International Finance

Investment Strategies Using the Movements of the Exchange Rate

Bakary Kolley Carlos Rodriguez

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

Types of Foreign Investments

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.

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.

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.

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.

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.

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.

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.

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.

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.

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

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.

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

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.

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.

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.

Data on U.S. International Capital Flows

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.

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.

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.

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.

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.

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
1+i = Set+k(1+i*)/St

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.

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:
(1+i) = (1+i*)F/S

Basics About Foreign Currency Derivatives

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.

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.

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.

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.

Trading Strategies in Foreign Currency Futures/Forwards and Options

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.

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.

The Futures Market

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

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

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.

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.

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.

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.

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.

Buy a Foreign Currency Call

Profit from a currency call held to expiration is
Profits = -C if ET<EE Profits = ET-EE-C if ET>EE

The break even exchange rate ET at expiration is EE+C 0 profits.

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 >.96 Profit Opportunity (ET>EE). 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.

Payoffs of Foreign Currency Call

Buy a Foreign Currency Put

Profit from the purchase of a single foreign currency put Profits = -P if ET>EE
Profits = EE-ET-P if ET<E

The breakeven exchange rate ET at expiration is EE-P.

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 $.90. Since ET<E, profits are 100,000($.975-$.90) = $7,500. Investor paid for the put 100,000($.0059)=$590 Net profit is $6,910.

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.

Payoff of Foreign Currency Put

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.

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.

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.

Outcome of Bid No Hedge Successful: Pound increases Gain on pound

Short Forward Option Hedge: Hedge Buy Put 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 Pound decreases No effect No effect Potentially large Put expires, loss on pound premium loss Potentially large Potentially large gain on pound. gain on pound by exercise put.

Assume Bid is Successful

Assume Bid is Not Successful

Other Instruments for Managing Foreign Exchange Risk

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.

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).

Example of Currency Swaps

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

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.

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.

a) Up front Firm Bondholders b) Semiannually for two years Firm Bondholders c) At termination date Firm Bondholders Bank Bank Bank

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.

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.

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.

Questions?

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