Transcription
International Finance:Putting Theory Into PracticePiet SercuLeuven School of Business and EconomicsKatholieke Universiteit Leuven14:20 on 2 July 2008
PrefaceAbout this bookThis book had a forerunner—“International Financial Markets and The Firm”, coauthored with Raman Uppal, which came out in 1995. By 2003 or 2004 Raman andI had agreed that a text full of Italian Lira or German Marks and where tradersstill had a full two minutes to respond to market makers’ quotes, might sooner orlater risk getting outdated. Starting the revision itself turned out to be much moredifficult than agreeing on the principle, though. In the end Raman, being so muchbusier and more rational than I am, preferred to bow out. How right he was. Still,now that the effort has become a sunk cost, forever bygone, I find that episodeswhere I sincerely curse the book (and myself and Princeton University Press) arebecoming fewer and farther between. Actually, there now are several passages Iactually begin to like.Like the previous book, the book still targets finance students, or at least studentsthat want a genuine finance text, not an international-management or -strategy textwith a finance slant nor an international monetary economics text with some corporate applications. There is a continued bias in favor of financial markets andeconomic logic; the aim is to provide students with a coherent picture of international markets and selected topics in multinational corporate finance. Sure, duringeveryday practice later on, this framework will then get amended and corrected andqualified; but the feeling of fundamental coherence will remain, we hope.This book is more analytical than the modal text in the field. Compared to theSercu-Uppal book, some of the math has been dropped and new matter has beenadded. As before, a lot of it is in Appendices, thus stressing its optional character.The main difference, I think, is that the in-text math is brought in differently.While in International Financial Markets we had every theorem or proof followedby an example, now the example comes first whenever that is possible. If so, theproof is often even omitted, or turned into a DoItYourself assignment. In fact, athird innovation is that, at least in the chapters or sections that are sufficientlyanalytical rather than just factual, the reader is invited to prove or verify claimsand solve analogous problems. The required level of math is surely not prohibitive;anybody who has finished a good finance course should be able to master theseDoItYourself assignments. Still, while the required level of mathematical prowess isiii
ivlow, a capacity for abstract thinking and handling symbols remains vital.Every Part, except the Intro one, now has its own introductory case, which isintended to stimulate the reader’s appetite and which can be a source of assignments.The cases usually cover issues from most chapters in the Part.A fifth change is that the Part on exchange-rate pricing is much reduced. Theformer three Chapters on exchange-rate theories, predictability, and forward bias arenow shrunk to two. And, lastly, three wholly new chapters have been added: two oninternational stock markets—especially crosslisting with the associated corporategovernance issues—and one on Value at Risk.Typically, a preface like this one continues with a discussion and motivation ofthe book’s content. But my feeling is that most readers—and surely students—skip prefaces anyway. Since the motivation of the structure is quite relevant, thatmaterial is now merged into the general introduction chapter, Chapter 1.How to use this bookThe text contains material for about two courses. One possibility is to take thesecond Part, International Financial Markets, as one course, and group the morebusiness-finance oriented material (grouped into Exchange Risk, Exposure, and RiskManagement (III) and Long-Term Financing and Investments (IV)) as a second.Fixed-income markets, which now is in Part III, could be included in the markets/instruments course, like it was in the 1995 book; and the whole package canalso duplicate as an intro derivatives course, along with the apocryphal Chapter ?that is available on my website. I myself run two 40-hr courses covering, respectivelyParts II-III (Instruments, Risk Management) and Part IV (Stocks, bonds, capitalbudgeting).For one single course one could focus, in Part II, on spot (Chapter 3) and forwards(Chapters 4 and 5), and then continue with the chapters on relevance of hedgingand exposure (Chapters 12 and 13), to finish with capital budgeting (Chapter 21);this shortlist can be complemented by a few chapters of your liking.Leuven, December 2006.c P. Sercu, K.U.Leuven. Free copying stops Oct 1st, ’08Formatted 2 July 2008—14:20.
About the authorPiet Sercu is Professor of International Finance at the Katholieke Universiteit Leuven. He holds the degrees of Business Engineer, Master of Business Administration,and Doctor in Applied Economics from K.U. Leuven. He taught at the FlemishBusiness School in Brussels (1980-1986), prior to returning to Leuven, where hecurrently teaches the International Business Finance courses in the Masters andAdvanced Masters programs. He also held Visiting Professor appointments at NewYork University, Cornell University, the University of British Columbia, the London Business School, and Université Libre de Bruxelles. He taught shorter financecourses in Helsinki, Bandung (Indonesia), Leningrad, and India (as an UNDP expert and, in 1994, as a fellow of the European Indian Cooperation and ExchangeProgramme), and regularly teaches executive courses. He held the 1996/7 Francqui Chair at the Facultés Universitaires Notre-Dame de la Paix at Namur, and the2000/04 PricewaterhouseCoopers Chair on Value and Risk at KU Leuven, togetherwith Marleen Willekens. Until 2000, he organized and taught doctoral courses inthe European Doctoral Education Network, as part of the Finance faculty of theEuropean Institute for Advanced Studies in Management. He was the 1994 VicePresident and 1995 President of the European Finance Association, won the 1999Western Finance Association award for Corporate Finance (with Xueping Wu andCharley Park) and was Hanken Fellow in 2002.His early research focused on International Asset Pricing with real exchange riskand inflation risk. He also did some work on corporate take-over models and lendingbut has recently returned to International Finance and hedging. He has publishedin the Journal of Finance, Journal of Banking and Finance, Journal of InternationalMoney and Finance, European Economic Review, and other journals. He is on theeditorial boards of the European Financial Management Journal and the Journalfor International Financial Markets, Institutions and Money.Piet Sercu and Raman Uppal jointly won the 1995 Sanwa Prize for a monographin International Finance, Exchange Rate Volatility, Trade, and Capital Flows underAlternative Currency Regimes, published by Cambridge University Press in 2000and 2006. They also have produced International Financial Markets and The Firm(International Thomson Publishers, Cincinnati-London, 1995), the forerunner tothis book and the source of much of its material. There are also a number of jointacademic articles.v
AcknowledgmentsThere are many individuals who played an important role in the production ofthis book. First and foremost I thank Raman Uppal, not only for his invaluablecontribution to the first book but also for the discussions about how to structurea new version, for translating the text parts of the old manuscript into LaTeX,and setting up a master file system to produce the whole. Thanks also to theformer and current doctoral students or assistants who read earlier drafts of the firstand second book and suggested several improvements: Badrinath H. R., Thi NgocTuan Bui, Katelijne Carbonez, Cédric de Ville de Goyet, Kathy Dehoperé, MarianKane, Fang Liu, Rosanne Vanpée, Tom Vinaimont, and Xueping Wu. Marian,especially, did lots of work on the exercises, and Katelijne on the revised text.Prof. Martina Vandebroek occasionally helped with spreadsheets and graphs, atwhich she Excels; she, Fang Liu and Badrinath H. R. provided the empirical resultsfor Chapters 10 and 11. Many thanks, lastly, to colleagues who read drafts andprovided comments, some of them at Princeton’s request but some even of theirfree will: Hu Shengmei, Karen Lewis, Bernard Dumas, Stan Standaert, Charles vanWymeersch, and an anonymous (but wholly positive) referee reporting to PrincetonUP. Of course, I remain responsible for all remaining errors. Comments and feedbackfrom readers about errors, presentation, and contents are very welcome: do emailto piet.sercu@econ.kuleuven.be.I dedicate this book to my parents, Jan Sercu and the late Térèse Reynaert,and to my wife Rita and children Maarten and Jorinde, who have patiently put upwith my inattentive absent-mindedness during the time it has taken to completethis project and, come to think of it, most of the time before and after.December 2007vii
ContentsIIntroduction and Motivation for International Finance1 Why does the Existence of Borders Matter for Finance?1.1 Key Issues in International Business Finance . . . . . . . . . . . . . . . . .1.1.1 Exchange-rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . .1.1.2 Segmentation of the Consumer-good Markets . . . . . . . . . . . .1.1.3 Credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1.1.4 Political risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1.1.5 Capital-Market Segmentation Issues, including Aspects of Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . .1.1.6 International Tax Issues . . . . . . . . . . . . . . . . . . . . . . . .1.2 What is on the International CFO’s desk? . . . . . . . . . . . . . . . . . .1.2.1 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1.2.2 Funding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1.2.3 Hedging and, more Generally, Risk Management . . . . . . . . . .1.2.4 Interrelations Between Risk Management, Funding and Valuation .1.3 Overview of this Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1.3.1 Part I: Motivation and Background Matter . . . . . . . . . . . . .1.3.2 Part II: International Financial Markets . . . . . . . . . . . . . . .1.3.3 Part III: Exchange Risk, Exposure, and Risk Management . . . . .1.3.4 Part IV: Long-term Financing and Investment Decisions . . . . . .2 International Finance: Institutional Background2.1 Money and Banking: A Brief Review . . . . . . . . . . . . . . . . . . . . .2.1.1 The Roles of Money . . . . . . . . . . . . . . . . . . . . . . . . . .2.1.2 How Money Is Created . . . . . . . . . . . . . . . . . . . . . . . .2.2 The International Payment Mechanism . . . . . . . . . . . . . . . . . . . .2.2.1 Some Basic Principles . . . . . . . . . . . . . . . . . . . . . . . . .2.2.2 Domestic Interbank Transfers: Real-time Gross Settlement vs. Periodic Netting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2.2.3 International payments . . . . . . . . . . . . . . . . . . . . . . . .2.3 International (“Euro”) Money and Bond Markets . . . . . . . . . . . . . .2.4 What is the Balance of Payments? . . . . . . . . . . . . . . . . . . . . . .2.4.1 Definition & Principles Underlying the Balance of Payments . . .2.4.2 Some Nitty-gritty . . . . . . . . . . . . . . . . . . . . . . . . . . . .2.4.3 Statistical Discrepancy/Errors and Omissions . . . . . . . . . . . .2.4.4 Where do Current Account Surpluses or Deficits Come From? . . .2.4.5 The Net International Investment Account . . . . . . . . . . . . .2.5 Exchange-rate Regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2.5.1 Fixed Exchange Rates Relative to Gold . . . . . . . . . . . . . . 53737404344454748
xiiCONTENTS2.5.22.5.32.5.42.6IIFixed Exchange Rates vis-à-vis a Single Currency . . . . . . . . .Fixed Exchange Rates Relative to a Basket . . . . . . . . . . . . .The 1979–1993 Exchange Rate Mechanism (ERM) of the EuropeanMonetary System . . . . . . . . . . . . . . . . . . . . . . . . . . . .2.5.5 Other Exchange Rate Systems . . . . . . . . . . . . . . . . . . . .Test Your Understanding . . . . . . . . . . . . . . . . . . . . . . . . . . . .2.6.1 Quiz Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2.6.2 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Currency Markets49535560616163673 Spot Markets for Foreign Currency3.1 Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.1.1 Definition of Exchange Rates . . . . . . . . . . . . . . . . . . . . .3.1.2 Our Convention: Home Currency per Unit of Foreign Currency . .3.1.3 The Indirect Quoting Convention . . . . . . . . . . . . . . . . . . .3.1.4 Bid and Ask Rates . . . . . . . . . . . . . . . . . . . . . . . . . . .3.1.5 Primary rates v cross rates . . . . . . . . . . . . . . . . . . . . . .3.1.6 Inverting Exchange Rates in the Presence of Spreads . . . . . . . .3.2 Major Markets for Foreign Exchange . . . . . . . . . . . . . . . . . . . . .3.2.1 How Exchange Markets Work . . . . . . . . . . . . . . . . . . . . .3.2.2 Markets by Location and by Currency . . . . . . . . . . . . . . . .3.2.3 Markets by Delivery Date . . . . . . . . . . . . . . . . . . . . . . .3.3 The Law of One Price for Spot Exchange Quotes . . . . . . . . . . . . . .3.3.1 Arbitrage across Competing Market Makers . . . . . . . . . . . . .3.3.2 Shopping Around across Competing Market Makers . . . . . . . .3.3.3 Triangular Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . .3.4 Translating FC Figures: Nominal rates, PPP rates, and Deviations from PPP3.4.1 The PPP rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.4.2 Commodity Price Parity . . . . . . . . . . . . . . . . . . . . . . . .3.4.3 The Real Exchange Rate and (Deviations from) Absolute PPP . .3.4.4 The Change in the Real Rate and (deviations from) Relative PPP3.5 CFO’s Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.6 TekNotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.7 Test Your Understanding . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.7.1 Quiz Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.7.2 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41161171171194 Understanding Forward Exchange Rates for Currency4.1 Introduction to Forward Contracts . . . . . . . . . . . . . . . . . . .4.2 The Relation Between Exchange and Money Markets . . . . . . . . .4.3 The Law of One Price and Covered Interest Parity . . . . . . . . . .4.3.1 Arbitrage and Covered Interest Parity . . . . . . . . . . . . .4.3.2 Shopping Around (The Pointlessness of —) . . . . . . . . . .4.3.3 Unfrequently Asked Questions on CIP . . . . . . . . . . . . .4.4 The Market Value of an Outstanding Forward Contract . . . . . . . .4.4.1 A general formula . . . . . . . . . . . . . . . . . . . . . . . .4.4.2 Corollary 1: The Value of a Forward Contract at Expiration4.4.3 Corollary 2: The Value of a Forward Contract at Inception .123123127132133135135140140142144c P. Sercu, K.U.Leuven. Free copying stops Oct 1st, ’08.Formatted 2 July 2008—14:20.
CONTENTSxiii4.4.44.54.64.74.8Corollary 3: The Forward Rate and the Risk-Adjusted ExpectedFuture Spot Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.4.5 Implications for Spot Values; the Role of Interest Rates . . . . . .4.4.6 Implications for the Valuation of Foreign-Currency Assets or Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.4.7 Implication for the Relevance of Hedging . . . . . . . . . . . . . .CFO’s Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Appendix: Interest Rates, Returns, and Bond Yields . . . . . . . . . . . .4.6.1 Links Between Interest Rates and Effective Returns . . . . . . . .4.6.2 Common Pitfalls in Computing Effective Returns . . . . . . . . . .Appendix: The Forward Forward and the Forward Rate Agreement . . . .4.7.1 Forward Contracts on Interest Rates . . . . . . . . . . . . . . . .4.7.2 Why FRAs Exist . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.7.3 The Valuation of FFs (or FRAs) . . . . . . . . . . . . . . . . . . .4.7.4 Forward Interest Rates as the Core of the Term Structure(s) . . .Test Your Understanding . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.8.1 Quiz Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.8.2 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1451471491501511531531561581581591591631681681695 Using Forwards for International Financial Management1715.1 Practical Aspects of Forwards in Real-world Markets . . . . . . . . . . . . 1715.1.1 Quoting Forward Rates with Bid-Ask Spreads . . . . . . . . . . . . 1715.1.2 Provisions for Default . . . . . . . . . . . . . . . . . . . . . . . . . 1735.2 Using Forward Contracts (1): Arbitrage . . . . . . . . . . . . . . . . . . . 1765.2.1 Synthetic Forward Rates . . . . . . . . . . . . . . . . . . . . . . . . 1775.2.2 Implications of Arbitrage and Shopping-around . . . . . . . . . . . 1775.2.3 Back to the Second Law . . . . . . . . . . . . . . . . . . . . . . . . 1785.3 Using Forward Contracts (2): Hedging Contractual Exposure . . . . . . . 1795.3.1 Measuring Exposure from Transactions on a Particular Date . . . 1805.3.2 Hedging Contractual Exposure from Transactions on a ParticularDate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1825.4 Using Forward Contracts (3): Speculation . . . . . . . . . . . . . . . . . . 1885.4.1 Speculating on the Future Spot Rate . . . . . . . . . . . . . . . . . 1885.4.2 Speculating on the Forward Rate or on the Swap Rate . . . . . . . 1905.5 Using Forward Contracts (4): Minimizing the Impact of Market Imperfections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1925.5.1 Shopping Around to Minimize Transaction Costs . . . . . . . . . . 1925.5.2 Swapping for Tax Reasons . . . . . . . . . . . . . . . . . . . . . . . 1965.5.3 Swapping for Information-cost Reasons . . . . . . . . . . . . . . . 1975.5.4 Swapping for Legal Reasons: Replicating Back-to-Back Loans . . . 1995.6 Using the Forward Rate in Commercial, Financial and Accounting Decisions 2075.6.1 The Forward Rate as the Intelligent Accountant’s Guide . . . . . . 2075.6.2 The Forward Rate as the Intelligent Salesperson’s Guide . . . . . . 2095.6.3 The Forward Rate as the Intelligent CFO’s Guide . . . . . . . . . . 2095.7 CFO’s Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2115.7.1 Key Ideas for Arbitrageurs, Hedgers, and Speculators . . . . . . . 2115.7.2 The Economic Roles of Arbitrageurs, Hedgers, and Speculators . . 2135.8 Test Your Understanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2155.8.1 Quiz Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2155.8.2 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217c P. Sercu, K.U.Leuven. Free copying stops Oct 1st, ’08Formatted 2 July 2008—14:20.
xivCONTENTS6 The Market for Currency Futures2196.1 Handling Default Risk in Forward Markets: Old & New Tricks . . . . . . . 2206.1.1 Default Risk and Illiquidity of Forward Contracts . . . . . . . . . . 2206.1.2 Standard Ways of Reducing Default Risk in the Forward Market . 2216.1.3 Reducing Default Risk by Variable Collateral or Periodic Recontracting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2226.2 How Futures Contracts Differ from Forward Markets . . . . . . . . . . . . 2256.2.1 Marking to Market . . . . . . . . . . . . . . . . . . . . . . . . . . . 2256.2.2 Margin Requirements . . . . . . . . . . . . . . . . . . . . . . . . . 2276.2.3 Organized Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 2286.2.4 Standardized Contracts . . . . . . . . . . . . . . . . . . . . . . . . 2306.2.5 The Clearing Corporation . . . . . . . . . . . . . . . . . . . . . . . 2316.2.6 How Futures Prices Are Reported . . . . . . . . . . . . . . . . . . 2326.3 Effect of Marking to Market on Futures Prices . . . . . . . . . . . . . . . . 2336.4 Hedging with Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . 2366.4.1 The Generic Problem and its Theoretical Solution . . . . . . . . . 2376.4.2 Case 1: The Perfect Match . . . . . . . . . . . . . . . . . . . . . . 2386.4.3 Case 2: The Currency-Mismatch Hedge or Cross-Hedge . . . . . . 2396.4.4 Case 3: The Delta hedge . . . . . . . . . . . . . . . . . . . . . . . 2416.4.5 Case 4: The Cross-and-Delta hedge . . . . . . . . . . . . . . . . . 2426.4.6 Adjusting for the Sizes of the Spot Exposure and the Futures Contract 2436.4.7 More About Regression-based Hedges . . . . . . . . . . . . . . . . 2436.4.8 Hedging with Futures Using Contracts on More than One Currency 2456.5 The CFO’s conclusion: Pros and Cons of Futures Contracts Relative toForward Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2456.6 Appendix: Eurocurrency Futures Contracts . . . . . . . . . . . . . . . . . 2476.6.1 The Forward Price on a CD . . . . . . . . . . . . . . . . . . . . . . 2486.6.2 Modern Eurodollar Futures Quotes . . . . . . . . . . . . . . . . . . 2496.7 Test Your Understanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2546.7.1 Quiz Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2546.7.2 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2577 Markets for Currency Swaps7.1 How the Modern Swap came About . . . . . . . . . . .7.1.1 The Grandfather Tailor-made Swap: IBM-WB .7.1.2 Subsequent Evolution of the Swap Market . . .7.2 The Fixed-for-Fixed Currency Swaps . . . . . . . . . .7.2.1 Motivations for Undertaking a Currency Swap7.2.2 Characteristics of the Modern Currency Swap .7.3 Interest Rate Swaps . . . . . . . . . . . . . . . . . . . .7.3.1 Coupon Swaps (Fixed-for-Floating) . . . . . .7.3.2 Base Swaps . . . . . . . . . . . . . . . . . . . .7.4 Cross-Currency Swaps . . . . . . . . . . . . . . . . . .7.5 CFO’s Summary . . . . . . . . . . . . . . . . . . . . . .7.6 TekNotes . . . . . . . . . . . . . . . . . . . . . . . . . .7.7 Test Your Understanding . . . . . . . . . . . . . . . . .7.7.1 Quiz Questions . . . . . . . . . . . . . . . . . .7.7.2 Applications . . . . . . . . . . . . . . . . . . .2612622622652672672672742752792802812832842842848 Currency Options (1): Concepts and Uses2878.1 An Introduction to Currency Options . . . . . . . . . . . . . . . . . . . . . 288c P. Sercu, K.U.Leuven. Free copying stops Oct 1st, ’08Formatted 2 July 2008—14:20.
CONTENTS8.28.38.48.58.68.78.8xv8.1.1 Call Options . . . . . . . . . . . . . . . . . . . . . . . .8.1.2 Put Options . . . . . . . . . . . . . . . . . . . . . . . . .8.1.3 Option Premiums and Option Writing . . . . . . . . . .8.1.4 European-style Puts and Calls as Chopped-up Forwards8.1.5 Jargon: Moneyness, Intrinsic Value, and Time Value . .Institutional Aspects of Options Markets . . . . . . . . . . . .8.2.1 Traded Options . . . . . . . . . . . . . . . . . . . . . . .8.2.2 Over-The-Counter Markets . . . . . . . . . . . . . . . .An Aside: Futures-style Options on Futures . . . . . . . . . . .8.3.1 Options on Currency Futures . . . . . . . . . . . . . . .8.3.2 Forward-style options . . . . . . . . . . . . . . . . . . .8.3.3 Futures-Style Options . . . . . . . . . . . . . . . . . . .8.3.4 Futures-Style Options on Futures . . . . . . . . . . . . .Using Options (1): Arbitrage . . . . . . . . . . . . . . . . . . . .Using Options (2): Hedging . . . . . . . . . . . . . . . . . . . .8.5.1 Hedging the Risk of a Loss without Eliminating Possible8.5.2 Hedging Positions with Quantity Risk . . . . . . . . . .8.5.3 Hedging Nonlinear Exposure . . . . . . . . . . . . . . .Using Options (3): Speculation . . . . . . . . . . . . . . . . . .8.6.1 Speculating on the Direction of Changes . . . . . . . . .8.6.2 Speculating on Changes in Volatility . . . . . . . . . . .CFO’s Summary . . . . . . . . . . . . . . . . . . . . . . . . . . .Test Your Understanding . . . . . . . . . . . . . . . . . . . . . .8.8.1 Quiz Questions . . . . . . . . . . . . . . . . . . . . . . .8.8.2 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Gains. . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Currency Options (2): Hedging and Valuation9.1 The Logic of Binomial Option Pricing: One-period Problems . . .9.1.1 The Replication Approach . . . . . . . . . . . . . . . . . .9.1.2 The Forward Hedging Approach . . . . . . . . . . . . . .9.1.3 The Risk-Adjusted Probability Interpretation . . . . . . .9.1.4 American-style Options . . . . . . . . . . . . . . . . . . .9.2 Notation and Assumptions for the Multiperiod Binomial Model .9.2.1 The Standard Version of the Binomial Model . . . . . . .9.2.2 Does the Model make Sense? . . . . . . . . . . . . . . . .9.2.3 Further Notation . . . . . . . . . . . . . . . . . . . . . . .9.2.4 How to Choose u and d? . . . . . . . . . . . . . . . . . . .9.3 Stepwise Multiperiod Binomial Option Pricing . . . . . . . . . . .9.3.1 Dynamic Hedging or Replication: a European-style option9.3.2 What can go Wrong? . . . . . . . . . . . . . . . . . . . .9.3.3 American-style Options . . . . . . . . . . . . . . . . . . .9.4 Toward Black-Merton-Scholes (European Options) . . . . . . . . .9.4.1 A Shortcut for European Options . . . . . . . . . . . . . .9.4.2 The General Formula . . . . . . . . . . . . . . . . . . . .9.4.3 The Delta of an Option . . . . . . . . . . . . . . . . . . .9.5 CFO’s Summary . . . . . . . . . . . . . . . . . . . . . . . . . . .9.6 TekNotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9.7 Test Your Understanding . . . . . . . . . . . . . . . . . . . . . . .9.7.1 Quiz Questions . . . . . . . . . . . . . . . . . . . . . . . .9.7.2 Applications . . . . . . . . . . . . . . . . . . . . . . . . .c P. Sercu, K.U.Leuven. Free copying stops Oct 1st, 3365Formatted 2 July 2008—14:20.
xviIIICONTENTSExchange Risk, Exposure, and Risk Management36910 Do We Know What Makes Forex Markets Tick?37510.1 The behavior of spot exchange rates . . . . . . . . . . . . . . . . . . . . . . 37810.1.1 Why Levels of (log) exchange rates have bad statistical properties37810.1.2 Changes in log rates: findings . . . . . . . . . . . . . . . . . . . . . 38110.1.3 Concluding Discussion . . . . . . . . . . . . . . . . . . . . . . . . . 38910.2 The PPP Theory and the behavior of the Real Exchange Rate. . . . . . . 39210.2.1 Issues with PPP Tests . . . . . . . . . . . . . . . . . . . . . . . . . 39210.2.2 Computations and Findings . . . . . . . . . . . . . . . . . . . . . . 39510.2.3 Concluding Discussion . . . . . . . . . . . . . . . . . . . . . . . . . 40110.3 Exchange Rates and Economic Policy Fundamentals . . . . . . . . . . . . 40710.3.1 The Monetary Approach to the Exchange Rate . . . . . . . . . . . 40810.3.2 Computations and Findings . . . . . . . . . . . . . . . . . . . . . . 41010.3.3 Real Business Cycle Models . . . . . . . . . . . . . . . . . . . . . . 41510.3.4 Taylor Rule Models . . . . . . . . . . . . . . . . . . . . . . . . . . 41610.3.5 Concluding discussion . . . . . . . . . . . . . . . . . . . . . . . . . 41710.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41911 Do Forex Markets Themselves See What’s Coming?11.1 The Forward Rate as a Black-Box Predictor . . . . . . . . . . . . . . . . .11.1.1 How to Verify the Forward Rate’s Performance as a Predictor . . .11.1.2 Statistical Analysis of Forecast Errors: Computations and findings11.1.3 Trading rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11.1.4 The Forward Bias: Concluding discussion . . . . . . . . . . . . . .11.2 Forecasts by Specialists . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11.2.1 Forecasts Implied by Central Bank Interventions . . . . . . . . . .11.2.2 Evaluating the Performance of Professional Traders and Forecasters11.3 The CFO’s summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11.4 Test Your Understanding . . . . . . . . . . . . . . . . . . . . . . . . . . . .11.4.1 Quiz Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43343343343644344745345345545846446412 (When) Should a Firm Hedge its Exchange Risk?47112.1 The effect of corporate hedging may not just be “additive” . . . . . . . . . 47212.1.1 Corporate Hedging Reduces Costs of Bankruptcy and FinancialDistress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47312.1.2 Hedging Reduces Agency Costs . . . . . . . . . . . . . . . . . . . 47612.1.3 Hedging Reduces Expected Taxes . . . . . . . . . . . . . . . . . . . 47812.1.4 Hedging May Also Provide Better Information for Internal DecisionMaking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47912.1.5 Hedged Results May Better Show Management’s Quality to Shareholders, and Pleases Wall Street . . . . . . . . . . . . . . . . . . . 48012.2 FAQs about hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48012.2.1 FAQ1: Why can’t Firms lea
Western Finance Association award for Corporate Finance (with Xueping Wu and Charley Park) and was Hanken Fellow in 2002. His early research focused on International Asset Pricing with real exchange risk and in ation risk. He also did some work on corporate take-over models and lending but has recently return
