International Finance Investment Strategies Using the Movements of the Exchange Rate

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International Finance Investment Strategies
Using the Movements of the Exchange Rate

• Bakary Kolley
• Carlos Rodriguez

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Outline

• Foreign investments
• Motives for foreign investments
• Risk and Diversification
• Hedging and Speculation in the spot market
• Covered and uncovered interest parity
• Basics about foreign currency derivatives
• Pricing
• Strategies using derivatives
• Other instruments

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Types of Foreign Investments
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Portfolio Investments

• The U.S. government defines as portfolio
  investment stock purchases that involve less than
  10 per cent of the voting stock of a corporation.
  
• Portfolio or financial investments take place
  primarily through financial institutions such as
  banks and investment funds.
• Portfolio Investments purely financial assets,
  such as stocks and bonds, denominated in a
  national currency.

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Stocks and Bonds

• With bonds, the investor simply lends capital to
  get fixed payouts or a return at regular
  intervals and then receives the face value of the
  bond at a pre-specified date.
• With stocks the investor purchases equity, or a
  claim on the net worth of the firm.

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Motives for International Portfolio Investments

• Earn higher returns abroad.
• Residents of one country purchase bonds of
  another country if the rates of return on the
  bonds are higher in the other country.
• Residents of one country purchase stock in a
  corporation in another country if they expect the
  future profitability of the foreign corporation
  to be higher than the domestic corporations.

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What Do We See in Reality With Portfolio
Investment Flows?

• One important fact is left unexplained. No
  account for the observed two-way capital flows.
• If returns on securities are lower in one nation
  that in another this would explain the flow of
  capital from the former nation to the latter
  nation but is inconsistent with the simultaneous
  flow of capital in the opposite direction, which
  is often observed in the real world.
• To explain two-way international flows, the
  element of risk must be introduced.

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Risks Associated With Investments

• Investors are interested not only in the rate of
  return but also in the risk associated with a
  particular investment.
• The risks with bonds consist of bankruptcy and
  the variability in their market value.
• The risks with stocks consist of bankruptcy, even
  greater variability in market value, and the
  possibility of lower that anticipated returns.
• Investors maximize returns for a given level of
  risk and generally accept a higher risk only if
  returns are higher.

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Diversification

• Portfolio theory thus tells us that by investing
  in securities with yields that are inversely
  related over time, a given yield can be obtained
  at a smaller risk or a higher yield can be
  obtained for the same level of risk for the
  portfolio as a whole.

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Diversification

• Since yields on foreign securities (depending
  primarily on the different economic conditions
  abroad) are more likely to be inversely related
  to yields on domestic securities, a portfolio
  including both domestic and foreign securities
  can have a higher average yield and/or lower risk
  than a portfolio containing only domestic
  securities.
• To achieve such a balanced portfolio, a two-way
  capital flow may be required.

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An Example of Diversification

• If stock A (with the same average yield but lower
  risk than stock B) is available in one country,
  while stock B (with yields inversely related to
  the yields on stock A) is available in another
  country, investors in the first nation must also
  purchase stock B (i.e. invest in the second
  nation).
• Investors in the second nation must also purchase
  stock A (i.e. invest in the first nation to
  achieve a balanced portfolio.
• Risk diversification can thus explain two-way
  international portfolio investments.

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Direct Investments

• Real investments in factories, capital goods,
  land and inventories where both capital and
  management are involved and the investor retains
  control over use of the invested capital.
• Usually takes the form of a firm starting a
  subsidiary of taking control of another firm (for
  example, by purchasing a majority of the stock).
• Any purchase of 10 percent or more of the stock
  of a firm is considered direct investments.

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Direct Investments

• Usually undertaken by multinational corporations
  engaged in manufacturing, resource extraction, or
  services.

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Motives for Foreign Direct Investments

• Earn higher returns from
• higher growth rates abroad
• more favorable tax treatment
• greater availability of infrastructures
• Diversify risks.
• Firms with a stronger international orientation,
  either through exports and/or through foreign
  production sales facilities, are more profitable
  and have a much smaller variability in profits
  that pure domestic firms.
• Source of cheaper raw materials.

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Motives for Foreign Direct Investments

• Avoid tariffs and other restrictions that nations
  impose
• Take advantage of various government subsidies to
  encourage direct foreign investments.
• Enter a foreign oligopolistic market so as to
  share in the profits
• Purchase a promising foreign firm to avoid future
  competition and the possible loss of exports
  market

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What Do We See in Reality With Foreign Direct
Investment?

• One basic question unanswered with regard to
  direct foreign investments
• Why do residents of a nation not borrow from
  another nation and themselves make real
  investments in their own nation rather than
  accepting direct investment from abroad??
• After all, the resident of a nation are expected
  to be more familiar with local conditions and
  thus be at a more competitive advantage with
  respect to foreign investors.

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What Do We See in Reality With Foreign Direct
Investment?

• Several possible explanations for this.
• The most important is that many large
  corporations (usually in monopolistic and
  oligopolistic market) often have some unique
  production knowledge and managerial skill that
  could easily and profitably be utilized abroad
  and over which the corporation wants to retain
  direct control.
• In such a situation, the firm will make direct
  investment abroad.

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Two Way Foreign Direct Investment

• Can be explained by some industries being more
  advanced in one nation (computer industry in the
  U.S.), while other industries are more efficient
  on other nations (automobile industry in Japan).
• Transportation.
• The regional distribution of foreign direct
  investments around the world also seems to depend
  on geographical proximity or established trade
  relations.

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Data on U.S. International Capital Flows
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Importance of the Exchange Rates in Investment
Flows

• All the aforementioned investment flows involve
  the use of the exchange rate, either in acquiring
  foreign assets or the receipt of the expected
  returns on foreign investment.

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Importance of the Exchange Rates in Investment
Flows

• Since the transfer of funds abroad to take
  advantage of higher interest rates in the foreign
  monetary centers involves the conversion of the
  domestic currency to make the investment, and the
  subsequent re-conversion of the funds (plus
  interest earned), of the foreign currency to the
  domestic currency at the time of the maturity, a
  foreign exchange risk is involved due to the
  possible depreciation of the foreign currency
  during the period of the investment.

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Hedging

• Refers to the avoidance of foreign exchange risk,
  or the covering of an open position. In a world
  of foreign exchange uncertainty, the ability of
  traders and investors to hedge greatly
  facilitates the international flow of trade and
  investments.
• Can take place in the spot, forward, futures and
  options markets.

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Speculation

• Is the opposite of hedging.
• The speculator accepts and even seeks out a
  foreign exchange risk, or an open position in the
  hope of making a profit.
• If the speculator correctly anticipates future
  changes in spot rates, he/she makes a profit
  otherwise he/she incurs a loss.
• Can take place in the spot, forward, futures and
  options markets.

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Interest Rate Arbitrage

• Interest arbitrage refers to the international
  flow of short-term liquid capital to earn higher
  returns abroad.
• Interest arbitrage can be covered or uncovered.

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Uncovered Interest Arbitrage

• Here the investor holds a foreign asset
  (T/Bills or any other form of foreign financial
  asset) without covering in the forward market.
• A risk neutral investor will be indifferent to
  where an extra 1 is invested and the uncovered
  interest parity holds when
• 1i Setk(1i)/St

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Covered Interest Parity

• Seeks to avoid the foreign exchange risk.
• To do this the investor exchange the domestic for
  the foreign currency at the spot rate in order to
  purchase the foreign T/bills, and at the same
  time he sells forward the amount of the foreign
  currency he is investing plus the interest to be
  earned so as to coincide with the maturity of the
  foreign investment.

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Covered Interest Rate Parity

• It involves the spot purchase of the foreign
  currency to make the investment and the
  offsetting simultaneous forward sale (swap) of
  the foreign currency to cover the foreign
  exchange risk.
• The following equality is expected to hold
• (1i) (1i)F/S

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Basics About Foreign Currency Derivatives
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Foreign Currency Spot and Forward Markets

• Spot markets market for immediate delivery of
  currency.
• Forward contract an agreement between two
  parties in which one party agrees to buy currency
  from the other party at a later date at an
  exchange rate agreed upon today.
• No central marketplace.
• Risk in forward markets.

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Foreign Currency Future Markets

• A currency futures contract is an agreement
  between two parties in which one party agrees to
  buy the currency from the other party at a later
  date at an exchange rate agreed upon today.
• Traded on a future exchanges.
• The expiration months are March, June, September
  and December.
• Only available for the major currencies.

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Foreign Currency Option

• A currency option is an agreement between two
  parties in which one party pays a premium and
  receives the right to buy or sell a currency at a
  later date at an exchange rate agreed upon today.
  
• Traded on exchange markets or over the counter.

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Foreign Currency Swaps Markets

• A currency swap is an agreement between two
  parties to exchange a series of payments at
  specific dates in which one series of payments is
  in one currency and the other is in another
  currency.
• Payments are based on the interest rates in two
  countries.
• Interest payments are calculated based on a fixed
  amount of notional principal, usually paid in the
  final payment.

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Trading Strategies in Foreign Currency
Futures/Forwards and Options
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A Long Hedge with Foreign Currency Futures

• Involves the purchase of futures contracts.
• The long hedger is concerned that the value of
  the foreign currency will rise.
• Example an American dealer who plans to buy 20
  British sports cars.

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Example of Long Hedge with Foreign Currency
Futures

• American auto dealer wants to purchase 20 British
  sports cars with payment to be made in British
  pounds in the future.
• Each car costs 35000 pounds.
• The dealer is concerned that the pound will
  strengthen over the next few months, causing the
  cars to cost more in dollars.

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The Futures Market

• Buy futures contracts today.
• Pound appreciated, price of futures go up at the
  time of buying the cars.
• Sell contracts.

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Analysis

• Suppose the cars end up costing more.
• The profit from the futures transaction is
• offsets the higher costs on the cars.

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Remember

• The hedger will be able to reduce some of the
  losses in the spot market as long as the pound
  price and futures rates move in the same
  direction.
• Forgo possible gains in spot markets.

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Short Hedge with Foreign Currency Forwards

• A short hedge is a commitment to sell a currency
  using futures or forwards.
• Is designed to protect against a decrease in the
  foreign currencys value.
• Example of a multinational firm that wants to
  transfer 10 million pounds that it will convert
  at a later date.
• Due to the size of the transactions, the use of
  Forwards is recommended.

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Example of Short Hedge with Foreign Currency
Forwards

• Today a multinational firm with a British
  subsidiary decides it will need to transfer 10
  million pounds from an account in London to an
  account with a New York Bank.
• The firm is concerned that in the next two months
  the pound will weaken.

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The Forward Market

• The Forward rate of the pound is 1.357 per
  pound.
• Suppose at delivery date, the spot exchange rate
  is 1.2375 per pound.
• Today, sell pounds forward for delivery on
  September 28 at 1.357.
• On September 28, deliver pounds and receive
  10Million (1.357) 13,570,000.

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Analysis

• The pounds end up worth 13,570,000-12,375,000
  1,195,000 less, but are delivered on the forward
  contract for 13,570,000, thus completely
  eliminating the risk.
• Had the transaction not been done, the firm would
  have converted the pounds at the spot rate of
  1.2375.

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Buy a Foreign Currency Call

• Profit from a currency call held to expiration is
• Profits -C if ETltEE
• Profits ET-EE-C if ETgtEE
• The break even exchange rate ET at expiration is
  EEC ? 0 profits.

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Example Buy a Foreign Currency Call

• Consider a February 96 euro call. Let the
  contract cover 100,000 Euros. The call costs 1.27
  cents per euro.
• If at expiration the exchange rate is 1.10,
  1.10 gt.96 ? Profit Opportunity (ETgtEE).
• If spot rate ends up below .96, the call will
  expire worthless and the loss will be the option
  cost 1270.
• To break even the spot rate must equal .96
  .0127) .9727.

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Payoffs of Foreign Currency Call
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Buy a Foreign Currency Put

• Profit from the purchase of a single foreign
  currency put
• Profits -P if ETgtEE
• Profits EE-ET-P if ETltE
• The breakeven exchange rate ET at expiration is
  EE-P.

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Example Buy a Foreign Currency Put

• February 97.5 euro put on January 31 of a
  particular year. The cost of the put is .59
  cents.
• Spot rate at expiration is .90.
• Since ETltE, profits are 100,000(.975-.90)
  7,500.
• Investor paid for the put 100,000(.0059)590
• Net profit is 6,910.

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Analysis

• If the spot rate at expiration exceeds 0.975,
  the put will expire worthless and the strategy
  will lose the premium, 590, which is the maximum
  loss.
• The breakeven spot price is .975 - .0059
  .9691.
• The maximum gain is if the euro falls to value
  zero. Then the put holder can sell the currency
  at .0975 for a profit of 100,000(.975-.0059)
  96,910.

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Payoff of Foreign Currency Put
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Foreign Currency Option Hedge

• Besides Futures and Forwards, foreign currency
  options can be used for hedging.
• Currency options provide flexibility to hedgers
  who are unsure of whether they will receive or
  make foreign cash payments.
• Example, an American firm making a bid on a
  project.

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Example of Foreign Currency Put Option Hedge

• If the American firm wins the bid, the foreign
  firm or government will pay the American firm in
  pounds.
• It is not appropriate to use forwards/futures
  because the contract could be awarded to other
  firm.

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Example of Foreign Currency Put Option Hedge

• An American firm is bidding for a contract to
  construct a sports complex in London.
• Bid must be submitted in British pounds.
• The firm plans to make a bid of 25Million pounds.
  
• At the forward exchange rate of 1.437, the bid
  in dollars is 25Million(1.437) 35,925,000.
• Once the bid is submitted the firm must be
  prepared to accept 25million pounds if successful
  and must be converted to US dollars.

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Outcome of Bid No Hedge Short Forward Hedge Option Hedge Buy Put
Successful
Pound increases Gain on pound Gain on pound reduced by hedge. Small profit or loss Put expires, premium loss
Pound decreases Loss on pound Loss on pound reduced by hedge. Small profit or loss Loss on pound reduced by exercise of put. Small profit or loss
Unsuccessful
Pound increases No effect Potentially large loss on pound Put expires, premium loss
Pound decreases No effect Potentially large gain on pound. Potentially large gain on pound by exercise put.
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Assume Bid is Successful
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Assume Bid is Not Successful
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Other Instruments for Managing Foreign Exchange
Risk
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Currency Swaps

• Transaction between two parties in which each
  promises to make a series of payments to the
  other at specific future dates, with each set of
  payments made in different currencies.
• The payments normally consist of a series of
  interest payments, often, but not always,
  followed by a final principal payment.

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Currency Swaps

• Payments can use a floating or fixed rate.
• Commonly used by firms that operate in one
  currency but need to borrow in another currency.
• A company can usually borrow cheaper in its own
  currency.
• Two parties involved are end user (firm) and
  dealer (large bank or investment firm).

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Example of Currency Swaps

• An American firm wants to borrow 10 million
  Euros.
• Exchange rate is .9804 per Euro.

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Example of Currency Swaps

• Borrow 9,804,000.
• Enter into a currency swap in which
• Bank pays firm 10M Euros up front.
• Firm pays Bank 9,804,000 up front.
• Bank pays firm interests semiannually for two
  years at 6.1.
• Firm pays bank interests semiannually for two
  years at 4.35.
• Bank pays firm 9,804,000 at end of contract and
  firm pays bank 10 million Euros at end of
  contract.

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Analysis

• Swap payments will be
• .061(180/360)9,804,000 299,022 from bank to
  firm
• .0435(180360)10M Euros 217,500 Euros from firm
  to bank.
• Equivalent to a series of forward contracts.
• Equivalent to issuing bond in one currency and
  using the proceeds to buy a bond in another
  currency.

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a) Up front
Bank
Firm
Bondholders
b) Semiannually for two years
Bank
Firm
Bondholders
c) At termination date
Bank
Firm
Bondholders
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Alternative Variations in Currency Swaps

• Bank pays interests at a floating rate, firm pays
  fixed.
• Bank pays interests at a fixed rate, firm pays
  floating.
• Bank and firm pay floating.
• No exchange or principal.
• Speculative purpose.

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Other Currency Derivatives

• FX Swap two foreign currency forwards with
  different expirations (spread).
• Basket of Options an option on a portfolio of
  currencies (less costly than the total cost of
  options on each component).
• Alternative Currency Option pays off the better
  or worse of two currencies.

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Example of Alternative Currency Options

• Yen-euro dominated in US dollars.
• Option can be better or worse call or
  put.
• Call pays off according to the better performing
  currency.
• If the Euro has gains more than the Yen against
  the Dollar, the option pays off as if it were a
  standard call option on the Yen.

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Questions?
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References

• International Economics by Dominick Salvatore
• An Introduction to Derivatives and Risk
  Management by Don Chance
• http//www.x-rates.com/cgi-bin/hlookup.cgi