Cº - Imba International Finance (E) Part 5 Lecture

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London
 IMBA
   
Marseille
International Master of Business Administration
Moscow
Valencia
Core Module
INTERNATIONAL FINANCE
Part 5 International Financing

AGENDA
Part 1 Global Economics
Part 2 International Accounting
Part 3 Corporate Governance
Part 4 International Investing
Part 6 Global Value Creating Management
Part 7 Current Topics
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IMBA International Finance (E) Part 5 Lecture Part 5 International Financing
AGENDA
Chapter 5.1 Global Cost & Availability of Capital
Chapter 5.2 Sourcing Equity Globally
Chapter 5.3 Financial Structure & International Debt
Chapter 5.4 Interest Rate & Currency Swaps
Chapter 5.5 Foreign Currency Derivatives
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GLOBAL COST AND
AVAILABILITY OF CAPITAL (I)
Global integration of capital markets has given many firms access to new
and cheaper sources of funds beyond those available in their home market.
A firm that must source its long-term debt and equity in a highly illiquid
domestic securities market will probably have a relatively high cost of
capital and will face limited availability of such capital.
This in turn will limit the firm’s ability to compete both internationally and
vis-à-vis foreign firms entering its market.
Firms resident in small capital markets often source their long-term debt
and equity at home in these partially-liquid domestic markets.
The costs of funds is slightly better than that of illiquid markets, however,
if these firms can tap the highly liquid international capital markets, their
competitiveness can be strengthened.
Firms resident in segmented capital markets must devise a strategy to
escape dependence on that market for their long-term debt and equity
needs.
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GLOBAL COST AND
AVAILABILITY OF CAPITAL (II)
A national capital market is segmented if the required rate of return on securities

differs from the required rate of return on securities of comparable expected return
and risk traded on other securities markets.
Capital markets become segmented because of such factors as excessive regulatory
control, perceived political risk, anticipated FOREX risk, lack of transparency,
asymmetric information, cronyism, insider trading and other market
imperfections.
Firms constrained by any of these above conditions must develop a strategy to
escape their own limited capital markets and source some of their long-term capital
needs abroad.
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GLOBAL COST AND
AVAILABILITY OF CAPITAL (III)
Local Market Access Global Market Access
Firm-Specific Characteristics
Firm’s securities appeal only Firm’s securities appeal to

to domestic investors international portfolio investors
Market Liquidity for Firm’s Securities
Illiquid domestic securities market Highly liquid domestic market and

and limited international liquidity broad international participation
Effect of Market Segmentation on Firm’s Securities and Cost of Capital
Segmented domestic securities Access to global securities market

market that prices shares that prices shares according to
according to domestic standards international standards
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WEIGHTED AVERAGE COST OF CAPITAL
E D
k WACC = k e + k d (1 − t)
V V
Where
kWACC = weighted average cost of capital
ke = risk adjusted cost of equity
kd = before tax cost of debt
t = tax rate
E = market value of equity
D = market value of debt
V = market value of firm (D+E)
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COST OF EQUITY AND DEBT
Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)
k e = k rf + β (k m − k rf )
Where
ke = expected rate of return on equity
krf = risk free rate on bonds
km = expected rate of return on the market
β = coefficient of firm’s systematic risk
The normal calculation for cost of debt is analyzing the various proportions of debt and their
associated interest rates for the firm and calculating a before and after tax weighted average
cost of debt.
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TRIDENT’S WACC
Maria Gonzalez, Trident’s CFO, believes that Trident has access to global capital markets and
because it is headquartered in the US, that the US should serve as its base for market risk and
equity risk calculations.
k WACC = 17.00%(0.60) +8.00%(1 − 0.35)(0.40)

k WACC = 12.28%
Where
ke = Trident’s cost of equity is 17.0%
kd = Trident’s before tax cost of debt is 8.0%
t = tax rate of 35.0%
E/V = equity to value ratio of Trident is 60.0%
D/V = debt to value ratio of Trident is 40.0%
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CALCULATING EQUITY RISK
PREMIA IN PRACTICE
Using CAPM, there is rising debate over what numerical values should be used in its
application, especially the equity risk premium:
• The equity risk premium is the expected average annual return on the
market above riskless debt.
• Typically, the market’s return is calculated on a historical basis yet others
feel that the number should be forward looking since it is being used to
calculate expected returns.
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EQUITY MARKET RISK PREMIUMS
IN SELECTED COUNTRIES, 1900-2000
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ALTERNATIVE ESTIMATES OF COST OF EQUITY FOR A
HYPOTHETICAL US FIRM
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GLOBAL COST AND
AVAILABILITY OF CAPITAL (I)
Global integration of capital markets has given many firms access to new and
cheaper sources of funds beyond those available in their home market.
A firm that must source its long-term debt and equity in a highly illiquid domestic
securities market will probably have a relatively high cost of capital and will face
limited availability of such capital.
This in turn will limit the firm’s ability to compete both internationally and vis-à-vis
foreign firms entering its market.
Firms resident in small capital markets often source their long-term debt and equity
at home in these partially-liquid domestic markets.
The costs of funds is slightly better than that of illiquid markets, however, if these
firms can tap the highly liquid international capital markets, their competitiveness
can be strengthened.
Firms resident in segmented capital markets must devise a strategy to escape
dependence on that market for their long-term debt and equity needs.
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GLOBAL COST AND
AVAILABILITY OF CAPITAL (II)
A national capital market is segmented if the required rate of return on securities

differs from the required rate of return on securities of comparable expected return
and risk traded on other securities markets.
Capital markets become segmented because of such factors as excessive regulatory
control, perceived political risk, anticipated FOREX risk, lack of transparency,
asymmetric information, cronyism, insider trading and other market
imperfections.
Firms constrained by any of these above conditions must develop a strategy to
escape their own limited capital markets and source some of their long-term capital
needs abroad.
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GLOBAL COST AND
AVAILABILITY OF CAPITAL (III)
Local Market Access Global Market Access
Firm-Specific Characteristics
Firm’s securities appeal only Firm’s securities appeal to

to domestic investors international portfolio investors
Market Liquidity for Firm’s Securities
Illiquid domestic securities market Highly liquid domestic market and

and limited international liquidity broad international participation
Effect of Market Segmentation on Firm’s Securities and Cost of Capital
Segmented domestic securities Access to global securities market

market that prices shares that prices shares according to
according to domestic standards international standards
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WEIGHTED AVERAGE COST OF CAPITAL
E D
k WACC = k e + k d (1 − t)
V V
Where
ke = risk adjusted cost of equity
kd = before tax cost of debt
t = tax rate
E = market value of equity
D = market value of debt
V = market value of firm (D+E)
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COST OF EQUITY AND DEBT
Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)
k e = k rf + β (k m − k rf )
Where
ke = expected rate of return on equity
krf = risk free rate on bonds
km = expected rate of return on the market
β = coefficient of firm’s systematic risk
The normal calculation for cost of debt is analyzing the various proportions of debt and their
associated interest rates for the firm and calculating a before and after tax weighted average
cost of debt.
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TRIDENT’S WACC
Maria Gonzalez, Trident’s CFO, believes that Trident has access to global capital markets
and because it is headquartered in the US, that the US should serve as its base for market
risk and equity risk calculations.
k WACC = 17.00%(0.60) +8.00%(1 − 0.35)(0.40)

k WACC = 12.28%
Where
ke = Trident’s cost of equity is 17.0%
kd = Trident’s before tax cost of debt is 8.0%
t = tax rate of 35.0%
E/V = equity to value ratio of Trident is 60.0%
D/V = debt to value ratio of Trident is 40.0%
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CALCULATING EQUITY RISK
PREMIA IN PRACTICE
Using CAPM, there is rising debate over what numerical values should be used in its
application, especially the equity risk premium:
• The equity risk premium is the expected average annual return on the
market above riskless debt.
• Typically, the market’s return is calculated on a historical basis yet others
feel that the number should be forward looking since it is being used to
calculate expected returns.
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EQUITY MARKET RISK PREMIUMS
IN SELECTED COUNTRIES, 1900-2000
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ALTERNATIVE ESTIMATES OF COST OF EQUITY FOR A
HYPOTHETICAL US FIRM
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LINK BETWEEN COST &
AVAILABILITY OF CAPITAL
Although no consensus exists on the definition of market liquidity, market liquidity

can be observed by noting the degree to which a firm can issue new securities
without depressing existing market prices.
In a domestic case, the underlying assumption is that total availability of capital at
anytime for a firm is determined by supply and demand within its domestic the
market.
In the multinational case, a firm is able to improve market liquidity by raising funds
in the Euromarkets, by selling securities abroad, and by tapping local capital
markets.
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MARKET SEGMENTATION
Capital market segmentation is a financial market imperfection caused mainly by

government constraints, institutional practices, and investor perceptions.
Other imperfections are:
• Asymmetric information.
• High securities transaction costs.
• Foreign exchange risks.
• Political risks.
• Corporate governance differences.
• Regulatory barriers.
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EFFECTS OF MARKET LIQUIDITY &
SEGMENTATION (I)
The degree to which capital markets are illiquid or segmented has an important
influence on a firm’s marginal cost of capital.
An MNE has a given marginal return on capital at differing budget levels determined
by which capital projects it can and chooses to take on.
If the firm is limited to raising funds in its domestic market, it has domestic marginal
cost of capital at various budget levels.
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SEGMENTATION (II)
If an MNE has access to additional sources of capital outside its domestic market, its
marginal cost of capital can decrease.
If the MNE has unlimited access to capital both domestic and abroad, then its
marginal cost of capital decreases even further.
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NOVO INDUSTRI A/S (I)
Illustrative case of a Danish multinational that sought to internationalize its capital

structure by accessing foreign capital markets.
Novo Industri is a Danish industrial enzyme and pharmaceutical firm.
In 1977 the management sought to tap in to other capital markets because the
Danish market was illiquid and segmented causing Novo to incur a higher cost of
capital than that of its international competitors.
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NOVO INDUSTRI A/S (II)
The Danish equity markets had at least six factors of market segmentation
• Asymmetric information for Danish and foreign investors.
• Taxation.
• Alternative sets of feasible portfolios.
• Financial risk.
• Foreign exchange risk.
• Political risk.
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NOVO INDUSTRI A/S (III)
Asymmetric information
• Denmark had a regulation that prohibited Danish investors from holding
foreign private sector securities.
- This left little incentive for Danish investors to seek out new
information or follow developments in other markets.
• Another barrier was the lack of equity analysts in Denmark following
Danish companies.
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NOVO INDUSTRI A/S (IV)
Taxation
• Danish taxation policy charged a capital gains tax of 50% on shares held
for over two years.
• Shares held for less than two years were taxed at a marginal income tax
rate as high as 75%.
• This led to bonds being the security of choice among Danes.
Feasible set of portfolios
• Because of the prohibition on foreign security ownership, Danish investors
had a limited set of securities from which to choose.
• Danish stocks offered international investors an opportunity to diversify,
but not the reciprocal for Danish investors.
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NOVO INDUSTRI A/S (V)
Financial, Foreign exchange and political risks

• Danish firms were highly leveraged relative to US and UK standards with
most debt being short-term.
• Foreign investors were subject to foreign exchange risk but this was not a
big obstacle for investment.
• Denmark was very stable politically.
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NOVO INDUSTRI A/S (VI)
The Road to Globalization

• When Novo’s management decided to access foreign equity markets in
1977 they had several barriers to overcome.
• Closing the information gap: Novo now needed to begin disclosing their
financials in accordance with international standards.
• In 1979 Novo had a successful Eurobond issues which lead to more
disclosure and international recognition among investors.
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NOVO INDUSTRI A/S (VII)

• During 1979, Novo also listed its convertibles on the London Stock
Exchange (LSE).
• Also during that year there was a big boom in biotechnology and Novo
went to the US to sell investors on their company.
• The road show worked and Novo’s shares on the Danish exchange and
the LSE rose in price from increased demand.
• This prompted Novo to consider an equity issue in the US.
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NOVO INDUSTRI A/S (VIII)

• During the first half of 1981 Novo prepared an SEC registration.
• Before the offering over 50% of Novo’s shareholders had become
foreign investors.
• On May 30, 1981 Novo listed in the NYSE and although it had lost 10% of
its value in Copenhagen the previous day, the $61 million offering was a
success and the share price quickly gained all its losses from the
previous day.
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COST OF CAPITAL FOR MNES
VERSUS DOMESTIC FIRMS (I)
Is the WACC or an MNE higher or lower than for its domestic counterpart?
• The answer is a function of
- The marginal cost of capital
- The after-tax cost of debt
- The optimal debt ratio
- The relative cost of equity
An MNE should have a lower cost of capital because it has access to a global cost
and availability of capital.
This availability and cost allows the MNE more optimality in capital projects and
budgets compared to its domestic counterpart.
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SUMMARY OF LEARNING OBJECTIVES (I)
Gaining access to global capital markets should allow a firm to lower its cost of
capital. A firm can improve access to global capital markets by increasing the
market liquidity of its shares and by escaping its home capital market.
The costs and availability of capital is directly linked to the degree of market liquidity
and segmentation. Firms having access to markets with high liquidity and low
segmentation should have a lower cost of capital.
A firm is able to increase its market liquidity by raising debt in the Euromarket, by
selling issues in individual national markets and by tapping capital markets through
foreign subsidiaries.
This causes the marginal cost of capital to lower for a firm and it results in a firm’s
ability to raise even more capital.
A national capital market is segmented if the required rate of return on securities in
that market differs from the required rate of return on securities of comparable
return and risk that are traded in other national capital markets.
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SUMMARY OF LEARNING OBJECTIVES (II)
The most important imperfections are asymmetric information, transaction costs,

foreign exchange risk, political risk, corporate governance differences, and
regulatory barriers.
Segmentation results in a higher cost of capital and less availability of capital.
If a firm is resident in a segmented capital market, it can still escape from this market
by sourcing its debts and equity abroad. The result should be a lower marginal cost
of capital, improved liquidity for its securities, and a larger capital budget.
Whether or not MNEs have a lower cost of capital than their domestic counterparts
depends on their optimal financial structures, systematic risk, availability of capital,
and the level of optimal capital budget.
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LINK BETWEEN COST &
AVAILABILITY OF CAPITAL
Although no consensus exists on the definition of market liquidity, market liquidity

can be observed by noting the degree to which a firm can issue new securities
without depressing existing market prices.
In a domestic case, the underlying assumption is that total availability of capital at
anytime for a firm is determined by supply and demand within its domestic the
market.
In the multinational case, a firm is able to improve market liquidity by raising funds
in the Euromarkets, by selling securities abroad, and by tapping local capital
markets.
I MBA
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MARKET SEGMENTATION
Capital market segmentation is a financial market imperfection caused mainly by

government constraints, institutional practices, and investor perceptions.
Other imperfections are:
• Asymmetric information.
• High securities transaction costs.
• Foreign exchange risks.
• Political risks.
• Corporate governance differences.
• Regulatory barriers.
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SEGMENTATION (I)
The degree to which capital markets are illiquid or segmented has an important
influence on a firm’s marginal cost of capital.
An MNE has a given marginal return on capital at differing budget levels determined
by which capital projects it can and chooses to take on.
If the firm is limited to raising funds in its domestic market, it has domestic marginal
cost of capital at various budget levels.
I MBA
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SEGMENTATION (II)
If an MNE has access to additional sources of capital outside its domestic market, its
marginal cost of capital can decrease.
If the MNE has unlimited access to capital both domestic and abroad, then its
marginal cost of capital decreases even further.
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SEGMENTATION (III)
Marginal cost of capital

and rate of return (percentage)
MCCF
MCCD MCCU
kD
20% kF
15% kU
13%
MRR
10%
Budget
10 20 30 40 50 60 (millions of $)
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NOVO INDUSTRI A/S (I)
Illustrative case of a Danish multinational that sought to internationalize its capital

structure by accessing foreign capital markets.
Novo Industri is a Danish industrial enzyme and pharmaceutical firm.
In 1977 the management sought to tap in to other capital markets because the
Danish market was illiquid and segmented causing Novo to incur a higher cost of
capital than that of its international competitors.
I MBA
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42
NOVO INDUSTRI A/S (II)
The Danish equity markets had at least six factors of market segmentation
• Asymmetric information for Danish and foreign investors.
• Taxation.
• Alternative sets of feasible portfolios.
• Financial risk.
• Political risk.
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NOVO INDUSTRI A/S (III)
Asymmetric information
• Denmark had a regulation that prohibited Danish investors from holding
foreign private sector securities.
- This left little incentive for Danish investors to seek out new
information or follow developments in other markets.
• Another barrier was the lack of equity analysts in Denmark following
Danish companies.
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NOVO INDUSTRI A/S (IV)
Taxation
• Danish taxation policy charged a capital gains tax of 50% on shares held
for over two years.
• Shares held for less than two years were taxed at a marginal income tax
rate as high as 75%.
• This led to bonds being the security of choice among Danes.
Feasible set of portfolios
• Because of the prohibition on foreign security ownership, Danish investors
had a limited set of securities from which to choose.
• Danish stocks offered international investors an opportunity to diversify,
but not the reciprocal for Danish investors.
I MBA
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NOVO INDUSTRI A/S (V)
Financial, Foreign exchange and political risks

• Danish firms were highly leveraged relative to US and UK standards with
most debt being short-term.
• Foreign investors were subject to foreign exchange risk but this was not a
big obstacle for investment.
• Denmark was very stable politically.
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NOVO INDUSTRI A/S (VI)

• When Novo’s management decided to access foreign equity markets in
1977 they had several barriers to overcome.
• Closing the information gap: Novo now needed to begin disclosing their
financials in accordance with international standards.
• In 1979 Novo had a successful Eurobond issues which lead to more
disclosure and international recognition among investors.
I MBA
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NOVO INDUSTRI A/S (VII)

• During 1979, Novo also listed its convertibles on the London Stock
Exchange (LSE).
• Also during that year there was a big boom in biotechnology and Novo
went to the US to sell investors on their company.
• The road show worked and Novo’s shares on the Danish exchange and
the LSE rose in price from increased demand.
• This prompted Novo to consider an equity issue in the US.
I MBA
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NOVO INDUSTRI A/S (VIII)

• During the first half of 1981 Novo prepared an SEC registration.
• Before the offering over 50% of Novo’s shareholders had become
foreign investors.
• On May 30, 1981 Novo listed in the NYSE and although it had lost 10% of
its value in Copenhagen the previous day, the $61 million offering was a
success and the share price quickly gained all its losses from the
previous day.
I MBA
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49
VERSUS DOMESTIC FIRMS (I)
Is the WACC or an MNE higher or lower than for its domestic counterpart?
• The answer is a function of
- The marginal cost of capital
- The after-tax cost of debt
- The optimal debt ratio
- The relative cost of equity
An MNE should have a lower cost of capital because it has access to a global cost
and availability of capital.
This availability and cost allows the MNE more optimality in capital projects and
budgets compared to its domestic counterpart.
I MBA
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VERSUS DOMESTIC FIRMS (II)
Marginal cost of capital

and rate of return (percentage)
MCCDC
20%
15% MCCMNE
10%
5% MRRMNE
MRRDC
Budget
100 140 300 350 400 (millions of $)
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VERSUS DOMESTIC FIRMS (III)
Is MNEwacc > or < Domesticwacc ?
kWACC = ke
[ Equity
Value ] + kd ( 1 – tx ) [ Debt
Value ]
Empirical studies indicate MNEs have a lower debt/capital ratio than
domestic counterparts indicating MNEs have a higher cost of capital.
And indications are that MNEs have a lower average cost of debt
than domestic counterparts, indicating MNEs have a lower cost of
capital.
The cost of equity required by investors is higher for multinational firms than for domestic firms. Possible
explanations are higher levels of political risk, foreign exchange risk, and higher agency costs of doing business
in a multinational managerial environment. However, at relatively high levels of the optimal capital budget, the
MNE would have a lower cost of capital.
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AGENDA
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SOURCING EQUITY GLOBALLY (I)
This requires management to agree upon a long-run financial objective and then
choose among various alternative paths to get there.
Depositary Receipts
• Depositary receipts are negotiable certificates issued by a bank to
represent the underlying shares of stock, which are held in trust at a
foreign custodian bank.
- Global Depositary Receipts (GDRs) – refers to certificates traded
outside the US.
- American Depositary Receipts (ADRs) – are certificates traded in the
US and denominated in US dollars.
- ADRs are sold, registered, and transferred in the US in the same
manner as any share of stock with each ADR representing some
multiple of the underlying foreign share.
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SOURCING EQUITY GLOBALLY (II)
Depositary Receipts
- This multiple allows the ADRs to possess a price per share
conventional for the US market.
- ADRs are either sponsored or unsponsored.
- Sponsored ADRs are created at the request of a foreign firm
wanting its shares traded in the US; the firm applies to the SEC
and a US bank for registration and issuance.
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ALTERNATIVE PATHS
Domestic Financial Market Operations
International Bond Issue --

Less Liquid Markets
International Bond Issue --

Target Market or Eurobond Market
Equity Listings -- Less Liquid Markets
Equity Issue -- Less Liquid Markets
Equity Listing -- Target Market
Euro equity Issue -- Global Markets
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AMERICAN DEPOSITARY RECEIPTS
Shares Shares held on deposit Receipts

at custodial bank
Publicly traded firm Receipts for shares

outside the U.S. listed on U.S. exchange
Traded by
U.S. investors
Shares traded on local

Shares stock exchange Arbitrage
Activity
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DEPOSITARY RECEIPT PROGRAMS
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FOREIGN EQUITY LISTING & ISSUANCE
By cross-listing and selling its shares on a foreign stock exchange a firm typically
tries to accomplish one or more of the following objectives:
• Improve the liquidity of its existing shares and support a liquid secondary
market.
• Increase its share price by overcoming mispricing in a segmented and
illiquid home market.
• Increase the firm’s visibility and political acceptance to its customers,
suppliers, creditors & host governments.
• Establish a secondary market for shares used for acquisitions.
• Create a secondary market for shares that can be used to compensate
local management and employees in foreign subsidiaries.
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IMPROVING LIQUIDITY
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EFFECT OF CROSS-LISTING
ON SHARE PRICE
If a firm’s home capital market is segmented, that firm could theoretically benefit by
cross-listing in a foreign market if that market values the firm more than does the
home market
• This was the example of Novo A/S
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OTHER MOTIVES FOR CROSS-LISTING
Increasing visibility and political acceptance

• MNEs list in markets where they have substantial physical operations.
• Political objectives might include the need to meet local ownership
requirements for an MNE’s foreign joint venture.
Increasing potential for share swaps with acquisitions.
Compensating management and employees.
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BARRIERS TO CROSS-LISTING
AND SELLING EQUITY ABROAD
Commitment to disclosure and investor relations

• A decision to cross-list must be balanced against the implied increased
commitment to full disclosure and a continuing investor relations program
- Disclosure is a double-edged sword.
- Increased firm disclosure should have the effect of lowering the cost
of equity capital.
- On the other hand, this increased disclosure is a costly burden to
corporations.
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ALTERNATIVE INSTRUMENTS
TO SOURCE EQUITY (I)
Alternative instruments to source equity in global markets include the following:

• Sale of a directed public share issue to investors in a target market.
• Sale of a Euro equity public issue to investors in more than one market,
including both foreign and domestic markets.
• Private placements under SEC Rule 144A.
• Sale of shares to private equity funds.
• Sale of shares to a foreign firm as a part of a strategic alliance.
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TO SOURCE EQUITY (II)
Directed Public Share Issues

• Defined as one which is targeted at investors in a single country and
underwritten in whole or in part by investment institutions from that
country
- Issue may or may not be denominated in the currency of the target
market.
- The shares might or might not be cross-listed on a stock
exchange in the target market.
- A foreign share issues, plus cross-listing can provide it with
improved liquidity.
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TO SOURCE EQUITY (III)
Euro equity Public Issue

• Gradual integration of worlds’ capital markets has spawned the emergence
of a euro equity market.
• A firm can now issue equity underwirtten and distributed in multiple
foreign equity markets; sometimes simultaneously with distribution in
the domestic market.
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TO SOURCE EQUITY (IV)
Private Placement Under SEC Rule 144A

• A private placement is the sale of a security to a small set of qualified
institutional buyers.
• Investors are traditionally insurance companies and investment
companies.
• Because shares are not registered for sale, investors typically follow “buy
and hold” strategy.
• Rule 144A allows qualified institutional buyers (QIB) to trade privately
placed securities without previous holding period restrictions and without
requiring SEC registration.
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TO SOURCE EQUITY (V)
Private Equity Funds

• Limited partnerships of institutional and wealthy individual investors that
raise their capital in the most liquid capital markets.
• Then invest these funds in mature, family-owned firms located in emerging
markets.
Strategic Alliances
• Normally followed by firms that expect to gain synergies from one or more
joint efforts.
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AGENDA
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OPTIMAL FINANCIAL STRUCTURE (I)
When taxes and bankruptcy costs are considered, a firm has an optimal financial
structure determined by an optimal mix of debt and equity that minimizes the firm’s
cost of capital
• If the business risk of new projects differs from the risk of existing
projects, the optimal mix of debt and equity would change to recognize
tradeoffs between business and financial risks.
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OPTIMAL FINANCIAL STRUCTURE (II)
Cost of Capital (%)
30
28 ke = cost of equity
26
Minimum cost
24
of capital range
22 kWACC = weighted average
20 after-tax cost of capital
18
16
14
12
10 kd (1-tx) = after-tax cost of debt
8
6
4
2
0 20 40 60 80 100
Total Debt (D)

Debt Ratio (%) =
Total Assets (V)
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OPTIMAL FINANCIAL STRUCTURE
& THE MNE (I)
The domestic theory of optimal capital structure is modified by four additional

variables in order to accommodate the MNE
• Availability of capital.
• Diversification of cash flows.
• Expectation of international portfolio investors.
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& THE MNE (II)
Availability of capital
• Allows MNEs to lower cost of capital.
• Permits MNEs to maintain a desired debt ratio even when new funds are
raised.
• Allows MNEs to operate competitively even if their domestic market is
illiquid and segmented.
Diversification of cash flows
• Reduces risk similar to portfolio theory of diversification.
• Lowers volatility of cash flows among differing subsidiaries and foreign
exchange rates.
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& THE MNE (III)
Foreign exchange risk & cost of debt

• When a firm issues foreign currency denominated debt, its effective cost
equals the after-tax cost of repayment in terms of the firm’s own currency.
• Example: US firm borrows Sfr1,500,000 for one year at 5.00% p.a.; the franc
appreciates from Sfr1.500/$ to Sfr1.440/$.
- Initial dollar amount borrowed.
Sfr1,500,000
= $1,000,000
Sfr1.500/$
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& THE MNE (IV)
• At the end of the year, the US firm repays the interest plus principal
Sfr1,500,000 x 1.05
= $1,093,750
Sfr1.440/$
• The actual dollar cost of the loan is not the nominal 5.00% paid in Swiss francs, but 9.375%
$1,093,750
= 1.09375
1,000,000
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& THE MNE (V)
• This total home currency cost is higher than expected because of the
appreciation of the Swiss franc.
• This cost is the result of the combined cost of debt and the percentage
change in the foreign currency’s value.
k = 1+ k
$
d [( Sfr
d ) x (1 + s ) ] − 1
Where
kd$ = Cost of borrowing for US firm in home country
kdSfr = Cost of borrowing for US firm in Swiss francs
s = Percentage change in spot rate
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& THE MNE (VI)
The total cost of debt must include the change in the exchange rate
The percentage change in the value of the Swiss franc is calculated as
S1 − S2 Sfr1.500/$ - Sfr1.440/$
x 100 = x 100 = 4.1667%
S2 Sfr1.40/$
The total cost is then
k $d = [ (1 + .05) x (1 + 0.041667 ) ] − 1 = 0.09375
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& THE MNE (VII)
Expectations of International Portfolio Investors

• If firms want to attract and maintain international portfolio investors, they
must follow the norms of financial structures.
• Most international investors for US and the UK follow the norms of a 60%
debt ratio.
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FINANCIAL STRUCTURE OF
FOREIGN SUBSIDIARIES (I)
Debt borrowed is from sources outside of the MNE (i.e. subsidiary borrows directly
from markets)
Advantages of localization
• Localized financial structure reduces criticism of foreign subsidiaries that
have been operating with too high (by local standards) proportion of debt.
• Localized financial structure helps management evaluate return on equity
investment relative to local competitors.
• In economies where interest rates are high because of scarcity of capital
and real resources are fully utilized, the penalty paid for borrowing local
funds reminds management that unless ROA is greater than local price of
capital, misallocation of real resources may occur.
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FOREIGN SUBSIDIARIES (II)
Disadvantages of localization
• An MNE is expected to have comparative advantage over local firms
through better availability of capital and ability to diversify risk.
• If each subsidiary localizes its financial structure, the resulting
consolidated balance sheet might show a structure that doesn’t conform
with any one country’s norm; the debt ratio would simply be a weighted
average of all outstanding debt.
• Typically, any subsidiary’s debt is guaranteed by the parent, and the parent
won’t allow a default on the part of the subsidiary thus making the debt
ratio more cosmetic for the foreign subsidiary.
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FOREIGN SUBSIDIARIES (III)
Financing the Foreign Subsidiary

• In addition to choosing an appropriate financial structure, financial
managers need to choose among the alternative sources of funds for
financing.
• Sources of funds can be classified as internal and external to the MNE.
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FOREIGN SUBSIDIARIES (IV)
Cash
Equity
Real goods
Funds from
Funds parent company Debt -- cash loans
From
Within Leads & lags on intra-firm payables
the
Multinational Debt -- cash loans
Enterprise Funds from
sister subsidiaries
(MNE) Leads & lags on intra-firm payables
Subsidiary borrowing with parent guarantee
Depreciation & non-cash charges

Funds Generated Internally by the
Foreign Subsidiary
Retained earnings
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FOREIGN SUBSIDIARIES (V)
Banks & other financial institutions

Borrowing from sources
in parent country
Security or money markets
Funds
External Local currency debt
to
Borrowing from sources
the Third-country currency debt
outside of parent country
Multinational
Enterprise Eurocurrency debt
(MNE)
Individual local shareholders
Local equity
Joint venture partners
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INTERNATIONAL DEBT MARKETS (I)
These markets offer a variety of different maturities, repayment structures and

currencies of denomination.
They also vary by source of funding, pricing structure, maturity and subordination.
Three major sources of funding are
• International bank loans and syndicated credits.
• Euronote market.
• International bond market.
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INTERNATIONAL DEBT MARKETS (II)
Bank loan and syndicated credits

• Traditionally sourced in eurocurrency markets.
• Also called eurodollar credits or eurocredits.
- Eurocredits are bank loans denominated in eurocurrencies and
extended by banks in countries other than in whose currency the
loan is denominated.
• Syndicated credits
- Enables banks to risk lending large amounts.
- Arranged by a lead bank with participation of other bank.
• Narrow spread, usually less than 100 basis points.
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INTERNATIONAL DEBT MARKETS (III)
Euronote market
• Collective term for medium and short term debt instruments sourced in the
Eurocurrency market.
• Two major groups
- Underwritten facilities and non-underwritten facilities.
- Non-underwritten facilities are used for the sale and distribution of
Euro-commercial paper (ECP) and Euro Medium-term notes (EMTNs)
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INTERNATIONAL DEBT MARKETS (IV)
• Euronote facilities
- Established market for sale of short-term, negotiable promissory
notes in eurocurrency market.
- These include Revolving Underwriting Facilities, Note Issuance
Facilities, and Standby Note Issuance Facilities.
• Euro-commercial paper (ECP)
- Similar to commercial paper issued in domestic markets with
maturities of 1,3, and 6 months.
• Euro Medium-term notes (EMTNs)
- Similar to domestic MTNs with maturities of 9 months to 10 years.
- Bridged the gap between short-term and long-term euro debt
instruments.
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INTERNATIONAL DEBT MARKETS (V)
International bond market

• Fall within two broad categories
- Eurobonds
- Foreign bonds
• The distinction between categories is based on whether the borrower is a
domestic or foreign resident and whether the issue is denominated in a
local or foreign currency.
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INTERNATIONAL DEBT MARKETS (VI)
Eurobonds
• A Eurobond is underwritten by an international syndicate of banks and
sold exclusively in countries other than the country in whose currency
the bond is denominated.
• Issued by MNEs, large domestic corporations, governments, government
enterprises and international institutions.
• Offered simultaneously in a number of different capital markets.
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INTERNATIONAL DEBT MARKETS (VII)
Eurobonds
• Several different types of issues
- Straight Fixed-rate issue
- Floating rate note (FRN)
- Equity related issue – convertible bond
Foreign bonds
• Underwritten by a syndicate and sold principally within the country of the
denominated currency, however the issuer is from another country.
• These include
- Yankee bonds
- Samurai bonds
- Bulldogs
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90
INTERNATIONAL DEBT MARKETS (VIII)
Bank Loans & International Bank Loans

Syndications
Eurocredits
(floating-rate,
short-to-medium term) Syndicated Credits
Euronote Euronotes & Euronote Facilities

Market
Eurocommercial Paper (ECP)
(floating-rate,
short-to-medium term) Euro Medium Term Notes (EMTNs)
International Eurobond
Bond Market * straight fixed-rate issue
* floating-rate note (FRN)
(fixed & floating-rate, * equity-related issue
medium-to-long term)
Foreign Bond
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INTERNATIONAL DEBT MARKETS (IX)
Unique characteristics of Eurobond markets

• Absence of regulatory interference
- National governments often impose controls on foreign issuers of
securities, however the euromarkets fall outside of governments’
control.
• Less stringent disclosure
• Favorable tax status
- Eurobonds offer tax anonymity and flexibility
Rating of Eurobonds & other international issues
• Moody’s, Fitch and Standard & Poor’s rate bonds just as in US market.
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PROJECT FINANCING (I)
Project Finance is the arrangement of financing for long-term capital projects, large
in scale and generally high in risk.
Widely used by MNEs in the development of infrastructure projects in emerging
markets.
Most projects are highly leveraged for two reasons
• Scale of project often precludes a single equity investor or collection of
private equity investors
• Many projects involve subjects funded by governments
This high level of debt requires additional levels of risk reduction.
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PROJECT FINANCING (II)
Four basic properties that are critical to the success of project financing
• Separation of the project from its investors
- Project is established as an individual entity, separated legally and
financially from the investors.
- Allows project to achieve its own credit rating and cash flows.
• Long-lived and capital intensive singular projects.
• Cash flow predictability from third-party commitments.
- Third party commitments are usually suppliers or customers of the
project.
• Finite projects with finite lives.
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AGENDA
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INTEREST RATE RISK
All firms, domestic or multinational, are sensitive to interest rate movements

The single largest interest rate risk of a non-financial firm is debt service
• For an MNE, differing currencies have differing interest rates thus making
this risk a larger concern
The second most prevalent source of interest rate risk is its holding of interest
sensitive securities
Ever increasing competition has forced financial managers to better manage both
sides of the balance sheet
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INTEREST RATE RISK
Whether it is on the left or right hand side, the reference rate of interest calculation
merits special attention
• The reference rate is the rate of interest used in a standardized quotation,
loan agreement, or financial derivative valuation
• Most common is LIBOR (London Interbank Offered Rate)
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MANAGEMENT OF INTEREST RATE RISK
The management dilemma is the balance between risk and return

Since most treasuries do not act as profit centers, their management practices are
typically conservative
Before treasury can take any hedging strategy, it must first form an expectation or a
directional and/or volatility view
Once management has formed its expectations about future interest rate levels and
movements, it must then choose the appropriate implementation of a strategy
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CREDIT AND REPRICING RISK
Credit Risk or roll-over risk is the possibility that a borrower’s creditworthiness at

the time of renewing a credit, is reclassified by the lender
• This can result in higher borrowing rates, fees, or even denial
Repricing risk is the risk of changes in interest rates charged (earned) at the time a
financial contract’s rate is being reset
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Example: Consider a firm facing three debt strategies

• Strategy #1: Borrow $1 million for 3 years at a fixed rate
• Strategy #2: Borrow $1 million for 3 years at a floating rate, LIBOR + 2% to
be reset annually
• Strategy #3: Borrow $1 million for 1 year at a fixed rate, then renew the
credit annually
Although the lowest cost of funds is always a major criteria, it is not the only one
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Strategy #1 assures itself of funding at a known rate for the three years; what is
sacrificed is the ability to enjoy a lower interest rate should rates fall over the time
period
Strategy #2 offers what #1 didn’t, flexibility (repricing risk). It too assures funding for
the three years but offers repricing risk when LIBOR changes
Strategy #3 offers more flexibility and more risk; in the second year the firm faces
repricing and credit risk, thus the funds are not guaranteed for the three years and
neither is the price
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TRIDENT’S FLOATING-RATE LOANS
Example using Trident corporation’s loan of US$10 million serviced with annual
payments and the principal paid at the end of the third year
• The loan is priced at US dollar LIBOR + 1.50%; LIBOR is reset every year
• When the loan is drawn down initially (at time 0), an up-front fee of 1.50% is
charged
• Trident will not know the actual interest cost until the loan has been
completely repaid
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If Trident had wished to manage the interest rate risk associated with the loan, it
would have a number of alternatives
• Refinancing – Trident could go back to the lender and refinance the entire
agreement
• Forward Rate Agreements (FRAs) – Trident could lock in the future interest
rate payment in much the same way that exchange rates are locked in with
forward contracts
• Interest Rate Futures
• Interest Rate Swaps – Trident could swap the floating rate note for a fixed
rate note with a swap dealer
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FORWARD RATE AGREEMENTS (FRAS)
A forward rate agreement is an interbank-traded contract to buy or sell interest rate

payments on a notional principal
• Example: If Trident wished to lock in the first payment it would buy an FRA
which locks in a total interest payment at 6.50%
• If LIBOR rises above 5.00%, then Trident would receive a cash payment
from the FRA seller reducing their LIBOR payment to 5.0%
• If LIBOR falls below 5.00% then Trident would pay the FRA seller a cash
amount increasing their LIBOR payment to 5.00%
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INTEREST RATE FUTURES
Interest Rate futures are widely used; their popularity stems from high liquidity of
interest rate futures markets, simplicity in use, and the rather standardized interest
rate exposures firms posses
Traded on an exchange; two most common are the Chicago Mercantile Exchange
(CME) and the Chicago Board of Trade (CBOT)
The yield is calculated from the settlement price
• Example: March ’03 contract with settlement price of 94.76 gives an annual
yield of 5.24% (100 – 94.76)
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INTEREST RATE FUTURES
If Trident wanted to hedge a floating rate payment due in March ’03 it would sell a
futures contract, or short the contract
• If interest rates rise, the futures price will fall and Trident can offset its
interest payment with the proceeds from the sale of the futures contracts
• If interest rates rise, the futures price will rise and the savings from the
interest payment due will offset the losses from the sale of the futures
contracts
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STRATEGIES USING INTEREST RATE FUTURES
Exposure or Position Futures Action Interest Rates Position Outcome
Paying interest on futures date Sell a futures (short) If rates go up Futures price falls;
Short earns profit
If rates go down Futures price rises;

short earns a loss
Earning interest on futures date Buy a futures (long) If rates go up Futures price falls;
Long earns a loss
If rates go down Futures price rises;

Long earns profit
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INTEREST RATE SWAPS
Swaps are contractual agreements to exchange or swap a series of cash flows

If the agreement is for one party to swap its fixed interest payment for a floating rate
payment, its is termed an interest rate swap
If the agreement is to swap currencies of debt service it is termed a currency swap
A single swap may combine elements of both interest rate and currency swap
The swap itself is not a source of capital but an alteration of the cash flows
associated with payment
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INTEREST RATE SWAPS
If firm thought that rates would rise it would enter into a swap agreement to pay
fixed and receive floating in order to protect it from rising debt-service payments
If firm thought that rates would fall it would enter into a swap agreement to pay
floating and receive fixed in order to take advantage of lower debt-service payments
The cash flows of an interest rate swap are interest rates applied to a set amount of
capital, no principal is swapped only the coupon payments
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TRIDENT CORPORATION:
SWAPPING TO FIXED RATES
Maria Gonzalez (Trident’s CFO) is concerned about the floating rate loan
• Maria thinks that rates will rise over the life of the loan and wants to
protect Trident from an increased interest payment
• Maria believes that an interest rate swap to pay fixed/receive floating would
be Trident’s best alternative
• Maria contacts the bank and receives a quote of 5.75% against LIBOR; this
means that Trident will receive LIBOR and pay out 5.75% for the three
years
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The swap does not replace the original loan, Trident must still make its payments at
the original rates; the swap only supplements the loan payments
Trident’s 1.50% fixed rate above LIBOR must still be paid along with the 5.75% as per
the swap agreement; however, Trident now receives LIBOR thus offsetting the
floating rate risk in the original loan
Trident’s total payment will therefore be 7.25% (5.75% + 1.50%)
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TRIDENT CORP:
SWAPPING DOLLARS INTO SWISS FRANCS
After raising the $10 million in floating rate financing and swapping into fixed rate
payments, Trident decides it would prefer to make its debt-service payments in
Swiss francs
• Trident signed a 3-year contract with a Swiss buyer, thus providing a
stream of cash flows in Swiss francs
Trident would now enter into a three-year pay Swiss francs and receive US dollars
currency swap
• Both interest rates are fixed
• Trident will pay 2.01% (ask rate) fixed Sfr interest and receive 5.56% (bid
rate) fixed US dollars
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TRIDENT CORP:
I MBA
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115
TRIDENT CORP:
The spot rate in effect on the date of the agreement establishes what the notional
principal is in the target currency
• In this case, Trident is swapping into francs, at Sfr1.50/$.
• This is a notional amount of Sfr15,000,000. Thus Trident is committing to
payments of Sfr301,500 (2.01% × Sfr15,000,000 = Sfr301,500)
• Unlike an interest rate swap, the notional amounts are part of the swap
agreement
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TRIDENT CORP:
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UNWINDING SWAPS
As with the original loan agreement, a swap can be entered or unwound if

viewpoints change or other developments occur
Assume that the three-year contract with the Swiss buyer terminates after one year,
Trident no longer needs the currency swap
Unwinding a currency swap requires the discounting of the remaining cash flows
under the swap agreement at current interest rates then converting the target
currency back to the home currency
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UNWINDING SWAPS
If Trident has two payments of Sfr301,500 and Sfr15,301,500 remaining (interest plus
principal in year three) and the 2 year fixed rate for francs is now 2.00%, the PV of
Trident’s commitment is francs is
Sfr301,500 Sfr15,301,500
PV(Sfr) = 1
+ 2
= Sfr15,002,912
(1.020) (1.020)
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UNWINDING SWAPS
At the same time, the PV of the remaining cash flows on the dollar-side of the swap
is determined using the current 2 year fixed dollar rate which is now 5.50%
$556,000 $10,556,000
PV(US$) = 1
+ 2
= $10,011,078
(1.055) (1.055)
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UNWINDING SWAPS
Trident’s currency swap, if unwound now, would yield a PV of net inflows of

$10,011,078 and a PV of net outflows of Sfr15,002,912. If the current spot rate is
Sfr1.4650/$ the net settlement of the swap is
Sfr15,002,912
Settlement = $10,011,078 = = ($229,818)
Sfr1.4650/$
Trident makes a cash payment to the swap dealer of $229,818 to terminate the swap
• Trident lost on the swap due to franc appreciation
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COUNTERPARTY RISK
Counterparty Risk is the potential exposure any individual firm bears that the second
party to any financial contract will be unable to fulfill its obligations
A firm entering into a swap agreement retains the ultimate responsibility for its debt-
service
In the event that a swap counterpart defaults, the payments would cease and the
losses associated with the failed swap would be mitigated
The real exposure in a swap is not the total notional principal but the mark-to-market
value of the differentials
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A THREE-WAY CROSS CURRENCY SWAP
Sometimes firms enter into loan agreements with a swap already in mind, thus
creating a debt issuance coupled with a swap from its inception
• Example: the Finnish Export Credit agency (FEC), the Province of Ontario,
Canada and the Inter-American Development Bank (IADB) all possessed
access to ready sources capital but wished debt service in another market
• FEC had not raised capital in Canadian dollar Euromarkets and an
issuance would be well received; however the FEC had a need for
increased debt-service in US dollars, not Canadian dollars
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• Province of Ontario needed Canadian dollars but due to size of provincial

borrowings knew that issues would push up its cost of funds; there was
however an attractive market in US dollars
• IADB had a need for additional US dollar denominated debt-service;
however it already raised most of its debt in the US markets but was a
welcome newcomer in the Canadian dollar market
Each borrower determined its initial debt amounts and maturities expressly with the
needs of the swap
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C$300 Province of Ontario C$150

million (Canada) million
$260 $130
million million
Borrows $390 million
at US Treasury + 48 bp
Finish Export Credit Inter-American

(Finland) Development Bank
Borrows C$300 million Borrows C$150 million

at Canadian Treasury + 47 bp at Canadian Treasury + 44 bp
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AGENDA
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FOREIGN CURRENCY DERIVATIVES (I)
Financial management in the 21st century needs to consider the use of financial
derivatives.
These derivatives, so named because their values are derived from the underlying
asset, are a powerful tool used for two distinct management objectives:
• Speculation – the financial manager takes a position in the expectation
of profit.
• Hedging – the financial manager uses the instruments to reduce the risks
of the corporation’s cash flow.
In the wrong hands, derivatives can cause a corporation to collapse (Barings, Allied
Irish Bank), but used wisely they allow a financial manager the ability to plan cash
flows.
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FOREIGN CURRENCY DERIVATIVES (II)
The financial manager must first understand the basics of the structure and pricing
of these tools.
The derivatives that will be discussed will be
• Foreign Currency Futures
• Foreign Currency Options
A foreign currency futures contract is an alternative to a forward contract

• It calls for future delivery of a standard amount of currency at a fixed time
and price.
• These contracts are traded on exchanges with the largest being the
International Monetary Market located in the Chicago Mercantile Exchange.
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FOREIGN CURRENCY FUTURES (I)
Contract Specifications
• Size of contract – called the notional principal, trading in each currency
must be done in an even multiple.
• Method of stating exchange rates – “American terms” are used; quotes are
in US dollar cost per unit of foreign currency, also known as direct quotes.
• Maturity date – contracts mature on the 3rd Wednesday of January, March,
April, June, July, September, October or December.
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FOREIGN CURRENCY FUTURES (II)
• Last trading day – contracts may be traded through the second business
day prior to maturity date.
• Collateral & maintenance margins – the purchaser or trader must deposit
an initial margin or collateral; this requirement is similar to a performance
bond.
- At the end of each trading day, the account is marked to market and
the balance in the account is either credited if value of contracts is
greater or debited if value of contracts is less than account balance.
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FOREIGN CURRENCY FUTURES (III)
• Settlement – only 5% of futures contracts are settled by physical delivery,
most often buyers and sellers offset their position prior to delivery date.
- The complete buy/sell or sell/buy is termed a round turn.
• Commissions – customers pay a commission to their broker to execute a
round turn and only a single price is quoted.
• Use of a clearing house as a counterparty – All contracts are agreements
between the client and the exchange clearing house. Consequently clients
need not worry about the performance of a specific counterparty since the
clearing house is guaranteed by all members of the exchange.
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USING FOREIGN CURRENCY FUTURES (I)
Any investor wishing to speculate on the movement of a currency can pursue one of
the following strategies
• Short position – selling a futures contract based on view that currency will
fall in value.
• Long position – purchase a futures contract based on view that currency
will rise in value.
• Example: Amber McClain believes that Mexican peso will fall in value
against the US dollar, she looks at quotes in the WSJ for Mexican
peso futures.
Her perspective:
Selling peso at a time
in future, fixing an
exchange rate against
a peso fall in value
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USING FOREIGN CURRENCY FUTURES (II)
Maturity Open High Low Settle Change High Low Open Interest
Mar .10953 .10988 .10930 .10958 --- .11000 .09770 34,481
June .10790 .10795 .10778 .10773 --- .10800 .09730 3,405
Sept .10615 .10615 .10610 .10573 --- .10615 .09930 1,4181
All contracts are for 500,000 new Mexican pesos. “Open,” “High” and
“Low” all refer to the price on the day. “Settle” is the closing price on the
day and “Change” indicates the change in the settle price from the
previous day. “High” and “Low” to the right of Change indicates the
highest and lowest prices for this specific contact during its trading
history. “Open Interest” indicates the number of contracts outstanding.
Source: Wall Street Journal, February 22, 2002, p.C13
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USING FOREIGN CURRENCY FUTURES (III)
Example (cont.): Amber believes that the value of the peso will fall, so she sells a
March futures contract.
By taking a short position on the Mexican peso, Amber locks-in the right to sell
500,000 Mexican pesos at maturity at a set price above their current spot price.
Using the quotes from the table, Amber sells one March contract for 500,000
pesos at the settle price: $.10958/Ps.
Value at maturity (Short position) = -Notional principal × (Spot – Forward)
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USING FOREIGN CURRENCY FUTURES (IV)
To calculate the value of Amber’s position we use the following formula
Value at maturity (Short position) = -Notional principal × (Spot – Forward)
Using the settle price from the table and assuming a spot rate of $.09500/Ps at
maturity, Amber’s profit is
Value = -Ps 500,000 × ($0.09500/ Ps - $.10958/ Ps) = $7,290
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USING FOREIGN CURRENCY FUTURES (V)
If Amber believed that the Mexican peso would rise in value, she would take a long
position on the peso
Value at maturity (Long position) = Notional principal × (Spot – Forward)
Using the settle price from the table and assuming a spot rate of $.11000/Ps at
maturity, Amber’s profit is
Value = Ps 500,000 × ($0.11000/ Ps - $.10958/ Ps) = $210
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FOREIGN CURRENCY FUTURES VERSUS
FORWARD CONTRACTS
Characteristic Foreign Currency Futures Forward Contracts

Size of Contract Standardized contracts per currency any size desired
Maturity fixed maturities, longest typically any maturity up to one
being one year year, sometimes longer
Location trading occurs on organized exchange trading occurs between
individuals and banks
Pricing open outcry process on exchange floor prices are determined
by bid/ask quotes
Margin/Collateral initial margin that is marked to market no explicit collateral
on a daily basis
Settlement rarely delivered, settlement normally takes contract is delivered
place through purchase of offsetting position upon, can offset position
Commissions single commission covers purchase& sell no explicit commissions;
banks earn money
through bid/ask spread
Trading hours traditional exchange hours markets open 24 hours
Counterparties unknown, go through clearing house parties in direct contact
Liquidity liquid but relatively small liquid and relatively large
in total sales volume and value in sales volume
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FOREIGN CURRENCY OPTIONS (I)
A foreign currency option is a contract giving the purchaser of the option the right to
buy or sell a given amount of currency at a fixed price per unit for a specified time
period.
• The most important part of clause is the “right, but not the obligation”
to take an action.
• Two basic types of options, calls and puts
- Call – buyer has right to purchase currency.
- Put – buyer has right to sell currency.
• The buyer of the option is the holder and the seller of the option is
termed the writer.
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FOREIGN CURRENCY OPTIONS (II)
Every option has three different price elements:

• The strike or exercise price is the exchange rate at which the foreign
currency can be purchased or sold.
• The premium, the cost, price or value of the option itself paid at time
option is purchased.
• The underlying or actual spot rate in the market.
There are two types of option maturities:
• American options may be exercised at any time during the life of the
option.
• European options may not be exercised until the specified maturity date.
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FOREIGN CURRENCY OPTIONS (III)
Options may also be classified as per their payouts:

• At-the-money (ATM) options have an exercise price equal to the spot rate
of the underlying currency.
• In-the-money (ITM) options may be profitable, excluding premium costs , if
exercised immediately.
• Out-of-the-money (OTM) options would not be profitable, excluding the
premium costs, if exercised.
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FOREIGN CURRENCY OPTIONS MARKETS (I)
The increased use of currency options has lead the creation of several markets
where financial managers can access these derivative instruments:
• Over-the-Counter (OTC) Market – OTC options are most frequently written
by banks for US dollars against British pounds, Swiss francs, Japanese
yen, Canadian dollars and the euro
- Main advantage is that they are tailored to purchaser.
- Counterparty risk exists.
- Mostly used by individuals and banks.
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FOREIGN CURRENCY OPTIONS MARKETS (II)
• Organized Exchanges – similar to the futures market, currency options

are traded on an organized exchange floor:
- The Chicago Mercantile and the Philadelphia Stock Exchange
serve options markets.
- Clearinghouse services are provided by the Options
Clearinghouse Corporation (OCC).
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FOREIGN CURRENCY OPTIONS MARKETS (III)
Table shows option prices on Swiss franc taken from the Wall Street Journal
Calls - Last Puts - Last
Options &
Underlying Strike Price Aug Sep Dec Aug Sep Dec
58.51 56 -- -- 2.76 0.04 0.22 1.16
58.51 56 1/2 -- -- -- 0.06 0.30 --
58.51 57 1.13 -- 1.74 0.10 0.38 1.27
58.51 57 1/2 0.75 -- -- 0.17 0.55 --
58.51 58 0.71 1.05 1.28 0.27 0.89 1.81
58.51 58 1/2 0.50 -- -- 0.50 0.99 --
58.51 59 0.30 0.66 1.21 0.90 1.36 --
Each option = 62,500 Swiss francs. The August, September and December listings are the option maturity dates
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FOREIGN CURRENCY OPTIONS MARKETS (IV)
• The spot rate means that 58.51 cents, or $0.5851 was the price of one
Swiss franc.
• The strike price means the price per franc that must be paid for the option.
The August call option of 58 ½ means $0.5850/Sfr.
• The premium, or cost, of the August 58 ½ option was 0.50 per franc, or
$0.0050/Sfr
- For a call option on 62,500 Swiss francs, the total cost would be
Sfr62,500 x $0.0050/Sfr = $312.50.
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FOREIGN CURRENCY SPECULATION (I)
Speculating in the spot market

• Hans Schmidt is a currency speculator. He is willing to risk his money
based on his view of currencies and he may do so in the spot, forward or
options market.
• Assume Hans has $100,000 and he believes that the six month spot for
Swiss francs will be $0.6000/Sfr.
- Speculation in the spot market requires that view is currency
appreciation.
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FOREIGN CURRENCY SPECULATION (II)
Speculating in the spot market

• Hans should take the following steps.
• Use the $100,000 to purchase Sfr170,910.96 today at a spot rate of
$0.5851/Sfr.
• Hold the francs indefinitely, because Hans is in the spot market he is not
committed to the six month target.
• When target exchange rate is reached, sell the Sfr170,910.96 at new spot
rate of $0.6000/Sfr, receiving Sfr170,910.96 x $0.6000/Sfr = $102,546.57.
• This results in a profit of $2,546.57 or 2.5% ignoring cost of interest income
and opportunity costs.
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FOREIGN CURRENCY SPECULATION (III)
Speculating in the forward market

• If Hans were to speculate in the forward market, his viewpoint would be
that the future spot rate will differ from the forward rate.
• Today, Hans should purchase Sfr173,611.11 forward six months at the
forward quote of $0.5760/Sfr. This step requires no cash outlay.
• In six months, fulfill the contract receiving Sfr173,611.11 at $0.5760/Sfr at
a cost of $100,000.
• Simultaneously sell the Sfr173,611.11 in the spot market at Hans’ expected
spot rate of $0.6000/Sfr, receiving Sfr173,611.11 x $0.6000/Sfr =
$104,166.67.
• This results in a profit of $4,166.67 with no investment required.
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FOREIGN CURRENCY SPECULATION (IV)
Speculating in the options market

• If Hans were to speculate in the options market, his viewpoint would
determine what type of option to buy or sell.
• As a buyer of a call option, Hans purchases the August call on francs at a
strike price of 58 ½ ($0.5850/Sfr) and a premium of 0.50 or $0.0050/Sfr.
• At spot rates below the strike price, Hans would not exercise his option
because he could purchase francs cheaper on the spot market than via his
call option.
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FOREIGN CURRENCY SPECULATION (V)

• Hans’ only loss would be limited to the cost of the option, or the premium
($0.0050/Sfr).
• At all spot rates above the strike of 58 ½ Hans would exercise the option,
paying only the strike price for each Swiss franc.
- If the franc were at 59 ½, Hans would exercise his options buying
Swiss francs at 58 ½ instead of 59 ½.
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FOREIGN CURRENCY SPECULATION (VI)

• Hans could then sell his Swiss francs on the spot market at 59 ½ for a
profit
Profit = Spot rate – (Strike price + Premium)
= $0.595/Sfr – ($0.585/Sfr + $0.005/Sfr)
= $0.005/Sfr
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FOREIGN CURRENCY SPECULATION (VII)

• Hans could also wait to see if the Swiss franc appreciates more, this is
the value to the holder of a call option – limited loss, unlimited upside.
• Hans’ break-even price can also be calculated by combining the premium
cost of $0.005/Sfr with the cost of exercising the option, $0.585/Sfr.
- This matched the proceeds from exercising the option at a price of
$0.590/Sfr.
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PROFIT & LOSS FOR THE BUYER OF A CALL OPTION
“At the money”

Profit
Strike price
(US cents/SF)
“Out of the money” “In the money”
+ 1.00
+ 0.50
Unlimited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Limited loss
- 0.50
Break-even price
- 1.00
Loss
The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50
cents/SF at spot rates less than 58.5 (“out of the money”), and an unlimited profit potential at
spot rates above 58.5 cents/SF (“in the money”).
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FOREIGN CURRENCY SPECULATION (VIII)

• Hans could also write a call, if the future spot rate is below 58 ½, then the
holder of the option would not exercise it and Hans would keep the
premium.
• If Hans went uncovered and the option was exercised against him, he
would have to purchase Swiss francs on the spot market at a higher
rate than he is obligated to sell them at.
• Here the writer of a call option has limited profit and unlimited losses if
uncovered.
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FOREIGN CURRENCY SPECULATION (IX)

• Hans’ payout on writing a call option would be
Profit = Premium – (Spot rate - Strike price)
= $0.005/Sfr – ($0.595/Sfr + $0.585/Sfr)
= - $0.005/Sfr
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PROFIT & LOSS FOR THE WRITER OF A CALL OPTION
“At the money”
Profit
Strike price
(US cents/SF)
+ 1.00
+ 0.50 Break-even price

Limited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
- 0.50 Unlimited loss
- 1.00
Loss
The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited profit
of 0.50 cents/SF at spot rates less than 58.5, and an unlimited loss potential at spot rates
above (to the right of) 59.0 cents/SF.
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FOREIGN CURRENCY SPECULATION (XI)

• Hans could also buy a put, the only difference from buying a call is that
Hans now has the right to sell currency at the strike price.
• If the franc drops to $0.575/Sfr Hans will deliver to the writer of the put
and receive $0.585/Sfr.
• The francs can be purchased on the spot market at $0.575/Sfr.
• With the cost of the option being $0.005/Sfr, Hans realizes a net gain
of $0.005/Sfr.
• As with a call option - limited loss, unlimited gain.
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FOREIGN CURRENCY SPECULATION (XII)

• Hans’ payout on buying a put option would be
Profit = Strike price – (Spot rate + Premium)
= $0.585/Sfr – ($0.575/Sfr + $0.005/Sfr)
= $0.005/Sfr
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PROFIT & LOSS FOR THE BUYER OF A PUT OPTION
“At the money”

Profit
Strike price
(US cents/SF)
“In the money” “Out of the money”
+ 1.00
+ 0.50 Profit up
to 58.0
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Limited loss
- 0.50
Break-even
price
- 1.00
Loss
The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of
0.50 cents/SF at spot rates greater than 58.5 (“out of the money”), and an unlimited profit
potential at spot rates less than 58.5 cents/SF (“in the money”) up to 58.0 cents.
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FOREIGN CURRENCY SPECULATION (XIII)

• And of course, Hans could write a put, thereby obliging him to purchase
francs at the strike price.
• If the franc drops below 58 ½ Hans will lose more than the premium
received.
• If the spot rate does not fall below 58 ½ then the option will not be
exercised and Hans will keep the premium from the option.
• As with a call option - unlimited loss, limited gain.
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FOREIGN CURRENCY SPECULATION (XIV)

• Hans’ payout on writing a put option would be
Profit = Premium – (Strike price - Spot rate)
= $0.005/Sfr – ($0.585/Sfr + $0.575/Sfr)
= - $0.005/Sfr
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PROFIT & LOSS FOR THE WRITER OF A PUT OPTION
“At the money”

Profit
Strike price
(US cents/SF)
+ 1.00
Break-even
+ 0.50 price
Limited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
- 0.50
Unlimited loss
- 1.00 up to 58.0
Loss
The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of
0.50 cents/SF at spot rates greater than 58.5, and an unlimited loss potential at spot rates
less than 58.5 cents/SF up to 58.0 cents.
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OPTION PRICING AND VALUATION (I)
The pricing of any option combines six elements

• Present spot rate, $1.70/£.
• Time to maturity, 90 days.
• Forward rate for matching maturity (90 days), $1.70/£.
• US dollar interest rate, 8.00% p.a.
• British pound interest rate, 8.00% p.a.
• Volatility, the standard deviation of daily spot rate movement, 10.00% p.a.
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OPTION PRICING AND VALUATION (II)
The intrinsic value is the financial gain if the option is exercised immediately (at-
the-money)
• This value will reach zero when the option is out-of-the-money.
• When the spot rate rises above the strike price, the option will be in-
the-money.
• At maturity date, the option will have a value equal to its intrinsic value.
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OPTION PRICING AND VALUATION (III)
When the spot rate is $1.74/£, the option is ITM and has an intrinsic value of $1.74 -
$1.70/£, or 4 cents per pound.
When the spot rate is $1.70/£, the option is ATM and its intrinsic value is $1.70 -
$1.70/£, or zero cents per pound.
When the spot rate is $1.66/£, the option is OTM and has no intrinsic value, only a
fool would exercise this option.
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OPTION PRICING AND VALUATION (IV)
Option Premium Strike Price of $1.70/£

(US cents/£)
-- Valuation on first day of 90-day maturity --
6.0
5.67
Total value
5.0
4.0 4.00
3.30
3.0
2.0 1.67
Time value Intrinsic
1.0
value
0.0
1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74
Spot rate ($/£)

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OPTION PRICING AND VALUATION (V)
The time value of the option exists because the price of the underlying currency can
potentially move further into the money between today and maturity
• In the exhibit, time value is shown as the area between total value and
intrinsic value.
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OPTION PRICING AND VALUATION (VI)
Option volatility is defined as the standard deviation of the daily percentage changes
in the underlying exchange rate
• It is the most important variable because of the exchange rate’s perceived
likelihood to move either in or out of the range in which the option would
be exercised.
• Volatility is stated per annum.
• Example: 12.6% p.a. volatility would have to be converted for a single day
as follows.
12.6% 12.6%
= = 0.66% daily volatility
365 19.105
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OPTION PRICING AND VALUATION (VII)
For our $1.70/£ call option, an increase in annual volatility of 1 percentage point will
increase the option premium from $0.033/£ to $0 .036/£
• The marginal change in option premium is equal to the change in option
premium itself divided by the change in volatility.
Δ premium $0.036 − $0.033

= = 0.30
Δ volatility .11 − .10
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OPTION PRICING AND VALUATION (VIII)
The primary problem with volatility is that it is unobservable, there is no single

correct method for its calculation.
Thus, volatility is viewed in three ways
• Historic – normally measured as the percentage movement in the spot
rate on a daily basis, or other time period.
• Forward-looking – a trader may adjust recent historic volatilities for
expected market swings.
• Implied – calculated by backing out of the market option premium.
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Cº - Imba International Finance (E) Part 5 Lecture

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Cº - Imba International Finance (E) Part 5 Lecture

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Part 5 International Financing

Part 1 Global Economics

Part 2 International Accounting

Part 3 Corporate Governance

Part 4 International Investing

Part 5 International Financing

Part 6 Global Value Creating Management

Part 7 Current Topics

Part 5 International Financing

Chapter 5.1 Global Cost & Availability of Capital

Chapter 5.2 Sourcing Equity Globally

Chapter 5.3 Financial Structure & International Debt

Chapter 5.4 Interest Rate & Currency Swaps

Chapter 5.5 Foreign Currency Derivatives

A national capital market is segmented if the required rate of return on securities

Firm’s securities appeal only Firm’s securities appeal to

Market Liquidity for Firm’s Securities

Illiquid domestic securities market Highly liquid domestic market and

Effect of Market Segmentation on Firm’s Securities and Cost of Capital

Segmented domestic securities Access to global securities market

k WACC = 17.00%(0.60) +8.00%(1 − 0.35)(0.40)

A national capital market is segmented if the required rate of return on securities

Firm’s securities appeal only Firm’s securities appeal to

Market Liquidity for Firm’s Securities

Illiquid domestic securities market Highly liquid domestic market and

Effect of Market Segmentation on Firm’s Securities and Cost of Capital

Segmented domestic securities Access to global securities market

k WACC = 17.00%(0.60) +8.00%(1 − 0.35)(0.40)

Although no consensus exists on the definition of market liquidity, market liquidity

Capital market segmentation is a financial market imperfection caused mainly by

Illustrative case of a Danish multinational that sought to internationalize its capital

Financial, Foreign exchange and political risks

The Road to Globalization

The Road to Globalization

The Road to Globalization

The most important imperfections are asymmetric information, transaction costs,

Although no consensus exists on the definition of market liquidity, market liquidity

Capital market segmentation is a financial market imperfection caused mainly by

Marginal cost of capital

Illustrative case of a Danish multinational that sought to internationalize its capital

Financial, Foreign exchange and political risks

The Road to Globalization

The Road to Globalization

The Road to Globalization

Marginal cost of capital

Is MNEwacc > or < Domesticwacc ?

Part 5 International Financing

Chapter 5.1 Global Cost & Availability of Capital

Chapter 5.2 Sourcing Equity Globally

Chapter 5.3 Financial Structure & International Debt

Chapter 5.4 Interest Rate & Currency Swaps

Chapter 5.5 Foreign Currency Derivatives

Domestic Financial Market Operations

International Bond Issue --

International Bond Issue --

Equity Listings -- Less Liquid Markets

Equity Issue -- Less Liquid Markets

Equity Listing -- Target Market

Euro equity Issue -- Global Markets

Shares Shares held on deposit Receipts

Publicly traded firm Receipts for shares