

When you buy 35,000 forward, you will need $49,000 in three months to fulfill the
forward contract.

The present value of $49,000 is computed as follows:

$49,000/(1.0035)3= $48,489.

Thus, the cost of Jaguar as of today is $48,489.

Option b:

The present value of 35,000 is 34,314 = 35,000/(1.02). To buy 34,314 today, it

will cost $49,755 =
34,314x1.45. Thus the cost of Jaguar as of today is $49,755.

You should definitely choose to use option a, and save $1,266, which is the
difference between $49,755 and $48489.

1. What are the main factors that contributed to the creation and
development of the Eurocurrency markets?

The incentive to establish the Eurocurrency market came from regulations in the
British and American markets that added to the cost of doing business onshore. In
Britain, the Bank of England restricted the use of sterling to finance foreign trade
and external loans. In the United States, interest rate ceilings (Regulation Q) gave
depositors an incentive to move funds offshore to earn higher market rates of
interest. In summary, a high Net Regulatory Burden in the onshore market gave
depositors and borrowers an incentive to set up alternative banking arrangements
in another regulatory setting.

2. What is the difference between onshore markets and offshore markets?

The onshore market is the regulatory environment where domestic currency is used
for transactions with domestic institutions. Thus, US$ for deposits and loans in the
United States, DM for deposits and loans in Germany, and so forth form the onshore
market. The offshore market is usually the regulatory environment where foreign
currency is used for transactions with domestic institutions. Thus, US$ for deposits
and loans in London, DM for deposits and loans in Zurich, and so forth form the
offshore market. The final part of the offshore market are distinct offshore banking
centers (in the United States, the term is International Banking Facility) that permit
domestic currency transaction with non-residents subject to a lower regulatory
burden.

2. Explain the differences among transaction, operating, and translation

exposure.

(a) Transaction exposure is the potential for a gain or loss in contracted-for near
term cash flows

caused by a foreign exchange rate-induced change in the value of amounts due to

the MNE or

amounts that the MNE owes to other parties. As such, it is a change in the home
currency value

of cash flows that are already contracted for.

(b) Operating exposure is the potential for a change in the value of a MNE, usually
viewed as the

present value of all future cash inflows, caused by unexpected exchange rate
changes. As such, it

is a change in expected long-term cash flows; i.e., future cash flows expected in the
course of

normal business but not yet contracted for.

(c) Translation exposure is the possibility of a change in the equity section (common
stock, retained

earnings, and equity reserves) of a MNEs consolidated balance sheet, caused by a

change

(expected or not expected) in foreign exchange rates. As such it is not a cash flow
change, but is

rather the result of consolidating into one parent companys financial statement the
individual

financial statements of related subsidiaries and affiliates.

3. Is there any difference between translation exposure and transaction

exposure? Explain.

Translation exposure measures accounting (book) gains and losses from a change in
exchange rates.

Transaction exposure measures cash (realized) gains and losses from a change in
exchange rates.

1. How would you define transaction exposure? How is it different from

economic exposure?

Answer: Transaction exposure is the sensitivity of realized domestic currency values

of the firms

contractual cash flows denominated in foreign currencies to unexpected changes in

exchange rates.

Unlike economic exposure, transaction exposure is well-defined and short-term.

2. Discuss and compare hedging transaction exposure using the forward

contract vs. money market
instruments. When do the alternative hedging approaches produce the
same result?

Answer: Hedging transaction exposure by a forward contract is achieved by selling

or buying foreign

currency receivables or payables forward. On the other hand, money market hedge
is achieved by

borrowing or lending the present value of foreign currency receivables or payables,

thereby creating

offsetting foreign currency positions. If the interest rate parity is holding, the two
hedging methods are

equivalent.

3. Discuss and compare the costs of hedging via the forward contract and
the options contract.

Answer: There is no up-front cost of hedging by forward contracts. In the case of

options hedging,

however, hedgers should pay the premiums for the contracts up-front. The cost of
forward hedging,

however, may be realized ex post when the hedger regrets his/her hedging decision.

4. What are the advantages of a currency options contract as a hedging

tool compared with the forward contract?

Answer: The main advantage of using options contracts for hedging is that the
hedger can decide whether to exercise options upon observing the realized future
exchange rate. Options thus provide a hedge against ex post regret that forward
hedger might have to suffer. Hedgers can only eliminate the downside risk while
retaining the upside potential.

7. Should a firm hedge? Why or why not?

Answer: In a perfect capital market, firms may not need to hedge exchange risk. But
firms can add to

their value by hedging if markets are imperfect. First, if management knows about
the firms exposure better than shareholders, the firm, not its shareholders, should
hedge. Second, firms may be able to hedge at a lower cost. Third, if default costs
are significant, corporate hedging can be justifiable because it reduces the
probability of default. Fourth, if the firm faces progressive taxes, it can reduce tax
obligations by hedging which stabilizes corporate earnings.

1. Give a full definition of the market for foreign exchange.

Answer: Broadly defined, the foreign exchange (FX) market encompasses the
conversion of purchasing power from one currency into another, bank deposits of
foreign currency, the extension of credit denominated in a foreign currency, foreign
trade financing, and trading in foreign currency options and futures contracts.

2. What is the difference between the retail or client market and the
wholesale or interbank market for foreign exchange?

Answer: The market for foreign exchange can be viewed as a two-tier market. One
tier is the wholesale or interbank market and the other tier is the retail or client
market. International banks provide the core of the FX market. They stand willing to
buy or sell foreign currency for their own account. These international banks serve
their retail clients, corporations or individuals, in conducting foreign commerce or
making international investment in financial assets that requires foreign exchange.
Retail transactions account for only about 14 percent of FX trades. The other 86
percent is interbank trades between international banks, or non-bank dealers large
enough to transact in the interbank market.

3. Who are the market participants in the foreign exchange market?

Answer: The market participants that comprise the FX market can be categorized
into five groups:

international banks, bank customers, non-bank dealers, FX brokers, and central

banks. International

banks provide the core of the FX market. Approximately 100 to 200 banks
worldwide make a market in

foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own
account. These

international banks serve their retail clients, the bank customers, in conducting
foreign commerce or
making international investment in financial assets that requires foreign exchange.
Non-bank dealers are

large non-bank financial institutions, such as investment banks, mutual funds,

pension funds, and hedge

funds, whose size and frequency of trades make it cost- effective to establish their
own dealing rooms to

trade directly in the interbank market for their foreign exchange needs.

Most interbank trades are speculative or arbitrage transactions where market

participants attempt to

correctly judge the future direction of price movements in one currency versus
another or attempt to profit

from temporary price discrepancies in currencies between competing dealers.

FX brokers match dealer orders to buy and sell currencies for a fee, but do not take
a position

themselves. Interbank traders use a broker primarily to disseminate as quickly as

possible a currency

quote to many other dealers.

Central banks sometimes intervene in the foreign exchange market in an attempt to

influence the

price of its currency against that of a major trading partner, or a country that it
fixes or pegs its

currency against. Intervention is the process of using foreign currency reserves to

buy ones own

currency in order to decrease its supply and thus increase its value in the foreign
exchange market, or

alternatively, selling ones own currency for foreign currency in order to increase its
supply and lower its

price.

1. What factors are responsible for the recent surge in international

portfolio investment (IPI)?
Answer: The recent surge in international portfolio investments reflects the
globalization of financial markets. Specifically, many countries have liberalized and
deregulated their capital and foreign exchange markets in recent years. In addition,
commercial and investment banks have facilitated international investments by
introducing such products as American Depository Receipts (ADRs) and country
funds. Also, recent advancements in computer and telecommunication technologies
led to a major reduction in transaction and information costs associated with
international investments. In addition, investors might have become more aware of
the potential gains from international investments.

1. Transaction risk, which is basically cash flow risk and deals with the effect of
exchange rate moves on transactional account exposure related to receivables
(export contracts), payables (import contracts) or repatriation of dividends. An
exchange rate change in the currency of denomination of any such contract will
result in a direct transaction exchange rate risk to the firm;

2. Translation risk, which is basically balance sheet exchange rate risk and relates
exchange rate moves to the valuation of a foreign subsidiary and, in turn, to the
consolidation of a foreign subsidiary to the parent companys balance sheet.
Translation risk for a foreign subsidiary is usually measured by the exposure of net
assets (assets less liabilities) to potential exchange rate moves. In consolidating
financial statements, the translation could be done either at the end-of-the-period
exchange rate or at the average exchange rate of the period, depending on the
accounting regulations affecting the parent company. Thus, while income
statements are usually translated at the average exchange rate over the period,
balance sheet exposures of foreign subsidiaries are often translated at the
prevailing current exchange rate at the time of consolidation; and

3. Economic risk, which reflects basically the risk to the firms present value of
future operating cash flows from exchange rate movements. In essence, economic
risk concerns the effect of exchange rate changes on revenues (domestic sales and
exports) and operating expenses (cost of domestic inputs and imports). Economic
risk is usually applied to the present value of future cash flow operations of a firms
parent company and foreign subsidiaries. Identification of the various types of
currency risk, along with their measurement, is essential to develop a strategy for
managing currency risk.

Overview

1. a. What are the five basic mechanisms for establishing exchange rates?

ANSWER. The five basic mechanisms for establishing exchange rates are free float,
managed float, target-zone arrangement, fixed-rate system, and the current hybrid
system.

b. How does each work?

ANSWER. In a free float, exchange rates are determined by the interaction of
currency supplies and demands. Under a system of managed floating, governments
intervene actively in the foreign exchange market to smooth out exchange rate
fluctuations in order to reduce the economic uncertainty associated with a free
float. Under a target- zone arrangement, countries adjust their national economic
policies to maintain their exchange rates within a specific margin around agreed-
upon, fixed central exchange rates. Under a fixed-rate system, such as the Bretton
Woods system, governments are committed to maintaining target exchange rates.
Each central bank actively buys or sells its currency in the foreign exchange market
whenever its exchange rate threatens to deviate from its stated par value by more
than an agreed-on percentage. Currently, the international monetary system is a
hybrid system, with major currencies floating on a managed basis, some currencies
freely floating, and other currencies moving in and out of various types of pegged
exchange rate relationships.

c. What costs and benefits are associated with each mechanism?

ANSWER.

Benefits of a Floating Rate System. At the time floating rates were adopted in 1973,
proponents said that the new system would reduce economic volatility and facilitate
free trade. In particular, floating exchange rates would offset international
differences in inflation rates so that trade, wages, employment, and output would
not have to adjust.

High-inflation countries would see their currencies depreciate, allowing their firms to
stay competitive without having to cut wages or employment. At the same time,
currency appreciation would not place firms in low-inflation countries at a
competitive disadvantage. Real exchange rates would stabilize, even if permitted to
float in principle, because the underlying conditions affecting trade and the relative
productivity of capital would change only gradually; and if countries would
coordinate their monetary policies to achieve a convergence of inflation rates, then
nominal exchange rates would also stabilize. Another benefit is thatas Milton
Friedman points outwith a floating exchange rate, there never has been a foreign
exchange crisis. The reason is simple: The floating rate absorbs the pressures that
would otherwise build up in countries that try to peg the exchange rate while
simultaneously pursuing an independent monetary policy. For example, the Asian
currency crisis did not spill over to Australia and New Zealand because the latter
countries had floating exchange rates. A floating rate system can also act as a
shock absorber to cushion real economic shocks that change the equilibrium
exchange rate. Costs of a Floating Rate System. Many economists point to excessive
volatility as a major cost of a floating rate system. The experience to date is that
the dollar's ups and downs have had little to do with actual inflation and a lot to do
with expectations of future government policies and economic conditions. Put
another way, real exchange rate volatility has increased, not decreased, since
floating began. This instability reflects, in part, nonmonetary (or real) shocks to the
world economy, such as changing oil prices and shifting competitiveness among
countries, but these real shocks were not obviously greater during the 1980s than
they were in earlier periods. Instead, uncertainty over future government policies
has increased.

Benefits of a Managed Float. The potential benefit of a managed float is that

governments can reduce the volatility associated with a freely floating exchange
rate.

Costs of a Managed Float. The costs of a managed float stem from the
demonstrated inability of governments to recognize the difference between a
temporary exchange rate disequilibrium and a permanent one. By trying to manage
exchange rates when a permanent shift in the equilibrium exchange rate has
occurred, governments run the risk of creating an exchange rate crisis and wasting
reserves.

Benefits of a Target Zone Arrangement. The experience with the European Monetary
System is that the target zone arrangement in effect forced convergence of
monetary policy to that of the countryGermanywith the most disciplined anti-
inflation policy and led to low inflation.

Costs of a Target Zone Arrangement. Maintaining a genuinely stable target zone

arrangement requires the political will to direct fiscal and monetary policies at that
goal and not at purely national ones. This turns out to be difficult for countries to
achieve. In the case of the European Monetary System, the result was periodic
currency crises. Another cost of this system is that fundamental changes in the
equilibrium exchange rate cannot get reflected in actual exchange rate changes
without a currency crisis occurring.

Benefits of a Fixed Rate System. A permanently fixed exchange rate systemsuch as

that achieved by a currency board, dollarization, or monetary unionresults in
currency stability and the absence of currency crises. In a system such as existed
under Bretton Woods, where there is a commitment to a fixed exchange rate
system, but no mechanism to bind that commitment, you will have more monetary
discipline than in a freely floating system and hence lower inflation than might
otherwise be the case.

Costs of a Fixed Rate System. In a permanently fixed system, the exchange rate
cannot cushion the effects of real economic shocks, such as devaluation of a major
competitors currency. Instead, prices must adjust. Given the lack of flexibility of
many pricesbecause of government regulations or union restrictionsthe result of
these economic shocks can be higher unemployment and less economic growth. In
a system such as Bretton Woods, the result of changes in the equilibrium exchange
rate will likely be currency crises and eventual devaluation or revaluation.

Benefits of a Hybrid System. The current system gives countries the option to select
the system that best meets their needs. However, all too often, the decision is
based on political rather than economic calculations.

Costs of a Hybrid System. The cost of a hybrid system, such as the one currently in
place, is that there is no constraint on the choices that governments can make. The
resulting choices can be good ones or bad ones.