International Financial Operations: Arbitrage, Hedging, Speculation, Financing and Investment

385 Pages·2003·2.61 MB·English

by  Imad Moosa

International Financial
Operations(cid:1)
Arbitrage,(cid:1) Hedging,(cid:1) Speculation,(cid:1) Financing and(cid:1)
Investment(cid:1)
Imad A.(cid:1) Moosa(cid:1)
International Financial
Operations
Arbitrage, Hedging, Speculation,
Financing and Investment
IMAD A. MOOSA
© Imad A. Moosa 2003
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Contents

List of Figures ix

List of Tables xiii

Currency Symbols xv

List of Abbreviations xvi

Notation and Conventions xviii

Preface xx

1 Two-Currency, Three-Currency and Multi-Currency Arbitrage 1

1.1 Definition of Arbitrage 1

1.2 Two-Currency Arbitrage 2

1.3 Three-Currency Arbitrage 12

1.4 Multi-Currency Arbitrage 15

1.5 Examples 17

2 Covered and Uncovered Interest Arbitrage 19

2.1 Covered Interest Arbitrage Without Distortions 19

2.2 The No-Arbitrage Condition With Bid–Offer Spreads 24

2.3 Deviations From the CIP No-Arbitrage Condition 26

2.4 Combining Covered Arbitrage With Three-Currency Arbitrage 36

2.5 Uncovered Interest Arbitrage 39

3 Other Kinds of Arbitrage and Some Extensions 44

3.1 Commodity Arbitrage 44

3.2 Arbitrage Under the Gold Standard 47

3.3 Arbitrage Between Eurocurrency and Domestic Interest Rates 49

3.4 Eurocurrency–Eurobond Arbitrage 51

3.5 Arbitrage Between Currency Futures and Forward Contracts 52

3.6 Real Interest Arbitrage 53

3.7 Uncovered Arbitrage When the Cross Rates Are Stable 54

3.8 Uncovered Interest Arbitrage When the Base Currency Is

Pegged to a Basket 57

3.9 Misconceptions About Arbitrage 60

v
vi CONTENTS
4 Hedging Exposure to Foreign Exchange Risk: The Basic Concepts 65

4.1 Definition and Measurement of Foreign Exchange Risk 65

4.2 Value at Risk 69

4.3 Definition and Measurement of Exposure to Foreign

Exchange Risk 73

4.4 Transaction Exposure 82

4.5 Economic and Operating Exposure 84

4.6 A Formal Treatment of Operating Exposure 93

4.7 Translation Exposure 100

5 Financial and Operational Hedging of Exposure to Foreign

Exchange Risk 105

5.1 Why Do Firms Hedge Exposure to Foreign Exchange Risk? 105

5.2 To Hedge or Not to Hedge? 106

5.3 The Design of a Hedging Strategy 110

5.4 The Basic Principles of Hedging 110

5.5 Money Market Hedging of Short-Term Transaction Exposure 118

5.6 Forward and Futures Hedging of Short-Term

Transaction Exposure 124

5.7 Options Hedging of Short-Term Transaction Exposure 128

5.8 Financial Hedging of Long-Term Transaction Exposure 137

5.9 Other Financial and Operational Techniques of

Hedging Transaction Exposure 138

5.10 Hedging Operating Exposure 147

5.11 Hedging Translation Exposure 149

5.12 What Do Firms Do in Practice? 150

6 Measuring the Hedge Ratio 156

6.1 The Concept of the Hedge Ratio 156

6.2 Measuring the Optimal Hedge Ratio 158

6.3 Empirical Models of the Hedge Ratio 160

6.4 Evaluating the Effectiveness of Hedging 167

6.5 Static and Dynamic Hedging 172

6.6 An Illustration Using Cross Currency Hedging 174

7 Speculation in the Spot and Currency Derivative Markets 183

7.1 Definition of Speculation 183

7.2 Spot Speculation 184

7.3 Spot Speculation Based on Special Events 191

7.4 Spot–Forward Speculation 193

7.5 Forward Speculation 194

7.6 Speculation With Currency Options 195

7.7 Combining Speculation With Arbitrage and Hedging 197

7.8 Hedging as a Speculative Activity 203
CONTENTS vii
7.9 Stabilising and Destabilising Speculation 204

7.10 Speculative Bubbles 206

8 Speculation: Generating Buy and Sell Signals 209

8.1 Speculation on the Basis of Expectation Formation 209

8.2 Speculation on the Basis of Technical Analysis 218

8.3 Speculation on the Basis of Trading Rules 226

8.4 Speculation on the Basis of Fundamentals 231

8.5 Heterogeneity of Speculators as a Source of Exchange

Rate Volatility 237

8.6 An Illustration 243

9 International Short-Term Financing and Investment 249

9.1 Why Foreign Currency Financing and Investment? 249

9.2 Sources of Financing and Investment Outlets 250

9.3 International Cash Management 253

9.4 The Effective Financing Rate and the Effective Rate of Return 258

9.5 Introducing the Bid–Offer Spreads 261

9.6 Implications of CIP and UIP 263

9.7 The Probability Distribution of the Effective Financing

Rate and the Effective Rate of Return 265

9.8 Using Currency Portfolios for Short-Term Financing

and Investment 267

10 International Long-Term Financing, Capital Structure and the

Cost of Capital 271

10.1 International Bank Loan Financing 271

10.2 International Bond Financing 274

10.3 International Equity Financing 277

10.4 Other Sources of Financing 279

10.5 The Cost of Capital 280

10.6 Variations in the Cost of Capital and Capital Structure 283

10.7 Debt and Equity Exposure 287

11 International Long-Term Portfolio Investment 294

11.1 Overview 294

11.2 Investment in Bonds 295

11.3 Investment in Equities 299

11.4 International Equity Returns and Diversification 303

11.5 International Capital Asset Pricing Model 308

11.6 Managing Foreign Exchange Risk in International Portfolios 312

12 Foreign Direct Investment 318

12.1 Definition and Classification 318
viii CONTENTS
12.2 Explaining Foreign Direct Investment 321
12.3 International Capital Budgeting 328
12.4 Project Evaluation Criteria 331
12.5 Adjusting Project Assessment for Risk 336
References 341
Index 357
List of Figures

1.1 The effect of two-currency arbitrage.

1.2 The no-arbitrage line (two-currency arbitrage).

1.3 The effect of two-currency arbitrage in the presence of brokerage fees.

1.4 The no-arbitrage line in the presence of brokerage fees.

1.5 The no-arbitrage zone in the presence of progressive brokerage fees.

1.6 The effect of two-currency arbitrage in the presence of partial capital

controls.

1.7 The effect of two-currency arbitrage in the presence of bid–offer spread.

1.8 The no-arbitrage condition in the presence of bid–offer spread.

1.9 The effect of three-currency arbitrage.

2.1 The no-arbitrage condition implied by CIP.

2.2 The effect of covered arbitrage.

2.3 The no-arbitrage line in the f – (ix – iy) space.

2.4 The covered margin (percentage points).

2.5 Covered arbitrage in the presence of transaction costs.

2.6 Covered arbitrage in the presence of political risk.

2.7 Covered arbitrage in the presence of tax differentials.

2.8 Covered arbitrage in the presence of transaction costs, political risk

and tax differentials.

2.9 The effect of covered arbitrage in the presence of inelastic supply and

demand and similar factors.

2.10 The effect of covered arbitrage in the presence of inelastic supply and

demand and similar factors (the CIP diagram).

2.11 The uncovered margin (percentage points).

3.1 The effect of commodity arbitrage.

3.2 The purchasing power parity relationship.

3.3 Actual and PPP exchange rates.

3.4 Exchange rate determination under the gold standard.

3.5 Determination of domestic and Eurocurrency interest rates.

3.6 Uncovered arbitrage when the base currency is pegged to a basket.

ix