TOPIC ONE

AN OVERVIEW OF MULTINATIONAL AND INTERNATIONAL FINANCE

HISTORY OF MULTI-NATIONAL COMPANIES

Multi-national Companies (MNCs) are large companies that operate in several countries at
the same time. The first MNCs were established in the 1920s. Many more came up in the
1950s and 1960s as US businesses expanded worldwide and Western Europe and Japan also
recovered to become powerful industrial economies. The worldwide spread of MNCs was a
notable feature of 1950s and 1960s. This was partly because high import tariffs imposed by
different governments forced MNCs to locate their manufacturing operations and become’
domestic producers ‘in as many countries as possible.
THE MEANING OF MULTI-NATIONAL COMPANIES
A multi-national corporation (MNC) or multi-national enterprise (MNE) is
corporation that is registered in more than one country or that has operation in more than one
country. It can also be referred to as an international corporation. They play an important
role in globalization. The first multinational corporation was the Dutch East India Company,
founded March 20, 1602.
TOP TEN MULTI-NATIONAL COMPANIES IN THE WORLD
✓ Apple Inc.
✓ IBM
✓ McDonalds corp.
✓ Amazon.com Inc.
✓ Caterpillar Inc.
✓ 3m Company
✓ United parcel service
✓ Coca-Cola
✓ Nestle
✓ Intel Corp

GLOBALIZATION
Multi-national corporations are important factors in the processes of globalization. National
and local governments often compete against one another to attract MNC facilities, with the

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expectation of increased tax revenue, employment, and economic activity. To compete,
political entities may offer MNCs incentives such as tax breaks, pledges of governmental
assistance or subsidized infrastructure, or lax environmental and labor regulations. These
ways of attracting foreign investment may be criticized as a race to the bottom, a push
towards greater autonomy for corporations, or both. MNCs play an important role in
developing the economies of developing countries like investing in these countries provide
market to the MNC but provide employment, choice of multi goods etc.
On the other hand, economist Jagdish Bhagwati has argued that in countries with
comparatively low labor costs and weak environmental and social protection, multinationals
actually bring about a 'race to the top.' While multinationals will certainly see a low tax
burden or low labor costs as an element of comparative advantage, Bhagwati disputes the
existence of evidence suggesting that MNCs deliberately avail themselves of lax
environmental regulation or poor labor standards. As Bhagwati has pointed out, MNC profits
are tied to operational efficiency, which includes a high degree of standardization. Thus,
MNCs are likely to adapt production processes in many of their operations to conform to the
standards of the most rigorous jurisdiction in which they operate (this tends to be the USA,
Japan, or the EU). Depending on the nature of the MNC, investment in any country reflects a
desire for a medium- to long-term return, as establishing plant, training workers, etc., can be
costly. Once established in a jurisdiction, therefore, MNCs are potentially vulnerable to
arbitrary government intervention such as expropriation, sudden contract renegotiation, the
arbitrary withdrawal or compulsory purchase of licenses, etc. Thus, both the negotiating
power of MNCs and the 'race to the bottom' critique may be overstated, while understating
the benefits (besides tax revenue) of MNCs becoming established in a jurisdiction.

FORMATION OF MULTI-NATIONAL COMPANIES

A multinational corporation is thought to be a giant business entity with operations in dozens
of countries. However, the minimum requirement for a corporation to be considered
multinational is that it operates at least three different countries. This is generally
accomplished by means of establishing a parent corporation and then establishing subsidiary
corporations in other countries that are majority- or wholly owned by the parent corporation.
Multinational companies are the enterprises or organizations that manage production or offer
services in more than one country. India has been the home to a number of multinational
companies. Indeed, since the financial liberalization in the country in 1991, the number of
multinational companies in India has increased noticeably.

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MERIT AND DEMERIT OF MULTI-NATIONAL COMPANIES
Merit of MNCs for the host country:
➢ The investment level, employment level and income levels of the host county
increases due to the operation of MNC’s.
➢ . The industries of host country get latest technology from foreign countries through
MNCs and the host country’s businesses also get management expertise through
MNCs.
➢ The domestic traders and market intermediaries of the host country gets increased
business from the operation of MNC’s.
➢ MNC’s break protectionism, curb local monopolies, create competition among
domestic companies and thus enhance their competitiveness.
➢ The host country can reduce imports and increase exports due to goods produced by
MNC’s in the host country. This helps to improve balance of payment.
➢ Level of industrial and economic development increases due to the growth of MNC’s
in the host country.
Merit of MNCs for the home country:
➢ MNC’s create opportunities for marketing the products produced in the home country
throughout the world.
➢ They create employment opportunities to the people of home country both at home
and abroad.
➢ It gives a boost to the industrial activities of home country.
➢ MNC’s help to maintain favorable balance of payment of the home country in the
long run.
➢ Home country can also get the benefit of foreign culture brought by MNC‘s.

Demerit of MNCs for the host country:

➢ MNC’s may transfer technology which has become outdated in the home country.
➢ As MNC’s do not operate within the national autonomy, they may pose a threat to
the economic and political sovereignty of host countries.
➢ MNC’s may kill the domestic industry by monopolizing the host country’s market.
➢ In order to make profit, MNC’s may use natural resources of the home country
indiscriminately and cause depletion of the resources.

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 ➢ A large sum of money flows to foreign countries in terms of payments towards
profits, dividends and royalty.

Demerit of MNCs for the home country:

➢ MNC’s transfer the capital from the home country to various host countries causing
unfavorable balance of payment.
➢ MNC’s may not create employment opportunities to the people of home country if it
adopts geocentric approach.
➢ As investment in foreign countries is more profitable, MNC’s may neglect the home
countries industrial and economic development.

INTERNATIONAL FINANCIAL MANAGEMENT

DEFINITION
International Finance is an area of financial economics that deals with monetary interactions
between two or more countries, concerning itself with topics such as currency exchange rates,
international monetary systems, foreign direct investment, and issues of international
financial management including political risk and foreign exchange risk inherent in managing
multinational corporations.

International Finance research concerns itself with macroeconomics, dealing with economies
as whole rather than individual markets. The World Bank, its subsidiary, the International
Finance Corporation (IFC) and the International Monetary Fund, as well as the National
Bureau of Economic Research (NBER) conduct international finance research. Most Central
Banks have International Finance divisions that do policy analysis that is relevant to the
respective countries’ external trade and capital flow and development of international
markets.

Firms continually devise strategies to improve cash flow necessary to enhance shareholder
wealth. What are these strategies? Some strategies involve penetrating foreign markets

• Foreign markets
– Distinctly different from local market.
– Offer opportunities for improving cash flows.
– Recently barriers of entering foreign markets removed.

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 – This has encouraged international business.
– Many firms have therefore evolved into Multinational Corporations (MNCs).
• Initially, firms may engage in international business merely through the export and
import of products and/ or supplies.

• Over time as they recognise additional foreign opportunities they eventually establish
subsidiaries in foreign countries in order to tap those opportunities. MNCs such as
Colgate-Palmolive, Coca-Cola, ExxonMobil, Ford, Pepsi, Apple, Shell, Toyota,
Nissan, Hyundai, and Nokia generate more than 50% of their sales from outside
countries. Meanwhile they have become Blue Chip Companies

Understanding of International Financial Management is very crucial to be able to

manage multinational firms in businesses across borders.

– It not only to the large multinational firms (MNCs).

– But also to small firms conducting international business.

– And to businesses that are local but deal with multinationals

• International financial management equally is important to companies with no

international business because these companies must recognize how their foreign
competitors are affected by:

• Movements in exchange rates

• Foreign interest rates

• Labour costs

• Inflation and other monetary factors. It is so because:

• Such economic characteristics can affect the foreign competitors’ costs of production
and pricing policies.

• Companies must also recognize how domestic competitors that obtain foreign
supplies or foreign financing will be affected by economic conditions in foreign
countries that they operate or come from.

• Domestic competitors may reduce their costs by capitalizing on opportunities in

international markets.
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MULTINATIONAL CORPORATION (MNC) – defined

For the purposes of this course, we refer to a Multinational Corporation as one controlled by
one headquarters but operations spread over many countries.

Goals of the MNC

• The commonly accepted goal of an MNC is to maximize shareholder wealth.

• Note that some MNCs may want to satisfy the goals of the following stakeholders:
– Governments
– Banks
– Employees
Constraints interfering with the MNC’s Goal

• Multinationals firms’ managers attempt to maximize their firm’s value, subject to

various constraints which usually include the following:
– Environmental constraints.
– Regulatory constraints.
– Ethical constraints.
Constraints interfering with the MNC’s Goal

– Environmental constraints.
• building codes
• -disposal of waste materials
• -pollution controls etc.
– Regulatory constraints.
• Taxes
• Currency convertibility rules
• Earnings remittance restrictions
– Ethical constraints.

• No consensus standard of business conduct applies to all countries

• What is ethical in one country may be unethical or illegal in another

country

• The dilemma faced by companies is if they do not practice that, they

may be at a competitive disadvantage.

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Theories of International Business

• The commonly held theories as to why firms become motivated to expand their
business internationally include
– The theory of comparative advantage
– The imperfect markets theory
– The product cycle theory

INTTERNATIONAL BUSINESS METHODS

Common methods used by firms to conduct international business include the following
International trade options:

· Licensing

· Franchising

· Joint ventures

· Acquisitions of existing operations

· Establishing new foreign subsidiaries

International trade is a relatively conservative approach involving exporting and/or

importing. Advantages of exporting in international business

– Capital requirements and start-up costs minimal

– Risk is low
– Profits are immediate
– Initial step provides the opportunity to learn about present and future supply
and demand conditions, competition, and channels of distribution, payment
conventions, financial institutions and financial techniques.
– If firm experiences decline in exporting or importing, it can discontinue this
part of its business at low cost
• Licensing allows a firm to provide its technology in exchange for fees or some other
benefits.

• Advantages

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 – Minimal investment

– Faster market-entry time

– Fewer financial and legal risks involved

• Disadvantages

– Cash flow relatively low

– There may be problems in maintaining product quality standards

– There may be difficulty controlling exports by the foreign licensee

• Franchising obligates a firm to provide specialized sales or service strategy, support

assistance, and possibly an initial investment in the franchise in exchange for periodic
fees.

• Firms may also penetrate foreign markets by engaging in a joint venture (joint
ownership and operation) with firms that reside in those markets.

• Acquisitions of existing operations in foreign countries allow firms to quickly gain

control over foreign operations as well as a share of the foreign market.

• Firms can also penetrate foreign markets by establishing new foreign subsidiaries.

In general, any method of conducting business that requires a direct investment in foreign
operations is referred to as a direct foreign investment (DFI). The optimal international
business method may depend on the characteristics of the MNC.

DEGREE OF INTERNATIONAL BUSINESS BY MNCS

Foreign Sales as a % of Total Sales

Foreign Assets as a % of Total Assets

70% 66%
62%
58%
60%
46% 50%
50% 47%
40%
EXPOSURE TO INTERNATIONAL RISK
40% 33%
International
30% 26%usually increases a MNC’s exposure to:
business
20% 12%
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10%

0%
Campbell's Soup IBM Nike
  exchange rate movements
– Exchange rate fluctuations affect cash flows and foreign demand.
 foreign economic conditions
– Economic conditions affect demand.
 political risk
– Political actions affect cash flows.

Managing for Value

• Like domestic projects, foreign projects involve an investment decision and a

financing decision.
• When managers make multinational finance decisions that maximize the overall
present value of future cash flows, they maximize the firm’s value, and hence
shareholder wealth.
Valuation Model for an MNC

• Domestic Model

n
E (CF$, t )
Value = 
t =1 (1+ k ) t

Valuation Model for an MNC

 m
  E (CFj , t )  E (ER j , t )

n
 
Value =   j =1 
t =1  (1 + k )t 

 


An MNC’s financial decisions include how much business to conduct in each country and
how much financing to obtain in each currency. Its financial decisions determine its exposure
to the international environment
Valuation Model for an MNC

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 Impact of New International Opportunities
on an MNC’s Value

E (CFj,t ) = expected cash flows denominated in currency j to be received by the parent

company at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be converted to parent
currency at the end of period t
k = the weighted average cost of capital of the parent company

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 TOPIC TWO
THE FOREIGN EXCHANGE MARKET
Foreign Exchange Markets facilitate international trade transactions.

· It is an over-the-counter market

· No centralized meeting place and no fixed and closing time

· Dealers located in the major commercial and investment banks around the world

· Participants communicate using computer terminals, telephones, and other

telecommunication facilities, e.g. Society for World Inter-bank Financial
Telecommunications (SWIFT).
The spot market: The spot market is the market for immediate exchange of currencies.

· The rate of exchange in this market is the spot rate (or the cash exchange rate)

· In practice, delivery and payment occur two days following the conclusion of the deal
· The local forex bureau market is an example of a spot market

The forward Market: In the forward market, currencies are bought and sold now for future
delivery.

✓ Payment is made upon delivery, but the exchange rate is agreed upon at the time of
contract
✓ Date of delivery is called the value date
✓ Forward rate is therefore the exchange rate for a currency to be delivered at a future
date
✓ Forward rates usually quoted for 30, 90, 180, 270, and 360 days. The forward market
enables an MNC to lock in the exchange rate at which it will buy or sell a certain
quantity of currency on a specified future date.

WHAT IS EXCHANGE RATE?

Amount of one currency needed to exchange for one unit of another currency. IN all:

➢ It measures the price of one currency in terms of another currency.

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 ➢ The exchange rate can be quoted in any direction. E.g. the exchange rate between the
cedi and the US dollar may be quoted either as:
1 Number of cedis needed to purchase one US dollar, i.e. the cedi price of the dollar;
e.g. GH¢0.95/$
2 Number of US dollars necessary to purchase one cedi or the dollar price of the cedi,
e.g. $1.0526/cedi.

EXCHANGE RATE QUOTATION CONVENTIONS: DIRECT OR INDIRECT

QUOTATION

⚫ Direct quotation; direct quotation expresses the number of local currency required to
buy a unit of foreign currency. E.g. GH¢1.20/$ in Ghana.
⚫ Indirect quote expresses number of units of a foreign currency exchanging for one
unit of a local currency. E.g. $0.8333/GH¢
⚫ UK uses indirect quotation. Many other countries use direct quotation conversion.

1
Direct quote =
indirect quote

Appreciation and Depreciation

Appreciation is the strengthening of a currency.

· Depreciation is the weakening of a currency.

Cross Rate: The calculation of foreign exchange rate from two separate quotes that contain a
common currency.

Arbitrage: Purchase of currency in one market for immediate resale in another market to
exploit price discrepancies between the two markets to make a risk free profit

· No investment required because the purchase of currency is financed with the sale of the
other currency. This is done by an arbitrageur.

⚫ Comparing Quotes From Different Traders

New York Frankfurt

$1.24/Є Є0.82/$

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 ⚫ Expressing quotes in same currency $/Є, we have

New York Frankfurt

$1.24/Є $1.22/Є

Differences in quotes make it possible for market participants to make profit by buying from
one trader and selling the same currency to another trader. Difference in quotation leads to
arbitrage.

RELATIONSHIP BETWEEN FORWARD AND SPOT RATES

The relationship between the spot and the forward exchange rates at any time can be
quantified. This is done by expressing it in the form of percentage per annum premium
or discount of the forward rate over the spot rate.

Forward Premium or Discount.

⚫ The foreign currency is at a forward discount against a given currency when the
forward price of the foreign currency is quoted lower than its spot price. The opposite
holds for the forward premium. See the example below:

Spot $1.4615/Є

1 month forward $1.4600/Є.

Quantifying Forward Premium or Discount

 Forward − spot   12 x100 

  x  
 spot   No of months forward 

⚫ Forward discount/premium of Є

(1.4600 − 1.4615) x12 x 100

=
1.4615 x 1
=-1.2316% p.a.

Major dealers in the Foreign Exchange Market

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 1. Commercial Banks
⚫ Banks are main participants in foreign exchange market
⚫ At the retail level they deal with
– Corporations
– Exporters
– importers
⚫ At the wholesale level – they maintain an inter-bank foreign exchange market.

2. Businesses

-international trade

-foreign direct investment.

3. Central Banks frequently intervene in the market to maintain the spot rates of their
currencies within a desired range.
Eurocurrency Market

⚫ U.S. dollar deposits placed in banks in Europe and other continents are called
Eurodollars.
⚫ In the 1960s and 70s, the Eurodollar market, or what is now referred to as the
Eurocurrency market, grew to accommodate increasing international business and to
bypass stricter U.S. regulations on banks in the U.S.
Composition of the Eurocurrency Market

⚫ Eurocurrency market composed of several large banks (Eurobanks)

⚫ They accept deposits and provide loans in various currencies
⚫ Transactions represent large deposits and loans (equivalent of $1million or more)
⚫ Such large transactions reduce operating expenses of a bank.
⚫ Deposits or loans from Eurobank described with “Euro” prefix

⚫ Thus a deposit of Japanese yen is a “Euroyen” deposit

⚫ A loan in Swiss francs by a Eurobank is “Euro-Swiss franc” loan

⚫ Interest rate on Eurocurrency reflects that currency’s rate in the home country.

Eurocurrency Market

⚫ Although the Eurocurrency market focuses on large-volume transactions, there are

times when no single bank is willing to lend the needed amount.

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 ⚫ A syndicate of Eurobanks may then be composed to underwrite the loans. Front-end
management and commitment fees are usually charged for such syndicated
Eurocurrency loans.
⚫ The recent standardization of regulations around the world has promoted the
globalization of the banking industry.

⚫ In particular, the Single European Act has opened up the European banking industry.

⚫ The 1988 Basel Accord signed by G-10 central banks outlined common capital
standards, such as the structure of risk weights, for their banking industries.

Eurocredit Market

⚫ Loans of one year or longer are extended by Eurobanks to MNCs or government

agencies in the Eurocredit market. These loans are known as Eurocredit loans.
⚫ Because of asset – liability mismatch, Eurobanks commonly use floating rates
⚫ LIBOR used as base rate.

Eurobond Market

There are two types of international bonds.

 Bonds denominated in the currency of the country where they are placed but issued by
borrowers foreign to the country are called foreign bonds or parallel bonds.
 Bonds that are sold in countries other than the country represented by the currency
denominating them are called Eurobonds.

TRIANGULAR ARBITRAGE

Action to capitalize on a discrepancy where the quoted cross exchange rate is not equal to the
rate that should exist at equilibrium.

⚫ Assume the euro and Japanese yen are both quoted versus the US dollar,
⚫ They appear as €0.7332/USD and ¥115.915/USD.
⚫ If the YEN/EURO cross rate is needed, it is simply a matter of division:
⚫ ¥115.915/€0.7332 = ¥158.0947/€
⚫ The YEN/EURO cross rate of 158.0947 is the third leg of the triangle.

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This must be true if the first two exchange rates are known. If one of the exchange rates
changes due to market forces, the others must adjust for the three exchange rates again to
align. If they are out of alignment, it would be possible to make a profit simply by
exchanging one currency for a second, the second for a third, and the third back to the first.
This is known as TRIANGULAR ARBITRAGE

Arbitrages

⚫ Locational Arbitrage
⚫ Triangular Arbitrage
⚫ Covered Interest Arbitrage

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 TOPIC THREE
FORECASTING EXCHANGE RATES

Why Firms Forecast Exchange Rates

◼ Hedging decisions; Receivables and payables – should they be hedged?

◼ Short-term financing decisions; Borrow in which currency? Low interest rate and
currency expected to depreciate
◼ Short-term investment decisions

Invest excess cash in which currency? High interest rate and expected to appreciate
◼ Capital budgeting decisions; Values of capital budgeting for subsidiaries must be
converted into parent company’s currency
◼ Earnings assessment; should subsidiary invest earnings in foreign country or remit?
◼ Long-term financing decisions; Currency borrowed should depreciate against
currency of sales revenue

FORECASTING TECHNIQUES

1. Technical Forecasting
2. Fundamental Forecasting
3. Market-Based Forecasting
Technical Forecasting

◼ Involves the use of historical exchange rate data to predict future values

Example: 10 million Ghanaian cedi has to be paid for supplies received by American
company. Today, the cedi appreciates by 3% against the dollar. The American
company can pay today to avoid any additional increase tomorrow. However, the
company has determined that an appreciation of the cedi against the dollar by more
than 1% is normally followed by a reversal of about 60% the following day. What
should the company do?

et =1 = et  (− 60%), et  1%

et =1 = 3%  (− 60%)

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 et =1 = −1.8%
** The company should make its payments tomorrow.

◼ Limitations of technical forecasting:

a. Focuses on the near future
b. Rarely provides point estimates or range of possible future values
c. Technical forecasting model that worked well in one period may not work
well in another
Fundamental Forecasting

1. Based on fundamental relationships between economic variables and exchange rates

e = f (INF , INT , INCGCEXP)

GHt = b0 + b1INTt + b2 INFt −1 + t

Use of sensitivity analysis to account for uncertainty by considering more than one possible
outcome. It is important when explanatory variables are a bit difficult to forecast.

◼ Use of PPP for fundamental analysis by forecasting inflation rate differentials.

EXAMPLE: Assume US inflation is expected to be 1% over the next year, while Australian
inflation is expected to be 6%. According to PPP, the Australian dollar exchange rate
should move as follows:

1 + IUS 1.01
ef = −1 ef = − 1  − 4 .7 %
1 + I AUS 1.06

If existing spot rate of the Australian dollar is $.50, then the expected spot rate at the end of
one year will be about $0.4765

E (St +1 ) = S AUS (1 + eAUS )  $.50[1 + (−.047)] = $.4765

Limitations of fundamental forecasting include:

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 ◼ Unknown timing of the impact of some factors; some factors have lagged effects,
hence, regressions models may have to adjusted.
◼ Forecasts of some factors may be difficult to obtain; if values of the factors cannot be
accurately determined, then prediction of exchange rate movements may be
inaccurate.
◼ Some factors are not easily quantified. E.g., political uncertainty, labor unrest and
strikes.
◼ Regression coefficients may not remain constant

Market-Based Forecasting

◼ Use of the spot rate to forecast the future spot rate.

If the Ghanaian cedi is expected to appreciate against the South African rand, speculator will
buy more cedis in anticipation of the rise in its value, hence, forcing the spot price of the cedi
up. That will imply that the current value of the cedi is a reflection of the expectations of its
value in the near future. The equation below can be used to solve such problem.

E (e) = p
( S )− 1
E (e) = F
where
E(e) = expected percentage change in the exchange rate
Mixed Forecasting p = percentage by which t he forward rate (F)
exceeds the spot rate (S)
1. Use a combination of forecasting techniques.
2. Mixed forecast is then a weighted average of the various forecasts developed.
Forecast Error

1. Measurement of forecast error: Absolute forecast error as a percentage of the realized

value = (forecasted value – realized value) / realized value
2. Forecast error among time horizons
3. Forecast error over time periods
4. Forecast errors among currencies
5. Forecast bias
Statistical Test of Forecast Bias

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S t = a0 + a1 Ft −1 +  t
where
S t = spot rate at time t
Ft −1 = forward rate at time t - 1
 t = error term
a0 = intercept
a1 = regression coefficien t
FORECASTING UNDER MARKET EFFICIENCY

Weak-form efficiency: historical and current exchange rate information is already reflected in
today’s exchange rate and is not useful for forecasting. The market is said to be weak form
efficient if prices fully reflect all information about past prices. In other words, market prices
will not follow any predictable patterns. Any forecast based on past price patterns will be
useless as investment tools and will not help an investor make a superior return. Competition
for profit will destroy any useful patterns or cycles in that analysis.

Semi-strong-form efficiency: all relevant public information is already reflected in today’s

exchange rate. This suggests an exchanges rate prices fully reflect all the relevant publicity
available information about the exchange. This include not only past prices movement but
also other related issues concerning that currency in question. It implies there is no advantage
in analyzing publicly available information because it is already absorbed into the exchange
rate prices prevailing in the market.

Strong-form efficiency: all relevant public and private information is already reflected in
today’s exchange rate. This states that current price of the currency reflects all knew public
information and all privilege or inside information concerning the currency. Insider
information gives insiders such as managers and directors an unfair advantage over investors
and analysts which is illegal and can create market inefficiency. The analysts spend enormous
amount of resources to uncover the latest and most useful information about any price
movement. The market competition among these professionals will ensure that market prices

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reflect all available information. Thus even access to inside information cannot be expected
to result in superior investment performance.

METHODS OF FORECASTING EXCHANGE RATE VOLATILITY

1. Use of recent volatility level

2. Use of historical pattern of volatilities
3. Implied standard deviation

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 TOPIC FOUR
VALUATION MODEL FOR AN MNC-INTERNATIONAL CASH
FLOW

 
E (CF$,t ) =  E (CFj ,t ) E (S j ,t )
m

j =1

▪ where CFj,t represents the amount of cash flow denominated in a particular foreign
currency j at the end of period t,
▪ Sj,t represents the exchange rate at which the foreign currency (measured in dollars
per unit of the foreign currency) can be converted to dollars at the end of period t.

RELEVANCE OF EXCHANGE RATE RISK MANAGEMENT

◼ Purchasing Power Parity Argument

◼ Investor Hedge Argument: exchange rate risk is irrelevant because investors
can hedge exchange rate risk on their own.
◼ Currency Diversification Argument: if U.S.-based MNC is well diversified
across numerous currencies, its value will not be affected by exchange rate
risk.
◼ Stakeholder Diversification Argument: if stakeholders are well diversified,
they will be somewhat insulated against losses due to MNC exchange rate
risk.
◼ Response from MNCs: If MNCs don’t hedge and face exchange rate risk, cost
of borrowing will rise.
Forms of Exchange Rate Exposure

Though exchange rates may not be forecasted with perfect accuracy, firms should still
measure their exposure to exchange rate movements and take steps to ameliorate the
impact from.
1. Transaction exposure
2. Economic exposure
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 3. Translation exposure
Transaction Exposure: Sensitivity of the firm’s contractual transactions in foreign
currencies to exchange rate movements. E.g., The value of exports denominated in a foreign
currency will decline if the currency were to depreciate. How to assess transaction exposure:

1. Estimate MNCs net cash flows in each currency

2. Measure potential impact of currency exposure
Consolidated Net Cash Flow Assessment

Currency Total inflow Total outflow Net Exp. Exch Net inflow/outflow
inflow/outflo rate at end dollars
w of quarter

British pound 17,000,000 7,000,000 +10,000,000 $1.5 +$15,000,000

Canadian 12,000,000 2,000,000 +10,000,000 $.80 +$8,000,000

dollar

Swedish krona 20,000,000 120,000,000 -100,000,000 $.15 -$15,000,000

Mexican peso 90,000,000 10,000,000 80,000,000 $.10 +$8,000,000

Estimating Range of Net Inflows/Outflows

Currency Net inflow/outflow Range of Possible Range of Possible Net In

Exchange Rate at
end of Quarter

British pound +10,000,000 $1.4 to $1.6 +14,000,000

to
+16,000,000

Canadian dollar +10,000,000 $.79 to $.81 +7,900,000

to
+$8,100,000
Swedish krona -100,000,000 $.14 to $.16 - $14,000,000
to
- $16,000,000

23 | P a g e
Mexican peso 80,000,000 $.08 to $.11 +$6,400,000
to
+$8,800,000
Transaction Exposure

Measured by the standard deviation of the portfolio of currencies, e.g., for a portfolio of two
currencies

 p = Wx2 x2 + Wy2 y2 + 2WxWy x y CORR xy

W = proportion of portfolio value in currency x or y
σ = standard deviation of percentage changes in currency x or y
CORR = correlatio n coefficien t of percentage changes in currencies x and y

Exposure of an MNC’s Portfolio is Affected by:

1. Measurement of currency variability

2. Currency variability over time
3. Measurement of currency correlations: using correlation coefficients
4. Applying currency correlations to net cash flows: positive CFs in highly correlated
currencies result in higher exchange rate risk for MNCs
5. Currency correlations over time
Transaction Exposure Based on Value at Risk (VaR)

Measures the potential maximum 1-day loss on the value of positions of an MNC that is
exposed to exchange rate movements.

(
Maximum one - day loss = E (et ) − 1.65   MXP )
Maximum one - day loss = 0% − (1.65 1.2%)
Maximum one - day loss = −.0198, or − 1.98%
If spot rate for peso is $0.09, maximum one day loss of -1.98 percent implies peso value of :

Peso value based onMaximum one - day loss = S  (1 − .0198)

Peso value based on Maximum one - day loss = $.09  (1 − .0198) = $.088218
24 | P a g e
If I have 10 million Mexican Pesos, the equivalent dollar loss will be: 10million x .09=
$900,000 x -.0198 = -$17,820
Transaction Exposure Based on Value at Risk (VaR)

Factors that affect the maximum 1-day loss:

a. Expected percentage change in the currency rate for the next day
b. Confidence level used for the currency
c. Standard deviation of the daily percentage changes in the currency
Using Value at Risk

Limitations of VaR
a. It presumes that the distribution of exchange rate movements is normal.
b. It also assumes that the volatility of exchange rate movements is stable over
time period.
Economic Exposure: The sensitivity of the firm’s cash flows to exchange rate movements
sometimes referred to as operating exposure. Economic exposure arises from:

a. Exposure to local currency appreciation

b. Exposure to local currency depreciation

ECONOMIC EXPOSURE TO EXCHANGE RATE FLUCTUATIONS

Transactions that influence the firms local currency Impact of local Impact of local curren
inflows currency depreciation on transa
appreciation on
transactions

Local sales (relative to foreign competition in local Decrease Increase

market)

Firm’s exports denominated in local currency Decrease Increase

Firm’s exports denominated in foreign currency Decrease Increase

Interest received from foreign investments Decrease Increase

25 | P a g e
Transactions that influence the firms local currency Impact of local currency Impact of loc
outflows appreciation on currency dep
transactions on transaction

Firm’s imported supplies denominated in local currency No change No change

Firm’s imported supplies denominated in foreign currency Decrease Increase

Interest owed on foreign funds borrowed Decrease Increase

Measuring Economic Exposure

1. Use of sensitivity analysis

2. Use of regression analysis

PCFt = a0 + a1et + t
where
PCFt = percentage change in inflation - adjusted
cash flows measured in home currency
et = percentage change in direct exchange rate
t = random error term
a0 = intercept
a1 = slope coefficien t

Translation Exposure: The exposure of the MNC’s consolidated financial statements to

exchange rate fluctuations. Most MNCs used standards established by the prevailing GAAP
and regulations.

1. Does translation exposure matter?

a. Cash flow perspective; effect of exchange rates on remitted cash flows.
b. Stock price perspective: Translation exposure affects earnings consolidation,
hence, the stock price.
2. Determinants of translation exposure:
a. The proportion of business conducted by foreign subsidiaries
b. The locations of foreign subsidiaries
c. The accounting methods used by these foreign subsidiaries

26 | P a g e
 TOPIC FIVE
FINANCIAL DERIVATIVES

An integral part of the uncertainties financial managers (and many of us ordinary folks) face
is uncertainty about future prices. Be they prices of inputs, outputs or consumables. One way
to handle such uncertainty is to enter into a contract today for transactions that will take place
in the future. Little or no money will take place today. This document is about such
contracts. One such contract is the forward contract. Another is the futures contract. A third
is the option contract. This document is mainly concerned with these three. Other forms exist
and will also be discussed.

The use of such contracts has exploded in recent times. Options contracts were first traded on
the Chicago Board Options Exchange in 1973. Within five years investors and others were
trading options to buy or sell 10 million company shares every trading day. Today, the
volume of options traded on the Chicago Board Options Exchange now exceeds the volume
of shares traded on the New York Stock Exchange.

Options are pervasive in most business decisions: investment, financing and operating
decisions right here in Ghana and everywhere.

Futures contracts are contracts about future prices of agricultural commodities, metals,
precious metals and interest rate sensitive securities. Given that the Ghanaian economy is
resource based and that our two major foreign earning commodities, gold and cocoa, are sold
by futures contracts, an understanding of how futures markets work is important.

While futures and options contracts are standardised and are traded on exchanges around
the world, forward contracts, though also widely used, are private arrangements to buy and
sell assets and are not traded. An example will be a trader who enters into an agreement with
a forex bureau operator today to buy United States dollars from the bureau in the future at a
price agreed to today.

Currently in Ghana, USAID is actively promoting an agricultural warehouse receipt system

as a basis for futures contracts in agricultural commodities sometime in the future. Many

27 | P a g e
categories of people utilize options, futures and forward contracts for different purposes.
Some are called investors, others hedgers, still others are called speculators. Then there are
arbitrageurs too. These market participants are also discussed here.

BASIC CONCEPTS

The course explores forwards, futures and options contracts as derivative securities as well
as valuation of these securities. Other derivatives are also discussed. Attention is paid to the
importance of these in day-to-day business and other activities.

A derivative security, also called a derivative or a contingent claim, is a financial

security (instrument) whose value depends on (i. e. is contingent on) the value of
some other underlying variable, usually the price of some other financial asset.
Forwards, futures and options contracts described below are examples of derivative
Securities These have become increasingly important as financial management tools in recent
times.

The rest of this chapter introduces forward, futures and options contracts and explains
how these may be used in the Ghanaian context. Exercises are also provided at the
end.

FORWARD CONTRACTS

Imagine that your company is entering into a contract to purchase computers from a
United States based supplier. Delivery will be made one year from now at a purchase
price agreed upon today in US dollars, payable at delivery. Your business operates
entirely in Ghana and all transactions are in cedis.

Faced with this situation your company might wish to know today how much these
computers will cost you in cedis when they are delivered. A forward contract may be a way
out. A forward contract is an agreement to buy or sell an asset on a fixed future date at a
price fixed today.

Clearly, the exchange rate between the cedi and the US$ today (called the spot rate) is

28 | P a g e
unlikely to be the same one year from now. To address this problem, your company
may enter into a contract with one of the banks. The bank would agree to sell you the
required amount of US$ when the time comes at an exchange rate between the US$
and the cedi agreed upon today.

For this contract the asset to be purchased is United States dollars, and the price at
which dollars will be converted to cedis is the exchange rate between the Ghanaian
cedi and the US dollar.

In agreeing to sell you US$ on that day at the agreed price, the bank is said to assume
a short position. Your company is then said to have assumed a long position in
agreeing to buy the US$ on that date at the agreed upon price.

One year from now, the bank delivers to your company the agreed upon amount of US$ and
you pay the agreed price. This date is called the maturity date and on this date the contract is
settled. The actual exchange rate between the cedi and the dollar one year from now (at
maturity) is often denoted ST. The exchange rate agreed upon today is called the delivery
price for US$. It is often denoted K.

Forward contracts are privately negotiated and generally not traded on organized exchanges.

Illustration

Suppose it costs GHC 3.50 to buy one US$ today (spot rate), and your company has
entered into a contract to buy US$ 5 million from bank A (to pay for the computers)
one year hence. Suppose the contract specifies that you will pay GHC 3.95 for each
dollar to be delivered to you when the time comes.

Imagine that one year hence, the spot exchange rate is 4.10 cedis to the US$. You
will have saved 5 million x (4.10 – 3.95) = GHC 0.75 million cedis by entering into the
contract one year earlier. This becomes a gain to you.

On the other hand, if the exchange rate one year hence is GHC 3.80 cedis your company
would still pay the contract amount, which is 5 million x (3.80 – 3.95) = GHC 0.75 million

29 | P a g e
more than if you had not entered into the forward contract. This time, this becomes a loss to
you. Entering into the contract however, gives you peace of mind. You would know exactly
what your costs are and will plan ahead. The value of the contract (gain or loss) depends on
the exchange rate between the US$ and the cedi. That is, it is derived from the exchange rate
between the US$ and the cedi. Thus the forward contract is called a derivative security.

Comments

Note that it costs nothing to enter into a forward contract today. At maturity, the payoff to
one in a long position is ST - K, the spot price then less the delivery price.
Whereas, the payoff to one in a short position is K - ST, the delivery price less the
spot price. The payoff from the contract is the investor’s total gain or loss from the contract.
Note. The variables ST and K are defined on the previous page.

FUTURES CONTRACTS

Consider a situation where the GHANA COCOBOD enters into a contract to sell
cocoa beans to a UK company at a date in the future at a price agreed upon today.
The cocoa will be paid for when delivered.

Consider another situation in which Ghana Food Distribution (GFD) enters into a
contract with a farmer for the farmer to supply GFD with a given quantity of maize
during the first maize harvest season of next year.

These kinds of arrangements may be considered as futures contracts (or futures) if

they satisfy the conditions described below. The contracts are in respect of:

- Standard type of asset,

- standard quality of asset and,
- standard quantity
- Delivery must be made to a registered warehouse.
- Delivery must be made during a specified month and year.
- The agent supplying the asset is allowed to choose the actual date of delivery
within the contract month (unlike a forward contract).

30 | P a g e
 - Delivery must take place by the last business day of the contract month.
- Payment will be made at delivery. !!!!

Since the value of the cocoa futures contract depends on the price of cocoa, it is a
derivative.

• The New York Cotton Exchange specifies the asset in its orange juice futures
category as
– US grade A, with Brix value of not less than 57 degrees, having a Brix value to
acid ratio of not less than 13 to 1 nor more than 19 to 1, with factors of color
flavor each scoring 37 points or higher and 19 for defects, with a minimum
score of 94

• The CME in its random-length lumber futures contract specifies

– Each delivery unit shall consist of nominal 2X4s of random lengths from 8 feet
to 20 feet, grade-stamped Construction and Standard, Standard and better, or
#1 and #2; however, in no case may the quantity of Standard grade or #2
exceed 50%. Each delivery unit shall be manufactured in California, Idaho,
Montana, Nevada, Oregon, Washington, Wyoming, or Alberta or British
Columbia, Canada, and contain lumber produced from and grade-stamped
Alpine fir, Englemann spruce, hem-fir, lodge pine and/or spruce pine fir.

Standardized futures contracts are traded on futures exchanges. It is the

exchange which specifies all aspects of the contract mentioned above except
the trading price. The warehouse to which the asset may be delivered must be registered with
the exchange. The trading price is agreed upon by negotiations between sellers and buyers.
The parties to the contract need not know each other. The exchange on which the contract is
traded provides the guarantee that the contract will be honoured.

Futures contracts are traded on many organized markets (futures exchanges) around the
world. Trading prices are reported in the press the same way stock prices are. These
exchanges include:
- The Chicago Mercantile Exchange
- The Chicago Board of Trade

31 | P a g e
 - International Monetary Market in Chicago
- New York Futures Exchange and New York Mercantile Exchange
- Sydney Futures Exchange
- Toronto Futures Exchange
- London International Financial Futures & Options Exchange
Internationally, futures contracts on agricultural commodities are written on
- Cocoa
- Coffee
- Wheat
- Corn
- Sugar
- Soybeans
- Cattle
- Pork bellies
- Wool
- Timber/Lumber, etc.
Futures are also written on metals and precious metals
- Aluminum
- Copper
- Gold
- Tin
- Silver
Currency futures are written on
- US $
- Euro
- Canadian $
- Japanese Yen
- UK pounds
- Australian dollars
- Swiss francs
Futures contracts are also written on
- Stock Indices
FTSE 100 - UK
DJIA - USA

32 | P a g e
 S&P 500 - USA
DAX 30 - Germany
CAC 40 - France
Nekkei 225- Japan
Hang Seng- Hong Kong
- Interest rates (Treasury bills and bonds)
OPTIONS CONTRACTS

* The English word “option” is associated with a right or a choice, but not an
obligation.
* A financial option confers on the owner the right to buy or sell a financial asset, but
not an obligation.
* Two types exist: an option to buy, called a call option and an option to sell, called a
put option.
Call Options
Consider the case of Ms Ama who is contemplating buying 100 shares of one of the
companies listed on the Ghana Stock Exchange. She has not yet made a firm decision
so she decides to give herself three months to decide. Mr. Kwame is prepared to enter
into a contract with Ama under which Kwame will sell 100 shares of the company to
Ama at a price agreed upon today should Ama decide to go ahead with the purchase.

Note that under this arrangement, it is Ama who must decide whether to buy the shares or
not. Kwame must only respond to Ama’s request to deliver the shares.

By this arrangement Ama has acquired the right to demand 100 shares of the company
from Kwame at the agreed upon price. So she knows exactly how much the purchase
will cost her.

To induce Kwame to enter into such a contract, Ama pays Kwame an amount called
the price (or premium) of the call option. Ama is said to have bought a call option on
the shares of this company, while Kwame has sold a call option.

A call option gives the holder the right to buy an underlying asset in the future for a
fixed price called the exercise price, strike price or delivery price.

33 | P a g e
In this case, the underlying assets are the shares of the company. The price Ama will pay for
the shares if she decides to buy the shares is the exercise or strike price. This is in addition to
what she paid to acquire this right. (The latter is small compared to the price of the shares).

The contract might specify the exact date on which Ama must make up her mind
whether to buy (exercise her right) or not. It might specify this date as the last day of
the three-month period. Such an option is called a European call option. This last day
is called the maturity date of the contract.

Alternatively, the contract may allow Ama the right to exercise her acquired right
anytime over the three month period. Such an option is called an American call
option. The contract will also specify the company whose shares may be bought or sold and
the number of shares (usually multiples of 100).

In all cases, if Ama does not exercise her right the option expires unexercised.
Kwame is said to have written the call option, upon receiving of the premium.
Note that in this context, the terms American and European do not refer to
geographical locations.

Options contracts are traded on many organized markets (Options Exchanges) around
the world.

These include
- The Chicago Board Options Exchange in Chicago
- American Stock Exchange in New York
- Trans-Canada Options markets in Toronto and Montreal
- London International Financial Futures and Options Exchange in London
Put option
Now consider the case of Kofi and Efua. Kofi has entered into an agreement with
Efua which allows him to sell 200 shares of a company listed on the GSE to Efua
anytime within the next 6 months at a price agreed upon today if Kofi chooses to.
This time Kofi has acquired the right to use 6 months to decide whether to sell the
shares or not. Efua must only respond to Kofi’s request. A put option gives the holder the
right to sell an underlying asset for a fixed price

34 | P a g e
called the exercise price or strike price.
The terms American and European used in reference to put options have the same
meaning as for call options. So are the terms exercised price, strike price and maturity.
The value of a call or a put option on a stock depends on the price of the stock. So once
again, we have a derivative.

Other terminology:

An option is referred to as being in-the-money if exercising it immediately will lead to

positive cash flow to the holder.

It is referred to as out-of-the-money if exercising it immediately will lead to negative

cash flow to the holder.

It is referred to as being at-the money if exercising it immediately will lead to zero cash flow
to the holder.
OTHER DERIVATIVES
Contingent claims of many other forms exist today. They include:

Forward contracts on interest rates (i. e., on interest sensitive securities such as treasury bills).

Futures contracts on financial obligations (financial futures) such as treasury bills and
treasury bonds, stock market indices, foreign currencies, etc.
Options on futures contracts also exist.
Swaps are contracts between two counter-parties to exchange two different cash flows. The
most common forms of swaps are of two types: currency swaps and interest rate swaps.

Currency Futures Market

Currency futures contracts specify a standard volume of a particular currency to be
exchanged on a specific settlement date, typically the third Wednesdays in March, June,
September, and December.

⚫ Used by MNCs to hedge their currency positions

35 | P a g e
 ⚫ Used by speculators who hope to capitalize on their expectations of exchange rate
movements.

CURRENCY FUTURES CONTRACTS

Currency futures are agreements to deliver or accept a currency at a specified future date at a price
set when the contract is entered into

⚫ Financial futures are traded face to face

⚫ Requires a trading floor e.g. the Chicago Mercantile Exchange (CME).
⚫ Deals in futures are executed by brokers

⚫ Futures contracts are available for the widely traded currencies e.g. British pound, the
Canadian dollar, the Swiss franc, the Japanese yen etc.

⚫ Contract for each currency specifies a standardized number of units.

⚫ Typical settlement dates are the third Wednesdays in March, June, September and
December.

Standardized currency Futures Contracts Traded on the CME

Currency Units per Contract

Australian dollar 100,000
British pound 62,500
Canadian dollar 100,000
Japanese yen 12,500,000
Swiss franc 125,000
Euro 125,000

PRICING CURRENCY FUTURES

❖ The price of currency futures is normally similar to the forward rate for a given
currency and settlement date. If this was not the case, there will be arbitrage in the
two markets
❖ Assume the currency futures price on the pound at October 30 is $1.6400 and that
forward contracts for the same period is quoted for $1.6200

36 | P a g e
 ❖ If such a situation should arise, dealers will attempt to purchase forward contracts and
simultaneously sell currency futures contracts.
❖ If the settlement date could be marched exactly for the two contracts, dealers could
generate guaranteed profits of $0.02 per unit.

Transaction Costs of Currency Futures

⚫ Brokers fulfilling orders to buy or sell futures contracts charge a transaction or

brokerage fee which is based on the bid/sell spread. (just like bureau spread).
⚫ By buying the futures contract for one price (“bid” price) and simultaneously selling
the contract to someone else at a higher price (‘sell’ price), they are able to make a
difference, which is the spread.

The Role of the Clearinghouse

⚫ Associated with every futures exchange is a clearinghouse. First, the clearinghouse

guarantees that the two parties to the futures transaction will perform.
⚫ Whenever someone takes a position in the futures market, the clearinghouse takes the
opposite position
⚫ The house agrees to satisfy the terms set forth in the contract.
⚫ Clearinghouse therefore interposes itself as the buyer for every sale and the seller for
every purchase.
⚫ Clearinghouse makes it simple for parties to a futures contract to unwind their
positions prior to the settlement date.
Liquidating a Position

❖ Most financial futures contracts have settlement dates in the months of, March, June,
September and December.
❖ A holder of futures contract has two choices to liquidate the position.
❖ First, the position may be liquidated before the settlement date
❖ In this situation, the holder takes an offsetting position in the same contract.
❖ The other choice of liquidating the futures contract is to wait until the settlement date.
❖ At this date, the party purchasing a futures contract accepts delivery of the underlying.
❖ The party that sells a futures contract liquidates the position by delivering the
underlying at the agreed-upon price.

37 | P a g e
 MARGIN REQUIREMENTS FOR FUTURES CONTRACT

⚫ Any time an investor takes a position in a futures contract, a minimum cedi amount
must be deposited per contract as specified by the exchange.
⚫ Individual brokerage houses are free to set margin requirement above the minimum
established by the exchange.
⚫ The price of the futures contract fluctuates each day. As this happens, the value of the
investor’s equity in the position changes.
⚫ The equity in a futures account is the sum of all margins posted and all daily gains
less all daily losses to the account.
⚫ At the end of each trading day, the exchange determines the “settlement price” This is
different from the closing price. It is a value the exchange considers to be
representative of trading at the end of the day

⚫ It is used by the exchange to determine an investor’s position with respect to a gain or

loss in the investor’s equity account.

⚫ maintenance margin - minimum levels to which an investor’s equity position may

fall as a result of unfavorable price movement before the investor is required to
deposit an additional margin

⚫ variation margin - amount necessary to bring the equity in the account back to the
initial margin level. The variation margin must be in cash and Any excess margin in
the account may be withdrawn by the investor

⚫ Any party who is expected to deposit a variation margin must do so within 24 hours.
If the party fails to deposit the amount, the exchange will close out the futures
position.

Illustration with cocoa futures market

✓ Initial Margin $7 per contract.

✓ Maintenance Margin $4 per contract.
✓ Assume ABC buys 500 contracts at a futures price of $100/contract.
✓ At the same time XYZ sells the same number of contracts at the same futures price.
✓ Thus, the initial margin requirement for ABC and XYZ are $7 X 500 = $3500

38 | P a g e
 ✓ The maintenance margin is $4 X 500 = $2000.
✓ Means the equity should not fall below $2000.
✓ Cash variation margin is paid should account fall below maintenance margin.
✓ Let us assume the following settlement prices for some trading days;

⚫ Trading day Settlement price Equity position

1 99 $3000
2 97 $2000

3 98 $2500

4 95 $1000

Daily Price Limits

⚫ Exchanges may impose a limit on daily price movements of futures contract from the
previous day’s closing price.
⚫ Price limit sets the minimum and maximum price within which the futures contract
may trade that day.
⚫ If a daily limit is reached, trading continues at a price which does not violate the
minimum or maximum price.
⚫ The rationale of daily price limits is to give stability to the market and some critics
have argued against this imposition of price limits.
Currency Futures Market

Forward Markets Futures Markets

Contract size Customized. Standardized.

Delivery date Customized. Standardized.

Participants Banks, brokers, Banks, brokers,

MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.

Security Compensating Small security

Deposit bank balances or deposit required.

39 | P a g e
 credit lines needed.

Forward Markets Futures Markets

Clearing Handled by Handled by

operation Handled by individual brokers Handled by exchange

and banks clearinghouse. Daily settlements
to market prices
Marketplace Worldwide telephone nertwork Central exchange with global
communication
Regulation Self-regulating Futures Trading
Commission,
National Futures Association.
Liquidation Mostly settled by actual delivery Offset
Transaction cost Bank’s bid/ask spread. Negotiated brokerage fees.

TO INSERT CURRENCY DERIVATIVES

CURRENCY OPTIONS

⚫ An option is a contract on which the writer of the option grants the buyer the right to
buy from or sell to the writer currency at the excise (or strike) price within a specified
period of time. An option is only a right and not an obligation. The price paid by the
option buyer is the option price or option premium
⚫ In options, we have a call option and a put option. Options are traded on an organized
exchange or in the over-the-counter market.
Currency Call Options

⚫ A currency call option grants the holder the right to buy a specific currency at a
specific price (called the exercise or strike price) within a specific period of time. A
call option is
⚫ in the money if spot rate > strike price,

40 | P a g e
 ⚫ at the money if spot rate = strike price,
⚫ out of the money

if spot rate < strike price.

Option owners can sell or exercise their options. They can also choose to let their options expire. At
most, they will lose the premiums they paid for their options. Call option premiums will be higher
when:

⚫ (spot price – strike price) is larger;

⚫ the time to expiration date is longer; and
⚫ the variability of the currency is greater.
Firms with open positions in foreign currencies may use currency call options to cover those
positions.They may purchase currency call options

⚫ to hedge future payables;

⚫ to hedge potential expenses when bidding on projects; and

⚫ to hedge potential costs when attempting to acquire other firms.

Speculators who expect a foreign currency to appreciate can purchase call options on that
currency. Profit = selling price – buying (strike) price – option premium

⚫ They may also sell (write) call options on a currency that they expect to depreciate.
Profit = option premium – buying price + selling (strike) price

⚫ The purchaser of a call option will break even when

selling price =buying (strike) price + option premium

⚫ The seller (writer) of a call option will break even when

buying price = selling (strike) price + option premium

Currency Put Options

⚫ A currency put option grants the holder the right to sell a specific currency at a
specific price (the strike price) within a specific period of time. A put option is
⚫ in the money if spot rate < strike price,
⚫ at the money if spot rate = strike price,
⚫ out of the money if spot rate > strike price.
⚫ Put option premiums will be higher when:

41 | P a g e
 ⚫ (strike price – spot rate) is larger;
⚫ the time to expiration date is longer; and
⚫ the variability of the currency is greater.
⚫ Corporations with open foreign currency positions may use currency put options to
cover their positions. For example, firms may purchase put options to hedge future
receivables.
⚫ Speculators who expect a foreign currency to depreciate can purchase put options on
that currency. Profit = selling (strike) price – buying price – option premium

⚫ They may also sell (write) put options on a currency that they expect to appreciate.
Profit = option premium + selling price – buying (strike) price

One possible speculative strategy for volatile currencies is to purchase both a put option
and a call option at the same exercise price. This is called a straddle. By purchasing both
options, the speculator may gain if the currency moves substantially in either direction, or
if it moves in one direction followed by the other.

FOR OPTION GRAPHS TO BE PRINTED AND INSERTED FROM SLIDE NO.34

AND 35

American & European options: American options are options that may be exercised at
any time up to and including the expiration date

European options: Are options that may be exercised only at the expiration date

DERIVATIVE SECURITIES IN PRACTICE

Illustrative examples
Following the basic definitions given in session 1, some of the other forms in which forwards,
futures and option contracts arise in practice are illustrated next. Other derivative securities
are also discussed.

FORWARD CONTRACTS ON INTEREST RATES

We consider another illustration of a forward contract.

42 | P a g e
It is May 1999. Suppose the one year interest rate is 19% p.a., (1 year treasury bill rate in
May 1999), and the two-year rate is 21% p.a. You borrow 84,034 cedis for one year
and lend out this amount for two years at 21% p.a. That is, the loan you made will be
re-paid in May 2,001. There are no intermediate interest payments.
Since the one-year and two-year interest rates exist today, they are called spot rates.
In May 2,000, the one year loan you took will be due and you must borrow to repay it since
you will not have received payment for the loan you made. The implied rate at which you
expect to borrow in May 2,000 for one year is 23% per annum. This is computed as
follows:

If markets are efficient, your total return on the loan you made which equals 84,034 x (1.21)2,
should equal the total that you pay on the two loans you would have taken (the one year loan
you just took, and the one you will take in May 2,000) which equals 84,034 x (1.19) x (1 + r),
where r is the rate at which you expect to borrow in May 2,000.

Thus, 84,034 x (1.21)2 = 84,034 x (1.19) x (1 + r)

solving, r = [(1.21)2 / (1.19)] – 1.

By borrowing short-term and lending long-term you have manufactured a forward loan. A
forward loan is a contract to borrow in the future at an implied rate. Thus, if it turns
out that in May 2000 the one year rate is lower than 23%, one gains.
If r is more,
FUTURES CONTRACTS ON INTEREST RATES
It is June. Company A wants to put aside enough money to pay a 100 million cedis bill
that comes due in six months.
The company may use futures contracts in this context as follows.
With six months to go, company A considers investing a fixed amount today that will
yield it the required amount in six months.

Company A cannot afford not to have the money on the due date, so it considers the
following risk free investments.
Case 1:

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 Buy an appropriate amount of treasury bills that will mature in six months
(December) yielding 100 million cedis to pay for the obligation.

Case 2:
Enter into a contract with B that calls for B to deliver to A in September T-bills that
will mature 91 days from September (i. e. in December) with 100 million cedis face
value.

Case 2 allows A to have use of its money for another three months (until September
when it pays for the T-bills) which case 1 does not allow.

Standardized contracts such as case 2 are traded on futures exchanges and are
examples of futures contracts on interest rates (fixed-income securities). In the US,
futures contracts on short-term, medium-term and long-term debt securities exist.

The following are some of the interest rate futures contracts that exist currently
internationally:

Underlying security Value of one contract Exchange

Canadian Government Bonds 100,000 Canadian $ Montreal
US Treasury Bonds, 15 years US$ 100,000 Chicago
US Treasury Notes, 10 years US$ 100,000 Chicago
US Treasury Bills 90 days US$ 1,000,000 Chicago
German Government Bonds Euro London
Long Gilt 50,000 pounds London
Sterling 3 month 500,000 pounds London

FUTURES CONTRACTS ON STOCK INDICES

Futures contracts are also written on stock indices. A futures contract on the GSE Composite
Index may run as follows.

Note. A stock index measures changes in a portfolio of stocks. (This is similar to the way the
consumer price index measures changes in consumer prices).

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Suppose you wish to hold a portfolio comprising shares of all the companies listed
on the Ghana Stock Exchange today. You may do so by buying all these shares
today, or arrange to buy later at time T at a price agreed upon today.

In the first case, one receives all dividends paid between today and time T but must pay for
the shares today. (Thus, you earn no [risk free] interest on the money used to pay for the
shares today).

In the second case, one earns interest on what would have been the cost of the purchase by
saving that amount between now and T but will not receive any dividends paid between now
and time T.

Note. Stock indices may not be adjusted for dividend payments.

To implement the second case, you may enter into a contract with Mr. X for him to deliver
one contract of GSE Composite Index to you at time T. At time T, Mr. X would buy a
contract of the GSE index at the market price and deliver it to you.

This agreement constitutes a futures contract. Such contracts do not exist in Ghana
today. Time T is called the delivery time of the futures contract. You are taking the
long position in this contract and Mr. X is taking the short position.

Futures contracts are written on the following market indices:

- S & P 500 Composite index (Chicago Mercantile Exchange)
- NYSE Composite index (New York Futures Exchange)
- Toronto 35 (Toronto Futures Exchange)
Illustration
Contracts on the Standard & Poor’s 500 stock index are the most popular in the world.
Suppose X entered into a futures contract with Y when the index was at 150 for
delivery of one contract of S & P 500 in two months. Suppose two months hence the
index rises to 155. Y must now buy a contract at the higher level of 155 and deliver to
X.
- Y will purchase the contract at the higher value of 155 to deliver to X
- X would then have gained by entering into this contract two months ago
- Y would then have lost under this arrangement

45 | P a g e
 Alternatively, the market index could have fallen. In this case Y would then have
gained at Xs expense by purchasing the contract at a lower value to deliver to Mr. X.

Settlement of futures contracts on market indices in practice

In practice, settlement of futures contracts on market indices involves what is

called a multiplier. A multiplier is the equivalent units of one contract of a
futures contract on a stock index. For most contracts that are currently traded on
futures exchanges, the multiplier is 500. Thus, a movement of the S&P 500 contract
from 150 to 151 is equivalent to

500 x (151 –150) = US$ 500.

Thus, in the first scenario of the preceding example, X would have gained

500 x (155 – 150) = US$ 2,500

by entering into the futures contract.

Settlement of a futures contract on stock indices involves payment of cash equal to a
multiplier times the difference between (a) the value of the index at the close of the last
trading day of the contract and (b) the purchase price (exercise price) of the futures
contract.

Alternatively, if the S & P 500 index had moved down from 150 to 147, Y would
have gained

500 x (150 – 147) = US$ 1,500

by delivering one contract to X.

Note. Technically, futures contracts are marked-to-market daily. See section 2.5 for
explanation.
FUTURES CONTRACTS ON CURRENCIES

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Standardized contracts involving delivery of foreign currencies in the future are traded
regularly on many established exchanges. [Not yet in Ghana]. The value of each contract
varies from currency to currency. Here are a few.

Currency Value of one contract

Pound sterling 62,500 pounds
Canadian $ 100,000 CDN $
Japanese Yen 12,500,000 Yen
Swiss Franc 125,000 SF
Australian $ 100,000 A$
US$
Euro є
For example, consider a US company that imports from Japan. The company has just
received supplies for which it must pay 500 million yen in 6 months. The spot
exchange rate is 120 yen to the US$ (equivalent to US$ 0.0083 to the yen). Thus, 40
[500m yen /12,500,000] yen contracts which are equivalent to 500 million yen would
cost US$ 4.12 million today (500 million divided by 120). If the US importer waits
for six months to buy yens, it faces the risk that the exchange rate may change
unfavorably.

The importer can remove this risk by entering into the long side of 40 futures
contract for yen for delivery in 6 months. Suppose the futures price for yen
deliverable in 6 months is $0.0084. The US importer can lock in the equivalent yens
for $4.20 million (i. e., 500 m x 0.0084). Thus, for $ 0.08 million (i. e., 4.2 million –
4.12 million) it can remove the risk of an appreciation of the yen.

HOW FUTURES CONTRACTS WORK

Illustration
A farmer wants to guarantee the price at which he will sell 10 metric tons of maize that he
expects to harvest three months hence (November, say). He thinks 1.5 million cedis is a good
price, (150,000 cedis per ton). A kenkey factory also looking to guarantee the price at which
to buy maize also thinks 1.5 million is a good price for delivery of 10 metric tons in three
months.

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To use a futures contract to achieve his objective, (that is, hedge the price he will get for his
maize in November), the farmer would approach his broker and open up the short side
of a futures contract.

For its part, the kenkey factory too will approach its broker and open a long position in a
futures contract (also to hedge the price it will pay for maize come November). Both of them
will be required to set up margin accounts (good faith deposits) with a clearing house in
order to enter into a contract to trade. (Their brokers may handle the mechanics of this). If the
initial margin requirement is 10%, each will be required to pay 150,000 cedis into their
margin account. Suppose the next day (day 2), the price of maize rises to 160,000 cedis per
ton on news
that Togo is placing a large order for Ghanaian maize. At this higher price, the farmer
has a natural incentive to renege on his earlier commitment to sell maize at 150,000.

To prevent this, immediately after close of trading on day 2, all futures contracts
traded on exchanges are rewritten at that day’s closing price.
That is, the exchange re-writes the contract such that the farmer now has a contract to
sell his maize for 160,000 cedis per ton and the factory obliged to buy at this new
price. This would give the farmer 100,000 cedis more and cost the factory an extra
100,000 cedis.

To redress this apparent complication (change in the terms of the original contract),
the clearing house withdraws 100,000 cedis from the farmer’s margin account and
credits the factory’s account with the same amount. Because the change in the price of
maize puts the kenkey factory in a profit position. This is called marking the margin
account to market [marking-to-market] or daily settlement.
Economically, both are back where they would have been had conditions backing the
terms of the contract not been changed.
However, the new arrangement has the effect of removing any incentive to renege on
the original contract due to movements of the underlying commodity price.

Marking-to-market means speculators can collect their gains even before maturity.
However, to ensure that the margin account is never negative, a maintenance margin
(below the original margin requirement) is required by the clearing house. That is, at

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any point in time, each is required to have a certain minimum amount of money in
their margin account.

That is, those in profit position are not allowed to draw their margin accounts down to
zero and those in loss position may be required to put extra money into their margin
accounts. In the later case, we say the person in the loss position is subject to a margin call.

Reversing a trade

Suppose that when the price of maize rose to 0.16 million cedis on day 2, the kenkey factory
takes the view that November maize price can never rise above that figure. Realizing that it is
in a profit position, the factory may decide to sell November maize (i. e. maize to be
delivered in November) at 0.16 million cedis per ton. (After all, the farmer is obliged to
deliver November maize to the factory at a lower price). The factory is then said to have
made a reversing trade. That is, on one hand the factory has a contract that requires it to take
delivery of 10 tons of November maize, and on the other hand, another contract that requires
it to deliver 10 tons of November maize.

The factory is said to have unwound, or closed out its position in November maize.

Comments
1. Suppose this is July 1, and that the November futures price of commodity X is 10,000
cedis. This means that 10,000 cedis is the price at which market participants agree to
buy or sell commodity X for November delivery. This price changes from time to
time. It is determined on the exchange by market forces (demand and supply).
2. On the delivery date, the futures price of the contract equals the spot price of the
underlying asset since both calls for immediate delivery (today).

Any discrepancy between the two will result in arbitrage opportunities.

3. While the expected future spot price of the underlying asset is important, the carrying
cost of the asset is also important. This comprises the cost of storage, spoilage,
insurance and foregone interest less any cash flow from the asset while it is being
held.

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 Thus, one can think of two trading strategies.

The first is to buy the underlying asset now at the spot price P, and bear carrying costs
for the period in question, three months say.

The other is to buy a three-month futures contract at a futures price of F.

Since these two strategies are alternate ways of acquiring the same asset, the costs
must be equal.

Thus,
Futures price = Spot price + Carrying cost

One may rewrite this as

Futures price - Spot price = Carrying cost

By definition, the carrying costs decrease as the maturity of the contract approaches.
On the delivery date the carrying cost vanish and the futures price equals the spot
price.

4. Daily settlement reduces the default risk of futures contracts compared to forward
contracts.
5. It also minimizes default amounts.
6. Investors in futures contracts have the option of closing out their positions
(liquidating) before the delivery date on well-organised exchanges, unlike investors in
forward contracts.
7. On the other hand, the following are considered disadvantages of futures contracts to
many commercial users
❑ Limited number of currencies traded
❑ Limited delivery dates
❑ Rigid contractual amounts

50 | P a g e
Illustration B

Sometime back, GNPC entered into 10 futures contracts each requiring them to purchase
1,000 barrels of oil from NNPC at US$ 18 per barrel. Today is the last day of trading for the
futures contracts. Oil is now selling for $ 23 per barrel. GNPC’s futures will be closed out
today when contracts are marked to market.

- As the price of oil rose from $18 to $23, $5 per barrel was added to GNPC’s margin
account.

- On ten 1,000 barrel contracts, this amounts to $ 50,000.

- The same amount is withdrawn from NNPC’s account.

- 10,000 barrels cost $ 230,000 today. With $ 50,000 already in their margin account,
GNPC needs come up with only $ 180,000 (additional) to buy the oil. Thus, paying
$18 per barrel as per the original contract.

- If they do not want to take actual delivery of the oil, GNPC would enter into an
offsetting futures contract. This time to sell oil at $ 23. In practice, over 90% of all
futures positions are closed out before maturity by entering into offsetting
contracts. This suggests substantial activity by speculators.

USAID initiates grain warehouse receipt system in Ghana… Holds action planning
programme for 40 stakeholders July 2011

THE AGRIBUSINESS and Trade Promotion (ATP) project, funded by the United States
Agency for International Development (USAID), has imitated the Ghana Pilot of the
Warehouse Receipts system with a two-day Action Planning Workshop for about 40
stakeholders in Kumasi.

The project intends to establish three warehouses certified for the upcoming harvest season.
The participants, mainly farmers, traders and processors, were drawn from the agricultural
sector to address major post-harvest problems, including the lack of adequate storage
facilities and the inability to access funds for investment capital facing Ghanaian farmers. Ms

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Sophie Walker, a consultant of the East African Grains Council in Kenya, told the workshop
that the warehouse receipts system was a critical factor in expanding and attracting
credit to the agricultural sector, raising farmer incomes and increasing investment in
production and storage infrastructure.

She said the warehouse receipts system allowed producers, traders and exporters to store their
crops in approved warehouses that were secure and meet proper conditions, and receive
receipts for their deposited goods which can be used at a bank to secure a loan worth a
percentage of its value. The Grains consultant indicated that under the system, once the goods
are sold, the loan and interest are first paid off, along with any management fees from the
warehouse, with the remaining profits going to the borrower. Walker said the storage of the
goods allows the seller to time the market to ensure the highest price for the goods, and that a
quality storage system enables sellers to spread out their financial gain over a longer time
span, as well as ensure more value for their products, as they are kept dry and clean.

It is a welcome the initiative of the USAID-sponsored ATP project, following the realisation
that major post-harvest problems facing the Ghanaian farmer was the lack of adequate
storage facilities for maize and rice, as well as legumes such as cowpeas and soya beans.
Reports from Agric Directorate shows that, about $429 million was tied up in the maize
production at harvest, 50% of which is held by farmers, with the other half by traders, making
the cost of tying up of capital quite enormous It is hope that the implementation of a
warehouse receipt system would enhance better storage conditions for foods.

It is suggested that for a successful long term warehouse receipt program, all stakeholders
must work together, and called for a regulator to make sure the system works. We need
warehouses willing to be certified, and willing to offer up their storage areas to anyone
with commodity to deposit, as well as insurance companies to offer comprehensive
policies to cover potential risks on the commodity stored, and banks to look at collateral
being offered, he noted.

HOW DOES THE WAREHOUSE RECEIPT SYSTEM WORK?

Warehouse Receipt Systems (WRS) have a long history of use in facilitating commodity
trade and finance. Basically, the systems involve the issuing of documents, Warehouse
Receipts (WR), as evidence that specified commodities of stated quantity and quality have

52 | P a g e
been deposited at a particular location by a named depositor(s). Depositors may be a
producer, a farmer group, a trader, an exporter, a processor or indeed any individual or
corporate body.

The issuer of the Warehouse Receipt holds the stored commodity by way of safe custody;
implying that the issuer is legally liable to make good any value lost through theft or damage
by fire and other catastrophes but has no legal or beneficial interest in the commodity. In
case of liquidation, creditors of the issuer will not be able to seek recourse to the
commodities stored since legal title remains with the depositor or bona fide holder of the
Warehouse Receipt. The only exception is the warehouse operator's lien covering
outstanding storage costs. The generic WRS model being promoted by the NRI
consortium in these Projects works as follows:
❖ The depositors deposit their commodities which meet defined quality standards at
designated warehouses.
❖ The designated warehouses have to meet prescribed physical standards.
❖ The Warehouse Operators issue Transferable Warehouse Receipts stating the
commodity, the quantity and quality of commodity deposited.
❖ The Warehouse Operator guarantees delivery of the commodity described on the
Warehouse Receipt and is liable for any losses incurred.
❖ The Warehouse Receipt issued is transferable, which means it may be transferred to a
new holder – a lender (where the stored commodity is pledged as security for a loan)
or to a trade counter-party (by which the buyer is entitled to take delivery of the
commodity upon presentation of the Warehouse Receipt at the warehouse).
❖ Hence, if the depositor requires short-term financing, he/she can obtain an advance
representing a percentage of the prevailing market value of the commodity from a
bank, using the warehoused crop as collateral.
❖ The depositor can wait until such time when market conditions are conducive to sell
the warehoused commodity.
❖ Where the depositor borrowed using the warehoused commodity as collateral, it will
be required that payment for the commodity is channeled through the financing bank.
The bank in turn deducts the loan advanced and any accrued interest and other
charges before crediting the account of the depositor with the balance.
❖ A depositor who has not borrowed against the stocks will be entitled to the full
proceeds from the sale.

53 | P a g e
 ❖ A depositor has to pay storage, and where applicable - collateral management fees.
❖ A depositor is also responsible for the cost of transporting the commodity to a
designated warehouse.

THE APPEAL OF WAREHOUSE RECEIPTS SYSTEM

The WRS can help address multiple constraints in commodity marketing and finance
systems. The main benefits include:
• The use of inventory as collateral can ease access to finance and lowers financing
costs, especially for smallholder producers (participating as groups).
• The application of standardized grades allows trading by description, thereby
reducing transaction costs, and also safeguarding against cheating on weights and
quality.
• Trade using the WRS shortens the marketing chain and can potentially increase
producer margins.
• Commodities are better stored by professional warehouse operators, therefore
reducing storage losses.
• The WRS can also help reduce the cost of procuring and managing public food
reserves; create incentives for private players to invest in new business ventures;
encourage proactive cooperation among producers and other players; and in creating
and maintaining a more enabling policy and regulatory framework for trade in
agricultural commodities.
eleni: Investors Rally to Finance New Ghana Commodity Exchange March 2014

ADDIS ABABA, ETHIOPIA — eleni, a private company positioned as the premier

commodity exchange promoter in Africa, has announced today the formation of a
private-public investment consortium to finance the establishment of the Ghana
Commodity Exchange (GCX).
Investment consortium partners include Ghana’s top tier financial institutions,

• Data Bank Agrifund Manager Ltd;

• Ecobank Ghana Ltd, UT Bank Ghana Ltd;
• IFC, 8 Miles Fund and eleni, with
• minority stake holding by the Government of Ghana, 10%.

54 | P a g e
The consortium partners and the Government of Ghana have jointly signed a Letter of Intent
with the aim of completing the investment process by April 2014 and launching the GCX
over a 12 month period through early 2015.

A second consortium is also in formation for a large-scale investment in warehouse and

logistics infrastructure and equipment in 8 delivery sites around Ghana as a strategic
eco-system partner to the GCX.

In his second State of the Nation address delivered on February 25, 2014, President John
Dramani Mahama announced that “as part of efforts to create an orderly, transparent and
efficient marketing system for Ghana’s key agricultural commodities to promote agricultural
investment and enhance productivity, the Government has committed itself to the
establishment of a Ghana Commodity Exchange (GCX) and associated Warehouse Receipt
System (WRS). This move is to encourage market access and fair returns for smallholder
farmers and to facilitate the formalization of informal agricultural trading activities. It is
expected that the establishment of the Ghana Commodity Exchange will position it as a West
Africa Regional Hub for commodity trading activities.”

Exercises
1. What is the difference between a long forward position and a short forward position?
2. What is the difference between entering into a long forward contract when the
forward price is 500 cedis, and taking a long position in a call option with a strike
price of 500 cedis?
3. What is the difference between a forward contract and a futures contract?
4. Compare and contrast a long position in a futures contract versus a long call option
position (of the same size) on the same asset.
5. You have written a call option on 1,000 FML shares with a strike price of ¢20,000
and an expiration date in 6 months. What have you committed yourself to? How much
would you possibly gain or lose?
`What if you had written a put option instead?

55 | P a g e
56 | P a g e
 TOPIC SIX
METHODS FOR INTERNATIONAL TRADE FINANCE

❖ Suppliers credit: credit is provided by either the exporter or importer, one or more
financial institutions or any combination of these.
❖ Prepayment: the exporter will not ship the goods until the buyer has remitted to the
exporter.
❖ Letters of Credit: is an instrument issued by a bank on an importer(buyer) promising
to the exporter (beneficiary) upon presentation of shipping documents in compliance
with the terms stipulated therein.
❖ Draft or bill of exchange is unconditional promise drawn by one party, usually the
exporter, instructing the importer to pay the face amount of the draft upon
presentation.
❑ documentary collection.
❑ Document against payment
❑ Document against acceptance
❑ Trade acceptance.
❑ Consignment: the exporter ships the goods to the importer while still retaining actual
titles to the merchandise.

❑ Open account: is the opposite of prepayment. In this case, the exporter ships the goods
and expects the importer to remit payment according to the agreed-upon terms. The
exporter relies fully on the creditworthiness of the buyer.

TRADE FINANCE METHODS

❖ Accounts receivable financing: The exporter takes loan from the bank backed by the
account receivables from the importer.
❖ Factoring: The exporter sells the account receivable to a factor house at a discount.
Cross-border factoring.
❖ Letters of credit: is an instrument issued by a bank on an importer(buyer) promising
to the exporter (beneficiary) upon presentation of shipping documents in compliance
with the terms stipulated therein.
⚫ revocable letters of credit
⚫ Irrevocable letters of credit\
57 | P a g e
 ⚫ Issuing bank
⚫ Advising bank

Bill of Lading: it serves as a receipt for shipment and summary of freight charges. Ocean bill
of lading and airway bill.

VARIATION OF LETTERS OF CREDIT

⚫ Standby letter of credit: it promises to pay the beneficiary if the buyer fails to pay as
agreed.
⚫ Transferable letters of credit: it allows the first beneficiary to all or part of the original
L/c to a third party
⚫ Assignment of proceeds.
⚫ Banker’s acceptance: is bill of exchange, or time draft, drawn on and accepted by a
bank. It is the accepting bank’s obligation to pay the holder of the draft at maturity.

OTHER METHODS OF FINANCING

✓ Working-capital Financing, Medium-Term Capital Goods Financing (Forfaiting):

Countertrade.
✓ Futures contracts traded by firms or individuals through brokers on the trading floor
of an exchange. (e.g. Chicago Mercantile Exchange), on automated trading systems or
over-the-counter. Participants in the currency futures market need to establish and
maintain a margin when they take a position.

58 | P a g e
 TOPIC SEVEN
RELATIONSHIPS AMONG INFLATION, INTEREST RATES AND
EXCHANGE RATES

Inflation, Interest Rates and Exchange Rates

1. Inflation and interest rates can affect exchange rates and so the value of MNC
2. MNC managers must have a good understanding of how these variables can impact
the values of the corporations they manage
Purchasing Power Parity (PPP) - Quantifies the relationship between inflation and
exchange rate

1. Interpretation of Purchasing Power Parity

a. Absolute Form of PPP: without international barriers, consumers shift their
demand to wherever prices are lower. Prices of the same basket of products in
two different countries should be equal when measured in common currency.
b. Relative Form of PPP: Due to market imperfections, prices of the same basket
of products in different countries will not necessarily be the same when
measured in a common currency. However, the rate of change in prices
should be somewhat similar when measured in common currency as long as
transportation costs and trade barriers are unchanged.
Purchasing Power Parity (PPP)
- Relative Form of PPP

1. Countries A and B trade with each other and initially have zero inflation.
2. If inflation in country A goes up to 9 % and that of country B goes to 5%, then
according the PPP theory, the exchange rate of B must appreciate by 4%.
3. The adjustment in the exchange rate is just enough to offset the difference in inflation.
4. If that occurs, the relative purchasing power of buying the same basket of goods in
both countries is the same.
Derivation of PPP

1. We assume the price indexes of the home and foreign country are the same. If home
and foreign country experience inflation subsequently, Then price indexes will
change as follows:
59 | P a g e
 2. Home country: Ph (1 + I h )

3. Foreign country: Pf (1 + I f )

4. With inflation, exchange rate changes in foreign country, hence, price index of
foreign country:

Pf (1 + I f )(1 + e f )

1. Under conditions of parity:

Pf (1 + I f )(1 + e f ) = Ph (1 + I h )

Purchasing Power Parity

1. Relationship between relative inflation rates (I) and the exchange rate (e).

1+ Ih
ef = −1
1+ I f

1. Simplified PPP relationship

ef  Ih − I f

Using PPP to Estimate Exchange Rate Effect

1. If home country experiences 5% inflation while foreign country experiences 3%

inflation, then the foreign currency should adjust by:

1 + .05
ef = − 1 = .0194  1.94%
1 + .03

1. If home inflation is 4% while foreign inflation is 7%,then:

1 + .04
ef = − 1 = −.028  −2.8%
1 + .07

1. Simplified PPP relationship; appropriate only if inflation differential is small.

ef  Ih − I f
60 | P a g e
Summary of Purchasing Power Parity

Illustration of Purchasing Power Parity

Why Purchasing Power Parity Does Not Occur

1. Confounding effects; PPP assumes that exchange rate movement is explained solely
by inflation differential. However, other factors such as relative interest rates, relative
income levels, change in government control and expectations about future exchange
rates
2. No substitutes for traded goods
International Fisher Effect (IFE)

1. IFE uses interest rate differential to explain exchange rates movements

2. IFE suggests that the nominal interest rate contain two components:
a. Expected inflation rate
b. Real interest rate
3. Implications of the IFE: currencies with high interest rates will have high expected
inflation and will be expected depreciate.

61 | P a g e
 4. Implications of the IFE for foreign investors: foreign investors will be adversely
affected by the effects of relatively high U.S. inflation rate if they try to capitalize on
high U.S. interest rates.
Derivation of the International Fisher Effect

1. Relationship between the interest rate (i) differential between two countries and
expected exchange rate (e)

1 + ih
ef = −1
1+ i f
1. Simplified relationship: appropriate only when interest rate differential is small:

e f  ih − i f

EXAMPLE of IFE

1. Assume interest rate on a one-year home country bank deposit is 11% and interest rate
on a one year foreign bank deposit is 12%. For these investment returns to be
considered similar from the home country investor, the foreign currency will have to
change by:

1 + 0.11
ef = − 1 = −0.0089  −0.89%
1 + 0.12

Summary of the International Fisher Effect

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63 | P a g e
 TOPIC EIGHTs
INTERNATIONAL FLOW OF FUNDS

Balance of Payments

1. Summary of transactions between domestic and foreign residents for a specific

country over a specified period of time.
a. Current Account: summary of flow of funds due to purchases of goods or
services or the provision of income on financial assets.
b. Capital Account: summary of flow of funds resulting from the sale of assets
between one specified country and all other countries over a specified period
of time.
Components of the Current Account

1. Payments for merchandise and services:

◼ Merchandise represent tangible products while services represent intangibles such as
tourism, legal and consulting services
◼ Balance of trade: difference between total exports and imports.

2. Factor income payments: e.g., interest and dividend payments on financial

instruments.

3. Transfer payments: aid, grants gifts from one country to another.

Capital and Financial Accounts

Capital account: value of financial assets transferred across countries by people who move to
a different country. Also includes transfer of nonfinancial assets such as patents and
trademarks.

Financial Account
1. Direct foreign investment (fixed assets)
2. Portfolio investment (e.g., bonds and stock)
3. Other capital investment (e.g., money market securities)
4. Errors and omissions (offsets imbalance between current account and capital/financial
account)
2008 Distribution of U.S. Exports and Imports

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International Trade Flows

1. Distribution of U.S. Exports and Imports: Canada, China, Mexico, and

Japan are the key exporters to the United States.
2. U.S. Balance-of-Trade Trend: value has grown substantially over time.
Impact of Huge Balance-of-Trade Deficit: could lead to higher U.S. unemployment but
increases competition leading to more efficient production.

Events That Increased International Trade

1. Removal of the Berlin Wall

2. Single European Act of 1987
3. North American Free Trade Agreement (NAFTA)
4. General Agreement on Tariffs and Trade (GATT)
5. Inception of the Euro
6. Expansion of the European Union

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 7. Other Trade Agreements
Trade Frictions – Examples

1. Environmental restrictions
2. Labor laws
3. Bribes
4. Government subsidies
5. Tax breaks
Trade Policies

1. Using the exchange rate as a policy

2. Outsourcing
3. Managerial decisions about outsourcing
4. Using trade policies for security reasons
5. Using trade policies for political reasons
Factors Affecting International Trade Flows

1. Inflation: current account decreases if inflation increases relative to trade partners.

2. National Income: current account decreases if national income increases relative to
other countries.
3. Government Policies
a. Subsidies for exporters
b. Restrictions on imports (taxes/tariffs and quotas)
c. Lack of restriction on piracy
4. Exchange Rates: current account decreases if currency appreciates relative to other
currencies
Limitations of a Weak Home Currency Solution

1. Counter pricing by competitors

2. Impact of other weak currencies (currency does not weaken against all other
currencies)
3. Prearranged international transactions: creates a lag between weakening currency and
upturn in demand. May lead to further deterioration in balance of trade in the short
run because of higher cost of imports (J-curve effect)
4. Intracompany trade (trade in this case will continue irrespective of the level of
exchange rate)

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Factors Affecting Direct Foreign Investment (DFI)

1. Changes in Restrictions
2. Privatization
3. Potential Economic Growth
4. Tax Rates
5. Exchange Rates
Distribution of Global DFI across Regions in 2007-2008

Factors Affecting International Portfolio Investment

1. Tax rates on Interest or Dividends

2. Interest Rates
3. Exchange Rates
Impact of the International Flow of Funds on U.S. Interest Rates and Business Investment in
the United States.

Agencies that Facilitate International Flows

1. International Monetary Fund (IMF)

2. World Bank
3. World Trade Organization (WTO)
4. International Financial Corporation (IFC)
5. International Development Association (IDA)
6. Bank for International Settlements (BIS)
7. Organization for Economic Cooperation and Development (OECD)

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 8. Regional development agencies

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 TOPIC NINE
MANAGING TRANSACTION EXPOSURE

Definition:
1. Sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate
movements, or
2. Transaction exposure exist when the anticipated cash flows of a firm are affected by
exchange rate fluctuations E.g., The value of exports denominated in a foreign
currency will decline if the currency were to depreciate. How to assess transaction
exposure:
1. Estimate MNCs net cash flows in each currency
2. Measure potential impact of currency exposure
Consolidated Net Cash Flow Assessment

Currency Total inflow Total Net Exp. Net inflow/outflow as m

outflow inflow/outflow Exch
rate at
end of
quarter

British pound 17,000,000 7,000,000 +10,000,000 $1.5 +$15,000,000

Canadian 12,000,000 2,000,000 +10,000,000 $.80 +$8,000,000

dollar

Swedish krona 20,000,000 120,000,000 -100,000,000 $.15 -$15,000,000

Mexican peso 90,000,000 10,000,000 80,000,000 $.10 +$8,000,000

Estimating Range of Net Inflows/Outflows

Currency Net inflow/outflow Range of Possible Range of Possible Net In

Exchange Rate at
end of Quarter

British pound +10,000,000 $1.4 to $1.6 +14,000,000

to
+16,000,000

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Canadian dollar +10,000,000 $.79 to $.81 +7,900,000
to
+$8,100,000
Swedish krona -100,000,000 $.14 to $.16 - $14,000,000
to
- $16,000,000

Mexican peso 80,000,000 $.08 to $.11 +$6,400,000

to
+$8,800,000
1. MNC must identify its individual net transaction exposure on a currency by currency
basis for its subsidiaries as shown above
◼ Offsetting effects of subsidiaries may insulate MNC and make hedging unnecessary
for each subsidiary
◼ Invoice policy can also be used to manage exposure: i.e., invoice (price) the exports in
the currency needed to pay for imports

2. MNC must consider the various techniques to hedge the exposure so that it can decide
which hedging technique is optimal and whether to hedge its transaction exposure.

Hedging Exposure to Payables

◼ MNC can hedge part or all of it payables to protect it against appreciation of the
currency in which payments are to be made
1. Forward or futures hedge allows the MNC to lock in the exchange rate at which it can
purchase a specific currency.
2. Money market hedge involves taking a money market position to cover a future
payables position.
3. Call option hedge on payables provides the right to buy a specified amount of a
particular currency at a specified strike price.
Example: Forward or futures hedge

Ghanaian MNC needs 100,000 euros in one year. Using a forward rate of 1.20 cedis to buy a
forward contract for euro (the same as currency futures contract for euros), the cedi
cost in one year is:

Cost in cedis = Payables x Forward rate

= 100,000 euros x 1.20 cedis

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 = 120,000 cedis

We use the same process if a futures contract were used instead of a forward contract.
Example: Money market hedge on payables (Using MCN cash)

MNC needs 100,000 euros in one year. If the company has cash, it can convert the cedis into
euros and deposit in a bank for one year. If the interest rate is 5%, euros to be
deposited:

Deposit amount to hedge payables = 100,000 euros/(1 + 0.05)

= 95,238 euro

If the spot rate today is 1.18 cedis to the euro, then we need a cedi equivalent of:

Deposit amount in cedis = 95,238 euros x 1.18 cedis = 112,381 cedis

Example: Money market hedge on payables (Using borrowed money)

If the MNC does not have cash, it can still use the money market hedge but that would
require it;
1. to borrow in the local currency
2. and invest in the foreign currency on a short term basis

If the MNC can borrow at 8%, at the end of the year it would have to pay:

Cedi amount of loan payment = 112,381 x (1+ 0.08)

= 121,371 cedis
Money Market Hedge vrs. Forward/Futures Hedge

◼ Because the cost of hedging is known well ahead of time, the MNC should choose the
one that is feasible and cost effective
◼ Money market hedge and Forward hedge yield the same if there is interest rate parity
between the two countries – forward premium reflects interest differential
◼ Hence, hedging of payables with a forward contract is similar to borrowing at the
domestic interest rate and investing at the foreign interest rate.
Currency Call Options

◼ Forward hedge and money market hedge have negative payoffs if the currency of
payables depreciates

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 ◼ Hence the risk insulation is one-sided. The best hedge will be one that protects the
firm from unfavorable currency movements but allows it to benefit from favorable
movements. OPTIONS?

Currency Call Option: - Gives MNC the right to buy a specified amount of a particular
currency at a specified price (strike or exercise price) within a given period of time.
◼ Locked in a maximum price (strike price) to buy the currency
◼ MNC lets option expire if spot rate is lower than strike price
◼ Cost of hedging with call options not known until payables are to be paid. Sensitivity
analysis using different spot rates?
Optimal Technique for Hedging Payables

1. Select optimal hedging technique by:

a. Considering whether futures or forwards are preferred.
b. Consider desirability of money market hedge versus futures/forwards based on
cost.
c. Assess the feasibility of a currency call option based on estimated cash
outflows.
2. Choose optimal hedge versus no hedge for payables
3. Evaluate the hedge decision by estimating the real cost of hedging payables versus the
cost of payables if not hedged.
Hedging Exposure to Receivables

◼ Risk of receivables: Currency in which receivables are to be collected may depreciate

1. Forward or futures hedge allows the MNC to lock in the exchange rate at which it can
sell a specific currency.
2. Money market hedge involves borrowing the currency that will be received and using
the receivables to pay off the loan.
3. Put option hedge on receivables provides the right to sell a specified amount of a
particular currency at a specified strike price by a specified expiration date.
Forward or Futures Hedge on Receivables

◼ Ghanaian firm to receive 200,000 Swiss Francs in 6 months. Ghanaian firm can go
into a forward contract to sell the SF200,000 in 6 months. Assume 6-month forward
rate is 0.71 cedis. The amount of cedis to be received in 6 months:

Cash inflow in cedis = Receivables x Forward rate

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 = SF200,000 euros x 0.71 cedis

= 142,000 cedis
Money Market Hedge on Receivables

◼ Ghanaian MNC to receive SF200,000 in 6 months. If funds can be borrowed in SF at

3% over 6 months, the amount it should borrow so that the receivables can be used to
repay the loan is:

Amount to borrow = SF200,000/(1 + 0.03)

= SF194,175

By borrowing the SF194,175 at 3% for 6 months, it will have to pay back SF200,000
to the bank in 6 months time.

If we assume the spot rate is 0.70 cedis to the SF:

Amount of cedis received from loan = SF194,175 x 0.70 cedis

= 135,922 cedis

If the cedis can be invested in the money market at 2%:

Value of investment = 135,922 cedis x (1+ 0.02) = 138,640 cedis

Currency Put Options

A put option gives the MNC the right to sell a specified amount of currency at a specified
price (exercise price) by a specified expiration date.
◼ Cost not known with certainty until receivables are due and spot rate is known.
Sensitivity analysis using different spot rates???
◼ Locked in a minimum price to sell receivables
◼ Cash to be received from the put option hedge is the cash received from selling
currency minus the put premium.
◼ If spot rate at the time of collecting receivables is greater than the exercise price,
MNC will let option expire without exercising it.
Optimal Technique for Hedging Receivables

1. Select optimal hedging technique by:

a. Considering whether futures or forwards are preferred.
b. Consider desirability of money market hedge versus futures/forwards based on
cost.

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 c. Assess the feasibility of a currency put option based on estimated cash
outflows.
2. Choose optimal hedge versus no hedge for receivables
3. Evaluate the hedge decision by estimating the real cost of hedging receivables versus
the cost of receivables if not hedged.
Hedging Policies of MNCs

1. Hedging most of the exposure (helps in planning)

2. Hedging none of the exposure (diversified MNCs)
3. Selective hedging
Limitations of Hedging

1. Limitation of hedging an uncertain amount of transaction

2. Limitation of repeated short-term hedging

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