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Week 1:

Maximize shareholder returns: Increase cash flows


(new market opportunities, value-accretive investments,
reduction in costs, stronger market power, improve
asset efficiency). Reduce capital costs: (lower cost of
debt and equity, optimal use of debt, reduce firmspecific business risks).

Week 3:
FX Market Participants: Two-tiered market (Interbank market (wholesale), Client market (retail)). Bid-ask (%) = (() ()) / ().
Week 5:

Week 9:
Average
of the bid-ask rate is the middle rate - Also known as mid-rate, midpoint price, average rate. Fairly indicative of the historical market (timeseries). Bid-ask: To incentivize dealers to bear ER and credit risk ( Very small spreads compared to other asset classes, Increase with volatility, Decrease
Total value (premium/price) of optionTransaction
= Intrinsic value
exposure:
+ time
FXvalue.
risks associated
Intrinsic value:
with single business transactions (contractual obligations). Hedging can reduce/eliminate FX risks
with dealer competition). From the angle of the dealer/bank (From investor angle): Bid: Dealer buy denominator currency (I sell)/Dealer sell
Financial gain if the option is exercised
without
immediately
affecting
(Max[STE,
operations
0]->
forimprove
call option,
cash Max[E
flow. However,

Hedging provides opportunities for employees to speculate instead of hedge. Shareholders


numerator currency (I buy). Ask: Dealer sells denominator currency (I buy), Dealer buys numerator currency (I sell). Always from Dealers point of view.
ST, 0] for put option). Time value (Current
only want
spot
firms
rate
to may
engage
move
in risk
further
that into
theythe
are money
competitive in, not in FX risk (Shareholders can manage FX risk themselves). Hedging may not reduce
between now and maturity, For American
market
option
risktime
of firm
value(CAPM
is always
beta),
>= so
0) investors
with
diversified
portfolioand
may
not benefit
firms hedge
FX risks.
Benefits:
Information
Market
microstructure:
How
exchange
occurs
in
markets,
How structures
processes
affect,when
Transaction
costs (and
price impact),
Prices(and
Challenges to financial management: FX risk
asymmetry
(management
has more
information
on exposure,
better for firm to hedge
vs considerations
shareholders). that
Lower
transaction
costsstrategic
as a firm
quotes),
Volume
(and imbalance).
Why is
it important?
Source ofthus
frictions/imperfections.
Practical
deviates
from optimal
(Foreign currency profits may evaporate due to
compared to individual shareholders. Reduced default risk (reduced discount rate/access to capital). Progressive corporate tax (stable earnings lead to
thinking
&
unfavorable exchange rate movements), political risk
lower taxes than volatile earnings; firm pays more tax in high earning periods than it saves during low earning periods).
(Sovereign governments can regulate the movement of
Forwards: Involves agreements to buy and sell foreign currencies in the future at prices agreed upon today (Amount to trade (typically min of USD 1
goods, capital, and people across their borders), market
million),
WeekWhen
10: to trade (1, 3, 6, 9, 12 month contracts), Rate to trade at (forward rate). Decentralized agreements between bank and creditworthy
imperfections (legal restrictions on movement of goods,
client: Bank takes on ER and credit risk -> can offset via opposite position -> Deal with many different clients to net
off position.
Hedge
ratio: thefirms.
ratio If
ofthe
change
in thefirms
price
Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely
domestic
domestic
capital and labor; transactions costs; shipping costs;
of the option
change
in the
price of
Forward
premium/discount:
products
compete with imported goods, their competitive position is affected by the strength or weakness
of the to
local
currency
. Economic
information
asymmetry;
discriminatory
taxation
exposure
is
the
sensitivity
of
the
future
home
currency
value
of
the
firms
assets
and
liabilities
and
the
firms
operating
cash
flow
to
random
practices).
changes in exchange rates.
underlying asset:
Globalization:
Emergence of globalized financial
Week
2:
Operating exposure cannot be readily determined from Calculating
the firmsthe
accounting
statements
as can if
transaction
exposure,
by: the
hedge ratio
is vitally important
you are going
to usebut
options:
Themarket
seller
markets (deregulation of financial markets, advances in
structure of inputs and products; how competitive or how monopolistic
markets
theratio
firm ifare;
to adjust
its profits
markets,or
product
mix, and
International
increased information
opportunity costs,
sets, foreign exchange risks, country
needs the
to know
thefacing
hedge
he firms
wantsability
to protect
his
eliminate
his
technology - finance:
greatly reduced
sourcing
in
response
to
exchange
rate
changes.
(political,
regulatory)
risks, market
imperfections
(trans. costs, barriers, info asymmetry
transaction
costs, leading
to financial
innovations),
downside
risk. market
The buyer
needs tonot
know
the hedge
ratio
decide
options
Due to government-initiated capital controls, the currencies of some
emerging
countries
freely
traded.
Fortomany
of how
thesemany
currencies,
and
taxes).
emergence of the Euro as a global currency (more than
to buy.
trading
in non-deliverable
contracts
exists.the
(A location
non-deliverable
forward contract
is settledthe
in effect
cash, of
usually
U.S. rate
dollars.
Settlementflexible
is
To manage:
select low costforward
production
sites (diversify
of its production
sites to mitigate
exchange
movements),
330 million Europeans in 19 countries are using the
calculated
the difference
between
forward price but
agreed
the contract
anddiversification
the spot priceofatmarket
maturity
of the
theadvantage
contract of
sourcingby
policy
(does not apply
onlythe
to components,
also to
to in
guest
workers),
(selling
in contract
multiple multiplied
markets toby
take
Decisions in corp. finance: Good investment policies (increases cash flows and
Convert future values from one currency to another using forward exchange rates ->
common currency on a daily basis), inclusion of the
economies of scale and diversification of exchange rate risks), R&D and product differentiation (R&D allows for: Cost-cutting, Enhanced productivity,
profitability, balance topline and variability of cash flows), Good financing policies (reduce
Convert present values using spot exchange rates -> Discount future values to present
Renminbi in the IMFs reserve currency basket (greater
Week
4: differentiation. Successful product differentiation gives the
Product
firm less elastic demandwhich may translate into less exchange rate risk), financial
costs of financing investments, increasing cash flow and profitability, reduces volatility of
values using the correct interest rate -> To find the risk-neutral probability, set the
demand for CNY due to increased investment into CNY
hedging (stabilize the firms cash flows in the near term).
cash flows).
Inflation: money supply increases faster than real economic output,
used to
formderived
an expectation
of prices
thethe
future
(Inflation
-> appreciation,
denominated assets (capital account increase)),
forward
price
from IRP
equalin to
expected
value
of the payoffs
deflation
-> depreciation).
FDI makes
investing company vested in the long term success
of local
venture
, in
exchange
treatment
and good
profits.
FDI
economic
integration
and trade liberalization
(GATT
Risk
and return
are independent
concepts: Risk-returns
are rule of thumb. Reducing
calculated
using
q and
solve
for qfor
->preferential
To find the tax
option
value discount
the
expected
cycle: Funds are raised in the lowest risk countries with capital markets infrastructure (law, CG) to protect investors -> Companies take funds and invest in
replaced
by WTO),
privatization,
global isfinancial
crisis
risk
does not
automatically
mean return
less. Strong
operation can minimize operational
Fisher effect: Nominal IR ~ Real IR + Inflation. Slight inflation is the policy objective of G: Real costs decreases over time. Room to stimulate
Week 6:
higher
risk
countries,
exposing
themselves
to
risk,
but
earning
a
return
via
lower
costs
and
expanded
market
opportunities
->
FDI
receiving
country
hope
(GFC)and
of 2008-09.
risks
increase/stabilize cash flows. Increase proportion of stable cash flow -> lower
economy.
to gain
income arrangement
and more importantly
risk.
In a swap, two counterparties agree
to a jobs,
contractual
wherein technology
they will -> Funds are returned to the financing countries, to go for the next round. FDI will seek path of
least
resistance
(lowest
costs/risk,
higher
margin).
Law
of one
price:
An
identical
good
should
costSingle
the same in different countries after adjusting for exchange rates (and transaction and transportation
exchange cash flows at periodic
intervals.
Two types
of interest
rate
swaps:
Efficient markets: Strong form (All public and private information are priced (i.e. reflected
Lawfixed-for-floating
of one price applies
to one
point in
time,
while purchasing power parity refers to a period of time. PPP deviations have very important
currency interest rate swap (Plaincosts).
vanilla
swaps
are
often
just
called
Reasons
to invest overseas:
Trade
barriers
(Government
action leads to market imperfections: Tariffs, quotas, and other restrictions on the free
in stock prices)), Semi-strong form (All public information are priced), Weak form (All
for
international
trade
(Affects thefixed
competitive positions of the pair of countries in the world export markets). The absolute version of
interest rate swaps); Cross-currencyimplications
interest
swap
(often called
a
currency
flow of rate
goods,
services,
and people.
Tradeswap;
barriers can also arise naturally due to high transportation costs, particularly for low value-to-weight goods),
historical prices are reflected). Implication: Even in weak form, cannot predict future
the
PPP
has
limited
use
in
real
life
->
Rely
on
the
relative version of the PPP. Real ER:
for fixed rate debt service in two (or more)
Laborcurrencies).
market imperfections (If there exist restrictions on the flow of workers across borders, labor services can be underpriced relative to
prices using past prices. Under-reaction is a persistent phenomenon: this is evident of
productivity),
Intangible
assets
(Firms
may protect
semi-strong mkt efficiency.
Swap bank is a generic term to describe
a financial
institution
that
facilitates
swaps their intangible assets via control of overseas subsidiaries), Vertical integration (MNCs may
undertake
FDI in
are available
between counterparties. The swap bank
can serve
ascountries
either a where
broker inputs
or a dealer.
As a to secure the supply of inputs at a stable accounting price), Product life cycle (develop new
Arbitraging the mechanism of price adjustments: market imperfections limit
products
in
the
developed
world
for
the
domestic
market, and then markets expand overseas), Shareholder diversification (indirect diversification to
broker, the swap bank matches counterparties but does not assume any of the risks of the
arbitrage (frictions) (transaction costs (fees and taxes), regulatory frictions, information
shareholders
if
there
exists
significant
barriers
to the cross-border flow of capital).
swap. As a dealer, the swap bankPPP
stands
ready
to =
accept
side ofposition
a currency
swap
holds
if q
1 -> either
competitive
holds.
q < 1 -> competitiveness of home country improves. q > 1 -> competitiveness of home country
asymmetry). By definition, arbitrage is riskless: simultaneously buy an under-valued
and then later lay off the risk, or match
it with a counterparty.
deteriorates.
Cross-border
MA: Inorganic growth: hit the ground running, time to market is fast (But integration efforts may be a nightmare). Domestic M&A
stock in country X and sell the over-valued counterpart in country Y.
to rate
sort out
What
products/services
to offer, Which group to handle what responsibilities, who to be in charge, How to execute cost
Swap banks will tailor the terms Forward
of issues
interest
and post-merger:
currency
swaps
torate
customers
premium/discount
= interest
differences. Current spot determined using current info. Expected spot will always change due to new
Examples of risky arbitraging: Identify two companies with the same characteristics (e.g.
savings
plan.
On topand
of that cross-borders
involve integrating: Business culture, Regulatory environment, Customer expectations, Rank and file
needs. They also make a market in
plain vanilla
quotes
for these.
information.
The swaps
Law of Oneprovide
Price and
Purchasing
Power Parity applies to identical products. Analogously, interest rate parity applies to financial
earnings, same-school CEOs, perfect competitors) -> Buy the undervalued one using
employee
power,
Corporate
governance.
Since the swap banks are dealers for
these swaps,
is aisbid-ask
spread.
securities,
where there
the price
the interest
rate. Value of
capital acquired by shorting the overvalued one (hedge portfolio). Other types of
the swap to a counterparty is the difference
the PV of
the payment
streams
that the -> With that comes agency issues (Career concerns: division managers may boost short term
Extendedincontrol
requires
division
managers
arbitraging: Route international sales to shell companies in tax havens (e.g. Cayman,
Interest rate parity: No arbitrage opportunities - exist between investments (in an identical financial instrument) at home or in a foreign country, after
counterparty will receive.
British Virgin Islands (BVI)) -> Pay 0% corporate tax compared to 35% in the US.
Week 11:exchange rate. Model
considering
Risks of Interest Rate and Currency Swaps: Interest rate risk (Interest rates might
Free trade can improve standard of living: Defined as /, where asset
The total market value of the worlds bond markets are about 50% larger than the worlds equity markets . More domestic bonds than
move against the swap bank after it has only gotten half of a swap on the books, or if it has
refers to any consumption goods. Same principle of CA to firm: if firm invests resources
international
an unhedged position), Basis risk :(Basis risk may occur if the floating rates of the two
efficiently -> reap profits.
counterparties are not pegged to the Asame
index),
rate risk,
Credit riskbond
(major
global
bond isExchange
a very large
international
offering by a single borrower that is simultaneously sold in North America, Europe, and Asia.
Currency carry trade involves buying a currency that has a high rate of interest and funding the purchase by borrowing in a currency with low rates of
After the workings of competitive markets and free trade, the intrinsic value of the
Types
of
Instruments:
Straight
fixed-rate
debt
(plain
vanilla
bonds
withrate
a specified
rate
and
no funding
optionscurrency
attached.
interest,
without
any
hedging
(The
carry
trade
is
profitable
as long
as the
interest
differentialcoupon
is greater
thanand
the maturity
appreciation
of the
Week 7:index. If a commodity
same product in both countries should be the same: Big-mac
Medium-Term Notes (MTNs): issue sold on a continuous basis), Floating-rate notes (Just like an adjustable rate mortgage: common reference rates
costs more in one country, arbitraging will bring it back to equilibrium. At the aggregate,
An agency relationship is formed Week
when
a
principal
contracts
an
agent
to
perform
are
3-month
and
6-month
U.S.
dollar
LIBOR),
Equity-related
bonds
(allows
the
investor
to
exchange
the
bond
for
a
predetermined
number
of equity
5:
implications for a country that imports more than exports: demand for foreign currencies >
some services on their behalf. The
writing
up issuer.
and enforcement
of of
contracts
to bond is its straight fixed-rate bond value. Convertibles usually sell at a premium above the larger
shares
of the
The floor-value
a convertible
local currency -> forex depreciation.
Derivatives:
Contingent
claim
securities.
Value
depends
on
(or
derives
from)
the
value
of
underlying
assets.
Market
Participants:
Speculators
align principal-agent incentives are costly
the and
contract,
Monitoring value),
and Zero coupon bonds (sold at a large discount from face value because there is no cash (Profit
of their(Structuring
straight debtofvalue
their conversion
flow until
from
short term
changes Residual
inbonds,
prices,losses
Long/short
position
based(Denominated
on own expectation
of future prices),
Hedgers
(Avoid
variation
in future
among agents
with
conflicting
interests,
(when
cost ofbonds
The value of a firm is the stock price, the value of a bonding
countrycontracts
is the currency
: In
maturity),
Dual-currency
Composite
currency
a currency
basket,
like the SDRs
or price
ECUs,Trading
insteadFrequency
ofbya locking
single(No.
currency).
Equity
market:invery
Measures
Liquidity:
trades
price,
FX risk to speculators). Market needs both: If only
speculators:
volatileof
market.
SpecsTrading
have novolume,
real need
to stick to one price.
Ifofonly
full of
enforcement
of contracts
exceeds
the Passes
benefits)
long run, a currencys value mirrors the fundamental strength
its underlying
economy,
time
period), Bid-ask
or %),
Quote size (no. of shares offered), Trade size (no.
hedgers: no speculators to take a price, no market depth -> noper
point
in hedging
becausespread
cost of(level
hedging
is high.
relative to other economies. In the short run, currency trader expectations play a much
The market anticipates conflicts in interests and will only pay less than the full value
of shares traded), Price impact coefficient (rise in price when buyer places a large order).
more important role. Traders and lenders act on fight-or-flight instincts (Internalize info
Currency
Forwards:
Privatethe
agreement
betweenAs
two
of the equity sold. The difference reflects
the costs
of monitoring
owner-manager.
he parties, OTC, Banks offer to their bigger/stable clients due to potential counterparty risk -> May
underreaction/fight-flight overreaction). Thus, fears of depreciation become selfEmerging
markets
tendto
towait
be till
much
more concentrated than our markets (a few issues
demand
margin
deposits
to
reduce
such
risks.
Cannot
be
easily resold,
client have
maturity.
sells more equity, the conflicts exacerbate, higher cost of monitoring in terms of lower
fulfilling prophecies, sometimes leading to currency crisis.
account for a much larger percentage of the overall market capitalization). Cross-listing
stock price.
Currency Futures: Made in advance of delivery. Commitment to buy/sell at a future date, at a set price. No exchange of payment at contract time, but
refers to a firm having its equity shares listed on one or more foreign exchanges The balance of payments is the bookkeeping record of a countrys international
margin deposit
as guarantee.
Standardized Contract size, Delivery month. Daily marked-to-market by clearinghouse profits
Equity agency costs are present require
where managers
do not
hold 100%Exchange-traded:
equity stake Different
from2%
dual-listing,
where there are
two entities
with bond
a single
transactions (people, business, government) with the rest of the world. A countrys balance
and losses
settled daily.
Margin:Such
Initialcosts
margin
bond
(around
of contract)/Maintenance
margin
/ performance
levelmanagement.
(around 90% of The
Also known as the cost of separation
of ownership
and control.
are/ performance
always
number of firms doing this has exploded in recent years.
of payments refer to the transactions of its citizens and government (Current
initialare
margin).
positive if monitoring and bonding costs
positive.
With futures contracts, we have daily resettlement of gains and losses
Account, Capital Account, Official Reserves Account, Statistical Discrepancy).
Advantage:
expands
the investor
base -for
a firm;
Establishes
name
recognition for the
rather
than one
big settlement
at maturity
If the
price
goes down,
the long
Monitoring and bonding activities: Expending resources to mitigate consumption of
Current Account: Includes all imports and exports of goods and services (categorized as
firm the
in new
markets,
advantages,
Cross-listing
into
developed markets
pays
short,capital
vice versa.
Aftermarketing
the daily resettlement,
each
party has a
new
non-pecuniary benefits. (Auditing, Formal control systems, Budget restrictions, Incentive
trade account and services account, includes unilateral transfers of foreign aid. Also
with strict
securities
regulations
and information
discloser may signal improved corporate
contract
at the
new price
with one-day-shorter
maturity.
compensation).
includes interests and dividends). If the debits exceed the credits, then a country is
ADRs: Foreign stocks often trade on U.S. exchanges. Advantage: denominated in USD, trade on U.S. exchanges, and can be bought through any
Open interest refers to the number of contracts outstanding for a particular
running a trade deficit.
Debt agency cost: risk-taking behavior, bankruptcy costs (Direct cost: Shareholders lose
broker.
Dividends
paid
in U.S.
dollars.
Most
stocks
are bearer
securities
and ADRs
registered.
ADRthat
trades
clear in 3 business
all claims. Difference between debt value
and market
valueare
(when
debt
> market)
borne
by underlying
delivery
month,
good proxy
for demand
forare
a contract.
Notice
open
Capital account measures the difference between local sales of assets to foreigners and
days
whereas
settlement
practices
for
the
underlying
stock
vary in foreign countries. Disadvantage: Cash flow rights and not control rights.
bondholders. Other direct costs (such as legal) to divide and enforce claims. Indirect
interest is greatest in the nearby contract. In general, open interest typically
local purchases of foreign assets, composed of Foreign Direct Investment (FDI), portfolio
costs: Unable to retain quality talent. Consumer
lose confidence
overGRSs
after-sales
support).
decreases
term
maturity
most markets
futures contracts.
Global Registered
Shares:
are traded
globally, unlike
ADRs,with
which
aretotraded
on of
foreign
- Different from Global Depositary Receipts
investments, and other investments.
which are behavior
local securities
representing
in foreign entities. Advantage: all shareholders have equal status and direct voting
Monitoring costs: covenants to limit(GDRs),
owner-managers
(Such covenants
may interest
At expiry, an American option is worth the same as a European option with
Official reserves assets include gold, foreign currencies, SDRs, and reserve positions in
rights. Disadvantage:
greater impossible
expense in establishing
the
global
and clearing
facility.
reduce firm profitability in certain circumstances.
It is generally
to cover
the
sameregistrar
characteristics.
If the
call is in the money, it is worth ST E. If
the IMF.
everything in detail); Bonding costs: Managers have incentives to minimize the costs of
the call is out-of-the-money, it is worthless. CaT = CeT = Max[ST E, 0]. If
monitoring
on them.
Sometimes,
Stat discrepancy: omissions and wrongly recorded transactions
-> plug
figure
to get managers may choose to provide bonding mechanisms so
the put is in-the-money, it is worth E ST. If the put is out-of-the-money,
as to reduce such costs.

Owner-manager bears the entire agency costs of debt, which should thus discourage
the use of such instruments.. But there are possible reasons for using debt: Tax