MM Notes - Chawla Topics

8/18/2019 MM Notes - Chawla Topics

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MANAGING MULTINATIONALS

__________________________________ Managing Multinationals - Executive MBA - Semester IV


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Ch-2, RM JoshiInternational Trade Theory and Application - ando!t "i#en $y %ro&' Cha(la

International Trade Theories• International trade is the exchange of goods and services across borders. Export

structures vary across countries. A number of international trade theories canexplain these different structures.

Co)parati#e Ad#anta"e Theory

• Co)parati#e Ad#anta"e explains and predicts trade of goods where absoluteadvantages may not exist.

• Opport!nity Cost – the amount of other goods which have to be given up toproduct one unit of a good.

• Comparative Advantage must be explained by: – Co)parati#e %rod!ction Cost – depends on the commodity’s production

process. – %rod!ction *actors – such as labor, land, capital, and natural resources.

ec+scher-Ohlin Theore)

• Countries export goods that mae intensive use of the country’s abundant factor.• Countries import goods that mae intensive use of the country’s scarce factor.• !ifferences in comparative advantage are attributed to differences in the structure of

the economy.• Ass!)ptions:

– Countries vary in the availability of various factors of production. – "he %rod!ction *!nction is identical anywhere in the world.

• "he amount of output produced by using any given amount of capitaland labor.

– "echnology is constant in all trading countries. – Conditions of demand for production factors are the same in all countries.



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• I)plications – "rade should be greatest between countries with the greatest differences in

economic structure. – "rade should cause countries to speciali#e more. – "rade policy should tae the form of trade restrictions. –

Countries should export goods that mae use of the abundant factors. – $ree trade should e%uali#e factor prices between countries with similar

relative factor endowments. – $actor prices should be nearly e%ual between countries with more liberal

mutual trade. – &nternational investment should be stimulated by difference in factor

endowments.

*actor endo()ent theory A trade theory which holds that nations will produce and export products that uselarge amounts of production factors that they have in abundance and will import

products re%uiring a large amount of production factors that they lac. "his theory isalso nown as the ec+scherOhlin theory 'after the two economists who firstdeveloped it(.

The Leontie& %arado

• )eontief challenges *ecscher+hlin on a number of grounds. – "he -. 'a capital intensive nation( exports labor+intensive goods. – "he -. also exports technically sophisticated goods that re%uire silled

labor. – "he -. imports capital intensive goods made with unsilled labor.

•

timulated a search for explanations. – !emand bias for capital+investment goods. – Existence of trade barriers. – &mportance of natural resources – /revalence of factor+intensity reversals.

!)an S+ills and Technolo"y-.ased /ie(

• 0eesing indicated that trade direction and flow is predicted by gaps in human skillsand technology .

• 1ations with higher levels of humans sills and technology will produce and exportgoods to nations with lower levels.

• *uman ills and "echnology+2ased 3iew• *uman ills are predicted by

– )evel of development in the scientific, technical, managerial, and silled labor sectors.



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• "echnology level is predicted by: – capital-intensive technology development

– imitation lag that exists as technology innovations diffuse to developingareas.

The %rod!ct Li&e-Cycle Model

• /roduct innovation and initial use occurs first in higher income countries• !iffuses to middle and lower income countries as technology and sills gaps

overcome and consumer preferences switch to the newer products.• Se#eral trends e)er"e in %LC0

– "he export performance of the mature innovating country is better thanothers.

– "echnology is better in the mature countries – as products diffuse productiontends to move from technology+intensive to labor+intensive.

–

Countries that were innovators can fall from that place. – "rade may increase in later stages of product maturity as costs and prices

decline and production economies rise.

1hi$it 2-0 /roduct cycle model of international trade – innovating country

1hi$it 2-30 /roduct cycle model of international trade – imitating country



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Linder4s Inco)e-%re&erence Si)ilarity Theory

• !eveloped countries trade more than less developed countries 'assumption(• "rade should tae place between developed nations producing manufactured

products and less developed nations producing primary products 'e.g. naturalresources( and labor+intensive goods.

• According to )inder, the range of production is determined by internal demand .• Countries with similar internal demand conditions should therefore trade. "his is

called %re&erence Si)ilarity.

The Ne( Trade Theory

• Countries do not speciali#e and trade solely to tae advantages of differences.• "hey also trade because of increasing returns.• 2ecause of econo)ies o& scale, there are increasing returns to speciali#ation.• 1cono)ies o& scale – reduction of manufacturing cost per unit as a result of

increased production %uantity during a given period.• Inter-ind!stry trade determined by *ecscher+hlin.• Intra-ind!stry trade driven by increasing returns resulting from speciali#ation within

the industry.• 1ternality – when the actions of one agent directly affect the environment of

another.

Theory Assess)ent• "hese theories provide insights in international trade.• 1o theorem can fully explain the range of motives for international trade.



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Theories o& International In#est)ent

"he $!& theories explain the reason why $!& occurs and the determinants of $!&

"hey are grouped into three categories:+

4(.Traditional theories "raditional theories are based on neo+classical economic andexplain $!& in terms of location+specific advantages.

5(.Modern theories 6odern theories emphasise the fact that product and factor maretsare imperfect both domestically and internationally and that considerable transactionalcosts are involved in maret solutions. Also they acnowledge that managerial andorganisational functions play an important role in undertaing $!&.

7(.Radical theories + "he radical theories, these tae a more critical view of 6ultinational1ational Corporation '61Cs(.

• 6onopolistic Advantage "heory

• /roduct and $actor 6aret &mperfections• &nternational /roduct )ife Cycle• ther "heories

$ollow+the+leader theory

Cross investment

&nternationalism theory

!unning’s Eclectic "heory of &nternational /roduction

wnership+specific

&nternali#ation



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)ocation+specific

TRA5ITIONAL T1OR6

Capital ar$itra"e theory + "he theory states that direct investment flows fromcountries where profitability is low to countries where profitability is high. &t meanstherefore that capital is mobile both nationally and internationally. 2ut sometimesimplication is that countries with abundant capital should export and countries with lesscapital should import. &f there was a lin between the long+term interest rate and return oncapital, portfolio investment and $!& should be moving in the same direction.

International trade theory+the country will specialise in production of, and export thosecommodities which mae intensive use of the country’s relatively abundant factor.

MO51RN T1OR6

%rod!ct-cycle theory – 1ew products appear first in the most advanced economy inrespond to demand conditions. "he maturing product stage is described by standardisationof the product, increased economies of scale, high demand and low price. "hestandardised product stage is reached when the commodity is sold entirely on price basis.

Internalisation Theories O& *5I

"he theory explain that why the cross+border transactions of intermediate products areorganised by hierarchies rather than determined by maret forces.

Theory O& Appropria$ility. "he theory explains why there is a strong presence of high+technology industries among 61Cs.

1clectic Theory o& *5I

"he theory tries to offer a general framewor for determining the extent and pattern of bothforeign+owned production undertaen by a country’s own enterprises, and that of domesticproduction owned or controlled by foreign firm. !unning and )undan'5889( assert that, theeclectic theory of international production enlarges the theoretical framewor by includingboth home+country and host+country characteristics as international explanatory factors. &targues that the extent, form, and patterns of international production are determined by the



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configuration of three sets of advantages as perceived by the enterprises.

• $irst wnership '( advantage

• 5nd )ocation ')( and

• 7rd &nternali#ation '&( advantage in order for the firm to transfer its ownership

advantages across national boundary

"heories of $!& may be classified under the following headings:

%rod!ction Cycle Theory o& /ernon

/roduction cycle theory developed by 3ernon in 4;; was used to explain certain types of foreign direct investment made by -.. companies in


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The Internalisation Theory"his theory tries to explain the growth of transnational companies and their motivations for achieving foreign direct investment. &n his !octoral !issertation, *ymer identified twoma?or determinants of $!&. #ne was the removal of competition. "he other was theadvantages which some firms possess in a particular activity '*ymer, 4>;(. 2ucley

and Casson, who founded the theory demonstrates that transnational companies areorgani#ing their internal activities so as to develop specific advantages, which then to beexploited.

• &nternalisation theory is considered very important also by !unning, who uses it in theeclectic theory, but also argues that this explains only part of $!& flows.

• *ennart '495( develops the idea of internali#ation by developing models between thetwo types of integration: vertical and hori#ontal.

• "he concept of firm+specific advantages and demonstrates that $!& tae place only if the benefits of exploiting firm+specific advantages outweigh the relative costs of theoperations abroad. According to *ymer '4>;( the 61E appears due to the maret

imperfections that led to a divergence from perfect competition in the final productmaret. *ymer has discussed the problem of information costs for foreign firmsrespected to local firms, different treatment of governments, currency ris 'Eden and6iller, 588@(. "he result meant the same conclusion: transnational companies facesome ad?ustment costs when the investments are made abroad. *ymer recogni#ed that$!& is a firm+level strategy decision rather than a capital+maret financial decision.

The 1clectic %aradi") o& 5!nnin""he eclectic theory developed by professor !unning is a mix of three different theories of direct foreign investments '+)+&(:

•

7O8 &ro) O(nership ad#anta"es: "his refer to intangible assets, which are, at leastfor a while exclusive possesses of the company and may be transferred withintransnational companies at low costs, leading either to higher incomes or reduced costs.2ut "1Cs operations performed in different countries face some additional costs."hereby to successfully enter a foreign maret, a company must have certaincharacteristics that would triumph over operating costs on a foreign maret. "heseadvantages are the property competences or the specific benefits of the company. "hefirm has a monopoly over its own specific advantages and using them abroad leads tohigher marginal profitability or lower marginal cost than other competitors.

"here are three types of specific advantages:a( 6onopoly advantages in the form of privileged access to marets throughownership of natural limited resources, patents, trademarsb( "echnology, nowledge broadly defined so as to contain all forms of innovationactivitiesc( Economies of large si#e such as economies of learning, economies of scale andscope, greater access to financial capital

• 7L8 &ro) Location:


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determining who will become host countries for the activities of the transnationalcorporations. "he specific advantages of each country can be divided into threecategories:

a( "he economic benefits consist of %uantitative and %ualitative factors of

production, costs of transport, telecommunications, maret si#e etc.b( /olitical advantages: common and specific government policies that affect $!&flowsc( ocial advantages: includes distance between the home and home countries,cultural diversity, attitude towards strangers etc.

• BI8 &ro) Internalisation: upposing the first two conditions are met, it must beprofitable for the company the use of these advantages, in collaboration with at leastsome factors outside the country of origin . "his third characteristic of the eclecticparadigm )& offers a framewor for assessing different ways in which the company willexploit its powers from the sale of goods and services to various agreements that mightbe signed between the companies. As cross+border maret &nternalisation benefits ishigher the more the firm will want to engage in foreign production rather than offeringthis right under license, franchise.

•

• Eclectic paradigm )& shows that )& parameters are different from company tocompany and depend on context and reflect the economic, political, socialcharacteristics of the host country. "herefore the ob?ectives and strategies of the firms,the magnitude and pattern of production will depend on the challenges and opportunitiesoffered by different types of countries.



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INT1RNATIONAL 1CONOMIC INT1GRATION

Re"ional 1cono)ic Inte"ration + agreements between countries in a geographic regionto reduce tariff and non+tariff barriers to the free flow of goods, services, and factors of



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production between each other

Le#els o& Re"ional 1cono)ic Inte"ration 9 Re"ional or %re&erential Trade A"ree)ent

4. A &ree trade area eliminates all barriers to the trade of goods and services among

member countries European $ree "rade Association 'E$"A( + 1orway, &celand, )iechtenstein,

and wit#erland 1orth American $ree "rade Agreement '1A$"A( + -.., Canada, and 6exico

5. A c!sto)s !nion eliminates trade barriers between member countries and adoptsa common external trade policy Andean Community '2olivia, Columbia, Ecuador, and /eru(

7. A co))on )ar+et has no barriers to trade between member countries, a commonexternal trade policy, and the free movement of the factors of production 6EC- '2ra#il, Argentina, /araguay, and -ruguay(

@. An econo)ic !nion has the free flow of products and factors of production

between members, a common external trade policy, a common currency, a harmoni#ed taxrate, and a common monetary and fiscal policy European -nion 'E-(

=. A political !nion involves a central political apparatus that coordinates theeconomic, social, and foreign policy of member states the E- is headed toward at least partial political union, and the -.. is an

example of even closer political union

5i&&erence $et(een *TA and %TA

:hat is %TA;

/"A stands for /referential "rade Agreement, and is an economic pact betweenparticipating countries to help improve $uantity of trade by gradually reducing tariffs



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between participating countries. "he barriers to trade are not altogether removed, but apreference is shown towards participating countries in comparison to other countries of theworld. "here are departures from


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1on tariff barriers are sometimes retaliatory in nature as when a country is antagonistic toa particular country and does not wish to allow goods from that country to be imported."here are instances where restrictions are placed on flimsy grounds such as when westerncountries cite reasons of human rights or child labor on goods imported from third worldcountries. "hey also place barriers to trade citing environmental reasons.

:hat is the di&&erence $et(een Tari&& .arriers and non Tari&& .arriers

• "he purpose of both tariff and non tariff barriers is same that is to impose

restriction on import but they differ in approach and manner.

• "ariff barriers ensure revenue for a government but non tariff barriers do not bring

any revenue. &mport )icenses and &mport %uotas are some of the non tariff barriers.

• 1on tariff barriers are country specific and often based upon flimsy grounds that

can serve to sour relations between countries whereas tariff barriers are moretransparent in nature.

Trade Creation and Trade 5i#ersion

• egional economic integration is only beneficial if the amount of trade it createsexceeds the amount it diverts trade creation occurs when low cost producers within the free trade area replace

high cost domestic producers trade di#ersion occurs when higher cost suppliers within the free trade area

replace lower cost external suppliers

• Trade Creation

This involves a shi&t in do)estic cons!)er spendin" from a higher cost domestic

source to a lower cost partner source within the E-, as a result of the abolition tariffson intra+union trade. o for example -0 households may switch their spending on car and home insurance away from a higher+priced -0 supplier towards a $renchinsurance company operating in the -0 maret.

"rade creation should stimulate an increase in trade within the customs union and

should, in theory, lead to an improvement in the efficient allocation of scarce resources

and gains in consumer and producer welfare.



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• Trade 5i#ersion

"rade diversion is best described as a shift in domestic consumer spending from a

lower cost world source to a higher cost partner source 'e.g. from another countrywithin the E-+5>( as a result of the elimination of tariffs on imports from the partner.

"he common external tariff on many goods and services coming into the E- maesimports more expensive. "his can lead to higher costs for producers and higher pricesfor consumers if previously they had access to a lower cost lower price supply from anon+E- country.

"he overall effect of a customs union on the economic welfare of citi#ens in a country

depends on whether the customs union creates effects that are mainly trade creatingor trade diverting.



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/roduct tandardi#ation vs Adaptation



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%a"e 3< - 3=Indices &or Meas!rin" the etent o& MN1s Internationalisation

Transnationality Inde + is the relationship between home and foreign activities for anyparticular company. "hus a company is considered to be very internationalised if the ratioof its foreign to domestic activities is very high, independently of whether those foreignactivities tae place in one single foreign country or in many of them."he "ransnationality &ndex '"1&( is a means of raning multinational corporations that isemployed by economists and politicians. &t is calculated as the arithmetic mean of thefollowing three ratios 'where FforeignF means outside of the corporationGs home country(:+

• the ratio of foreign assets to total assets

• the ratio of foreign sales to total sales

• the ratio of foreign employment to total employment

Internationalisation Inde - Net(or+ Spread Inde A different indicator of internationalisation has been developed and values calculated in 3ernon '4>(. "he

indicator assesses the overall spread of activities in terms of the number of countries inwhich the "1Cs have direct linages 'affiliatessubsidiaries(. A company is thereforeassessed as having a high degree of internationalisation if it operates in many foreigncountries. &t is an attempt to measure the overall geographical spread of "1Cs subsidiariesaccording to the number of countriesnationsstates in which they are established.



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MANAGEMENT OF FOREIGN EXPOSURE

Exposure occurs because of unanticipated change in the exchange rate.

• Types of exposures….

Accounting Exposures

Transaction Exposure

Translation Exposure

Operating / Economic Exposure

Economic Exposure

• Economic exposure is the risk to the firm that its long-term cash flows will be affected,positively or negatively, by unexpected future exchange rate changes.

• It emphasizes that there is a limit to a firm’s ability to predict either cash flows or exchange

rate changes in the medium to long term.

• Management of economic exposure is being prepared for the unexpected.

Translation exposure

• Translation exposure is the risk that arises from the legal requirement that all firms

consolidate their financial statements of all worldwide operations annually.

• Unlike transaction and economic exposures, which are “true” exposures, translation exposure

is an economic problem.

Transaction Exposure Risk in adverse movement of exchange rates from the time the

transaction is budgeted till the time of exposure is extinguished – by sale / purchase of a foreign

currency against domestic currency

The two conditions necessary for a transaction exposure to exist are:

1. A cash flow that is denominated in a foreign country.

2. The cash flow will occur at a future date.

Impact of Transaction Exposure.

• It will be of short term in nature

• Will have an impact on cash flow of a company

Managing transaction exposures

• Managing transaction exposures usually is accomplished by either natural hedging or

contractual hedging.

Natural hedging describes how a firm might arrange to have foreign currency cash flows

coming in and going out at roughly the same times and same amounts.

Contractual hedging is when a firm uses financial contracts to hedge the transaction



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exposure. The most common foreign currency contractual hedge is theforward contract.

Hedging Transaction Exposure

Since exposure arises due to unanticipated movement of exchange rate , entering into a

financial counter-transaction at a future point in time is known as hedging The amount receivable (exports) is technically referred aslong position

The amount payable ( imports) is technically referred asshort position

The basic rule of hedging is:

The payables (short position) in a currency in the future is to be hedged with buying (long

position) in the same currency in the forward; and receivables (long position) in a currency

in the future is to be hedged with selling (short position) the same currency in the forward

Instruments of Hedging• Forward contract

• Money market hedge

• Future contract

• Option contract

• Currency invoicing

• Exposure netting

• Currency Risk Sharing

Forward Contract

A forward contract is an agreement made today between a buyer and a seller to exchange the

commodity or instrument for cash at a predetermined future date at a price agreed upon today.

In a forward contract, two parties agree to do a trade at some future date, at a stated price and

quantity. No money changes hands at the time the deal is signed

Forward contracts are not traded on an exchange, they are said to trade over the counter

(OTC).

The secondary market do not exist for the forward contracts and faces the problem of liquidity



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and negotiability

Forward contracts face counter party risk

The longer the time period, larger is the counterparty risk

Hedging with Forward contract

Suppose an importer has imported a machine worth $ 1,00,000

The machine is expected to arrive in a month when the amount is payable

The current exchange rate is $1= Rs. 46.75

He expects to move the rate to $1= Rs. 47.75

He checks the forward market and finds that one month forward rate is $1= Rs. 47.50

The importer buys $1,00,000 as the dollar was cheaper in the forward market as compared to

his own perception

Money Market Hedge

Money market hedge involves mixing of foreign exchange and money markets to hedge at the

minimum cost

It involves taking advantage of disequilibrium between the two markets

One possibility: The importer buys that amount of dollars in the spot market which when

deposited in the US at US interest grows to $1,00,000 in one month

Second possibility: The importer buys $1,00,000 in the forward market and to make the

payment in Indian rupees, deposits that much amount in the bank deposit to grow to honour thecontract

Futures Contract

A futures contract is a financial security, issued by an organised exchange to buy or sell a

commodity, security or currency at a predetermined future date at a price agreed upon today

Futures are exchange traded contracts to sell or buy financial instruments or physical

commodities for future delivery at an agreed price

The contract expires on a pre-specified date which is called the expiry date of the contract

On expiry, futures can be settled by delivery of the underlying asset or cash

The futures contract relates to a given quantity of the underlying asset and only whole

contracts can be traded

Currency Futures

Currency Futures means a standardised foreign exchange derivative contract traded on a

recognized stock exchange to buy or sell one currency against another on a specified future



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date, at a price specified on the date of contract

Currency future contracts allow investors to hedge against foreign exchange risk

Reserve Bank of India Act, 1934 permitted currency futures trading with effect from August 6,

2008.

Forwards Vs. Futures

Two parties negotiate aforwardtransaction

Futures is structured as two transactions

Difference between Forward Hedge and a Future Hedge

Forward Market Hedge Future Hedge

Contracts executed by banks Contracts executed by brokerage houses offuture exchanges

Tailor-made contracts Standardised contracts

Price quoted reflects banker’s perception of

future price

Price paid is determined by forces of demand

and supply

Contract bilateral between two parties Contract with the future exchange

Options

‘ An option is a contractual agreement that gives the option buyer the right, but not theobligation, to purchase (call option) or to sell (put option) a specified instrument at a specified

price at any time of the option buyers choosing by or before a fixed date in the future

The buyer / holder of the option purchases the right from the seller/writer for a consideration

which is called the premium

Call Option : A call option gives the buyer the right to buy a fixed number of



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shares/commodities at the exercise price upto the date of expiration of the contract

Put Option: A put option gives the buyer the right to sell a fixed number of

shares/commodities at the exercise price upto the date of expiration of the contract

Options Example

Current price of oil is $65 per barrel. An airlines company feels oil prices might rise 6 months

later & wishes to hold an option to buy oil 6 months hence at, at most $67. An oil refinery feels

prices will fall 6 months later & wishes to hold an option to sell oil 6 months hence at, at least

$67. Both companies approach the exchange and place their orders.

Exchange has options which fulfill the requests at $67 per barrel.

1.What is the expiration period ?

2.Is Airline Company a holder or writer ?

3.Is Oil Refinery a holder or writer ?

4.What option type does Airline Company hold ?

5.What option type does Oil Refinery hold ?

6.What are the Strike Prices ?

Features of Options

The option is exercisable only by the owner, namely the buyer of the option

The owner has limited liability

Options have high degree of risk to the option writers Options involve buying counter positions

by the option sellers

Options are popular because they allow the buyer profits from favourable movements in

exchange rate

Option Benefits

Holder (Buyer who has gone Long) Writer (Seller who has gone Short)

Call Right to Buy

No Obligation

Premium Pay

No Right

Obligation to Sell

Premium ReceivePut Right to Sell

No Obligation

Premium Pay

No Right

Obligation to Buy

Premium Receive

Hedging with Options

In the case of hedging with options, if the price surpass the expectations, only then the option



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is exercised and the hedge comes into operation.

This kind of hedging is usually resorted when there is a possibility of non-performance of

contract

The cost involved in purchasing an option is called premium

Hedge through Currency Invoicing

If during the negotiation of an import contract, an importer of a country having weak currency

may get goods invoiced in domestic currency and the exporter from this country should invoice

goods in strong currency

The risk shifts from one party to the other

MNCs and Transaction Exposure Management

The companies dealing in multicurrency environment or multicurrency cash flows need toprepare cash budgets to know the exact extent of transaction exposure

The net transaction exposure is arrived at on quarterly basis

The net positive transaction exposure (+ ve flows) indicates strengthening of domestic currency

against foreign currency ($) will cause loss to the firm and depreciation makes it profitable

The net negative transaction exposure (- ve flows) indicates strengthening of domestic currency

against foreign currency ($) will give profit to the firm and weakening of domestic currency

would cause the loss

Hedging Transaction Exposure of MNCs

MNCs by nature are risk takers and they take risk when adequate compensation is present in

the venture

In a multicurrency environment, it is not necessary that foreign exchange risk to be zero for

international business to become attractive for the firm

Strategies to decrease transaction exposure:

• International Diversification

• Hedging

Countertrade

Countertrade is a sale that encompasses more than an exchange of goods, services, or ideas

for money.

Historically, countertrade was mainly conducted in the form of barter, which is a direct

exchange of goods of approximately equal value, with no money involved.

Conditions that encourage countertrade are:

• lack of money,

• lack of value of or faith in money,



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• lack of acceptability of money as an exchange medium,

• greater ease of transaction by using goods.

Reasons for Countertrade

Increasingly, countries and companies are deciding that sometimes countertrade transactionsare more beneficial than transactions based on financial exchange.

The use of countertrade permits the covert reduction of prices and therefore allows the

circumvention of price and exchange controls.

Many countries are responding favorably to the notion of bilateralism.

Countertrade is viewed as an excellent mechanism to gain entry into new markets.

*INANCIAL S:A%S

A s(ap is a derivative in which two counterparties exchange cash flows of one partyGsfinancial instrument for those of the other partyGs financial instrument. "he benefits in%uestion depend on the type of financial instruments involved. pecifically, twocounterparties agree to exchange one stream of cash flows against another stream. "hesestreams are called the legs of the swap. "he swap agreement defines the dates when thecash flows are to be paid and the way they are accrued and calculated.H4I -sually at thetime when the contract is initiated, at least one of these series of cash flows is determinedby an uncertain variable such as a floating interest rate, foreign exchange rate, e%uityprice, or commodity price.H4I

Interest Rate S(ap

&n the basic 'Fplain vanillaF( fixed-for-floating rate interest rate swap, one counterpartyexchanges the interest payments of a floating+rate debt obligation for the fixed rate interest



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payments of the other counterparty. 2oth debt obligations are denominated in the samecurrency.

ome reasons for using an interest rate swap are to better match cash inflows andoutflows andor to obtain a cost savings. "here are many variants of the basic interest rate

swap, some of which are discussed below.

"he diagram below is an example of a fixed+for+floating interest+rate swap:

Counterparty A 'the &nvestment 2an( is said to Jswap’ a fixed+interest payment toCounterparty 2 'the /ension $und( for a floating+rate interest payment. ver the life of theswap, the /ension $und will pay the &nvestment 2an a floating rate and receive a fixedrate of interest in return.

C!rrency S(ap

&n a currency swap, one counterparty exchanges the debt service obligations of a bond

denominated in one currency for the debt service obligations of the other counterpartydenominated in another currency. "he basic currency swap involves the exchange of fixed)for)fixed rate debt service.

ome reasons for using currency swaps are to obtain debt financing in the swappeddenomination at a cost savings andor to hedge long+term foreign exchange rate ris.

ed"in"

A hedge is an investment position intended to offset potential lossesgains that may beincurred by a companion investment. &n simple language, a hedge is used to reduce anysubstantial lossesgains suffered by an individual or an organi#ation.

A hedge can be constructed from many types of financial instruments, including stocs,exchange+traded funds, insurance, forward contracts, swaps, options, many types of over+the+counter and derivative products, and futures contracts.



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>Ar$itra"e> "he simultaneous purchase and sale of an asset in order to profit from adifference in the price. &t is a trade that profits by exploiting price differences of identical or

similar financial instruments, on different marets or in different forms.

>Cross Rate> "he currency exchange rate between two currencies, both of which are notthe official currencies of the country in which the exchange rate %uote is given in.

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MM Notes - Chawla Topics