International lending CHAPTER 10 Introduction International lending forms

International lending CHAPTER 10

Introduction International lending forms the heart of the international financial systems The raising of funds and the lending of those funds allows for intermediation across all financial markets Additionally, corporate activity creates a competitive environment where there is a huge demand for funds Accordingly, rates are kept low for borrowing and are higher for the investor due to the lack of total supervision from local or country central banks

Overview of international lending - To study international banking and lending, it is important to understand the structure of international financial system and how it works The international system is dynamic and change is the norm Accordingly, it is important to understand the factors that are essential for survival. The major factors, include: Payment system World trade and finance The availability of funds Country risk analysis

International Business Transactions Key principal in all business transactions: � maximize sales & profits while simultaneously � managing risk & reducing exposure Risks in international transactions include: � legal risk � political risk � marketing risk � financial risk

International Finance System The modern financial system began in the 50 s of last century The system in the early years was protected by international agreements to avoid the protectionist of the pre-war years The international financial markets are made up of the foreign exchange market, the global capital market, the international bond market, the international equity market, the euro market and the future and the swaps markets Accordingly, a truly international financial institution is involved in a wide variety of financial activities. The activities, in general are similar to the domestic operations, but vary in terms of risk, exposure and

International Finance System Why Financial Institutions consider international markets? Banks and financial institutions operate in the international markets because they have expertise in one or more of the following functions: Foreign exchange markets Credit for importers and funding for exporters International lending (both corporate and project based) International banking exists because there is an economic benefit to be derived for the market in general and for individual institution in particular Diversification is a major driving force for the expansion of the system because it allows for geographic spread and risk reduction

Country risk analysis and international credit evaluation The evaluation requires accurate information, hence, care must be taken because the quality of information can vary widely according to source and country. This variance demonstrates the need for experienced staff. § The information can be available from many sources, including: ü local commercial banks can be important sources for external entities who are willing to penetrate that market ü Central banks who are responsible for the implementation of monetary policies ü Rating agencies can be approached for information about the attitudes of the government ü Magazines and recognized publications are also excellent sources of information as long as the reader is aware of the accuracy.

Country risk analysis and international credit evaluation § § Country risk assessment is the process of gaining a degree of comfort about dealing with an institution or individuals in a foreign country. By gaining the assurance, lenders can reduce default probabilities. Problems may arise, but careful analysis lowers the potential of catastrophic incidents. The main problems are: legal issues, time, communication, country insolvency , potential interference from the government and distance. If these problems are addressed in the analysis stage, not the workout stage, then international operations can be a valued addition to any portfolio.

Country risk analysis and international credit evaluation Other problems that may arise are: Exporters lack information about importer's credit rating, and importers lack information about exporter’s reliability. Exact amounts of the trade and date of payment must be known before one party can hedge foreign exchange risk. Bank wants a clean deal without disputes and delay of funds flow.

The Difficulties of International Trade Information Asymmetry between Suppliers and Customers. � Information or incorrect. about customers and suppliers is lacking Differences in Legal & Business Systems � No country has authority over all aspects of transaction. Exchange Rate Risk � The risk that profit will be affected because of changes in currency values.

Foreign Exchange Rates Foreign exchange rate - the price of a unit of one currency in terms of another. Foreign Exchange rates are market determined. Currencies can depreciate and appreciate relative to each other: � If more dollars ($) are now required to purchase one Euro (€), the $ has depreciated relative to €. � If fewer dollars are required to buy one €, the dollar has appreciated.

Meaning of Exchange Rate Risk Risk of fluctuating value of a currency over time If the time and size of cash inflows in one currency does not match the time and size of cash outflows in the same currency, we face exchange rate risk Impacts dollar value of foreign currency cash inflows and foreign currency cash outflows If we have foreign currency cash inflows, we face risk of foreign currency depreciating against domestic currency If we have foreign currency cash outflows, we face risk of foreign currency appreciating against domestic currency

Types of Exchange Rate Exposures Transaction Exposure � Only companies engaged in global business and doing transactions in foreign currency face this risk � Arises due foreign currency transactions of a firm � Arises from the possibility of incurring future exchange gains/losses on transactions already entered into and denominated in a foreign currency.

Types of Exchange Rate Exposures Translation Exposure The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations If the assets/liabilities are translated at something other than the historical exchange rates, the Balance Sheet will be affected by fluctuations in currency values over time

Types of Exchange Rate Exposures Economic Exposure: The extent to which the economic value of a company can decline because of exchange rate changes Decline can be due to a decline in the level of expected cash flows or an increase in the riskiness of these cash flows Overall effect of exchange rate changes in competitive relationships between alternative foreign locations Extent of exposure depends on � structure of markets for a firm’s product � Price elasticity of demand for the product � Availability of close substitutes for the product Even pure domestic firms may face economic exposure

HEDGING FORGIEN XCHANGE RISK

Defining Hedge refers to an offsetting contract made in order to insulate the home currency value of receivables or payables denominated in foreign currency. Objective of hedging is to offset exchange risk arising from transaction exposure.

Types of Hedging 1. Forward Market Hedges: use forward contracts to offset exchange rate exposure 2. Money Market Hedges: use borrowing and lending in the money markets 3. Hedging with Swaps: use combination of forward and money market instruments 4. Hedging with Foreign Currency Futures: use futures contracts to offset exchange rate exposure 5. Hedging with Foreign Currency Options: use currency options to hedge the downside risk

Forward Market Hedges: Objective: To nullify future spot rate 2 Situations: 1. Expected Inflows of Foreign Currency: Make forward contracts to sell the foreign currency at a specified rate to insulate against depreciation of value of that foreign currency (in terms of home currency). 2. Expected Outflows of Foreign Currency: Make forward contracts to buy the foreign currency at a specified rate to insulate against appreciation of value of the currency (in terms of home currency).

Examples 1. A US firm is expected to receive 200, 000 UK pound in 60 days from a UK buyer. UK pound may depreciate against US $ in 60 days. What to do for offsetting the risk of receiving less amount of US $? 2. A US firm will have to pay 400, 000 Euros in 30 days to a German seller. Euro may appreciate against US $ in 30 days. What to do for offsetting the risk of spending more US $?

Money Market Hedges Objective: borrow/lend to lock in home currency value of cash flow q If a foreign currency receivable is expected after a defined period of time and currency risk is desired to be hedged via the money market, this would necessitate the following steps: Borrow the foreign currency in an amount equivalent to the present value of the receivable. Why the present value? Because the foreign currency loan plus the interest on it should be exactly equal to the amount of the receivable. � Convert the foreign currency into domestic currency at the spot exchange rate. � Place the domestic currency on deposit at the prevailing interest rate. � When the foreign currency receivable comes in, repay the foreign currency loan (from step 1) plus interest. �

Money Market Hedges Objective: borrow/lend to lock in home currency value of cash flow Similarly, if a foreign currency payment has to be made after a defined period of time, the following steps have to be taken to hedge currency risk via the money market: � Borrow the domestic currency in an amount equivalent to the present value of the payment. � Convert the domestic currency into the foreign currency at the spot rate. � Place this foreign currency amount on deposit. � When the foreign currency deposit matures, make the payment.

Practical Examples Example 1: Consider a small Canadian company that has exported goods to a U. S. customer and expects to receive US$50, 000 in one year. The Canadian CEO views the current exchange rate of US$1 = C$1. 10 as favorable, and would like to lock it in, since he thinks that the Canadian dollar may appreciate over the year ahead (which would result in fewer Canadian dollars for the U. S. dollar export proceeds when received in a year’s time). The Canadian company can borrow US$ at 1. 75% for one year and can receive 2. 5% per annum for Canadian-dollar deposits. From the perspective of the Canadian company, the domestic currency is the Canadian dollar and the foreign currency is the US dollar. Here’s how the money market hedge is set up.

Answer to example 1 The Canadian company borrows the present value of the U. S. dollar receivable (i. e. US$50, 000 discounted at the US$ borrowing rate of 1. 75%) = US$50, 000 / (1. 0175) = US$49, 140. 05. Thus, after one year, the loan amount including interest at 1. 75% would be exactly US$50, 000. The amount of US$49, 104. 15 is converted into Canadian dollars at the spot rate of 1. 10, to get C$54, 054. 05. The Canadian dollar amount is placed on deposit at 2. 5%, so that the maturity amount (after one year) is = C$54, 054. 05 x (1. 025) = C$55, 405. 41. When the export payment is received, the Canadian company uses it to repay the US dollar loan of US$50, 000. Since it received C$55, 405. 41 for this US dollar amount, it effectively locked in a one-year forward rate = C$55, 405. 41 / US$50, 000 or US$1 = C$1. 108108

Practical Examples Example 2: Suppose you live in the U. S. and intend on taking your family on that long-awaited European vacation in six months. You estimate the vacation will cost about EUR 10, 000, and plan to foot the bill with a performance bonus that you expect to receive in six months. The current EUR spot rate is 1. 35, but you are concerned that the euro could appreciate to 1. 40 to the USD or even higher in six months, which would raise the cost of your vacation by about US$500 or 4%. You therefore decide to construct a money market hedge. You can borrow U. S. dollars (your domestic currency) for six months at an annual rate of 1. 75%, and receive interest at an annual rate of 1. 00% on sixmonth EUR deposits.

Answer to example 2 Borrow U. S. dollars in an amount equivalent to the present value of the payment, or EUR 9, 950. 25 (i. e. EUR 10, 000 / [1 + (0. 01/2]). Note that we divide 1% by 2 to reflect half a year or six months, which is the borrowing period. At the spot rate of 1. 35, this works out to a loan amount of US$13, 432. 84. Convert this USD amount into euros at the spot rate of 1. 35, which from step 1 is EUR 9, 950. 25. Place EUR 9, 950. 25 on deposit at the 1% annualized rate for six months. This will yield exactly EUR 10, 000 when the deposit matures in six months, in time for your vacation. The total amount repayable of the US$ loan including interest (1. 75% annual rate for six months) is US$13, 550. 37 after six months. Now all you have to do is hope that you receive a performance bonus of at least that amount to repay the loan. By using the money market hedge, you have effectively locked in a sixmonth forward rate of 1. 355037 (i. e. USD 13, 550. 37 / EUR 10, 000). Note that you could have arrived at the same result if you had used a currency forward, the rate for which would have been calculated as: EUR 1 (1 + (0. 01/2)) = USD 1. 35 (1 + (0. 0175/2)), or EUR 1. 005 = USD 1. 3618125, or EUR 1 = USD 1. 355037.

Foreign-Exchange Risks One of the more common corporate uses of derivatives is for hedging foreign-currency risk, or foreign-exchange risk, which is the risk that a change in currency exchange rates will adversely impact business results. Let's consider an example of foreign-currency risk with ACME Corporation, a hypothetical U. S. based company that sells widgets in Germany. During the year, ACME Corp sells 100 widgets, each priced at 10 Euros. Therefore, our constant assumption is that ACME sells 1, 000 Euros worth of widgets:

Foreign-Exchange Risks

Foreign-Exchange Risks When the dollar-per-euro exchange rate increases from $1. 33 to $1. 50 to $1. 75, it takes more dollars to buy one euro, or one euro translates into more dollars, meaning the dollar is depreciating or weakening. As the dollar depreciates, the same number of widgets sold translates into greater sales in dollar terms. This demonstrates how a weakening dollar is not all bad: it can boost export sales of U. S. companies. (Alternatively, ACME could reduce its prices abroad, which, because of the depreciating dollar, would not hurt dollar sales; this is another approach available to a U. S. exporter when the dollar is depreciating. ) The above example illustrates the "good news" event that can occur when the dollar depreciates, but a "bad news" event happens if the dollar appreciates and export sales end up being less.

Foreign-Exchange Risks In the above example, we made a couple of very important simplifying assumptions that affect whether the dollar depreciation is a good or bad event: (1) We assumed that ACME Corp. manufactures its product in the U. S. and therefore incurs its inventory or production costs in dollars. If instead ACME manufactured its German widgets in Germany, production costs would be incurred in Euros. So even if dollar sales increase due to depreciation in the dollar, production costs will go up too! This effect on both sales and costs is called a natural hedge: the economics of the business provide their own hedge mechanism. In such a case, the higher export sales (resulting when the euro is translated into dollars) are likely to be mitigated by higher production costs. (2) We also assumed that all other things are equal, and often they are not. For example, we ignored any secondary effects of inflation and whether ACME can adjust its prices

Foreign-Exchange Risks – Hedging Foreign Currency Future Now let's illustrate a simple hedge that a company like ACME might use. To minimize the effects of any USD/EUR exchange rates, ACME purchases 800 foreign-exchange futures contracts against the USD/EUR exchange rate. The value of the futures contracts will not, in practice, correspond exactly on a 1: 1 basis with a change in the current exchange rate (that is, the futures rate won't change exactly with the spot rate), but we will assume it does anyway. Each futures contract has a value equal to the "gain" above the $1. 33 USD/EUR rate. (Only because ACME took this side of the futures position, somebody - the counter-party - will take the opposite position):

Foreign-Exchange Risks – Hedging Foreign Currency Future

Foreign-Exchange Risks – Hedging Foreign Currency Future In this example, the futures contract is a separate transaction; but it is designed to have an inverse relationship with the currency exchange impact, so it is a decent hedge. Of course, it's not a free lunch: if the dollar were to weaken instead, then the increased export sales are mitigated (partially offset) by losses on the futures contracts

Money Market Hedge A money market hedge is a technique for hedging foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances and commercial paper are traded Since there a number of avenues such as currency forwards, futures, and options to hedge foreign exchange risk, the money market hedge may not be the most cost-effective or convenient way for large corporations and institutions to hedge such risk. However, for the retail investor or small business looking to hedge currency risk in amounts that are not large enough to warrant getting into the futures market or entering into a forward contract, the money market hedge is a neat way to protect against currency fluctuations.

Money Market Hedge Foreign exchange risk can arise either due to transaction exposure - i. e. due to receivables expected or payments due in foreign currency - or translation exposure, which occurs because assets or liabilities are denominated in a foreign currency. Translation exposure is a much bigger issue for large corporations than it is for small business and retail investors. The money market hedge is not the optimal way to hedge translation exposure - since it is more complicated to set up than using an outright forward or option - but it can be effectively used for hedging transaction exposure.

Money Market Hedge 1 - If a foreign currency receivable is expected after a defined period of time and currency risk is desired to be hedged via the money market, this would necessitate the following steps: Borrow the foreign currency in an amount equivalent to the present value of the receivable. Why the present value? Because the foreign currency loan plus the interest on it should be exactly equal to the amount of the receivable. Convert the foreign currency into domestic currency at the spot exchange rate. Place the domestic currency on deposit at the prevailing interest rate. When the foreign currency receivable comes in, repay the foreign currency loan (from step 1) plus interest.

Money Market Hedge 2 -Similarly, if a foreign currency payment has to be made after a defined period of time, the following steps have to be taken to hedge currency risk via the money market: Borrow the domestic currency in an amount equivalent to the present value of the payment. Convert the domestic currency into the foreign currency at the spot rate. Place this foreign currency amount on deposit. When the foreign currency deposit matures, make the payment.

Forward Exchange rates A forward exchange rate is merely the spot exchange (benchmark) rate adjusted for interest rate differentials. The principle of “Covered Interest Rate Parity” holds that forward exchange rates should incorporate the difference in interest rates between the underlying countries of the currency pair, otherwise an arbitrage opportunity would exist Example: Assume U. S. banks offer a one-year interest rate on U. S. dollar (USD) deposits of 1. 5%, and Canadian banks offer an interest rate of 2. 5% on Canadian-dollar (CAD) deposits. Although U. S. investors may be tempted to convert their money into Canadian dollars and place these funds in CAD deposits because of their higher deposit rates, they obviously face currency risk. If they wish to hedge this currency risk in the forward market by buying US dollars one year forward, covered interest rate parity stipulates that the cost of such hedging would be equal to the 1% difference in rates between the U. S. and Canada. To calculate the one-year forward rate for this currency pair. If the current exchange rate (spot rate) is US$1 = C$1. 10, then based on covered interest rate parity, US$1 placed on deposit at 1. 5% should be equivalent to C$1. 10 at 2. 5% after one year. Thus, US$1 (1 + 0. 015) = C$1. 10 (1 + 0. 025), or US$1. 015 = C$1. 1275 The one-year forward rate is therefore US$1= C$1. 1275 ÷ 1. 015 = C$1. 110837

Money Market Hedge Conditions for Use Firms have access to money market for different currencies The dates of expected future cash flows and money market transaction maturity match Offshore currency deposits or Eurocurrency deposits are main money market hedge instruments

Comparison: Forward and Money Market Hedge The covered interest parity implies that a firm cannot be better off using money market hedge compared to forward hedge. In reality, firms find use of forward contracts more profitable than use of money market instruments; because firms: A) B) Borrow at a rate> inter-bank offshore lending rate Put deposits at a rate< inter-bank offshore deposit rate.

Summary What is the structure of international market? ü What are the main principles of international lending? ü international trade forms the major physical component of the international financial markets. Why are international operations important to financial institutions ? ü The principles of international lending (safety, suitability and profitability) add To the normal principles of borrowing Why are trade finance products so important in the international finance? ü the international markets consists of several components, from foreign exchange to equities involvement in the international financial markets allows a financial institution to grow markets outside its core location What is suggested as the most efficient process of country risk analysis? ü q The most efficient approach is a step down approach, which calls for the following order: looking at the country, its government, its central bank, its commercial banks and its corporate sector