Money, Banking, and International Finance ( PDFDrive )

Money, Banking, and International Finance

Did you notice something strange about the call and put options? Investors exercise call and put options “as opposites” when an investor exercises an option. Furthermore, we switched the exercise and spot prices in Equations 8 and 10.

Special Derivatives

Several financial institutions offer futures and options that are based on a market index, such as the Dow Jones Industrial Average and S&P 500. For example, the Chicago Board of Options Exchange (CBOE) offers options on the Dow Jones Industrial Average, which it calls DJX. Technically, the derivatives are not tied to a commodity. A financial company does not invest in a mutual fund that mirrors a stock index. For example, a fund manager could buy 1,000 shares each of every company listed in the Dow Jones Industrial Average and let investors buy into the fund. Instead, the financial companies base the stock market index on a computed stock market index and settle accounts in cash. Since no commodities are exchanged, the financial companies offer call and put options on the stock market indices. These companies cannot offer futures and forwards because buyers and sellers cannot trade a commodity.

Issuers of index derivatives could suffer large losses to rapid market changes. For example, one investor, Nick Leeson, bankrupted Barings, P.L.C. Nick Lesson observed the stocks on the Tokyo stock market fluctuated over a narrow range. The Nikkei stock index fluctuated around 20,000 points in 1995. Nick Leeson used a straddle and issued an equal number of call and put options with identical maturities for the Nikkei stock index. Hence, the investors rarely exercised the options because the stock prices fluctuated over a narrow range. Thus, the option premiums became pure profits to Barings. As profits were soaring, the top management at Barings let Nick Leeson continue his speculation. Then an earthquake struck Kobe, Japan, and both the stock prices and Nikkei average fell rapidly on the Tokyo stock exchange. Leeson speculated the stock prices would increase and bought futures contracts to protect his position. Subsequently, the stock prices continued plummeting, resulting in a $1.4 billion loss for Barings. Unfortunately, Barings was forced to settle with option holders who bet the Nikkei average would fall.

The Chicago Board of Options Exchange (CBOE) offers put and call options for the Volatility Index (VIX), calculated from Standard & Poor's (S&P) 500-stock index. The VIX represents a measure of risk and volatility, otherwise known as the investor's fear gauge. Similar to a stock index derivative, the options are not tied to an asset or commodity. On maturity, a holder receives payment as the CBOE settles the obligation in cash. Furthermore, the VIX suffers from exposure if the VIX increases or decreases dramatically. Then CBOE could suffer large losses as it pays out for exercised options.

One must be careful with the meaning of the VIX number. For example, if the VIX equals 20, subsequently, the investors expect the S&P 500-stock index to swing by 20% over the next 12 months. If the VIX increases, then investors become more pessimistic and the financial markets become more volatile. Some economists and analysts use the VIX as a recession indicator, shown in Figure 1. During the 2008 Financial Crisis, the VIX peaked at 60, and the stock markets lost roughly half their market value during 2009.

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Investors trade CDSs contracts in the derivatives markets. Anyone can buy them, even if the investors do not own the risky bonds that are specified under the CDS contract. Therefore, speculators can enter the market and gamble on outcomes. For example, gamblers believe Company XYZ will bankrupt. These gamblers do not hold any bonds for this company, but they buy CDS contracts. Gamblers only pay the CDS premiums. However, if this company does indeed bankrupt, then the gamblers receive a payout from the issuer of the CDS contract. If Company XYZ does not bankrupt, subsequently, the gamblers lose their bet, the CDS premiums. Imagine the money people could earn if they had inside information about a company’s finances.

Some investors bet the housing market would collapse and bought CDS contracts on risky mortgage pools. Investors bought CDS contracts on mortgage asset-backed securities because they predicted the collapse of the housing bubble in 2007 and purchased CDS contracts as a bet. As the mortgage asset-back funds bankrupted, the holders of CDS contracts requested their payouts. If you are experiencing trouble understanding CDS contracts, then think of this analogy. You bought insurance on your neighbor’s house, and you pray for the house to burn down to collect the insurance.

The CDS contracts have a flaw. A company can stack CDS contracts upon other CDS contracts. For example, Company X buys a CDS contract from an insurance company and pays 2% of the contract’s value as a premium. Unfortunately, the financial health of the company, specified in the CDS contract, deteriorates, increasing the risk on its bonds. Company X can exploit this situation, and create and sell a new CDS contract to Company Y for a 6% premium, earning 4% commission on the deal. If that company does bankrupt, then the insurance company pays Company X its CDS insurance, and in turn, Company X transfers its payout to Company Y, earning a quick 4% commission on the deal. Thus, multiple CDS contracts insure the same debt. Unfortunately, the CDS contracts depend on one important assumption. Issuing companies can indeed pay out the CDS contracts if the companies fail.

The CDS market in the United States quickly grew into $47 trillion market by June 2008, covering a debt of roughly $34 trillion. Putting this number into perspective, the size of the U.S. economy was roughly $14 trillion in Gross Domestic Product (GDP) in 2012. Consequently, the potential losses if the investment banks and insurance companies must pay out all CDS contracts would exceed three times the size of the U.S. economy. Commercial and investment bankers used CDS contracts to guarantee an AAA rating for Collateralized Debt Obligations, which contained securities tied to the mortgage market. They used the CDS contracts to cancel the impact of subprime mortgages contained in the mortgage securities. We had discussed the Collateralized Debt Obligations in Chapter 10 under Securitization.

During the downturn of the U.S. economy in December 2007, AIG quickly accumulated billions in losses as investors requested the payouts from the CDS contracts. AIG’s losses exceeded $60 billion in 2009 and grew by the day. This became the largest loss in U.S. corporate history. The U.S. federal government bailed out AIG by purchasing 80% equity into the company. Furthermore, it promised AIG four bailout loans worth a total of $163 billion. Unfortunately, AIG worked with several investment banks like Goldman Sachs and Lehman Brothers, which also experienced severe financial troubles.

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12.A farmer bought 100 put options for corn. Strike price of corn equals $5 per bushel; the option premium is $0.01 per bushel, and each contract specified a quantity of 100 bushels. Calculate the farmer’s premium, and whether he will exercise this option if the market price of corn equals $6 per bushel?

13.Can you identify any problems for a finance company to issue derivatives that are not based on a commodity, but on a stock market index?

14.What are Credit Default Swaps (CDS)?

15.Could the Federal Reserve or U.S. government have prevented the 2008 Financial Crisis?

16.Company XYZ enters into a 5-year swap agreement with a dealer, and four years have passed. Payments are semi-annual, and two payments are left. Swap's face values are $100 million and 110 million euros with a coupon interest of 3% for U.S. dollars and 4% for the euros. Current discount rates are 5% APR for the U.S. and 6% APR in Europe while the current spot exchange is St = $1.2 / euro. Calculate the swap's present value.

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19.Transaction and Economic Exposures

As a business invests or operates in a foreign country, a changing exchange rate causes gains or losses on international business activities. We define these gains or losses as transaction exposure, economic exposure, translation exposure, and tax exposure. Consequently, this chapter defines the types of exposures and outlines the strategies an international company can use to reduce its losses from the transaction and economic exposures. Unfortunately, the translation and tax exposures are beyond the scope of this book.

Exposure Types

Firms are subjected to currency risk, called exposure. Exposure changes a company's profits, net cash flow, and market value. Every international corporation or business can experience four exposures, originating from their international activities. We explain each exposure in detail.

Transaction exposure comes from the risk of transactions denominated in different currencies. Consequently, a change in an exchange rate alters the value of outstanding financial obligations, such as accounts receivable and accounts payable. Unfortunately, a change in an exchange rate impacts cash flow and alters a company's current contractual obligations. For example, Swiss Cruises, a Swiss company, buys U.S. supplies and sells cruises to U.S. customers. Hence, it prices its supplies and vacation cruises in U.S. dollars. Any fluctuations in the U.S. dollar-Swiss franc exchange rate will alter its financial obligations.

Economic exposure is how a firm’s expected cash flows are affected by unexpected changes in currency exchange rates. Exchange rate alters future sales, prices, and costs. We also call it operating exposure, competitive exposure, or strategic exposure. For example, Swiss Cruises pays most its costs in francs and receives 50% of its revenues in U.S. dollars. Unfortunately, Swiss Cruises cannot raise its price because vacation cruises are highly competitive, and it would lose customers by raising the price. If the Swiss franc is appreciating while the U.S. dollar is depreciating, subsequently, its cash flows will worsen. Unfortunately, its revenues are in U.S. dollars that are losing value while its costs are in francs that are strengthening in value. Keeping them straight, economic exposure is how a change in an exchange rate influences a company's finances over time, while transaction exposure is a change in exchange rates impact current assets and liabilities.

Translation exposure, referred to as accounting exposure, is fluctuations in currency exchange rates affect a firm’s consolidated statements. For example, Swiss Cruises has inventories of U.S. dollars and U.S. dollar loans of an equal amount. Then accountants convert balance sheet items into francs. A depreciating U.S. dollar causes the value of loans to decrease because its liabilities are decreasing. However, the value of current assets is decreasing from the dollar inventories. Nevertheless, due to Swiss accounting rules, accountants use different exchange rates to convert U.S. dollar inventories and the U.S. dollar loans into francs. Consequently, accountants generate accounting gains or losses by using the various exchange

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rates to calculate a company’s financial statements. Company must consider the accounting rules among different countries, and how cash flows will impact a company’s financial statements.

Tax exposure is fluctuations in currency exchange rates affect a company's cash flow, and hence its taxable income. Thus, losses from transaction exposure can reduce taxable income, whereas losses from economic exposure reduce taxable income over future years. On the other hand, translation exposures are not related to cash flows and do not reduce taxable income. Thus, companies could gain profit from favorable changes in the exchange rates.

Measuring and Protecting against Transaction Exposure

We can identify and measure transaction exposure. Firms sell products or purchase resources by entering contracts. Firms can even buy and sell contracts on the derivatives markets to hedge against price uncertainty. If firms do not have contracts, then they must forecast future spot prices, and spot prices can fluctuate wildly.

For example, Swiss Cruises sold cruise packages to a U.S. wholesaler for $2.5 million U.S. dollars and bought fuel oil for $1.5 million in U.S. dollars. Both transactions will occur in 30 days, giving a predictable cash flow. If today's spot exchange rate is 1.45 Swiss francs equal $1, then we calculated the profit, 1.45 million francs by using Equation 1.

However, the transaction occurs in 30 days, and the spot exchange rate can fluctuate. Consequently, Swiss Cruises profits in francs will fluctuate along with the exchange rate. A large company would employ a specialist who predicts and forecasts prices and exchange rates. In Swiss Cruises' case, the specialist has determined the franc-U.S. dollar exchange rate fluctuates ±10%. Thus, the net transaction exposure could fluctuate between 1,305,000 and 1,595,000 francs, which we calculate by multiplying the profit by 1±0.10, or by 0.9 for the lower number and 1.1 for the upper number. In this case, Swiss Cruises has a favorable transaction exposure because revenues in dollars always exceed the costs in dollars.

A company can use strategies to protect its revenues and expenses in a foreign country. For example, a U.S. company, Trident, sold equipment to a British company for 3 million pounds due in 90 days as an accounts receivable. Although Trident sold the equipment, it must wait 90 days for its revenue, and anything could happen within 90 days. An analyst at Trident views four strategies to reduce any losses from this international transaction. Strategies are:

1.Spot exchange rate equals $1.762 per 1 pound, and the company will use the spot exchange rate in 90 days.

2.Trident Company can use a derivatives contract. Trident can buy a 90-day forward contract with an exchange rate of $1.785 / 1 pound from a large bank.

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