Finanças Internacionais

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ISCTE-IUL Business School
Mestrado em Economia Moneta´ria e Financeira
Financ¸as Internacionais
Pedro Prazeres
2014/2015
ISCTE-IUL Business School Financ¸as Internacionais - 2014/2015 1
Presentation
Presentation
Docente
- Pedro Prazeres
- pmprazeres@gmail.com
Avaliac¸a˜o
- Exame final (100%)
Bibliografia
- Slides da disciplina
- Outros materiais distribu´ıdos
- Leitura recomendada - Eitman, D., A. Stonehill e M. Moffett (2012),
”Multinational Business Finance”, 13th Edition, Pearson Series in Finance
ISCTE-IUL Business School Financ¸as Internacionais - 2014/2015 2
Presentation
Presentation - Outline
1 Concepts in IF, investments and international parity conditions
I International finance and multinational enterprises
I Corporate governance
I International monetary system
I Foreign exchange market
I International parity conditions
I Foreign exchange exposure and hedging
2 Foreign direct investment
I Modes of foreign involvement
I Basic concepts: NPV, PV and APV
I Methods of evaluation
I Perspectives of evaluation
I Cost of capital
I Taxation
I Inflation and hiper-inflation
I International financing
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
International finance and multinational enterprises
The subject of international finance deals with multinational enterprises
(MNEs), which include both profit and not-for-profit organizations
MNEs are defined as organizations that have operations in more than one country,
and conduct their business through foreign subsidiaries, branches, or joint
ventures with host country firms [Eiteman, Stonehill and Moffett (2012)]
MNEs are headquartered around the world
In some cases, the ownership of firms is so dispersed across countries, that they
are known as transnational corporations. These companies are managed with a
global perspective, rather than from the perspective of any single country
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Questions that affect MNEs
How will the fluctuations in major currencies affect the outlook for currency
exchanges, reserve currencies, and the roles of the euro and the dollar in the
international financial markets?
How will the large fiscal deficits of the major trading currencies affect fiscal and
monetary policies, and consequently interest and exchange rates?
How damaging was the 2008 credit crisis for international financial institutions?
What will be the role played by emerging markets, many of them with cronic
balance of payments imbalances, in international financial markets?
How will ownership, control and governance evolve across different foreign
markets?
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Questions that affect MNEs
EUR vs. Major currencies (USD, CHF, GBP and JPY)
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Questions that affect MNEs
EUR/GBP vs. UK trade balance
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Questions that affect MNEs
EUR vs. Emerging markets currencies (SGD, BRL, RUB and CNY)
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Questions that affect MNEs
EUR/RUB vs. Key rate
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Questions that affect MNEs
EUR/USD vs. 10YR Greek government bond yield
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Main strategic motivations to become a MNE (not mutually exclusive)
Seek new markets, either to produce to satisfy local demand, or to export to
markets other than their home market
Seek sources of raw materials, either for export or for further processing and
sale in the country in which they are found (firms in the oil, mining, plantation
and forest industries)
Increase production efficiency, producing in countries were one or more of the
production factors are underpriced relative to their productivity (labor-intensive
production firms)
Seek knowledge, operating in countries to gain access to technology and/or
managerial expertise (technology firms)
Seek political safety, operate in countries considered unlikely to expropriate or
interfere with private enterprises
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Domestic vs. international financial management
Despite the importance of MNEs in international finance, purely domestic firms
can also have significant international activities:
- Import and export of products and services
- Licensing of foreign firms to conduct their foreign operations
- Indirect exposures, namely through customers, suppliers and other stakeholders
As such, domestic firms must also understand the economic and financial risks
stemming from this international exposure
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Domestic vs. international financial management
The main differences between domestic (DM) and international financial
management (IM) encompass several aspects
Culture, history and institutions
- DM - Each country has a known environment
- IM - Each foreign country is unique and not always understood
Corporate governance
- DM - Regulations and institutions are well known
- IM - Regulations of foreign countries and institutional practices are uniquely
different
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Domestic vs. international financial management
Foreign exchange risk
- DM - Foreign exchange risks from import and export activities and foreign
competitors
- IM - Foreign exchange risks from import and export activities, and also from
subsidiaries and foreign competitors
Political risk
- DM - Negligible political risks (not always true)
- IM - Political risks from subsdiaries
Modification of financial theories
- DM - Base case
- IM - Financial theories must be modified, (budgeting and cost of capital) due to
foreign complexities
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Concepts in IF, investments and international parity conditions International finance and multinational enterprises
Domestic vs. international financial management
Modification of financial instruments
- DM - Base case
- IM - Modified financial instruments, such as options, futures, swaps, etc.
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Concepts in IF, investments and internationalparity conditions Corporate governance
Corporate governance
Corporate governance: relationship between stakeholders (namely shareholders
and management), used to determine and control the strategic direction and
performance of an organization, constructed in order to optimize returns to
shareholders - way to solve the agency problem!
In order to achieve this, good governance practices must focus the attention of
the board of directors for this objective by developing and implementing a
corporate strategy which:
- Ensures corporate growth and improvement in the value of the
corporation’s equity
- Ensures an effective relationship with stakeholders
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance
In multinational business management, agency theory must be adapted to the
complexities of the MNE, namely:
- Subsidiaries
- Branches
- Affiliates
- Host foreign governments
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance
Primary areas of corporate governance (OECD definition):
- Shareholder rights: shareholders are the equity owners, and their interests
should prevail over the interests of the other stakeholders
- Board responsibilities: the board has full legal responsibility for the firm,
including proper oversight of management
- Equitable treatment of shareholders: domestic vs foreign resident
shareholders, majority vs minority interests
- Stakeholders rights: governance practices should formally acknowledge the
interest of other stakeholders (employees, creditors, community and government)
- Transparency and disclosure: public reporting of firm results and parameters
should be done in a timely manner, and available to all interests equitably
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Concepts in IF, investments and international parity conditions Corporate governance
Structure of corporate governance
Corporate (internal structure):
- Board of directors: accountable for the governance of the corporation. It is
composed of both employees (inside members) and senior and influential
nonemployees (outside members)
In this area, common areas of controversy include:
- Proper balance between inside and outside members
- Compensation of board members
- Monitoring ability of the board, regarding management performance, specially
when some of the board members spend very little time in board activities
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Concepts in IF, investments and international parity conditions Corporate governance
Structure of corporate governance
Corporate (internal structure) (cont.):
- Officers and management: senior officers of the corporation (CEO, CFO, CIO,
COO, etc.), responsible for the strategic and operational direction of the firm.
They are positively motivated by salary, bonuses and stock options, and
negatively motivated by the risk of losing their jobs. They may have biases or
personal agendas, which the board and other corporate stakeholders are
responsible for monitoring
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Concepts in IF, investments and international parity conditions Corporate governance
Structure of corporate governance
Marketplace (external):
- Equity markets: publicly traded companies are highly susceptible to the
changing opinion of the markets
- Debt markets: financing providers that are not interested in building
shareholder value, but in the financial health of the company
- Auditors and legal advisers: responsible for providing an external, independent
and professional opinion about the financial statements of the company
- Regulators: entities that require regular disclosure processes from companies
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance regimes
Corporate governance practices differ across countries, economies and
cultures
The various corporate governance ’regimes’ can be divided into:
- Market-based: efficient equity markets, dispersed ownership (North America)
- Family-based: management and ownership are combined, family are between
majority and minority shareholders (Emerging Markets, France)
- Bank-based: government influence in bank lending, lack of transparency, family
control (Germany)
- Government-affiliated: State ownership of enterprise, lack of transparency, no
minority influence (China, Russia)
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance regimes
Main factors driving corporate governance regimes:
- Development of financial markets
- Separation between management and ownership
- Disclosure and transparency
- Historical development of the legal system
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance best practices
Good corporate governance practices include:
- Composition of the board of directors: both internal and external members,
always with experience and knowledge
- Management compensation: existence of management compensation system
aligned with corporate performance (financial or otherwise), with significant
oversight by the board and open disclosure to shareholders and investors
- Corporate auditing: existence of periodic and independent auditing of
corporate financial results. The auditing process should be overseen by a board
committee composed primarily of external members
- Public reporting and disclosure: timely public reporting of both financial and
nonfinancial results, with transparency regarding off-balance items
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance best practices
The existence of a set of good corporate governance practices is inseparable of
the quality of the country’s corporate law, its protection of creditor and
investor rights (including minority shareholders), and the country’s ability of
provide adequate enforcement
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance failures and emergence of regulation and reforms
Notable examples of corporate governance failures:
Enron (October 2001)
- Founded in 1985, Enron was an American energy, commodities and services
company. It employed around 20,000 staff and was one of the world’s largest
electricity, natural gas, communications, and pulp and paper companies
- Enron’s executives conducted a series of wrongful practices, which led ultimately
to the company’s downfall, which also caused the dissolution of Arthur Andersen,
at that time one of the world’s 5 largest audit firms
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance failures and emergence of regulation and reforms
These wrongful practices can be shortly divided into:
- Accounting practices: Mark-to-market accounting (PV of future cash-flows,
many times without even receiving them - as opposed to the actual revenues and
costs of one year) was misused in manybusinesses, leading to overinflated profits
- Use of special purpose entities (SPEs): Enron created hundreds of SPEs,
under minimal disclosure to stakeholders, used to hide debt, altering the firm’s
consolidated statements by understating its liabilities and overstating its equity
- Poor corporate governance system: Focused in short-term profits, share price
and executive compensation, disregarding risk management, expert and audit
committees (which did not have enough knowledge and experience to understand
the company’s complex businesses), and with the support of an auditor with lack
of business knowledge and conflicts of interest, because of large consultancy fees
generated by Enron
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance failures and emergence of regulation and reforms
Notable examples of corporate governance failures (cont.):
Lehman Brothers (September 2008)
- Founded in 1850, Lehman Brothers was one of the largest financial institutions
in the United States, operating in investment banking, trading, private equity and
private banking
- In 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection, playing a
major role in the 2007-2008 financial crisis.
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance failures and emergence of regulation and reforms
The main causes of the collapse of Lehman Brothers were:
- Accounting practices: Lehman Brothers constantly made use of cosmetic
accounting practices (which included repurchase agreements, registered as normal
sales of securities, celebrated shortly before the end of each quarter), to alter its
financial statements
- Subprime crisis
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance failures and emergence of regulation and reforms
Other notable examples of corporate governance failures:
- WorldCom (July 2002)
- Parmalat (December 2004)
- Bear Stearns (March 2008)
In many cases:
- Audit firms missed the violations or minimized their importance, possibly
because of lucrative consulting deals or other conflicts of interest
- Security analysts and banks urged investors to buy the shares and debt issues
of firms that they knew to be highly risk or even close to bankruptcy
- Management top executives, mostly responsible for mismanagement that led
firms to bankruptcy, walked away with large severance packages, sometimes
before their downfall
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance failures and emergence of regulation and reforms
Given the several corporate governance failures, and since most individual
shareholders do not have the power and resources to monitor management, the
majority of countries/markets are increasingly relying on regulation to
perform this task
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Concepts in IF, investments and international parity conditions Corporate governance
Corporate governance failures and emergence of regulation and reforms
Emergence of regulation activity towards corporate governance -
Sarbanes-Oxley Act (2002), which set new standards concerning US public
company boards and management, as well as accounting/audit firms. Some
of the main changes include:
- The CEOs and CFOs of publicly quoted companies must attest the veracity of
the firm’s financial statements
- Audit and compensation committees must composed by independent directors
- Companies cannot make loans to corporate directors
- Companies must test their internal financial controls against fraud
Other national and international regulations
Public corporate governance indexes
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Concepts in IF, investments and international parity conditions International monetary system
International monetary system - Currency regimes
IMF classification of currency regimes:
- Hard pegs: includes countries that give up their own sovereignty over monetary
policy, and adopted other country currencies (for example, countries pursuing a
dollarization) and countries utilizing a currency board structure (structure with an
explicit legislative commitment to maintain a fixed exchange rate with a foreign
currency)
- Soft pegs: includes currencies with fixed exchange rates against other currency
(or a basket of currencies). Soft peg regimes are differentiated on the basis of
what the currency is fixed to, whether that fix is allowed to change, what types,
magnitudes and frequencies of intervention are allowed/used and the degree of
variance about the fixed rate
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Concepts in IF, investments and international parity conditions International monetary system
International monetary system - Currency regimes
IMF classification of currency regimes:
- Floating arrangements: currency predominantly market-driven, and includes
floating currencies (with government intervention, in order to moderate, not
target, the rate of change) and free floating currencies (with their value
determined by open market forces)
- Residual: includes currencies that not meet the criteria for any other category
(for example, country systems demonstrating frequent shifts in exchange rate
policy)
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Concepts in IF, investments and international parity conditions International monetary system
International monetary system - Currency regimes
The choice of currency regime reflects the country’s priorities about inflation,
unemployment, interest rate levels, trade balances and economic growth
The choice between fixed and flexible rates may change over time as priorities
change
In principle, countries would prefer fixed exchange rate regimes because:
- Fixed rates provide stability in international prices for the conduct of trade.
Stable prices aid growth and decrease risk
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Concepts in IF, investments and international parity conditions International monetary system
International monetary system - Currency regimes
In principle, countries would prefer fixed exchange rate regimes because
(cont.):
- Fixed rates provide stability in international prices for the conduct of trade.
Stable prices aid growth and decrease risk
- Fixed exchange rates are inherently anti-inflationary. In the case of an
isolated economy, budget deficits will lead to central bank financing, which
increases the money supply of a country and lowers interest rates. Investors tend
to move savings abroad, which increases the supply of domestic currency on the
foreign exchange market.
As the central bank has the mandate to fix exchange rates, the increase in supply
of domestic currency will be absorbed by the central (by selling foreign currency),
balancing supply and demand at the fixed rate - the net effect on the money
supply should be such that no inflation occurs
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International monetary system - Currency regimes
But...
- Fixed rate regimes require central banks to maintain large quantities of
international reserves, for usein the defense of the fixed rate
- Fixed rates, once in place, may be maintained at levels inconsistent with
economic fundamentals
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Concepts in IF, investments and international parity conditions International monetary system
International monetary system - Currency regimes
Swiss National Bank (September 6, 2011):
’Swiss National Bank sets minimum exchange rate at CHF 1.20 per euro
The current massive overvaluation of the Swiss franc poses an acute threat to the
Swiss economy and carries the risk of a deflationary development. The Swiss
National Bank (SNB) is therefore aiming for a substantial and sustained
weakening of the Swiss franc. With immediate effect, it will no longer tolerate a
EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will
enforce this minimum rate with the utmost determination and is prepared to buy
foreign currency in unlimited quantities. Even at a rate of CHF 1.20 per euro, the
Swiss franc is still high and should continue to weaken over time. If the economic
outlook and deflationary risks so require, the SNB will take further measures.’
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Concepts in IF, investments and international parity conditions International monetary system
International monetary system - Currency regimes
EUR vs. Major currencies (USD, CHF, GBP and JPY)
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Concepts in IF, investments and international parity conditions International monetary system
International monetary system - Currency regimes
Three characteristics which an ideal currency should possess (the ’Impossible
Trinity’):
- Exchange rate stability: currency value fixed in relationship to other major
currencies, decreasing risks for companies and investors
- Full financial integration: investors should be allowed to easily move funds from
one country to another in response to perceived economic opportunities or risks
- Monetary independence: domestic monetary and interest rate policies would
be set by each individual countries to pursue desired national economic policies
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Concepts in IF, investments and international parity conditions International monetary system
International monetary system - Currency regimes
In practice, the co-existence of the three characteristics is impossible
because:
- Countries with pure float exchange regimes: monetary independence and
high degree of financial integration, but low exchange rate stability
- Countries with tight control over inflow and outflow of capital: monetary
independence and stable exchange rates, but low degree of integration with global
financial markets
In conclusion, when choosing a currency regime, countries must decide the
main characteristic to pursue, giving up one of the remaining two
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments
Balance of payments (BOP): measures all international economic transactions
between the residents of a country and foreign residents
BOP data influences and is influenced by key macroeconomic variables such as:
- Gross domestic product
- Employment levels
- Price levels
- Exchange rates
- Interest rates
- Etc.
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments
For policymakers, BOP is data is fundamental because such measures of
economic activity in order to:
- Evaluate the general competitiveness of domestic industry
- Set exchange rate or interest rate policies and goals
- Etc.
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments for MNEs
For MNEs, BOP measures are used to assess the growth and health of trade
and financial transactions by country and region of the world:
- It is an indicator of pressure on a country’s foreign exchange rate, and thus
of the potential for a firm trading with or investing in that country to
experience foreign exchange gains or losses
- The BOP aids in forecasting a country’s market potential. A country with
trade deficits is not as likely to expand imports as it would be if running a surplus.
It may, however, welcome investments that increase its exports
- Changes in the BOP may anticipate the imposition of removal of foreign
controls
- Changes in a country’s BOP may indicate the imposition or removal of
controls of payment of dividends, interest, license fees, royalties or other
cash disbursements to foreign firms and investors
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments structure
The BOP is comprised of three primary subaccounts: the current account, the
financial account and the capital account
In addition, the BOP includes the official reserves account and the net errors
and omissions account
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments structure
A - Current Account:
1 Goods trade balance (net exports/imports of goods)
2 Services trade balance (net exports/imports of services)
3 Net investment income from direct and portfolio investment plus employee
compensation
Includes net income items associated with investments made in previous periods,
plus wages and salaries paid to nonresident workers
4 Net transfers from abroad
Includes remittances from emigrants/immigrants, financial aid, gifts, grants, etc.
A1 + A2 + A3 + A4 = Current Account Balance
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments structure
B - Capital Account:
1 Capital transfers related to the purchase and sale of fixed assets (e.g. real estate)
Includes the purchase and sale of nonproduced/nonfinancial assets
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments structure
C - Financial Account:
1 Net foreign direct investment
Includes net investment from and into a country, with the purpose of exerting
control over assets (with a threshold percentage)
2 Net portfolio investment
Includes net investment items from and into a country, made to pursue profits,
rather than to control or manage the investment (for example, purchase of debt
securities, bank accounts, etc.)
3 Other financial items
Includes short- and long-term trade credits, cross-border loans, deposits and other
accounts receivable and payable related to cross-border trade
C1 + C2 + C3 = Financial Account Balance
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments structure
In summary:
A - Current Account
B - Capital Account
C - Financial Account
A + B + C = Basic Balance
D - Net Errors and Omissions (includes missing data, errors and statistical
discrepancies)
E - Reserves and related items (includes total reserves held by official monetary
authorities within a country,which are normally composed of the major currencies
used in international trade and financial transactions. The significance of official
reserves usually depends on whether a country is operating under a fixed or
floating exchange rate regime)
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments - Interaction with key macroeconomic variables - The
BOP and GDP
Using an expenditure approach, the GDP of a country can be represented by:
GDP = C + I + G + X - M,
where
- C = Consumption spending
- I = Capital investment spending
- G = Government spending
- X = Exports of goods and services
- M = Imports of goods and services
- X - M = Current account balance
Therefore, a positive (negative) current account balance (for example due to
changes in competitiveness) directly contributes to an increase (decrease) in
GDP
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Balance of payments - Interaction with key macroeconomic variables - The
BOP and GDP
Japan GDP vs. Current Account Balance (USD billions) - 1980-2019
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Balance of payments - Interaction with key macroeconomic variables - The
BOP and exchange rates
BOP data can be quickly summarized by the following equation:
BOP = (X - M) + (CI - CO) + (FI - FO) + FXB,
where
- X = Exports of goods and services
- M = Imports of goods and services
- CI = Capital inflows
- CO = Capital outflows
- FI = Financial inflows
- FO = Financial outflows
- FXB = Monetary reserves
The effect of a BOP imbalance is different, depending on whether the
country has fixed or floating exchange rates or a managed exchange rate
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Balance of payments - Interaction with key macroeconomic variables - The
BOP and exchange rates
Countries with fixed exchanges rates: monetary authorities have the
responsibility to ensure the stability of exchange rates. If not, they are expected
to intervene in the market by buying or selling official foreign reserves
For example, if Current account balance + Capital account balance > 0:
there exists a surplus demand for the domestic currency. In order to preserve the
fixed exchange rate, monetary authorities must intervene in the market and sell
domestic currency for foreign currencies or gold
Otherwise Current account balance + Capital account balance < 0: there
exists an excess supply of the domestic currency. So, monetary authorities must
intervene and buy the domestic currency for the foreign currency or gold
Obviously, it is fundamental for a government to maintain significant foreign
exchange reserve balances
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments - Interaction with key macroeconomic variables - The
BOP and exchange rates
Countries with floating exchanges rates: the monetary authorities do not have
the responsibility to peg its foreign currency rate. Theoretically, a BOP near zero
is obtained through market equilibrium conditions
For example, a country with Current account balance < 0, Capital account
balance = 0 and Financial account balance = 0 will have a net BOP < 0
In this case, the excess supply of domestic currency will lead to its
devaluation (thus increasing exports, which are now cheaper, and decreasing
imports, which are now more expensive), and the BOP will move back
toward zero
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments - Interaction with key macroeconomic variables - The
BOP and exchange rates
Countries with managed floats: monetary authorities of countries with managed
floats still rely on market conditions for exchange rate determinations, but often
find it necessary to take action to maintain desired exchange rate levels
Primary actions taken in such regimes is to change relative interest rates, thus
influencing economic fundamentals that affect exchange rate determination
For example, a country may wish to defend its currency by raising domestic
interest rates to attract additional capital from abroad. This will alter market
forces and create additional market demand for the domestic currency
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Concepts in IF, investments and international parity conditions International monetary system
Balance of payments - Interaction with key macroeconomic variables - The
BOP and interest rates
Besides the use of interest rate to intervene in the exchange rate market, the level
of a country’s interest rates compared to other countries has an impact on the
financial account of the balance of payments
Relatively low interest rates should normally stimulate an outflow of capital,
seeking higher interest rates in other country currencies, leading to a depreciation
of the domestic currency
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Balance of payments - Interaction with key macroeconomic variables - The
BOP and inflation rates
In countries with relatively higher inflation rates, consumers will tend to find it
more attractive to buy imports. As such, imports have the potential to lower a
country’s inflation rate - in particular, imports of lower-priced goods and services
place a limit on what domestic competitors charge for comparable goods and
services
On the other hand, countries with relatively lower inflation rates tend to have
more competitive exports (and less attractive imports). As a result, there will
be an increasing demand for the domestic currency, which will lead to an
appreciation of its value
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Foreign exchange market - Introduction
Foreign exchange market: provides the physical and institutional structure
through which one currency is traded by another, the exchange rate rate between
currencies is determined, and foreign exchange transactions are physically
completed
Foreign exchange transaction: agreement between to parts that a fixed amount
of one currency will be delivered for some other currency at a specified rate, on a
specified date
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Foreign exchange market - Market participants
Main types of participants in the foreign exchange market:
- Bank and nonbank foreign exchange dealers: main objective is to buy foreign
exchange at a bid price and resell it at a larger ask price. Many institutions
operate as market makers, willing to buy and sell specific currencies at all times,
and thus maintaining an inventory position in those currencies
- Individuals and firms conducting commercial and investment transactions:
includes MNEs, companies with import and export businesses, portfolio managers
with positions in foreign currencies,etc.
- Speculators/arbitragers: entities that seek profit from exchange rate changes
- Central banks and treasuries: main objective is to pursue monetary policies,
like exchange rates stability
- Foreign exchange brokers: facilitate trading between dealers, earning
commissions for the service
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Foreign exchange market - Transactions
Main types of transactions in the foreign exchange market:
- Spot transactions
- Forward transactions
- Swap transactions
Spot transactions: purchase of foreign exchange, with delivery and payment
taking place, normally, on the second following business day (the value date)
Example: on a Monday, a US bank contracts a trade of £10,000,000 to a UK
bank, a the GBP/USD spot rate of 1.8420
- In this trade, the US bank sells pounds and buys dollars, whereas the UK
bank sells dollars and buys pounds
- To settle the trade, on Wednesday the US bank transfers £10.000.000 to the
UK bank, and receives $18.420.000 at the same time (delivery versus payment)
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Foreign exchange market - Transactions
Forward transactions: require the delivery at a future value date of a specified
amount of one currency for a specified amount of another currency, at a exchange
rate established at the time of the agreement
Forward exchange rates are normally quoted for value dates ranging from one
week to twelve months
Example: a US bank contracts a one-year forward trade of £10,000,000 to a UK
bank, a the GBP/USD spot rate of 1.8420
- In this trade, the US bank sells pounds and buys dollars forward, whereas the
UK bank sells dollars and buys pounds forward
- One year later, to settle the trade, the US bank transfers £10.000.000 to the
UK bank, and receives $18.420.000
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Foreign exchange market - Transactions
Swap transactions: simultaneous purchase and sale, both with the same
counterparty, of a given amount of foreign exchange for two different value dates.
There are several types of foreign exchange swap transactions:
- Spot against forward swaps: the dealer buys (sells) a currency in the spot
market and simultaneous sells (buys) the same amount back, to the same
counterparty, in the forward market
- Forward-forward swaps: the dealer buys (sells) a currency in the forward market
(for delivery in a specific date), and sells (buys) the same amount back also in the
forward market (for delivery in a specific date, which can differ from the first one)
- Non-deliverable forwards
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Foreign exchange market - Rates and quotations
Foreign exchange rate: price of one currency expressed in terms of another
currency
Currency symbols:
- European euro - e/EUR
- US dollar - $/USD
- Great Britain - £/GBP
- Japanese yen - U/JPY
Every exchange rate involves two currencies, currency 1 (CUR1) and currency
2 (CUR2), e.g. CUR1 / CUR2
- Currency 1 is named the base currency or the unit currency
- Currency 2 is named the price currency or the quote currency
- The exchange rate always indicated the number of units of the price currency
(CUR2), required in exchange for one unit of the base currency (CUR1)
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Foreign exchange market - Rates and quotations
Direct quotation: price of a foreign currency in domestic currency units
Indirect quotation: price of a domestic currency in foreign currency units
Example: quote on EUR/USD of 1.2174
- In Europe, it is an indirect quote on the euro (X units of the foreign currency,
for one unit of the domestic currency)
- In USA, it is a direct quote on the euro (X units of the domestic currency, for
one unit of the foreign currency)
- The equivalent USD/EUR quote (direct on the euro and indirect on the dollar)
is obtained by 1/1.2174 = 0.8214
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Foreign exchange market - Cross rates
Many currency pairs are only inactively traded, so their exchange rate is
determined through their relationship to a widely traded third currency
Example: assume that the USD/JPY is quoted at 76.73 and the USD/MXN is
quoted at 13.6455.
Using this quotes, a Mexican importer can buy one dollar for MXN 13.6455, and
with that dollar can buy JPY 76.73
The corresponding MXN/JPY exchange rate is given by
76.73 (USD/JPY )
13.6455 (USD/MXN)
= 5.6231 MXN/JPY
Similarly, taking into account the JPY/MXN exchange rate:
13.6455 (USD/MXN)
76.73 (USD/JPY )
= 0.17784 JPY /MXN
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Foreign exchange market - Percentage changes in spot rates
Example: the EUR/USD changes its value from 1.2 to 1.3 (similarly, the
USD/EUR changes from 0.833 to 0.769). What is the percentage change in the
value of the USD with respect to the EUR?
When the foreign currency price of the home currency is used (indirect
quote on the domestic currency), the percentage change is given by:
%∆ =
Beginning rate − Ending rate
Ending rate
=
1.2− 1.3
1.3
= −7.7%
On the other hand, when the home currency price of the foreign currency is
used (direct quote on the home currency), the percentage change is given
by:
%∆ =
Ending rate − Beginning rate
Beginning rate
=
0.769− 0.833
0.833
= −7.7%
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Foreign exchange market - Forward quotes
Forward exchange rates are normally quoted in terms of points (or pips), the last
digits of a currency quote
A forward quote expressed in points is not a foreign currency as such, but rather
it is the difference between the forward rate and the spot rate
Example: using Bloomberg data (next slide), it is possible to sell (buy) euros, or
buy (sell) dollars at a fixed EUR/USD exchange rate of 1.2751 (1.2753), for
delivery in one year
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Foreign exchange market - Forward quotes
EUR/USD - Contract table
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Foreign exchange market - Forward quotes in percentage terms
The percent per annum deviation of the forward from the spot rate is termed the
forward premium
Example: using the Bloomberg data from the previous slide, calculate the
3-month forward premium (bid) on the dollar against the euro, in home currency
terms and foreign currency terms
In foreign currency terms (i.e. using an indirect quote on the euro):
f =
Spot − Forward
Forward
× 360
90
× 100 = 1.2696− 1.2708
1.2708
= −0.38%
In home currency terms (using a direct quote on the euro):
f =
Forward − Spot
Spot
× 360
90
× 100 = 0.7869− 0.78760.7876
= −0.38%
In both calculations, the result is similar: a forward 0.38% discount of the dollar
against the euro
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International parity conditions - Absolute purchasing power parity
Law of one price: if identical products or services can be sold in two different
markets, and no restrictions exist, the price of that product or service should be
equal in both markets
The absolute version of the purchasing power parity states that the law of one
price is verified, i.e., the spot exchange rate is determined by the relative
prices of similar goods (or baskets of goods)
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International parity conditions - Absolute purchasing power parity
Big Mac Index (published by The Economist): assuming that the Big Mac is
identical across countries, it serves as a benchmark of whether currencies are
trading at market rates that are close to the rates implied by the index
Assume that a Big Mac costs e3.44 in the Euro Area, and $ 4.07 in the USA.
The implied purchasing power parity EUR/USD exchange rate is given by:
EUR/USD =
Big Mac Price (USD)
Big Mac Price (EUR)
=
USD 4.07
EUR 3.44
= 1.18 EUR/USD
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International parity conditions - Absolute purchasing power parity
The Big Mac is a good benchmark for the application of the law of one price
because:
- The product is nearly the same in every market
- It is a result of mainly local materials and input, and not imported ones
However, it also possesses some limitations:
- The product cannot be traded across markets
- Material and input costs are influenced by a variety of factors specific of each
country, such as real estate rental rates, taxes, etc.
An alternative to this would be to apply the law of one price in terms of
a basket of goods. In this case, the previous EUR/USD exchange rate would
be given by:
EUR/USD =
Basket Price (USD)
Basket Price (EUR)
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International parity conditions - Relative purchasing power parity
Relative purchasing power parity: the relative change in prices between two
countries over a period of time determines the change in the exchange rate of
over that same period, i.e.
S1 = S0 × 1 + piF
1 + piD
where
- S1 = Exchange rate between the two currencies in moment 1
- S0 = Exchange rate between the two currencies in moment 0
- piF = Foreign inflation rate
- piD = Domestic inflation rate
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International parity conditions - Relative purchasing power parity
Example: consider a EUR/USD spot exchange rate of 1.2, and that the inflation
rates in the Euro Area and in USA are 0.5% and 1%, respectively. The implied
purchasing power parity one year forward exchange rate is given by:
S1 = 1.2× 1 + 1%
1 + 0.5%
= 1.20597
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International parity conditions - Relative purchasing power parity
Alternative: consider good which costs EUR 6 in the Eurozone, and USD 5 in
the USA. Assume that the two goods are equivalent in both markets, and that the
inflation rates in the Euro Area and in USA are once again 0.5% and 1%,
respectively. The implied purchasing power parity one year forward exchange
rate is given by:
6× (1 + 1%)
6× (1 + 0.5%) = 1.20597
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International parity conditions - Exchange rate pass-through
Purchasing power parity implies that all exchange rate changes are directly
reflected, through equivalent changes, in prices of similar goods
Exchange rate pass-through: measure of response of imported and exported
product prices to exchange rate changes
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International parity conditions - Exchange rate pass-through
Example: assume that the price of a computer produced in Europe is EUR 1,000,
and the exchange rate on the EUR/USD is currently at 1.2. The price in dollars
of the same computer is therefore given by
PUSD = EUR 1, 000× 1.2 = USD 1, 200
In a situation where the euro would appreciate 10% against the dollar (the
EUR/USD would rise to 1.32), the computer would be theoretically priced at
USD 1,320. If the computer price in dollars rises only, for example, to USD 1,300,
the degree of exchange rate pass-through is only partial
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International parity conditions - Exchange rate pass-through
In this example, the degree of exchange rate pass-through is given by
USD 1, 300
USD 1, 200
− 1 = 8.3%
In this case, the computer price rose only 8.3%, while the EUR/USD increased in
10%. The computer manufacturer absorbed the remaining 1.7% of the price
increase
Logically, the degree of exchange rate pass-through is usually inversely
proportional to the price elasticity of the good
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International parity conditions - Fisher effect
Nominal interest rate: interest rate before adjusting for inflation
Real interest rate: interest rate for the investor, after considering the effect of
inflation
Fisher effect: nominal interest rates are equal to real interest rates, plus a
compensation for expected inflation. More formally:
i = r + pi + rpi = (1 + r) (1 + pi)− 1
where:
- i = Nominal interest rate
- r = Real interest rate
- pi = Expected inflation rate over the period of time under analysis
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International parity conditions - International Fisher effect and interest rate
parity
Example: consider a market with two currencies - currency A, domestic, and
currency B, foreign - and an investor, which has two investment opportunities,
and an initial wealth of one monetary unit (1 A):
- Invest 1 A for one year, earning an interest rate iA
- Exchange the 1 A for foreign currency, and invest that amount abroad for one
year, earning an interest rate of iB . One year later, the investment proceedings of
this alternative must be exchanged back for domestic currency
With this setting, what is the implied exchange rate for one year from now,
between currencies A and B?
First, we must analyze the investment proceedings in both alternatives...
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International parity conditions- International Fisher effect and interest rate
parity
Example: consider a market with two currencies - currency A, domestic, and
currency B, foreign - and an investor, which has two investment opportunities,
and an initial wealth of one monetary unit (1 A):
- Invest 1 A for one year, earning an interest rate iA
- Exchange the 1 A for foreign currency, and invest that amount abroad for one
year, earning an interest rate of iB . One year later, the investment proceedings of
this alternative must be exchanged back for domestic currency
With this setting, what is the implied exchange rate for one year from now,
between currencies A and B?
First, we must analyze the investment proceedings in both alternatives...
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International parity conditions - International Fisher effect and interest rate
parity
Proceedings in the first alternative (P1):
P1 = 1 + iA
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International parity conditions - International Fisher effect and interest rate
parity
Proceedings in the second alternative (P2):
P2 =
S0 × (1 + iA)
S1
where
- S0 = Spot exchange rate
- S1 = One year implied exchange rate
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International parity conditions - International Fisher effect and interest rate
parity
Two guarantee the nonexistence of arbitrage opportunities, and assuming
unrestricted capital flows, the proceedings from both alternatives must be
equal:
P1 = P2
⇒ A = B
⇒ (1 + iA) = S0 × (1 + iB )
S1
⇒ S1
S0
=
(1 + iB )
(1 + iA)
where
- S0 = Spot exchange rate
- S1 = One year implied exchange rate
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International parity conditions - International Fisher effect and interest rate
parity
This relationship is known as the international Fisher effect - it relates the
percentage change in the spot exchange rate over time, with the differential
between comparable interest rates in different capital markets
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International parity conditions - International Fisher effect and interest rate
parity
For example, an Eurozone investor (dealing in euros) buying a 1-year US dollar
government bond earning 1% interest, instead of a 1-year euro government
bond earning 2% interest, is expecting the dollar to appreciate against the
euro by at least 1% during the forthcoming year (ignoring other issues, such as
sovereign default risk)
If the dollar appreciates more than 1% against the euro, the investor will
have an excess bonus return
Applying the international Fisher effect, the investor should be indifferent to
invest in euros or dollars, because all investors should take advantage of the
same investment opportunities (unrestricted capital flows)
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International parity conditions - Covered interest arbitrage
The spot and forward exchange rates are not always in the state of equilibrium
described by these market conditions. Therefore, opportunities for arbitrage
may arise
An investor who recognizes an opportunity of this type may, for example, invest
in whichever currency offers the highest return on a covered basis (covered
interest arbitrage)
Example: an investor with EUR 1,000,000 is considering whether to invest
domestically in euros, or to invest in US dollars using a covered interest arbitrage
strategy. Furthermore, let us consider:
- Investment horizon = 6 months
- Deposit rate in the Eurozone - iEUR = 2% (annual rate)
- Deposit rate in the USA - iUSD = 3% (annual rate)
- Spot EUR/USD - S0 = 1.1
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International parity conditions - Covered interest arbitrage
Proceedings from investing in euros (PEUR ):
PEUR = EUR 1, 000, 000× (1 + 2%)0.5 = EUR 1, 009, 950
Scenario 1: six-month EUR/USD forward (S0.5) at 1.11 (depreciation in the
dollar against the euro)
Proceedings from investing in dollars (PUSD):
PUSD =
EUR 1, 000, 000× 1.1× (1 + 3%)0.5
1.11
= EUR 1, 005, 746
Best alternative in scenario 1: to invest in euros
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International parity conditions - Covered interest arbitrage
Scenario 2: six-month EUR/USD forward (S0.5) at 1.09 (appreciation in the
dollar against the euro)
Proceedings from investing in dollars (PUSD):
PUSD =
EUR 1, 000, 000× 1.1× (1 + 3%)0.5
1.09
= EUR 1, 024, 000
Best alternative in scenario 2: to invest in dollars
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International parity conditions - Covered interest arbitrage
Covered interest arbitrage opportunities will continue to exist until interest
rate parity is reestablished. For example, in Scenario 2:
- The purchase of dollar in the spot market, and sale in the forward market, will
narrow the premium on the forward exchange rate (the spot dollar will strengthen
from the increased demand, and the forward dollar will weaken, from the extra
sales)
- The decreased demand for euro-denominated investments will lead to an
increase in the domestic interest rate. On the other hand, the increased demand
for investments in dollar will lead to a decrease in the foreign interest rate
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International parity conditions - Uncovered interest arbitrage
Uncovered interest arbitrage: deviation from covered interest rate arbitrage,
where investors borrow money in countries/currencies with relatively low interest
rates, and convert the proceedings into currencies that offer higher interest rates
This transaction is deemed uncovered because the investor does not sell the
investment proceeds forward, therefore bearing the foreign exchange risk until the
end of the period
Example: consider the following data (assume that interest rates are applicable
both to investments and financing), and a capital to invest of EUR 1,000:
- Investment horizon = 1 year
- Interest rate in the Eurozone - iEUR = 5% (annual rate)
- Deposit rate in the USA - iUSD = 2% (annual rate)
- Spot EUR/USD - S0 = 1.15
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International parity conditions - Uncovered interest arbitrage
The uncovered interest arbitrage strategy is implemented with the following steps:
1 Take a one year loan of USD 1,150 (the USD equivalent to EUR 1,000), paying
the 2% interest rate - the total capital to be reimbursed in one year will beUSD 1, 150× (1 + 2%) = USD 1, 173
2 Buy euros at a 1.15 exchange rate, therefore earning EUR 1,000
(= USD 1, 150/1.15)
3 Invest the proceedings in a one year deposit, earning EUR 1,050
(= EUR 1, 000× (1 + 5%))
4 Convert the funds back to dollars and repay the loan
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International parity conditions - Uncovered interest arbitrage
Scenario 1 - One-year EUR/USD exchange rate (1.77% appreciation of the
dollar):
- Proceedings from the conversion to dollars =
EUR 1, 050× 1.13 = USD 1, 186.50
- Total profit (USD) = USD 1, 186.50− USD 1, 173 = USD 13.50
Scenario 2 - One-year EUR/USD exchange rate (3.60% appreciation of the
dollar):
- Proceedings from the conversion to dollars =
EUR 1, 050× 1.11 = USD 1, 165.50
- Total profit (USD) = USD 1, 165.50− USD 1, 173 = −USD 7.50
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Foreign exchange exposure
Foreign exchange exposure: measure of the potential for a firm’s main economic
and financial figures - i.e. profitability, net cash flow, market value, etc. - to
change due to changes in exchange rates
It is crucial for a financial manager to measure foreign exchange exposure and to
manage it, in the firm’s best interest
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Foreign exchange exposure
The three main types of corporate foreign exchange exposure are:
- Transaction exposure: occurs due to changes in the value of outstanding
financial obligations incurred prior to a change in exchange rates, but due to be
settled only after the exchange rate changes
- Translation exposure: potential for accounting-derived changes in financial
statements, due to the need of converting (in other words, ’translating’) foreign
currency financial statements of foreign subsidiaries into a single reporting
currency, in order to prepare consolidated statements
- Operating exposure: changes in the present value of the firm resulting from
any unexpected changes in exchange rates
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Foreign exchange exposure - Hedging
Hedge: financial/investment position, created to reduce potential losses (due to
other positions) suffered by an individual or organization
A hedge can be constructed with (virtually) any type of financial instrument
A hedge may be used to reduce the risk associated with (virtually) any type of
financial position
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Foreign exchange exposure - Hedging
Arguments in favor of hedging:
- Improvement of the planning capability of the firm, as it reduces the risk of
future cash flows. This also improves the firm’s credit quality, as it decreases
the probability that future cash flows will not be sufficient to make
debt-service payments
- Given the level of disclosure provided by the firm, management teams have a
comparative advantage over the individual shareholder in knowing the actual
currency risk of the firm
- Management teams are in a better position to take advantage of selective
hedging opportunities, which enhance firm value
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Foreign exchange exposure - Hedging
Arguments against hedging:
- Shareholders are more capable of diversifying currency risk than is the
management of the firm. If stock holders do not wish to accept the currency risk
of any specific firm, they can diversify their portfolio to manage the risk in a way
that satisfies their individual preferences and risk tolerance
- Rather than increasing the expected cash flows for the firm, hedging consumes
resources and reduces cash flows
- Management is generally more risk averse than shareholders, which makes them
conduct hedging activities that are not in the best interest of shareholders
- Management cannot know more than the market does, and as such the expected
net present value of hedging should be zero
- Proponents of the efficient markets theory believe prices already include foreign
exchange risk. Therefore, hedging only adds costs
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Foreign exchange exposure - Transaction exposure
Transaction exposure may arise in several situations
Situation 1 - Purchasing or selling goods or services on credit, when prices
are stated in foreign currencies
- Example: EURO (an European firm) bought merchandise from USA (a US
firm), for USD 1,000,000, with payment to be made in 60 days
- The spot EUR/USD is at 1.12, and as such EURO expects to purchase the
necessary USD 1,000,000 with USD 1,000,000/1.12 = EUR 892,857.14 when
payment is due
- Because accounting practices stipulate that foreign currency transactions must
be listed at the spot exchange rate in effect on the transaction date, the firm’s
books must reflect an account payable of EUR 892,857.14
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Foreign exchange exposure - Transaction exposure
Situation 1 (cont.)
- In this situation, foreign exchange exposure arises from the potential future
changes in the EUR/USD. For example, if the EUR weakens to 1.1 60 days later,
EURO will have to pay USD 1,000,000/1.1 = EUR 909,090.91, with a EUR
16,233.50 loss on the purchase
- On the other hand, if the euro strengthens to 1.2, EURO will pay USD
1,000,000/1.2 = EUR 833,333.33, booking a EUR 59,523.81 gain on the purchase
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Foreign exchange exposure - Transaction exposure
Situation 2 - Borrowing or lending funds in a foreign currency
- Example: following the previous example, EURO has a USD 1,000,000
outstanding debt to a US bank, payable in one year. Today, the spot EUR/USD is
at 1.12, so EURO expects to pay USD 1,000,000/1.12 = EUR 892,857.14 in one
year
- In this situation, foreign exchange exposure arises also from the potential future
changes in the EUR/USD. For example, if the EUR weakens to 1.1 in one year.
EURO will have to pay USD 1,000,000/1.1 = EUR 909,090.91, with a EUR
16,233.50 increase on the amount to be reimbursed
- On the other hand, if the EUR strengthens to 1.2, EUR will pay only USD
1,000,000/1.2 = EUR 833,333.33, with a EUR 59,523.81 decrease on the amount
to be reimbursed
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Situation 3 - Being a party to an unperformed foreign exchange forward
contract
Situation 4 - Otherwise acquiring assets or liabilities denominated in foreign
currencies
We will get back to this...
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Financial derivatives: financial contracts between two parties, whose value
derives from the value of other asset, index, interest rate or exchange rate,
generally named the underlying asset
In the context of the MNE, derivatives may be used for hedging purposes, i.e., to
reduce the risks associated with cash flows, or for speculation purposes, i.e., to
take positions in the expectation of profit
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Futures contract: financial contract between two parties, which constitutes an
alternative to forward contracts, and involves the future delivery of a standard
amount of an asset at a fixed time, place and price. There are futures
contracts on equities (stocks and indexes), bonds and interest rates,
exchange rates, commodities, etc.
In a futures contract:
- The party agreeing to buy the underlying asset, i.e., the buyer of the contract, is
said to be long
- The party agreeing to sell the underlying asset, i.e., the seller of the contract, is
said to be short
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One of the main characteristics of futures contracts is that both parties (the buyer
and the seller of the contract) are required to put up an initial cash amount,
called margin or collateral
Contracts are marked-to-market daily (i.e. the contract is revalued using the
closing price for the day), and all changes in value are paid in cash. The paid
amount is generally called variation margin. If the margin amount falls below a
pre-specified amount named maintenance margin, the trader is expected to post
a margin call, enough to raise the collateral value to the initial margin value
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On the delivery date, the exchange is not made at the specified contract
price, but at the spot price, because all gains and losses have already been
settled by mark-to-market procedures
Futures contracts are most generally traded with clearinghouses (owned and
guaranteed by all members of the exchange). This way, technically all contracts
are between the trader and the clearinghouse, and not between the two parties
Only a small percentage of futures contracts are settled by the physical
delivery of foreign exchange between the parties. Generally, both buyers and
sellers offset their original position prior to delivery by taking an opposite
position
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Main differences between futures contracts and forward contracts:
- Futures are standardized and exchange-traded contracts, whereas forwards are
customized and traded over-the-counter
- Futures are margined contracts, while forwards are not
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Example 1 - Futures contract on equities (illustration without daily
settlements: on a given Thursday, a trader decides to buy a futures contract on
stocks of XYZ. Suppose that:
- Current futures price: EUR 100 per stock
- Contract size: 100 stocks (since the trader bought two contracts, he/she has
contracted to buy a total of 200 stocks)
- The contract will be closed on Friday of the following week
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Suppose now that, on the Friday of the following week, the stock may be quoted
at one of two prices: EUR 50 (-50% decrease on the stock price) and EUR
150 (+50% increase on the stock price)
In the first scenario:
- The long position will be obligated to buy 200 stocks at EUR 100 per stock
(spending a total of EUR 20,000), but the ending position will value only 50%
of that, i.e., EUR 10,000
- The short position will (happily) be obligated sell 200 stocks at EUR 100 per
stock (earning a total of EUR 20,000), but in the reality that position valued
only 50% of that, i.e., EUR 10,000
- In this case, the short position will have a 50% gain on the trade, but the long
position will have to post a 50% loss, which may considerably increase its credit
risk before other counterparties
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In the second scenario:
- The long position will be obligated to buy 200 stocks at EUR 100 per stock
(spending a total of EUR 20,000), but the ending position will value 50%
more, i.e., EUR 30,000
- The short position will have to sell 200 stocks at EUR 100 per stock (earning
a total of EUR 20,000), but the market value of that position was EUR 30,000
- Here, the long position will have a 50% gain on the trade, but the short position
will have to post a 50% loss, which may also considerably increase its credit risk
To prevent these situations from happening, which may cause domino effects and
endanger the stability of the financial systems as a whole, the mechanism for daily
settlements of futures contracts was introduced
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Example 2 - Futures contract on equities (illustration with daily settlements:
on a given Thursday, a trader decides to buy a futures contract on stocks of XYZ.
Suppose that:
- Current futures price: EUR 100 per stock
- Contract size: 100 stocks (since the trader bought two contracts, he/she has
contracted to buy a total of 200 stocks)
- Initial margin: EUR 350 per contract (EUR 700 in total)
- Maintenance margin: EUR 200 per contract (EUR 400 in total)
- The contract will be closed on Friday of the following week
The next table illustrates the operation of the margin account for one
possible sequence of futures prices, in the long position
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Example 2 - Futures contracts on equities - Margin account operations
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The total long position result (in EUR) will be:
Result = (98.20− 100.00)× 2× 100 = −360
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