Wednesday June 25, 2008 MS&E247s International … week... · Case—Deutsche Bank: Discussing the Equity ... THE STARBUCKS INDEX ... 17/04/01 0 - 29 The price of a burger depends

MS&E247s International Investments Handout #2 Page 1 of 54Wednesday June 25, 2008

MWF 3:15-4:30 Gates B1

Course web pages:http://stanford2008.pageout.net

Handout #2 (updated on June 25, 2008)Sample Topics for International Investments

Yee-Tien “Ted” Fu

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Sample Topics forMS&E 247S International Investments

Wednesday June 25, 2008Topic 1: The Hamburger Standard, Carry-Trade

Topic 2: Arbitrage

Topic 3: A Macroeconomic Theory of the Open Economy

Topic 4: Building Blocks of The Parity Framework, Carry-Trade

Topic 5: Monetary Policy, Interest, and Exchange Rates

Topic 6: Swaps & Linkage Across International Capital Markets

Topic 7: Topics in Financial Innovation and Challenges, Financial Contract Design, International Financial Reporting and Corporate Governance, CFA Exam Questions, etc.

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Wednesday June 25, 2008

Topic 8: International Financial Innovations

Case—Deutsche Bank: Discussing the Equity Risk Premium.

Case—Swedish Lottery Bonds. Case—Bank Leu’s Prima Cat Bond Fund. Case—Catastrophe Bonds at Swiss Re. Case—Mortgage Backs at Ticonderoga. Case—KAMCO and the Cross-Border Securitization of

Korean Non-Performing Loans. Case—Nexgen: Structuring Collateralized Debt

Obligations (CDOs). Case—The Enron Odyssey (A):The Special Purpose of

SPEs.

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Topic 9: International Finance Cases

Exchange Rates and Firms. Case—Foreign Exchange Hedging Strategies at General Motors: Transactional and Translational Exposures.

Case—Foreign Exchange Hedging Strategies at General Motors: Competitive Exposures.

Financing Decisions within the Firm. Case—The Refinancing of Shanghai General Motors.

Valuing Cross-Border Investments. Case—Valuing a Cross-Border LBO: Bidding on the Yell Group.

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Mankiw / Macroeconomics 5E (good optional reading)

Chapter 5 Open-Economy Macroeconomics

http://www.bfwpub.com/pdfs/mankiw/0716752379_12.pdf

http://www.bfwpub.com/pdfs/mankiw/0716752379_05.pdf

Chapter 12 Aggregate Demand in the Open Economy

Chapter 9 Introduction to Economic Fluctuationshttp://www.bfwpub.com/pdfs/mankiw/0716752379_09.pdf

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Investors’ Dictionaries (Use them Often!)

http://www.duke.edu/~charvey/Classes/wpg/glossary.htm(Campbell R. Harvey's Hypertextual Finance Glossary)

http://www.quote123.com/usmkt/edu/glossary/glossary.asp(Mandarin edition of the above)

http://www.individualinvestor.com/investor_university/inv_glos.asp

http://personal.fidelity.com/products/fixedincome/ladders.shtml(Fixed Income Glossary, excellent!)


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Excel Gallery of Finance Models

http://www.thomasho.com/mainpages/analysoln.asp(The Oxford Guide to Financial Modeling)

All formula are typed in Microsoft Word, handy for your literature review.

Central Banks, Monetary Policy, and Financial Stability http://highered.mcgraw-hill.com/sites/0073523097/student_view0/chapter15/powerpoints.html

…15, 16, 17, 18, 19…http://highered.mcgraw-hill.com/sites/0073523097/student_view0/chapter19/powerpoints.html

Modern Monetary Economics http://highered.mcgraw-hill.com/sites/0073523097/student_view0/chapter20/powerpoints.html

…20, 21, 22, 23…http://highered.mcgraw-hill.com/sites/0073523097/student_view0/chapter23/powerpoints.html

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Currency Forecasting with BigMac Index

http://www.economist.com/markets/bigmac/http://www.economist.com/markets/indicators/displaysto

ry.cfm?story_id=8649005

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Standard & Poor's Market Insight and Web-based Problems

Corporate Data Cascade ModelsMoney and Capital Markets 9e by Rose and Marquis

Questions are available at:http://highered.mcgraw-

hill.com/sites/0072957395/student_view0/chapter10/standard___poor_s_questions.html

There are 24 chapters--just change the number 10 to 24, for example.

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A Study of the Fed Funds MarketFederal Data Cascade Models

Money and Capital Markets 9e by Rose and Marquis

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Sample Slides for

MS&E 247S International Investments

0 - 12Building Blocks of International Investments

International Investments

Exchange Rate Determination and Key Relationships

International Financial Institutions and Instruments

International Corporate Finance: Currency Risk and Taxes

International Portfolio Management: Allocation and Currency Risk

International FinancialInnovation and Risk Management


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The Hamburger Standard http://www.economist.com/editorial/justforyou/focus/bi

g_mac_index.html

THE BIG MAC INDEXhttp://www.economist.com/markets/Bigmac/Index.cfm

THE STARBUCKS INDEXhttp://www.economist.com/markets/bigmac/displaySt

ory.cfm?story_id=2361072

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BIG MAC INDEXBurgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country. In other words, a dollar should buy the same amount everywhere. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPsindicates whether a currency is under- or overvalued.

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Evidence: The Law of One Price• One test of the Law of One Price is the Big

Mac index, which has been published annually in The Economist since 1986.

• The Big Mac index was devised as a light-hearted guide to whether currencies are at their “correct” level, based on PPP.– Our “basket” is a McDonalds’ Big Mac, which

is produced and consumed in various countries around the world.

– The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in America as abroad.

The Economist 4-34

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Evidence: The Law of One Price

¤ Comparing actual exchange rates with PPPssignals whether a currency is under- or over-valued.

• The result of the 2000 survey suggested that the average price of a Big Mac in the U.S. was $2.51, but was as little as $1.19 in Malaysia, and as much as $3.58 in Israel.

• Hence the Israeli shekel is the most overvalued currency (by 43%), while the Malaysian ringgit is the most undervalued (by 53%).

The Economist 4-35

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The Economist convert into dollars at the spot rate

Big MacPPP rate(of the US$)

foreign-currency priceUS($) price

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=25/04/00 0 - 18

4-37The Economist

25/04/00


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Big Mac PPP rate (of the foreign

currency)

US($) priceforeign currency price=

Big Mac PPP rate(of the foreign currency)

x 100spot rate

(of foreign currency)Big Mac PPP rate

(of the foreign currency)–Under (-) / Over (+)

valuation againstthe dollar, %

=

Big Mac PPP rate (of the US$)

foreign currency priceUS($) price=

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Example 1. Canada

Purchasing power of C$2.85 = Purchasing power of $2.51= a Big Mac

Hence Big Mac PPP implies 1 C$ = $ (2.51/2.85)

However from the market spot rate, 1 C$ = $ (1/1.47)

(-)/(+) valuation against $, % (based on Big Mac PPP)(1/1.47) - (2.51/2.85)

(2.51/2.85)=

= - 22.8%


=(1/1.47)

(2.51/2.85)= - 1

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Example 2. Denmark

Purchasing power of 24.75 DKr = Purchasing power of $2.51= a Big Mac

Hence Big Mac PPP implies 1 DKr = $ (2.51/24.75)

However from the market spot rate, 1 DKr = $ (1/8.04)

(-)/(+) valuation against $, % (based on Big Mac PPP)(1/8.04) - (2.51/24.75)

(2.51/24.75)=

= + 22.6%


(1/8.04)(2.51/24.75)= - 1

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The Economist

• The Big Mac index is not a perfect measure of PPP. Price differences may be distorted by trade barriers on beef, sales taxes, local competition and changes in the cost of non-traded inputs such as rents.

• But despite its flaws, the Big Mac index produces PPP estimates close to those derived by more sophisticated methods.¤ A currency can deviate from PPP for long

periods, but several studies have found that the Big Mac PPP is a useful predictor of future movements.

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The Economist

¤ Indeed, the Big Mac has had several forecasting successes.

¤ When the euro was launched at the start of 1999, most forecasters predicted that it would rise. But the euro has instead tumbled -exactly as the Big Mac index had signaled. At the start of 1999, euro burgers were much dearer than American ones.

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*

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*

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The first column of the table shows local-currency prices of a Big Mac; the second converts them into dollars. The average price of a Big Mac in America is $2.54 (including sales tax). In Japan, Big Mac scoffers have to pay ¥294, or $2.38 at current exchange rates. The third column calculates PPPs. Dividing the yen price by the dollar price gives a Big Mac PPP of ¥116. Comparing that with this week’s rate of ¥124 implies that the yen is 6% undervalued.

(1/124 - 1/116)/(1/116) = -0.0645 = -6% (yen is 6% undervalued)

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The cheapest Big Macs are found in China, Malaysia, the Philippines and South Africa, and all cost less than $1.20. In other words, these countries have the most undervalued currencies, by more than 50%. The most expensive Big Macs are found in Britain, Denmark and Switzerland, which by implication have the most overvalued currencies. Sterling, for example is 12% overvalued against the dollar - less than two years ago, it was overvalued by 26%.

17/04/01

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The price of a burger depends heavily on local inputs such as rent and wages, which are not easily arbitraged across borders and tend to be lower in poorer countries. For this reason PPP is a better guide to currency misalignments between countries at a similar stage of development.

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The greatest triumph of the Big Mac index has been in tracking the euro. When Europe’s new currency was launched in January 1999, virtually everybody predicted that it would rise against the dollar. Everybody, that is, except the Big Mac index, which suggested that the euro started off significantly overvalued. One of the best-known hedge funds, Soros Fund Management, admitted that it chewed over the sell signal given by the Big Mac index when the euro was launched, but then decided to ignore it. The euro tumbled; Soros was cheesed off.


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The average price today in the 12 euro countries is euro2.57, or $2.27 at current exchange rates. The euro’s Big Mac PPP against the dollar is euro1=$0.99, which shows that it has now undershot McParity by 11%. That, in turn, implies that sterling is 26% overvalued against the euro.euro2.57 = One BigMac = $2.27euro1=$0.99 by Big Mac PPP 0.88 – 0.99 / 0.99 = -11% Euro is 11% undervalued against US$And if sterling pound is 15% overvalued against US$, it is then 26% overvalued against the euro.

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Overall, the dollar has never looked so overvalued during 15 years of burgernomics. In the mid 1990s the dollar was cheap against most currencies; now it looks dear against all but three. The most undervalued of the rich-world currencies are the Australian and New Zealand dollars, which are both 40-45% below McParity. They need to ketchup.All the emerging-market currencies are undervalued against the dollar on a Big Mac PPP basis. That, in turn, means that a currency such as Argentina’s peso, which is undervalued only a tad against the dollar, is massively overvalued compared with other currencies, such as the Brazilian real and virtually all of the East Asian currencies.

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Some of our readers find the Big Mac index hard to swallow. Not only does the theory of purchasing-power parity hold only for the very long run, but hamburgers are a flawed measure of PPP. Local prices may be distorted by trade barriers on beef, sales taxes, or big differences in the cost of property rents. Nevertheless, some academic studies of the Big Mac index have concluded that betting on the most undervalued of the main currencies each year is a profitable strategy.Please update the Big Mac index (May 27th 2004) from the following urls:http://www.economist.com/markets/Bigmac/Index.cfmhttp://www.economist.com/markets/bigmac/PrinterFriendly.cfm?Story_ID=2708584

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Please update the Big Mac index (Jun 9th 2005) from the following urls:http://www.economist.com/markets/bigmac/http://www.economist.com/markets/Bigmac/Index.cfmhttp://economist.com/PrinterFriendly.cfm?Story_ID=4065603

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http://www.economist.com/PrinterFriendly.cfm?Story_ID=1730909Economics focusMcCurrencies

Apr 24th 2003 From The Economist print editionHamburgers should be an essential part of every economist's diet

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Apr 24th 2003

*


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*

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Economist: May 27th, 2004

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*

*


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Feb 2007

*

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Feb 2007*

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July 2007

*

*

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July 2007


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The price of a burger depends heavily on local inputs such as rent and wages, which are not easily arbitraged across borders and tend to be lower in poorer countries. For this reason PPP is a better guide to currency misalignments between countries at a similar stage of development.

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The most overvalued currencies are found on the rich fringes of the European Union: in Iceland, Norway and Switzerland. Indeed, nearly all rich-world currencies are expensive compared with the dollar. The exception is the yen, undervalued by 33%. This anomaly seems to justify fears that speculative carry trades, where funds from low-interest countries such as Japan are used to buy high-yield currencies, have pushed the yen too low. But broader measures of PPP suggest the yen is close to fair value.

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Carry Trade: borrow money at a cheaper rate than you can earn on an investment elsewhere

The biggest risk is generally that the exchange rate moves against you – the higher-interest rate currency rapidly devalues, reducing the value of your assets relative to your borrowing. That's why these trades are often described as “picking up nickels in front of a steamroller”

2007

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http://www.centralbankrates.com/

2008

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Japan’s low Interest Rate

The savings rates of Japanese households have been among the highest in the world, and high savings rates push down the interest rate.

In addition, Japanese investment was low in 2002 because of the weak economy at that time. Low investment also reduced real interest rates.

http://www.worthpublishers.com/ballpreview/casestudy1.PDF

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http://www.pageout.net/user/www/s/t/stanford2007/Taxes%20and%20Prosperity%20-%20WSJ%20-%200525%202007.PDF

Taxes and Prosperity


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http://www.kpmg.com/NR/exeres/EC5931FC-261B-4D7D-80DF-9E5C49C6F2F8.htm

KPMG’s Corporate Tax Rate Survey 1993-2006

Since 1993, KPMG firms have published annual analysis of corporate tax rates around the world. In the initial survey, the rates from 23 countries were examined. Now in 2006, the list stands at86 countries.

Summary and Comment

The survey has recorded a consistent and dramatic reduction in corporate tax rates over that 14-year period. This reduction began in the mid-1980s in the United Kingdom when the government of Margaret Thatcher lowered the corporate tax rate from 52 percentto 35 percent between 1982 and 1986, forcing other countries to follow suit.

http://www.kpmg.com/NR/rdonlyres/D8CBA9FF-C953-45FA-940A-FAAC86729554/0/KPMGCorporateTaxRateSurvey.pdf

http://www.kpmg.co.nz/download/102964/110012/KPMG's%20Corporate%20Tax%20Rate%20Survey%202006.pdf

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14 Cayman Islands (2006 rate = 0%)There are no notes for 2006.


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32 Hong Kong (2006 rate = 17.5%)

Hong Kong SAR is a Special Administrative Region of the People’s Republic of China. The 17.5 percent rate (with effect from financial year 2003/04) applies to Hong Kong sourced profits that are derived from a business carried on in Hong Kong. Offshore profits, capital gains, dividends and most bank deposit interest income are also exempt from tax. Profits derived from certain securities or types of business (e.g. qualifying debt instruments or profits derived from the business of reinsurance of offshore risks by a professional re-insurer) are either exempt from tax or subject to a concessionary rate of 8.75 percent (half the 17.5 percent standard rate).

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40 Japan (2006 rate = 40.69%)Japanese corporate income taxes consist of corporation tax (national tax), business tax (local tax) and prefectural and municipal inhabitant taxes (local tax). The corporation tax rate is 30 percent (22 percent on the first 8 million yen for companies with paid-in capital of JPY 100 million or less). Local tax rates vary depending on the locality, the amount of paid-in capital of the company, etc.. The tax rate shown is the illustrative effective tax rate for a company in Tokyo with paid-in capital of more than JPY 100 million after taking into account a deduction for business tax (the business tax itself is tax deductible). Size-based business tax is also levied on a company with paid-in capital of more than JPY 100 million, in addition to the income-based business tax. So the overall tax rate for such companies can be higher than 40.69 percent. The size-based business tax rates in Tokyo are 0.504 percent on the “added value component” tax base (total of labor costs, net interest payments, net rent payments and income/loss of the current year) and 0.21 percent on the “capital component” tax base (total paid-in capital and capital surplus). For small and medium-sized companies with paid-in capital of JPY 100 million or less, the effective tax rate in Tokyo is 42.05 percent and no size-based business tax is imposed.

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67 Singapore (2006 rate = 20% on income derived in 2005)

From the Year of Assessment (YA) 2002 onwards, a partial tax exemption is granted on the first S$100,000 of income as follows: 75 percent up to the first S$10,000 of income and 50 percent on the next S$90,000 are exempt from corporate income tax. For new companies whose first three assessment years fall within YA 2005 to 2009, full tax exemption of regular income (excluding Singapore franked dividends) up to S$100,000 can be claimed provided certain conditions are met. Entities engaged in certain prescribed activities are subject to a concessionary tax rate of 10 percent or lower, or are granted tax incentives.

Such activities or incentives include the financial sector incentive scheme,offshore leasing, offshore insurance and reinsurance, offshore global trading, international art and antique dealers, cyber trading, finance and treasury centers, international headquarters and shipping enterprises. For certain activities, approval needs to be sought before tax exemption or the concessionary tax rate can apply.

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75 Taiwan (2006 rate = 25%)

The corporate income tax rate of 25 percent is the maximum rate in a progressive rate structure. The rate is applicable on income in excess of TW$100,000.

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82 United States (2006 rate = 40%)

The highest marginal federal corporate income tax rate is 35 percent. State and local governments may also impose income taxes at rates ranging from less than one percent to 12 percent. A corporation may deduct its state and local income tax expense when computing its federal taxable income, generally resulting in a net effective rate of approximately 40 percent. The effective rate may vary significantly, depending on the locality in which a corporation conducts business.

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Arbitrage: Transactions intended to take advantage of observed pricing discrepancies, and earn profits with little or no exposure to risk (have arbitrage opportunities diminished due to the issue of the single European currency €?)

· Spatial arbitrageFor a single currency, spatial arbitrage refers to price differences across market locations or dealers.$/DM (NY) ≠ $/DM (London) or $/DM (Dealer A) ≠ $/DM (Dealer B)

· Triangular arbitrageFor three currencies, triangular parity implies: SF/MP = SF/$ x $/MP MP: Mexican PesoImportance of triangular parity for constructing “cross rates”Direct markets in DM/£ were observed, but prices constrained by DM/£ = DM/$ x $/£


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Triangular Arbitrage

$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Suppose we observe these banks posting these exchange rates.

First calculate the implied cross rates to see if an arbitrage exists.

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$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

80¥1£

120¥1$

1$50.1£

=×

The implied S(¥/£) cross rate is S(¥/£) = 80

Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.

So, how can we make money?

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$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

80¥1£

120¥1$

1$50.1£

=×

As easy as 1 – 2 – 3:

1. Sell our $ for £,

2. Sell our £ for ¥,

3. Sell those ¥ for $.

1

2

3Sell $Regain $

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Triangular ArbitrageSell $100,000 for £ at S(£/$) = 1.50

receive £150,000 Sell our £ 150,000 for ¥ at S(¥/£) = 85

receive ¥12,750,000

Sell ¥ 12,750,000 for $ at S(¥/$) = 120receive $106,250

profit per round trip = $ 106,250- $100,000 = $6,250

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The Bid-Ask Spread

• The bid price is the price a dealer is willing to pay you for something.

• The ask price is the amount the dealer wants you to pay for the thing.

• The bid-ask spread is the difference between the bid and ask prices.

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Taking Advantage of aTriangular Arbitrage Opportunity

• A cross-rate trader at Bankers Trust notices that :– Credit Lyonnais is buying dollars at S(FF/$b)=5.0515, the

same as Bankers Trust’s bid price (bank’s $ buying price)– Barclays is offering (selling) dollars at S($/£b)=1.5573, also

the same as Bankers Trust’s selling price– Credit Agricole is making a direct market between the franc

and the pound, with a current FF bid price of S(£/FFb) =0.1273 (which implies a reciprocal £ ask price (offering price, bank’s currency selling price) of S(FF/£a)=7.8555)

• The FF/£ bid price should be no lower than S(FF/£b) = 1.5573 ×5.0515 = 7.8667. Yet Credit Agricole is offering to sell British pounds at a rate of only 7.8555! Opportunity knocks!

Eun/Resnick 4.3


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Eun/Resnick 4.3

S

£ FFCredit Agricole

S(FF/£a) = 7.8555

BarclaysS($/£b) = 1.5573

Credit LyonnalsS(FF/$b) = 5.0515


1.5573($/£b) x 5.0515(FF/$b) = 7.8667(FF/£b)

Buy Pound low...

And sell Pound high

1. Sell $3. Regain $

2. FF is just a vehicle

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$ 5,000,000× 5.0515FF 25,257,500÷ 7.8555£ 3,215,263× 1.5573$ 5,007,129$ 5,000,000$ 7,129

Bankers Trust Arbitrage Strategy

Sell U.S. dollars to Credit Lyonnaisfor French francsSell French francs to Credit Agricolefor British poundsSell British pounds to Barclaysfor U.S. dollars

Arbitrage profit

Eun/Resnick 4.3


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• Credit Agricole must raise its asking price above FF7.8555/£1.00.– The cross exchange rates gave FF/£ bid-ask prices (bank’of

FF7.8667-FF7.8717. These prices imply that Credit Agricolecan deal inside the spread and sell for less than FF7.8717, but not less than FF7.8667.

– An ask price of FF7.8700, for example, would eliminate the arbitrage profit. At that price, the FF25,257,500 would be resold for FF25,257,500/7.8700=£3,209,339, which in turn would yield only £3,209,339×1.5473=$4,965,810, or a loss of $34,190.

Eun/Resnick 4.3


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Cross-Rate Foreign Exchange Transactions

a. Bank Customer wants to sell £1,000,000 for French franks. The Bank will sell U.S. dollars (buy British pounds) for $1.5573. The sale yields Bank Customer: £1,000,000 x 1.5573 = $1,557,300.The Bank will buy dollars (sell French franks) for FF5.0515. The sale of dollars yields Bank Customer: $1,557,300 x FF5.0515 = FF7,866,701Bank Customer has effectively sold British pounds at a FF/£ bid price ofFF7,866,701/£1,000,000 = FF7.8667/£1.00

American Terms ($/FC) European Terms (FC/$)Bank Quotations Bid Ask Bid AskBritish pounds 1.5573 1.5578 .6419 .6421French franks 0.1979 0.1980 5.0515 5.0531

0.1980 x 5.0515 = 1.000 and 0.1979 x 5.0531 = 1.000

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Cross-Rate Foreign Exchange Transactions

b. Bank Customer wants to sell FF10,000,000 for British pounds. The Bank will sell U.S. dollars (buy French franks) for FF5.0531. The sale yields Bank Customer: FF10,000,000 /5.0531 = $1,978,983.The Bank will buy dollars (sell British Pounds) for $1.5578. The sale of dollars yields Bank Customer: $1,978,983 / $1.5578 = £1,270,370.Bank Customer has effectively bought British pounds at a FF/£ ask price of FF10,000,000/£1,270,370 = FF7.8717/£1.00.

From parts (a) and (b), we see the currency against currency bid-ask spread for British pounds is FF7.8667-FF7.8717.

American Terms ($/FC) European Terms (FC/$)Bank Quotations Bid Ask Bid AskBritish pounds 1.5573 1.5578 .6419 .6421French franks 0.1979 0.1980 5.0515 5.0531

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A Macroeconomic Theory of the Open Economy


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The Market for Loanable Funds

Saving = Domesticinvestment

Net foreigninvestment+

S = I + NFI

Net foreign investment is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.

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http://www.bfwpub.com/pdfs/mankiw/0716752379_05.pdfhttp://www.bfwpub.com/pdfs/mankiw/0716752379_12.pdf

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Some Important IdentitiesY (GDP, gross domestic product) =

C (consumption) + I (investment)+ G (government purchases) + NX (net export)

(for open economies)

Y=C+I+G (for a closed economy)

Y-C-G=IY-C-G is called the national saving, or just saving, and is denoted S

S=I (For economy as a whole, saving must be equal to investment.)

S=Y-C-G=(Y-T-C) + (T-G) where T is the net tax amount collected by the government, Y-T-C is called private saving, and T-G is called public saving.

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Equilibriumquantity

Quantity ofLoanable Funds

RealInterest

Rate

Equilibriumreal interest

rate

Supply of loanable funds(from national saving)

Demand for loanable funds (for domestic investment

and net foreign investment)

A MACROECONOMIC THEORY OF THE OPEN ECONOMYA MACROECONOMIC THEORY OF THE OPEN ECONOMY

The Market for Loanable Funds

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The Market for Loanable FundsThe interest rate in an open economy, as in a closed economy, is determined by the supply and demand for loanable funds.National saving is the source of the supply of loanable funds. Domestic investment and net foreign investment are the sources of the demand for loanable funds.At the equilibrium interest rate, the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets.

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The Market for Foreign Currency Exchange

Net foreign investment = Net exports

NFI = NX

Suppose that Boeing sells some planes to a Japanese airline for yens. This sale increases U.S. net exports and U.S. net foreign investment by the same amount. Boeing then exchanges its yen for dollars with a U.S. mutual fund that wants the yen to buy stock in Sony (Japan). NX and NFI are still of the same amount!

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The Market for Foreign-Currency Exchange...

Quantity of Dollars Exchangedinto Foreign Currency

RealExchange

RateSupply of dollars

(from net foreign investment)

Demand for dollars(for net exports)

Equilibriumquantity

Equilibrium real exchange

rate

Copyright © 2001 by Harcourt, Inc. All rights reserved


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Real and Nominal Exchange Rates

International transactions are influenced by international prices.The two most important international prices are the nominal exchange rate and the real exchange rate.

http://highered.mcgraw-hill.com/sites/dl/free/0073523097/238722/chap10_stu.ppt#285,1,Chapter 10

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Nominal Exchange Rates

The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another.

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The nominal exchange rate is expressed in two ways:

In units of foreign currency per one U.S. dollar.And in units of U.S. dollars per one unit of the foreign currency.

0 - 88


Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar.

One U.S. dollar trades for eighty yen.One yen trades for 1/80 (=0.0125) of a dollar.

0 - 89


If a dollar buys more foreign currency, there is an appreciation of the dollar.If it buys less there is a depreciation of the dollar.

0 - 90

Real Exchange Rates

The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another.


0 - 91

Real Exchange Rates

The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy.

If a case of German beer is twice as expensive as American beer, the real exchange rate is 1/2 case of German beer per case of American beer.

0 - 92

Real Exchange Rates

The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.

0 - 93

Real Exchange Rates

The real exchange rate is a key determinant of how much a country exports and imports.

price ForeignpriceDomestic x rate exchange Nominal =

Real Exchange

Rate

(Foreign currency denominated price of a domestic unit)

0 - 94

Real Exchange Rates

A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods.This encourages consumers both at home and abroad to buy more U.S. goods and fewer goods from other countries.

0 - 95

Real Exchange Rates

As a result, U.S. exports rise, and U.S. imports fall, and both of these changes raise U.S. net exports.Conversely, an appreciation in the U.S. real exchange rate means that U.S. goods have become more expensive compared to foreign goods, so U.S. net exports fall.

0 - 96

Purchasing-Power Parity

The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates.


0 - 97

Purchasing-Power Parity

According to the purchasing-power parity theory, a unit of any given currency should be able to buy the same quantity of goods in all countries.

0 - 98

Basic Logic of Purchasing-Power Parity

The theory of purchasing-power parity is based on a principle called the law of one price.According to the law of one price, a good must sell for the same price in all locations.

0 - 99


If the law of one price were not true, unexploited profit opportunities would exist.The process of taking advantage of differences in prices in different markets is called arbitrage.

0 - 100


If arbitrage occurs, eventually prices that differed in two markets would necessarily converge.According to the theory of purchasing-power parity, a currency must have the same purchasing power in all countries and exchange rates move to ensure that.

0 - 101

Implications of Purchasing-Power Parity

If the purchasing power of the dollar is always the same at home and abroad, then the exchange rate cannot change.The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

0 - 102

Implications of Purchasing-Power Parity

When the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.


0 - 103

10,000,000,000

1,000,000,000,000,000

100,000

1

.00001

.00000000011921 1922 1923 1924 1925

Exchange rate

Money supply

Price level

Indexes(Jan. 1921 = 100)

Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation

0 - 104

Limitations of Purchasing-Power Parity

Many goods are not easily traded or shipped from one country to another.Tradable goods are not always perfect substitutes when they are produced in different countries.

0 - 105

6-132

The Market for Foreign Currency ExchangeThe real exchange rate is determined by the supply and demand for foreign-currency exchange.The supply of dollars comes from net foreign investment (NFI). Because NFI does not depend on the real exchange rate, the supply curve is vertical. The demand for dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve is downward sloping.At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports.

0 - 106

6-133

Net Foreign Investment :The Link Between the Two Markets

S = I + NFI

NFI = NX

0 - 107

6-134

0 Net ForeignInvestment

Net foreign investmentis negative.

Net foreign investmentis positive.

RealInterest

Rate

A MACROECONOMIC THEORY OF THE OPEN ECONOMYA MACROECONOMIC THEORY OF THE OPEN ECONOMY

How Net Foreign Investment Depends on the Interest Rate0 - 108

6-135

How Net Foreign InvestmentDepends on the Interest Rate

Because a higher domestic real interest rate makes domestic assets more attractive, it reduces net foreign investment.Note the position of zero on the horizontal axis: Net foreign investment can be either positive or negative.


0 - 109

Principles of Macroeconomics Figure 18.4

0 - 110


The Real Equilibrium in an Open Economy

In panel (a), the supply and demand for loanable funds determine the real interest rate. In panel (b), the interest rate determines net foreign investment, which provides the supply of dollars in the market for foreign-currency exchange. In panel (c), the supply and demand for dollars in the market for foreign-currency exchange determine the real exchange rate.

0 - 111


0 - 111 0 - 112

The Effects of a Government Budget Deficit

When the government runs a budget deficit, it reduces the supply of loanable funds from S1 to S2in panel (a). The interest rate rises from r1 to r2 to balance the supply and demand for loanable funds. In panel (b), the higher interest rate reduces net foreign investment. Reduced net foreign investment, in turn, reduces the supply of dollars in the market for foreign-currency exchange from S1 to S2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate from E1 to E2. The appreciation of the exchange rate pushes the trade balance toward deficit.


0 - 113


0 - 113 0 - 114


The Effects of an Import QuotaWhen the U.S. government imposes a quota on the import of Japanese cars, nothing happens in the market for loanable funds in panel (a) or to net foreign investment in panel (b). The only effect is a rise in net exports (exports minus imports) for any given real exchange rate. As a result, the demand for dollars in the market for foreign-currency exchange rises, as shown by the shift from D1 to D2in panel (c). This increase in the demand for dollars causes the value of the dollar to appreciate from E1to E2. This appreciation of the dollar tends to reduce net exports, offsetting the direct effect of the import quota on the trade balance.


0 - 115


0 - 115 0 - 116


The Effects of Capital FlightIf people in Mexico decide that Mexico is a risky place to keep their savings, they will move their capital to safer havens such as the United Sates, resulting in an increase in Mexican net foreign investment.Consequently, the demand for loanable funds in Mexico rises from D1 to D2, as shown in panel (a), and this drives up the Mexican real interest rate from r1 to r2. Because net foreign investment is higher for any interest rate, that curve also shifts to the right from NFI1 to NFI2 in panel (b). At the same time, in the market for foreign-currency exchange, the supply of pesos rises from S1 to S2, as shown in panel (c). This increase in the supply of pesos causes the peso to depreciate from E1 to E2, so the peso becomes less valuable compared to other currencies.

0 - 117Building Blocks of The Parity Framework

The Parity Framework

Four Definitions: S, F, r, I

Four Derived Key Terms: rF - rD, IF - ID,f, s

Purchasing Power Parity + Uncovered Interest Parity (Fisher International Effect)

Forward Rate Unbiased Property + Interest Rate Parity

Key Interest – Exchange Rates Linkages

0 - 118

Four DefinitionsThe spot exchange rate, S. The rate of exchange of two currencies tells us the amount of foreign currency that one unitof domestic currency can buy. Spot means that we refer to the exchange rate for immediate delivery.The forward exchange rate, F. The rate of exchange of two currencies set on one date for delivery at a future specified date, the forward rate is quoted today for a delivery taking place at a future date.The interest rate, r. The rate of interest for a given time period is a function of the length of the time period and the denomination of the currency. Interest rates are usually quoted in the market place as an annualized rate.The inflation rate, I. This is equal to the rate of consumer price increase over the period specified. The inflation differential is equal to the difference of inflation rates between two countries.

0 - 119

The interest rate differential, rF - rD. The interest rate differential is equal to the difference in interest rates between two countries.

The inflation differential, IF - ID. The inflation differential is equal to the difference of inflation rates between two countries.

The forward discount or premium, f. This is often calculated as an annualized percentage deviation from the spot rate:

The exchange rate movement, s. This is equal to the spot exchange rate movement over the period specified. f = (F-S0)/S0 and s = (S1-S0)/S0

Four Derived Key Terms

annualized forward premium (discount)

forward rate - spot ratespot rate

= × × 100 %12no. months forward

0 - 120

t = 0 1 2 3 n……

S1S0

F0,1

F0,2

F1,1

F1,2

S2 S3

Forward exchange rate premium f = (F-S0)/S0

Exchange rate movement over the period specified

s = (S1-S0)/S0

Spot rate: S0 = S current time

Forward rate: F0,1 = F contract signing time, time to maturity


0 - 121

· Parity conditions are useful when parity holds· Parity conditions are useful when parity does not hold

Key Interest Rate-Exchange Rate Linkages: The Parity Framework

Please note that parity conditions are long-term equilibrium conditions. It might not happen in the near future (e.g., in three months) but it more likely to happen in the long-run (e.g., in six years).

0 - 122Four International Parity ConditionsPurchasing Power Paritylinking spot exchange rates and inflationAbsolute PPP: The price of a market basket of U.S. goods equals the price of a market basket of foreign goods when multiplied by the exchange rate.Relative PPP: The percentage change in the exchange rate equals the percentage change in U.S. goods prices less the percentage change in foreign goods prices.

Uncovered Interest Paritylinking interest rates and inflationFisher Effect: For a single economy, the nominal interest rate equals the real interest rate plus the expected rate of inflation.International Fisher Effect: For two economies, the U.S. interest rate minus the foreign interest rate equals the expected difference in inflation rates between the two countries.

0 - 123

Interest Rate Paritylinking forward exchange rates and expected spot exchange rate The forward exchange rate premium equals (approximately) the U.S. interest rate minus the foreign interest rate.

Forward Rate Unbiased Propertylinking forward exchange rates and expected spot exchange ratesForeign Exchange Expectations: Today’s forward premium (for delivery in n days) equals the expected percentage change in the spot rate (over the next n days).

Four International Parity Conditions 0 - 124

International Parity Relations Linear Approximationwhere Spot Rate S are in indirect quote (FC/DC or FC/$)

Solnik 2.1

Interest Rate Parity

Forward Rate Unbiased Property

Uncovered Interest Parityor Fisher International Effect

Purchasing Power Parity (relative version) PPP

IRPFIE

FRU

0 - 125

An Example of Interest Rate Parity

Suppose an investor with $1,000,000 to invest for 90 days is trying to decide between investing in U.S. dollars at 8% per annum (2% for 90 days) or in DM at 6% per annum (1.5% for 90 days).The current spot rate is DM 1.5311/$ and the 90-day forward rate is DM 1.5236/$.As shown in the next slide, regardless of the investor’s currency choice, his hedged return will be identical.

Multinational Financial Management 6-136

0 - 126

An Example of Interest Rate Parity

Multinational Financial Management Ex 5.7

Alternative investment:Invest $1,000,000 in

New York for 90 days at 2%and receive $1,020,000 in 90 days

New York

Start$1,000,000

Finish$1,020,000

Convert $1,000,000to DM at DM 1.5311/$ for DM 1,531,100

1.

DM 1,531,100Frankfurt: today

DM 1,554,066.50Frankfurt: 90 days

Invest DM 1,531,100 at 1.5%for 90 days, yielding DM 1,554,066.50 in 90 days

2.

Simultaneously with the DMinvestment, sell the DM1,554,066.50 forward at arate of DM 1.5236/$ for delivery in 90 days, &receive $1,020,000in 90 days

3.

6-137


0 - 127

Korean Won: Depreciation versus Interest Rate Differential(in % per year)

Solnik 2.3

0 - 128

From 1991 to 1996, the won had a much higher interest rate than the dollar (an annual differential around 10%), but the exchange rate with the dollar remained stable. In 1997, the Asian crisis hit many currencies in the region and the won was devalued by some 50%.

Averaging over the 1991-97 period, we find that the interest rate differential roughly matches the currency depreciation. So any investor applying the strategy to invest in this high-interest-rate currency would have made a profit for several years and lost all of it in 1997.

Solnik 2.3

0 - 129

An Example of Covered Interest ArbitrageSuppose the interest rate on pounds sterling is 12% in London, and the interest rate on a comparable dollar investment in New York is 7%. The pound spot rate is $1.75 and the one-year forward rate is $1.68. These rates imply a forward discount on sterling of 4% [(1.68 - 1.75) / 1.75] and a covered yield on sterling approximately equal to 8% (12% - 4%). Because there is a covered interest differential in favor of London, funds will flow from New York to London.To illustrate the profits associated with covered interest arbitrage, we will assume that the borrowing and lending rates are identical and the bid-ask spread in the spot and forward markets is zero.

Multinational Financial Management 6-138

0 - 130

An Example of Covered Interest Arbitrage

Multinational Financial Management Ex 5.8

New Yorktodayone year

Borrow $1 million at an interestrate of 7%, owing $1,070,000at year end

1.

London : todayLondon: one year

Start:

Convert the $1 million to pounds at $1.75/£ for£571,428.57

2.

Invest the £571,428.57in London at 12%,generating £640,000by year end

3.

Simultaneously, sell the £640,000 in principal plus interest forward at a rate of $1.68/£ for delivery in year, yielding $1,075,200 at year end

4.

Net profit equals$5,200

7.Finish:

Repay the loan plus interest of $1,070,000 out of the $1,075,200

6.

Collect the £640,000 and deliver it to the bank’s foreign exchange department in return for $1,075,200

5.

6-139

0 - 131

Monetary Policy, Interest Rates,and Exchange Rates

In an open economy with flexible exchange rates, assume that there is no inflation (so, nominal rates = real rates) and that initially, domestic and foreign interest rates are expected to be constant and equal to each other.

The central bank announces that one-year interest rates will be 2% lower for each of the next five years, after which they will return to normal. Financial markets fully believe this announcement.

What is the effect on the exchange rate today?

B21 - 22

0 - 132

0 1 2 3 4 50

2

4

6

8

10%

0 1 2 3 4 5- 2

0%

Years

Years

Interest rate, i

Exch

ange

rate

, E (D

C/F

C)

DC depreciation

Expected DCappreciation

The announcement does not affect the interest rates (and hence, exchange rates) beyond the first five years.

Interest parity: For the five years, the domestic currency is expected to appreciate by 2% each year, so that the rates of return on domestic and foreign bonds are equal.

So, a 2% decrease in interest rates expected to last for five years leads to a depreciation of 5x2%=10% today, followed by expected appreciation of 2% a year over the next five years.

Monetary Policy, Interest Rates,and Exchange Rates

B21 - 23


0 - 133

The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.

- John Maynard Keynes

7-48

Long-Run versus Short-Run

0 - 134

Technical analysis vs. Fundamental Analysis

Technical analysis is the form of charting involves the search of current and predictable patterns in stock prices to enhance returns.

Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine the stock prices.

0 - 135 0 - 136

0 - 137 0 - 138

International Financial Innovation:

(1) Constructing Outright Forward Contract

(2) Exotic Swap


0 - 139

t = 0 1 2 3 n……

S1S0

F0,1

F0,2

F1,1

F1,2

S2 S3

Forward exchange rate premium f = (F-S0)/S0

Exchange rate movement over the period specified

s = (S1-S0)/S0

Spot rate: S0 = S current time

Forward rate: F0,1 = F contract signing time, time to maturity

0 - 140

Suppose you need DM in 180 days.

Option 1buy DM in the spot market- and earn interest in DM (money market hedging)

Option 2buy DM in the forward market (hedging with forward)- will have to pay 1.3022% more than the spot price

Option 3buy DM in the spot market 180 days later- but is exposed to foreign exchange rate risk

Spot v.s. Forward

0 - 141

D

A

Foreign Exchange MarketProducts and Activities

time dimension

curr

ency

dim

ensi

on

Jan 1 Jul 1US$

DM

A manager wishes to own DM on July 1.(DM A/P Due)

buy DMforward

at F

Option 2

The Relationship between Spot and Forward Contracts

0 - 142

D


time dimension

curr

ency

dim

ensi

on

Jan 1 Jul 1US$

DM

A


Bborrow US$ at i$

Option 1

C

buy DMspot at S

lend DM at iDM

A manager wishes to own DM on July 1.(DM A/P Due)

0 - 143

D

A


time dimension

curr

ency

dim

ensi

on

Jan 1 Jul 1US$

DM

sell DMforward

at F


A manager wishes to own US$ on July 1.(DM A/Rdue)

0 - 144

D


time dimension

curr

ency

dim

ensi

on

Jan 1 Jul 1US$

DM

A


Blend US$ at i$

C

sell DMspot at S

borrow DM at iDM

A manager wishes to own US$ on July 1.(DM A/Rdue)


0 - 145

time dimension

curr

ency

dim

ensi

on

Jan 1 Jul 1US$

DM

B A

C D

Spot v.s. Forward

Levich Figure 3.2 Pg. 78

borrow DM at iDM

lend DM at iDM

borrow US$ at i$

lend US$ at i$

buy DMspot at

S

sell DMspot at

S

buy DMforward

at F

sell DMforward

at F

0 - 146

Subject: Regarding the "Box" Diagram

(1) An arrow from DM to US$, can be thought of as SELLING DM or BUYING US$.

(2) The reverse arrow from US$ to DM represents the reverse transaction, SELLING US$ or BUYING DM.

(3) An arrow from right to left (from the future to the present), can be thought of as borrowing - taking cash from the future and bringing it to the present.

(4) The reverse arrow from left to right (from the present to the future), can be thought of as investing - taking cash that you have now and putting it away until the future.

0 - 147

Note: A forward purchase of DM (equivalent to a forward sale of US$) is shown by the arrow AD. This outright forward contract can be replicated by (1) borrowing US$ (arrow AB), (2) buying DM in the spot market (arrow BC), and (3) lending the DM (arrow CD).

The borrowing and lending are carried out as a single transaction – a foreign exchange swap. The maturity of the forward contracts is identical to the maturity of the borrowing and lending contracts.

A forward sale of DM can be described by reversing the direction of the arrows.

0 - 148

Using Figure 3.2:Constructing Outright Forward Contracts

Forward Purchase of DM on January for Value on July 1Line segment AD (price F, forward rate $/DM)Can be replicated by:Borrowing $, line segment AB (price i$)Buying DM spot, line segment BC (price S)Lending DM, line segment CD (price iDM)

Forward Sale of DM on January 1 for Value on July 1Line segment DA (price F) Can be replicated by:Borrowing DM, line segment DC (price iDM)Selling DM spot, line segment CB (price S)Lending $, line segment BA (price i$)

0 - 149

Implication:In the absence of transaction costs, price of forward contract = price of three replicating contracts.F ($/DM) = S ($/DM) × (1 + i[$])

(1 + i[DM])

Further Implications:Forward contracts are 'redundant'; that is, a forward contract can be replicated by a spot contract and a swap (a simultaneous borrowing and lending in the money market).

0 - 150

A corporation that uses an outright forward contract has a contingent, off-balancesheet liability. No cash changes hand so there is no direct effect on the firm's balance sheet. The forward contract uses part of the firm's scarce credit capacity at its bank. (Reference: Accounting for Derivatives in Intermediate Accounting, Eleventh Edition by Donald E. Kieso)

A bank that constructs or hedges a forward position by using a ‘spot and a swap’ alters the asset and liability exposure of the bank. In other words, the trader’ s position must be funded.


0 - 151Medical Swap vs. Financial Swap

http://www.pageout.net/user/www/s/t/stanford2007/medical%20swap.pdf

0 - 152

Swaps & Linkages Across International Capital Markets

Cross Currency Interest Rate Swap

Interest Rate Swap

Interest Rate Swap Floating-Floating Currency Sw

apFixe

d-Fi

xed

Cur

renc

y Sw

ap

A B

C D

Cur

renc

y X

Cur

renc

y Y

Fixed RateAsset or Liability

Floating RateAsset or Liability

Interest Rate Base

Currency ofDenomination

Figure 13.8 Pg 469

ExamplesA Dollar-denominated

straight EurobondB Eurodollar floating-

rate note (FRN)C Samurai bondD Euroyen floating-

rate note (FRN)13-32

Cross Curre

ncy In

teres

t Rate

Swap

0 - 153

13-36

Price Quoting Conventions in the Swap Market

CounterParty A

SwapDealer

CounterParty B

Swap dealer receives

floating rate

Swap dealer pays fixed

rate

Swap dealer pays

floating rate

Swap dealer receives fixed rate

Bid Quote Offer QuoteSwap Quotes

Quotes are given from the perspective of the swap dealer.The convention is to quote only the fixed side of the swap.All fixed quotes are against LIBOR unless otherwise stated.

Panel C of Table 13.5 Pg 470

0 - 154

Applications of Swaps:Magnifying Risk and Return

Many of the illustrations in this chapter have linked a swap with a bond issue, but these decisions are separable. A firm can issue a bond in one year and then decide to swap later, using the swap as a risk management tool. However, a firm could enter into a swap without a prior bond issue. This transaction is the same as a pure speculation on the direction of exchange rates or interest rates.

0 - 155

An Unsuccessful Exotic Swap

Procter and Gamble (P&G) (based in Cincinnati and with $30 billion in annual sales) lost $157 million on an exotic swap whose payments (“in most cases”) were defined by the formula:

17.0415 x (5-year Treasury rate) - (price of 6.25 percent Treasury due 8/2023)- 0.75%

The amount of interest that P&G would pay under this formula is shown in Table 13.7.

0 - 156

30-Year Interest Rate5-year Int 6% 7% 8%

5% -0.75% -0.75% 4.20%6% -0.75% 10.80% 21.20%7% 15.10% 24.90% 38.20%

Table 13.7 Interest Cost (Premium over the CP Rate)in the Procter & Gamble/Bankers Trust Interest Rate Swap


0 - 157

International Risk Management

How Leeson Broke Barings

0 - 158

The activities of Nick Leeson on the Japanese and Singapore futures exchanges, which led to the downfall of his employer, Barings, are well-documented. Barings collapsed because it could not meet the enormous tradingobligations, which Leeson established in the name of the bank. When it went into receivership on February 27, 1995, Barings, via Leeson, had outstanding notional futures positions on Japanese equities and interest rates of US$27 billion: US$7 billion on the Nikkei 225 equity contract and US$20 billion on Japanese government bond (JGB) and Euroyen contracts. Leeson also sold 70,892 Nikkei put and call options with a nominal value of $6.68 billion. The nominal size of these positions is breathtaking; their enormity is all the more astounding when compared with the banksreported capital of about $615 million.

0 - 159

The size of the positions can also be underlined by the fact that in January and February 1995, Barings Tokyo and London transferred US$835 million to its Singapore office to enable the latter the meet its margin obligations on the Singapore International Monetary Exchange (SIMEX).

0 - 160

0 - 161 0 - 162

The Building Blocks of Contingent Decisions

(a) Long a bond (invest in a bond)

0

0

(b) Short a bond (issue a bond)

Payo

ff at

mat

urity

Payo

ffat

mat

urity

+

−


0 - 163

The Building Blocks of Contingent Decisions

(c) Purchase of Right toBuy at a Fixed Price

(d) Purchase of Right toSell at a Fixed Price

Opt

ion

Payo

ff

Value of Underlying Asset at Decision Date

(e) Sell Right toBuy at a Fixed Price

(f) Sell Right toSell at a Fixed Price

$0 $0

Real Options: Amram & Kulatilaka Figure 4.1

0 - 164

The Building Blocks of Noncontingent Decisions(g) Forward Purchase

(long position)(g) = (c) + (f)

(h) Forward Sale(short position)

(h) = (d) + (e)

Payo

ff

Value of Underlying Asset at Decision Date

$0 $0

Real Options: Amram & Kulatilaka Figure 4.2

A forward contract is the right to buy or sell an asset at a specified date in the future at a specified price. The payoffs to a forward are not contingent on a future decision (hence there is no kink) but do depend on the realized value of an uncertain asset (the line is sloped).

0 - 165

A Short Straddle (sale both a call and a put) in the $/£

0.10

0.05

0.00

-0.05

-0.10

-0.15

-0.201.25 1.30 1.35 1.40 1.45 1.50 1.55 1.60 1.65 1.70 1.75

Pro

fit o

r Los

s in

$

$/£

Profit and Loss Positions

Sell Call

Sell Put

ShortStraddle

Box 12.1 Figure A

0 - 166

0 - 167

Use of a Butterfly SpreadFrom the Trader’s DeskA stock is currently selling for $61. The prices of call options expiring in 6 months are quoted as follows:

Strike price = $55, call price = $10Strike price = $60, call price = $7Strike price = $65, call price = $5

An investor feels it is unlikely that the stock price will move significantly in the next 6 months.

The StrategyThe investor sets up a butterfly spread:

1. Buy one call with a $55 strike.2. Buy one call with a $65 strike.3. Sell two calls with a $60 strike.

The cost is $10 + $5 - (2 x $7) = $1. The strategy leads to a net loss (maximum $1) if the stock price moves outside the $56-to-$64 range but leads to a profit if it stays within this range. The maximum profit of $4 is realized if the stock price is $60 on the expiration date.

0 - 168

Butterfly Spread Using Call Options

X1 X3

Profit

STX2


0 - 169

Topics in Financial Innovation and ChallengesThe innovation of credit derivative instruments does not stop at single name credit default swaps, which shift credit exposure to a credit protection seller, and operate like standby letters of credit or insurance.Collateralized Debt Obligations (CDOs) alone, where a pool of credits such as bonds or loans are created and pieces of the pool are sold to different investors based on their risk/return appetite, is another trillion-dollar market.

0 - 170

Topics in Financial Innovation and Challenges

The CDO market started with cash CDOswhere the underlying pool contains actual bonds or loans. The life insurer is the largest investor's group of the cash CDO securities. Then synthetic CDOs, which have a collateral pool consisting of a portfolio of single name default swaps, quickly followed suit. This innovation overcame the constraint that only limited actual assets could be taken as collateral in the cash CDO markets. Be alert!

0 - 171Topics in Financial Innovation and Challenges 0 - 172Topics in Financial Innovation and Challenges

0 - 173Topics in Financial Innovation and Challenges

The modelling of default events using survival time distribution is very similar to the modelling of the death of a human life. A credit curve, which describes the term structures of default probabilities for an obligor, is very much like a mortality table. Pricing a default swap is not much different from pricing a life insurance contract. David Li on Synthetic CDO

0 - 174

Fixed Income Securities: Analytics and DerivativesFabozzi: Bond Markets, Analysis,

and Strategies

Individual Bond Strategies:

Barbells Strategy

Ladders Strategy

Bullets Strategy


0 - 175

Example: Ladder strategyYou buy three bonds with different maturity dates: two years, four years, and six years. As each bond matures, you have the option of buying another bond to keep the ladder going. In this example, you buy 10-year bonds. Longer-term bonds typically offer higher interest rates.

Ladders are a popular strategy for staggering the maturity of your bond investments and for setting up a schedule for reinvesting them as they mature. A ladder can help you reap the typically higher coupon rates of longer-term investments, while allowing you to reinvest a portion of your funds every few years.

Ladders

Ladders Strategy0 - 176

Ladders Strategy

4. Investors should be aware that laddering can require commitment of assets over time, and return of principal at time of redemption is not guaranteed

3. Interest rate volatility is reduced because the investor now determines the best investment option every few years, as each bond matures

2. The income derived from principal and interest payments can either be directed back into the ladder if interest rates are relatively high or invested elsewhere if they are relatively low

1. The periodic return of principal provides the investor with additional income beyond the set interest payments.

Ladders have several potential advantages:

Ladders are popular among investors who want bonds as part of a long-term investment objective, such as saving for college tuition, or seeking additional predictable income for retirement planning.

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Barbell Strategies

Example: Barbell strategyYou see appealing long-term interest rates, so you buy two long-term bonds. You also buy two short-term bonds. When the short-term bonds mature, you receive the principal and have the opportunity to reinvest it.

Barbells are a strategy for buying short-term and long-term bonds, but not intermediate-term bonds. The long-term end of the barbell allows you to lock into attractive long-term interest rates, while the short-term end insures that you will have the opportunity to invest elsewhere if the bond market takes a downturn.

Barbells

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Example: Bullet strategyYou want all bonds to mature in 10 years, but want to stagger the investment to reduce the interest rate risk. You buy the bonds over four years.

Bullets are a strategy for having several bonds mature at the same time and minimizing the interest rate risk by staggering when you buy the bonds. This is useful when you know that you will need the proceeds from the bonds at a specific time, such as when a child begins college.

Bullets

Bullets Strategies

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Topics in International Financial Reporting

International financial disclosure and transparency issues

Incentives for off-balance sheet liabilities

Hedge accounting

Lease accounting

Footnote disclosures

Intercorporate equity investments

International financial reporting differences and inflation

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Topics in Financial Contract DesignRead the following episode carefully.Italian Asset Swap Volumes Soar on Buyback PlansVolumes in the basis-swap spread market doubled last week as traders entered swaps in response to the Italian treasury's announcement that it "does not rule out buybacks." Traders said the increase in volume was exceptional given that so many investors are on holiday at this time of year.Traders and investors were entering trades designed to profit if the treasury initiates a buyback program and the bonds increase in value as they become scarcer and outperform the swaps curve. A trader, said in a typical trade the investor owns the 30-year Italian government bond and enters a swap in which it pays the 6% coupon and receives 10.5 basis points over six-month Euribor. "Since traders started entering the position last Monday the spread has narrowed to 8bps over Euribor," he added. The trader thinks the spread could narrow to 6.5bps over Euribor within the next month if conditions in the equity and emerging markets improve. A trader at a major European bank predicts this could go to Euribor flat over the next six months. The typical notional size of the trades is EUR50 million (USD43.65 million) and the maturity is 30 years. (IFR Issue 1217)


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(a) Suppose there is an Italian swap curve along with a yield curve obtained from Italian government bonds (sovereign curve). Suppose this latter is upward sloping. Discuss how the two curves might shift relative to each other if the Italian government buys back some bonds.

(b) Is it important which bonds are bought back? Discuss.(c) Show the cash flows of a 5-year Italian government

coupon bonds (paying 6%) and the cash flows of a fixed-payer interest-rate swap.

(d) What is the reason behind the existence of the 10.15 bpspread?

(e) What happens to this spread when government buys back bonds? Show your conclusions using cash flow diagrams.

0 - 182Foreigners buying Australian dollar instruments issued in Australia have to pay withholding taxes on interest earnings. This withholding tax can be exploited in tax-arbitrage portfolios using swaps and bonds. First let us consider an episode from the markets related to this issue.

Under Australia's withholding tax regime, resident issuers have been relegated to second cousin status compared with non resident issuers in both the domestic and international markets. Something has to change.In the domestic market, bond offerings from resident issuers incur the 10% withholding tax. Domestic offerings from non resident issuers, commonly known as Kangaroo bonds, do not incur withholding tax because the income is sourced from overseas. This raises the spectre of international issuers crowding out local issuers from their own markets.In the international arena, punitive tax rules restricting coupon washing have reduced foreign investor interest in Commonwealth government securities and semi-government bonds. This has facilitated the growth of global Australian dollar offerings by Triple A rated issuers such as Fannie Mae, which offer foreign investors an attractive tax-free alternative.The impact of the tax regime is aptly demonstrated in the secondary market. Exchangeable issues in the international markets from both Queensland Treasury Corporation and Treasury Corporation of 'NSW are presently trading through comparable domestic issues. These exchangeable issues are exempt from withholding tax.If Australia wishes to develop into an international financial centre, domestic borrowers must have unfettered access to the international capital markets—which means compliance costs and uncertainty over tax treatment must be minimized. Moreover, for the Australian domestic debt markets to continue to develop, the inequitable tax treatment between domestic and foreign issues must be corrected. (IFR, Issue 1206)

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We now consider a series of questions dealing with this problem. First, take a 4-year straight coupon bond issued by a local government that pays interest annually. We let the coupon rate be denoted by c%. Next, consider an Aussie dollar Eurobond issued at the same time by a Spanish company. The Eurobond has a coupon rate d%.The Spanish company will use the funds domestically in Spain. Finally, you know that interest rate swaps or FRAs in Aussie$ are not subject to any tax,(a) Would a foreign investor have to pay the withholding tax on the Eurobond? Why

or why not?(b) Suppose the Aussie$ IRSs are trading at a swap rate of d + 10bp. Design a 4-year

interest rate swap that will benefit from tax arbitrage. Display the relevant cash flows.

(c) If the swap notional is denoted by N, how much would the tax arbitrage yield?(d) Can you benefit from the same tax-arbitrage using a strip of FRAs in Aussie$?(e) Which arbitrage portfolio would you prefer, swaps or FRAs? For what reasons?(f) Where do you think it is more profitable for the Spanish company to issue bonds

under these conditions, in Australian domestic markets or in Euromarkets? Explain.

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About the CFA Program• The Chartered Financial Analyst (CFA) Program is a

globally recognized standard for measuring the competence and integrity of financial analysts.

• Its curriculum develops and reinforces a fundamental knowledge of investment principles.

• Three levels of examination measure a candidate’s ability to apply these principles at a professional level.

• The CFA exam is administered annually in more than 70 nations worldwide.

• http://www.aimr.org/cfaprogram/

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a. Explain the following three concepts of purchasing power parity (PPP):i. The law of one price.ii.Absolute PPP.iii.Relative PPP.

b. Evaluate the usefulness of relative PPP in predicting movements in foreign exchange rates on a:i. Short-term basis (e.g., three months).ii.Long-term basis (e.g., six years).

CFA (level III, 1997)

CFA-1

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i. The law of one price is that, assuming competitive markets and no transportation costs or tariffs, the same goods should have the same real prices in all countries after converting prices toa common currency.

ii. Absolute PPP, focusing on baskets of goods and services, states that the same basket of goods should have the same price in all countries after conversion to a common currency. Under absolute PPP, the equilibrium exchange rate between two currencies would be the rate that equalizes the prices of a basket of goods between the two countries. This rate would correspond to the ratio of average price levels in the countries. Absolute PPP assumes no impediments to trade and identical price indexes that do not create measurement problems.


CFA-2


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CFA (level III, 1997)iii.Relative PPP holds that exchange rate movements reflect

differences in price changes (inflation rates) between countries. A country with a relatively high inflation rate will experience a proportionate depreciation of its currency’s value vis-à-vis a country with a lower rate of inflation. Movements in currencies provide a means for maintaining equivalent purchasing power levels among currencies in the presence of differing inflation rates.Relative PPP assumes prices adjust quickly and price indexes properly measure inflation rates. Because relative PPP focuses on changes and not absolute levels, relative PPP is more likely to be satisfied than the law of one price or absolute PPP.

CFA-3

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CFA (level III, 1997)i. Short-term basis (e.g., three months). Relative PPP is not

consistently useful in the short run because: (1) Relationships between month-to-month movements in market exchange rates and PPP are not consistently strong, according to empirical research. Deviations between the rates can persist for extended periods; (2) exchange rates fluctuate minute by minute because they are set in the financial markets. Price levels, in contrast, are sticky and adjust slowly; and, (3) manyother factors can influence exchange rate movements rather than just inflation.

ii. Long-term basis (e.g., six years). Research suggests that over the long term a tendency exists for market and PPP rates to move together, with market rates eventually moving toward levels implied by PPP.

CFA-4

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Even though the investment community generally believes that country M’s recent budget deficit reduction is “credible, sustainable, and large,” analysts disagree about how it will affect country M’s foreign exchange rate. Juan DaSilva, CFA, states “the reduced budget deficit will lower interest rates, which will immediately weaken country M’s foreign exchange rate.”


a. Discuss the direct (short-term) effects of a reduction in country M’s budget deficit on:i. Demand for loanable funds.ii.Nominal interest rates.iii.Exchange rates.

CFA-5

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CFA (level III, 1998)b. Helga Wu, CFA, states, “Country M’s foreign

exchange rate will strengthen over time as a result of changes in expectations in the private sector in country M.” Support Wu’s position that country M’s foreign exchange rate will strengthen because of the changes a budget deficit reduction will cause in:i. Expected inflation rates.ii.Expected rates on return on domestic securities.

CFA-6

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CFA (level III, 1998)i. Demand for loanable funds. The immediate effect of reducing

the budget deficit is to reduce the demand for loanable funds because the government needs to borrow less to bridge the gap between spending and taxes.

ii. Nominal interest rates. The reduced public sector demand for loanable funds has the direct effect of lowering nominal interest rates because lower demand leads to lower cost of borrowing.

iii.Exchange rates. The direct effect of the budget deficit reduction is a depreciation of the domestic currency and the exchange rate. As investors sell lower yielding country M securities to buy the securities of other countries, country M’s currency will come under pressure and country M’s currency will depreciate.

CFA-7

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CFA (level III, 1998)i. Expected inflation rates. In the case of a credible,

sustainable, and large reduction in the budget deficit, reduced inflationary expectations are likely because the central bank is less likely to monetize the debt by printing money. Purchasing power parity and international Fisher relationships suggest that a currency should strengthen against other currencies when expected inflation declines.

ii. Expected rates on return on domestic securities. A reduction in government spending would tend to shift resources into private sector investments, where productivity is higher. The effect would be to increase the expected return on domestic securities.

CFA-8


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CFA (level III, 1996)The HFS Trustees have decided to invest in international equity markets and have hired Jacob Hind, a specialist manager, to implement this decision. He has recommended that an unhedged equities position be taken in Japan, providing the following comment and data to support his views:

“Appreciation of a foreign currency increases the returns to a U.S. dollar investor. Since appreciation of the yen from 100¥/$ to 98 ¥/$ is expected, the Japanese stock position should not be hedged.”

CFA-9

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CFA (level III, 1996)Market Rates and Hind’s Expectations

Spot rate (direct quote)Hind’s 12-month currency forecast1-year Eurocurrency rate (% per annum)Hind’s 1-year inflation forecast (% per annum)

n/an/a6.003.00

100980.800.50

U.S. Japan

Assume that the investment horizon is one year and that there are no costs associated with currency hedging. State and justify whether Hind’s recommendation should be followed. Show any calculations.

CFA-10

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CFA (level III, 1996)Appreciation of a foreign currency will, indeed, increase the dollar returns that accrue to a U.S. investor. However, the amount of the expected appreciation must be compared with the forward premium or discount on that currency in order to determine whether hedging should be undertaken or not.

In the present example to yen is forecast to appreciate from 100 to 98 (2 percent). However, the forward premium on the yen as given by the differential in one-year eurocurrency rates, suggests an appreciation of over 5 percent:

Forward premium = [(1.06)/(1.008)] -1 = 5.16%

CFA-11

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CFA (level III, 1996)Thus, the manager’s strategy to leave the yen unhedged is not appropriate. The manager should hedge because by doing so, a higher rate of yen appreciation can be locked in. Given the on-year eurocurrency rate differentials, the yen position should be left unhedged only if the yen is forecast to appreciate to over 95 yen per US dollar.

CFA-12

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SPEs.

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Setting:London; 2003

Subjects Covered:Asset allocation, Bonds, Capital markets, Financial instruments, Institutional investments, Risk management.

Learning Objective:To help students understand how the sales and trading function works within an investment bank. To discuss the motivations and incentives of sell-side firms, of the various functions within these firms, and how these firms interact with clients. Also, to discuss basic portfolio mathematics, estimation of the equity risk premium, and how the equity risk premium affects the bonds vs. equities asset allocation decision.

Description:Two members of Deutsche Bank's Fixed Income Research Group are discussing how to advise clients on bond vs. equity asset allocation. A critical aspect to this asset allocation decision is the equity risk premium. Discusses a unique way developed by the bank for understanding the implications of the risk premium.


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Case—Swedish Lottery Bonds.Case—Bank Leu’s Prima Cat Bond Fund. Case—Catastrophe Bonds at Swiss Re. Case—Mortgage Backs at Ticonderoga. Case—KAMCO and the Cross-Border Securitization of



SPEs.

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Setting:Stockholm; Government & regulatory; 25 employees; 2003

Subjects Covered:Bonds, Capital markets, Debt management, Financial instruments, Financing, Institutional investments.

Description:Profiling nonsystematic risk for a bond investor, the case describes lottery bond issues by the Swedish National Debt Office (SNDO). Swedish lottery bonds are a specific type of financial fixed income instrument for Swedish retail investors. The distinctive feature of lottery bonds is that, unlike traditional institutional bonds, the normally guaranteed interest--the coupon--here only is paid as "wins" to bondholders selected in drawings.The case takes place in March 2003, when Anders Holmlund, head of analysis, is reviewing the proposal for the next lottery bond issue. While reviewing the features of the bond issue, he also considers the larger picture: What are the benefits to the Debt Office of issuing lottery bonds, especially in view of a recently launched Internet-based sales system that allows retail investors to take part in government bond auctions?

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Case—Swedish Lottery Bonds. Case—Bank Leu’s Prima Cat Bond Fund.Case—Catastrophe Bonds at Swiss Re. Case—Mortgage Backs at Ticonderoga. Case—KAMCO and the Cross-Border Securitization of



SPEs.

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Setting:Zurich; Switzerland; Banking industry; 116 million CHF revenues; 600 employees; 2001

Subjects Covered:Bonds, Capital markets, Financial instruments, Financing, Institutional investments, Risk management.

Learning Objective:To explore how insurance risks can be transferred to the capital markets and how risks in general can be brokered, securitized, and traded.

Description:In 2001, Bank Leu, a Swiss private bank, is considering creating the world's first public fund for catastrophe bonds. Cat bonds are securities whose payments depend on the probability of a catastrophe occurring, such as an earthquake or hurricane. Cat bonds are traditionally issued by large insurance or reinsurance companies. This case outlines the traditional reinsurance market and securitization efforts that have taken place in the past and focuses on Bank Leu's decision as a buy-side participant in the cat bond market.

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Case—Swedish Lottery Bonds. Case—Bank Leu’s Prima Cat Bond Fund. Case—Catastrophe Bonds at Swiss Re.Case—Mortgage Backs at Ticonderoga. Case—KAMCO and the Cross-Border Securitization of



SPEs.

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Setting:Zurich; Switzerland; Insurance industry; 31 million Swiss francs revenues; 2002

Subjects Covered:Bonds, Capital markets, Financial instruments, Financing, Institutional investments, Insurance, Risk management.

Learning Objective:To explore how insurance risks can be transferred to the capital markets and how risks in general can be brokered, securitized, and traded.

Description:In 2002, Swiss Re, the world's second--largest insurance company, is considering securitizing parts of its risk portfolio in the capital markets. This would be a first for the company that, until then, had never transferred risk off its balance sheet. Peter Giessmann, head of the Retrocession Group, is considering catastrophe bonds as a way of transferring risk. "Cat bonds" are securities whose payments depend on the probability of a catastrophe occurring, such as an earthquake or hurricane. This case outlines the traditional reinsurance market and securitization efforts that have taken place in the past and then focuses on Swiss Re's decision as a sell-side participant in the cat bond market.


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Case—Swedish Lottery Bonds. Case—Bank Leu’s Prima Cat Bond Fund. Case—Catastrophe Bonds at Swiss Re. Case—Mortgage Backs at Ticonderoga.Case—KAMCO and the Cross-Border Securitization of



SPEs.

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Setting:London; Financial industry; 10 employees; 2005

Subjects Covered:Derivatives, Finance, Hedging, Over the counter trading, Securities, Trade.

Learning Objective:To learn about the institutional details behind the mortgage-backed securities (MBS) market, covering both the actors as well as the mechanics (with special emphasis on the important prepayment feature). Also, to go through the mathematics and calculations behind MBSs--in essence, students are asked to behave as if they worked at a mortgage-back trading desk.

Description:Ticonderoga is a small hedge fund that trades in mortgage-backed securities--securities created from pooled mortgage loans. They often appear as straightforward so-called "pass-throughs," but can also be pooled again to create collateral for a mortgage security known as a collateralized mortgage obligation (CMO). CMOs allow cash flows from the underlying pass-throughs to be directed, allowing the creation of different classes of securities--tranches--with different maturities, coupons, and risk profiles. In April 2005, the general managers of Ticonderoga are looking at the market data, trying to construct a trade given their view on the prepayment speed of mortgages vs. the implied prepayment speed they derive from CMOs in the market.

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Korean Non-Performing Loans.Case—Nexgen: Structuring Collateralized Debt


SPEs.

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Setting:Koreas; South Korea; $160 million; 1,500 employees; 2000

Subjects Covered:Capital markets, Debt management, Financial instruments, Financing.

Learning Objective:To understand financial securitization--both structuring and valuation principles.

Description:Covers the first international nonperforming loan securitization done in Korea. The CEO of KAMCO is trying to dispose of a portfolio of nonperforming commercial loans that the organization acquired from a number of banks. A group of investment bankers have proposed securitizing the loans and selling them to institutional investors. Securitization of loans (or any other type of assets) is not common in Korea, so the CEO must think through several factors as he decides whether to accept this proposal, the most important of which is the recovery price.

0 - 209







Obligations (CDOs).Case—The Enron Odyssey (A):The Special Purpose of

SPEs.

0 - 210

Setting:France; Financial industry; 20 employees; 2004

Subjects Covered:Bonds, Capital markets, Credit risk, Debt management, Derivatives, Finance, Securities, Securitization.

Learning Objective:To examine the process of securitization--in this case, a financial intermediary creates value by putting together a package of securities and offering the client a risk tranche that the client could not otherwise obtain. In terms of credit risk, to look at the impact of correlation in credit risk in portfolios of collateralized debt securities.

Description:A client asks Luc Giraud, CEO of the structured finance solutions provider Nexgen Financial Solutions, to put together a solution that allows the client to add AAA-rated bonds to its portfolio. The client cannot find suitably priced top-rated bonds in the market and wonders whether Nexgen can use lower grade bonds to create AAA-equivalent instruments. The process of securitization packages together securities to create new securities with different risk and return profiles.


0 - 211








SPEs.

0 - 212

Setting:Houston, TX; Energy; $100 billion revenues; 50,000 employees; 2001

Subjects Covered:Accounting, Accounting & control, Financial analysis, Financial institutions, Financial instruments, Financial management, Financial services, Financial strategy.

Learning Objective:To learn about structured finance.

Description:The board has asked Ron Tolbert, an employee in the Risk Assessment and Control Group, to analyze three SPE transactions executed by Enron executives: the Destec, Rhythms, and Fishtail/Bacchus transactions, which were prominently featured in the Examiner's Report in the ensuing Enron bankruptcy. Tolbert's job is to assess why Enron used SPEs for these transactions, whether risk was successfully transferred off the balance sheet, and whether risk transfer was the only motivation.

0 - 213








0 - 214

Setting:New York, NY; Automotive industry; $177.3 billion revenues; 365,000 employees; 2001

Subjects Covered:Currency, Derivatives, Financial management, Foreign exchange, Hedging, International finance, Multinational corporations, Risk management.

Learning Objective:To analyze foreign exchange hedging decisions, the appropriate design of risk management policies, and multinational financial management.

Description:How should a multinational firm manage foreign exchange exposures? Examines transactional and translational exposures and alternative responses to these exposures by analyzing two specific hedging decisions by General Motors. Describes General Motors' corporate hedging policies, its risk management structure, and how accounting rules impact hedging decisions. Although the overall corporate hedging policy provides a consistent approach to the foreign exchange risks that General Motors must manage, the company also has to consider deviations from prescribed policies. Describes two such situations: a significant exposure to the Canadian dollar with adverse accounting consequences and GM's exposure to the Argentinean currency when devaluation is widely anticipated. Students must evaluate the risks General Motors faces in each situation and consider which hedging strategy--if any--might be appropriate. Additionally, asks students to analyze the financial costs and accounting treatment of alternative derivative transactions for hedging purposes. A rewritten version of an earlier case.

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Exchange Rates and Firms.Case—Foreign Exchange Hedging Strategies at General Motors: Transactional and Translational Exposures.




0 - 216

Setting:New York, NY; Automotive industry; $177.3 billion revenues; 365,000 employees; 2001

Subjects Covered:Competition, Currency, Derivatives, Financial management, Foreign exchange, Hedging, International finance, Multinational corporations, Risk management.

Learning Objective:To analyze competitive exposures and appropriate hedging policies.

Description:How can a multinational firm analyze and manage currency risks that arise from competitive exposures? General Motors has a substantial competitive exposure to the Japanese yen. Although the risks GM faces from the depreciating yen are widely acknowledged, the company's corporate hedging policy does not provide any guidelines on managing such competitive exposures. Eric Feldstein, treasurer and vice-president of finance, has to quantify GM's yen exposure and recommend a way for GM to manage the risks that arise from its competitive exposure. Students must analyze the impact of a yen depreciation on GM sales and profits. A rewritten version of an earlier case.


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Setting:China; Automotive industry; $185 billion revenues; 390,000 employees; 2000

Subjects Covered:Automobiles, Capital structure, Financial strategy, Financing, International business, International finance, Joint ventures, Multinational corporations, Partnerships, Subsidiaries.

Learning Objective:To understand the core elements of financing a multinational subsidiary overseas, from its initial formation to subsequent refinancing discussions. Capturing this "life-cycle" of subsidiary finance is accomplished in

Description:The CFO of General Motors' joint venture in Shanghai, Shanghai General Motors (SGM), wants to refinance almost $900 million of project finance it raised to begin operations. The highest priority is improving the terms of the financing with regard to costs and specific covenants. Several factors complicate the CFO's objective, including the presence of capital controls, theimpending entry of China into the World Trade Organization, the joint venture partner's captive finance subsidiary, and the conflicting goals of the joint venture partners. The case illustrates how subsidiary financial decisions must trade off entity-level and parent-level concerns. It also illustrates how multinational financial decision making--including transfer pricing, repatriation, and funding decisions--must be designed to accommodate governance concerns, financial objectives, and the potentially divergent interests of joint venture partners. The framework of the on-going operational and investment decisions that Shanghai General Motors undertakes in its early growth demonstrates the "life cycle" of subsidiary finance. The case also touches on elements of foreign governments' attempts to regulate capital markets, the dynamic between domestic and international banks in competing for lending opportunities to multinational subsidiaries, and how subsidiary management can achieve the most desirable funding terms. To obtain executable spreadsheets (courseware), please contact our customer service department at [email protected].

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0 - 220

Setting:United Kingdom; $100 million revenues; 500 employees; 2001

Subjects Covered:Equity capital, Financial strategy, International business, International finance, Leveraged buyouts, Mergers & Acquisitions, Valuation.

Learning Objective:To understand the core elements of cross-border valuation in the setting of a leveraged buyout. In the process, students must employ exchange rates, decide among betas, and translate values from two mature, developed economies to arrive at a bid. Students must conduct this valuation in a private equity setting with the idiosyncrasies of a leveraged buyout, including the economies of carried interest.

Description:A team of private equity investors must value the leveraged buyout of a Yellow Pages business that operated in both the United States and the United Kingdom. In the process, they must wrestle with issues of how to conduct cross-border valuations and how to value a stable cashcow business along with a growth business. The case analyzes the economics and incentives of carried interest and compares different valuation methods--Capital Cash Flow and Free Cash Flow. To obtain executable spreadsheets (courseware), please contact our customer service department at [email protected].

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Good Sources of Information onInternational Investments

· Datastream is an extremely rich source of international financial data (currencies, stocks, bonds, macro statistics, etc.).

· International Financial Statistics, published monthly by The International Monetary Fund, contains much financial and macroeconomic data for IMF member countries.

· The Economist's Intelligence Unit publishes quarterly Country Reports and annual Country Profiles. These are good, for example, for details on countries’ foreign exchange regimes.

0 - 222

· Commercial and investment banks: most produce valuable research on current developments (e.g., Bank of America's monthly Currency Review).

· Euromoney is a periodical that focuses on issues relevant to this class; occasionally, a particular topic will be treated in depth in a EuromoneySupplement.

· The National Bureau of Economic Research (NBER) produces a working paper series that contains current academic articles on international topics (check http://www.nber.org).

· See my web page for links to useful sites in international finance http://www.stanford.edu/~ffuy/weblinks.htm

The Big Mac Index Sizzling Jul 5th 2007 From The Economist print edition

Food for thought about exchange-rate controversies

第 1 頁，共 3 頁Economist.com

2008/6/25http://www.economist.com/finance/PrinterFriendly.cfm?story_id=9448015

AMERICAN politicians bash China for its policy of keeping the yuan weak. France blames a strong euro for its sluggish economy. The Swiss are worried about a falling franc. New Zealanders fret that their currency has risen too far.

All these anxieties rest on a belief that exchange rates are out of whack. Is this justified? The Economist's Big Mac Index, a light-hearted guide to how far currencies are from fair value, provides some answers. It is based on the theory of purchasing-power parity (PPP), which says that exchange rates should equalise the price of a



basket of goods in any two countries. Our basket contains just a single representative purchase, but one that is available in 120 countries: a Big Mac hamburger. The implied PPP, our hamburger standard, is the exchange rate that makes the dollar price of a burger the same in each country.

Most currencies are trading a long way from that yardstick. China's currency is the cheapest. A Big Mac in China costs 11 yuan, equivalent to just $1.45 at today's exchange rate, which means China's currency is undervalued by 58%. But before China's critics start warming up for a fight, they should bear in mind that PPP points to where currencies ought to go in the long run. The price of a burger depends heavily on local inputs such as rent and wages, which are not easily arbitraged across borders and tend to be lower in poorer countries. For this reason PPP is a better guide to currency misalignments between countries at a similar stage of development.

The most overvalued currencies are found on the rich fringes of the European Union: in Iceland, Norway and Switzerland. Indeed, nearly all rich-world currencies are expensive compared with the dollar. The exception is the yen, undervalued by 33%. This anomaly seems to justify fears that speculative carry trades, where funds from low-interest countries such as Japan are used to buy high-yield currencies, have pushed the yen too low. But broader measures of PPP suggest the yen is close to fair value. A New Yorker visiting Tokyo would find that although Big Macs were cheap, other goods and services seemed pricey. A trip to Europe would certainly pinch the pocket of an American tourist: the euro is 22% above its fair value.

The Swiss franc, like the yen a source of low-yielding funds for foreign-exchange punters, is 53% overvalued. The franc's recent fall is a rare example of carry traders moving a currency towards its burger standard. That is because it is borrowed and sold to buy high-yielding investments in rich countries such as New Zealand and Britain, whose currencies look dear against their burger benchmarks. Brazil and Turkey, two emerging economies favoured by speculators, have also been pushed around. Burgernomics hints that their currencies are a little overcooked.

Copyright © 2008 The Economist Newspaper and The Economist Group. All rights reserved.



May 3, 2008

What's Subprime's Magic Number? Key Gauges Begin To Bring Into View The Crisis's Cost By LIAM PLEVEN

DOW JONES REPRINTS This copy is for your personal,

non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now.

May 3, 2008; Page B3

No one really has a clue how much money will be lost on subprime mortgages -- estimates range from $400 billion to $1 trillion and more. But with each passing month, investors come a little bit closer to knowing the full extent of the damage.

The banks, hedge funds and insurers whose financial futures depend on those final numbers are focusing most intensely on monthly data on delinquencies, housing prices, interest-rate resets and the "roll rate," which shows how many borrowers are falling further and further behind on their payments. They also are watching the slowing economy and rising unemployment. Some expect the subprime picture to start to clear as early as this fall, while others think it could take much longer.

"Right now, we're still right in the middle of it, and so you have enormous variation using verysmall differences in assumptions about what's going to happen," says Joseph "Jay" Brown, chief executive of MBIA Inc., a bond insurer that sold protection on mortgage-linked bonds, and took a write-down of more than $3 billion for 2007.

These days, worst- and best-case projections about what will happen with recent mortgages often vary by at least 50%, Mr. Brown says. But, he adds, "time narrows that uncertainty."

For insurers, it's akin to a hurricane churning toward land. When a storm is days away and its path and strength still uncertain, losses could be small or catastrophic. But as it gets closer and then makes landfall, insurers get a better idea, for better or worse, of how costly the damage will be.

In the mortgage market, things are still getting worse. For typical subprime mortgages issued between the second half of 2005 and the first half of 2007, when underwriting standards were at their weakest,

between 25% and 40% of borrowers on average are more than 60 days behind on their

第 1 頁，共 3 頁What's Subprime's Magic Number? - WSJ.com

2008/6/22http://online.wsj.com/article_print/SB120976475747763607.html

YTF

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YTF

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YTF

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payments. Overall, that number of delinquencies is still rising each month, though some people are noticing potentially important shifts in some delinquency rates and expect greater clarity in the next several months.

The subprime crisis really began to bite when mortgages issued in 2006 and 2007 began to go bad much more quickly than in any recent year. For instance, nearly 15% of subprime borrowers who took out mortgages in 2006 were 60 days late within a year, according to First American CoreLogic, LoanPerformance data. It took nearly twice as long for loans from 2000 and 2001 to look that bad.

This early jump suggested that defaults would reach heights unseen in the years since it became routine to package loans into securities. The question now is: Even though the delinquency rates are climbing, will the loans follow the same path as in previous years? In 2000 and 2001, for instance, the growth in the 60-day delinquency rate slowed when those subprime loans were about three years old and peaked after a little more than four years, then started to fall.

"Every single month, what we're looking for is a peaking in the delinquencies," says Robert Selvaggio, a managing director at Ambac Financial Group Inc., which also insured mortgage-linked bonds.

That appears to be happening for loans issued in 2005, where the growth in 60-day delinquency rates has been effectively flat for four months at just over 30%, according to First American. If delinquency rates begin to decline, it would mean that 2005 is following the pattern of previous years, even though underwriting standards were already weakening. That would give investors confidence that 2006 and 2007 might do the same, even though default rates would likely be higher.

Analysts are also looking at the "roll rate." That shows how many 30-day delinquencies become 60-day and 90-day delinquencies, and so helps determine what lenders and investors lose on mortgages. Last month, roll rates for most recent subprime mortgages went down, according to Clayton Fixed Income Services.

A short-term drop might not be so meaningful, however. "Those things can bump around a bit," says Kevin Kanouff, president of the firm, a unit of Clayton Holdings Inc. But a drop that lasts for a few months could be more significant.

Another key number that could drive delinquencies is interest-rate resets. Mr. Kanouff points to autumn, when the proportion of subprime mortgages due to reset at higher interest rates will begin to decline, so a shrinking percentage of those borrowers will face higher monthly payments.

For example, more than 4% of the nation's subprime mortgages outstanding with adjustable rates are due to reset in May. That percentage will start a steady decline in the fall, ending the year below 3% and dropping to less than 1% by mid-2009.

On the other hand, recent interest-rate cuts by the Fed are already dulling the impact of rate resets on some borrowers.

Because all of these numbers are linked, improvements in one can affect others. Other factors, such as the unemployment rate, also affect how much investors and insurers ultimately lose. And when home prices stabilize, lenders will have a better sense of how much they'll recover in foreclosures, and that will further clarify the picture.

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June 9, 2008

Next on Crunch's Hit Parade: Corporate Synthetic CDOs? By NEIL SHAH



June 9, 2008; Page C1

LONDON -- The investments were "synthetic" but the pain may be real.

Investors are already paying the price for buying billions of dollars of complex securities, known as synthetic collateralized debt obligations, tied to the fate of U.S. homeowners. Now, they may be in for some unpleasant surprises from the much larger market for similar investments linked to the credit-worthiness of companies.

All but nonexistent a decade ago, synthetic CDOs grew popular in recent years, especially in Europe, as a way for insurance firms, banks and hedge funds to invest in a diversified portfolio of companies without actually buying their bonds. While the investments have stabilized since suffering with the broader credit markets earlier this year, some analysts are warning of more trouble ahead.

The problem: Most corporate synthetic CDOs are linked to the debt of U.S. companies, some of which are looking a lot shakier amid an economic slowdown. To make matters worse, some credit-rating experts burned by the subprime-mortgage crisis are taking a closer look at the way they rated synthetic CDOs. That could trigger downgrades in the $6 trillion market, forcing some investors to sell their securities or at least post significant losses.

"We will start seeing investors getting increasingly nervous" as downgrades pick up, says Michael Hampden-Turner, credit strategist at Citigroup in London. "There is more...pain for synthetic CDO investors."

As opposed to regular CDOs, which contain actual bonds, synthetic CDOs provide investors with income by selling insurance against debt defaults, typically on a pool of 100 or more companies with relatively high "investment-grade" credit ratings.

To attract different types of investors, they issue securities with different levels of risk and return: Holders of the riskiest pieces reap the highest return but suffer the first of any losses. That makes it possible for other, more-senior pieces to win top-notch grades from ratings companies.

Banks and insurance companies, such as American International Group and French insurance giant Axa, snapped up highly rated pieces, which typically offered a better return than similarly rated corporate bonds. Hedge funds often bought the riskier pieces, attracted by even higher returns.

Now, though, the CDOs aren't looking as good as they once did. That is in part because the

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Chapter 24 in Fabozzi: Credit Derivatives

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banks that created them, in order to achieve more attractive returns, often filled them with companies that had among the lowest of investment-grade ratings, meaning they were among the riskiest of high-quality borrowers.

As the financial crisis takes its toll on the broader economy, some of those companies are seeing their credit ratings downgraded to "junk" -- moves that have a negative impact on the ratings and value of CDOs that contain them. In May, ratings firm Standard & Poor's downgraded to junk status Countrywide Financial Corp., one of the more widely referenced companies in synthetic CDOs. Another investment-grade company popular in CDOs was Sprint Nextel Corp., which S&P downgraded to junk last month.

CDOs' problems could also be magnified in coming months by a new policy at Fimalac SA's Fitch Ratings, the third-largest bond-rating service after Moody's Corp.'s Moody's Investors Service and McGraw-Hill Cos.' S&P. Fitch plans to apply a much more severe methodology when it reviews the ratings on hundreds of synthetic CDOs over the next few months.

Nearly half of the $50 billion of top-rated synthetic CDO paper Fitch rates could face a warning and possibly a downgrade, while about $8 billion of lower-rated deals could fall to "junk" status, according to a report by J.P. Morgan Chase analysts Jonny Goulden and Yasemin Saltuk.

Analysts aren't expecting a similar wave of downgrades by Moody's and S&P just yet, but they aren't ruling out the possibility. S&P spokesman Mark Tierney said his firm has focused mainly on adjusting the way it rates mortgage CDOs, though key assumptions on all CDOs are "under review." A Moody's spokesman said the firm may tweak its methods for synthetic CDOs rated out of Europe, but that this shouldn't result in downgrades.

Because many banks and insurance companies face strict limits on the ratings of the investments they can hold, downgrades could trigger selling, pushing prices down and exacerbating losses.

"There are some investors that could become forced sellers," says Jeffrey Kushner, managing director at New York-based BlueMountain Capital Management, an asset manager that focuses on credit investments.

To be sure, whatever troubles synthetic CDOs face in the months ahead probably won't be as bad as those seen with CDOs linked to mortgage debt, analysts and investors say. Most companies' finances remain relatively healthy. Also, corporate CDOs are simpler beasts with a longer track record, having survived a downturn early this decade.

To some extent, the current prices of synthetic CDOs already account for significant difficulties to come. One index that tracks the cost of default insurance, the Markit CDX index, suggests investors are expecting about one in 13 investment-grade companies to default over the next five years, according to Ashish Shah, global head of credit strategy at Lehman Brothers in New York. That is more than has been seen over a five-year period since the 1980s, he says.

Still, analysts see ample reason for concern. For one, many economists are expecting the current downturn in the U.S. to be worse than the relatively mild recessions of the past couple decades. Beyond that, says Brian Yelvington, a strategist at independent research firm CreditSights in New York, the original credit ratings on many deals were far too rosy. So even if defaults don't break records, many CDOs could still face downgrades.

Write to Neil Shah at [email protected]

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when being created... among lowest of investment-grade ratings, just above junk bond. among the riskiest of high-quality borrowers. downgrade to junk when the financial crisis hit.

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Google Earnings Gave Options Traders a 17,530% Gain (Update1)

By Michael Patterson and Jeff Kearns

April 18 (Bloomberg) -- Options traders who predicted Google Inc. would beat estimates earned as much as 17,530 percent on their investments today, the most-profitable bet among all U.S. equity derivatives.

Contracts giving the right to buy Google shares for $530 before the close of trading today jumped as high as $17.63 from their 10-cent closing price yesterday. That gain almost matched the 18,760 percent advance in the Dow Jones Industrial Average since the beginning of 1900, according to Bloomberg data.

``Today in Google you see the power of leverage in options, especially going into earnings,'' said Peter Bottini, executive vice president of trading at OptionsXpress Holdings Inc., a Chicago-based online brokerage. ``We were swamped with customers who were calling in at the open of the market.''

Google shares climbed 20 percent, the most since its initial public offering in 2004, to $539.41 after the owner of the most popular Internet search engine beat the average analyst profit estimate by 7.1 percent. Google had dropped 35 percent this year on concern the U.S. economic slump would hurt spending on online advertising.

Google call-option volume jumped to 311,139 contracts, the most since January 2006. Those contracts outnumbered trading in bearish bets, or puts, by 1.6-to-1. Call options give the right to buy a security for a certain amount, called the strike price, by a given date. Puts convey the right to sell.

`Playing Google'

``We expect our more active customers to come out of the woodwork and start playing Google again,'' Bottini said.

Today's share surge was more than triple what the options market was expecting as of yesterday, based on prices paid for April contracts with a strike price closest to yesterday's closing share price, Bloomberg data show.

Google closed yesterday at $449.54. At the same time, the price of $450 straddles, which combine a put and a call at that strike price, was $30. That indicates traders expected a move of at least that amount, or 6.7 percent, in order to break even on the position.

``The market viewed this as a long shot, but not an impossibility,'' said Chris Jacobson, a senior options strategist at Susquehanna Financial Group in Bala Cynwyd, Pennsylvania.

Google contracts were the fifth-most traded among U.S. stock options in the first quarter, according to Chicago-based Options Clearing Corp., which settles all trading of exchange-listed contracts. There were 7.69 million Google options traded during the first three months of the year.

To contact the reporters on this story: Michael Patterson in New York at [email protected]; Jeff Kearns in New York at [email protected].

Last Updated: April 18, 2008 17:06 EDT

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Chapter 12 Currency and Interest Rate Options

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Counting the clicks, and the money, at Google By Miguel Helft Monday, June 2, 2008

MOUNTAIN VIEW, California: If Google were the U.S. government, the data that streams into Nicholas Fox's laptop every day would be classified as top secret.

Fox is among a small group of Google employees who keep a watchful eye on the vital signs of one of the most successful and profitable businesses on the Internet. The number of searches and clicks, the rate at which users click on ads, the revenue all this generates - everything is tracked hour by hour, then compared with the data from a week earlier, then charted.

"You can see very, very quickly if anything is amiss," said Fox, the director of business product management at Google.

Fox and his "ads quality" team can also quickly see whether something is working particularly well. His group's mission, to constantly fine-tune Google's ad delivery system, has one overriding objective: show users only the ads they are most likely to be interested in and click on.

Google runs a complex auction-based system that determines which ads will appear where, and in what order. Every time the team alters the formulas that select and rank ads, Fox can run a test and quickly see the effect of the changes on users, advertisers and Google's revenue - which, in this year's first quarter, came in at the rate of more than $2 million an hour.

The job has given Fox, a soft-spoken 29-year-old with an obvious affinity for nuance and numbers, a detailed understanding of the complex dynamics at work inside Google's ad-driven economic engine.

Fox, who graduated from Harvard with a degree in economics and spent two years at McKinsey & Co., the management consulting firm, before joining Google in 2003, also helped organize its "Revenue Force." This select group of company engineers, sales and finance people, product managers and statisticians is charged with keeping top executives apprised of the forces that make Google tick.

Google reveals little of these forces to the outside world. Even on Wall Street, many experts describe Google as a giant black box that they struggle to comprehend. In recent months, for instance, analysts and investors grew increasingly worried about reports of a decline in clicks on Google ads in the United States, which they interpreted as a sign that Google's business could be suffering from the economic slowdown. But inside Google, Fox and others were growing confident that the company would do just fine.

"I wouldn't quite go so far as to say we are recession-proof," said Hal Varian, Google's chief economist. "But we are recession-resistant."

Google's financial results for the first three months of the year surpassed expectations. Still, some analysts point out that Google's growth is slowing, especially in the United States. The extent to which that slowdown is the fault of the economy or just the size and maturity of Google's business remains a matter of debate on Wall Street.

Fox acknowledged that searches and clicks in some areas, including real estate and travel, have grown more slowly recently. But he noted that there is not an exact correlation between clicks and revenue: "Clicks are only part of the story."

The idea of linking ads with search results was first developed not by Google but by GoTo9.com, which later changed its name to Overture Services and then was bought in 2003 by Yahoo. Overture ranked ads based on how much advertisers were willing to bid for a certain keyword. The higher the bid, the better the placement.

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A good investor has to pay attention to corporate governance and strength/weakness.

As Google's engineers developed their own search advertising system, they understood early on that giving top billing to the highest bidder would have little benefit for Google if that ad did not attract clicks. That is because advertisers typically pay Google only when a user clicks on their ad. So Google decided to rank ads based on a combination of bid price and "click-through rate," the frequency with which users click on a given ad.

Fox's team took things from there and gradually became better at figuring out what ads would click with users. Yahoo tried to catch up by building a new search advertising system that works more like Google's. It helped increase revenue, but by Yahoo's own account, Google still earns 60 percent to 70 percent more on average than Yahoo on every search. Microsoft has also lagged, in part because it lacks enough advertisers. It acknowledged as much with its recent attempt to buy Yahoo.

Fox said Google's ability to constantly fine-tune its operations was intricately linked with its obsession with measuring just about everything that happened on its system.

The tools to do so, however, were not always there. About four years ago, as revenue was more than doubling every year and profit was growing even faster, top executives became concerned that Google's business could be riding a bubble in online advertising.

Traffic was growing rapidly, as was the average price that advertisers were paying for clicks. But Fox and others realized that measuring the average cost-per-click was not good enough. Google users might be clicking on more high-priced ads and fewer lower-priced ads. That would cause the average cost-per-click to rise, but it would say little about the health of the overall system.

So Varian and Diane Tang, principal engineer in the ads quality group, helped devise what they call a basket of keywords. Much like the consumer price index, a basket of goods and services that economists use to track inflation, the measure is made up of a broad sample of keywords and is weighted to make it statistically accurate. This internal benchmark helps Google get a clearer picture of its performance.

As measurements improved, Fox's team was able to unleash a stream of experiments meant to optimize the ad system. They evaluated changes to things as diverse as the clickable area and background color of ads, and the criteria for placing ads above search results, rather than alongside them.

Over time, the company also looked beyond click-through rates to rank ads. Google now takes into account the "landing page" that the ad links to, and, for example, gives low grades to pages whose sole purpose is to show more ads. Soon, the loading speed of a landing page will also be considered, Mr. Fox said.

These factors contribute to an ad's "quality score." The higher that score, the less the advertiser has to bid to secure top billing. For example, an advertiser who offers to pay $1 per click to attract those searching for "vacation rentals in Colorado" may receive more prominent placement than another who bids $1.50 for the same query but has a lower quality score. An advertiser with a very low quality score may have to bid so much for placement as to make it uneconomical.

Quality scores work as an incentive to advertisers to improve their ads, which benefits users and, in turn, benefits Google, Fox said.

Not all advertisers appreciate Google's approach. Many complain that despite efforts by Google to be more transparent, they remain in the dark about what really goes on inside the company's ad machine.

"To the extent that Google is a black box, it is not a good thing for advertisers," said Anil Kamath, co-founder and chief technology officer of Efficient Frontier, which runs search advertising campaigns for marketers. Kamath said Google still offered the most effective system for search marketers, but said many advertisers complain that the company was, in essence, deciding who can and cannot advertise on its system.

By the nature of their work, Fox and other members of the Revenue Force have a front-row seat to the sometimes peculiar relationship between world events and Google's business.

In mid-February, for instance, the group was taken aback when they saw the number of searches drop unexpectedly. With their antennas keenly tuned to any sign that the economic slowdown could be



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hitting Google's business, members of the team rushed to come up with a diagnosis. That meant poring over statistics, calling field offices and checking data centers worldwide to ensure none were afflicted by bugs.

The team eventually determined that Google was suffering from a series of unrelated minor ailments. The celebrations of Mardi Gras and the Chinese New Year were keeping people away from their computers, while bad weather had knocked out electricity in parts of China, Varian said.

Other events have given Google unexpected increases in traffic because they kept people at home, like heavy rains and flooding in England last summer and a transport strike in France last fall.

"Bad weather is good for Google," Varian said, "as long as it is not too bad."

Notes:

Copyright © 2008 The International Herald Tribune | www.iht.com



June 5, 2008

HEARD IN ASIA

Symbiosis in Samurais Japanese Investors, Corporate Issuers See Bonds' Benefits By ANDREW MORSE and LAURA SANTINI



June 5, 2008; Page C2

TOKYO -- As the continuing credit crunch caps bond issuance world-wide, an unlikely oasis of normalcy has begun to attract global financial institutions looking to raise funds: Japan.

Issuance of Samurai bonds, or yen-denominated bonds sold by non-Japanese issuers to Japanese investors, is hitting record levels -- with companies as diverse as Goldman Sachs Group, Deutsche Telekom of Germany and France's Renault seeking to tap capital from Japanese investors. Australian banks have been particularly active issuers.

Samurai bonds' appeal slices two ways. Foreign corporations, many in financial services, are able to raise sorely needed funds. Meanwhile, yield-starved Japanese investors are getting better returns than they can in more traditional investment vehicles. Samurai bonds are often bought by institutions, then packaged for sale to individuals in bond funds.

Nearly $5 Billion in Quarter

For the first quarter of the year, 19 foreign companies -- many in

financial services -- raised just shy of $5 billion. That was about 4.5 times the figure for the year-earlier period, and a record for any first quarter, according to data tracker Thomson Financial. Since March, Samurais continued to flow into Japan's bond market, and the total for the first half of 2008 may set a record for any half-year.

Though it is unlikely Japan will fill the shoes of other big bond markets in the world -- most notably the U.S. market -- during the continuing credit crunch, use of Samurai bonds is making life easier for many high-rated companies looking for affordable financing during tough times.

"We've seen continued strength in new credits coming to the market," says Brian Mccappin, head of fixed-income products at Nikko Citigroup, one of the most active underwriters of

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Chapter 10 The Eurobond Market

Samurai bonds. "Japan is a relatively safe haven of liquidity."

While the Samurai market has attracted issuers from around the world, a group of first-time borrowers has emerged: Australian banks. Australia & New Zealand Banking Group, Westpac Banking, Commonwealth Bank of Australia and National Australia Bank have turned to the Samurai market this year.

While Australian lenders largely avoided problem loans in the U.S. subprime-mortgage sector, the banks have struggled to raise funds from global bond investors -- except buyers of Samurais.

As stock markets tumbled in January, Westpac launched a Samurai-bond offering. The bank easily raised 50 billion yen, equivalent then to roughly $470 million, opening floodgates to subsequent deals of equal value or bigger by Australian lenders.

The Samurai process was "extremely smooth," says Fergus Blackstock, head of debt capital markets in Australia for UBS, one of Westpac's investment banks for the transaction. "Since then, deal sizes have increased, and the market remains open for new and existing issuers," he says.

The emergence of Japan as a source of corporate funding comes as other bond markets have withered in the credit drought. Investors became jittery about buying bonds amid fears that financial institutions in the U.S. and Europe might be sitting on piles of mortgages that go bad. Global bond issuance fell 47% to $1.1 trillion in the first quarter. U.S. corporate-bond issuance also dropped 47%, to $547 billion, according to Thomson.

In Japan, low interest rates at home have forced investors to scout out ways to improve their return on savings. The yield on a five-year Japan-government bond is 1.32%, about two percentage points lower than that on a comparable U.S. Treasury note.

Skittish about debt denominated in foreign currencies, Japanese investors have shown preference for Samurais, which offer higher yield without piling on much more risk.

Investment-grade companies from overseas do have to pay investors more than the Japanese government does to borrow money. But for most of these companies, borrowing in Japan through Samurai issuance is still cheaper than in their home markets.

Luke Davidson, who heads funding activities at ANZ, says he saw a Samurai issue as a way broaden his bank's investor base to what he deems buy-and-hold investors in Japan. In March, ANZ raised $1.3 billion in its inaugural Samurai issuance.

From Renault to Goldman

Meanwhile, Australian companies are far from the only ones to tap the Japanese market. Earlier this year, Deutsche Telekom and Renault each raised about $300 million in Samurai-bond offerings.

Goldman Sachs, a longtime Samurai issuer, raised $1.2 billion as part of an overall strategy to diversify its investor base globally.

And Hyundai Motor unit Hyundai Capital Services of South Korea has sold about $393 million in yen-denominated debt this year. In November, General Electric Capital Corp., a unit of U.S.-based General Electric Co., received about $500 million in a Samurai sale.



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Write to Andrew Morse at [email protected] and Laura Santini at [email protected]

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June 18, 2008

RBS to issue yen-denominated samurai bonds By MEGUMI FUJIKAWA THE WALL STREET JOURNAL EUROPE



June 18, 2008

TOKYO -- Royal Bank of Scotland Group PLC said it plans to issue its first yen-denominated bonds in Japan, underlining foreign borrowers' recent increased interest in the samurai market.

Royal Bank of Scotland named RBS Securities and Daiwa Securities SMBC as joint-lead managers for its first such issue. Details such as the timing and issuance amount haven't been announced.

RBS's decision to tap the samurai market comes as foreign borrowers increasingly seek inexpensive funding in Japan.

Recently, UBS AG announced plans to sell its inaugural samurai in five-year fixed- and floating-rate tranches, aiming to diversify its debt into additional currencies.

So far this year, there has been a total of 1.252 trillion yen ($11.6 billion) in samurai issuance, already exceeding the 1.092 trillion yen in the first half of 2007, according to Thomson Reuters.

At the same time, some foreign issuers have decided to refrain from raising funds in the samurai market, given the recent heightened volatility in the Japanese market and domestic concerns about the creditworthiness of foreign financial institutions.

Prudential Financial Inc. and Suncorp-Metway Ltd. ABN both decided on Tuesday to postpone pricing their planned samurais.

Write to Megumi Fujikawa at [email protected]

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Barclays in talks with Japanese lender to replenish capital By Julia Werdigier Friday, June 20, 2008

LONDON: Barclays, the British bank that is seeking funds to replenish its capital, is in discussions with Sumitomo Mitsui Financial Group about a ¥100 billion cash injection, a person with knowledge of the talks said Friday.

Barclays had said Monday that it was "actively considering" the sale of new shares to raise $927 million worth of capital to better cope with first-quarter write-downs of £1.7 billion, or $3.35 billion, as a result of the credit crunch. An investment by Sumitomo would also allow the two banks to cooperate more closely in Asia, said the person, who declined to be identified because the talks were not public. But some analysts said the British bank would need at least £4 billion to weather the difficult credit markets.

"The Sumitomo investment would not be enough," said Arturo de Frias, an analyst at Dresdner Kleinwort in London. "I'm a bit surprised that they haven't made a rights issue yet because the longer they wait the lower the rights issue will be."

Barclays has so far refrained from following some of its British rivals in tapping existing shareholders for capital. But rights issues announced recently by HBOS, Royal Bank of Scotland and Bradford & Bingley all faced challenges when the banks' share prices dropped sharply ahead of the planned sales. Bradford & Bingley even had to cut the price of the new shares that it offered and the volatile share prices prompted Britain's financial regulator to announce new rules for short-selling stocks.

European banks have raised about $125 billion of capital since the beginning of 2007 to compensate for losses stemming from the turmoil in the subprime mortgage market in the United States. British banks offering mortgages are also suffering as the housing market declines and more customers default on their loans. HBOS, the biggest mortgage lender in Britain, said Thursday that house prices in Britain would fall as much as 9 percent this year and that charges for bad mortgages would rise.

Barclays said this week that pretax profit in May was "well ahead" of the figure a year earlier as its consumer and commercial banking units expanded. Write-downs at the bank, which is set to announce figures on Aug. 7, have been smaller so far than at other British lenders but some analysts expect further mark-downs of about £3 billion.

Barclays previously declined to say whether it would ask its existing investors China Development Bank, which owns a 3 percent stake, or Temasek Holdings of Singapore, which owns a 2.1 percent stake, to increase their holdings. The bank's shares fell 3.7 percent to £3.04 in London on Friday.

Japanese banks have not been immune to the subprime market turmoil. Mitsubishi UFJ, the biggest bank in Japan, had ¥51 billion in subprime-related losses and reported a 68 percent decline for its third-quarter profit. Subprime-related losses at Sumitomo, whose discussions with Barclays were reported earlier in the Japanese business newspaper Nikkei, reached ¥99 billion in the nine months through the end of December.

Credit Suisse to cut more jobs

Credit Suisse will cut about 75 jobs across its investment banking division in Britain, the bank said Friday.

"Due to market conditions and projected staffing levels required to meet client needs, we are reducing head count by approximately 75 in the United Kingdom within the investment bank and certain support functions," the bank said.

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Prior to the latest layoffs, Credit Suisse had cut about 1,000 investment banking jobs this year, after shedding 170 jobs in the same division last year and 150 jobs in its residential mortgage-backed securities business.

Many other financial companies have scaled back their work forces since the U.S. housing crisis escalated in August.

Notes:

Copyright © 2008 The International Herald Tribune | www.iht.com

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