INTERNATIONAL FINANCE MANAGEMENT

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INTERNATIONAL FINANCE

MANAGEMENT

CONTENT


Introduction


CH
1: WORLD

S MONETARY SYSTEM


CH 2: FOREIGN EXCHANGE RISK MANAGEMENT


CH

3
: CHALLENGES IN GLOBAL FINANCI
AL MARKET



CH
4
: THE MULTINATIONAL FINANCIAL SYSTEMS



CH
5
: INTERNATIONAL AND MULTINATIONAL BANKING


SYSTEMS



CH
6
: EXCHANGE RATE
REGIME
-

A HISTORICAL RET
ROSPECTIVE















Introduction


Since the beginning in the 1980, there has been an explosion in the international investment
through mutual funds, insurance products, bank derivatives, and other intermediaries by individual
firms and through direct

investments by institutions. On the other side of the picture, you must have
realized that the capital raising is occurring at a rapid speed across the geological boundaries at the
international arena. In the given scenario, financial sector


especially
the international financial and
banking institution cannot be anything but go international. With the India’s entry into the world trade
organization since 1st January 1995 and consequent upon a series of economic and banking
reforms, initiated in India si
nce 1991, barriers to international flow of goods, services and investments
have been removed. In effect, therefore, Indian economy has been integrated with the global
economy with highly interdependent components.

Rapid advancement in science and technol
ogy


especially supported by astronomical
development and growth in telecommunication and information technology, has provided a cutting
-

edge and global leadership for India to participate in the international business. This, in turn, has
stimulated a ph
enomenal growth in India’s proactive participation in international exchange of goods,
services, technology and finance so as to knit national economies into a vast network of global
economic partners.

In the given scenario, as you are exposed to above, t
he financial managers now, in a fast
growing economy, such as India, must search for the best price in a global market place. A radical
restructuring of the economic systems, consisting of new industrial policy, industrial and banking
deregulation, liberal
ization of policies relating to foreign direct investment, public enterprise reforms,
reforms in taxation, trade liberalization etc. in the post
-

liberalization era, has provided the right
ambience for India to participate more aggressively in internationa
l financial market.

To accommodate the underlying demands of investors and capitals raisers, financial
institutions and instruments need now to change dramatically to cope with the global trends.

Financial deregulation, first in the United States, and th
en in Europe and in Asia, has prompted
increased integration of the world financial markets. As a result of this rapidly changing scene,
financial managers today must have a global perspective

In this unit we try to help you to develop and understanding o
f this complex, vast and
opportunistic environment and explore how a company or a dynamic business manager goes about
making right decisions in an international business environment with sharp focus an international
financial management.

The field of inte
rnational finance has witnessed explosive growth dynamic changes in recent time.
Several forces such as the following have stimulated this transformation process:



Change in international monetary system from a fairly predictable system of exchange.



Emerge
nce of new institutions and markets, involving a greater need for international financial
intermediation.



A greater integration of the global financial system.































CHAPTER 1


WORLD MONETARY SYSTEM

AND
FOREIGN EXCHANGE MARKET


Wor
ld Monetary System


In order to understand the present world monetary system, it is helpful to look at development
during the last few decades. From the end of the Second World War until February 1973, an
adjustable peg exchange rate system
-

administered
by the international monetary fund, prevailed.
Under this system, the US dollar, which was linked to gold ($35 per ounce), served as the base
currency. Other currencies were expressed in terms of the dollar and through this standard; exchange
rates between

currencies were established. A special feature of this system was that close control
was exercised over the exchange rates between various currencies and the dollar


a fluctuation of
only ±one percent was allowed around the fixed exchange rate.

What mec
hanism was used to hold fluctuations within one per cent limit? Central banks of
various countries participated actively in the exchange market to limit fluctuation. For example, when
the rupee would fall vis

a


vis other currencies, due to forces of dem
and and supply in the
international money and capital markets, the Reserve Bank of India would step in to buy rupees and
offer gold or foreign currencies in exchange to buy the rupee Rate. When the rupee rate tended to
rise, the Reserve Bank of India sells

Rupees.

What happened when the central bank of a country found it extremely difficult to maintain the
exchange rate within limits? If a country experienced continued difficulty in preventing the fall of its
exchange rate below the lower limit, it could w
ith the approval of the international monetary fund,
devalue its currency. India, for example, devalued its currency in 1966 in a bid to cope with its
balance of payments problem. A country enjoying continued favorable balance of payments situation
would f
ind it difficult to prevent its exchange rate from rising above the upper limit. Such a country
would be allowed, again with the approval of the International Monetary Fund, to revalue its currency.
West Germany for example, was allowed to revalue its curr
ency in 1969.


Present System of Floating Exchange Rates


In 1971, the US dollar was delinked with gold. Put differently, it was allowed to ‘float’. This
brought about a dramatic change in the international monetary system. The system of fixed exchange
r
ates, where devaluations and revaluations occurred only very rarely, gave way to a system of
floating exchange rates.

In a truly floating exchange rate regime, the relative prices of currencies are decided entirely
by the market forces of demand and suppl
y. There is no attempt by the authorities to influence
exchange rate movements or to target the exchange rate. Such an idealized free float probably does
not exist. Governments of almost all countries regard exchange rate as an important macro
-

economic va
riable and attempt to influence its movements either through direct intervention in the
exchange markets or through a mix of fiscal and monetary policies. Such floating is called managed
or dirty float.

Unlike the Breton Woks era, there are few, if any, r
ules governing exchange rate regimes
adopted by various countries. Some countries allow their currencies to float with varying degrees and
modes of intervention, some tie their currencies with a major convertible currency while others tie it to
a known bas
ket of currencies, and the general prescription is that a country must not manipulate its
exchange rate to the detriment of international trade and payments.

The exchange rate regime of the Indian rupee has evolved over time moving in the direction of les
s
rigid exchange controls and current account convertibility.

The RBI manages the exchange rate of the rupee. More specifically, during the last two years
or so, the RBI has been intervening heavily in the market to hold the rupee


dollar rate within tig
ht
bounds while rupee rates with other currencies fluctuate as the US dollar fluctuates against them.

These changes in the exchange rate regime have been accompanied by a series of measures
relaxing exchange control as well as significant l
iberalization o
f foreign trade.



Foreign Exchange Market


An economic transaction is an exchange of value, which typically involves a transfer of title to
an economic good from one party to another. Normally, an economic transaction involves a payment
and a rec
eipt of money in exchange for an economic good, service or asset. But in barter system,
goods are exchanged fo
r goods, assets against assets.


Characteristics of Foreign Exchange Market




Barter exchange (Double coincidence of wants): In the foreign exchang
e market, for anybody
wanting to sell dollars to get British pound, there must be someone else wanting to sell the
pound for the dollar at the same exchange rate (like in barter exchange). The FE market
performs an international clearing function by bringi
ng two parties wishing to trade currencies
at agreeable exchange rates.



The FE market takes place between dealers and brokers in financial centers around the world.
During the hours of business common to different time zones, they rapidly exchange shortha
nd
messages expressing their bids for different currencies. To make a profit on FE maneuvers, a
trader or broker has to make quick decisions correctly. Foreign exchange traders lead an
exciting and hectic life, and the pressure often shortens many careers.




The fastest possible communications are used. Before the trans
-
Atlantic cable was laid in 1865
by Cyrus West Field (after many failed attempts), somebody wanting to exchange dollars for
pounds often had to wait the time required for a roundtrip voyage to

clear up the transaction.
Modern telephone links have reduced the transaction costs on foreign exchange to near zero
for large transactions.


The advantages of the Foreign Exchange Market


The daily volume of business dealt with on the foreign exchange m
arkets in 1998 was
estimated to be over $2.5 trillion dollars. (Daily volume on New York Stock Exchanges is about $20
billion) Today (2006) it may be about $5 trillion dollars. The daily volume of the foreign exchange
market in North America in October 200
5 was about $440 billion. The Foreign Exchange market
expanded considerably since President Nixon closed the gold window and currencies were left afloat
vis
-
á
-
vis other currencies and speculators could profit from their transactions.

Until recently, this
market was used mostly by banks, who fully appreciated the excellent
opportunities to increase their profits. Today, it is accessible to any investor enabling him to diversify
his portfolio.

The emergence of Yen as a major currency, and new Euro, in addit
ion to the Dollar beside
many other currencies, and the frequent fluctuations in relative value of these currencies provide a
great opportunity to generate substantial profits. Chinese Renminbi is convertible on current account,
but not on capital account.

When it becomes fully convertible, which is not likely to occur until 2020 or
later, it will fundamentally affect the foreign exchange market due to its sheer volume.

The foreign exchange market operates 24 hours a day permitting intervention in the majo
r
international foreign exchange markets at any point in time.





Some Foreign Exchange Customs




Although there is an exchange rate between the domestic currency and every other currency,
most FE transactions involve only a small number of international
currencies.



Average daily transactions in 1998 was over $2.5 trillion. $637B (London), $351B (New York),
$149B (Tokyo).



Before the single currency euro was launched in 2002, the composition of foreign currency
transactions in the New York market in 1985
was as follows: Mark 32%, Pound 23%, Canada
$ 12%, Yen 10%, Swiss Franc 10%, others 13%.



The introduction of euro in 2002 dramatically changed the composition of these foreign
currencies as most of European currencies were no longer circulated. The foreig
n exchange
markets were handling over $450 billion per day through New York, London and Frankfurt.
(most market economies have less GNP). Today it is estimated to be more than $5T a day.



The exchange rate is the domestic price of a foreign currency. The F
E quotations list selling
price in dollars or foreign currency per dollar.



The selling price refers to the price at which a large customer could have bought the currency
from the dealers. The buying price at which one could have sold foreign currency to t
he
dealers is normally 0.1% below the selling price, which represents the commission of FE
dealers or banks. This is called interbank trading as it occurs usually between foreign
exchange dealers in different banks in major financial centers. Obviously, th
e "retail" rates for
corporate customers are less favorable than the "wholesale" rates.



This spread can be higher in foreign exchange markets other than New York/London, and also
in exchange crisis, and in rarely traded currencies. Because the market part
icipants know this
customary spread, usually selling prices are published.



For most currencies, only a spot rate is quoted. Spot exchange is foreign exchange for
immediate delivery that is used for international payments (for imports and investment). The
daily quotations are for bank (cable) transfers. While transactions between these banks are
instantaneous, these funds become available for use by customers 1
-
2 working days after the
purchase.



Transactions agreed on Monday will result in payments on Wedn
esday. Those agreed on
Thursday will be available on Monday. Canadian/US dollar business is cleared in one day
(because Toronto and New York are in the same time zone).



Some New York banks maintain 2 shifts (one arriving at office at 3 am when London and
Frankfurt are open). Large New York banks also have branches in Tokyo, Frankfurt, and
London. Thus, they are in contact with all financial centers 24 hours.



When a FE dealer or broker quotes a price on the telephone, he can be held to it for only a few
se
conds (It used to be up to 1 minute). Dealers may quote different prices to different
customers. Prices change throughout the day. Bluffing/counterbluffing for a large sum of FE.
For average customers, it does not pay to get more than one quote.



Bank note
s: Buying and selling rates for bank notes may be listed. Prices do not change
throughout the day. Selling price for BN may be higher/lower than the selling price for Cable
transfers. The spread is much larger than 0.1% for cable transfers, and may go up t
o 5
-
10%.



Forward Rates: forward rates are for currency to be delivered 30, 90 or 180 days later at the
known price on a given day. Forward rates are available for major international currencies.



Currency futures markets were established by Chicago Mercan
tille exchange in 1972. Futures
prices are for contracts applicable to a specific calendar dates (Third Wednesday of June,
September, December and March).


Participants of the Foreign Exchange Market




Retail customers = importers/exporters of goods, servi
ces and financial assets (stocks/bonds).
They are most numerous. They buy and sell FE for transaction purposes. These do not usually
trade currencies one another because it is difficult to match double coincidence of wants.
Instead they go to a commercial
bank for the transaction.



FE dealers = they are large commercial banks, which buy and sell FE. Specifically, they are
the international departments of large commercial banks in the financial centers of the world:
London, New York, Tokyo, zurich, Frankfurt
, Paris, Singapore, Hong Kong, Toronto. In New
York City, there are about 100 such banks. Large banks outside the center also participate
through their affiliates. Small regional banks do not directly participate in the FE market. But to
meet their custome
rs' FE need, they deal with correspondant banks. Almost 14,000
commercial banks maintain corresponent relationship with FE dealers.



FE dealers typically maintain a trading room equipped with telephones and telex machines.
They ususally communicate directl
y with the trading rooms of banks in other centers. They go
through a broker when dealing with other banks in the same center. They are exposed to FE
risks.



FE broker: These are wholesale dealers between FE dealers. FE dealers may develop
shortage/surplus
. Then they go to brokers. Brokers do not take open positions in the FE
market. There are 8 brokers in New York, and less than 100 in the U.S. They usually
specialize in a few currencies, and earn commission = 1/10 of 1%
-

1/8 of 1%.



Central Banks: partic
ipate (i) to facilitate Treasury's transactions, and (ii) to prevent or effect a
change in the value of their currency.

o

in the US, Federal Reserve Bank of NY acts as agent for the entire Federal Reserve
System and the Treasury Department.

o

it usually try
to conceal its intervention. It may
requires

an obscure bank in Midwest to
place an order in the New York market.

o

Sometimes it tries to publicize its buying intent.


Exchange Arbitrage




Exchange arbitrage
involves

the simultaneous purchase and sale of a
currency in different
foreign exchange markets. Thus, arbitragers take a closed position.



Arbitrage becomes profitable whenever the price of a currency in one market differs from that
in another market.



Suppose the pound quoted in NY is $1.75, but pound
quoted in London is $1.78. Then an
arbitrager in NY and his partner in London can take the following steps:

o

buy 10 M pounds in NY: cost = $17.5 M

o

sell 10 M pounds in London: revenue = $17.8 M

o

profit = $300,000 less the cost of telephone, cable transfer.

The supply of pound shrinks in NY, increases in London.



Effect of arbitrage = wipe out the spread in exchange rates between FE markets.


Currency Speculation




Speculators assume an open position, i.e., take risk in the FE markets. Their intention is to

make windfall gains from the fluctuations in the FE markets.




When speculators expect a rise in the exchange rate in the future, they go long (buy that
currency), i.e., buy FE if ESt+1 > St.

They go short by selling FE if they expect a fall in the excha
nge rate, sell FE if ESt+1 < St.




in the forward market for pound,

if F90 > ES90, then sell forward pound

if F90 < ES90, then buy forward pound.



Speculation under fixed exchange rate system is destabilizing. If dollar is weak, the
speculators correctly

expect that dollar will be depreciated soon and sell dollar. This makes it
harder for government to defend its exchange rate.


Forward Exchange Rate


Forward exchange markets deal in promises to sell or buy foreign exchange at a specified
rate, and at a s
pecified time in the future with payment to be made upon delivery. These promises are
known as forward exchange and the price is the forward exchange rate. Forward exchange markets
do not operate during periods of hyperinflation.

The forward exchange mark
et resembles the futures markets found in organized commodity
markets, such as wheat and coffee. The primary function of forward market is to afford protection
against the risk of fluctuations in exchange rates. Forward markets are most useful



under flexi
ble exchange rate system and if there are significant exchange variations,



under fixed exchange rate system, if there is a strong possibility of devaluation/revaluation,



it cannot function when exchange control is imposed.



it cannot function during peri
ds of hyperinflation.


Interest Parity Theory (Keynes)



When short term interests are higher in one market than in another, investors will be motivated
to shift funds between markets, say New York and London. Investors borrow (or buy) a low inte
rest
currency and lend the same amount in a high interest currency. This is called carry trade. There is
roughly a 5% difference in the interest rates between Japan and the US. To make profits from
differeing interest rates, investors must convert, for exa
mple, dollars (a low interest currency) into
pound sterling (a high interest currency) for investment in London. However, they would be exposed
to an exchange risk. If the exchange rate is stable, the investors gain the interest differential, (i
-

i*),
by
shifting funds from New York to London.


If pound appreciates during the investment period, the foreign investors will reap additional gain
in the change in the exchange rate. However, if pound depreciates, they will experience an exchange
loss.
The exchange loss may partially or more than offset the gain in the interest income.


To avoid this exchange loss, dollar investors want cover against the exchange loss by selling
pound forward. The amount of forward pound to sell is equal to the

purchase of spot pound plus the
interest earned in London. This practice is called interest arbitrage. Interest arbitrage links the two
national money markets and the forward market.


Assume:

a US investor has A dollars to invest, either in New York or i
n London. The annual interests
in the US and the UK are 8% and 12%, respectively. The quarterly interest rates in the US and UK
are then 2% and 3%, respectively.


Do Nothing (Take Risk)

(1) Invest in New York for 90 days.

$1M(1 + .02) = $1.02M

(2) Inve
st in London

£t=0 = $1M/spot = $1M/1.5 = £666,667.

If St=90 = St=0, then investing overseas is better ($10,000 more return).

If St=90 = 1.65 (£ rose 10%), then

$10,000 (interest gain) + $103,000 (appreciation of £) = $113,000 (foreign investment is defi
nitely
better).

If St=90 = 1.35 (£ fell 10%), then

$10,000 (interest gain)
-

$103,000 (depreciation of £) =
-

$93,000.

Most investors would rather avoid this exchange risk.

How does one avoid this risk?


You may enter the forward exchange market. As lon
g as the return from overseas investment
is greater than the domestic return, one would sell forward pound (or whichever currency in question).
Only when the forward transactions are made, the risk can be avoided. However, avoiding the foreign
exchange ris
k may be too costly, in which case it is not profitable to avoid the risk.

If F = $1.47, then

S
t=90

= 686.667 x 1.47 < 1.02 million. You are worse off. Even if i* > i, do not invest in the UK. (That is,
taking the foreign exchange risk is cheaper)

If F = $
1.53, then

S
t=90

= 686.667 x 1.53 >1.02 million. You are better off. Invest in the UK. (In this case, forward
transactions are profitable and eliminate the foreign exchange risk.)


Enter the Forward Exchange Market



If one invested A dollars in New York, t
hen at the end of 90 days, the return will be

(1) A(1 + i)

i = i
90

= annual interest rate ÷4. However, the subscript 90 is suppressed (too cumbersome)



If one invested in London (by buying pounds in the spot market, and selling pound forward, the
investo
r can cover against the exchange risk (interest arbitrage)

(2) A(1 + i*)(F/S)

F = price of one pound sterlilng for delivery 90 days hence

S = price of one pound sterling in the spot market

Interest arbitrarage will cause the forward rate to adjust to t
he interest rate differential until it
reaches an equilibrium rate. This equilibrium rate F is determined by

(3) A(1 + i) = A (1 + i*)(F/S).

(4) F = S(1 + i)/(1 + i*).

Since i and i* are small fractions, this is approximately equal to:

F = S(1 + i
-

i*
), or

i
-

i* = (F
-

S)/S.

That is, if the domestic interest rate is higher, the forward pound must be sold at a
premium. Specifically, the domestic interest advantage (i
-

i*) must be equal to %premium on
the forward pound when the forward rate is at its

parity. For example,
if the domestic interest is
1% above the foreign interest rate, forward pound must be higher than the spot rate by the
same proportion

to prevent capital flows.



Covered Arbitrage Margin (CAM)

= (i
-

i*)
-

(F
-

S)/S.

If i
-

i* > (F
-

S)/S, then K* inflow occurs. (Domestic investors have no incentive to invest
abroad, but foreign investors will invest in America)

If i
-

i* < (F
-

S)/S, then K outflow occurs. (Foreign investors will stay put, but domestic
investors will move funds abro
ad)

Remark:

If i = i*, there is no incentive for any investors to move funds between countries,
except for the forward premium. In this case, if F > S, domestic investors would make money
by selling forward currency and invest abroad. As a matter of fact,

if the forward premium is
sufficiently large and more than offset the possible interest loss (i
-

i* > 0), one could invest
overseas.



If i
-

i* = (F
-

S)/S, then no capital flow.

Let F
o

be the rate at which no capital flow occurs. If F = F
o
, then the fo
rward rate is at its
interest parity.

Federal Reserve Bulletin publishes CAM, e, i, i*. CAM are very nearly zero.

Problems of IRP Theory

Keynes' theory does not take into account differing investment risks between the two countries.



Interest rates in dev
eloping and transition economies are generally higher, due to higher risks.



Inflation rates also differ between countries. It is not the nominal payoffs, but real interest rates. Thus,
different inflation rates will affect investment decisions.

Foreign Exc
hange Markets and Rates


The foreign exchange market is the market where one country’s currency is traded for others.
It is the largest financial market in the world. The daily turnover in this market in mid


2000s was
estimated to be about $1600 billion
. Most of the trading, however, is confined to a few currencies: the
US dollar ($), the Japanese Yen, the Euro, the German deutsche mark (DM), the British pound
sterling, the Swiss France (SF), and the French franc (FF). Exhibit 1 lists some of the major
I
nternational currencies along with their symbols:

Exhibit 1: Major International Currencies and Their Symbols


Exhibit 1: Major International Currencies and Their Symbols


County

Currency

Symbol

Australia

Dollar

A$

Austria

Shilling

Such

Belg
ium

Franc

BF

Canada

Dollar

Can $

Denmark

Crone

Dkr

EMU

Euro



Finland

Markka

FM

France

Franc

FF

Germany

Deutsche
mark

DM

Greece

Drachma

Dr

India

Rupee

Rs

Iran

Rial

RI

Italy

Lira

Lit

Japan

Yen

¥

Kuwait

Dinar

KD

Mexico

Peso

Ps

Netherlands

Gulder

FL

Norway

Krone

NKr

Saudi Arabia

Riyal

SR

Singapore

Dollar

S$

South Africa

Rand

R

Spain

Peseta

Pta

Sweden

Krona

Skr

Switzerland

Franc

SF

United kingdom

Pound



United states

D
ollar

$


CHAPTER 2


FOREIGN EXCHANGE RISK MANAGEMENT



Purpose

This document sets out the minimum policies and procedures that each financial institution
needs to have in place and apply within its foreign exchange risk management programme, and the
mi
nimum criteria it should use to prudently manage and control its exposure to foreign exchange risk.

Foreign exchange risk management must be conducted in the context of a comprehensive business
plan. Although this document focuses on the responsibility of

an institution for managing foreign
exchange risk, it is not meant to imply that foreign exchange risk management can be conducted in
isolation from other risks or asset/liability management considerations, such as the paramount need
to maintain adequate
liquidity.



Definition


Foreign exchange risk is the exposure of an institution to the potential impact of movements in
foreign exchange rates. The risk is that adverse fluctuations in exchange rates may result in a loss in
Jamaican dollar terms to the
institution.

Foreign exchange risk arises from two factors: currency mismatches in an institution’s assets
and liabilities (both on
-

and off
-
balance sheet) that are not subject to a fixed exchange rate vis
-
a
-
vis
the Jamaican dollar, and currency cash flow

mismatches. Such risk continues until the foreign
exchange position is covered. This risk may arise from a variety of sources such as foreign currency
retail accounts and retail cash transactions and services, foreign exchange trading, investments
denomin
ated in foreign currencies and investments in foreign companies. The amount at risk is a
function of the magnitude of potential exchange rate changes and the size and duration of the foreign
currency exposure.






Foreign Exchange Risk Management Program
me


Managing foreign exchange risk is a fundamental component in the safe and sound
management of all institutions that have exposures in foreign currencies. It involves prudently
managing foreign currency positions in order to control, within set paramet
ers, the impact of changes
in exchange rates on

the financial position of the
institution. The frequency and direction of rate
changes, the extent of the foreign currency exposure and the ability of counterparts to honour their
obligations to the instituti
on are significant factors in foreign exchange risk management.

Although the particulars of foreign exchange risk management will differ among institutions
depending upon the nature and complexity of their foreign exchange activities, a comprehensive
fore
ign exchange risk management programme requires:



establishing and implementing sound and prudent foreign exc
hange risk management policies;




developing and implementing appropriate and effective foreign exchange risk management
and control procedures.


F
oreign Exchange Risk Management Policies


Well articulated policies, setting forth the objectives of the institution’s foreign exchange risk
management strategy and the parameters within which this strategy is to be controlled, are the focal
point of effe
ctive and prudent foreign exchange risk management. These policies need to include:



a statement of risk principles and objectives governing the extent to which the institution is
willing to assume foreign exchange risk;




explicit and prudent limits on th
e institutions’ exposure to foreign exchange risk; and




clearly defined levels of delegation of trading authorities.



Statement of Foreign Exchange Risk Principles and Objectives


Before foreign exchange risk limits and management controls can be set i
t is necessary for an
institution to decide the objectives of its foreign exchange risk management programme and in
particular its willingness to assume risk.

The tolerance of each institution to assume foreign exchange risk will vary with the extent of
o
ther risks (e.g. liquidity, credit risk, interest rate risk, investment risk) and the institution’s ability to
absorb potential losses. As with other aspects of financial management, a trade
-
off exists between
risk and return. Although the avoidance of for
eign currency exposure or the hedging of such exposure
may eliminate foreign exchange risk, such a position may not be desirable for other sound business
reasons. Accordingly, the objective of foreign exchange risk m
anagement need not necessarily
be the
co
mplete elimination of exposure to changes in exchange rates. Rather, it should be to manage the
impact of exchange rate changes within self imposed limits after careful consideration of a range of
possible foreign exchange rate scenarios.


Foreign Exchang
e Risk Limits


Each institution needs to establish explicit and prudent foreign exchange limits, and ensure
that the level of its foreign exchange risk exposure does not exceed these limits. Where applicable,
these limits need to cover, at a minimum:



the

currencies in which the institution is permitted to incur exposure; and




the level of foreign currency exposure that the institution is prepared to assume.


Foreign exchange risk limits need to be set within an institution’s overall risk profile, which
reflects factors such as its capital adequacy, liquidity, credit quality, investment risk and interest rate
risk. Foreign exchange positions should be managed within an institution’s ability to quickly cover
such positions if necessary. Moreover, foreign e
xchange risk limits needs to be reassessed on a
regular basis to reflect potential changes in exchange rate volatility, the institution’s overall risk
philosophy and risk profile.

Authorised currencies will normally include currencies in which the institu
tion may be called on
to settle foreign exchange transactions. These are usually the currencies in which the institution or its
customers conduct business.

Limits on an institution’s foreign exchange exposure should reflect both the specific foreign
curre
ncy exposures that arise from daily foreign currency dealing or trading activities (transactional
positions) and those exposures that arise from an institution’s overall asset/liability infrastructure, both
on
-

and off
-
balance sheet (structural or translat
ional positions). The establishment of aggregate
foreign exchange limits that reflect both foreign currency dealing and structural positions helps to
ensure that the size and composition of both positions are appropriately and prudently managed and
control
led and do not overextend an institution’s overall foreign exchange exposure.

Usually, risk limits are established in terms of a relationship between the foreign exchange
position and earnings or capital, or in terms of foreign exchange volume, such as to
tal dollars or
numbers of transactions.

Although the overall assessment of foreign exchange counterparties is an integral component
of any foreign exchange operation, this may be conducted by an institution’s credit risk management
function, thus obviatin
g the need for separate counterparty assessment within the institution’s foreign
exchange operations.


Delegation of Authority


Clearly defined levels of delegated authority help to ensure that an institution’s foreign
exchange positions do not exceed t
he limits established under its foreign exchange risk management
policies. Authorities may be absolute, incremental or a combination thereof, and may also be
individual, pooled, or shared within a committee.

The delegation of authority needs to be clearly

documented, and must include at a minimum,



the absolute and/or incremental authority being delegated;




the units, individuals, positions or committees to whom authority is being delegated;




the ability of recipients to further delegate authority; and




the restrictions, if any, placed on the use of delegated authority.


The extent to which authority is delegated will vary among institutions according to a number of
factors including:



the institution’s foreign exchange risk philosophy;




the size and n
ature of an institution’s foreign exchange operations; and




the experience and ability of the individuals for carrying out the foreign exchange risk
management activities.


Foreign Exchange Risk Management and Control Procedures



Each institution engage
d in foreign exchange activities is responsible for developing,
implementing and overseeing procedures to manage and control foreign exchange risk in accordance
with its foreign exchange risk management policies. These procedures must be at a level of
soph
istication commensurate with the size, frequency and complexity of the institution’s foreign
exchange activities.

Foreign exchange risk management procedures need to include, at a minimum:



accounting and management information systems to measure and moni
tor foreign exchange
positions, foreign exchange risk and foreign exchange gains or losses;




controls governing the management of foreign currency activities; and




independent inspections or audits.



Measurement of Foreign Exchange Risk


Managing fore
ign exchange risk requires a clear understanding of the amount at risk and the
impact of changes in exchange rates on this foreign currency exposure. To make these
determinations, sufficient information must be readily available to permit appropriate actio
n to be
taken within acceptable, often very short, time periods.

It is only through the accurate and timely recording and reporting of information on exchange
transactions and currency transfers that foreign currency exposure can be measured and foreign
e
xchange risk controlled. Accordingly, each institution engaged in foreign exchange activities needs
to have an effective accounting and management information system in place that accurately and
frequently records and measures:



its foreign exchange exposu
re; and




the impact of potential exchange rate changes on the institution.


At a minimum, each institution should have in place monitoring and reporting techniques that
measure:



the net spot and forward positions in each currency or pairings of currenci
es in which the
institution is authorised to have exposure;




the aggregate net spot and forward positions in all currencies; and




transactional and translational gains and losses relating to trading and structural foreign
exchange activities and exposure
s.



Control of Foreign Exchange Activities


Although the controls over foreign activities will vary among institutions depending upon the
nature and extent of their foreign exchange activities, the key elements of any foreign exchange
control programme
are well
-
defined procedures governing:



organizational controls to ensure that there exists a clear and effective segregation of duties
between those persons who;


o


initiate foreign exchange transactions; and

o


are responsible for operational functions su
ch as arranging prompt and accurate
settlement, and timely exchanging and reconciliation of confirmations, or account for
foreign exchange activities.




procedural controls to ensure that:


o


transactions are fully recorded in the records and accounts of t
he institution;


o


transactions are promptly and correctly settled; and


o


unauthorized dealing is promptly identified and reported to management; and




controls to ensure that foreign exchange activities are monitored frequently against the
institution’s
foreign exchange risk, counterparty and other limits and that excesses are
reported.


Moreover, each institution needs to ensure that employees conducting foreign exchange
trading activities on behalf of the institution do so within a written code of cond
uct governing foreign
exchange dealing. Such a code of conduct should include guidance respecting trading with related
parties and transactions in which potential conflicts of interest exists. These should include trading
with affiliated entities, personal

foreign exchange trading activities of foreign exchange traders, and
foreign exchange trading relationships with foreign exchange and money market brokers with whom
the institution deals. Each institution should ensure that these guidelines are periodical
ly reviewed
with all foreign exchange traders.

The use of hedging techniques is one means of managing and controlling foreign exchange
risk. In this regard, many different financial instruments can be used for hedging purposes, the most
commonly used, bei
ng derivative instruments. Examples include forward foreign exchange contracts,
foreign currency futures contracts, foreign currency options, and foreign currency swaps.

Generally, few institutions will need to use the full range of hedging techniques or
instruments. Each
institution should consider which ones are appropriate for the nature and extent of its foreign
exchange activities, the skills and experience of trading staff and management, and the capacity of
foreign exchange rate risk reporting and c
ontrol systems.

Financial instruments used for hedging are not distinguishable in form from instruments that
may be used to take risk positions. Before using hedging products, institutions must ensure that they
understand the hedging techniques and that t
hey are satisfied that the instrument meets their specific
needs in a cost
-
effective manner.

Further, the effectiveness of hedging activities should be assessed not only on the basis of the
technical attributes of individual transactions but also in the c
ontext of the overall risk exposure of the
institution resulting from a potential change in asset/liability mix and other risk exposures such as
credit, interest rate and position risk.

In this context, hedging activities need to take place within the fr
amework of a clear hedging
strategy, the implications of which are well understood by the institution under varying market
scenarios. In particular, the objectives and limitations of using hedging products should be uniformly
understood, so as to ensure th
at hedging strategies result in an effective hedge of an exposure rather
than the unintentional assumption of additio
nal or alternate forms of risk.



Independent Inspections/Audits


Independent inspections/audits are a key element in managing and control
ling an institution’s
foreign exchange risk management programme. Each institution should use them to ensure
compliance with, and the integrity of, the foreign exchange policies and procedures. Independent
inspections/audits should, at a minimum, and over
a reasonable period of time, test the institution’s
foreign exchange risk management activities in order to:



ensure foreign exchange management policies and procedures are being adhered to;




ensure effective management controls over foreign exchange posi
tions;




verify the adequacy and accuracy of management information reports regarding the
institution’s foreign exchange risk management activities;




ensure that foreign exchange hedging activities are consistent with the institution’s foreign
exchange ri
sk management policies, strategies and procedures; and




ensure that personnel involved in foreign exchange risk management are provided with
accurate and complete information about the institution’s foreign exchange risk policies and
risk limits and posit
ions and have the expertise required to make effective decisions consistent
with the foreign exchange risk management policies.


Assessments of the foreign exchange risk operations should be presented to the institution’s
Board of Directors on a timely ba
sis for review.

Role of the board of directors


The Board of Directors of each institution is ultimately responsible for its exposure to foreign
exchange risk and the level of risk assumed. In disc
harging this responsibility, a
Board of Directors
usually
charges management with developing foreign exchange risk management policies for the
board’s approval, and developing and implementing procedures to measure, manage and control
foreign exchange risk within these policies.

A Board of Directors needs to hav
e a means of ensuring compliance with the foreign exchange
risk management programme. A Board of Directors generally ensures compliance through periodic
reporting by management and independent inspectors/auditors. The reports must provide sufficient
inform
ation to satisfy the Board of Directors that the institution is complying with its foreign exchange
risk management programme.

At a minimum, a Board of Directors should:



review and approve foreign exchange risk management policies based on recommendation
s
by the institution’s management;




review periodically, but at least once a year, the foreign exchange risk management
programme;




ensure that an independent inspection/audit function reviews the foreign exchange operations
to ensure that the institutio
n’s foreign exchange risk management policies and procedures are
appropriate and are being adhered to;




ensure the selection and appointment of qualified and competent management to administer
the foreign exchange function; and




outline the content and f
requency of foreign exchange risk reports to the board.


ROLE OF MANAGEMENT


The management of each institution is responsible for managing and controlling the
institution’s exposure to foreign exchange risk in accordance with the foreign exchange risk
m
anagement programme.

Although specific foreign exchange risk management responsibilities will vary from one
institution to another, management is responsible for:



developing and recommending foreign exchange risk management policies for approval by the
B
oard of Directors;




implementing the foreign exchange risk management policies;




ensuring that foreign exchange risk is managed and controlled within the foreign exchange risk
management programme;




ensuring the development and implementing of an approp
riate management reporting system
with respect to the content, format and frequency of information concerning the institution’s
foreign exchange risk position, in order to permit the effective analysis and sound and prudent
management and control of existi
ng and potential foreign exchange exposure;




establishing and utilizing a method for accurately measuring the institution’s foreign exchange
risk;




establishing procedures for accurately measuring realised and unrealised foreign exchange
trading gains an
d losses;




ensuring that an independent inspection/audit function reviews and assesses the foreign
exchange risk management programme;




establishing and implementing procedures governing the conduct and practices of foreign
exchange traders;




developing

lines of communication to ensure the timely dissemination of the foreign exchange
policies and procedures to all individuals involved in foreign exchange activities and the foreign
exchange risk management process;




reporting comprehensively on foreign e
xchange risk activities to the Board of Directors at least
once a year.




recommending counterparty limits.















CHAPTER 3


CHALLENGES IN GLOBAL FINANCIAL MARKET


Growth in World Trade


In Past Five Decades


The five decades, following the seco
nd war, have witnessed an enormous growth in the
volume of international trade. This was also the period when significant progress was made towards
removing the obstacles to the free flow of goods and services across nations. However, today, the
case for a
nd against free trade continues to be debated, international trade disputes in various forms
erupt between nations every once in a while, and protectionism in novel disputes in various forms
erupt between nations every once in a while, and protectionism in

novel disguised is raising its head
once again. Nevertheless, there is no denying the fact that the rapid economic growth and increasing
prosperity in the west and in some parts of Asia is mostly because of this ever
-

growing flow of goods
and services in

search of newer and more remunerative markets, and the resulting changes in the
allocation of resources within and across countries. Table 1 gives some idea of the pervasiveness of
cross
-
border trade in goods and services and its phenomenal growth since 1
950.

However, the growth in world trade has not been even, spatially or over different sub
-
periods,
during the four decades following the Second World War. But it has grown at a pace much faster than
the world output so that for many countries the share o
f exports in GDP has increased significantly.
Table 2 provides some data on the comparative average annual growth rates in real GDP and
exports for different country groupings, over different time periods.

Even developing countries like India, which for a

long time, followed an inward looking
development strategy, concentrating on import substitution have, in recent years, recognized the vital
necessity of participating vigorously in international exchange of goods, services, and capital. The
eighties witn
essed a significant shift in policy towards a more open economy, a considerable
liberalization of imports and a concerted effort to boost exports. Starting in 1991, the first half of the
1990s ushered in further policy initiatives aimed at integrating the
Indian economy with the
international economy. Quantitative restrictions on imports were to be gradually phased out as part of
WTO commitments, and import duties were also to be lowered. Foreign direct and portfolio
investments continued to show a rising t
rend.

Table 1. Growth of World Exports 1950

2000




World

Industrial countries

Developing countries


Asia

Other

1950

59.6

36.4

7.081

16.056

1961

124.8

88.7

9.704

26.196

1971

334.5

249.1

19.187

66.249

1981

1904.8

1238.3

172.92
4

493.637

1991

3501.4

2503.3

511.524

486.597

1995

5122.9

3470.7

926.205

726.298

1996

5352.3

3560.8

966.953

824.473

1997

5534.8

3640.5

1029.828

864.515

1998

5444.9

3656.5

974.751

813.431

1999

5577.2

3469.8

1041.820

803.5
40

2000

3134.7

1980.4

583.130

510.800


Table 2. Annual Growth Rates of Real GDP and Exports



1982
-
91

1992

1995

2000


GDP

EXP

GDP

EXP

GDP

EXP

GDP

EXP

Advanced economies

3.1

5.5

2.1

4.6

2.7

9.0

3.6

7.8

Developing countries

4.
3

4.2

6.4

10.4

6.1

11.9

5.4

10.2


A unified market determined exchange rate, current account convertibility, and a slow but
definite trend in the direction of liberalizing the capital account opened up the India economy to a
great extent.

In keep
ing with the commitments made to WTO, all quantitative restrictions on trade were
abolished at the end of March 2001. Further lowering of tariff barriers, greater access to foreign
capital, and finally, capital account convertibility were certainly on the
reform agenda of the Indian
government.

The apparently inexorable trend towards opening up of national economies and financial
markets and their integration into a gigantic global marketplace appeared to have suffered a serous
setback in 1997 and 1998 fol
lowing the east
-

Asian crisis and the Russian debacle. In particular,
doubts were raised regarding the advisability of the developing countries opting for an open capital
account, which might render them more vulnerable to the kind of currency crises that
rocked some of
the Asian Tigers in the summer of 1997. Some economists argued that the benefits of unfettered
cross border capital flow had been overestimated, while the enormous damage, that even a short

lived currency crisis can cause, had not been adeq
uately emphasized in policy discussions.
Extensive debates were conducted in various international fora on the subject of a new architecture
for the global financial system. While everyone agreed that the system needed closer monitoring and
some built
-

in
safeguards against systemic crises, what form the safeguards should be taken care of
remained an open question.


Foreign Direct Investment Opportunities


By 1999, some of the East Asian economies had recovered from the crisis and a sort of stable
order h
ad appeared to emerge in Russia. Multilateral negotiations regarding phased removal of trade
barriers had made considerable progress, and WTO had emerged as a meaningful platform to carry
these matters further. No serious reversal of the trend towards more

open financial markets had
taken place.

Today, along with the growth in trade, cross border capital flow and in particular, direct
investments have also grown enormously. The world has witnessed the emergence of massive
multinational corporations with pr
oduction facilities spread across the world. Singer et al (1991)
conjectured that “it is just possible that within the next generation about 400 to 500 of these
corporations will own about two thirds of fixed assets of the world economy”. Table 3 presents
a
selected data on the inflow of foreign direct investment into developing countries. Such an enormous
growth in international trade and investment would not have been possible without the simultaneous
growth and increased sophistication of the internation
al monetary and financial system. Adequate
growth in international reserves, that is means of payment in international transactions, an elaborate
network of banks and other financial institutions to provide credit, various forms of guarantees and
insurance
s, innovative risk management products, a sophisticated payments system, and an efficient
mechanism for dealing with short
-

term imbalances are all prerequisites for a healthy growth in trade.
A number of significant innovations have taken place in the int
ernational payments and credit
mechanisms, which have facilitated the free exchange of goods and services. Any company that
wishes to participate in trade on a significant scale must master the intricacies of the international
financial system.


Table 3.
Foreign Direct Investment Inflows into Developing Countries


(In US $ million)


1987

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India’s share in world trade has been continuously falling. Domestic industry is in a transitional phase,
learning to cope with the environment of greater competition from imports and multinationals as
bar
riers imposed by import quotas and high tariffs are being gradually dismantled, though even now,
trade barriers in India are among the highest in the world.

Table 4 presents some data on India’s growing dependence on international financial markets.
While

the rate of growth of total external debt has moderated during the latter half of nineties, there
has been a significant increase in the share of commercial borrowing and the share of non


government borrowing: facts not revealed by the summary data in T
able 4.





Table4. India’s Growing Dependence on International Financial Market


End March End Sept

Item

1991

1996

1998

1999

2000

2000

Total debt

83.80

93.73

93.53

97.
68

98.44

97.86

Long term debt

75.26

88.70

88.49

63.29

94.40

93.36

Short term debt

8.54

5.03

5.04

4.39

4.4

4.50


By the end of September 2000, India’s total external debt stood at a little over 97 billion dollars,
of which 93 billion was

long
-

term and the rest, was short
-

term. In addition, a substantial amount of
equity capital has been mobilized by Indian corporations
-

both via investment by foreign financial
institutions directly in the Indian stock market and via the global and Amer
ican Depository Receipts
(GDR and ADR) route. During the period 1993

94 to 1999

2000 Fiji’s investment in Indian stock
markets is estimated to be nearly 10 billion US dollars. In the budget presented in February 2001, the
government raised the ceiling on

FDI ownership stake in Indian companies from 40% to 50%. Also
the guidelines for Indian companies investing abroad, acquiring foreign companies were significantly
liberalized. Starting in May 1992, there have been over 60 GDR issues by Indian companies
ag
gregating over USD 5 billion and 10 convertible bond issues totaling over a billion dollars are
currently listed overseas. During the closing decades of the last millennium, large IT companies have
taken the ADR route to raise capital from the vast America
n Capital markets. A large number of
investment banking firms from the OECD countries have become active in India either on their own,
or in association with Indian firms.

Along with an increasing flow of inward foreign investment, Indian companies have a
lso been
venturing abroad for setting up joint ventures and wholly owned subsidiaries. At the end of
September, 1999, there were 912 active joint ventures abroad as compared to 788 at the end of
September 1998 out of the former, 392 were in production/ ope
ration and 520 under various stages of
implementation. The approved equality of these 912 active joint ventures amounted to USD 1,150.32
million. The number of fresh and supplementary proposals approved in respect of joint ventures
during the period April
to September 1999 was 42 and 11 respectively involving a total investment of
USD 46.33 million by way of equity and USD 1.53 million by way of loans. The total of 912 active joint
ventures are dispersed over 91 countries with almost 80% of them being conce
ntrated in 21
countries, that is USA (97), UK (74) UAE (68) Russian (38) etc. out of the 42 cases of fresh approvals
for new joint ventures during the period April


September 1999, 20 proposals involving an equity
investment of USD 31.58 million were in t
he non


financial services sector, primarily in the field of
computer software, followed by 12 proposals involving USD 5.42 million for manufacturing activities, 7
proposals involving USD 2.49 million for trading activities and 3 proposals involving USD 0
.04 million
for other activities. Of course by global standards, these are small amounts but Indian presence
abroad is bound to grow at an accelerated pace.


The Emerging Challenges


A firm as a dynamic entity has to continuously adapt itself to change i
n its operating
environment as well as in its own goals and strategy. An unprecedented pace of environmental
changes characterized the 1980s and 1990s for most Indian firms. Political uncertainties at home and
abroad, economic liberalization at home, great
er exposure to international markets, marked increase
in the volatility of critical economic and financial variables, such as exchange rate and interest rates,
increased competition, threats of hostile takeovers are among the factors that have forced many
firms
to thoroughly rethink their strategic posture.


The responsibilities of today’s finance managers can be understood by examining the principal
challenges they are required to cope with. Following five key categories of emerging challenges can
be iden
tified:



To keep up
-

to
-
date with significant environmental changes and analyse their implications for
the changes in industrial tax and foreign trade policies, stock market trends, fiscal and
monetary developments, emergence of new financial instruments
and products and so on.




To understand and analyze the complex interrelationships between relevant environment
variables and corporate responses
---
own and competitive
-
to the changes in them. Numerous
examples can be cited. What would be the impact of a st
ock market crash on credit conditions
in the international financial markets? What opportunities will emerge if infrastructure sectors
are opened up to private investment? What are the potential threats from liberalization of
foreign investment? How will a

default by a major debtor country affect funding prospects in
international capital markets? How will a takeover of a major competitor by an outsider affect
competition within the industry? If a hitherto publicly owned financial institution is privatized,

how will its policies change and how will that change affect the firm?




To be able to adapt the finance function to significant changes in the firm's own strategic
-
posture. A major change in the firm's product
-
market mix, opening up of a sector or an ind
ustry
so far prohibited to the firm, increased pace of diversification, a significant change in operating
results, substantial reorientation in a major competitors’ strategic stance are some of the
factors that will call for a major financial restructuring
, exploration of innovative funding
strategies, changes in dividend policies, asset sales etc to overcome temporary cash
shortages and a variety of other responses.




To take in stride past failures and mistakes to minimize the adverse impact. A wrong take
over
decision, a large foreign loan in a currency that has since started appreciating much faster
than expected, a floating rate financing obtained when the interest rates were low and have
since been rising rapidly, a fix
-
price supply contract which becom
es insufficiently remunerative
under current conditions and a host of other errors of judgment which are inevitable in the face
of the enormous uncertainties. Ways must be found to contain the damage.




To design and implement effective solutions to take a
dvantage of the opportunities offered by
the markets and advances in financial theory. Among the specific solutions, we will discuss in
detail later, are uses of options, swaps and futures for effective risk management,
securitisation of assets to increase

liquidity, innovative funding techniques etc. More generally,
the increased complexity and pace of environmental changes calls for greater reliance on
financial analysis, forecasting and planning, greater coordination between the treasury
management and c
ontrol functions and extensive use of computers and other advances in
information technology.


The finance manager of the new century cannot afford to remain ignorant about intentional
financial markets and instruments and their relevance for the treasury

function. The financial markets
around the world are fast integrating and evolving around a whole new range of products and
instruments. As nations’ economies are becoming closely knit through cross
-
border trade and
investment, the global financial system

must innovate to cater to the ever
-
changing needs of the real
economy. The job of the finance manager will increasingly become more challenging, demanding and
exciting.



Interest Rate Swap


What is an interest rate swap?


An interest rate swap is a con
tractual agreement entered into between two counterparties
under which each agrees to make periodic payment to the other for an agreed period of time based
upon a notional amount of principal. The principal amount is notional because there is no need to
ex
change actual amounts of principal in a single currency transaction: there is no foreign exchange
component to be taken account of. Equally, however, a notional amount of principal is required in
order to compute the actual cash amounts that will be period
ically exchanged.

Under the commonest form of interest rate swap, a series of payments calculated by applying
a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly
calculated but using a floating rate of i
nterest. This is a fixed
-
for
-
floating interest rate swap.
Alternatively, both series of cashflows to be exchanged could be calculated using floating rates of
interest but floating rates that are based upon different underlying indices. Examples might be Li
bor
and commercial paper or Treasury bills and Libor and this form of interest rate swap is known as a
basis or money market swap.



Pricing Interest Rate Swaps


If we consider the generic fixed
-
to
-
floating interest rate swap, the most obvious difficulty

to be
overcome in pricing such a swap would seem to be the fact that the future stream of floating rate
payments to be made by one counterparty is unknown at the time the swap is being priced. This must
be literally true: no one can know with absolute cer
tainty what the 6 month US dollar Libor rate will be
in 12 months time or 18 months time. However, if the capital markets do not possess an infallible
crystal ball in which the precise trend of future interest rates can be observed, the markets do
possess
a considerable body of information about the relationship between interest rates and future
periods of time.

In many countries, for example, there is a deep and liquid market in interest bearing securities
issued by the government. These securities pay in
terest on a periodic basis, they are issued with a
wide range of maturities, principal is repaid only at maturity and at any given point in time the market
values these securities to yield whatever rate of interest is necessary to make the securities trade

at
their par value.

It is possible, therefore, to plot a graph of the yields of such securities having regard to their
varying maturities. This graph is known generally as a yield curve
--

i.e.: the relationship between
future interest rates and time
--

and a graph showing the yield of securities displaying the same
characteristics as government securities is known as the par coupon yield curve. The classic example
of a par coupon yield curve is the US Treasury yield curve. A different kind of security to

a
government security or similar interest bearing note is the zero
-
coupon bond. The zero
-
coupon bond
does not pay interest at periodic intervals. Instead it is issued at a discount from its par or face value
but is redeemed at par, the accumulated discoun
t which is then repaid representing compounded or
"rolled
-
up" interest. A graph of the internal rate of return (IRR) of zero
-
coupon bonds over a range of
maturities is known as the zero
-
coupon yield curve.

Finally, at any time the market is prepared to qu
ote an investor forward interest rates. If, for
example, an investor wishes to place a sum of money on deposit for six months and then reinvest
that deposit once it has matured for a further six months, then the market will quote today a rate at
which the
investor can re
-
invest his deposit in six months time. This is not an exercise in "crystal ball
gazing" by the market. On the contrary, the six month forward deposit rate is a mathematically
derived rate which reflects an arbitrage relationship between cur
rent (or spot) interest rates and
forward interest rates. In other words, the six month forward interest rate will always be the precise
rate of interest which eliminates any arbitrage profit. The forward interest rate will leave the investor
indifferent a
s to whether he invests for six months and then re
-
invests for a further six months at the
six month forward interest rate or whether he invests for a twelve month period at today's twelve
month deposit rate.

The graphical relationship of forward interest
rates is known as the forward yield curve. One
must conclude, therefore, that even if
--

literally
--

future interest rates cannot be known in advance,
the market does possess a great deal of information concerning the yield generated by existing
instrumen
ts over future periods of time and it does have the ability to calculate forward interest rates
which will always be at such a level as to eliminate any arbitrage profit with spot interest rates. Future
floating rates of interest can be calculated, therefo
re, using the forward yield curve but this in itself is
not sufficient to let us calculate the fixed rate payments due under the swap. A further piece of the
puzzle is missing and this relates to the fact that the net present value of the aggregate set of
cashflows due under any swap is
--

at inception
--

zero. The truth of this statement will become clear
if we reflect on the fact that the net present value of any fixed rate or floating rate loan must be zero
when that loan is granted, provided, of course,

that the loan has been priced according to prevailing
market terms. This must be true, since otherwise it would be possible to make money simply by
borrowing money, a nonsensical result However, we have already seen that a fixed to floating interest
rate
swap is no more than the combination of a fixed rate loan and a floating rate loan without the
initial borrowing and subsequent repayment of a principal amount. The net present value of both the
fixed rate stream of payments and the floating rate stream of

payments in a fixed to floating interest
rate swap is zero, therefore, and the net present value of the complete swap must be zero, since it
involves the exchange of one zero net present value stream of payments for a second net present
value stream of pa
yments.

The pricing picture is now complete. Since the floating rate payments due under the swap can
be calculated as explained above, the fixed rate payments will be of such an amount that when they
are deducted from the floating rate payments and the ne
t cash flow for each period is discounted at
the appropriate rate given by the zero coupon yield curve, the net present value of the swap will be
zero. It might also be noted that the actual fixed rate produced by the above calculation represents
the par c
oupon rate payable for that maturity if the stream of fixed rate payments due under the swap
are viewed as being a hypothetical fixed rate security. This could be proved by using standard fixed
rate bond valuation techniques.


Financial Benefits Created B
y Swap Transactions


Consider the following statements:



A company with the highest credit rating, AAA, will pay less to raise funds under identical
terms and conditions than a less creditworthy company with a lower rating, say BBB. The
incremental borrowi
ng premium paid by a BBB company, which it will be convenient to refer to
as a "credit quality spread", is greater in relation to fixed interest rate borrowings than it is for
floating rate borrowings and this spread increases with maturity.




The counterpa
rty making fixed rate payments in a swap is predominantly the less creditworthy
participant.




Companies have been able to lower their nominal funding costs by using swaps in conjunction
with credit quality spreads.


These statements are, I submit, fully c
onsistent with the objective data provided by swap
transactions and they help to explain the "too good to be true" feeling that is sometimes expressed
regarding swaps. Can it really be true, outside of "Alice in Wonderland", that everyone can be a
winner a
nd that no one is a loser? If so, why does this happy state of affairs exist?


(a) The Theory of Comparative Advantage

When we begin to seek an answer to the questions raised above, the response we are most
likely to meet from both market participants an
d commentators alike is that each of the counterparties
in a swap has a "comparative advantage" in a particular and different credit market and that an
advantage in one market is used to obtain an equivalent advantage in a different market to which
access
was otherwise denied. The AAA company therefore raises funds in the floating rate market
where it has an advantage, an advantage which is also possessed by company BBB in the fixed rate
market.

The mechanism of an interest rate swap allows each company to

exploit their privileged access to
one market in order to produce interest rate savings in a different market. This argument is an
attractive one because of its relative simplicity and because it is fully consistent with data provided by
the swap market i
tself. However, as Clifford Smith, Charles Smithson and Sykes Wilford point out in
their book MANAGING FINANCIAL RISK, it ignores the fact that the concept of comparative
advantage is used in international trade theory, the discipline from which it is deri
ved, to explain why
a natural or other immobile benefit is a stimulus to international trade flows. As the authors point out:
The United States has a comparative advantage in wheat because the United States has wheat
producing acreage not available in Japa
n. If land could be moved
--

if land in Kansas could be
relocated outside Tokyo
--

the comparative advantage would disappear. The international capital
markets are, however, fully mobile. In the absence of barriers to capital flows, arbitrage will eliminat
e
any comparative advantage that exists within such markets and this rationale for the creation of the
swap transactions would be eliminated over time leading to the disappearance of the swap as a
financial instrument. This conclusion clearly conflicts wit
h the continued and expanding existence of
the swap market.

It would seem, therefore, that even if the theory of comparative advantage does retain some
force
--

not withstanding the effect of arbitrage
--

which it almost certainly does, it cannot constitu
te
the sole explanation for the value created by swap transactions. The source of that value may lie in
part in at least two other areas.


(b) Information Asymmetries

The much
-

vaunted economic efficiency of the capital markets may nevertheless co
-

exist

with certain
information asymmetries. Four authors from a major US money centre bank have argued that a
company will
--

and should
--

choose to issue short term floating rate debt and swap this debt into
fixed rate funding as compared with its other finan
cing options if:



It had information
--

not available to the market generally
--

which would suggest that its own
credit quality spread (the difference, you will recall, between the cost of fixed and floating rate
debt) would be lower in the future than th
e market expectation.



It anticipates higher risk
-

free interest rates in the future than does the market and is more
sensitive (i.e. averse) to such changes than the market generally.

In this situation a company is able to exploit its information asymmetr
y by issuing short term
floating rate debt and to protect itself against future interest rate risk by swapping such floating rate
debt into fixed rate debt.


(c) Fixed Rate Debt and Embedded Options

Fixed rate debt typically includes either a prepayment
option or, in the case of publicly traded
debt, a call provision. In substance this right is no more and no less than a put option on interest rates
and a right which becomes more valuable the further interest rates fall. By way of contrast, swap
agreement
s do not contain a prepayment option. The early termination of a swap contract will involve
the payment, in some form or other, of the value of the remaining contract period to maturity.

Returning, therefore, to our initial question as to why an interest r
ate swap can produce apparent
financial benefits for both counterparties the true explanation is, I would suggest, a more complicated
one than can be provided by the concept of comparative advantage alone. Information asymmetries
may well be a factor, toge
ther with the fact that the fixed rate payer in an interest rate swap
--

reflecting the fact that he has no early termination right
--

is not paying a premium for the implicit
interest rate option embedded within a fixed rate loan that does contain a pre
-
p
ayment rights. This
saving is divided between both counterparties to the swap.


Reversing or Terminating Interest Rate Swaps


The point has been made above that at inception the net present value of the aggregate
cashflows that comprise an interest rate
swap will be zero. As time passes, however, this will cease
to be the case, the reason for this being that the shape of the yield curves used to price the swap
initially will change over time. Assume, for example, that shortly after an interest rate swap h
as been
completed there is an increase in forward interest rates: the forward yield curve steepens. Since the
fixed rate payments due under the swap are, by definition, fixed, this change in the prevailing interest
rate environment will affect future float
ing rate payments only: current market expectations are that
the future floating rate payments due under the swap will be higher than those originally expected
when the swap was priced. This benefit will accrue to the fixed rate payer under the swap and wi
ll
represent a cost to the floating rate payer. If the new net cashflows due under the swap are computed
and if these are discounted at the appropriate new zero coupon rate for each future period (i.e.
reflecting the current zero coupon yield curve and not

the original zero coupon yield curve), the
positive net present value result reflects how the value of the swap to the fixed rate payer has risen
from zero at inception. Correspondingly, it demonstrates how the value of the swap to the floating rate
payer

has declined from zero to a negative amount.

What we have done in the above example is mark the interest rate swap to market. If, having
done this, the floating rate payer wishes to terminate the swap with the fixed rate payer's agreement,
then the posit
ive net present value figure we have calculated represents the termination payment that
will have to be paid to the fixed rate payer. Alternatively, if the floating rate payer wishes to cancel the
swap by entering into a reverse swap with a new counterpart
y for the remaining term of the original
swap, the net present value figure represents the payment that the floating rate payer will have to
make to the new counterparty in order for him to enter into a swap which precisely mirrors the terms
and conditions

of the original swap.


Credit Risk Implicit in Interest Rate Swaps


To the extent that any interest rate swap involves mutual obligations to exchange cashflows, a
degree of credit risk must be implicit in the swap. Note however, that because a swap is a

notional
principal contract, no credit risk arises in respect of an amount of principal advanced by a lender to a
borrower which would be the case with a loan. Further, because the cashflows to be exchanged
under an interest rate swap on each settlement d
ate are typically "netted" (or offset) what is paid or
received represents simply the difference between fixed and floating rates of interest. Contrast this
again with a loan where what is due is an absolute amount of interest representing either a fixed o
r a
floating rate of interest applied to the outstanding principal balance. The periodic cashflows under a
swap will, by definition, be smaller therefore than the periodic cashflows due under a comparable
loan.

An interest rate swap is in essence a series

of forward contracts on interest rates.. In
distinction to a forward contract, the periodic exchange of payment flows provided for under an
interest rate swap does provide for a partial periodic settlement of the contract but it is important to
appreciate

that the net present value of the swap does not reduce to zero once a periodic exchange
has taken place. This will not be the case because
--

as discussed in the context of reversing or
terminating interest rate swaps
--

the shape of the yield curve used
to price the swap initially will
change over time giving the swap a positive net present value for either the fixed rate payer or the
floating rate payer notwithstanding that a periodic exchange of payments is being made.


Users and Uses of Interest Rate
Swaps


Interest rate swaps are used by a wide range of commercial banks, investment banks, non
-
financial operating companies, insurance companies, mortgage companies, investment vehicles and
trusts, government agencies and sovereign states for one or more

of the following reasons:



To obtain lower cost funding



To hedge interest rate exposure



To obtain higher yielding investment assets



To create types of investment asset not otherwise obtainable



To implement overall asset or liability management strategies



To take speculative positions in relation to future movements in interest rates.


The advantages of interest rate swaps include the following:



A floating
-
to
-
fixed swap increases the certainty of an issuer's future obligations.



Swapping from fixed
-
to
-
float
ing rate may save the issuer money if interest rates decline.



Swapping allows issuers to revise their debt profile to take advantage of current or expected