cfs class 10

7/21/2019 CFS Class 10

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Certified Finance

SpecialistM M Fakhrul Islam

Email: [email protected]

7/21/2019 CFS Class 10


7/21/2019 CFS Class 10


International Financial Managemen

Terminology used in International Finance

The cross-rate is an exchange rate between two currencies computed ba third currency, usually the US dollar

A Eurobond is an international bond that is denominated in a currency ncountry where it is issued

Eurocurrency is money deposited in a bank or financial firm outside of thcurrency is involved

Foreign bonds, unlike Eurobonds, are issued in a domestic market by a foare usually denominated in that country’s currency

Gilts, technically, are British and Irish government securities, although theincludes issues of local British authorities

The London Interbank Offer Rate (LIBOR) is the rate that most internationone another for loans of Eurodollars overnight in the London market

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Foreign exchange transactions

A spot trade is an agreement to exchange currency “on the spot,”

means that the transaction will be completed or settled within two b

A forward trade is an agreement to exchange currency at some tim

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Exchange rate risk

Exchange rate risk also called currency risk is the natural conseque

international operations in a world where relative currency values mdown

A company may become exposed to foreign exchange risk or currany of the following way:

As an exporter of goods or services

As an importer of goods or services

Through having an overseas subsidiary company

Through being the subsidiary of an overseas company

By borrowing in a foreign currency or lending a foreign currency

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Three different types of exchange ra

Short-run exposure also called transaction exposure

The day-to-day fluctuations in exchange rates create short-run risks for in

Long-run exposure also known as economic exposure

the value of a foreign operation can fluctuate because of unanticipaterelative economic conditions

Translation exposure

When the consolidated financial accounts are prepared for the group,

liabilities, and the profits of the subsidiary must be translated into the curparent company.

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Interest rate risk

the risk of paying more interest on debt than necessary,

the risk of losses on interest-earning investments and

the risk of being unable to meet debt payment obligations

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Hedging

The term immunisation is sometimes used as well

financial engineering

create a way by using available financial instruments to create new one

derivative securities

financial asset that represents a claim to another financial asset.

Financial engineering frequently involves creating new derivative securitcombining existing derivatives to accomplish specific hedging goals.

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Hedging transaction exposures

Forward exchange contracts

Buy or sell in domestic currency

Matching receipts and payments

Leading and lagging

Matching assets and liabilities in a currency

Money market hedges

Currency options

Currency futures

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Hedging economic exposure

Matching assets and liabilities.

Diversifying the supplier and customer base.

Diversifying operations world-wide.

Currency swaps

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Hedging Translation exposures

Group borrowing in the currency of the foreign subsidiary

For example, the parent company could hedge the translation exp

borrowing in euros, possibly as much as the assets of the subsidiary.

the subsidiary fall in value when translated into sterling, there would

corresponding fall in the sterling value of the company's debt liabilit

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Hedging with Forward contract

Agreement between two counterparties - a buyer and seller

The terms of the contract call for one party to deliver the goods to the ocertain date in the future, called the settlement date. The other party ppreviously agreed-upon forward price and takes the goods.

delivery of the asset occurs at a later time, but the price is determined apurchase

Highly customised

All parties are exposed to counterparty default risk Transactions take place in large, private and largely unregulated marke

Underlying assets can be a stocks, bonds, foreign currencies, commoditcombination

Forwards can be based on interest rates is known as a Forward Rate Ag

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Cont’d

buyer of a forward contract benefits if prices increase because the

have locked in a lower price

seller wins if prices fall because a higher selling price has been locke

forward contract is a zero-sum game

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Hedging with FRA

Forward contract on an interest rate for a short-term loan or deposit

Not an actual short-term loan or deposit

an agreement about a rate of interest at a future date, but there is undertaking by either party to the agreement to either borrow or lemoney

The buyer of an FRA obtains a fixed rate of interest for payment, andtherefore use an FRA to fix an interest rate on future borrowing.

The seller of an FRA obtains a fixed rate of interest to receive, and cuse an FRA to fix an interest rate on a future deposit or future lending

FRAs are very similar to swaps except that in a FRA a payment is onlat maturity. Instruments such as interest rate swap could be viewed FRAs.

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Hedging with Futures contract

Futures are exchange-traded forward contract

A futures contract is exactly the same as a forward contract with on

With a forward contract, the buyer and seller realise gains or losses only settlement date.

With a futures contract, gains and losses are realised on a daily basis.

If we buy a futures contract on oil, then, if oil prices rise today, we haand the seller of the contract has a loss. The seller pays up, and we

tomorrow with neither party owing the other. The daily resettlement feature found in futures contracts is called m

market .

Someone who has bought futures contracts is said to be 'long' in thehold a long position

Someone who has sold futures contracts is said to be 'short' in the fua short position.

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How Futures works?

The farmer and the bread maker may enter into a futures contract requiring the delive

of grain to the buyer in June at a price of $4 per bushel.

By entering into this futures contract, the farmer and the bread maker secure a price th

believe will be a fair price in June

Farmer would be the holder of the short position (agreeing to sell) while the bread mak

holder of the long (agreeing to buy)

Say the futures contracts for wheat increases to $5 per bushel the day after the above

maker enter into their futures contract of $4 per bushel. The farmer, as the holder of the

lost $1 per bushel because the selling price just increased from the future price at which

sell his wheat. The bread maker, as the long position, has profited by $1 per bushel bec

obliged to pay is less than what the rest of the market is obliged to pay in the future for

On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X

the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels). As the

every day, these kinds of adjustments are made accordingly.

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Cont’d

A person can buy an option, and becomes the option holder. The term

and 'option holder' effectively mean the same thing. The purchase price of an option is called the option premium.

The premium for an option consists of two elements, intrinsic value andTogether, intrinsic value and time value add up to the option premium.

The intrinsic value of calls and puts can be summarised in the following f

(a) The intrinsic value of a call option is the higher of (i) the current market

underlying item minus the exercise price, and (ii) zero. An out-of-the-moneytherefore has an intrinsic value of zero.

(b) The intrinsic value of a put option is the higher of (i) the exercise price mcurrent market price of the underlying item, and (ii) zero. An out-of-the montherefore has an intrinsic value of zero.

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Time value of an option

Value placed by the market on the possibility that the price of the u

might move against the option writer in the time remaining until the

Time value reflects the possibility that an option will become in-the-m

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Cont’d

A person might hold a call option on 2,000 shares in ABC at a price of 50

This would give the holder the right, but not the obligation, to buy 2,000

company, at a price of 500c.

The fixed purchase price for a call option and the fixed selling price for a

known as the exercise price, strike price or strike rate for the option.

European-style options: right to exercise the option ONLY at the expiry d

American-style options: right to exercise the option at any time before t Options offer a choice to the option holder between:

exercising the right to buy or sell at strike price, and

not exercising this right and allowing the option to lapse.

The option seller or option writer does not have any choice. The seller isso

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Call Option example

Zico holds a call option on 2,000 shares of ABC at a strike price of 46

premium was 25c per share. Calculate the gain/loss for the option boption writer if the share price at the expiry date for the option is:

(a) 445c

(b) 476c

(c) 500c

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Solution

The option will not be exercised. The option writer will make a profit

share ($500 in total), from the option premium. The option holder (Zicamount, by paying the premium.

The option will be exercised by Zico, giving him a gain of (476 – 460)share. However, the gain from exercising the option is more than offof the premium (25c per share), leaving the option writer with a net share, and the option buyer with a loss of the same amount. This is ($180 in total.

The option will be exercised by Zico, giving him a gain of (500 – 460)share. This gives him a net gain, after deducting the premium of 25c15c per share or (× 2,000 shares) $300 in total. The option writer suffe$300.

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Put Option Example

Ms. Pessimist feels quite certain that BMI will fall from its current $160

price. She buys a put. Her put-option contract gives her the right to

BMI stock at $150 one year from now.

If the price of BMI is $200 on the expiration date, she will tear up the put o

because it is worthless. That is, she will not want to sell stock worth $200 fo

price of $150.

On the other hand, if BMI is sell ing for $100 on the expiration date, sheoption. In this case, she can buy a share of BMI in the market for $100 paround and sell the share at the exercise price of $150. Her profit w$100). The value of the put option on the expiration date therefore will b

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7/21/2019 CFS Class 10


SWAP

Agreement between two counterparties to exchange the obligatio

streams of cash over a given period. Swaps are over-the-counter instruments.

SWAPS

Interest rate

swaps

Currency

swaps

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SWAP Example

Charlie owns a $1,000,000 investment that pays him LIBOR + 1% every mgoes up and down, the payment Charlie receives changes.

Now assume that Sandy owns a $1,000,000 investment that pays her 1.5The payment she receives never changes.

Charlie decides that that he would rather lock in a constant payment adecides that she'd rather take a chance on receiving higher paymentsSandy agree to enter into an interest rate swap contract.

Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + on a $1,000,000 principal amount (called the "notional principal" or "notSandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional

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Scenario A: LIBOR = 0.25%

Charlie receives a monthly payment of

$12,500 from his investment ($1,000,000 x

(0.25% + 1%)). Sandy receives a monthly

payment of $15,000 from her investment

($1,000,000 x 1.5%).

Now, under the terms of the swap

agreement, Charlie owes Sandy $12,500($1,000,000 x LIBOR+1%) , and she owes

him $15,000 ($1,000,000 x 1.5%). The two

transactions partially offset each other and

Sandy owes Charlie the difference: $2,500.

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Scenario B: LIBOR = 1.0%

Now, with LIBOR at 1%, Charlie receives a

monthly payment of $20,000 from his

investment ($1,00,000 x (1% + 1%)). Sandy

still receives a monthly payment of $15,000

from her investment ($1,000,000 x 1.5%).

With LIBOR at 1%, Charlie is obligated

under the terms of the swap to pay Sandy

$20,000 ($1,000,000 x LIBOR+1%), and

Sandy still has to pay Charlie $15,000. The

two transactions partially offset each other

and now Charlie owes Sandy the

difference between swap interest

payments: $5,000.

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Cont’d

We will focus on the simplest and most common type of interest rate

called 'plain vanilla coupon swap' or 'generic' interest rate swap. In swap:

One party pays the other interest on a notional loan at a fixed rate of int

The other party pays interest on the same notional loan amount, but at ainterest.

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Uses of SWAP

Interest rate swaps have several potential uses for a

company

To manage the mix of fixed and floating rate interest in the comp

mix. They can be used to switch fixed rate borrowing to effective

borrowing, or from floating rate borrowing to effective fixed rate

To obtain fixed rate borrowing commitments when the company

obtain debt finance at a fixed rate.

Possibly, to borrow at a cheaper fixed rate than by borrowing di

fixed rate, or to borrow at a floating rate more cheaply than bo

at a floating rate. Using swaps to reduce borrowing costs is know

arbitrage.

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Cont’d

Currency swaps can provide a hedge against exchange rate movements fothan the forward market. Forward contracts are available for periods up to ain liquid currencies, and less with other currencies. Currency swaps can also using a currency for which no forward market is available.

With a currency swap, a company can obtain debt finance in another currethe liability into its own currency.

Currency swaps can therefore be used by companies to restructure the currtheir liabilities. This may be important where the company is trading overseasrevenues in foreign currencies, but its borrowings are denominated in the cu

home country. Currency swaps therefore provide a means of reducing exchexposure.

At the same time as exchanging currency, the company might also be ablerate debt to floating rate or vice versa. Thus it may obtain some of the benerate coupon swap in addition to achieving the other purposes of a currencyswaps are called 'fixed-floating currency swaps'.)

A currency swap could be used to absorb excess liquidity in one currency wneeded immediately to create funds in another where there is a need.

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SWAP: Maths

Brew has issued $20 million of fixed rate bonds, on which the interest

and which have eight years remaining to maturity. It would like to swfixed rate to a floating rate interest commitment and arranges a fiveswap with a bank. The bank is prepared to pay fixed interest at 7.25six-month LIBOR in return.

By arranging the swap, the company changes its fixed interest paymper annum into a floating rate commitment of LIBOR plus 75 basis phundredth of a percentage point), as follows.

%

Bonds: pay fixed interest (8.00)

Swap

Receive fixed interest 7.25

Pay floating rate (LIBOR)

Overall cost (LIBOR + 0.

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Example 2: SWAP

Cord is too small to issue bonds, but would like to take on fixed rate

$3 million. It therefore obtains a five-year loan of $3 million from its b

interest is payable at LIBOR plus 125 basis points. It also arranges a fi

with a bank in which the company pays a fixed rate of 5.70% and re

in return.

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%

Bank loan: pay floating rate interest (LIBOR + 1.25)

Swap

Receive floating rate interest LIBOR

Pay fixed rate (5.70)

Overall cost (6.95)

As a result of the swap, the overall borrowing cost is at a fixed rate of 6.95%, as a

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