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International Financial Management

Rappel:  Security= financial asset. It can be convert into portfolio  Currency is an asset like other  Purchasing Power Parity  Interest rate parity theory International Finance: - International Financial Management - International Economics and finance Banking risk management: more regulations to follow since 2008 financial crisis. Derivatives (instrument financier): good tool to help a company to speculate. FOREX (foreign exchange markets): the market where you trade currency. A currency compared to another currency. Lot of turnover in this market. USD is the most traded currency. With five currencies you summarize 95% of the turnover of the Forex. The rest is qualified as “exotic” - USD (90%) - EUR - JPY - GBP (Sterlin) - CHF Managing Forex exposure. We have what we need to manage the risk, but it is quite hard to forecast future spot. If a market is efficient: the information is included in the price. It is very difficult to make money in the Forex. It is only by complicating the products that you can make money on this market. Sourcing capital: how to raise funds to limit Forex risk. Foreign Investment Decisions: how to forecast the CFs. You have counties where you can’t use the CAPEM. Sometime you can use a adjusted CAPEM to calculate the COC of a company. The objective is to forecast the Free Cash Flows. What is special about international finance? - Foreign exchange risk - Political risk - Market imperfections You make money thanks to market imperfections. It is hard to make money in an efficient market. - Expanded opportunity set

3 categories of investors: Risk averse Risk neutral Risk lovers (using leverage) => hedge funds I diversify to reduce the risk, then I optimize the return for each level of risk CML: Capital Market Line Financial Risk management Risk management is more and more important. What quantity of risk do you introduce in your balance sheet? Financial risk: - Micro risks: failure (bankruptcy) of a single operator. Organisation of a trading room: Front office: build a strategy to make money. - Sales: selling products - Traders: pricing the strategies - Structurers: combining products which have different natures Middle office Back office: register the positions, checking if the counterparties are existing and so on. Risk management: check if strategy implemented by the trader is good for the bank. He is controlling the quality of the strategy of the traders taking into account the risk and the return. Internal Audit Compliance -

Macro risk: system failure. If a bank go in bankruptcy it can affect other banks. In a financial system, you need a lender in last resort (preteur de dernier resort), but only in last resort. In the international financial system, the lender in last resort are: 1) IMF 2) Central Banks (manage the liquidity and sovereign risk) 3) Governments

Microprudentials: The banking business model is to lend money to a counterparty. It is a trade of money you land (asset) and money you have on reserve (liabilities). The risk for the banker is on the asset side. Balance sheet of a bank

Asset Lend money

Liabilities Reserves (borrowed on the money market or in central banks) Equity capital

Risks in banking: typology of risks Credit risk: the quality of the counterparty to which I lend money. It is possible to quantify it thanks to notations or internal models. Country and transfer risk: lend money to sovereign debtors (governments, ex: SNCF). It is possible to quantify. Market risk: it is a package. You have a market risk each time an investor invest on a asset which price can fluctuate: - Stocks - Stock industries - Commodities (agricultural, energetic products) - Currencies - Derivatives Interest rate risk: risk when we operate on a money market or financial market. It is normally a market risk (because the price of money can fluctuate). Liquidity risk: the banker is unable to find the liquidity on the money market to run the business. Central banks are in charge of providing the missing money/liquidity. The liquidity risk is when we hold an asset impossible to change into cash. Operational/ Legal. Reputational risk: difficult to define and quantify Operational risk: when supervision is not under control (fraud…) Legal risk: bank can be persecuted. In M&A field, we can have such risk = confidential info transmission Reputational risk: brand of the bank is damaged of other risk like failure, etc. Distinction Bank are also doing off-balance sheet operations. The risk is in and off the balance sheet. To control this risk, there is “capital adequacy” regulations. You want to control if the bank has enough equity capital to face risk. Capital adequacy ration: Equity capital (common stocks, preferred stock, convertible stocks)/ RWA (Risky Weighted Assets) Ex: if I manage credit risk, the counterparty has a certain level of probability of default. If I lend money to a government, the weight is 0

To calculate the weight (0 is not risky, 100% is risky) you use ratings (S&P, Moodies) or an internal model. This models are under control of the financial authorities of the country. CAR should not be lower than 8%. Each time you trade an asset I have to have an equivalent amount of equity capital regulated by CAR. If cost of equity is high, it is difficult to generate equity capital. The return should be adjusted to the risk we introduce in the BS Basel III will be implemented by the end of 2019 (more equity capital and more regulations) Chapter 1: Foreign Exchange Risk and Markets Money Market (MM): inter-bank market. what can you do? You can lend or borrow money (maturity < 1years). MM USD (0: Long net position - The NTP is 4 possibilities - Buy a call - Buy a put - Sell a call - Sell a put Strike price is the agreed price for the purchase or sale Maturity date is the final date at which the buyer can exercise the option American option/ European option Difference: American option: you can exercise your right at every moment European option: you can only exercise your right at the maturity date The price of an American option is higher. •

UNDERLYING ASSET IS THE ASSET TO BE PURCHASED OR SOLD – STOCKS AND STOCKS INDICES – COMMODITIES (agricultural, energy products) – BONDS / INTEREST RATES – CURRENCIES – OPTIONS ! – …

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OPTION BUYER ’S ASYMMETRIC PRIVILEGE MUST HAVE A PRICE THIS PRICE IS CALLED THE PREMIUM OPTIONS CAN BE STANDARDISED AND EXCHANGE TRADED OR BILATERAL AND TAILORMADE CONTRACTS (OTC)

How to know if you sell or buy a currency (short or long)? • Use the « + » and « - » system • + : buy, option to buy, call • - : sell, option to sell, put

CURRENCIES OPTIONS • OPTION BUYER ’S ASYMMETRIC PRIVILEGE MUST HAVE A PRICE • THIS PRICE IS CALLED THE PREMIUM • OPTIONS CAN BE STANDARDISED AND EXCHANGE TRADED OR BILATERAL AND TAILORMADE CONTRACTS (OTC) •

EUR/USD OPTIONS HEDGING

ASSUMPTIONS – SPOT PRICE = FORWARD = STRIKE = 1.00 EUR/USD – EUROPEAN EXPORTER DEALING IN USD – PAYMENT MATURITY : 3 MONTHS Voir feuille. •

Result= with currencies options, you are able: - To manage the currency volatility - To manage conditional operations

Chapter 2: Managing the fluctuations of interest rates Less volatility on interest rates than currencies. Bank Assets Loans

Liabilities MM

CAR is putting a lot of pressure on the strategy of the bank. Don’t mix the underlying assets (commodities/ stocks/ currencies, etc.) INTEREST RATE RISK •

INTEREST RATES : THE PROBLEM – FIXED RATES – FLOATING RATES • ROLL OVER (REVIEWED AT EACH DATE) • VARIABLE (CALCULATED AT THE END OF THE PERIOD) when you invest, you don’t know the interest you are going to receive or pay if you borrow money.

Yield curve (courbe des taux) voir feuille. The advantage of borrowing in the MM is that you have better interest rate (if it is a normal shape). Better situation for the cost of debt. The inconvenient is that the situation on MM can change. I need some tools to manage the fluctuations. – FLOATING RATES • ROLL OVER (REVIEWED AT EACH DATE) – EURIBOR : EURO INTERBANK OFFERED RATE – LIBOR : LONDON INTERBANK OFFERED RATE • VARIABLE (CALCULATED AT THE END OF THE PERIOD) – EONIA : EUROPEAN OVERNIGHT INDEX AVERAGE

– T4M : TAUX MOYEN MENSUEL DU MARCHE MONETAIRE (arithmetical average of EONIA for a month) – TAM : TAUX ANNUEL MONETAIRE (geometrical average of the 12 past T4M) Measuring the interest rate risk Assets LONG e.g. deposits, investments

Liabilities SHORT e.g. loans, notes

– SAME APPROACH THAN FOR FER – NET POSITION CALCULATION • ASSETS - DEBTS – FIXED OR FLOATING – MATURITY – CURRENCY – There is 4 types of exposure level you could have to manage 1) A L LONG Fixed I can lose opportunity to benefit from favorable fluctuation of IR (bullish) 2) A L SHORT Fixed I can lose opportunity to benefit from favorable fluctuation of IR (bearish) 3) A LONG Floating

L

4) A

L SHORT Floating The cost of my loan can increase if the IR on the MM increase (risque de taux opperationnel) OTC CONTRACTS •

INTEREST RATE SWAPS (one of the most traded contract to manage the interest rate risk)

FRA or Forward Rate Agreements (équivalent du marché à terme des taux d’intérêts) • CAPS, FLOORS and COLLARS = european options based on fixed interest rates • OPTIONS, OPTIONS ON FRA, SWAPTIONS ORGANISED MARKETS • FUTURES (contrats à terme de taux d’intérêt) • OPTIONS (options sur contrats à terme de taux d’intérêt) •

More flexibility on OTC markets. Slide 7-19: How to trade on OTC and Organized market. (not compulsory to know) INTEREST RATES SWAPS (swaps de taux d’intérêt) it is a type of forward: you trade now for a future delivery of something. It is a contract by which 2 counterparties exchange a fixed interest rate against a floating one. LEG (jambe): Interest rate paid (fixed or floating) and interest rate received (fixed or floating) •

– DEFINITION AND OBJECTIVES – EXAMPLE • A COMPANY BORROWED 10 MILLIONS GOOD STRONG EUROS AT FIXED RATE (6% per year) FOR 5 YEARS • INTERESTS ARE PAID EACH YEAR (END) • REPAYMENT « in fine » or « balloon » • BEARISH ANTICIPATIONS (baisse anticipée) 2 objectives: - Manage the interest rate risk - Reduce the coast of debt •

SECOND EXAMPLE (a better one!) – CONSIDER 2 OPERATORS, ONE (A) WITH A BETTER CREDIT RATING THAN THE OTHER (B). – CLEARLY, A CAN GET A LOWER INTEREST RATE THAN COMPANY B IN BOTH THE FIXED AND THE FLOATING RATE MARKETS (avantage absolu)

Fixed market Floating market

A AA+ 5% LIBOR (Outright: no margin)

B A6% LIBOR +0,5%

Risk premium 1% 0.50%

Net premium= 0.50% (Arbitrage opportunity) •

HOWEVER, THE RISK PREMIUM FOR CORPORATE DEBT IS GREATER IN THE FIXED MARKET THAN THE FLOATING MARKET.

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THEREFORE, A HAS A GREATER RELATIVE ADVANTAGE IN THE FIXED MARKET THAN THE FLOATING MARKET. (avantage comparatif) So, we could try to enjoy a free lunch (arbitrage opportunity=net risk premium)

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What strategy for A? What strategy for B? Ask for intermediaries’ help! Everybody should gain something! How to check? Sum of gains=net premium Any problems for the banker?

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Voir schéma feuille. Swap Market: ROE=

Margin (0,10 %) Credit Risk

RAROC (Risk adjusted return on capital) =

Margin (0,10 %) Equity Capital for hedging credit risk

Course summary: For the Exam: - Read chapter 27 and 28 of BMA and practice end of chapters’ exercise plus sample exams - Basel typology: the framework - Foreign Exchange market and risks:  Exposure (currencies balances)  FOREX organization  Currency forwards: pricing based on an arbitrage  Currency options: strategies (vanilla, ZPO)...