International Financial Management

Posted: August 26th, 2021

International Financial Management

Name

Institutional Affiliation

Section A

Question 1

1. Forward Premium

A forward premium refers to the situation where the conventional currency futures price is higher than the current spot rate.  It indicates that the domestic exchange rate’s present market value will increase the foreign currency. It is measured as the variance in the current spot rate plus forward rate. When the value of the forward premium is negative, then it will be equal to a discount. Therefore, forward premium replicates possible changes from interest rate variations in two currencies.

Exchange Rates $/£

Spot $1.280800/£

6-month Forward $1.285210/£

Interest Rates

USA ($)

6-month 1.1339% p.a.

U.K. (£)

6-month 0.6806% p.a.

Domestic currency= (£)

Foreign currency = ($)

1.497388316

The amount is a positive value implying it is a forward premium as the forward rate is higher than the spot rate.

• Fair Value of Forward

Where; S= spot rate

      = discount factor

Spot $1.280800/£

6-month Forward $1.285210/£

• Market Arbitrage

            Market arbitrage is taking advantage of price differences of the same underlying asset but in different locations to gain a riskless profit. When trading market arbitrage, an arbitrageur sells financial security that is highly-priced in one market and, subsequently, purchases the same financial protection in the location where it is priced lowly. The profit is realized in the spread of the underlying asset’s price between the two markets. The concept is only viable if an underlying asset is priced differently in international markets or different markets. Thus, market arbitrage is a riskless activity as investors purchase and dispose he same underlying asset concurrently at different markets.

            In question (b) above, there exists an arbitrage opportunity because the fair value is higher than the forward premium. Thus, an investor would sell the underlying asset on the U.K. and purchase the same asset in the USA to gain arbitrage.

• XYZ Bank’s Profit Margin

            The bank’s margin is from the currency exchange rate dealings between the U.K pound and the USA dollar.

Exchange Rates $/£

Spot $1.280800/£

6-month Forward $1.285210/£

• ABC Bank Bid-Ask Spread

            The bank has posted spot exchange rate quotes: $1.280600/£—$1.281100/£. It implies that the current market value of the underlying asset is $1.280600/£ and the forward rate of the same underlying asset is $1.281100/£.

100%

100%

• Currency Arbitrage

            The investor did not take account of the currency arbitrage when making the forward arrangement. Currency arbitrage refers to a foreign exchange strategy in which investor trades in different currencies spread, taking advantage of a particular currency pair. The currency’s different spreads mean a disparity in the bid and ask price. Therefore, currency arbitrage entails taking advantage of price variation of different currencies and trading on the same to generate a profit. The arbitrage gain is realized on the different quotes and not exchange rate movements. The investor would have practiced a two-currency arbitrage to exploit the benefit between the spread.

The investor instructed XYZ bank to execute an arbitrage trading strategy to earn a profit of $5,940 during the inception of the agreement. However, after six months, the bank delivers £4,621. The bank staffs explain that the dollar amount in the forward is equivalent to the pound amount with the exchange rate ($1.285210/£). With the help of bank staff, the investor could have hedged against exchange rates to realize the presumed profit of £5,940 for the period. More so, he could have specified on which currency he is taking the forward on. Hence, the bank statement is correct based on the currency arbitration concept, exchange rates, and the investor did not specify the currency.

Section B

Question 3: Market Risks on Swap and Currency Swap Dealers

When making payments or receiving payments between themselves from different financial instruments, currency and interest rate swap dealers are faced with various risks that affect their operations. Firstly, it is the interest rate risk that occurs when interest rates are shifting unfavorably even before the swap dealers can begin laying off a different counterparty. Secondly, there is the basis risk, which is a result of the floating rates of two counterparties that are pegged to two varying indices. Equally, in interest and currency situations, the indexes are often not positively or correctly correlated. Further, the mismatch risk happens when the dealers’ experience difficulties in finding a precise different counterpart for a swap that was to happen.  Finally, sovereign risk occurs when a nation imposes currency exchange rate restrictions in a swap. In this case, it makes the swaps expensive or sometimes even impossible for the counterparties to fulfill their swap duties to the dealer. 

Question 4: Depository Receipts over Actual Company in International Portfolio

Investors find it easier to buy depository receipts since they ensure that trading only deals with pre-verified assets that possess an excellent title. The main challenge with purchasing shares for the investor is that they may not have enough time to do thorough research on the company, resulting in them making losses in their investment. Depositaries will also ensure the investor has no worry about wrong deliveries and that the settlement cycle computation is done very fast, ensuring they get their returns quickly.  The depositaries will also ensure that the trader does not incur trading costs as they are done in electronic form, which eliminates stamp duty costs. Depositaries will also reduce all the risks connected with dealing with a physical certificate to the investor. The investor will also gain from there being no share certificate as it deals with paperless trading while also ensuring that the investor gets a nomination certificate. Account-holders can also completely freeze their accounts for any period they wish as a security measure, which is not comparable to the trading of shares.

Question 5: U.S. Balance of Payments

The balance of payment shows a country’s record of its financial and trade transactions with other nations. It also indicates it shows the trade receipts and is made up of the financial, capital, and current accounts. The Japanese gift to the American university is part of the single Transfer transactions, resulting in added value to the Current account. The financing of the Japanese gift is from funds already invested in the country, which will not affect the current account as the funds are not leaving the country. However, it will decrease the U.S Balance of Financial reports by $2million. It is because it is reducing the country’s foreign-owned assets in the country.

Question 6: U.S.Investor’s Perspective

The U.S investor perspective as of 2012 includes that sovereign bonds carry no risks, and they earn interest mostly annually, which is crucial in giving investors a steady return over a long period. The sovereign bonds will offer the investor tax benefits to the investor if they decide to withdraw their funds before the maturity period. The funds from the sovereign bonds are used to finance special projects by the government, resulting in promoting or stimulating economic growth in those nations. They can also be traded on exchange plus also be used collateral for loans. The bonds usually have lower rates of investment, and the investors often expose themselves to inflation risk as the investment will take a lot of years. The investment suits the risk-averse investor, who is patient enough and does not expect high returns.