(C89SM) Securities Markets 1 PDF

Heriot-Watt Management Programme
Securities Markets 1
Ian Hirst Michael A Kerrison Alexandra Berketti
School of Management and Languages Heriot-Watt University Edinburgh EH14 4AS, United Kingdom. Version 2010.1
Heriot-Watt Management Programme School of Management and Languages Heriot-Watt University Edinburgh Scotland UK EH14 4AS Telephone Fax E-Mail +44(0) 131 451 3864 +44(0) 131 451 3865 external@sml.hw.ac.uk
http://www.sml.hw.ac.uk/external First published 2000 by Heriot-Watt Management Programme (ISBN: 0-273-64538-2). Republished 2009 (ISBN: 978-1-907291-29-6). This edition published in 2010 by Heriot-Watt Management Programme. Copyright Heriot-Watt Management Programme. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publishers. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers.
Distributed by Heriot-Watt University. Heriot-Watt Management Programme : Securities Markets 1 ISBN 978-1-907291-43-2 Printed and bound in Great Britain by Graphic and Printing Services, Heriot-Watt University, Edinburgh.
Acknowledgements
Ian Hirst MA, MBA, PhD is Professor of Finance at Heriot-Watt Univerity. He studied for his PhD at the University of Chicago and has taught at several universities in the UK, the USA and Australia. His teaching experience covers undergraduate, postgraduate and executive levels. His research interests centre on stock market prices and activity. He is the author of articles on share valuation and stock market behaviour, has written a textbook on Business Investment Decisions and has also produced a number of case studies on coporate nance. Michael A Kerrison is the Director of Educational Policy Development and Solutions at the ifs School of Finance. Mr Kerrison is a qualied Chartered Accountant, an afliate Member of the Chartered Institute of Bankers in Scotland and graduated with rst class honours in accountancy and nance from Dundee University. He is an active researcher and has published and presented papers in the eld of accountancy and nance education. He has been awarded grants to enable the development of educational courseware supporting learning on accountancy and nance programmes in ratio analysis, introduction to basic mathematics in nance and capital investment appraisal. He continues to keep a close involvement with accountancy, banking and investment professional institutes through positions as examiner and visiting lecturer. Mr Kerrison has been invited to and has helped to develop and deliver nance courses on modern portfolio theory and the role of Capital Markets for European Business Schools and Colleges in France and Hungary. He combines his professional knowledge with his experience as a lecturer, programme designer and courseware developer in designing the materials for this programme. Alexandra Berketti BSc, MSc, PhD is a senior Economist of the Hellenic Capital Market Commission and a visiting Professor at ICBS College. She studied for her doctorate at HeriotWatt University, from where she graduated with a PhD in Actuarial Science. Her current research interests center on regulatory issues that ensure the development of a single European nancial market. She is professionally involved with the Committee of European Securities Regulators (CESR) participating in expert groups dealing with Market Abuse and the revised Investment Services Directive.
Contents
1 Bonds 1.1 Introduction . . . . . . . . . . . . . . . . . 1.2 The size and growth of the bond markets 1.3 Basic bond characteristics . . . . . . . . . 1.4 Bond issuers . . . . . . . . . . . . . . . . 1.5 Bond purchasers . . . . . . . . . . . . . . 1.6 Types of bond . . . . . . . . . . . . . . . . 1.7 Bond default . . . . . . . . . . . . . . . . 1.8 Bond rating agencies . . . . . . . . . . . . 1.9 Bond ratings and efcient markets . . . . 1.10 Conclusions . . . . . . . . . . . . . . . . . 1.11 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 2 3 4 8 9 14 17 20 21 21 23 24 24 25 26 26 27 30 31 36 36 39 40 40 41 45 46 51 52 53 55 57 57 59 62 63 67 68 70
2 Bond Yields, Prices and Bond Swaps 2.1 Introduction . . . . . . . . . . . . . . . . . . . . 2.2 Bond yields with annual coupon payments . . . 2.3 Bond yields with semi-annual coupon payments 2.4 Interest yield . . . . . . . . . . . . . . . . . . . 2.5 Real yields . . . . . . . . . . . . . . . . . . . . 2.6 Bond price quotations . . . . . . . . . . . . . . 2.7 Bond issuance and bond trading . . . . . . . . 2.8 Bond swaps (Interest rate swaps) . . . . . . . . 2.9 Conclusions . . . . . . . . . . . . . . . . . . . . 2.10 Review Questions . . . . . . . . . . . . . . . .
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3 Bond Price Sensitivity 3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Bonds and risk . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 The price/yield relationship . . . . . . . . . . . . . . . . . . . 3.4 Using duration . . . . . . . . . . . . . . . . . . . . . . . . . . 3.5 Characteristics of duration numbers and duration calculations 3.6 Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.8 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . 4 Yield Curves and the Term Structure of Interest Rates 4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Drawing the yield curve . . . . . . . . . . . . . . . . . 4.3 The shapes of yield curves . . . . . . . . . . . . . . . 4.4 The economic interpretation of yield curve shapes . . 4.5 Spot rates and forward interest rates . . . . . . . . . . 4.6 Approximate yield curve calculations . . . . . . . . . . 4.7 Yield curves and bond investment . . . . . . . . . . . 4.8 The pure expectations hypothesis (PEH) . . . . . . . .
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ii
CONTENTS
4.9 4.10 4.11 4.12 4.13
The liquidity preference hypothesis . . Preferred habitat/market segmentation Evidence . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . .
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73 74 75 78 78 81 83 83 84 86 88 89 91 92 93 107 107 108 111 113 113 114 133 135 139 141 141 145 147 147 151 152 155 157 161 162 162 165 167 167 170 171 175 175 175
5 Currency Exchange Rates 5.1 Introduction . . . . . . . . . . . . . . . . . . . 5.2 Dealing in the Foreign Exchange Market . . . 5.3 Exchange rate arrangements among markets 5.4 International swift codes . . . . . . . . . . . . 5.5 Exchange rate quotations . . . . . . . . . . . 5.6 Bid-offer prices . . . . . . . . . . . . . . . . . 5.7 Cross exchange rates . . . . . . . . . . . . . 5.8 Triangular arbitrage . . . . . . . . . . . . . . . 5.9 Overview of strong currencies . . . . . . . . . 5.10 Summary . . . . . . . . . . . . . . . . . . . . 5.11 Further reading . . . . . . . . . . . . . . . . . 5.12 Review Questions . . . . . . . . . . . . . . .
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6 International Exchange Rate Parity Theories 6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2 Determining foreign exchange rates using the fundamental approach 6.3 Foreign exchange rate parity theories . . . . . . . . . . . . . . . . . 6.4 Determining foreign exchange prices using Technical Analysis . . . 6.5 Determining foreign exchange prices using other approaches . . . . 6.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.7 Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.8 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 International Portfolio Diversication 7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2 Risk and return in portfolios: the core principles . . . . . . . . . . 7.3 Risk diversication . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4 Diversifying risk in world markets . . . . . . . . . . . . . . . . . . 7.5 Other factors to consider when investing in international markets 7.6 The efcient frontier and a world market portfolio . . . . . . . . . 7.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.8 Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.9 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Measuring Portfolio Risk, Return and Performance 8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . 8.2 Portfolio returns . . . . . . . . . . . . . . . . . . . . 8.3 Portfolio risk . . . . . . . . . . . . . . . . . . . . . . 8.4 Benchmarking performance . . . . . . . . . . . . . 8.5 Summary . . . . . . . . . . . . . . . . . . . . . . . 8.6 Further Reading . . . . . . . . . . . . . . . . . . . 8.7 Review Questions . . . . . . . . . . . . . . . . . .
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Heriot-Watt University Securities Markets 1
CONTENTS
iii
Answers to questions and activities 1 Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Bond Yields, Prices and Bond Swaps . . . . . . . . . 3 Bond Price Sensitivity . . . . . . . . . . . . . . . . . . 4 Yield Curves and the Term Structure of Interest Rates 5 Currency Exchange Rates . . . . . . . . . . . . . . . 6 International Exchange Rate Parity Theories . . . . . 7 International Portfolio Diversication . . . . . . . . . . 8 Measuring Portfolio Risk, Return and Performance . .
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176 176 179 182 185 188 190 193 195
Chapter 1
Bonds
Contents
1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The size and growth of the bond markets . . . . . . . . . . . . . . . . . . Basic bond characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond purchasers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Types of bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.7.1 Declaring default . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond rating agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond ratings and efcient markets . . . . . . . . . . . . . . . . . . . . . . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2 3 4 8 9 14 17 17 20 21 21
Learning Objectives On completion of this chapter students should be able to understand: The basic characteristics of bonds; The major categories of bond issuers and bond purchasers; The different types of bond that may be issued; What happens when bonds default The function and activities of bond rating agencies
Chapter 1. Bonds
1.1
Introduction
This chapter will explain the basic types of bonds that are issued in nancial markets and the main categories of issuers. It will look at the rights which investors acquire when they buy bonds and how these rights can protect (or, sometimes, fail to protect) investors if the bond goes into default. It will also look at the role of Rating Agencies, which play a very important part in the functioning of bond markets.
1.2
The size and growth of the bond markets
Bond markets are enormous. They play a central role in the global nancial system. In 2001 there were 33 trillion dollars of bonds outstanding. Of these, about 15 trillion dollars were bonds issued by companies and the remainder by Governments or governmentlinked agencies. The bond markets have also been growing rapidly. The total nominal value of outstanding bonds in 1996 was about 25 trillion dollars, and this amount grew by about 34% over the subsequent 5 years. Why have bond markets been growing so quickly? One important reason has been the trend in nancial markets to securitisation and to disintermediation. Bonds are securities, so an increased use of bonds is called securitisation. They are loans which are marketable. Loans which are not marketable are made by banks. Bank loans and bonds are, for many issuers, alternatives. They are both types of debt. A bank is an intermediary. The saver makes a deposit in the bank and the bank then lends the money on to the borrower. This process of intermediation has a cost. In particular, the bank has its own capital and it has to earn a return on that capital. The bond markets bring savers and borrowers together directly. Intermediaries (such as banks) are not required. For this reason, the switch from bank nance to bond nance is called disintermediation. The nancial markets have found that, in many cases, disintermediation or securitisation is the most efcient form of nance. Bond markets have grown as a result. Although banks have grown too, they have not grown as fast as bond markets. Sometimes an intermediary can add value. Banks, for example, can be more exible in their lending than the bond markets. A bank borrower who is in nancial difculty can meet with his banker and, perhaps, negotiate a change in the loan agreement. A bond issuer cannot meet or negotiate with the hundreds of investors who own its bonds. The issuer may not even know who the bondholders are, and they will be a constantly changing group as the bonds are bought and sold.
Securitisation - the case of the Rock dinosaurs

The great era of Rock and Roll was the 1960s and the 1970s. Many of the great stars from that era are still performing. They are known as Rock dinosaurs. Their music is still played on radio and their music still sells on CDs. The Rock dinosaurs are rich. Suppose you are a banker and a Rock dinosaur comes to you for a loan. How will you react? Rock dinosaurs (although they vary greatly in their way-of-life) are often not Heriot-Watt University Securities Markets 1
1.3. Basic bond characteristics
ideal borrowers. Expensive life-style, wild parties, alimony to ex-wives, maintenance payments for numerous children. . .. Bankers like to lend money to sober, reliable and responsible borrowers. But there is another way. A bond can be issued, and the cash to repay the bond can come from the royalties on the back-catalogue of songs from the Rock dinosaurs past. Legal arrangements are made so that bondholders have the rst claim to the royalty income. They dont have to worry about the Rock dinosaurs life-style and behaviour. As long as the old songs keep selling, they will get their money. So a good answer to give the rock-star when he comes asking for a loan is Yes, I can certainly get the money for you - but I have a better idea than a bank loan. Why dont you issue a bond?
1.3
Basic bond characteristics
Bonds come in many different varieties as this chapter will soon explain. However, a basic plain vanilla bond would have the following characteristics. Unit 100 nominal or face value. This is the principal amount of the bond. It is the amount which will be paid to the bondholder when the bond is redeemed at the end of its life. Coupon Rate Suppose the coupon rate is 7%. This would mean that each 100 nominal bond would pay 7 in interest each year. The coupon is a percentage of the principal amount of the bond. The coupon rate is set when the bond is issued and remains the same throughout the bonds life. The coupon rate will be, roughly, the interest rate at the time the bond is issued. Payment Frequency Some bonds pay interest annually, some semi-annually and some quarterly. Semiannual payment is most common in the UK. For a 7% coupon bond, this would mean that each 100 (nominal) bond would make interest payments of 3.50 at 6 monthly intervals. Redemption When the bond is redeemed (or reaches maturity) the nominal value is repaid to the bondholder and the bond ceases to exist. The repayment of the 100 (the principal amount) will coincide with the nal interest payment. The life of a bond, from issue to redemption, is generally in the range 5-30 years. A bond is normally described as Name of Issuer Coupon Rate Redemption Year. British Land is a large real estate company in the UK. It has a bond outstanding which is British Land 63 /4 2028. Bond is an American term. In the UK, bonds are often called by other names, such as Loan Stock or, for bonds with a specic legal structure, Debentures. However, the Heriot-Watt University Securities Markets 1
Chapter 1. Bonds
American term is now commonly used world-wide and we shall use it in this module. A bondholder has the right to be paid the coupon rate of interest and, eventually, to the repayment of the principal. Owning a bond which has been issued by an organisation does not give ownership of that organisation and does not give any right to inuence the running of the organisation. Bonds differ from shares in this respect. A shareholder in a company has a right to receive the annual report, a right to attend and vote at the annual general meeting and a right to propose resolutions or to propose individuals as directors. Bondholders are not involved in any of these activities. For example, a company can be taken over, and new management with new policies can be introduced, without the bondholders being involved or consulted in any way. Companies will normally only have one class of shares. All shareholders are equal. Every share carries one vote. When new shares are issued, they carry exactly the same rights as the old ones. With bonds, the situation is different. Generally a new issue of bonds will have a different coupon rate and a different redemption date from the ones that preceded it. Organisations will typically have a number of different bond issues outstanding at the same time.
1.4
Bond issuers
Bond Issuers must be credit-worthy organisations. No-one would lend money to an organisation if they did not believe it would repay the debt. They must also be large organisations. Bond issues of less than 50 million or $100 million would be rare. Bonds are marketable securities and a successful market needs constant activity by buyers and sellers. A small issue of bonds would be held by a small number of investors and would not generate sufcient trading activity. The main categories of bond issuers are: Sovereigns States raise money partly through taxes and partly by issuing bonds. If they want to raise money quickly or to meet a temporary need, then bond nance is more convenient. Some states are unstable or lack a strong, reliable institutional structure. They will be unable to issue bonds because no one will buy them. A sovereign state is usually the largest issuer of bonds in its own currency and these form the benchmark. Bonds from other issuers are priced in relation to the sovereign benchmark bonds. Examples
1. The Kingdom of Italy In the mid 19th century the Kingdom of Italy was created from the variety of smaller states that had previously existed in the Italian peninsula. A new Italian parliament was created. Soon, the new nance minister was able to announce that Kingdom of Italy bonds had successfully been sold in London. Wild cheering and celebrations broke out in the parliament. The new state had passed Heriot-Watt University Securities Markets 1
1.4. Bond issuers
a key test. In the eyes of the world it was a stable, creditworthy institution.
2. Alexander Hamilton In the 18th century, when the American colonists had won their war of independence against Britain, they founded the United States of America. The rst nance minister (Secretary of the Treasury) was Alexander Hamilton. To pay the costs of the war of independence, the individual states had issued bonds and, in several cases, these bonds were in default. The states were not paying the interest that had been promised. Hamilton insisted that the new United States government should take over these state bonds and make the promised payments. He made sure that the necessary taxes were raised to make these payments. When small whiskeydistillers refused to pay excise tax, he personally led the troops to crush their resistance. He was not very popular. But the benet of a high credit rating was soon clear for the young Republic. In 1803 the United States had the chance to buy Louisiana from France. Louisiana was a huge territory stretching from the Mississippi River to the Rocky Mountains and covering about a million square miles. How could the United States afford such a large purchase? No problem - it had established its credit-worthiness. It could, and did, issue bonds. Today, the United States is the most credit-worthy borrower in the world. For more than two centuries, it has always paid its debts. States have defaulted, and cities in the US have gone bankrupt, but not the Federal government. A nancially secure government has been an enormous advantage in the economic growth and development of the United States. Credit-worthiness, once lost, is very difcult to restore. The United States government established its nancial credibility at the very beginning. Some countries in Latin America have not succeeded after 200 years. The impeccable credit standing of the United States is sometimes called Hamiltons Blessing.
Sovereign bond issues, especially from major industrial economies, are generally lowrisk. But they are not free of default-risk. How likely is default? Default is less likely when the bond is issued in the sovereign governments own currency. Most British government bonds are denominated in British pounds. If necessary the British government could singly provide the currency needed to repay them. So default is unlikely. If a Latin American country issues bonds denominated in US dollars then repayment may be more difcult and default is more likely. What happens if default takes place? Can legal action be taken against a sovereign state? Every bond issue species which countrys legal system is to be used if there is a default. Most sovereign issues will specify the laws of the issuing country. Within its own boundaries, a sovereign state makes the law. Suing a sovereign state in its own courts is not likely to be successful. However, some sovereign bonds specify a different jurisdiction. Latin American countries, for example, have often issued bonds denominated in US dollars and governed by the law of New York State. These bonds are largely sold to US investors. In case of default, they can sue in the New York courts and can win the right to seize Heriot-Watt University Securities Markets 1
Chapter 1. Bonds
any assets, within the US, owned by the debtor nation. If the sovereign borrower has a state owned airline, the bondholders can seize any of its aircraft that land in the US. Sovereign governments will be keen to avoid this sort of embarrassment. The other tactic for sovereign bondholders is patience. A sovereign government may default and, at the time, there is not much that the bondholder can do about it. But, some time in the future, the sovereign government will want to borrow again. Will investors be willing to buy new bonds when the old bonds are in default? Making a settlement on the old bonds may be a necessary condition for a sovereign government to return to the credit markets.
Example : Tsarist Bonds In 1917 a Communist Revolution took place in Russia. The new Communist government defaulted on all the bonds issued by the previous Tsarist governments. The Communist government had nothing to do with the nancial markets of the capitalist world. In 1991 the Communist system in Russia collapsed. The post-Communist government had to negotiate a settlement on old bonds, which had been in default for 70 or more years, before they could issue new ones.
International Agencies The International Bank for Reconstruction and Development (usually called the World Bank), the European Investment Bank, and other international bodies are major bond issuers. These international agencies are controlled by the major industrialised countries. This gives them a high credit rating. Local and Regional Governments Some countries give bond-issuing powers to city or provincial governments. The UK does not. British cities and regions do not issue bonds, nor do the devolved governments in Scotland, Wales and Northern Ireland. But, in Germany, the states (the Lnder) can issue bonds. In the US there is a very large market in bonds issued by states and cities. It is a curious feature of the federal system of government in the US that interest on these bonds (called Municipal bonds) is exempt from federal income tax. Local government units can default. Cities in the US sometimes default on their debt. Generally, however, local and regional governments are low-risk borrowers. Most sovereign states would try to avoid defaults by local units. These defaults might affect their own credit rating. Agencies and Para-statal Organisations Sovereign states often set up state-owned organisations to carry out specic tasks. Sometimes these organisations are set up like ordinary companies in which the government owns 100% of the shares. Sometimes these organisations are created by special legislation.
1.4. Bond issuers
Examples of major state-owned bond issuers are Electricit de France (electricity generation, distribution and supply in France), PDVSA (the Venezuelan oil company), and Federal National Mortgage Association (FNMA, called Fannie Mae), which issues bonds in the US backed by mortgages on US homes. Fannie Mae is a government agency, but it is nancially distinct from the US government itself. It is unlikely, but perfectly possible, that it could default on its bonds. The US government has not provided a legal guarantee that its bonds will be paid. Corporates Bonds are a very important source of long-term nance for companies around the world. To issue bonds, a company will need to get a satisfactory rating from one or more of the leading bond rating agencies. How these agencies operate and how they award ratings will be explained later in this chapter. Corporate bonds vary greatly in their level of default risk. Until the 1980s almost all corporate bonds, at the time they were issued, were regarded as safe. They had high ratings and a fairly low coupon rate. However, in the 1980s there was a new development in the corporate bond market. Companies started to issue High-Yield bonds (also known as Junk bonds). Previously, the only high risk-of-default/high yield bonds were bonds which had originally been issued as low risk, but the issuing company had got into nancial difculty. These bonds were called fallen angels. Junk bonds were known to be high-risk bonds at the time they were issued. There was a signicant likelihood that they would go into default. But the coupon was set at a sufciently high level to compensate for this risk.
Example : Michael Milken Why did junk bonds suddenly appear in the 1980s? One man was largely responsible, Michael Milken, who worked for the US investment bank Drexel Lambert. In the early 1980s, interest rates in the US were high (policy makers were using high interest rates to try and reduce the level of ination) and share prices were low. Mr Milken saw that Investors would like to buy bonds that offered very high interest rates. The recent performance of the stock exchange discouraged them from buying shares. With share prices low, it was possible to buy companies cheaply (for example, by take-overs). These acquisitions could be funded by issuing high-yield bonds. If interest rates were to fall, the bonds were designed in such a way that they could be repurchased and replaced with cheaper debt. So many businesses found it attractive to issue high-yield bonds. Historically there was evidence that high-yield fallen angel bonds had given investors good returns. Mr Milken drew attention to this evidence when encouraging investors to buy high-yield bonds. The high-yield bond market grew very rapidly and was energetically promoted by Mr Milken. Mr Milken was perhaps a little too energetic. He fell foul of US securities law and went to prison. Drexel Lambert went out of business. But the high-yield Heriot-Watt University Securities Markets 1
Chapter 1. Bonds
bond market has ourished ever since. Mr Milken was a pioneer. But remember the old Business School saying. What do pioneers get? Arrows in their backs.
Corporate bonds are private sector nancial claims. In the event of default, a standard legal process will operate, normally without any government intervention. The process of default will partly be governed by the legal arrangements under which the bond was issued. This is not a law module, but there will be a short discussion of different legal clauses associated with bond issues later in this chapter. The default process will also be affected by the legal jurisdiction in which it takes place. Developed countries have very different systems. In France, the process of restructuring a company that cannot pay its debt gives great importance to preserving as many jobs as possible. In the US, companies can go into Chapter 11 reorganisation and managers keep their jobs while they try to negotiate new arrangements with the companys creditors. In Britain, the priority is getting as much money back for bondholders and other creditors as possible. Both managers and other employees may lose their jobs as part of this process. Why is London such a giant nancial centre? One reason is that the legal system in the UK strongly protects the rights of creditors (including bondholders) and shareholders. Investors from around the world are happy to invest their money in London.
1.5
Bond purchasers
There are three main types of buyer. Insurance Companies - Life Insurers have to pay out when their policyholders die. Every individual death is unpredictable, but the laws of statistics mean that an insurance company, with many thousands of policyholders, can predict fairly accurately how many of them will die each year and how much money it will have to pay out. Bonds are very suitable investments under these circumstances. They pay xed amounts of money in future years. The insurance company can buy a portfolio of bonds so that the cash inow each year from the bonds will match the expected cash outow each year to policyholders who have died. Insurance companies also write annuity policies. These give the policyholder an annual payment for each year until they die. For these policies, too, the insurance company can calculate the expected pattern of future cash outows and match them by suitable purchases of bonds. Pension Funds - Pensions are very similar to annuities. If pensions are xed in money terms, then bonds are suitable assets to match a pension funds liabilities. If pensions are to be protected against ination, then bonds may not be so suitable. The assets of most pension funds will be invested in a mixture of bonds and equities. Private Investors - Investing in bonds has not been very popular with private investors in the UK. Britain has experienced substantial ination and since bonds offer an income Heriot-Watt University Securities Markets 1
1.6. Types of bond
which is xed in money terms, UK bondholders have suffered from this. In countries such as Switzerland or Germany, where ination has been considerably lower, private investors buy considerable quantities of bonds.
1.6
Types of bond
Bonds can be categorised in several different ways. Term to maturity - Most bonds have a specied date on which they are redeemed. A bond with more than 15 years before redemption is generally called long-dated; 515 years is medium dated and less than 5 years is short-dated. When bonds are rst issued, it is rare for them to have less than 5 years or more than 30 years before redemption. A few bonds have no redemption date; they will pay interest forever. They are sometimes called perpetuities, irredeemables, or undated bonds. The UK government has irredeemable bonds outstanding. They were originally linked to the nancing of the Great War 1914-18. Almost 100 years later, they are still in existence. There is no xed redemption price, but of course, if the UK government wanted to terminate these bonds, it could buy them in the market at the open market price. Most bonds are bullet bonds. The whole bond issue will be redeemed on a single date. This may not suit the issuers cash ow. It might prefer to divide the redemption process over a number of years. This can be done in two ways. 1. Divide the bond issue into different tranches each with a different redemption date. One tranche in, say 2010, one in 2012, one in 2014 and one in 2016. The danger here is that each tranche is smaller in market value than the overall package. If the tranches are too small, the marketability of the bonds will suffer. 2. Establish a sinking fund. The sinking fund provides for the issuer to make additional payments each year (separate from the interest payments) to retire part of the debt. Sometimes the debt to be retired is bought in the market at the market price. Sometimes, however, the issuer has the right to repurchase a specic number of bonds each year at the nominal price. If the market price is above the nominal price, bondholders will not volunteer to have their bonds redeemed. The numbers of all the bond certicates will be put into a hat and the numbers of the ones to be redeemed will be drawn by lot. In this way, by using a sinking fund system, all the bonds are identical and the marketability of the bond issue is increased. The bondholders face some uncertainty. They do not know when each of the bonds they hold will be redeemed. But an institution that holds a large number of bonds will have a fairly accurate idea of how many of its bonds will be retired at each redemption date. Interest and principal payments - For straight bonds the interest and principal payments are xed at issue for the life of the bond. However some bonds make interest and redemption payments that are protected against ination. The coupon rate on these bonds is generally low, about 2 per cent or 3 per cent, but all the interest and principal payments are increased in the proportion Heriot-Watt University Securities Markets 1
10
Chapter 1. Bonds
Price index at the time of payment Price index at the time the bond was issued
These are known as index-linked bonds. The bondholder knows the purchasing power of each of the payments he will receive, but he does not know exactly how much money he will get. Ination is a major risk for bondholders, so bonds offering ination protection can be attractive. Several major developed countries (including US, UK, Canada, France and Sweden) have issued sovereign index-linked bonds. One major UK company, the supermarket group Tesco, has issued Limited price indexation (LPI) bonds. Each year, the interest payment is increased in line with ination up to a maximum of 5 per cent. Why issue such a bond? In fact this is an example of creative bond design. In the UK, certain pensions must be index-linked each year up to a maximum of 5 per cent. The pension payment does not have to match any ination level above 5 per cent. So the Tesco LPI bond exactly matches the needs of an important class of bondholder and, from Tescos point of view, it is much more attractive to offer LPI than to offer protection against all possible future rates of ination. Investment bankers draw very high salaries for inventing nancial investments, like LPI bonds, which suit the needs of both bond issuers and bondholders. A Floating Rate Note (FRN) makes interest payments which vary every six months according to changes in the short-term interest rate. In the UK, the benchmark for FRNs is usually the 6 month LIBOR (London Inter-bank Offer Rate) and the interest rate paid is a specied spread above this level. The spread might be 50 basis points (0.5%). So for a six month period over which LIBOR (in the relevant currency) was 4.70%, the interest paid by the bond would be 4.70% + 0.50% = 5.20% of the nominal value. Both index-linked bonds and FRNs offer bondholders some protection against ination. Index-linkers offer protection directly. FRNs offer some protection because interest rates tend to rise when ination rises. Note that, with an FRN, the bond issuers compensate for ination during the life of the bond. The nal repayment of principal is xed in money terms. If ination (and interest rates) rise, then compensation is made through higher payments during the life of the bond. With an index-linker, much of the compensation is likely to come in the increased principal repayment at redemption. Zero-coupon bonds, as their name implies, make no interest payments at all. When they are issued, they are sold at a substantial discount from the nominal value. The bondholders return simply comes from the fact that the bond is redeemed at a higher price than it was originally sold. The cash payments relating to a zero are very simple. But zeros create complex accounting and tax issues. The issuing company will have to record a charge each year in its prot and loss statement. And bondholders may have to pay tax each year - on the basis that the bond is expected to rise in value each year - even though they have received no cash income. The tax authorities are always quick to close loopholes in the tax system. Repayment Options - These are a variety of bonds where the bond issuer or the bondholder has options over the nal redemption of the bond. 1. Callable Bonds - A callable bond gives the issuer the option to redeem the bond at a xed price before the nal redemption date. For example, a 12-year bond with a Heriot-Watt University Securities Markets 1
1.6. Types of bond
11
coupon of 8 per cent issued in 2003 might be callable at its nominal value (100) on specied dates in 2009, 2011, 2013. The call provision is triggered by the bond issuer and the bonds will only be called if early redemption creates value for the issuer (and reduces value for the bondholder). In general, call provisions reduce the price at which a bond can be sold when it is rst issued and keep the price lower throughout the bonds life. The bond issuer will exercise the call if he can renance the bond at a lower interest rate than the implicit rate he pays if he leaves the bond outstanding. If the bond is callable at par, then the issuer will call if current interest rates fall below the coupon rate at which the bond was issued. Bonds are not usually callable in the rst ve years of their lives. Sometimes the price at which the bond is callable is above the nominal value. Since the costs of calling a bond and replacing it with other debt are signicant, issuers will not call unless they can make a substantial improvement in the interest rate that they pay. Most corporate bonds in the US are callable. This feature is less common in the UK. 2. Puttable Bonds - A puttable bond gives the bondholder the right to demand that the issuer redeem the bond early. The bond agreement will spell out the specic dates at which the holders can exercise the put and the prices at which the issuer must redeem. A put feature makes the bond more valuable to the holder. Market prices of bonds with a put option will, other factors equal, be more valuable than those without. Bondholders will exercise their put option if they can earn a higher return by reinvesting the redemption money than if they continue to hold the bond. Put options are not as common as call options. Bond issuers are reluctant to agree to a put option. If interest rates rise, the company will be forced to renance its debt at a higher interest rate. Since rises in interest rates are often associated with economic recession, the company may nd that the increased cost of debt comes at an inconvenient time. Bondholders may exercise the put in other circumstances. If the companys credit rating deteriorates, the market price of the bonds will fall and the redemption price received through the put-option may look attractive to bondholders. The need to nd cash to redeem the bond at a time when the companys nancial position is already weak can put the company into nancial difculty. Generally, companies will try to avoid put clauses in their bond agreements, although bond purchasers may ask for them. So bonds with put clauses tend to be issued by companies in a weak bargaining position. And, if the company is nancially weak to start with, the chances that the put option will cause trouble (with bondholders exercising at an inconvenient time) are increased. 3. Convertible bonds- A convertible bond gives bondholders the right to convert each bond into a specic number of shares in the issuing company on specic future dates. For example each 100 nominal of XYZ plc 9% 2018 (issued in 2003) might be exchangeable for 40 XYZ shares on specied dates in 2006, 2007 and 2008. This exchange rate will be set so that conversion is only worthwhile if the share price rises by about 20 or 30%.
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Chapter 1. Bonds
Generally, opportunities for conversion will come in the earlier part of a bonds life. Company management will usually want to encourage bond conversion. By increasing equity and reducing debt it strengthens the nancial position of the company. Option holders tend to delay exercising their options as long as possible. By setting a nal date for conversion after, say, 5 years, bondholders are forced to make up their minds. If the bond is not converted at that stage, it simply continues as an ordinary straight bond for the remaining years of its life. A convertibility feature makes a bond more attractive to bondholders (other factors equal) and enables an issuing company to set a lower coupon rate on its bonds. Notice that the callability and convertibility features of a bond may interact. If company management would like bondholders to convert, but bondholders are reluctant to kill their option by exercising it, management may be able to call the bonds. This will force bondholders to make up their minds. Either they convert or they face early redemption. Company management will try to time the call so that conversion is the lesser of two evils. This is known as forced conversion. 4. Exchangeable bonds - these bonds are similar to convertibles, except that the shares acquired if the bondholder exercises his exchange option are not shares in the bond issuing company. So a company will only issue exchangeables if it has a large shareholding in another company that it would be happy to sell. Perhaps the company has sold a subsidiary and has agreed to accept shares rather than cash. Why not simply sell the shares? The company that owns them may feel that the price it would get is currently too low. By issuing an exchangeable it may dispose of the shares at a considerably higher price. And, even if the exchangeability option is never taken up, the company will have reduced the interest cost of the bond by offering the exchangeability option. As with convertibles, exchangeable bonds are generally designed so that exchange would take place at a price 20-30% above the current price level of the share. 5. Domestic, Foreign and International Bonds - A domestic bond is one for which the bond issuer, the bondholders and the banks organising and trading the issue are all located in the same country. The law governing the issue is the law of this country. A foreign bond is one where the bond issuer is located in country A, but everything else (the bondholders, the banks organising the issue, the relevant law etc) is in country B. This is a foreign bond in the country B bond market. It will be denominated in country Bs currency. Foreign bonds have a long history going back to the 19th century. For example mining companies and railway companies based in South America would issue foreign bonds in the UK or US bond markets. Foreign bonds go by a number of colourful names. For example a foreign bond in the UK domestic market is a Bulldog bond, in the US market a Yankee bond, in the Japanese market a Samurai bond and in the Spanish market a Matador bond. An international bond is often called a Eurobond, and this module will generally use this term. A Eurobond is sold to bondholders in a variety of different countries which may or may not include the country where the bond issuer is located. The currency denomination of a Eurobond can be the currency of any major developed economy. The governing law can be the law of any major nancial centre.
1.6. Types of bond
13
However, the process of issuing the bond will not come under the jurisdiction of any national authority. In the US, the Securities and Exchange Commission (SEC) sets out the rules for issuing a domestic bond or a foreign bond in the US bond market. There are similar regulatory bodies in the UK, France etc. A Eurobond, however, escapes all these regulatory nets. The Eurobond market is very large, there are several trillion (= million million) dollars of bonds outstanding (at nominal value). The market has grown rapidly and continues to grow rapidly. Why? One reason is tax efciency. Eurobonds pay interest without any deduction of tax at source. So they cannot be issued directly by a US company. The US applies a withholding tax to bond interest. The Eurobond will be issued by a subsidiary company located in a country with no withholding tax and a suitable tax treaty with the US (or other headquarters country of the issuing company). The Netherlands Antilles is popular although it is not very easy to nd on a map. (Try looking off the coast of Venezuela). Eurobonds are bearer securities. There is no register of who owns the bonds. If you have a bond in your possession, you are assumed to be the owner or his agent and you can collect the coupon payments. Figure 1.1 shows what a Eurobond looks like (although the real thing is elaborately engraved to discourage forgery. Some bonds are so attractively engraved that they are considered works of art. They are collected, after redemption, by people called scripophilists).
Figure 1.1: Illustration showing the general layout and appearance of a Eurobond Every six months the holder of the bond will cut off the coupon which has reached its payment date and present it at the bank. He will get the interest payment in exchange. This payment system makes it difcult for the authorities to collect tax on the interest payments. There is a widespread suspicion that many Eurobond holders do not declare their interest income. For individuals who collect some or all of their income in cash, and who take the money to Switzerland or Luxembourg to buy Eurobonds and collect the interest, it is very difcult for the tax authorities to get their share. It is said that the typical buyer of Eurobonds is a Belgian dentist. Who gains from the tax-efciency of Eurobonds? The bondholders, of course, but not only the bondholders. Bond issuers can get away with offering lower coupon rates if the coupons are going to be paid in a tax-efcient way. The losses fall Heriot-Watt University Securities Markets 1
14
Chapter 1. Bonds
on the tax authorities. The gains are divided between the bond issuers and the bondholders. At one point in the 1990s, the Coca-Cola corporation could sell bonds with a lower coupon than the US treasury. It was not such a good credit risk, of course. But the Treasury bonds were fully taxable, while Coca-Cola issued eurobonds. The eurobonds were more attractive to many bondholders.
1.7
Bond default
Bondholders have no voting rights and no power to replace management if they think their money is being badly used. Any protection that bondholders have must be written into the bond agreement at the time that the bond is issued. These protections come in three main forms - Covenants, Security and Seniority. Each will be discussed in turn. Also this section will consider the process by which a bond is declared to be in default. Bond default will be explained in the context of corporate bonds. Covenants (also known as Indentures) - If the nancial position of the bond issuer deteriorates, eventually it will be unable to make a coupon payment. However, the bond issuing company might be badly managed for a long period of time before this stage was reached. Bondholders would like to see provisions in the bond agreement that will create a default-event before all the money has gone. When a bond goes into default, the issuer is immediately liable to redeem the bond at its nominal value (and there may be additional penalties). Bondholders want a declaration of default while there is still enough money available to do this. Bond covenants are usually based on accounting ratios. For example, they might specify that the Debt/Equity ratio must not rise above 100%, that the Net Asset Value of the company must not fall below 200 million, that the companys prot number must be positive, or that Net Working Capital must be at least 100 million. If accounts are produced semi-annually, the default can only be triggered at two points of time in any given year. However, the issuers nance director will have the covenants in mind, and if there is a danger that they will be breached, he will take rectifying action. He may sell-off loss making subsidiaries or cancel risky new investments. This, of course, is exactly what the bondholders would want him to do. Security - Certain specic assets owned by the company may be pledged as security for the bond. Often the assets are land or buildings, but other assets are also used. Intellectual property rights, such as movie rights or music rights, are accepted. The bond agreement gives control of the assets to a third party who, if the company defaults on the bond, can sell the assets and use the proceeds to repay the bond. Offering security is a simple way of giving bondholders condence that they will be repaid. And this condence will enable the company to pay a lower coupon rate. But there are several problems with security. 1. Asset suitability - The asset used as security must be valuable to other Heriot-Watt University Securities Markets 1
1.7. Bond default
15
businesses. A city centre ofce building is good security. A football stadium is not so good. If the football club is a nancial failure, who will want to pay a high price for its stadium? The most popular aeroplane around the world for short-haul commercial ights is the Boeing 737. It is used by dozens of different airlines. So a Boeing 737 is good security for a loan or a bond. Another aircraft might be just as good from an engineering point of view, but if few airlines use it, it will not be acceptable as security and airlines will nd it hard to borrow money to buy it. 2. Flexibility - A company may pledge its head ofce building as security for a bond. What if the company expands and wants to move to a new, bigger head ofce? What if a company decides on a new strategy and wants to sell certain movie rights that are used as security? Bond agreements will often have provision for one set of pledged assets to be replaced by another set of at least equal value and suitability. But renegotiating the security for a bond is a complex business which most nance directors would prefer to avoid. 3. Enforceability - If an airline goes into default on a bond secured by its aircraft, the bondholders will want the planes to be sold to redeem their bond. But selling the aircraft will immediately close the airline down and put all the employees out of work. It might leave some cities without air services. In most countries, the legal system will prevent bondholders from suddenly removing key assets from the business. Companies can apply to the courts for protection from their creditors (including bondholders). While they are protected, the company can try and develop a new and credible business plan. This may involve negotiating with bondholders over changes in the bond agreement. If the law courts are preventing the bondholders from getting hold of the assets pledged as security, the bondholders may have little choice but to accept new and less favourable terms. The legal system varies from country to country. Some legal systems are much more favourable to bondholders than others. Seniority - Large companies will often have several different bond issues outstanding. They will have been issued at times in the past when the company needed to raise money and decided to use bond nance. All the bond issues (as well as the companys various bank loans) will be ranked in terms of seniority. If the company goes bankrupt and its assets are sold off, the most senior debt is paid off rst, the second most senior next, and so on. The shareholders are last in the queue. Only after all the debt-holders have been paid in full would any remaining money be divided among the shareholders. In the US and the UK, the legal system works on the basis of absolute priority. Senior bondholders must get 100% of the money due to them before junior bondholders get anything at all. Bond agreements are likely to specify for example, No bond issues made subsequent to this one can have priority over this bond in the event of liquidation. Senior bonds may also have security associated with them. Bondholders will require a higher coupon rate, other factors equal, on a junior bond compared to a senior bond.
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Chapter 1. Bonds
Example : Ill lend you money as long as you are bankrupt! Imagine the following conversation between a banker and the nance director of a company. Finance Director Banker Finance Director Banker Finance Director Banker Lend us some money, quickly. Our company is running out of cash. How is business going? Badly. If things go on the way they are, we shall be in real nancial difculty. That doesnt sound good. But never mind. Id be happy to lend you money. Theres just one condition. Whats that. Go bankrupt rst.
Does that sound CRAZY? It isnt. If a company goes into administration (UK) or Chapter 11 of the Bankruptcy Code (US), the company, with the agreement of the lawcourt, can borrow fresh money on terms that have priority over all the existing debts of the company. In the US, these new loans are called debtor-in-possession nancing. From the bankers point of view, it is obviously attractive to make loans on terms that have priority over every other loan to the company. These rules are designed to try and help rescue companies that have got into nancial difculty. In bankruptcy, they can borrow money and keep operating (temporarily) while plans are made to restructure the company.
If a company is liquidated (i.e. if all its assets are sold off to the highest bidder) then absolute priority will operate. Only when the more senior debt has been paid in full will the more junior debt-holders qualify for any repayment at all. However, sometimes companies will seek a voluntary restructuring. The company tells its debt-holders, We are not breaching any of our covenants at the moment but, look, business conditions are very bad and there is a risk that we may default in the future. The risk of default is creating problems for the company. Customers wont buy from us because they see that we are a heavily indebted company with a risk of going bankrupt. If we default and our assets are sold off, there will be very little money for any debt-holders. It is in your interest to agree to give up some of your rights and to support a nancial restructuring. Restructuring may involve exchanging bonds which are likely to default for a new bond with a lower nominal value - but a much higher chance of actually being paid. It may involve a debt-for-equity swap, where bondholders agree to exchange bonds for shares. In a voluntary restructuring, absolute priority may not apply. The bondholders may be told that they must all make sacrices if the company is to be rescued. The junior bondholders may be asked to make a large sacrice; the senior bondholders may be asked to make a smaller one. Such an arrangement violates the principle of absolute priority, but under some circumstances it may be in the interest of all bondholders to agree.
1.8. Bond rating agencies
17
1.7.1
Declaring default
When does a bond go into default? The bond agreement may specify a set of default events, but there are a number of alternative ways in which default can be declared and the bond agreement will generally specify which one is to be used. Bond trustees - Some bond agreements will set up a trustee who has the right and the obligation to act if a default event occurs. If, for example, a bond is secured by a property asset, then a trustee company may hold the deeds to that asset. If the bond defaults, the Trustee Company will have the job of selling the property and distributing the proceeds to bondholders. In these cases, individual bondholders cannot take possession of the security; they must wait for the Trustee Company to act. Bondholder vote - For some bonds, the bondholders must vote to declare an issuer in default. If the bondholders are private investors who are not very active in protecting their rights, the need for a vote may be a substantial barrier to a declaration of default. It is even possible that some of the bonds could be bought up, cheaply, by allies of the bond issuer. These allies would then vote against a default being declared. Individual bondholder rights - The bond agreement may give every individual bondholder the right to call default and to take legal action to secure repayment. For a large bondholder, this can be a useful right. Small bondholders will not want to incur the cost of legal action. If bonds are held by a large number of small, isolated bondholders, there may be no one willing to take action. This, of course, would be to the benet of the bond issuer.
1.8
Bond rating agencies
Some bond issuers are in a much stronger nancial position than others. Some bond agreements protect bondholders better than others. Analysing a bond and identifying its level of risk is a skilled and time-consuming business. It doesnt make sense for every potential bond-buyer to do the analysis himself. Bond rating agencies analyse almost all new bond issues and allocate each of them into a risk category (called a rating). The bond-rating agency will continue to monitor a bond during its life. If circumstances change, it will change the rating of the bond to reect the new level of risk. The two largest rating agencies are Moodys and Standard and Poors (S & P) which operate internationally although they are based in the US. Their rating symbols are as follows:
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Chapter 1. Bonds
Both Moodys and S & P make further renements to their ratings. Moodys add 1, 2 or 3 to a rating, with 1 being the highest. S & P will add a+ or a- to modify a rating (+ means less risk; - means more risk). A rating of Baa (Moodys) or BBB (S & P) and above is called Investment Grade. The other B-graded bonds (Ba, B for Moodys ; BB, B for S & P) are classed as speculative. The C ratings are given to bonds which have a substantial risk of default. The D (S & P) rating refers to bonds which are actually in default. Often a bond will be rated, independently, by both Moodys and S & P. Generally, they will agree on the rating, but sometimes a bond will hold a higher rating from one agency than the other. How is the rating of a bond determined? Partly, the rating agency will look at the bond issuers accounting ratios. Five key ratios which are important to assessing the risk-level of a bond are Gearing Ratio - the ratio of debt to equity. The higher the proportion of debt in the companys capital structure the greater the risk of default. Current Ratio - current assets divided by current liabilities. The higher the current ratio the safer the bond. Protability ratio - the rate of return on the companys assets (or equity). Higher protability reduces the risk of a bond. Cash ow ratio - the ratio of cash ow to company debt. The more the cash ow, the lower the probability of default. Times Interest Earned - is the companys earnings (before interest and tax) divided by the total amount of interest payable. A higher TIE ratio is associated with a lower risk of default and hence a higher bond rating. The information given by these ratios tends to overlap. Companies with a strong nancial position measured by one ratio are likely to have strong values measured by other ratios too. The ratios alone are not enough to determine a rating. In addition 1. The rating agency will consider the industry within which a company operates. A real-estate company can safely take on more debt than a toy manufacturing company. A real estate company has solid assets with long-term earning power. Heriot-Watt University Securities Markets 1
1.8. Bond rating agencies
19
Toys are often fads which rise and fall quickly in popularity. Toy making companies rise and fall with their products. 2. The rating agency will consider all aspects of the bond agreement. If good security is offered, a bond might qualify for a high rating even if the issuers nancial ratios were weak. Companies may often have several different bonds outstanding. The bonds will not all have the same rating. Senior or secured bonds can qualify for a higher rating than junior unsecured bonds from the same company. 3. Rating agencies offer issuing companies the opportunity of a meeting to discuss company policy. A company can argue its case that its bonds are low risk and should be rated accordingly. For example, a company might make a take-over and take out bank loans to fund the acquisition. More debt could have a negative effect on the ratings of its outstanding bonds. But if the company assures the rating agency that the high debt level will be temporary, and that it plans to act quickly to sell assets and get the debt level down - then the rating agency might not lower the ratings. How signicant are bond ratings? The obvious relationship is between the rating given to a bond and the coupon rate that a company will have to offer. For example, the average coupon rates at which a 10-year US $ bond could be issued might vary as follows AAA 5.4% AA 5.7% A 6.0% BBB 6.6% etc. These would be promised returns. In fact, some bonds will default, so that the actual returns will be lower. The evidence shows that lower rated bonds do, in practice, default more often. The difference between the actual returns from BBB and AAA bonds will be smaller than the difference in the promised returns listed in the table. But the evidence is that lower rated bonds generally give higher actual returns than high-rated ones and this, of course, is what we should expect since they carry more risk. Note that even an AAA corporate bond is not perfectly safe, and it will have to offer a higher coupon than a US Treasury bond. The second signicant feature of bond ratings is that they can determine whether a company can make a bond issue or not. Many institutions will not buy bonds unless they are rated investment grade, Baa/BBB or above. In the US, insurance companies which are major purchasers of bonds, can be restricted by law from investing in lessthan-investment grade bonds. For many companies, if they cannot get an investment grade rating, they wont even try to issue bonds. Bond ratings play a very important part in the nancial policy of major corporations. If, for example, the board of directors decides that company policy is to maintain an A credit rating, then this will largely determine the nancial structure of the business. Bond rating agencies are very powerful organisations. For many companies, they effectively determine the amount of debt that the company can issue.
20
Chapter 1. Bonds
A third signicant feature of bond ratings is that they may affect the coupon rate after the bond has been issued. Some bonds have a step-up clause which species that the bond must stay at or close to its original rating. If the bond falls to, say, a B rating, then the coupon rate must rise by a specied amount to compensate the bondholders. Most bonds, when they are issued, have an investment grade rating. If the valuing later falls to Ba/BB or below, they are called fallen angels. Bonds which are originally issued with a below-investment grade rating are called high-yield bonds by the companies that issue them and junk bonds by everyone else. Junk bonds are particularly purchased by private investors who are attracted by the high coupon rates.
Example : Who pays for bond ratings? For many decades, Moodys and Standard & Poors issued huge books with details, and ratings, of outstanding bond issues. Their income came from selling these books to subscribers, especially banks and insurance companies. The books were expensive, and users were tempted to save the subscription and get the information they needed by phoning their broker (who would, of course, have a copy). They could ask for a photocopy of the pages they wanted. One of the problems in the economics of information is that it is difcult to sell information. Once you have sold the information to one customer, that customer may decide to pass the information on for free - or at a price that undercuts the original information producer. So the rating agencies switched. Now if they are invited to rate a bond, they will charge the issuer for doing so (although some bonds are still rated in the original way, with no invitation from the issuer). One advantage of working with issuers is that the bond rating can be informed by a direct discussion with corporate management about company plans and policies (as discussed above). A possible disadvantage is that, if the issuers are paying, they might have an inappropriate inuence over the ratings they get. But, so far, there have been no scandals of this sort.
1.9
Bond ratings and efcient markets
Bond ratings are related to bond prices. All other factors equal (including the coupon rate) a bond with a higher rating will have a higher price. So when a rating agency downgrades a bond, should we expect the price of the bond to fall? It seems logical, but the evidence suggests that this effect is not very large. Why? Remember the Efcient Markets Hypothesis covered in 2nd level nance. According to the semi-strong form, new publicly available information is immediately incorporated into securities prices. Immediately! Rating Agencies dont act as quickly as that. They use, generally, publicly available information, and they take time to review a bonds rating. So, in most cases, the change in a bonds rating will lag behind the change in the bonds market price. Sometimes rating agencies are criticised for lagging behind the market and being slow Heriot-Watt University Securities Markets 1
1.10. Conclusions
21
to regrade bonds when circumstances change. Investors, of course, would like to be told in advance of circumstances in which a bond price is likely to fall. Then they could sell without suffering a loss. But could rating agencies ever hope to provide such a service? The Efcient Markets Hypothesis says no.
1.10
Conclusions
This chapter has provided an introduction to bonds as marketable securities. It has described the basic characteristics of a bond; the categories of bond issuers and bond purchasers; the different types of bond that can be issued; bond default and the effect of various features that may be found in bond agreements; the rle of ratings agencies.
1.11
Q1:
Review Questions
a) What is the difference between the principal amount of a bond and the price of a bond? b) What is the difference between the amount of a bond issue and the principal amount of a bond? c) What is the difference between the coupon of a bond and the coupon rate of a bond? Q2: Explain how the holder of a corporate bond is protected against irresponsible decisions by corporate management that might put the value of the bond at risk. Is the protection system for bondholders the same as the protection system for shareholders? Q3: Identify and distinguish between ve different types of bond issuer. Q4: Briey explain the character of each of the following types of bond. a) Zero-coupon bond b) Exchangeable bond Heriot-Watt University Securities Markets 1
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Chapter 1. Bonds
c) Floating rate note d) Puttable bonds Q5: What does a rating agency do? Who pays the fees of the rating agency? What effect does a rating have on bond issuers? What is a junk bond? What is a fallen angel?
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Chapter 2
Bond Yields, Prices and Bond Swaps

Contents
2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond yields with annual coupon payments . . . . . . . . . . . . . . . . . . Bond yields with semi-annual coupon payments . . . . . . . . . . . . . . . Interest yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond price quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond issuance and bond trading . . . . . . . . . . . . . . . . . . . . . . . Bond swaps (Interest rate swaps) . . . . . . . . . . . . . . . . . . . . . . . 2.8.1 Risk in interest-rate swap . . . . . . . . . . . . . . . . . . . . . . 2.8.2 Banks and swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.9 2.10 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 24 25 26 26 27 30 31 34 35 36 36
Learning Objectives On completion of this chapter students should be able to understand: the denition and calculation of bond yields-to-maturity; the denition and calculation of interest yield and real yield; the way in which bond prices are quoted; some basic aspects of bond issuance and bond trading; the nature and logic of bond swaps, with associated calculations.
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Chapter 2. Bond Yields, Prices and Bond Swaps
2.1
Introduction
This chapter is concerned with the basic operations of the bond market. It will explain how yield-to-maturity (YTM) is calculated, and also the calculation of interest yield and real yield. Some of this material will review material already covered at levels 1 and 2. The chapter will also explain how bonds are quoted and the division of the price actually paid by investors in the secondary market into two parts - the clean price and accrued interest. It will briey discuss the operation of the primary market for UK gilts and for Eurobonds. Finally, this chapter will cover interest-rate swaps and will demonstrate how borrowers can gain from using swaps compared to direct bond nance.
2.2
Bond yields with annual coupon payments
The concept of a bond yield has been introduced in level 1 and level 2 modules but is reviewed here. A bond yield is the internal rate of return (IRR) of the cash ows gained by purchasing a bond at the market price and holding it to maturity. Consider a bond with the following characteristics Coupon of 7 per cent, paid annually, next payment due in 1 year. Redemption date 5 years hence. Current market price 105.33. What is the yield of the bond? Note, rst, that we can assume that the bond has a nominal or par value of 100. The coupon is based on this nominal value, so the interest paid by this bond is 7 per year. For an investor who buys the bond today and holds to maturity, the annual cash ows are
1 yr 2 yr 3 yr 4 yr 5 yr Now (105.33) 7 7 7 7 7
The IRR is the interest rate (r) at which these cash ows have zero present value
7 1+r
7 + r
7 + r
7 + r
107 + r
The bond is selling at a premium. The market price is above the nominal price. A higher price reduces the yield of the bond. So the yield will be below the coupon rate of 7 per cent. In the real world, yields are calculated by computer. In university examinations, they are calculated by trial-and-error. Try 6 per cent. The NPV of the cash ows is
7 7 7 7 107 + + + + 1.06 1.06 1.06 1.06 1.06
The lower the interest rate we use, the greater will be the discounted value of the future cash ows. We want to increase the present value, so we try a lower interest rate. Try 5 Heriot-Watt University Securities Markets 1
2.3. Bond yields with semi-annual coupon payments
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per cent.
7 7 7 7 107 + + + + 1.05 1.05 1.05 1.05 1.05
We now have a positive NPV, so 5 per cent is too low. The yield lies between 5 per cent and 6 per cent. Clearly it is closer to 6 per cent than to 5 per cent, because the NPV is closer to zero at 6 per cent. We nd the solution by interpolation. From 5 per cent to 6 per cent, the difference in NPV is 3.33 - (-1.12) = 4.45 From 5 per cent to the point where NPV is zero, the difference is 3.33. So the yield is 5+
3.33 4.45
2.3
Bond yields with semi-annual coupon payments
For most UK government bonds, and most corporate bonds (including Eurobonds), coupon payments are made at half-yearly intervals. This makes the calculation more complex. If the calculation is carried out using half-ayear as the interval of time, then the calculated yield is a yield per half-year. Consider a bond with the following characteristics Coupon 9 per cent, payable semi-annually, next coupon due in 6 months. Redemption in 3 years time. Current market price 106.45. For an investor who buys the bond today, the cash ows are
Now 6 mths 12 mths 18 mths 24 mths 30 mths 36 mths - 106.45 4.5 4.5 4.5 4.5 4.5 104.5
At a discount rate of 4 per cent per half-year, the present value is -3.83. At 3 per cent per half-year the present value is +1.68. So, by interpolation, the yield per half-year on this bond is
1.68 (1.68 + 3.83)
per half - year
Interest rates are usually measured per year. If the rate is 3.30 per cent per half-year then the compounded rate for a whole year is (1.0330)2 - 1 = 0.0671 or 6.71% But this is not how bond yields are quoted. Generally, a bond yield is quoted as twice the half-yearly rate. This is called the US/UK convention. For our example, the bond yield would be quoted as 3.30% 2 = 6.60% Heriot-Watt University Securities Markets 1
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This conventional method quotes a bond yield that is less than the true rate of 6.71%. So quoted bond yields in the UK/US are not true rates and are misleading unless you understand the curious convention by which they are measured. Conventions differ in different national markets. Most Continental European markets do not follow the US/UK convention, and will quote true yields.
2.4
Interest yield
The interest yield on a bond, which is also known as the current yield or the running yield, is the annual coupon payment as a percentage of the current market price of the bond. If the annual coupon amount is C and the bond price is P, then Interest yield =
C P
In our example, this is

9 106.45
or 8.45%
When a bond is priced above par, then Coupon rate Interest yield Yield to maturity
The yield to maturity has to take into account the capital loss when the bond is redeemed for less than the current market price. The interest yield ignores this factor. Hence interest yield yield to maturity. When a bond is selling below its nominal value Coupon rate Interest yield Yield to maturity
Most investors look at yield-to-maturity and ignore the interest yield. But institutions that want to obtain interest income to match expected cash outows will watch the interest yield. Interest yield can also be signicant if investors pay a different tax rate on interest than on capital gains.
2.5
Real yields
The general relationship between the nominal (or money) interest rate (N) and the real (a purchasing power) interest rate (R) depends on ination (I). If ination is zero, then the nominal and real rates are equal. If ination is non-zero, the relationship is 1 + N = (1 + I)(1 + R) = 1 + I + R + IR Both ination and real rates are generally small numbers far below 1 (i.e. far below 100%). So IR the product of two small numbers, will be a minor element in the equation. So investors sometimes use the approximate relationship N I+R
This approximation is useful in showing the general relationship between these three
2.6. Bond price quotations
27
numbers, but the full version is preferred for nancial calculations. We return to the example used earlier of a bond paying annual interest at 7%, with 5 years to maturity and a current market price of 105.33. The (nominal) yield to maturity was calculated as 5.75%. Suppose that the rate of ination is 2%, and is expected to remain constant at that level. The nominal yield to maturity is found from
7 7 7 107 7 + + + + 1 + N 1 + N 1 + N 1 + N 1 + N 7 7 107 7 7 + + + (1 + I)(1 + R) + (1 + I)(1 + R) (1 + I)(1 + R) (1 + I)(1 + R) (1 + I)(1 + R)

Since we know 1 + N = 1.0575 solves this equation (1 + I)(1 + R) = 1.0575 must also solve it, and if I = 0.02 (1.02)(1 + R) = 1.0575 1.0575 1+R= 1.0368 1.02 and R = 0.368 or 3.68% So long as future ination is assumed to be constant, the real yield on a bond can easily be calculated by this method.
2.6
Bond price quotations
The price paid for a bond will tend to have a saw-tooth pattern over time, as illustrated in Figure 2.1.
Figure 2.1: Typical pattern of a bond price over time The price will follow a six-monthly cycle. For every coupon payment, there will be a nal day on which an investor can buy the bond and get the payment. Then the list of names to receive the coupon will be closed. The next day the bond will be traded ex-dividend or XD and purchasers will only get a coupon when the following six-monthly payment
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is made. As soon as the bond goes ex-dividend, the price paid for the bond must fall to reect the fact that the buyer wont get the coupon. This accounts for the sudden, sharp falls in bond prices. Although interest payments are made on specic dividend dates, bondholders will expect a positive return on their investment every day, every week and every month. This expected return comes in the form of a rising bond price between the XD dates. Hence the saw-tooth pattern. Bond prices follow this pattern, but bond price quotations do not. Prices are quoted in a way that removes the saw-tooth pattern. Each coupon payment is deemed to accrue at a steady daily rate over the 6-monthly coupon interval. The quoted bond price excludes this accrued interest and is called a clean price. The price actually paid is called the dirty price. To see how this works, consider an example.
Example It is 84 days since the last coupon payment on Treasury 12 per cent 2013 stock. The quoted, clean price is 115.60. How much must a purchaser pay to buy this stock? Solution The bond pays 12 interest per year (365 days). Over 84 days, the interest that has accrued is
84 / 365
12.00 = 2.76.
So the bond purchaser pays (and the bond seller receives) Dirty price = Clean price + Accrued interest = 115.60 + 2.76 = 118.36.
There is an additional complication. The day that a bond goes XD is generally 37 days before the actual coupon payment is made. The bond issuer needs time to write the cheques and address the envelopes etc. So how is the accrued interest calculated if a bond is trading XD? In this case, the accrued interest is negative. Why? Because the seller of the bond is going to collect the whole six-month coupon even though he is selling the bond before the six-month period is up. So he isnt entitled to the whole coupon, and has to compensate the buyer for the part he isnt entitled to. Again, this can be illustrated by an example.
Example It is 170 days since the last coupon payment on Treasury 12 per cent 2013 stock. The quoted, clean price is 112.35 XD. How much must a purchaser pay to buy this stock? Solution The seller of this stock is entitled to 170 days worth of coupon, which is
170 / 365
13.00 = 5.59
2.6. Bond price quotations
29
He is actually going to collect the whole coupon payment (6.00) because the bond is trading ex-dividend. So he must give up 6.00 - 5.59 = 0.41 to the buyer. This is negative accrued interest. So the price the buyer actually pays is Dirty price = Clean price + Accrued interest = 112.35 - 0.41 = 111.94.
Remember - if the buyer is going to collect a coupon payment to which the seller is partly entitled then Accrued interest is positive, and Dirty price is greater than clean price. If the seller is going to collect a coupon payment to which the buyer is partly entitled (which occurs when a bond is traded ex-dividend) then Accrued interest is negative and, Clean price is greater than dirty price. Why is this complicated system used? Why are quoted bond prices different from the prices that bond buyers actually have to pay? It is all due to tax. In the bad old days when there was a trading strategy called bond washing, bonds were quoted and traded at the dirty price. It was based on the fact that different investors had different obligations to pay tax. A type 1 investor would pay income tax on interest received, but would pay a lower tax rate, or no tax, on capital gains. Most private investors would be in this category. A type 2 investor would be tax exempt on both income and capital gains. Pension funds and charitable institutions would be in this category. So how do you wash a bond? Simple. Suppose a type 1 investor owns a bond. He sells it to a type 2 investor just before it goes ex-dividend. He buys it back from the type 2 investor just after it goes ex-dividend. As a result the type 2 investor receives the coupon payment - which is tax free to him. And the type 1 investor makes his return in the form of capital gains, which are tax-efcient for him. Everyone wins except the taxman! But the taxman is a sore loser. By forcing bond markets to quote clean prices and making investors pay for accrued interest separately, the tax authorities can identify any accrued interest that investors have received - and make them pay the appropriate tax on this interest. If a type 1 investor sells a bond just before it goes ex-dividend, he will receive a clean price plus a lot of accrued interest. He must report how much accrued interest he has received to the tax authorities - and pay tax accordingly. Note that a bond has an ex-dividend date. One of the basic rules of nance is that shares pay dividends, bonds pay interest. So why isnt it called the ex-interest date or the ex-coupon date? Logically it should be, but it isnt.
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2.7
Bond issuance and bond trading
By far the largest issuer of bonds in the UK is the British government. These bonds (gilt) are issued to cover a government decit (i.e. government spending greater than government tax receipts) and also to replace bonds that are redeemed. The government wants to issue gilts at the best possible prices. It has to choose methods of issuance and bond trading mechanisms that will achieve this objective. The UK government decides how much it needs to borrow. A separate agency, the Debt Management Ofce (DMO) then decides the maturity and coupon of the bonds to be issued. The DMO has the duty of minimising the governments cost of borrowing. It is in close contact with the big buyers of gilts and will know what maturities they would prefer to buy. Gilts are issued in two ways a) by tender b) by auction. Any investor is allowed to participate in the offer. Investors specify the amount of giltedged stock they are willing to buy and the price they are willing to pay. The key difference between the two methods is: in a tender, the DMO sets an allotment price and every successful application pays the same price. Applicants who have offered more than the allotment price get all the bonds they asked for at a price below what they were willing to pay. Applicants who offered less than the allotment price get nothing. Applicants whose offer is exactly equal to the allotment price get a portion of their offer accepted. in an auction, the DMO sets a lowest accepted price, and every applicant who has offered that price or more receives bonds at the price he has offered. Some investors will pay a higher price than others. Why does the DMO use tenders? Surely, if the DMO issues gilts to investors at a price below what they have offered to pay, it isnt doing its duty? That argument is too simple. Applicants will submit different offers for tenders and auctions. In an auction, they will be nervous that, if they judge the price wrongly, they could end up buying bonds for more than fair market price. So, unless they feel very condent of their ability to judge the right price, investors will tend to stay away from auctions (or to be very cautious about the price they offer). In fact, when gilts are sold by auction, there is an opportunity for small investors to submit non-competitive bids. They will be allocated bonds at whatever the average acepted price turns out to be. The tender system encourages investors to participate and to offer higher prices. If they have made a misjudgment and offered too much - never mind. The price they actually pay will be lower. From the DMOs point of view, there is no clear advantage to either the tender method or the auction method. So they use both. Heriot-Watt University Securities Markets 1
2.8. Bond swaps (Interest rate swaps)
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Once gilts have been issued, bid-ask prices are quoted on a continuous basis by GiltEdged Market Makers (GEMMs). Investors (mainly large institutions) are free to try and negotiate better prices which fall within the bid-ask spread. There are many different gilts issues outstanding at any point in time. How can the GEMMs meet demand for a particular issue if they dont hold large amounts of all the issues on their own books? The answer comes from the repo market. Repo is short for Repurchase agreement. A GEMM or a major investing institution sells gilts but agrees to repurchase them again at a pre-agreed price. Repo agreements are often short-term. They may just run from one day to the next. Effectively, the repo market enables gilt-edged stock to be lent and borrowed efciently. Because GEMMs can lend and borrow gilts easily, they can create a highly liquid market. For investors trading in gilts is inexpensive and large amounts can be bought and sold. Large issues are actively traded and the bid-ask spread may be as little as 2 pence (per 100 nominal) for a transaction of 10 million on a 10-year gilt. Gilt-edged stock is not a very popular investment for private, retail investors in the UK, but there is a special arrangement for private individuals to buy stock with low dealing costs through the Post Ofce. Eurobonds are sold by a different process. A corporate issuer will agree terms with an investment bank which takes on the role of lead manager. The lead manager may bring in other banks as managers and yet more banks will participate as underwriters. A Eurobond issue will be fully underwritten. The group of underwriting banks will have agreed a price at which they will purchase the whole amount of the issue. The number of underwriting banks may be large - there may be more than 100. Each underwriter brings with it the possibility of sales to its own customers. So a large issue may require a large number of underwriters spread geographically across the main bond-buying countries. Eurobonds are expensive to issue. The lead manager, other managers and underwriters will all charge fees. The total cost is likely to fall in the range 1.25 per cent to 2.5 per cent. The lower fee would be for a large issue by a well-known issuer with a high rating. Once issued, Eurobonds are generally not actively traded. The lead manager for an issue will generally quote a bond-asked price but especially for smaller corporate issues, the spread will not be tight. Many Eurobond investors simply hold the bonds until they are redeemed. If they need cash, they would tend to sell more liquid assets in their portfolio.
2.8
Bond swaps (Interest rate swaps)
Interest rate swaps are a major activity in bond markets. Billions of dollars-worth of bonds are swapped every year. Organising bond swaps is an important and protable activity for major banks. The standard swap is between xed interest and oating interest. A oating interest rate is one that is reset at regular intervals, usually 6 months. A company might be offered a 7-year loan at 85 basis points (0.85%) above the London Inter-Bank Offer Rate (LIBOR). The actual interest paid for each 6-month period would vary and would be based on the 6-month LIBOR rate at the beginning of the period. In a simple swap, Company A borrows Xm for N years at a xed interest rate. Company B borrows Xm for N years at a oating interest rate. Then the companies agree to swap Heriot-Watt University Securities Markets 1
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interest payments. Company B agrees to make xed payments relating to Company As loan - and Company A agrees to make the variable interest payments on Bs loan. There may be side-payments between the two companies as well. Why would companies enter into a complex arrangement like this? If Company B wants to make xed interest payments, why doesnt it simply borrow at a xed-rate in the rst place? If it has borrowed on a variable interest rate basis, why doesnt it simply make the variable interest payments? First, nance directors will have very strong preferences as to whether they want their interest payments to be xed or variable. Consider a UK property company that is going to build a large ofce building in London and will rent it on a 25-year agreement to a major bank. Such long-term rental agreements are common in London. The agreement will probably specify that the annual rental will be reset every ve years to reect current rent levels - but that the reset is upward-only. During the 25-year agreement, the rent level can never fall. If the Property Company wants to borrow to nance the ofce building, it will want a xed rate. It can then be sure that the money being received in rent will be enough to service its debt. On the other hand, a utility company may have its prices set by a regulator. The regulator may set the prices in relation to the utilitys costs and these costs may include the cost of servicing debt. If the interest-cost allowed by the regulator is based on current interest rate levels, then the appropriate policy for the utility is to borrow at a variable rate. It can then be sure that its revenues will cover its interest payments. Second, some companies will have a comparative advantage in the xed rate market. Bond investors like to buy bonds from large, well-known public companies. They have a preference for companies which have issued bonds successfully in the past and which are based in a major developed economy. A company that doesnt meet these conditions can nd it hard to issue a bond. It would have to pay a high coupon rate, even if it were a nancially-sound, creditworthy business. Although variable-rate bonds exist, most variable-rate nance comes from banks. Most money deposited in banks is deposited on a short-term basis. The depositors want to be able to take their money out whenever they need it. When banks lend money, they will generally want to lend at a variable rate which matches the short-term rate which represents their own cost-of-funds. Bankers are professionals at credit analysis. They will be less impressed than the bond markets by size and reputation. They will carry out detailed analysis of nancial statements and cash ow projections. So, because bond markets (mainly xed rate nance) and banks (mainly variable rate nance) look at credit-worthiness in slightly different ways, companies can have a relative advantage in one compared to the other. Consider an example. Company X and Company Y both want to borrow 100m for 10 years. The rates obtainable by X are Fixed Rate Floating Rate The rates obtainable by Y are Fixed Rate Floating Rate 6.50% LIBOR + 0.75%. Heriot-Watt University Securities Markets 1 5.75% LIBOR + 0.30%.
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Notice that Company X can get better terms than Y both xed and oating. It has an absolute advantage in both markets. Company X might be a giant, global oil company. It can borrow on favourable terms in any market. Company Y might be a smaller company, perhaps a private company, perhaps operating very successfully in East Asia but not known to investors in the West, where most bond-buyers are located. Company X pays 0.75% less than Y in the xed rate market. It pays 0.45% less than Y in the oating rate market. So X has a comparative advantage in xed rate and Y has a relative advantage in oating rate. A swap saves money if X and Y both have a preference to borrow in the form (xed or oating) where they have a comparative disadvantage. If X wants a oating rate and Y wants a xed rate, then they can save money by borrowing in the market where they each have a relative advantage agreeing to swap the interest payments agreeing side-payments between the two-parties so that the gains are fairly divided between them. How large are the potential gains from a swap? In the present example, if each company borrows on its preferred basis, the total interest paid will be X borrows oating Y borrows xed Total LIBOR + 0.30% 6.50% LIBOR + 6.80%
If each company borrows in the market where it has a relative advantage, then the total interest paid is X borrows xed Y borrows oating Total 5.75% LIBOR + 0.75% LIBOR + 6.50%.
So, by borrowing where they have relative advantage, the two companies overall can save 6.80% - 6.50% = 0.30% or 30 basis points. This may look like a very small gain. However, on a loan of 100M 0.30% is 300000 per year. This would continue every year for 10 years. Enough to make a useful contribution to a nance directors salary. Companies X and Y will have to negotiate how to divide the gain of 30 basis points. Suppose they agree that X will get two-thirds (20 basis points) and Y will get one-third (10 basis points). In this case the effective result of the swap is that X borrows at a oating rate of LIBOR + 0.10% (0.20% less than it would have paid if it had not swapped) Y borrows at a xed rate of 6.40% (a 0.10% saving as a result of the swap). How is this result achieved? By payments between X and Y. The payments can be calculated as follows. Heriot-Watt University Securities Markets 1
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X borrows at a xed rate of X effectively pays a oating rate of
5.75% LIBOR + 0.10%.
So X must receive from Y the difference between these two amounts 5.75% - (LIBOR + 0.10%) = 5.65% - LIBOR Y borrows at a oating rate of Y effectively pays a xed rate of LIBOR + 0.75% 6.40%
So Y must receive from X the difference between these amounts (LIBOR + 0.75%) - 6.40% = LIBOR - 5.65% This swap would be described as LIBOR against 5.65%. At the end of every 6-month period, a payment will be made between X and Y. If LIBOR for the period (i.e. the 6month interest rate prevailing at the beginning of the period) is above 5.65%, then X pays money to Y. If it is below 5.65%, Y makes a payment to X. Table 2.1 shows the amounts payable during the rst two years of the loans, on the basis that LIBOR for the four 6-monthly periods is 6.20%, 5.80%, 5.30% and 5.90%. Remember that the amount of the loans is 100m and the period is half a year. The payment in Period 1 is calculated as 100m
0.0602 - 0.0565 2
275000
Table 2.1: Example of payments under an interest-rate swap agreement Payment at end of period 6-monthly period 1 2 3 4 . . . LIBOR 16.20% 25.80% 35.30% 45.90% . . . from X to Y 275000 75000 - 175000 125000 . . .
2.8.1
Risk in interest-rate swap
What will happen if one of the partners to an interest rate swap gets into nancial difculties and cannot make the promised payments? Notice that the repayment of principal at the end of the bonds or loans is not affected by the swap at all. In the current example, neither X nor Y has guaranteed the others loan. If X cant repay the 100M of principal, Y has no obligation and is not involved in any way. Investors lent money to X and they must look to X for repayment. They may not even know about the swap agreement. The only risk for the two companies involved relates to the interest differential payments. If X fails nancially, the swap becomes void and Y is left to make the payments on the
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oating-rate loan for which it originally contracted. The interest differential payments will be relatively small, so the risk involved in an interest-rate swap is not very great. Even this risk is generally avoided, as the liabilities of the swap counter-party are guaranteed by a bank.
2.8.2
Banks and swaps
So far we have described interest-rate swaps as transactions that only involve two companies. In reality, there is usually a bank involved as well. The bank will: identify the opportunity for a swap through its knowledge of the nancial plans of companies with which it has a business relationship; guarantee (in exchange for a fee) the interest differential amounts that become payable under the swap agreement; undertake to make up the difference if there is not an exact match between the nancial requirements of the two companies. Consider this last point in more detail. In the example, it was assumed that companies X and Y wanted to borrow exactly the same amount, at exactly the same time, for exactly the same number of years. If this happened in the real world it would be a considerable coincidence. In practice, a bank will agree to bridge any mismatches. For example, Company X (which, remember, is a major, well-known, highly credit-worthy company) may come to the bank for a oating-rate loan. The bank may reply wed be happy to make you a oating-rate loan, but we have an alternative that would be even cheaper for you. Make a xed-rate bond issue in your name, and do an interest-rate swap with us. If company X agrees, the bank takes the swap onto its own books. The bank has lots of customers. It is condent that company Y (or a company similar to Y) will come along soon and ask for a xed rate loan. Then it will put the other half of the swap into place. The bank would step in in a similar way if X wanted 100m but Y only wanted 80m. Or if X wanted a 10-year loan and Y wanted 7 years. Banks can also arrange cross-currency swaps. Suppose Company V is a Japanese company which wants to borrow euros for expansion in Europe. Company W is a German company which is planning an acquisition in Japan and needs to borrow in yen. The investors who want to buy Euro-denominated bonds are mainly in Europe. They know Company W; they have never heard of company V. In the same way, the buyers of yen bonds are mainly in Japan and they know V but not W. So there is an opportunity for a currency swap. V issues a yen-bond in Japan. W issues a Euro-bond in Europe. The two companies then swap the obligation to service the two bonds. Note that a currency-swap is more complex than a pure interest-rate swap because the nal repayments are in different currencies and cannot simply be netted off against each other. This will create a greater level of risk but again, for a fee, the bank will provide each party with a guarantee that the obligations due from the other company will be met.
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Although banks are centrally involved in the interest rate swaps market, they try to avoid lending money themselves. When a bank makes a loan, the loan appears on its balance sheet and the bank has to hold capital in proportion to the size of its outstanding loan book. Capital is expensive. If a bank arranges a swap, the bank collects fees but the loan does not appear on the balance sheet. If the bank provides guarantees, a small amount of capital may be needed to back them. But the capital commitment is much smaller.
2.9
Conclusions
The major topics covered by this chapter have been: the calculation of bond yields, both true yields and yields using the US/UK convention; the calculation of interest yields and real yields; bond price quotations and the relationship between the clean quoted price and the dirty price actually paid; the issue methods for UK gilts and for Eurobonds; the logic of interest swaps; the calculation of gains from swaps and the establishment of the effective cost of borrowing for both parties after a swap has taken place.
2.10
Q1:
Review Questions
The current date is June 1st 2002. Bond A has a 10% coupon (interest paid semiannually), a redemption date of June 1st 2005 and a principal amount of 100. The next interest payment will be in six months time. The current market price of the bond is 110.20. Required a) Calculate the yield-to-maturity of this bond, using the US/UK convention. b) Calculate the true yield-to maturity of this bond. Explain why the true YTM differs from the YTM using the US/UK convention. Q2: Bond A pays interest annually. The next interest payment is due in one years time. The current bond price is 94.60, the coupon is 4% and the bond will be redeemed 4 years from now. The annual rate of ination throughout the life of the bond is expected to be 3%. Explain the meaning of each of the following terms, and calculate their value for Bond A. Heriot-Watt University Securities Markets 1
2.10. Review Questions
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a) Yield to maturity b) Interest yield c) Real yield Q3: a) Explain what is meant by bond washing. How has the market in gilt-edged bonds attempted to solve the problem of bondwashing. b) An 11% gilt is purchased 125 days after the last coupon payment (the coupon is paid semi-annually). If the quoted price is 115.60, what is the total price payable by the purchaser? Q4: Briey explain the difference between the methods of issue for UK government giltedged securities and for eurobonds Q5: Benbow plc would like to borrow 50m for a 10 year period, preferably at a oating interest rate. The company has been offered the following interest rates Floating rate debt LIBOR + 0.3% Fixed rate debt 5.80%
Hawkins plc would also like to borrow 50m for a 10 year period, but would prefer a xed interest rate. Hawkins has been offered the following interest rates Floating rate debt LIBOR + 0.8% Fixed rate debt Required a) Explain what is meant by an interest rate swap, and why an interest rate swap would benet these two companies. b) Calculate the total joint saving that would be made by an interest rate swap, expressed as an annual rate of interest (assuming no intermediation or transaction costs). c) Assume that the two companies agree to make an interest rate swap with the terms being LIBOR against 6.10% i ii Calculate the gains to each company from this swap, expressed as an annual rate of interest. Assume that the interest rate on the oating rate debt is reset for every six monthly period and that payments between the two parties are made every six months. What would be the payment between Benbow and Hawkins at the end of a period in which LIBOR has been 5.20%? 7.20%
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Chapter 3
Bond Price Sensitivity

Contents
3.1 3.2 3.3 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bonds and risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The price/yield relationship . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 Macaulay duration . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.2 Modied duration . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 3.5 3.6 3.7 3.8 Using duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Characteristics of duration numbers and duration calculations . . . . . . . Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 40 41 42 44 45 46 51 52 53
Learning Objectives On completion of this chapter students should be able to understand: the different types of risk in bond investment; the denitions of duration and how they measure the sensitivity of bond prices to interest rate changes; the calculation and use of duration numbers; the concept of convexity in bond prices.
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Chapter 3. Bond Price Sensitivity
3.1
Introduction
Modern theories of nance are very much concerned with risk. Earlier modules (particularly Investment and Portfolio Theory) have been concerned with the risk involved in equity investment. Bond investors, too, are very much interested in the risk level associated with their portfolios. The key measure of risk for investors in high-quality bonds are duration and Modied duration. This chapter will explain why these measures are important to bond investors, how they are calculated and how they are used by investors to control and manage their bond portfolios. It will also explain the concept of convexity and its signicance for bond investment.
3.2
Bonds and risk
It may seem illogical to discuss risk in the context of high-quality bonds. US Treasury bonds are generally regarded as the safest investment available. How can they be described as risky? The answer is that bonds carry several different types of risk. 1. Credit Risk (or Repayment Risk). This is the risk that the bond issuer will not make payments of interest and principal on schedule. For junk bonds, this risk may be signicant. For bonds issued by governments of major, advanced economies, it is very low. US Treasury bonds and UK gilt-edged bonds (gilts) are risk-free in the sense that they carry an insignicant credit risk. 2. Ination Risk. This is the risk that, although the payments will be made as promised on the bond, the purchasing power of these payments will be lower (or higher) than expected. Some investors buy bonds to match monetary liabilities. These investors will not be concerned about ination risk. However, many bond investors are interested in securing future purchasing power; ination puts this at risk. 3. Interest Rate Risk The yield-to-maturity of a bond and the price of the bond have a direct mathematical connection. Consider a bond with an annual coupon of 7 (next coupon in 1 years time) which will be redeemed 5 years from now. Chapter 2 demonstrated how a yield-to-maturity can be calculated if the bond price is given (this same bond was used as an example). Using this calculation method If the price is 110, the yield to maturity is 4.71% If the price is 105, the yield to maturity is 5.82% If the price is 100, the yield to maturity is 7.00% If the price is 95, the yield to maturity is 8.26% If the price is 90, the yield to maturity is 9.61% This example shows that a higher price means a lower yield (and vice versa). It Heriot-Watt University Securities Markets 1
3.3. The price/yield relationship
41
follows that price volatility for bonds is directly linked to yield volatility. Professional managers of bond funds (like professional managers of equity funds) expect to have their portfolios valued every quarter. They expect to be held to account for any rise or fall in value. These investors measure risk in terms of bond price volatility - even if they intend to hold the bond to maturity and are condent that all the promised payments will be made. If the manager accurately predicts a fall in interest rates and buys bonds which will benet strongly from such a fall - then the managers fund will outperform and the manager has done his job successfully. Most bond investors are very much focused on uctuations in bond prices and, therefore, they are very much concerned about interest rate risk. Interest rate risk and ination risk are closely linked. Interest rates can be broken down into the real rate and the expected level of ination. In the UK, ination expectations have, historically, been the larger and more volatile component of interest rates.
3.3
The price/yield relationship
Figure 3.1 plots the price of two bonds against their yields. Both bonds have a 6 per cent coupon and a nominal value of 100. Both bonds pay interest annually and the next coupon payment is due in 1-years time. If the bonds are priced at par, therefore, they will offer a yield-to-maturity of 6 per cent. Bond A has 3 years until maturity. Bond B has 10 years.
Figure 3.1: The relationship between bond price and bond yield-to-maturity for two bonds Figure 3.1 shows the market prices of these bonds at a set of yields ranging from 3 per cent to 10 per cent. The calculations linking bond price and bond yield have already been reviewed in Chapter 2. Figure 3.1 demonstrates again that higher interest rates are associated with lower bond prices. It also demonstrates that the prices of some bonds are more sensitive to interest rate changes than others. The 3-year bond (Bond A) is clearly less sensitive than the Heriot-Watt University Securities Markets 1
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10-year bond (Bond B). Bond investors will be very interested in knowing the sensitivity of their bonds to interest rate changes. A speculator who is forecasting a fall in interest rates will want to buy bonds which are highly sensitive to yield changes. In this way, he will make more money if his forecast is successful. Investors who are risk-averse may want low-sensitivity bonds. Investors who are buying bonds to cover specic liabilities will want bonds with a sensitivity level which matches those liabilities. This measure of sensitivity of a bonds price to changes in yield is called duration.The next task is to demonstrate how a bonds duration can be calculated. Duration is a fairly mathematical topic. The derivation of the duration formulae is explained in this text. It is preferable to show how formulae are derived rather than for them to appear by magic. But this module does not require that students should derive the duration formulae in examinations. The examinations do require students to explain, calculate and use duration numbers.
3.3.1
C 1+r
Macaulay duration
C (1 + r)2 C (1 + r)3 100 + C (1 + r)N
The standard valuation formula for a bond is P= + + + +
C is the (annual) bond coupon. The next coupon is payable in 1 year and the maturity date is N years in the future. P is the market price of the bond and r is the yield to maturity. To explain Macaulay duration, we shall rewrite this standard formula. Let Discount factor = x = 1 + r Write the formula using x instead of 1 + r giving P = C.x-1 + C.x-2 + C.x-3 + Macaulay duration, D, measures
change in bond price (P) %% change in discount factor (x)
+ (100 + C)x-N
for small changes in P and X. It is an elasticity formula, relating the percentage (or proportional) change in one variable to the percentage (or proportional) change in another. A small change in P is P or, at the limit, dP. A small change measured as a proportion of the current value of P is dP /P . So Macaulay Duration = Proportional change in P Proportionate change in x
dP P dx x
x P
dP dx
We have the relationship between P and x P = C.x-1 + C.x-2 + C.x-3 + + (100 + C)x-N
To get dP /dx , we differentiate this expression using the standard rules for differentiation. (Remember that, if V = WM , dV /dW = M.WM - 1 . We apply this rule to each term in the expression.) Hence
dP / dx
= -Cx-2 - Cx-3 - 3.Cx-4 -
-N (100 + C)x-(N + 1) Heriot-Watt University Securities Markets 1
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43
And x dP P dx N (100 + C).x - N C.x - 1 + 2.C.x - 2 + 3.C.x - 3 = P The logic of this formula may be clearer if it is described in words. Macaulay Duration = D = Macaulay Duration is the average number of years before the cash ow from a bond is received. The weight given to each year in the calculation is the present value of its cash ow calculated at the internal rate of return (i.e. the yield) of the bond. So Macaulay Duration can be interpreted as a period of time. It is a number of years in our current example where the coupon is paid annually. The adjustment needed if the coupon is paid semi-annually will be considered later. Look at the formula again. On the top line we have the time periods when payments on the bond will be made. One year from now; Two years from now; etc. 1 2 3 N
Each of these future dates is weighted by the present value of the cash ow to be received at that date. 1. C.x-1 2. C.x-2 3. C.x-3 N (100 + C).x-N
These values are added together and divided by the sum of the weights =
C.x - 1 + 2.C.x - 2 + 3.C.x - 3 C.x - 1 + C.x - 2 + C.x - 3
N (100 + C).x - N (100 + C).x - N
The bottom line in this expression is simply P (see equation above) so the average number of years that a bondholder has to wait to get his cash inow from the bond is =
C.x - 1 + 2.C.x - 2 + 3.C.x - 3 P
N
(100 + C).x - N
We originally dened Macaulay Duration as an elasticity. It is

change in bond price (P) %% change in discount factor (x)
We have shown mathematically that this value is the average number of years that a bondholder has to wait to get cash back from the bond (with the average being calculated in a specially dened way). In general, the longer a bondholder has to wait for his cash inows, the more sensitive the bond price will be to changes in the discount factor. Note that this ts the facts as illustrated in Figure . It shows that the price of the 10-year bond is much more sensitive to changes in interest rates than the price of the 3-year bond. The logic of the duration formula If the duration formula is still looking unfriendly, try looking at it this way. Remember that duration is an average number of years Suppose we want to calculate the average age of children in a class. There are 6 aged (exactly) 7 years; 11 aged exactly 8; and 3 aged 9. We are going to take an average of 7, 8 and 9 and the weights are in the proportions 6, 11 and 3. So we calculate
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Average age =
(7
6) + (8 11) + (9 3)
6 + 11 + 3
years
The bottom line is the sum of the weights. N years when The duration formula is logically very similar. The ages are 1, 2, 3 the bond is redeemed. The weights are the present values of the cash ows to be (100 + C)x-N . The bottom line is the received at each of these dates i.e. C.x-1 C.x-2 sum of the weights which is equal to the current market price of the bond. Macaulay duration measures sensitivity to changes in the discount factor. Investors usually think in terms of changes in yield. Sensitivity of bond prices to changes in yield is measured by a number which is closely related to Macaulay duration and which is called Modied duration.
3.3.2
Modied duration
Modied duration is generally denoted by the symbol D* to distinguish it from Macaulay duration (which is simply D). Modied duration = D* = % change in bond price change in yield (measured in % )
Note that Modied duration is closely related to ordinary (Macaulay) duration. It does a similar job. It is just a bit easier to use. The denition has change in yield instead of change in discount factor. Investors generally think in terms of yields, not discount factors. So Modied duration is popular with bond investors. How is Modied duration linked mathematically to Macaulay duration? Note that % change in bond price change in yield % change in bond price in discount factor change in discount factor % change change in yield % change in discount factor D change in yield d(1 + r)/(1 + r) D dr Since d (1 + r) = dr (a small change in the discount factor is equivalent to exactly the same small change in the yield. The other component of the discount factor (the number one) is a constant which does not change). D* = D*= D
1 1+r
or Modied duration = Macaulay duration
Note: The concept of duration was rst invented in 1938 by Frederick Macaulay. His measure was simply called duration for many years. Now Modied duration is widely used, and the original duration measure is generally called Macaulay duration to distinguish the two. If you are asked simply to do a calculation involving duration you should assume Macaulay duration unless otherwise specied. If an essay question asks you to explain the concept of duration and how it is used, it would be appropriate to cover both measures of duration.
3.4. Using duration
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3.4
Using duration
The purpose of duration is to measure the sensitivity of a bond price to changes in yield. Its use is illustrated by the following example.
Example Treasury 9 per cent stock (nominal value 100) pays interest annually (next coupon payment in exactly one year). It will be redeemed at par in 5 years time. Currently the bond is priced to give a yield-to-maturity of 6 per cent. Required a) Calculate the current market price of this bond b) Calculate the Macaulay duration of this bond and use this measure to estimate the percentage fall in the bond price if its yield rose to 7 per cent. c) Calculate the Modied duration of this bond and use this measure to estimate the percentage fall in the bond price if its yield rose to 7 per cent. d) Calculate the actual bond price that would offer a yield of 7 per cent and compare this price with the price estimated by using the duration measures [in sections b) and c)]. Solution a) This value is simply calculated by discounting the future cash ows from the bond at a rate of 6% 9 9 9 9 9 + + + + P= 1.06 1.06 1.06 1.06 1.06 = 112 .64 b) To calculate the Macaulay duration, the number of years to each cash ow is multiplied by a weight which is the present value of the cash ow. These numbers are summed and the total is divided by the sum of the weights. The weights have already been calculated in part a). The sum of the weights is the current market price of the bond (112.64). The calculation can be set out as follows Years to Weight payment (= PV of Payment) 1 2 3 4 5 8.49 8.01 7.56 7.13 81.45 Total 112 .64 Hence Macaulay duration = D = Heriot-Watt University Securities Markets 1
482.96 / 112.64
Year Weight 8.49 16.02 22.68 28.52 407.25 Total 482.96
= 4.29 years.
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We now use this number to calculate the percentage fall in the bond price if the yield goes from 6 % to 7% (i.e. if the discount factor goes from 1.06 to 1.07). Macaulay duration = or % change in bond price = - Macaulay duration % change in discount factor. The discount factor has gone from 1.06 to 1.07, so the percentage change is
1.07 - 10.6 1.06 % change in bond price change in discount factor
Hence
% change in bond price = -4.29 0.9434 = -4.05%. So the new bond price is estimated to be 4.05% lower than its current value of 112.64. Estimated new bond value =
100 - 4.05 100
112.64 = 108.08.
c) The same calculation can be carried out in a slightly different way using Modied duration. 1 Modied duration = D* = Macaulay duration 1 + yield 1 = 4.29 1.06 = 4.05 years and % change in bond price = . Modied duration percentage)
change in yield (measured as a
The yield has gone from 6% to 7%, so the change in yield (measured as a percentage) is 1. % change in bond price = .4.05 1 = -4.05. The new estimated bond price would be calculated, (exactly as in part b), to be 108.08. The use of Macaulay duration and Modied duration will lead to exactly the same result. d) If the bond offers a yield of 7% its price must be P= 9 9 9 9 9 + + + + 2 3 4 1.07 (1.07) (1.07)5 (1.07) (1.07) = 108.20.
3.5
Characteristics of duration numbers and duration calculations
A) The accuracy of bond price calculations using duration The duration formula was derived by differentiating the bond price formula. Differentiation is a mathematical technique that relates changes in one variable to changes in another variable if the changes are very small (innitesimally small). When more sizeable changes are considered, the duration method will not be completely accurate. Heriot-Watt University Securities Markets 1
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The example above illustrates this. Using the duration approach, the bond price was estimated to fall by 4.56 to 108.08. Part d) of the calculation showed that the true fall in price if yield rose to 7% was 4.44, and the new price was 108.20. This inaccuracy arises because the relationship between a bond price and its yield is not linear. It is curved. Its shape is convex. Later in this chapter, convexity will be considered in more detail. But despite this limitation on their accuracy, duration measures and duration calculations are widely used by bond investors. B) How is duration linked to bond life - specically, the number of years to maturity? Duration is a measure of the average number of years until cash ow is received, so duration and years-to-maturity are linked. For a zero-coupon bond, all the cash ow will be received at nal maturity. For such a bond, Macaulay duration = No. of years to maturity. For all other bonds, Macaulay duration No. of years to maturity because the coupon payments shorten the average period that an investor must wait to receive the promised cash ows. For a perpetuity, the bond life is innite but the Macaulay duration is the yield of 5%, the Macaulay duration is 1.05 /0.05 = 21 years.
1 + r/ . r
If r is
It might seem that, for any given coupon level, Macaulay duration would be greater the longer the period until the bond is redeemed. As a generalisation, this is true, but it is possible to provide counter examples, especially for bonds with low coupon rates and high yields-to-maturity. C) How is duration linked to the coupon rate? Other factors equal, a higher coupon rate leads to a lower duration. Consider Figure 3.2.
Figure 3.2: Comparative cash ow patterns from low coupon and high coupon bonds These diagrams show the present values of the cash ows from two bonds both with 6 years to maturity. One has a low coupon and the other a high coupon.
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It can be seen visually that the cash ow pattern of the high coupon bond is weighted towards the nearer dates. This gives the high coupon bond a shorter duration. D) How is duration linked to bond price volatility? A short-dated bond might have a duration of 3.5 years. A long-dated bond might have a duration of 10.5 years. Would this mean that the price volatility (or the variance of monthly returns) would be three times greater for the long-bond? Not necessarily - duration measures interest rate sensitivity which is not quite the same thing as volatility. If the yield on the short and the long bond were always the same, so that interest rate changes for the long and the short bond were always equal then, indeed, the volatility of a bond would be proportional to its duration. A world in which long and short term interest rates were always the same would be described as having a structure of interest rates which was always at. A world in which short and long term interest rates were always guaranteed to move up or down by equal amounts would be described as having parallel shifts. With parallel shifts, if short-term interest rates went up by 0.5%, then long-term rates would go up by 0.5% also. If neither of these conditions is met, then the volatility of bonds will not be proportional to their durations. Suppose, for example, that the yield on the shortterm bond (duration 3.5 years) uctuates more than the yield on the long-term bond (duration 10.5 years). In this case, the price volatility of the long bond will not be 3 times the price volatility of the short bond. The multiple will be a smaller number. In fact, as we shall see in Chapter 4, there is evidence that short-term interest rates vary more than long-term ones. E) The duration of a portfolio Is it useful to calculate the duration of a bond portfolio? Most professional investors hold portfolios of bonds. A duration for the portfolio can be calculated as a weighted average of the durations of the constituent bonds. The weights would be based on the market value of each bond held in the portfolio. Is such a portfolio duration a useful number? In a world of parallel shifts, such a portfolio duration number will measure the sensitivity of portfolio value to a change in the general level of interest rates. Many bond investors calculate portfolio duration for this reason. But if yields on long and short-dated bonds do not move by equal amounts, - if they move by amounts that are considerably different - then portfolio duration will not be a very useful number to investors. F) Duration and Immunisation Many institutions which invest in bonds have specic future monetary liabilities. Life insurance companies and pension funds fall into this category. For such institutions, the way to avoid commercial risk is to hedge their liabilities by purchasing assets which have exactly similar risk characteristics. If the value of the liabilities rises due to interest rate changes, then the value of the assets should change by an exactly equal amount. A nancial institution which achieves such a balance is said to have immunised itself against interest rate risk. The most complete form of immunisation is to Heriot-Watt University Securities Markets 1
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buy assets which give cash ows which exactly match the liabilities on a year-byyear basis. This is called a dedication strategy. Once such assets have been purchased, there will be no need to trade or to adjust the portfolio. But a dedication strategy may be difcult to put into practice. There may, for example, be a shortage of very long dated bonds. And most bonds pay coupons which create problems if the liability cash-outows do not begin for several years. Because of these problems, many institutions will follow a policy of immunisation which involves matching the duration of their assets and their liabilities. The liabilities can be expressed as a series of known annual cash outows and a duration can be calculated (just as it can for the series of cash-inows offered by a bond). If the average duration of the liabilities exactly matches the average duration of the assets (the portfolio duration) then the position of the insurance company or pension fund is said to be immunised against interest rate risk. As we have already seen, such immunisation only works perfectly if there are parallel shifts in interest rates and this is not an accurate description of the real world. Note also that an institution that immunises in this way will have to keep its asset portfolio under continuous review. The duration of the assets may equal the duration of the liabilities today; but, even if the same assets and liabilities are retained, the duration will not necessarily match in a years time. If the liabilities are xed, the bond portfolio will have to be restructured to keep an immune nancial structure. Even though it does not remove all interest rate risk, immunisation, by equalising the duration of asset and liability portfolios, is commonly practised by nancial institutions. G) Duration and semi-annual coupons Most bonds pay coupons semi-annually, but our examples so far have only considered annual coupons. The principles involved in calculating duration remain the same. The period used is six months instead of 1 year. And, once calculated, duration is still quoted as a number of years. This can be illustrated by an example.
Example A bond with an 8% coupon and a nominal value of 100 pays interest semiannually. The next interest payment is due in 6 months and nal redemption of the bond is due in three years time. The bond is currently priced to offer a yield-to-maturity of 6% (using the US/UK convention. Required a) Calculate the current market price of this bond. b) Calculate the Macaulay duration and Modied duration of this bond. c) Use the Modied duration to estimate the new price of the bond if the yield to maturity (using the US/UK convention) rose to 7%.
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Solution a) The current market price is P= 4 4 4 4 4 4 + + + + + 5 2 3 4 1.03 (1.03) (1.03) (1.03) (1.03) (1.03)6

b) Macaulay duration is calculated using 6-months as the period. Period 1 2 3 4 5 6 Weight 3.88 3.77 3.66 3.55 3.45 87.10 105.41 So Macaulay duration D = (which is
5.47 / 2 576.45 / 105.41 =
Period Weight 3.88 7.54 10.98 14.20 17.25 522.60 576.45
5.47 periods
= 2.73 years).
D 1+r 5.47 1.03
Using the six-monthly periods Modied duration = D* = = 5.31 periods (or 2.66 years). Note that the discount factor 1+ r is per period (not per year). c) We use the formula % change in price = -Modied duration change in yield where yield is expressed as a percentage rate per period. In this case the change in yield is from 3% per half-year to 3.5% per half-year. So the change in yield is 0.50. Hence % change in bond price = -5.31 0.50 = -2.66. The original price was 105.41. The price falls by 2.66% so the estimated new price is
100 - 2.66 100
105.41 = 102.61 ()
The calculations are straightforward as long as the period is consistently treated as 6-months rather than a year.
Note that, in order to use a duration number, we must know whether it relates to an annual coupon bond or a semi-annual coupon bond whose yield is quoted according to the US/UK convention. Whenever you are asked to use a duration number, this information will be provided. Whenever you calculate or quote a duration number, the type of bond to which it relates must be clearly shown, either explicitly or by the context. Heriot-Watt University Securities Markets 1
3.6. Convexity
51
3.6
Convexity
The Modied duration measure suggests that there will be a straight-line relationship between yield and price. In fact the relationship is not straight; it is curved. Figure 3.3 shows the true price/yield relationship as a solid line. If Modied duration is used to estimate the new price after a change in yield, the estimates will lie along the straight, dotted line.
Figure 3.3: The relationship between bond yield and bond price, illustrating convexity For small changes, Modied duration works well. For larger changes, it is appropriate to take into account the curvature or convexity of the price/yield relationship. Professional bond investors use a mathematical measure of convexity. Modied duration measures the slope (of the price/yield relationship) using the rst derivative, dP /dr . 2 P . Convexity measures the rate of change of the slope using the second derivative, d dr2 Even when professional investors use a convexity measure, they do not achieve perfect accuracy because the third and higher derivatives will also affect prices. But their effects are comparatively minor in practical applications and are generally ignored. In Figure 3.3 A shows the adjustment for convexity after a major rise in the yield. B shows the adjustment for convexity after a major fall in the yield. The size of the convexity adjustment is, roughly, proportional to the square of the change in yield. Notice that in Figure 3.3, both A and B are positive. In other words, whether interest rates rise or fall, duration alone will underestimate the new bond price. Professional bond investors will measure the overall convexity of their portfolios as well as the overall duration. Consider Figure 3.4. This shows, for two bond portfolios X and Y, how the portfolio value will vary with the yield. (We must assume here that the yield curve is at and moves in parallel shifts.) The initial value of both portfolios is V 0 and the interest rate is r0 .
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Figure 3.4: The relationship between portfolio value and interest rates for two bond portfolios, X and Y. Both portfolios have the same Modied duration, but Y has greater convexity than X These two portfolios have the same duration (because both lines have the same slope at V0 , r0 ) but they do not have the same convexity. Portfolio Y is more convex than portfolio X. Whichever way interest rates move, an investor in Y will get a better return than an investor in X. So investors want convexity and will value convexity. The value of convexity will depend on the volatility of interest rates. If investors expect large and sudden interest rate changes, then convexity will be particularly important to them. How can investors put convexity into their portfolios? Suppose that the investor wants a Modied duration of 7 years, and that only zero-coupon bonds are available. Investing 100% of the portfolio in a single bond with a Modied duration of 7 years will give the lowest possible level of convexity. A bar-bell portfolio, with 50% invested in a bond with a Modied duration of 3, and 50% invested in a bond with a Modied duration of 11 will have higher convexity - but the same overall Modied duration Professional investors are very interested in duration, but they are not exclusively concerned with duration. They will be interested in bonds convexity as well.
3.7
Conclusion
This chapter has discussed the three types of risk in bond investment Credit risk Interest risk Ination risk Bonds which are regarded as risk-free because there is a negligible danger of default (such as US Treasury bonds), are still affected by the other risks. Heriot-Watt University Securities Markets 1
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Interest rate risk for a bond is primarily measured by duration. The chapter has explained two measures of this type of risk. Macaulay duration Modied duration and has shown how they can be used by investors. The chapter has explained how duration is linked to bond life and to bond coupon. The concept of portfolio duration has been introduced. The chapter showed how nancial organisations can match the duration of their assets to the duration of their liabilities, thus achieving immunisation. The concept of convexity in bond pricing was discussed. It was demonstrated that convexity was attractive to bond investors.
3.8
Q1:
Review Questions
Identify three different types of risk that can affect a bond investor. Is there such a thing as a risk-free bond? Q2: Bond X has a 6% coupon and will be redeemed in 5 years time. The coupon is paid annually and the next coupon is due to be paid in one year. The bond is currently priced to give a yield to maturity of 4%. Required a) Calculate the current market price of Bond X b) Calculate the duration of Bond X c) Calculate the Modied duration of Bond X d) Explain the usefulness of duration and Modied duration to bond investors e) Use Modied duration to estimate the new price of the bond if the bonds yield to maturity falls to 3.75% f) Will the estimate of the new price made using Modied duration be entirely accurate? Explain the reason for your answer. Q3: Explain the relationship between the duration of a bond and a) The remaining life of the bond b) The coupon of the bond c) The price volatility of the bond
54
Q4: Explain what is meant by the following terms a) Bond immunisation b) Bond convexity (include a diagram in your explanation)
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Chapter 4
Yield Curves and the Term Structure of Interest Rates

Contents
4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Drawing the yield curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . The shapes of yield curves . . . . . . . . . . . . . . . . . . . . . . . . . . The economic interpretation of yield curve shapes . . . . . . . . . . . . . Spot rates and forward interest rates . . . . . . . . . . . . . . . . . . . . . Approximate yield curve calculations . . . . . . . . . . . . . . . . . . . . . Yield curves and bond investment . . . . . . . . . . . . . . . . . . . . . . The pure expectations hypothesis (PEH) . . . . . . . . . . . . . . . . . . . 4.8.1 Implications of the pure expectations hypothesis . . . . . . . . . The liquidity preference hypothesis . . . . . . . . . . . . . . . . . . . . . . 4.9.1 Implications of the liquidity preference hypothesis . . . . . . . . . Preferred habitat/market segmentation . . . . . . . . . . . . . . . . . . . . 4.10.1 Implications of the preferred habitat hypothesis . . . . . . . . . . Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.11.1 Pure expectations hypothesis . . . . . . . . . . . . . . . . . . . . 4.11.2 Liquidity preference hypothesis . . . . . . . . . . . . . . . . . . . 4.11.3 Preferred habitat/market segmentation hypothesis . . . . . . . . 4.12 4.13 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 57 59 62 63 67 68 70 71 73 74 74 75 75 75 76 77 78 78
Learning Objectives On completion of this chapter students should be able to understand: the concept and denition of the yield curve; the different possible shapes of the yield curve and their economic interpretation; denition and calculation of forward interest rates using yield curve data; three models of the yield curve
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Chapter 4. Yield Curves and the Term Structure of Interest Rates
the Pure Expectations Hypothesis the Liquidity Preference Hypothesis the Preferred Habitat/Market Segmentation Hypothesis.
4.1. Introduction
57
4.1
Introduction
Bonds which have different numbers of years to maturity are likely also to have different yields. The relationship between bond yield and bond life is called the Yield Curve or the Term Structure of Interest Rates. This chapter shows how the term structure of interest rates is calculated and looks at the different shapes that the yield curve can assume. The key question for investors is how to use the yield curve to make bond investment decisions. In order to use the yield curve, it is necessary to understand it. This chapter will look at the theories which attempt to explain the shape of the yield curve.
4.2
Drawing the yield curve
To draw the yield curve, we need to know the 1 year interest rate 2 year interest rate 3 year interest rate
30 year interest rate (In most developed countries, the yield curve stops at about 30 years because 30-year bonds are the longest available. In the UK, however, as we saw in Chapter 1, there are some perpetual bonds available.) The yields of 10-year bonds will vary for a number of reasons. One will be the creditworthiness of the issues. Another will be the coupon rate. A bond with a 12 per cent coupon offers a signicantly different cash ow pattern compared to one with a 3 per cent coupon. A yield must be drawn on a consistent basis. It is possible to draw a yield curve for Currency Creditworthiness Coupon US dollar AA rated corporate bonds 5%.
By nding a lot of corporate bonds which meet this specication, a yield curve could be drawn which plotted yield-to-maturity against years-to-redemption. The biggest bond issuers are governments. The government bonds issued by major developed economies have the highest credit ratings and are virtually risk-free. The simplest type of bond is the zero-coupon bond. So the standard type of yield curve for the UK, the main yield curve considered in this chapter, is
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Currency Creditworthiness Coupon
UK pound UK-government issued (AAA rating) Zero
Note that the standard yield curve discussed in this module uses zero-coupon bonds even though most governments, including the UK government, do not issue bonds in zero-coupon form. How can the interest rate on a theoretical zero-coupon bond be calculated if no such bond has been issued? It can be calculated indirectly, as follows
Example : Problem A one-year bond, paying a 5 per cent annual coupon, will be redeemed for 105 in one years time. The current market price of this bond is 100.75. A two- year bond, paying a 10 per cent coupon, will pay 10 in one year and 110 on redemption in two years time. Its market price is 108.50. (With this information you can calculate the yield of the bond. It is 5.40 per cent.) What would be the price and yield-to-maturity of a zero-coupon two-year bond? Solution The one-year interest rate is
105 / 100.75
- 1 =0.0422 or 4.22%
The cash ow from buying the two-year bond would be Now Cash ow from buying the 2-year bond If 9.595 is borrowed today, the repayment in 1 year will be 9.595 1.0422 = 10 The cash ow from buying the 2-year bond and borrowing on a 1-year basis is -108.50 +9.595 1 yr +10 -10 2 yr +110 -
-98.905
+110
So the two-year interest rate (on a zero-coupon basis) is calculated from

r)2 1 + r)2
1.112
r = 0.0546 or 5.46% So the two-year zero coupon rate is 5.46%. The two-year 10%-coupon rate was 5.40%. The difference is 6 basis points - not large in most contexts, but signicant in the bond market.
It may be possible to observe zero-coupon interest rates directly, without doing calculations. Major investment banks sometimes strip coupon bonds. They sell off, Heriot-Watt University Securities Markets 1
4.3. The shapes of yield curves
59
separately, the rights to each element of the cash ow. The original government security is held in trust and this guarantees that the payments will be made. The stripped nal payment is effectively a zero coupon bond. It is traded, and its market price can be used in a direct calculation of the zero-coupon yield. The yield curve in the UK in early 2002 is shown below.
Figure 4.1: The yield curve in the UK 2002 The short-term interest rate was 4.0%, the yield curve peaked between 5 and 10 years at about 5.25%, and , for longer time periods, the yield curve steadily declined to a rate just below 5% at 30 years.
4.3
The shapes of yield curves
Figure 4.2, Figure 4.3, Figure 4.4, andFigure 4.5 show some of the shapes that yield curves assume. Figure 4.2 shows a normal or rising curve. It is rising throughout its length. Figure 4.3 is a humped curve (the curve in Figure 4.1 is slightly humped). Figure 4.5 shows a at curve.
Figure 4.2: A rising yield curve A rising yield curve is the most common shape, but each of the others appears from time to time.
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Figure 4.3: An inverted yield curve
Figure 4.4: A humped yield curve
Figure 4.5: A at yield curve Yield curves exhibit several other characteristics. 1. The slope of the yield curve is generally greatest at the near end and it attens out at the far end. This is true for both upward-sloping and downward sloping yield curves. There can be a substantial difference between the one-year rate and the 5-year rate. But the 25-year rate and the 30-year rate are unlikely to be close together. The shapes shown in Figure 4.6 are very unlikely to be observed. Heriot-Watt University Securities Markets 1
4.3. The shapes of yield curves
61
Figure 4.6: Yield curve shapes that are unlikely to be observed 2. Short-term interest rates tend to vary more than long-term interest rates. The highest interest rates observed on government bonds, and the lowest rates, are on short-term securities. Figure 4.7 shows a typical pattern of yield curves observed at annual intervals over a 10-year period. A 10-year period is likely to display several different yield curve shapes. The range between the highest and lowest short-term rates will generally be greater than the range between the highest and lowest long-term rates. Theories of the term structure of interest rates (discussed later in this chapter) offer an explanation for this.
Figure 4.7: A set of yield curves that might be observed over a 10-year period 3. The previous chapter (Chapter 3) discussed the sensitivity of bond prices to yield changes. It introduced the concept of duration and showed how the concept of duration could be applied to a portfolio bond if the yield curve was always at or if the yield curve always moved in parallel shifts. However, the yield curve generally does not move in parallel shifts. A 2% rise in short-term interest rates is not generally associated with an equivalent 2% rise in long-term rates. In fact it is quite common for short-term interest rates and longterm rates to move in opposite directions. An example of this occurred in the UK in 1992. Short-term interest rates fell when the UK abandoned its exchange rate link with the Deutsche Mark and other European currencies - but the long-term interest rate rose. This is illustrated on Figure 4.8.
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Figure 4.8: Yield curve changes in the UK in 1992 when the pound left the European Exchange Rate Mechanism (which tied the currency to the DM) and effectively devalued.
4.4
The economic interpretation of yield curve shapes
This module is mainly concerned with investment. It is not an economic module and is not primarily concerned with economic policy. But, in order to understand yield curves, it is appropriate to make some brief observations on how they relate to economic policy and the economic cycle. Governments can control short-term interest rates. Sometimes this job is assigned to an independent monetary authority or a central bank. But the short-term interest rate is a policy decision - a decision about the interest rate at which the monetary authority will lend to banks on rst-class security. In the short-run, the rate of ination is xed, so a low short-term interest rate means a low (short-term) real interest rate. A low real rate will encourage business to borrow money and invest. Economic growth will be stimulated. In the UK it will encourage private individuals to borrow and buy homes. The price of houses will rise and economic growth will be stimulated. A low interest rate will also tend to lower the exchange rate of a currency. Investors sell the currency because they can get a better return elsewhere, so the value of the currency falls. Domestic goods become cheaper than foreign goods, and domestic manufacturers gain market share both at home and abroad. This effect also stimulates the growth in the economy. But if the interest rate is held at a low level for a long time, the economy will overheat and the result will be ination. So, a strongly upward-sloping yield curve (i.e. low short-term rates) means that economic policy is trying to promote growth. The policy-makers are not very worried about ination or a low value for the exchange rate. The policy-makers have their foot on the accelerator. A strongly downward sloping curve has the opposite interpretation. The policy-makers are trying to slow the economy down. They may be trying to reduce ination and/or hold up the exchange rate. Consider again the case of the British devaluation in September 1992. The steeply
4.5. Spot rates and forward interest rates
63
downward sloping yield curve in Figure 4.8 (before devaluation) reects the fact that until September 1992 the government was trying to maintain the exchange rate. The long-term interest rate was low because ination was being forced out of the economy. But the cost of maintaining the exchange rate was slow growth and rising unemployment. Eventually these costs became too great. The government devalued, cut short-term interest rates and allowed economic growth to start again. But long-term interest rates rose because extra growth would probably allow extra ination into the economy. These factors explain the sudden transformation of the sterling yield curve demonstrated in Figure 4.8. The shape of the yield curve is a good indicator of an economys position in the economic cycle. In an economic boom, the yield curve will be downward sloping. Policy-makers are putting the brakes on the economy. At the bottom of the cycle, the curve will be upward sloping. Policy-makers will use a low short-term rate to stimulate growth.
4.5
Spot rates and forward interest rates
First, some nomenclature - the interest rates that are plotted to draw the yield curve are called spot rates because they are interest rates for investments starting today (the investment is made on the spot). The symbols used to describe these rates are 0 s1 the interest rate available on a one-year investment or bond investing today
0 s2 0 sn
the interest rate for a two-year bond, investing today the interest rate for a bond with n years to maturity, with the investment made today.
All these rates refer to zero coupon bonds. Forward rates refer to investments that will not be made until some date in the future. f the forward rate for a loan or investment that will start one
1 2
year from now and end two years from now.

1 f3
the forward rate for a loan or investment that will start one year from now and end three years from now. the forward rate for a loan or investment that will start 2 years from now and end ve years from now.
2 f5
Forward interest rates can be calculated from the spot interest rates. This will be illustrated by an example.
Example Suppose that

0 s1 0 s2
= 5.0% = 6.0%
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0 s3 0 s4
= 6.5% = 7.0%
and we want to calculate 1 f2 , 2 f3 and 2 f4 . Solution Suppose that each zero-coupon bond will pay 100 at maturity, so the current price of the 1-year bond is
100 1.05
The price of the two-year bond is

100
1.06
The price of the three-year bond is

100
1.065
(Here we have been given the spot rates and have calculated the bond prices. If we had been given the bond prices we could have calculated the spot rates.) We now consider the following transactions 1. Buy a two-year bond Now The cash ows are -89.00 1 year 2 years +100
2. Borrow 89.00 at the one year interest rate. Repay 89.00 x 1.05 = 93.45 in one year +89.00 -93.45 -93.45 +100
Aggregate cash ows from these transactions -93.45 +100 These aggregate cash ows represent a loan which starts in one years time and is repaid in two years time. The interest on this loan is 1 f2 = 100 / 93.45 - 1 = 0.0701 or 7.01%. The general formula for calculating 1 f2 is derived from the following logic. If, today, you arrange to invest for one year at the spot rate ( 0 s1 ), and you also arrange, today, to reinvest the proceeds of this loan for a second year (at 1 f2 ), then you know exactly how much you will receive in two years. You are not taking any risk. This must be exactly the same amount that you get from investing, today, in a two-year bond. Algebraically (1 + 0 s1 )(1 + 1 f2 ) = (1 + 0 s2 )2 or 1 + 1 f2
(1 + 0 s2 (1 + 0 s1 (1.06 1.05
Using this formula for our example gives 1 + 1 f2

1 f2
or
4.5. Spot rates and forward interest rates
65
which conrms the original calculation. The underlying logic is that, if you invest money for n years, at rates which you x today, you will always end up with the same amount. This is an application of the economists Law of one price. Consider an individual who wants to invest for a 4-year period (i.e. n = 4). He has several alternative investment policies, but, if he xes all the rates today (i.e. he takes no risk), all the policies will give the same terminal wealth. Buy a four year bond (1 + 0 s4 )4 equals equals (1 + 0 s3 )3 (1 + 3 f4 ) (1 + 0 s2 )2 (1 + 2 f3 )(1 + 1 +3 f4 ) Buy a three-year bond and take the forward rate for the 4th year Buy a two-year bond and contract at the forward rates for years 3 and 4 Contract separately for each of the four years.
equals
(1 + 0 s2 )(1 + 1 f2 )(1 + 2 f3 )(1 +3 f4 )
This does not exhaust the possibilities. So far we have only considered forward rates covering a one-year period. The 4-year return could also be written Buy a two-year bond and contract equals (1 + 0 s2 )2 (1 +2 f4 )2 for the following two years at a forward rate which covers both years. We now return to our numerical example and calculate 2 f3 . investment over a three-year period, by the Law of one price (1 + 0 s3 = (1 + 0 s2 f3
f3
If we consider
(1 + 0 s3 (1 + 0 s2
(1.065)3 (1.06)2
f3
To calculate 2 f4 we consider investment over a four-year period (1 + 0 s4 )4 = (1 + 0 s2 )2 (1 + 2 f4 )2 taking the square root of both sides (1 + 0 s4 = (1 + 0 s2 f4
f4
f4
(1 + 0 s4 (1.07)2 1 + 0 s2 (1.06) 0.0801 or 8.0
The interest rate that an investor can obtain over any time period (say from one year hence to 3 years hence) can be calculated in several different ways by linking spot and forward rates in an appropriate way. The following diagram (Figure 4.9) shows the time periods over which the different interest rates operate. If the spot rates (i.e. the yield curve) are given, then the forward rates can be calculated. If the forward rates are given, then it is possible, using the Law of one price, to calculate the yield curve. Heriot-Watt University Securities Markets 1
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Figure 4.9: The time period covered by spot rates and forward rates
Example The following interest rates are currently available

0 s1
= 6%
1 f2
= 5.5%
2 f3
= 5%
3 f4
= 5%
4 f5
= 6.5%
Calculate the values in the yield curve. Solution We need to calculate 0 s2 , 0 s3 , 0 s4 and 0 s5 Using (1 + 0 s1 )(1 + 1 f2 ) = (1 + 0 s2 )2 We have (1.06)(1.055) = 1.1183 = (1 + 0 s2 )2 1 + 0 s2 = 1.0575 Using (1 + 0 s2 )2 (1 + 2 f3 ) = (1 + 0 s3 )3 (1.0575)2 (1.05) = 1.1742 = (1 + 0 s3 )3 1 + 0 s3 = 1.0550 Using (1 + 0 s3 )3 (1 + 3 f4 ) = (1 + 0 s4 )4 (1.0550)3 (1.05) = 1.2329 = (1 + 0 s4 )4 1 + 0 s4 = 1.0537 0 s4 = 0.0537 or 5.37% and, nally, using (1 + 0 s4 )(1 + 4 f5 ) = (1 + 0 s5 )5 (1.0537)4 (1.065) = 1.3131 = (1 + 0 s5 )5 Heriot-Watt University Securities Markets 1
0 s3 0 s2
= 0.0575 or 5.75%
= 5.50%
4.6. Approximate yield curve calculations
67
1 + 0 s5 = 1.0560
0 s5
= 0.0560 or 5.6%
Figure 4.10 shows the yield curve that has been calculated in this example. It also shows the forward rate curve, based on the original data, which plots each forward rate against the year to which it relates.
Figure 4.10: A yield curve calculated from a set of forward interest rates Notice the relationship between the forward rates and the yield curve. The spot rates are averages over n years. The forward rate is the marginal rate for one extra year. The forward rate pulls the yield curve up or down. In the example,
3 f4 4 f5
is below 0 s3 - so 0 s4 will be below 0 s3 is above 0 s4 - so 0 s5 will be above 0 s4 .
4.6
Approximate yield curve calculations
All our calculations have used compounding which is, of course, appropriate when dealing with interest rates. But a spot rate over n years is, roughly, a simple average of the successive one-year rates over the period. For 3 years
s3
0 s1
+ 1 f2 + 2 f3
with the numbers in our example
s3
0.060 + 0.055 + 0.050
or 5.5% exactly
The true answer, using compounding, is 5.499%. The difference isnt very great! To calculate a forward rate using this approximate method, use the relationship
n fn
n 0 sn + 1 n
0 sn
If you want the four year forward rate ( 4 f5 ) simply calculate 5 times 0 s5 and subtract 4 Heriot-Watt University Securities Markets 1
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times 0 s4 . This can provide a quick check on an answer that you have calculated the long way.
4.7
Yield curves and bond investment
Every bond investor needs an investment strategy. An investor will typically have an investment horizon. In the case of a pension fund, for example, the fund manager will know the outows from the fund that are expected in future years. He may know, for example, that 90 million will be paid out from the fund in 10 years time. He has to work out how to make that outpayment at the lowest possible cost in current money. In other words, he wants to earn the highest possible return over the 10-year period. We shall assume that the fund manager is only considering risk-free investments. Even so, he has a choice between many alternative investment strategies. Strategy 1 Strategy 2 Strategy 3 He could buy a 10-year bond and hold it to redemption. He could buy a 20-year bond and sell it after 10 years. He could buy a 5-year bond and, when it matures, buy another 5-year bond.
Clearly there is a very large number of different possibilities in addition to these three. For example, he could buy a fresh one-year bond every year for each of the 10 years. How should the fund manager choose between them? Lets think about it. The strategy that the fund manager expects will have the highest return depends on what the fund manager expects interest rates (= the yield curve) will look like in the future. Consider an example. Suppose that Figure 4.11 shows three yield curves. The rst is the yield curve today; the second the yield curve as the fund manager expects it to be in 5 years time; the third the yield curve that he expects in 10 years time.
4.7. Yield curves and bond investment
69
Figure 4.11: The current yield curve and a fund managers forecast of future yield curves Strategy 1 The current yield curve shows that a 10-year bond offers a return of 6.0%. So if the fund manager buys a 10 year zero-coupon bond and holds it to maturity 100 will grow to 100 (1.06) 10 = 179.08. Strategy 2 The current yield curve shows that a 20-year bond offers a yield of 6.2%. However the expected T + 10 yield curve predicts that, in 10 years time, the bond will be priced to
70
yield 7% (for the remaining 10 years of its life). So, following this strategy 100 is expected to grow to 100 Strategy 3 Currently, the 5-year bond yields 5.5%. The expected T + 5 yield curve predicts that, when this bond matures, a second 5-year bond can be purchased which will yield 6.70%. Using this strategy 100 is expected to grow to 100(1.055) 5(1.067)5 = 180.75. So strategy 3 gives the best return, and will be chosen by the fund manager. This example has demonstrated that forecasts of future yield curves are absolutely central to bond investment decisions. To forecast a future yield curve, it is necessary to understand the forces that shape the yield curve. A model which explains the yield curve is usually called a theory of the term structure. There are three main theories which compete with each other in this eld and we shall consider them each in turn. They are The pure expectations hypothesis The liquidity preference hypothesis The preferred habitat/market segmentation
(1.062)20 (1.070)10
= 163.03.
4.8
The pure expectations hypothesis (PEH)
This theory supposes that the market has expectations of what interest rates will be in the future. Specically, the market has expectations of what the one-year spot rate will n years in the future. The notation used for these rates is as follows: be 1, 2 E1 s2 - the expected one - year spot rate in 1 years time E2 s3 - the expected one - year spot rate in 2 years time E8 s9 - the expected one - year spot rate in 8 years time According to the pure expectations hypotheses, the n-year interest rate which is observed in the yield curve is the (compounded) average of the one-year rates which are expected to prevail for each of the n years. In algebraic symbols
sn n s2 2 1 + 0 s1 E1 s2 E2 s3 1 + 0 s1 E1 s2 En - 1 sn
if N = 2, then
In the section on forward rates (earlier in this chapter), the equation for the one-year forward rate ( 1 f2 ) was (1 + 0 s2 )2 = (1 + 0 s1 )(1 + 1 f2 ) Compare these two equations. Another way of explaining the PEH is to say that, according to the hypothesis E1 s2
1 f2
4.8. The pure expectations hypothesis (PEH)
71
or, more generally Em sn

m fn
In words, the PEH states that The forward rate for any future year is the markets expectation of the spot rate which will prevail for that year. By markets expectation we mean an expectation that is rationally based on all available information. And year in this statement could be replaced by any period.
4.8.1
Implications of the pure expectations hypothesis
Implication #1 is that the expected yield curve for any date in the future can be calculated from the yield curve today. Todays yield curve contains all the available information about expected interest rates in the future. This can be illustrated with an example.
Example The yield curve today is

0 s1 0 s2 0 s3 0 s4 0 s5 0 s6
= 4.5% = 5.5% = 6.25% = 7.0% = 7.0% = 6.90%
What is the expected yield curve two years from today? Solution First, calculate the forward rates from todays yield curve (1 + 0 s2 )2 = (1 + 0 s1 )(1 + 1 f2 ) and from the given values of 0 s1 and 0 s2 , 1 f2 = 6.51% (1 + 0 s3 )3 = (1 + 0 s2 )2 (1 + 2 f3 ) and from the given values of 0 s2 and 0 s3 , 2 f3 = 7.77% (1 + 0 s4 )4 = (1 + 0 s3 )3 (1 + 3 f4 ) and from the given values of 0 s3 and 0 s4 , 3 f4 = 9.28% and, using the same method, 4 f5 = 7.0% and 5 f6 = 6.40%. The expected value of the one-year rate in two years time is E2 s 3
f3
7.77%
The expected value of the two-year rate in two years time is calculated from (1 + E2 s4 )2 = (1 + E2 s3 )(1 + E3 s4 ) = (1 + 2 f3 )(1 + 3 f4 ) = 1.1769 hence E2 s4 = 0.0849 or 8.49% . For the three-year rate (in two years time) we have
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(1 + E2 s3 )3 = (1 + E2 s3 )(1 + E3 s4 )(1 + E4 s5 ) = (1 + 2 f3 )(1 + 3 f4 )(1 + 4 f5 ) = 1.2602 hence E2 s3 = 0.0801 or 8.01% . You can check that, using this method, E2 s6 = 0.0761 or 7.61% . Figure 4.12 shows both the original yield curve observed at t = 0 and the expected yield curve for t = 2 that is derived from it. The PEH does not say that, in two years time, the yield curve will denitely look like this. It might be inuenced by a variety of surprise economic and nancial developments over the next two years. But these rates are the expectation, the best guess that can be made today.
Figure 4.12: Implication #2 is that all bond investment strategies are likely to be equally successful! Consider (again) an investor with a 10-year horizon choosing an investment strategy. 1. Buy and hold a 10 year bond gives (1 + 0 s10 )10 2. Buy a 5-year bond and then, when it matures, buy another 5-year bond. This is expected to give (1 + 0 s5 )5 (1 + E5 s10 )5 which, since E5 s10 = 5 f10
s5 5 s10
= (1 + 0 s10 Heriot-Watt University Securities Markets 1
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3. Buy a 20-year bond and sell it after 10 years. This is expected to give
+ 0 s20 + E10
(1 + 0 s20 (1 + 10 f10
(1 + 0 s10
According to the pure expectations hypothesis, you can expect the same return, for any given investment horizon, whatever investment strategy you follow. Buy short-dated bonds and keep renewing them; buy long-dated bonds and sell them before they mature; buy bonds that exactly match your investment horizon. Every investment strategy offers the same expected return. Implication #3 - Look at the bond market from the point of view of an organisation that issues bonds. Governments are the largest issuers in most bond markets. And governments will sometimes have to decide whether to issue short-term debt, mediumterm debt or long-term debt to cover their nancing needs. High-level government committees will debate what to do. But, according to the PEH, the committees need not debate for long. Given the governments nancing requirements, it is expected to cost the same amount over any given time horizon if the government issues short-term bonds (and replaces them with new short-term bonds when they mature) as if it issues long-term bonds (which will not need frequent replacement). According to the PEH, the returns from investing in bonds, and the interest cost of issuing bonds, are expected to be the same whatever strategy is followed. Implication #4 is that, on average, the yield curve will be at. Long rates are simply an average of expected future short-term rates. Long rates will not be consistently higher, or lower, than short rates. The yield curve will sometimes be upward sloping, sometimes downward-sloping and sometimes humped. But, if the slope is averaged out over a large number of economic cycles, PEH predicts that it will be at. Note also that, if the long rate is an average of (expected) short rates, the long rate would be expected to vary less than the short rate. This is observed in the bond markets, as reported earlier in this chapter.
4.9
The liquidity preference hypothesis
This hypothesis might have been named the risk-aversion hypothesis. An investor who buys a one-year risk-free bond knows exactly what return he will get over the year. An investor who buys a long-dated bond does not know what return he will have received at years end. If interest rates have fallen unexpectedly, he may be showing a high return. A surprise rise in interest rates might give him a low return or even a negative return over the year. Long bond prices are more volatile, annual returns are more risky, and hence, according to the liquidity preference hypothesis, long bonds should offer a higher expected return. In contrast to the PEH, the liquidity preference hypothesis argues that forward rates will be higher than the expected future spot rate and the difference between the two is a risk premium. In algebraic terms
m fn
E m sn
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or
m fn
= E m sn a positive risk premium
The LPH predicts that the further into the future we look, the larger the risk premium will be.
4.9.1
Implications of the liquidity preference hypothesis
Implication #1 is that, over any investment horizon, investors can expect higher returns if they buy long bonds than if they rollover a series of short bonds. The implication for bond issuers is that, on average, they will get cheaper funding by issuing short bonds (and re-issuing as necessary when the bonds mature) rather than issuing a long bond in the rst place. Implication #2 is that the yield curve will, on average, be upward sloping. There is an underlying tendency for long rates to be greater than short rates. Downward-sloping yield curves may be observed, but they will be less common than ones that slope upward.
4.10
Preferred habitat/market segmentation
The liquidity preference hypothesis is based on the idea that long bonds are riskier than short bonds. Certainly, if investors calculate their returns at the end of every year, this will be true. But perhaps bond investors look at risk in a different way. The pension fund manager who knows that his fund must pay out 90M in 10 years time can take a risk-free position if he buys 10-year bonds which exactly cover this liability. It would be possible for the fund manager to calculate the return on year 1; the return on year 2 etc from the market price of the bonds at the end of each year. But these annual returns would have no signicance. If they were highly volatile, the fund manager would not mind. He knows that he has hedged his exposure to interest rate changes by matching the duration of his liabilities with the duration of his assets. For this investor, a bond with 10 years to maturity is his preferred habitat. These bonds are risk-free for him, taking into account the specic nature of the funds liabilities. It follows that, if he is to be persuaded to buy bonds that are shorter dated or longer dated than 10 years, he will have to be offered a risk premium. The further he goes from his preferred habitat, the larger the risk premium he will require. Some investors may have a short preferred habitat; some medium; some long. Issuers will also have preferred habitats. Corporate issuers will want to match their bond repayments to the cash ows generated by their business operations. Risk premiums in the bond market will depend on the balance of supply and demand at different maturities. If supply exceeds demand at the short end, and demand exceeds supply at the long end, then some investors who prefer long bonds will nd that the bonds they want are not available and they will have to buy short bonds instead. They will demand a risk premium to persuade them to move away from their preferred habitat. According to the preferred habitat hypothesis, forward rates might be higher, or lower,
4.11. Evidence
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than expected future spot rates. This can be expressed mathematically as

m fn
E m sn = E m sn a positive risk premium
or
m fn
The market segmentation hypothesis is an extreme form of the preferred habitat hypothesis. Market segmentation assumes that investors and issuers are so committed to a specic maturity that they cannot be tempted by a risk premium to participate in any other sector of the market. In this case, the forces of supply and demand at the short end of the market will set short rates. Supply and demand for medium term bonds will set the medium-term rate. The same will be true for the long rate. The different rates along the yield curve will be entirely unrelated. There will be no logical link between them. They will reect the balance of supply and demand in several distinct markets.
4.10.1
Implications of the preferred habitat hypothesis
Implication #1 is that any bond investor who is trying to maximize expected return has a complex decision to make. It is not true that all investment strategies will give the same expected return (pure expectations). Nor can the investor be sure that longer bonds will give a higher expected return (liquidity preference). A bond investor has to identify the maturity sectors in which supply is strong relative to demand. These sectors will carry a risk-premium and will offer the highest expected return. Although it may be difcult to judge which sectors offer a premium, investment banks which are active in trading and issuing bonds might be able to identify them. The premium sectors might change from time to time, as supply and demand change. Implication #2 is that there is no normal or natural slope for the yield curve. There is no reason to suppose that an upward slope, a downward slope or a humped pattern will predominate. Implication #3 is that todays yield curve does not offer a prediction of future yield curves (unlike pure expectations). Todays yield curve reects the balance of supply and demand, today, at different maturities. Next years yield curve will depend on the supply/demand balance which exists in one year. It is not at all surprising if forward rates bear no relationship to future spot rates.
4.11
Evidence
The three theories of the term structure are not necessarily mutually exclusive. Each of them might have some explanatory power.
4.11.1
Pure expectations hypothesis
This model claims that forward rates are the best possible estimates of future spot rates. It follows that: estimates of future spot rates based on forward rates should have smaller errors than estimates made in any other way; Heriot-Watt University Securities Markets 1
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forward rates should be unbiased forecasts of future spot rates; i.e. they should turn out to be too high just as often as they turn out to be too low. The evidence suggests that the Pure Expectations model is a major factor inuencing the yield curve. Forward rates do predict future interest rates better than other simple models. If the predictions of the PEH are compared to the nave prediction that the future yield curve will be the same as todays, then the pure expectations model clearly wins. On average, a downward-sloping yield curve correctly predicts that interest rates are going to fall. Equally, a rising yield curve is usually followed by increasing interest rates. The evidence on whether forward rates are unbiased forecasts of future spot rates is more mixed. Studies suggest that forward rates may be slight overestimates of future spot rates, but the effect seems to be fairly small.
The Treasury Accord

A long, long time ago, after the end of the Second World War, interest rates were low. The 1930s had been a decade of depression and deation. People thought that the 1950s would probably go the same way. The short-term interest rate was about 0.5% and the long-term rate was about 2%. The US government thought that this interest rate structure was just ne. It announced an intention to freeze the yield curve and keep interest rates at their current levels. The government got a big surprise. As soon as the policy was announced, investors rushed to sell short bonds and buy long bonds. This took place on such a large scale that the policy soon had to be abandoned. Why did this happen? The pure expectations hypothesis provides an explanation. Before the freeze announcement there was an upward-sloping yield curve. Investors were expecting interest rates to rise. A long-term bond yielding 2.0% could be bought, but the price of this bond was expected to fall (interest rate , bond price ). Investors would expect a capital loss if they sold after 1 year. Taking this expected capital loss into account the long bond did not offer a higher return than the short bond. Over a 1-year period investors expected 0.5% return either way. These expectations were suddenly overthrown by the announcement of the freeze. If you buy the long bond, its yield is not expected to rise; its price is not expected to fall; and an investor can expect to make a 2% return over the coming year. The short-bond only offers 0.5%. So sell the short-bond and buy the long. This story is one piece of evidence that the pure expectations hypothesis can help to explain how bond markets work.
4.11.2
Liquidity preference hypothesis
There is evidence to suggest that liquidity preference does play a part in bond market prices. Forward rates (as stated above) are, on average, biased and slightly high estimates of future spot rates. Heriot-Watt University Securities Markets 1
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77
Historically the yield curve has been upward sloping more often than it has been downward sloping. In particular, the short-end of the yield has tended to slope upward. These factors suggest that liquidity preference plays some role in the bond market, but its inuence seems to be minor compared to Pure Expectations. The risk premium on long bonds relative to short ones is hard to measure, but it seems to be a few basis points (quite unlike the Equity Risk Premium, which is generally estimated at several hundred basis points).
4.11.3
Preferred habitat/market segmentation hypothesis
These theories do not make specic testable predictions about future interest rates and future yield curves. The proponents of these models generally point to the following facts: Short term and long term interest rates appear to move more independently. Sometimes they move in opposite directions. It looks as though the long and short ends are separate and distinct markets. Many bond investors have strong preferences for a particular habitat and this becomes clear either by talking to bond fund managers or by looking at the bond portfolios that they choose. These arguments can be countered. The Pure Expectations hypothesis does not state that forward rates are accurate predictions - only that they are the best predictions that can be made with current information. The fact that the yield curve sometimes twists (short and long rates move different ways) is also consistent with the Expectations model. Higher short-term rates will squeeze ination out of the economy and this justies lower long-term rates. There is no doubt that many bond investors do have a preferred habitat. There will be other bond investors who are simply seeking to maximize expected return. If there are enough return-motivated investors, then they will push bond yields into conformity with the Pure Expectations model. If there are too few, then the bond market will tend to t the Preferred Habitat model. The evidence generally suggests that return-maximizing investors are a powerful force in the market, and that Preferred Habitat factors play a comparatively minor role. The extreme case of Market Segmentation can be rejected. There are some investors who are prepared to move between the different maturity-sectors of the market in search of higher return. The evidence in support of Pure Expectations is also evidence that the bond market is not rigidly segmented in the way that the Market Segmentation model requires.
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4.12
Conclusions
This chapter has: explained the concept of the yield curve, and dened the zero-coupon yield curve which is analysed in the remainder of the chapter; demonstrated the variety of shapes that the yield curve has historically assumed; explained, briey, the signicance of the yield curve for the real economy; dened forward interest rates and shown how they can be calculated from the yield curve; explained how an optimal bond investment strategy must be based on forecasts of future yield curves. Finally, the chapter has explained three theories of the yield curve (often called theories of the term structure of interest rates). These theories are Pure Expectations Hypothesis Liquidity Preference Hypothesis Preferred Habitat Hypothesis (along with its more extreme variant, the Market Segmentation Hypothesis). The implications of each of these theories were set out and the evidence relating to each theory was very briey explained. The theories were not mutually exclusive. It is possible that each of them gives some insight into the forces shaping the yield curve. The chapter concluded that the Pure Expectations Hypothesis was a major factor in determining the term structure of interest rates and was useful in predicting the future shape of the yield curve. Liquidity Preference appeared to be a more minor factor. The Preferred Habitat Hypothesis was a difcult model to test, but major bond investors clearly do have a preferred maturity for their investments and it is quite possible that Preferred Habitat considerations play some part in determining the term structure. The Market Segmentation hypothesis, which suggests that different maturity-sectors are entirely distinct, independent and unrelated markets, can be rejected.
4.13
Q1:
Review Questions
What is meant by a yield curve? What shapes can a yield curve have? What does the shape of a yield curve tell us about the state of the economy? Q2: a) What is meant by a forward rate? What is meant by a spot rate? b) Information about interest rates is given in the following table using the conventional notation. Heriot-Watt University Securities Markets 1
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0 s1 0 s2 0 s3 0 s4 0 s5
4.0% 1 f2 3.8% 2 f3 3.6% 3 f4 3.5% 4 f5 4.1%
1. Using the information in the table, calculate the value of 2f3. What theory of the yield curve have you used in this calculation? 2. Using the information in the table, calculate the value of 0s5. What theory of the yield curve have you used in this calculation? 3. What is the two-year spot rate expected to be in two years time? What theory of the yield curve have you used in your calculation? Q3: A UK investor is working overseas on a xed term contract that will last 6 years. He has just sold his house in the UK, and intends to invest the money in government guaranteed zero coupon bonds. When his contract ends, he intends to return to the UK and buy another house. The current yield curve is at, with all maturities offering a return of 6%. What different investment strategies could this investor follow, and how should he choose between them? Relate your answer to theories of the yield curve. Q4: Explain briey each of the following theories of the yield curve a) Pure Expectations Hypothesis b) Liquidity Preference c) Preferred Habitat d) Market Segmentation Briey discuss the evidence for and against each theory.
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Chapter 5
Currency Exchange Rates

Contents
5.1 5.2 5.3 5.4 5.5 5.6 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dealing in the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . Exchange rate arrangements among markets . . . . . . . . . . . . . . . . International swift codes . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exchange rate quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . Bid-offer prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.6.1 Quoting bid-offer prices indirectly . . . . . . . . . . . . . . . . . . 5.6.2 The bid-offer spread . . . . . . . . . . . . . . . . . . . . . . . . . 5.7 5.8 5.9 Cross exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Triangular arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Overview of strong currencies . . . . . . . . . . . . . . . . . . . . . . . . . 5.9.1 The performance of the US dollar (USD) . . . . . . . . . . . . . . 5.9.2 The performance of the British pound (GBP) 5.9.3.1 5.9.3.2 5.9.3.3 5.9.3.4 5.9.3.5 . . . . . . . . . . . 5.9.3 The Euro currency (EUR) . . . . . . . . . . . . . . . . . . . . . . Why the Euro currency was introduced? . . . . . . . . . Joining the Euro . . . . . . . . . . . . . . . . . . . . . . The convergence criteria . . . . . . . . . . . . . . . . . The rise of Euro as a global / reserve currency . . . . . The performance of the Euro in the FOREX . . . . . . . 83 83 84 86 88 89 90 90 91 92 93 94 96 97 98 99 99 100 101 102 103 105 107 107 108
5.9.4 The performance of the Japanese yen (JPY) . . . . . . . . . . . 5.9.5 The performance of the Swiss Franc (CHF) . . . . . . . . . . . . 5.9.6 The performance of the Chinese Renminbi Yuan (CNY) . . . . . 5.10 5.11 5.12 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Learning Objectives On completion of this chapter students should be able to understand: the importance and uses of the Foreign Exchange Market (FOREX);
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Chapter 5. Currency Exchange Rates
the three principal exchange rate arrangements among markets: the xed exchange rate regime and the Bretton Woods system; the oating exchange rate regime, and the exchange rate is pegged to a single currency (usually the USD) or to a basket of currencies; how to calculate the direct and indirect methods of exchange rate quotations; the terms bid-offer and bid-spread and how each is calculated; calculating exchange rates through the cross exchange rate method; the term triangular arbitrage and how to calculate the prot from arbitrage; the key reasons contributing to the strength of currencies and the relative performance of major currencies in recent years. Summary Chapter aim The aim of this chapter is to understand currency exchange rates and how foreign currencies can be traded on the Foreign Exchange Market and the various methods used to establish exchange rates between the currencies of different countries.
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5.1
Introduction
In this Chapter and the one that follows, we will broaden our view of nancial markets to encompass the pricing of not only domestic nancial instruments denominated in local currency but also foreign currency - denominated instruments. To do so, however, requires knowledge of the Foreign Exchange Market (FOREX, thereafter) and the determinants of the exchange rate. A currency exchange rate is a price at which one currency of one country can be converted into anothers. In the U.K. market, we presume that nancial assets can be purchased with British pounds (). However, as the world is a big place, the U.K. market is only one of the many nancial markets. In these other markets, entrepreneurs, households and large rms enter the market to obtain funds for investment, just as we do in the U.K. Likewise, individuals and institutions in those markets provide these funds, just as we do in our domestic market. Each of these markets deals in its own currency; i.e. the British market in pounds, the U.S. market in dollars, the Japanese market in yen etc. To participate in another market, the investors go to the FOREX to obtain local currencies and it is to this market that they return to convert these currencies to domestic-denominated money to be used for future consumption or investment.
5.2
Dealing in the Foreign Exchange Market
The FOREX is an interbank over-the-counter market. This means that there are no centralised trading locations, such as an exchange or trading oor, for currencies. The currency markets are essentially over-the-counter markets with no set hours for trading. Market participants are brought together through an informal network using only wires, telephones, faxes and satellites. There are no membership requirements or special rules to allow one to become a participant, although trading conforms to an unwritten code of rules among the larger, more active participants. The participants in the FOREX are usually large institutions, such as commercial and investment banks and the worlds central banks. The employees of these rms enter the FOREX either as brokers operating on behalf of their clients or as traders (dealers) buying and selling currencies for their own accounts. In any case, the participants enter the FOREX to buy one currency, using another in exchange. For example, a New York bank may buy Japanese yen, offering U.S. dollars in exchange, because it believes that the Japanese currency will go up in price relative to the U.S. currency. If the price does go up, the bank can sell the yen for dollars and make a prot. Apart from trading prots, dealers in the FOREX realise revenue from the bid-offer spread and the commissions charged on foreign exchange transactions with their clients. The bid is the highest price a prospective buyer is prepared to pay at a particular time for a unit of foreign currency. The offer is the lowest price acceptable to a prospective seller of the same foreign currency. Together the bid-offer prices constitute a quotation. The difference between the two prices is the spread.
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5.3
Exchange rate arrangements among markets
The exchange rate arrangements among markets are classied into 3 major categories: 1. Fixed exchange rate regime and the Bretton Woods system. In the 19th and early 20th centuries gold played a key role in international monetary transactions. The gold standard (i.e. the monetary system in which a regions currency was freely convertible into pre-set, xed quantities of gold) was used to back currencies. In this way, the international value of currency was determined by its xed relationship to gold and the gold was used to settle international accounts. However, the gold standard had a major drawback; the gold production internationally was not sufcient to meet the demands of the growing international trade and investment. Consequently, after the Second World War the U.S. dollar started serving as the primary world currency, given the strength of the American economy in comparison to the European ones. More specically, the strength of the U.S. economy, the xed relationship of the U.S. dollar to gold ($35 an ounce) and the commitment of the U.S. government to convert dollars into gold at that price made the U.S. dollar as good as gold. In fact, the U.S. dollar was even better than gold; it earned interest and it was more exible than gold. The xed exchange rate regime with another currency was introduced at the Bretton Woods international monetary conference in 1944 and lasted until early 1970s when a oating exchange rate system was adopted. The xed foreign exchange rate mechanism decided in Bretton Woods had the following main characteristics. The price of one U.S. dollar per 1 ounce of gold was locked at $35 per ounce and could not change. All other main currencies were given a xed exchange rate with the U.S. dollar. For example, the exchange rate between the British pound (GBP) and the U.S. dollar (USD) was locked from 1944 to 1967 at 1 GBP = 2.80 USD. The use of the U.S. dollar as the world reserve currency had as pre-required the strict maintenance of the Bretton Woods price between U.S.dollar and the gold; in turn this meant that all main currencies could be converted into gold via the U.S. central Bank and that the U.S. government had the ability to buy and sell gold at this price. The Bretton Woods mechanism collapsed in the early 1970s when the U.S. central bank was unable to exchange every USD for gold. The Bretton Woods mechanism collapsed in the early 19710s when the U.S. central bank was unable to exchange every U.S. dollarUSD for gold. This outcome caused considerable nancial stress in the world economy and created the unique situation whereby the U.S. dollar became the "reserve currency" for those 44 countries which had signed the Bretton Woods agreement. Subsequently, the U.S. dollar became (a) the currency which was held in signicant quantities by many governments and institutions as part of their foreign exchange reserves and (b) the international pricing currency for products traded on a global market, such as oil, gold and other commodities.
5.3. Exchange rate arrangements among markets
85
2. The oating exchange rate regime Since the early 1970s, countries have increasingly preferred to allow their currency to oat, that is to change price relative to other currencies based upon supply and demand for the currency rather than by regulatory requests. This is the regime mostly used today. In a oating exchange rate regime, the FOREX and its participants dictate the price for a currency in much the same way that they dictate the price for any other nancial asset or commodity. As a result, the value of the currency (i.e. the exchange rate) is determined directly by the market forces and the changing market conditions and it uctuates continually as it becomes more or less attractive to potential buyers and sellers. Under this regime, the observed trend for strong currencies (such as the US dollar, the British pound, the Swiss franc, the Euro and the Japanese yen) is to appreciate over time while soft currencies tend to depreciate over time. In a oating exchange rate regime, when a currency appreciates over time, it means that its price increases relative to other currencies. If it depreciates over time, it means that its price decreases relative to stronger currencies. In a oating exchange rate regime the price of a currency, like any other marketdetermined price, depends on the relevant forces of supply and demand. To illustrate this point let us consider, the factors that determine the relationship between the Australian dollar and the Japanese yen. The Japanese require dollars to pay for their imports of goods and services from Australia and to fund any investment they may wish to undertake in this country. Assume that they obtain these dollars on the FOREX by supplying (selling) yen in return. So the Japanese demand for Australian dollars is determined by the imports of Japan on Australian goods and services. On the other side of the market, the Australian demand for yen is determined by their need to pay for imports from Japan and for any capital investment that they undertake there. Australians buy the yen they need by supplying Australian dollars in return. Thus the supply of Australian dollars is determined by the imports of Australia on Japanese goods and services. In summary, the demand for Australian dollars reects the behaviour of Australian exports while the supply of Australian dollars reects the behaviour of Australian imports. Let us now suppose, for example, that recession in the Japanese economy leads to a decline in the Japanese demand for Australian imports. This twist will tend to reduce the demand for Australian dollars by the Japanese. Since reduced demand for a good usually indicates that its price falls. This means that under the oating exchange rate regime the price of the Australian dollar will fall i.e. the Australian dollar will eventually depreciate. 3. The exchange rate is pegged to a single currency (usually the USD) or to a basket of currencies. This exchange rate regime is a combination of the xed and the oating exchange rate regimes. It is commonly used in Asian and Latin American countries which usually peg their currencies to the USD. Heriot-Watt University Securities Markets 1
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In this case, the currencys daily exchange rate depends entirely on the price of the USD. Similar to the xed exchange rate regime, it is the central bank here that dictates the xed exchange rate at which local currency will be pegged to USD. As this exchange rate changes only infrequently, if it is set incorrectly the mechanism collapses. For example, if the price of a currency is set too high, that is, if its true value in terms of the other currency (the USD in this case) is lower than the xed exchange rate, then investors will sell the currency. This increases the selling pressure on the overpriced currency and eventually causes the central bank to lower the xed price of the currency. This is called devaluation. The reverse, called appreciation of a currency, is also possible. In 1991, Argentina pegged the price of its domestic currency (Argentinean peso) to the USD. In the years that followed the true value of the Argentinean peso became dramatically lower than the xed exchange rate decided in 1991. Argentinas central bank took no action to devaluate the Argentinean peso until 2002, at which time the huge devaluation decided upon caused Argentinas economy to collapse. In more recent years, there are several currencies pegged to the Euro 1 , some with uctuation bands around a central rate and others with no uctuations allowed around the central rate. This can been seen as a safety measure, especially for currencies of areas with weak economies, as Euro is seen as a stable currency and therefore would prevent collapse of currencies pegged to it, unless the Euro itself were to collapse or the country were to run out of Euros to exchange for their currency. Bosnia and Hercegovina, Bulgaria, Cape Verde, Denmark, Estonia, Latvia, Lithuania, Morocco, West Sahara, Cameroon, Central African Republic, Chad, Republic of the Congo, Equatorial Guinea, Gabon, Benin, Burkina Faso, Cte dIvoire, Guinea-Bissau, Mali, Niger, Senegal, Togo, French Polynesia, New Caledonia, Wallis and Futuna
1
5.4
International swift codes
Every currency has its own unique swift code. The swift code is a short name for a currency. Each international swift code is made out of 3 letters; the rst two come from the rst two letters of the countrys name and the last from the rst letter of the name of its currency. For example, USD = United States Dollar, GBP = Great Britain Pound, GRD = Greek Drachma etc. Swift codes are internationally accepted, understood and used by practitioners. They are also the ones we see reported in nancial pages, databases, the internet etc. Figure 5.1 shows the main currencies of the world and their swift codes. Table 5.1: SWIFT codes of the main currencies in the world
5.4. International swift codes
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MAJOR CURRENCIES EUR Euro USD U.S.Dollar JPY Japanese Yen British Pound GBP CHF Swiss Franc CURRENCIES PARTICIPATING IN EURO BEF Belgian Franc DEM German Mark ESP Spanish Peseta FRF French Franc IEP Irish Punt ITL Italian Lire LUF Luxembourg Franc NLG Netherlands Gulden ATS Austrian Schilling PTE Portuguese Escudo FIM Finish Markkaa GRD Greek Drachma CYP Cypriot Lira MTL Maltese Liri SIT Slovenian Tolars SKK Slovakian Koruny OTHER EUROPEAN CURRENCIES DKK Danish Kroner SEK Swedish Kronor Norwegian Kroner NOK Bulgarian Lev BGL CZK Czech Koruna PLZ Polish Zloty Romanian Leu ROL RUR Russian Rouble HUF Hungarian Forint ALL Albanian Lek LVL Latvian Lat EEK Estonian Krooni LTL Lithuanian Litas
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ASIAN CURRENCIES HKD Hong Kong Dollar SAR Saudi Arabian Riyal SGD Singapore Dollar CNY Chinese Yuan Renminbi INR Indian Rupee IDR Indonesian Roupiah ILS Israeli Shequel KRW Korean Won KWD Kuwait Dollar AED UAE Dirhaim THB Thailand Bat TLR Turkish Lira AMERICAN CURRENCIES CAD Canadian Dollar MXP Mexican Peso ARP Argentinian Peso BRR Brazilian Real CLP Chilean Peso AUSTRALASIAN CURRENCIES AUD Australian Dollar NZD New Zealand Dollar
5.5
Exchange rate quotations

The exchange rates are usually quoted direct. A direct quote is the number of units of local currency exchangeable for 1 unit of foreign currency. For example, assume that the Swiss Franc is the domestic currency. The exchange rate quote USD/CHF = 1.4315 means that in Switzerland, 1 US dollar costs 1.4315 Swiss Francs (i.e. 1USD = 1.4315 CHF). Similarly, the exchange rate quote EUR/CHF = 1.6005 means that 1 Euro costs 1.6005 Swiss Francs (i.e. 1EUR = 1.6005 CHF). In all countries using the direct method for quoting exchange rates, the swift code on the left-hand side belongs to the foreign currency and is called the base currencys swift code. The swift code on the right-hand side belongs to the domestic currency and it is called the variable currencys swift code. The variable currencys swift code is also the one that indicates the country in which the foreign exchange rate quote takes place. For example, in the USD/CHF exchange rate quote, the USD is the foreign or base currency while the CHF is the domestic or variable currency. The country in which this exchange rate quote takes place is Switzerland. In a direct quote, the foreign or base currency always comes in 1 unit while the variable currency, as its name indicates, varies.
a) The direct method
5.6. Bid-offer prices
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b) The indirect method An indirect quote is the number of units of foreign currency exchangeable for one unit of local currency. The indirect quote is the reciprocal (1/x) of the direct quote (x). For example, the indirect quote of USD/CHF is: CHF/USD =
1 USD/CHF 1 1.4315
i.e. 1 Swiss franc costs 0.6986 US dollars. Similarly, the indirect quote of EUR/CHF is: CHF/EUR =
1 EUR/CHF 1 1.6005
i.e. 1 Swiss franc costs 0.6248 Euros. Within their national borders, most countries in the world are using the direct way for quoting exchange rates. Exceptions are Great Britain, Cyprus, Australia, New Zealand and Ireland where the indirect way of quoting foreign exchange rates is used at all times. In the international FOREX, when the EUR and the USD are quoted against each other, the base currency is always the EUR. The same rule applies when the GBP is quoted against the USD (i.e. the GBP will always appear as the base currency). In all other cases, the base currency is usually a strong currency such as the USD.
5.6
Bid-offer prices
The exchange rates are usually quoted in a bid-offer price format. The rst price, bid, is the price the foreign currency is bought by banks. The second price, offer, is the price the foreign currency is sold by banks. In all cases, the price of the bid is lower than the price of the offer.
Example The exchange rate USD/JPY is 5.78 - 95.88 In this case, the bid price is 95.78 (i.e. 1 USD is bought for 95.78 JPY) and the offer price is 95.88 (i.e. 1 USD is sold for 95.88 JPY). In practice, the bid-offer prices are always quoted using 4 decimal points or pips. The integer part of the price is called the big gure. The big gure appears only in the bid price quote: USD/JPY = 5.7792 - 8792. Bid-offer prices are always quoted from the sellers (in this case the bank) perspective. Consequently, if we - the customers - want to buy USD, we will pay the price offered by the bank (i.e. USD/JPY = 95.88) while if we want to sell USD we will receive the price asked by the bank (i.e. USD/JPY = 95.78). A simple way to remember this is: buy high - sell low (i.e. when we buy foreign currency we pay the higher price of the bid-offer quote while when we sell foreign currency we receive the lower price of the bid-offer quote).
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5.6.1
Quoting bid-offer prices indirectly
To calculate the indirect bid - offer exchange rate, we do the following. a) First we calculate separately the reciprocals of the direct bid and offer prices. b) Then we swap the calculated prices around in order to give the bid price the lower value of the two.
Example a) From the previous example, we calculate the reciprocal of the quoted bid price: JPY/USD = JPY/USD =
1 95.7792
0.01044 0.01043
and the reciprocal of the quoted offer price:

1 95.8792
b) Then, we swap the two gures around so that the bid price is given the lower value of the two: JPY/USD = 0.01043 - 0.01044
5.6.2
The bid-offer spread
The difference between the bid and the offer prices is called the bid-offer spread. To calculate the bid - offer spread simply subtract the bid price from the offer price. Banks and dealers offering their services in the FOREX realise prot from the bid-offer spread. Thus, this estimate is very important to them. In the previous example, the USD/JPY bid-offer spread is: USD/JPY spread = 95.88 - 95.78 = 0.1 JPY I.e. one USD is bought (using JPY) and then sold again (for JPY) the bank earns 0.1JPY. Alternatively, the JPY/USD bid-offer spread is: JPY/USD spread = 0.01044 - 0.01043 = 0.00001 USD I.e. If one JPY is bought (using USD) and then sold again (for USD) the bank earns 0.00001USD. Tip: To make this earning more meaningful you can multiply this prot by 1 billion JPY bought and then sold and you see that the bank makes a risk-free prot of 10000USD. The magnitude of the bid-offer spread depends on the marketability and availability of the currencies involved. When the two currencies involved are highly marketable (such as the strong currencies), the spread between them is low. The opposite usually holds for other currencies. It is exceptionally rare to have zero spread between bid and offer prices. Heriot-Watt University Securities Markets 1
5.7. Cross exchange rates
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5.7
Cross exchange rates
In many cases, the exchange rate between two currencies is not recorded directly (e.g. CHF/JPY), but we can easily calculate it using each currencys exchange rate with a common third currency such as the USD. This method of calculating exchange rates is called cross exchange rates. We will illustrate how this method works using some examples. Examples
1. The exchange rate CHF/JPY is not recorded directly in the nancial press. However we know that the exchange rate between the USD and the JPY is USD/JPY = 95.7792 and the exchange rate between the USD and the CHF is USD/CHF = 1.1101. Given this information, what is the exchange rate CHF/JPY? Solution
USD/JPY USD/CHF
= =
95.7792 1.1101
CHF/JPY = 86.2806 (i.e. 1 CHF buys 86.2806 JPY) JPY/CHF = 0.0116 (i.e. 1 JPY buys 0.0116 CHF)
If we were asked to calculate the JPY/CHF exchange rate, we should do the following:
USD/CHF USD/JPY 1.1101 95.7792
2. The exchange rate GBP/CHF is not recorded directly in your countrys nancial press. However you know that the exchange rate between the USD and the CHF is USD/CHF = 1.7045 and the exchange rate between the USD and the GBP is USD/GBP = 0.6903. What is the exchange rate GBP/CHF and what is its indirect quote? Solution
USD/CHF USD/GBP
1.7045 0.6903
GBP/CHF = 2.4692 (i.e. 1 GBP buys 2.4692 CHF)

1 2.4692
The indirect quote is: CHF/GBP

1 CHF/GBP
= 0.4120 (i.e. 1 CHF buys 0.4120 GBP)
3. The exchange rate between the GBP and the USD is GBP/USD = 1.6500 and the exchange rate between the AUD and the USD is AUD/USD = 0.6550. From a British perspective, how much AUD costs 1 GBP? Solution GBP/AUD =
GBP/USD AUD/USD
1.6500 0.6550
= 2.519 (i.e. 1 GBP costs 2.519 AUD)
4. The exchange rate between the USD and the CHF is USD/CHF = 1.1101 and the exchange rate between the EUR and the USD is EUR/USD = 1.3627. Using the cross exchange rate calculation nd how much CHF buys 1 EUR. Solution EUR/CHF =
USD/CHF USD/EUR
1.1101 (1/1.3627)
= 1.5127 (i.e. 1 EUR buys 1.5127 CHF)
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5.8
Triangular arbitrage
The calculation of cross exchange rates assumes that the value of the exchange rate between two currencies, once it is estimated, will be quoted as such in both countries. For example, if the EUR/AUD is calculated at 1.5549 and quoted as such in the Eurozone then its exact reciprocal price, AUD /EUR = 1 /1.5549 = 0.6431, should be quoted in Australia. However, in the real world there are rare instances where the theoretical cross rates (i.e. the ones calculated) differ from the actual ones (i.e. the ones really quoted). To exploit any price differences and realize some prot, FOREX participants buy and sell the currencies involved until these price differences disappear. This strategy is called triangular arbitrage because it involves trading in 3 currencies. Triangular arbitrage eliminates any foreign exchange mispricing. Examples
1. On the 6th May 200X, a British bank quoted the following exchange rates: GBP/EUR = 1.6200 GBP/AUD = 2.5190 On the same day, miles away an Australian Bank was quoting the AUD/EUR at 0.6832. a) Assuming a zero bid-ask spread and absence of transaction costs, does an arbitrage opportunity exist? b) If an arbitrage opportunity does exist what would be your realized prot if you had GBP10000 to invest? Solution a) To check whether an arbitrage opportunity exists, we have to calculate the theoretical cross rate between the AUD and the EUR. If the estimated price is different to the one quoted by the Australian bank then an arbitrage opportunity exists. GBP/EUR 1.6200 = = 0.6431 AUD/EUR = GBP/AUD 2.5190 This means that 1 AUD buys 0.6431 EUR; this is different from the price, which the Australian bank quotes. Consequently, an arbitrage opportunity exists. b) To exploit the price difference between the 2 banks, we pursue the following strategy. i Go to the British bank and exchange GBP 10000 for AUD 25190. (i.e. GBP 10000 2.5190 = 25190 AUD) ii At the Australian bank, exchange the AUD 25190 for EUR 17209.8 (i.e. AUD 25190 0.6832 = 17209.8 EUR) iii Back to the British bank, to exchange the EUR 17 209.8 for GBP (i.e EUR 17209.8/1.62 = 10623 GBP) Prot from triangular arbitrage = Final capital - Initial capital = GBP 10623 - GBP 10000 = GBP 623 Heriot-Watt University Securities Markets 1
5.9. Overview of strong currencies
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2. On the 21st June 20XX, the following exchange rates were quote by an American bank. USD/CNY = 8.2771 - 2971 USD/CHF = 1.5926 - 6026 On the same day, a Chinese bank was quoting the CHF/CNY at 5.2372 - 2963. a) Assume absence of transaction costs, does an arbitrage opportunity exist? b) If an arbitrage opportunity does exist, how much would your prot be if you had USD 100000 to invest? Solution a) To check whether an arbitrage opportunity exists, we have to calculate the theoretical cross rate between the CHF and the CNY. If the estimated prices are different from the ones quoted by the American bank then an arbitrage opportunity exists. USD/CNY 8.2971 = = 5.1773 (Bid) CHF/CNY = USD/CHF 1.6026 USD/CNY 8.2771 = = 5.1972 USD/CHF 1.5926 Thus, CHF/CNY = 5.1773 - 5.1972, which means that the theoretical cross rates differ from the ones quoted by the Chinese bank. Consequently, an arbitrage opportunity exists. (Offer) CHF/CNY = b) To exploit the price differences between the two banks, we employ the following strategy. i Go to the American bank and exchange USD 100000 for CHF 159260. (i.e. USD 100000 1.5926 = 159260 CHF) ii Exchange the CHF 159260 in CNY at the Chinese bank (i.e. CHF 159260 5.2372 = 834123. 6 CNY) iii Back to the American bank, to exchange the CNY 834123.6 in USD (i.e CNY 834123.6 / 8.2971 = 100532 USD) Prot from triangular arbitrage = Final capital - Initial capital = USD 100532 - USD 100000 = USD 532
5.9
Overview of strong currencies
There are 4 main reasons for a currency to be strong. 1. The currency is widely used in international transactions. 2. The creditworthiness of the currency has been supported by political and economic stability in its country of origin for decades. Heriot-Watt University Securities Markets 1
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3. The currencys country of origin has a highly developed, transparent and open nancial market in which the cost and risk of transactions are low. 4. Many other countries exports have been highly dependent on the strong currencys domestic market for decades. To give you an example, think of the US dollar. 1. The USD is widely used in international transactions. 2. Its creditworthiness has been supported by American political and economic power for long time. 3. The highly developed, transparent and open nancial markets in the US reduce the cost and the risk of transactions. 4. Asian, Latin American and European exports have been highly dependent on the US market for decades. Historically, the other hard currencies participating with the USD in the nancial international transactions arena, are the German mark (which was replaced by the Euro in 1999), the British pound, the Japanese yen (mainly in the Asian markets) and the Swiss franc. Recently, the Chinese Yuan was added to the list. Let us now take a look at the performance of strong currencies over the years.
5.9.1
The performance of the US dollar (USD)
According to the Bank of International Settlements (BIS), in 1992, eight out of ten international transactions were made in USD. It is mainly the persistent robustness and the size of the American economy since the Second World War that has kept the US dollar on the top of the strong currencies pyramid all these years. Fourteen years before the introduction of the Euro, in 1985, the USD/DEM exchange rate was 1USD = 3.5 DEM. During 1985-97, the American currency lost more than 50% of its value against the German one. As a result in 1998 the USD/DEM was 1 USD = 1.58 DEM.
Data source: US Federal Reserve annual reports (1985-2000) Figure 5.1: Performance of US Dollar versus the German Mark (DEM) Heriot-Watt University Securities Markets 1
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As shown in the following graph, the dramatic depreciation of the USD was due to soaring trade decits (i.e. excess imports over exports) accumulated since 1985.
Data source: US Federal Reserve Figure 5.2: US Merchandise International Trade Net Export-Import During the period 1985-1998, the US Treasury trying to turn trade decits into surpluses allowed the USD to depreciate substantially. It was believed that a weaker USD would boost exports and reduce imports. As a result, the USD reached its lowest price against the DEM in 1992, when 1 USD = 1.3430 DEM. Since then the US trade decit has exploded. For example, in 2008 the US trade performance was a $821 billion trade decit - the second largest negative trade balance in the American history, $300 billion worse than 4 years ago. This meant that the American economy became gradually less competitive vis--vis other countries. The worsening performance of the USD during the years 2000 - 2008 was mainly due to costs stemming from its particular foreign policy in Middle East during these years, the successful introduction of the Euro as an alternative reserve currency and the gaining strength of the Asian currencies. It was also due to the higher ination and lower productivity levels in the US which made the American currency less appealing to FOREX participants.
Data source: US Federal Reserve Figure 5.3: Performance of the US dollar versus the Euro during the period 2004-2009 Not long after the introduction of the Euro as a cash currency in 2002, the US dollar
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began to depreciate steadily in value. As U.S. trade and budget decits continued to increase, the Euro started rising in value. By December 2004, the dollar had fallen to new lows against all major currencies; the Euro rose above $1.36 for the rst time, in contrast to previous lows in early 2003 (0.87Euros per one US$). Since 2002, the only year in which the dollar actually recovered against the Euro was 2005. An interest rate reduction by the Federal Reserve on September 18, 2007, raised the Euros value signicantly and caused the dollar to fall below 0.70 one month later, to new record lows. Another reason for the continued fall of the dollar is its decreasing role as the worlds reserve currency. Some economists foresee that the dollars value will fall even further in the years to come, especially against the Chinese Yuan. However, this still remains to be seen.
5.9.2
The performance of the British pound (GBP)
The GBP is a very tradable currency in both the American and the Continental European markets although much less so in other nancial markets like the Asian, the Latin American and the Australian, all of which traditionally trade in USD and the last years also in Euro. The preference of the USD over the GBP in the international nancial arena before the inception of the Euro was due to the unpredictable volatility of the GBP during the years 1986-1995. For example, in August 1992 the GBP/USD exchange rate was 2 (i.e. 1GBP = 2 USD) while 6 months later (February 1993) it was 30% less at 1.4063 (i.e. 1 GBP = 1.4063 USD). The purchasing power of the GBP was restored in the following years, with the GBP uctuating around 1.9 (i.e. 1 GBP was buying around 1.9 USD). However, the nancial crisis of the mid 2007-2009 led to a massive depreciation of the GBP against the USD to the extent that in February 2009 one GBP was buying less that 1.4 USD. The relationship between GPP/USD is shown in the graph below.
Data source: Bank of England Figure 5.4: Performance of the GBP versus the US dollar during the period 2004-2009 However, there are features like Britains creditworthiness and its political and economic power as well as its highly developed, transparent and open nancial markets, which make the GBP one of the strongest and safest currencies in the world.
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In addition, the British economy is the worlds largest by nominal Gross Domestic Product (GDP) measurement, the British growth rates have consistently been between 2% and 3% from 2000 to early 2008, ination has been among Europes lowest at around 2% and the Bank of Englands control of interest rates has also been proven a major factor in the stability of the British economy over time.
5.9.3
The Euro currency (EUR)
The Euro (EUR or ) is the ofcial currency of 16 of the 27 Member States of the European Union (EU). The States, known collectively as the Eurozone, are Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. The Euro is used also in Andorra, Monaco, San Marino and Vatican City, as well as in the Azores, the Canaries, French Guiana, Guadeloupe, Madeira, Martinique, Mayotte, Runion, and Saint Pierre and Miquelon, which are all part of EU countries using the euro. Consequently the Euro is used daily by some 327 million Europeans. Over 175 million people worldwide use currencies which are pegged to the Euro, including more than 150 million people in Africa. The Euro notes are identical in all countries but each country produces its own coins with one common side and one side displaying a distinctive national emblem. Monaco, San Marino and Vatican City also have their own Euro coins. All the notes and coins can be used anywhere in the Euro area. Denmark, Sweden and the United Kingdom are not currently participating in the single currency. The Euro is the second largest reserve currency and the second most traded currency in the world after the U.S. dollar. As of November 2008 with more than 751 billion in circulation, the Euro is the currency with the highest combined value of cash in circulation in the world, having surpassed the U.S. dollar. The EUR is actually a basket of currencies of the above mentioned 16 European Members. Since 1/1/02 and up to the time of writing, the countries participating in the EUR have locked their exchange rate to a specic level as follows: EUR/BEF EUR/ESP EUR/IEP EUR/LUF EUR/ATS EUR/FIM EUR/DEM EUR/FRF = 40.3399 = 166386 = 0.787564 = 40.3399 = 13.7603 = 5.94573 = 1.95583 = 655957 EUR/ITL EUR/NLG EUR/PTE EUR/GRD EUR/CYP EUR/MTL EUR/SIT EUR/SKK = 1936,27 = 2.20371 = 200.482 = 340.75 = 0.585274 = 0.4293 = 239,640 = 30.1260
These exchange rates are xed and cannot change unless the European Central Bank (ECB) dictates so. Since 1st January 2002, all European countries joining the EUR have withdrawn their national currencies and are using the Euro coins and notes within their domestic borders.
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5.9.3.1 Why the Euro currency was introduced? The Euro was created because a single currency offers many advantages and benets over a situation where each European Member State had its own currency. Not only are exchange rate uctuation risks and exchange costs eliminated and the single European market strengthened, but the Euro also means closer co-operation among Member States. When the EU was founded in 1957, the Member States concentrated on building a common market for trade. However, over time it became clear that closer economic and monetary co-operation was needed for the internal market to develop and ourish further and for the whole European economy to perform better, bringing more jobs and greater prosperity for Europeans. In 1991, the Member States approved the Treaty on European Union (the Maastricht Treaty), deciding that Europe should have a strong and stable currency for the 21st century. The benets of the Euro are diverse and are felt on different scales, from individuals and businesses to whole economies. They include: More choice and stable prices for consumers and citizens Greater security and more opportunities for businesses and markets Improved economic stability and growth More integrated nancial markets A stronger presence for the EU in the global economy A tangible sign of a European identity Many of these benets are interconnected. For example, economic stability is good for a Member States economy as it allows its government to plan for the future. But economic stability also benets businesses because it reduces uncertainty and encourages companies to invest. This, in turn, benets citizens who see more employment and better-quality jobs. In addition, the single currency brings new strengths and opportunities arising from the integration and scale of the euro-area economy, making the single market more efcient. Before the Euro, the need to exchange currencies meant extra costs, risks and a lack of transparency in cross-border transactions. With the single currency, doing business in the euro area is more cost-effective and less risky. Furthermore, being able to compare prices easily encourages cross-border trade and investment of all types, from individual consumers searching for the lowest cost product, through businesses purchasing the best value service, to large institutional investors who can invest more efciently throughout the euro area without the risks of uctuating exchange rates. Within the euro area, there is now one large integrated market using the same currency. The scale of the single currency and the euro area also brings new opportunities in the global economy. A single currency makes the euro area an attractive region for third countries to do business, thus promoting trade and investment. Prudent economic management makes the Euro an attractive reserve currency for third countries, and Heriot-Watt University Securities Markets 1
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gives the euro area a more powerful voice in the global economy. However, the Euro does not bring economic stability and growth on its own. This is achieved through the sound management of the euro-area economy under the rules of the Maastricht Treaty, a central element of Economic and Monetary Union (EMU). These rules are described below.
5.9.3.2 Joining the Euro An EU Member State can join the Euro only once all the necessary conditions are fullled. Adopting the single currency is a crucial step in a European Member States economy. Its exchange rate is irrevocably xed and monetary policy is transferred to the hands of the European Central Bank (ECB), which conducts it independently for the entire euro area. The economic entry conditions are designed to ensure that a European Member States economy is sufciently prepared for the adoption of the single currency and it can be integrated smoothly into the monetary regime of the Euro area without the risk of disruption for the Member State or the Euro area as a whole. The economic entry criteria which are intended to ensure economic convergence are known as the convergence criteria (or Maastricht criteria) and were agreed by the EU Member States in 1991 as part of the preparations for introduction of the Euro. The Member States which were the rst to adopt the euro in 1999 had to meet all these conditions. The same entry criteria apply to all countries which have since then adopted the Euro and all those that will in the future.
5.9.3.3 The convergence criteria The convergence criteria are formally dened as a set of macroeconomic indicators which measure 1. Budget discipline; 2. Low interest rates; 3. External Debt discipline; 4. Low relative ination; 5. Stable exchange rate The specic requirements for a Member State aiming to join the Euro are: 1. For budget discipline: The Member States government decit should not exceed more than 3% the countrys annual Gross Domestic Product. 2. For interest rates: The Member States long term interest rates should not be more Heriot-Watt University Securities Markets 1
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than 2 percentage points above the rate of the three best performing Member States in terms of price stability. 3. For external debt discipline: The Member States government debt should not exceed more than 60% the countrys annual Gross Domestic Product. 4. For ination: The Member States consumer price ination rate should not be more than 1.5 percentage points above the rate of the three best performing Member States. 5. For stable exchange rate: Participation in Exchange Rate Mechanism (ERM) II for at least 2 years without severe deviations from a predened central rate. The exchange-rate stability criterion is chosen to demonstrate that the Member State can manage its economy without recourse to excessive currency uctuations. It also provides an indication of the appropriate conversion rate that should be applied when the Member State qualies for joining the Euro and its currency is irrevocably xed. Finally, in addition to meeting all the above economic convergence criteria, a Member State must make changes to its national laws notably governing its National Central Bank. In particular, its National Central Bank must be independent, such that the monetary policy decided by the European Central Bank is also independent.
5.9.3.4 The rise of Euro as a global / reserve currency Currencies are the means by which wealth is stored, protected and exchanged between countries, organisations and individuals. A global (or reserve) currency does this on an international scale. Since its introduction in 1999, the Euro has rmly established itself as a major international currency, second only to the US dollar. Within the Euro area, the single currency, the Euro, is the means by which governments, companies and individuals make and receive payments for goods and services. It is also used to store and create wealth for the future in the form of savings and investments. However, the size, stability and strength of the Euro-area economy - the worlds second largest after the United States - make the Euro increasingly attractive beyond its borders, too. Public and private sectors in third countries acquire and use the Euro for many purposes, including for trade or as currency reserve. For this reason, today, the Euro is the second most important international currency behind the US dollar. The widespread use of the Euro in the international nancial and monetary system demonstrates its global presence: The Euro is increasingly used to issue government and corporate debt worldwide. At the end of 2006, the share of the Euro in international debt markets was around one-third, while the US dollar accounted for 44%. Global banks make signicant loans denominated in Euro around the world. The Euro is the second most actively traded currency in foreign exchange markets; it is a counterpart in around 40% of the daily transactions. Heriot-Watt University Securities Markets 1
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The Euro is extensively used for invoicing and paying in international trade, not only between the Euro area and third countries but also, to a lesser extent, between third countries. The Euro is widely used, alongside the US dollar, as an important reserve currency to hold for monetary emergencies. At the end of 2008, more than one-quarter of the global foreign exchange holdings were being held in Euros, compared to 18% in 1999. Developing countries are among those which have increased their reserves in Euro the most, from 18% in 1999 to around 30% in 2006. Several countries manage their currencies by linking them to the Euro, which acts as an anchor or reference currency. The status of the Euro as a global currency, combined with the size and economic weight of the euro area, is leading international economic organisations, such as the IMF and the G8, increasingly to view the euro-area economy as one entity.
5.9.3.5 The performance of the Euro in the FOREX After the introduction of the Euro, its exchange rate against other major currencies fell heavily, especially against the U.S. dollar. From an introduction at US$1.18/ where one Euro was buying 1.18 US dollars, the Euro fell to a low of $0.8228/ by 26 October 2000. After the appearance of the Euro coins and notes on 1 January 2002 and the replacement of the twelve national currencies which by then were joining the Eurozone area, the Euro began steadily appreciating and soon regained parity (i.e. one Euro was buying one US dollar) with the U.S. dollar on 15 July 2002. Since December 2002, the Euro has not again fallen below parity with the U.S. dollar but instead began ascendancy as the following graph illustrates.
Data source: European Central Bank Figure 5.5: The performance of Euro versus the US dollar during the period 2004-2009 On 23 May 2003, the Euro surpassed its initial ($1.18) trading value for the rst time. At the end of 2004, it reached $1.3668 as the U.S. dollar fell against all major currencies. The Euro temporarily weakened in 2005, falling to $1.18 in July 2005, and was stable Heriot-Watt University Securities Markets 1
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throughout the third quarter of 2005. In November 2005 the Euro again began to rise steadily against the U.S. dollar, hitting one record high after another. By 15 July 2008, the Euro has risen to an all-time high of $1.5990 against the US dollar. However in August 2008 and amidst the nancial crisis the Euro began to drop against the U.S. dollar. In just two weeks the Euro fell from its peak to $1.48 and by late October it reached a two and a half year low below $1.25. The reasons behind Euros gradual appreciation against the USD are mainly nancial (e.g. higher growth in the Euro area in comparison to the American one, lower trade decits, greater nancial stability in the Eurozone, etc.) but also political (e.g. political stability in the Europe Union, uncertainty about the impacts on the American economy from its continuing military involvement in the Middle East etc.).
5.9.4
The performance of the Japanese yen (JPY)
Japan is a country with a signicant market share in international trade; it is one of the most active exporters in the world. This feature makes the JPY a very important currency. The Japanese yen is the most heavily traded currency in Asia and the fourth most actively traded currency in the world. It is also the most liquid currency in Asia. At one point during the 1980s, there was conjecture that the Japanese yen would join the U.S. dollar as one of the worlds reserve currencies. Japans extended economic decline has ended this supposition, at least temporarily, but the JPY remains an extremely important currency in the global nancial markets. Regarding its performance during the period 1972-1995, the JPY was strengthening remarkably over the USD. For instance, in 1972 the USD/JPY exchange rate was 351.02 (i.e. one USD was buying 351.02 JPY) but 15 years later the USD/JPY was only 125 (i.e. one USD was buying 125 JPY).
Data source: US Federal Reserve Figure 5.6: The performance of the JPY versus the US dollar during the period 2004-2009 As the Japanese yen appreciates over the USD, Japanese exporters lose some of their competitive advantage since the goods they export become more expensive to the American people. Heriot-Watt University Securities Markets 1
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To illustrate further this point let us assume that the price of a Japanese car exported to the US is 2,400,000 JPY. With an exchange rate at 120/$ in June 2007 (see graph), this car costs US$20,000 to the American customer. However, following the signicant appreciation of the Japanese Yen in December 2008, where the exchange rate reached 90/$ (see relevant graph), the same car costs US$26,667 to the American customer; i.e. US$6,667 or approximately 34% more than some months ago. Below is a list of Japans top 15 export customers, based on World Trade Organisation (WTO) statistics. Japans major trading partners are the Asian Pacic countries, the United States and the EU. The United States is Japans largest single trading partner. Total Japanese exports amounted to US$595 billion in 2005. The top 5 countries in the list account for some two-thirds of total Japanese exports. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Top 15 Countries for Japanese Exports United States (22.9% of total Japanese exports) $135.9 billion European Union $87.6 billion (14.7% of total Japanese exports) China (13.5% of total Japanese exports) $80.1 billion South Korea (7.8% of total Japanese exports) $46.6 billion Chinese Taipei (7.3% of total Japanese exports) $43.6 billion Hong Kong (6.0% of total Japanese exports) $36 billion Thailand (3.8% of total Japanese exports) $22.5 billion Singapore (3.1% of total Japanese exports) $18.4 billion Malaysia (2.1% of total Japanese exports) $12.5 billion Australia (2.1% of total Japanese exports) $12.4 billion Indonesia (1.5% of total Japanese exports) $9.2 billion Philippines (1.5% of total Japanese exports) $9.1 billion Canada (1.5% of total Japanese exports) $8.8 billion Panama (1.2% of total Japanese exports) $7.4 billion Mexico (1.2% of total Japanese exports) $6.9 billion
Source: World Trade Organisation The major exports of Japan include electrical equipment, machinery, electronics, telecommunication, computer devices and parts, transport equipment, motor vehicles, non-electrical machinery, chemicals and metals. Japans exports to China rose 13.8% in 2008 to US$124.2 billion setting China as Japans largest trading partner.
5.9.5
The performance of the Swiss Franc (CHF)
At the end of 2008, around 0.2% of the global foreign exchange holdings were being held in Swiss Francs. Switzerland is a country with a well-established, reliable and reputable banking system. It is also considered world-wide, as one of the safest, soundest and most discreet nancial centres, and one that is usually unaffected by international political crises, such as wars. Switzerland had the second highest European rating after Ireland in the Index of Economic Freedom for 2008, while also providing large coverage through public services to its citizens. During the same period, its nominal per capita Gross Domestic Product (GDP) was higher than those of the larger western European economies and
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Japan, ranking sixth behind Luxembourg, Norway, Qatar, Iceland and Ireland. Between mid-2003 and mid-2006, the CHFs exchange rate with the Euro had been stable at a value of about 1.55 CHF per Euro, so that the Swiss franc has risen and fallen in tandem with the Euro against the U.S. dollar and other currencies. Thanks to the role of the Swiss franc as a safe haven currency, the EUR/CHF exchange rate has exhibited a good correlation with the development of the equity markets in recent years. Periods of higher uncertainty, as during the period mid 2007-2009 are generally characterised by falling stock prices and in turn appreciation of the CHF (i.e. lower EUR/CHF exchange rate levels), as investors shift their assets into the safe haven of Switzerland. And vice-versa, during periods when the equity markets are on the rise, investors pull out of Switzerland as a safe haven, and thus good performance by stocks results in depreciation pressure on the CHF (i.e. EUR/CHF rises). Consequently, the path of EUR/CHF depends to a great degree on the development of the equity markets. FOREX borrowers who speculate that the CHF will weaken must also anticipate good performance on the equity markets. In recent times and due to the nancial market crisis, there has also been an enormous increase in the EUR/CHF exchange rate volatility which was something scarcely seen in the FOREX markets for this particular pair of currencies. In addition, periods of exaggerated movement in EUR/CHF exchange rate are currently much stronger than in recent years.
Data source: European Central Bank Figure 5.7: The performance of the CHF versus the Euro during the period 2004-2009 Regarding the performance of the Swiss franc vis--vis the U.S. dollar, in March 2008 the Swiss franc traded above parity (i.e. above one U.S. dollar) for the rst time. However this performance did not last long (see graph below).
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Figure 5.8: The performance of the CHF versus the US dollar during the period 2004-2009 The Swiss economy experiences virtually zero ination and had until recently an appealing legal requirement that a minimum of 40% of the countrys monetary reserves be backed by gold reserves. That is the reason for the Swiss franc being historically considered a safe haven currency. However, this link to gold, which dates from the 1920s, was terminated on 1 May 2000 following a referendum regarding the Nazi gold affair with Swiss banks and an amendment to the Swiss Constitution. By March 2005, following a gold selling program, the Swiss Central Bank held 1,290 tonnes of gold in reserves which equalled to 20% of its total assets. As a result the CHF currency was no longer backed by gold. Despite this fact, Iin times of global political uncertainty, risk-averse investors have always found sanctuary with the Swiss franc. Thisese factors contribute to the CHF being one of the strong currencies in the world.
5.9.6
The performance of the Chinese Renminbi Yuan (CNY)
Today the Republic of China has a dynamic, export-driven economy with gradually decreasing state involvement in investment and foreign trade. In keeping with this trend, some large state-owned banks and industrial rms are being privatized. Real growth in GDP has averaged about 8% during the past three decades. Exports have provided the primary impetus for industrialization. The trade surplus is substantial, and foreign reserves are the worlds third largest. China is the worlds largest producer of rice and is among the principal sources of wheat, corn (maize), tobacco, soybeans, peanuts and cotton. The country is one of the worlds largest producers of a number of industrial and mineral products. About 80 percent of Chinas exports consist of manufactured goods, most of which are textiles and electronic equipment, with agricultural products and chemicals constituting the remainder. Chinas primary trading partners include Japan, the EU, the U.S., South Korea, Hong Kong, and Taiwan. For most of its early history, the Chinese Renminbi Yuan was pegged to the U.S. dollar at 2.46 yuan per USD. When Chinas economy gradually opened during the 1980s, the Chinese Renminbi Yuan was devalued in order to reect its true market price and to Heriot-Watt University Securities Markets 1
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improve the competitiveness of Chinese exports. Thus, the ofcial CNY/USD exchange rate declined from 1.50 yuan in 1980 to 8.62 yuan by 1994 (lowest ever on the record). Improving current account balance during the latter half of the 1990s enabled the Chinese government to maintain a peg of around 8.27 yuan per USD from 1997 to 2005 (see Figure 5.9).
Data source: http://www.x-rates.com/ Figure 5.9: The performance of the CNY versus the US dollar during the period 2000-2009 On 21 July 2005, the peg was nally lifted, which saw an immediate one-off RMB revaluation to 8.11 per USD. The exchange rate against the euro stood at 10.07060 yuan per Euro.
Data source: http://www.x-rates.com/ Figure 5.10: The performance of the CNY versus the EUR during the period 2000-2009
5.10. Summary
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The CNY is now moved to a managed oating exchange rate based on market supply and demand with reference to a basket of foreign currencies. The daily trading price of the U.S. dollar against the CNY in the inter-bank foreign exchange market would be allowed to oat within a narrow band of 0.3% around the central parity published by the Peoples Bank of China (PBC); in a later announcement published on 18 May 2007, the band was extended to 0.5%. The PBC has stated that the basket is dominated by the United States dollar, Euro, Japanese yen and South Korean won, with a smaller proportion made up of the British pound, Thai baht, Russian ruble, Australian dollar, Canadian dollar and Singapore dollar.
5.10
Summary
In this chapter, we have introduced the Foreign Exchange Market (FOREX) and analyzed its importance in the nancial world. We also discussed the evolution of the exchange rate arrangements among markets and their application today. We then focused on the products of the FOREX, including the currencies, and their characteristics, i.e. swift codes, methods for quoting exchange rates, bid-offer prices, bid-offer spreads etc. Methods for calculating exchange rates when relevant information is not directly recorded were presented (cross exchange rates) and strategies, which eliminate any foreign exchange mis-pricing were discussed (triangular arbitrage). Finally, we indicated the main features of a strong currency and presented an overview of the performance of strong currencies over the last 30 years.
5.11
Further reading
Solnik, B. (1996), International Investments, (3rd edition), Addison-Wesley. Chapters 1. Rutterford, J. (1993), Introduction to Stock Exchange Investment, (2nd edition) MacMillan. Chapter 11. Brealy R and Myers S (2000), Principles of Corporate Finance (6th edition) McGraw-Hill. Chapter 27. Web Sites The Universal Currency Converter: http://www.xe.net/ucc Contains more than 180 currencies and allows users to nd foreign exchange rates using their swift codes. US Federal Government: http://www.stat-usa.gov One-stop source for business and economic related data. US Department of Commerce: http://www.stat-usa.gov Contains current and historical trade-related releases for a number of countries
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Bank of England: http://www.xe.bankofengland.co.uk UKs central bank provides monetary and policy analyses, market and European reports. European Central Bank: http://www.ecb.int Home page of the ECB. It provides extensive information on the European system of central banks, the monetary union (EMU) and the Euro. Asian Central Banks Links: http://www.anancyweb.com/central-banks-asian.html Asian Central Banks links, sites, and pages by Anancyweb.
5.12
Q1:
Review Questions
a) From what sources do the dealers in the Foreign Exchange realize prot? b) Give an example for each of the 3 major categories of exchange rate arrangements among countries. c) What is it meant by (i) direct quote, (ii) indirect quote (iii) theoretical cross exchange rates, (iv) triangular arbitrage? Q2: The following foreign exchange rates were reported on January 8, 2000: German mark (DM) 0.874 Japanese yen (JPY) 0.0079 British pound (GBP) 1.9905
U.S.$
The exchange rates indicate the number of U.S. dollars necessary to purchase one unit of foreign currency. a) From the perspective of a US investor, are the foreign exchange rates direct or indirect quotes? b) How much of each of the foreign currencies is needed to buy one US dollar? c) Calculate the theoretical cross rates between: i the German mark and the Japanese yen: DM/JPY ii the German mark and the British pound.: GBP/DM iii the Japanese yen and the British pound: GBP/JPY Q3: Assume the following information provided by ABN bank: Value of Euro (Euro) in US dollars ($) $0.9116 Value of British Pound () in US dollars ($) $1.5802 Value of Euro (Euro) in British Pounds () 0.5877 Given these quotes explain whether triangular arbitrage is possible. If so, construct the strategy which would reect triangular arbitrage and - assuming that no transaction costs are involved - compute the prot from this strategy if you had $5000000 to invest. Heriot-Watt University Securities Markets 1
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Q4: Assume the following information for a particular bank: Value of Canadian dollar in US$ (CAD/USD): Value of German Mark in US$ (DM/USD): Value of Canadian dollar in German Marks (CAD/DM): Given this information, is triangular arbitrage possible? If so, explain the steps, which would reect triangular arbitrage and - assuming that no transaction costs are involved - compute the prot from this strategy if you had $1000000 to use. Q5: a) What features make a strong currency? b) Discuss the performance of 2 strong currencies over that last decade. Q6: a) Why the Euro currency was introduced? b) What is it meant by the term Maastricht criteria? $0.90 $0.30 DM 3.02
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Chapter 6
International Exchange Rate Parity Theories

Contents
6.1 6.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Determining foreign exchange rates using the fundamental approach . . . 6.2.1 Interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2.2 International trade . . . . . . . . . . . . . . . . . . . . . . . . . . 6.3 Foreign exchange rate parity theories 6.3.1.1 6.3.1.2 6.3.1.3 6.3.1.4 6.3.1.5 6.3.2.1 6.3.2.2 6.3.3.1 6.3.3.2 6.3.4.1 6.4 . . . . . . . . . . . . . . . . . . . . 6.3.1 Purchasing Power Parity (PPP) . . . . . . . . . . . . . . . . . . . Absolute PPP . . . . . . . . . . . . . . . . . . . . . . . Relative PPP . . . . . . . . . . . . . . . . . . . . . . . . Forecast accuracy of PPP . . . . . . . . . . . . . . . . . The Big Mac Index . . . . . . . . . . . . . . . . . . . . . Currencies over or under valued? . . . . . . . . . . . . How to use the Fishers equations . . . . . . . . . . . . Forecast accuracy of IFP . . . . . . . . . . . . . . . . . Expressing FERE through forward discounts/premiums Forecast accuracy of FERE . . . . . . . . . . . . . . . . Forecast accuracy of IRP . . . . . . . . . . . . . . . . . . . . . . . 113 113 114 114 114 116 116 117 118 119 123 124 125 126 126 127 128 128 132 133 133 133 134 135 135 137 137 137
6.3.2 International Fisher Parity (IFP) . . . . . . . . . . . . . . . . . . .
6.3.3 Foreign Exchange Rate Expectations (FERE) . . . . . . . . . . .
6.3.4 Interest Rate Parity (IRP) . . . . . . . . . . . . . . . . . . . . . . Determining foreign exchange prices using Technical Analysis
6.4.1 The technical analysis is based on three underlying principles: . 6.4.2 Commonly used technical analysis methods are: . . . . . . . . . 6.4.3 Pros and Cons of Technical Analysis: 6.5 . . . . . . . . . . . . . . . Determining foreign exchange prices using other approaches . . . . . . . 6.5.1 Balance of Payment Approach . . . . . . . . . . . . . . . . . . . 6.5.1.1 6.5.1.2 Links between BoP and the exchange rate movements Forecast accuracy of BoP approach . . . . . . . . . . .
6.5.2 The Asset Market Approach . . . . . . . . . . . . . . . . . . . . .
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Chapter 6. International Exchange Rate Parity Theories
6.5.3 The Market Microstructure Approach . . . . . . . . . . . . . . . . 6.6 6.7 6.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Learning Objectives On completion of this chapter students should be able to understand: the alternative foreign exchange rate parity theories which use the fundamental approach; that purchasing power parity links spot exchange rates and ination; that international Fisher parity links interest rates and ination; that the foreign exchange rate expectations rate theory links forward and expected spot exchange rates; that interest rate parity links spot exchange rates, forward exchange rates and interest rates; how to calculate exchange rates using the absolute and relative purchasing power parity theory; how to calculate exchange rates using the international Fisher parity theory; how to calculate exchange rates using the foreign exchange rate expectations rate theory; how to calculate exchange rates using the interest rate parity theory; and the forecast accuracy of the various foreign exchange rate parity theories; how technical analysis is used for the prediction of future exchange rates; and what other methodologies exist for exchange rate determination and what is their forecasting accuracy. Summary Chapter aim To understand and critically analyse the foreign exchange rate parity theories and to consider their relevance for the pricing of currencies in the foreign exchange market.
6.1. Introduction
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6.1
Introduction
In this Chapter we will discuss and illustrate the basic methods for pricing currencies in the foreign exchange market. The two primary methods for determining and analysing currency prices are fundamental analysis and technical analysis. Other methods include the balance of payment approach, the asset market approach and the market microstructure approach. Fundamental analysis focuses on nancial and economic theories as well as political developments to determine forces of supply and demand for a particular currency. Technical analysis looks at the past price behaviour of a currency and its volume data to discover trends and to determine if they are expected to continue as such in the future. One clear point of distinction between fundamental and technical analysis is that fundamental analysis studies the causes of the foreign exchange market movements while technical analysis studies the effects of the foreign exchange market movements. Most foreign exchange traders rely on some kind of market analysis to make their trading plans and develop their trading strategies. In this module we will focus on fundamental analysis for determining foreign exchange prices. Further discussion on technical analysis as well as on the other theories determining the foreign exchange prices also takes place later in this Chapter.
6.2
Determining foreign exchange rates using the fundamental approach
The foreign exchange market, as well as any other nancial market, submits to the rules of supply and demand. If there is high demand for a particular currency and shortage of supply for this currency, its price will go up and inevitably this will trigger some other changes and developments in the countrys economy and even political situation. The same way, currencies are affected by different economic and political developments in one country or sometimes even in the world. Nowadays, everything is interconnected in our global economy and sometimes economic or political changes in one country will affect the currency of another country. That is why it is so important for foreign exchange traders to pay attention to both economic and political developments taking place in the world when they plan their trading or develop their FOREX strategy. The fundamental analysis comprises the examination of macroeconomic indicators and political considerations when evaluating a nations currency in terms of another. Macroeconomic indicators include gures such as growth rates as measured by the Gross Domestic Product (GDP), interest rates, ination, unemployment, money supply, foreign exchange reserves and levels of productivity. Political considerations include the level of condence in a nations government, its political stability and the level of uncertainty in the country. Most economic data and political events that are coming out in global news releases and have an impact on a countrys economy both directly and indirectly are considered fundamental factors. These fundamental factors are divided into two major groups: economic factors and political factors.
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Economic news releases come out in so called fundamental reports. These reports are kept under strict secrecy up to the time of the actual occurrence. Central banks, for example, change the discount rate condentially and even though the markets closely watch these events, sometimes the outcomes do not coincide with the predictions. The deciding factor in whether a fundamental release will have an effect on the currency market is how closely the actual results come to economists predictions. If the fundamental release matches predictions then it should have already been priced in to the market beforehand. However, if the release strays from the anticipated numbers, then it will have a bigger impact on the market. The dates and times of economic data release are well known and are anticipated by the market. There are many resources available on the television, newspapers and internet. Two of the most important nancial factors which are watched closely by FOREX traders are a countrys interest rates and its level of international trade.
6.2.1
Interest rates
Interest rates can have either a strengthening or weakening effect on a particular currency. On the one hand, high interest rates attract foreign investment which will strengthen the local currency. On the other hand, stock market investors often react to interest rate increases by selling off their holdings in the belief that higher borrowing costs will adversely affect many companies.
6.2.2
International trade
A trade balance which shows a decit (i.e. more imports than exports) is usually an unfavourable indicator for the future trend of the currency under consideration. Decit trade balances means that money is owing out of the country to purchase foreign-made goods and this may have a devaluing effect on the currency. Trade decits will only affect currency prices when they are higher than market expectations. Finally, political factors are closely watched because the political situation in a country can impact market sentiment greatly and affect human psychology that plays important role in foreign excange market. Political factors can include elections, high level talks, and crises. Some political factors, such as a presidential election or a G-7 meeting are scheduled beforehand and can be anticipated. Fundamental analysis is quite effective at forecasting economic conditions, but not necessarily exact FOREX market prices. Studying GDP forecasts or employment reports can give us a fairly clear picture of an economys health and the forces at work behind it. But we still need a method to translate that into specic levels of change in a currencys future price. Using the foreign exchange rate parity theories provide us with a means to do so.
6.3
Foreign exchange rate parity theories
Foreign exchange parity theories determine exchange rates by linking currency prices to domestic and foreign economic variables such as ination rates and interest rates; i.e. they use the fundamental approach for determining foreign exchange prices.
6.3. Foreign exchange rate parity theories
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Foreign exchange rate parity is reached when the supply and the demand for the two currencies involved are balanced. In this case, the price of the exchange rate is in equilibrium. The supply of and the demand for currencies may be inuenced by: a) the ination rate, I: it is the rate of consumer price increase over a specied period of time. b) ination rate differential, (ID - IF ): this is the difference in ination rates between the two countries whose currencies are involved in the exchange rate determination. In the above notation, I D is the ination rate of the domestic currency and IF is the ination rate of the foreign currency. c) nominal interest rate, N: this is the spot interest rate ignoring ination. d) nominal interest rate differential, (ND - NF ): this is the difference in nominal interest rates between the two countries whose currencies are involved in the exchange rate determination. In the above notation, N D is the nominal interest rate of the domestic currency and NF is the nominal interest rate of the foreign currency. e) real interest rate, R: this is the spot interest rate after allowing for ination. f) real interest rate differential, (RD - RF ): this is the difference in real interest rates between the two countries whose currencies are involved in the exchange rate determination. In the above notation, R D is the real interest rate of the domestic currency and RF is the real interest rate of the foreign currency. g) a countrys balance of payments: i.e. the difference between the value of its imports and exports. h) speculation. i) government policy and intervention. There are four exchange rate parity theories in international nance. 1. Purchasing Power Parity 2. International Fisher Parity 3. Foreign Exchange Expectations theory 4. Interest Rate Parity Purchasing Power Parity links spot exchange rates and ination. The International Fisher Parity links interest rates and ination. Foreign Exchange Expectations theory links forward exchange rates and expected spot exchange rates that will occur in the near future. Finally, Interest Rate Parity links spot exchange rates, forward exchange rates and interest rates. All four theories are based on perfect capital markets where a oating exchange rate regime exists. Heriot-Watt University Securities Markets 1
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6.3.1
Purchasing Power Parity (PPP)
PPP theory states that exchange rates are determined by the relative prices of similar goods in two countries. Exchange rates are in equilibrium when their purchasing power is the same in each of the two countries. There are two versions of PPP: the absolute PPP and the relative PPP.
6.3.1.1 Absolute PPP The basis for PPP is the law of one price. In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries. For example, if a pint of milk costs 1 dollar in the US and 0.5 pound in the UK, then according to PPP, the GBP/USD exchange rate must be 2 dollars per one British pound. If the prevailing market exchange rate is 1.8 dollars per British pound, then in the absence of transportation and transaction costs, consumers in the UK would prefer importing the milk from the US. If this process (called arbitrage) is carried out on a large scale, the price of the milk in Britain will eventually fall as the demand for it has dropped. According to PPP, this process continues until a pint of milk has the same price in both countries. Gustav Cassel, a Swedish economist, devised the absolute PPP at the close of World War I. Cassel attempted to derive a crude measure of equilibrium exchange rates by comparing market prices of goods in various currencies. The result was the Absolute PPP. Cassels equation was the following. Absolute PPP:
Price leveldomestic Proce levelforeign
S0
where S0 is the exchange rate in terms of domestic currency per unit of foreign currency which, according to PPP, should hold today.
Example A kilo of silver cost 225 US dollars in the US and 150 EUR in Cyprus. If the current exchange rate, S0 is USD/EUR = 0.7500, what does the Absolute PPP imply for the price of silver in Cyprus? Solution Absolute PPP:
Price level CYPRUS Price level US
= S0
Price level CYPRUS = 225
0.7500 = 168.75
For the Absolute PPP to hold, the equilibrium price of a kilo of silver in Cyprus should be 168.75 CYP. Alternatively, if the price of silver in both countries remained unchanged, then the USD/CYP exchange rate should adjust in order to eliminate price differences. Absolute PPP: S0 =
Price level CYPRUS Price level US
= S0 =
150 225
= 0.6667 Heriot-Watt University Securities Markets 1
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6.3.1.2 Relative PPP Relative PPP refers to rates of changes of price levels, that is, ination rates. This proposition states that the rate of appreciation/depreciation of a currency is equal to the difference in ination rates between the foreign and the domestic country. For example, if Canada has an ination rate of 1% and the US has an ination rate of 3%, the US dollar will depreciate against the Canadian dollar by 2% per year. This proposition holds well empirically, especially when the ination differences are large. In equation form, the relationship may be represented as follows: Relative PPP:
1S
0S
1 + Idomestic 1 + Iforeign
where:
0S
= is the current spot exchange rate in terms of domestic currency per unit of foreign currency.
Idomestic = is the ination rate in the domestic country. Iforeign = is the ination rate in the foreign country.
1S
= is, according to the PPP, the spot exchange rate which will occur at time 1.
Example The current spot GBP/USD exchange rate is 0 S =1.5000. The annual rate of ination in the UK is 4% and in the US is 6%. According to the Relative PPP is this exchange rate correctly set? Solution Relative PPP:
1S
1 + Idomestic 1 + Iforeign 1 + 0.06 S = 1.5000 1 + 0.04 S = 1.5288 =

0S
This means that according to the Relative PPP, the GBP/USD exchange rate should be 1.5288. In other words the USD should depreciate against the GBP so that the GBP/USD exchange rate will reach its equilibrium point at 1.5288. We can calculate the extent of the USD (domestic currency) depreciation relative to the GBP (foreign currency) as follows: % change in the exchange rate =
1 + Idomestic 1 + Iforeign
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In the previous example, the USD will depreciate relative to GBP by 1.923 percent annual rate. (i.e. 1.06 /1.04 - 1 = 0.01923 or 1.923%) Heriot-Watt University Securities Markets 1
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Notice that in the above calculations the domestic currency (USD) depreciates approximately by the ination rate differential (i.e. difference in the ination rates between UK and US) which is 0.02 or 2%. This observation will provide you with a quick method for cross-checking the correctness of your calculations.
Example A kilo of silver cost today USD 225 in the US and GBP 150 in the UK. By the end of the year the kilo of silver is expected to cost USD 238.5 in the US and GBP 156 in the UK. Use the Absolute PPP to calculate the current GBP/USD exchange rate, and then use the Relative PPP to show how this price change will affect the exchange rate calculated. Assume that USD is the domestic currency. Solution According to the Absolute PPP, the current spot GBP/USD exchange rate should be 0 S =1.5000 (i.e. 225 /150 ). By the end of the year the price of a kilo of silver in the US will be USD 238.5 which implies that the annual ination rate in the US is 6% (i.e. (238.5 -225) / 225 = 0.06). Similarly, by the end of the year a kilo of silver will cost GBP 156 in the UK, so the annual ination rate in the UK is 4% (i.e. (156 -150) /150 = 0.04). Consequently, according to the Relative PPP, by the end of the year the exchange rate will become: 1 + 0.06 1 S = 1.5000 1 + 0.04 1 S = 1.5288
6.3.1.3 Forecast accuracy of PPP PPPs major weakness is that it assumes goods are easily tradable, with no costs to trade such as tariffs, quotas or taxes. Another weakness is that it applies only for goods and ignores services where room for differences in value is signicant. Furthermore, there are several factors besides ination differentials impacting exchange rates, such as interest rate differentials, economic releases/reports, asset markets and political developments. In addition, exchange rate movements in the short term are news driven and cannot be explained by the PPP. Announcements about interest rate changes, changes in perception of the growth path of economies and markets are all factors driving exchange rates in the short run. PPP, by comparison, describes the long-run behavior of the exchange rates. There was little empirical evidence on the effectiveness of PPP prior to the 1990s. Thereafter, PPP was seen to have worked in the long run (3-5 years) when prices eventually correct towards parity. Heriot-Watt University Securities Markets 1
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For those students interested in the empirical evidence on PPPs effectiveness, I recommend Kenneth Rogoffs research paper 1 in which he provides an overview of developments with respect to research on PPP. Rogoff: The Purchasing Power Parity Puzzle, Journal of Economic Literature, 34(2), June 1996, pages 647-668.
1 Kenneth
6.3.1.4 The Big Mac Index The simplest way to calculate PPP between two countries is to compare the price of a standard good, which is identical across countries. Every year in April, The Economist magazine publishes a light-hearted version of Absolute PPP, its Big Mac Index which compares the price of a McDonalds Big Mac hamburger around the world. According to this idea the price of a Big Mac in country A is rst translated into US dollars and it is then compared with its cost in the United States. If the price of the Big Mac in country A is above its cost in the United States then the currency of this country is overvalued (i.e. in simple words it is expensive). If the price of the Big Mac in country A is below its cost in the United States then the currency of this country is undervalued (i.e. cheap).
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Figure 6.1: Big Mac Index Heriot-Watt University Securities Markets 1
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More sophisticated versions of PPP look at a large number of goods and services and combine them in a representative market basket. Then the price of this market basket is compared between countries and PPP is calculated. The Joint OECD-Eurostat PPP Program (JOEP), which was established in the 1980s, calculates PPP this way. More specically, the JOEP includes in the basket of goods and services used for the PPP calculation, consumer goods and services, government services, equipment goods and construction projects. The product groups are weighted and averaged to obtain PPPs. The weights used to aggregate the PPPs are the expenditures on the product groups in each country. In the following table we present the comparative price levels as reported by JOEP. Each column shows the number of specied monetary units needed in each of the countries listed to buy the same representative basket of consumer goods and services. In each case the representative basket costs 100 units in the country whose currency is specied. Take for example the case of Canada: the same representative basket of consumer goods and services costs 100 Canadian dollars in Canada, 67 Canadian dollars in Mexico, 94 Canadian dollars in the US, 105 Canadian dollars in Australia etc. The cheapest price you can buy this basket of goods and services is Poland; there its cost is 62 Canadian dollars.
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COMPARATIVE PRICE LEVELS (Price of identical basket of goods in various countries) Source: www.oecd.org New Czech Canada Mexico United States Australia Japan Korea Zealand Austria Belgium republic Denmark Finland France Germany Greece Hungary Iceland Ireland Slovak Spain Italy Luxembourg Netherlands Norway Poland Portugal republic EUR EUR EUR NOK PLN EUR SKK EUR SEK CHF NZD EUR EUR CZK DKK EUR EUR EUR EUR HUF ISK EUR
United Sweden Switzerland Turkey Kingdom TRY GBP
Monetary Unit
CAD
MXN
USD
AUD
JPY
KRW
Figure 6.2: OECD

100 59 130 118 103 103 85 61 136 126 96 101 100 129 58 77 63 87 114 124 60 102 100 221 197 175 176 144 104 232 214 164 172 171 220 98 130 107 148 194 210 102 173 100 89 79 80 65 47 105 97 74 78 77 99 44 59 48 67 88 95 46 78 100 89 89 73 53 118 109 83 87 87 111 50 66 54 75 99 107 52 88 100 101 83 60 133 123 94 98 98 126 56 75 61 85 111 121 58 99 100 82 59 132 122 93 98 97 125 56 74 61 84 111 120 58 98 100 72 160 148 114 119 118 152 68 90 74 102 135 146 71 120 100 222 206 157 165 164 211 94 125 102 142 187 202 98 166 100 92 71 74 74 95 42 56 46 64 84 91 44 75 100 77 80 80 103 46 61 50 69 91 98 48 81 100 105 104 134 60 79 65 90 119 128 62 105 100 100 128 57 76 62 86 113 123 59 101 100 129 57 76 62 86 114 123 60 101 100 45 59 49 67 89 96 46 79
Canada Mexico United States Australia Japan Korea New Zealand Austria Belgium Czech republic Denmark Finland France Germany Greece Hungary Iceland Ireland Italy Luxembourg Netherlands Norway Poland Portugal Slovak republic Spain Sweden Switzerland Turkey United Kingdom 100 110 108 63 140 125 110 111 91 66 147 135 104 109 108 139 62 82 67 93 123 133 65 109 100 98 58 128 114 101 102 83 60 134 124 95 99 99 127 57 75 62 85 112 122 59 100 100 133 109 151 198 215 104 177 100 82 113 149 162 78 133 100 139 182 198 96 162
100 67 94 105 112 88 101 110 108 64 141 126 111 112 92 66 148 137 105 109 109 140 62 83 68 94 124 134 65 110
100 140 156 167 131 150 164 161 95 209 187 165 166 137 99 219 203 155 162 162 208 93 123 101 140 184 199 97 164
100 111 119 94 107 117 115 68 149 133 118 119 98 70 157 145 111 116 115 148 66 88 72 100 131 142 69 117
100 107 84 96 105 103 61 134 120 106 107 88 63 141 130 100 104 104 133 60 79 65 90 118 128 62 105
100 79 90 98 97 59 126 112 99 100 82 59 132 122 93 98 97 125 56 74 61 84 111 120 58 98
100 114 125 123 72 160 142 126 127 104 75 167 155 119 124 123 159 71 94 77 107 140 152 74 125
100 132 142 69 117
100 108 52 89
100 48 82
100 170
100
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6.3.1.5 Currencies over or under valued? We can use The Economists Big Mac index or the JOEP reports in conjunction with the actual exchange rates as reported in the nancial press in order to estimate whether a currency is undervalued or overvalued. The following chart compares the PPP of a currency with its actual exchange rate. The PPP of a currency has been calculated using the Absolute PPP technique and data from The Economists Big Mac index. Actual exchange rates have been taken from the nancial press.
Figure 6.3: Over & under value The currencies listed above are compared to the US dollar. A grey bar indicates that the local currency is overvalued by the percentage gure shown on the axis; the currency is thus expected to depreciate against the US dollar in the long run. A black bar indicates undervaluation of the local currency; the currency is thus expected to appreciate against the US dollar in the long run. The JOEP was established in the 1980s to provide internationally comparable price and volume levels of GDP and its component expenditures for all member countries of the OECD. For those students interested in reading more on the Joint OECD-Eurostat PPP Program and its reports, visit JOEPs WebPage at: http://www.oecd.org/std/ppp Heriot-Watt University Securities Markets 1
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6.3.2
International Fisher Parity (IFP)
Along with the Purchasing Power Parity (PPP), the International Fisher Parity (IFP) is another major theory in international nance for pricing foreign currencies and explaining why exchange rates move over time. Prof. Irving Fisher developed this theory back in the1930s. Fisher theorized that the differences in nominal interest rates on similar assets denominated in several currencies should equal the differences in expected ination rates. Thus, according to IFP, it is interest rate rather than ination rate differentials, which are directly related to, and explain, exchange rate movements. Extrapolating from Fishers theory for the case of a single country, nominal interest rates (N) could be viewed as the product of expected ination E(I) and the real rate of interest (R) within the country as follows2 : [1 + N] = [1 + E (I)] [1 + R] The above formula is also known as Fisher Closed because it deals with a closed domestic economy; i.e. an economy not involved in international trade activity. Fisher also theorized about open economies and looked at interest rate differentials in an international context. This theory, called Fisher Open, is as follows: Fisher Open:
1 + ND NF 1 + E(ID E(IF
1 + RD RF
where D and F stand for domestic and foreign country respectively. In deriving the above equation, Fisher assumed that the real rate of interest is the same in both countries; i.e. R D = RF .
Example The nominal interest rate in the UK is 2.95% and the expected rate of ination 2.7%. If, in Germany, the expected rate of ination is 3.8%, what is the German nominal interest rate according to Fishers equations? Solution a) From Fisher Closed, the real interest rate in the UK is: RUK = RUK RUK [1 + NUK ] -1 [1 + E(IUK )] [1 + 0.0295] -1 = [1 + E0.027] = 0.0024 or 0.24%
b) )According to IFP, the real rate of return will be the same in both countries; i.e.: RUK = RGERMANY = 0.24% c) To calculate the German nominal interest rate we use the Fisher Open:
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[1 + E(IUK )] [1 + NUK ] [1 + RUK ] = [1 + NGERMANY ] [1 + E(IGERMANY )] [1 + RGERMANY ] [1.027] [1 + 0.0295] [1.0024] [1.0024] = [1 + NGERMANY ] [1.038] NGERMANY = 0.0405 or 4.05%
Thus, according to Fishers equations, the nominal interest rate in Germany should be 4.05%.
6.3.2.1 How to use the Fishers equations If you compare the PPP and the Fisher Open, you will nd that there is a common clause, the ination, which links the two formulae together: PPP: 1 + ID IF 0S 1 + ND Fisher Open: NF
1S
1 + E (ID E (IF
This observation enabled nancial economists to calculate exchange rates using an alternative method to PPP. The second method is called the International Fisher Parity( IFP): IFP =
1S 0S
ND NF
The IFP claims that exchange rates movement may be explained by changes in nominal interest rates ND and NF , given that Fishers assumption (i.e. that real interest rates are the same in both countries) holds.
Example The nominal interest rates per annum in US and Brazil are 4.25% and 13.15% respectively, and the current spot exchange rate, 0 S, is USD/BRR = 2. a) If the real interest rates in both countries are the same, what is the expected spot exchange rate, 1 S, one year from now? b) If the expected ination rate in Brazil is 7%, what is the annual real interest rate (RBR ) in Brazil? c) Given that IFP holds and without performing any calculations, can you estimate the American real interest rate (RUS )?
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Solution 1 + ND NF 0S 1 + ND S = 0S NF a) 1.1315 S = 2 1.0425 S = 2.1707 USD/BRR

1S
RBR = b) RBR RBR
[1 + NBR ] [1 + E(IBR )] [1.1315] = [1.07] = 0.0575 or 5.75%
c) RUS = RBR = 5.75%
In its original form, the right-hand side of the equation also includes an interaction term. We shall ignore this term here.
6.3.2.2 Forecast accuracy of IFP Empirical evidence conrms that, for major currencies, interest rate differentials are linked to expected ination rate differentials. However, IFP is not always met in practice because real interest rates are not necessarily equal in all markets nor are they stable over time. In addition, the foreign exchange uctuations are very large in comparison to interest or ination rate movements. Thus, a large part of foreign exchange uctuations cannot be explained by the IFP.
6.3.3
Foreign Exchange Rate Expectations (FERE)
Foreign exchange rate expectations theory equates expected exchange rates to the daily-recorded forward exchange rates. FERE theory (i.e. the relationship between future spot and forward exchange rates) is analogous to the Pure Expectations theory of the term structure of interest rates. FERE supports the theory that the forward exchange rate (F) recorded in the nancial press today for delivery at some time N in the future, equals the spot exchange rate (S) expected to apply at time N in the future. FERE is expressed mathematically as: FERE: N F = E (N S) FERE is based on the assumption that the forward exchange rate ( N F) is an unbiased predictor of the future spot exchange rate ( E ( N S) which, in turn, implies that the foreign exchange market is efcient. For FOREX to be efcient, (a) exchange rates should Heriot-Watt University Securities Markets 1
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reect all available information, (b) economic agents should use all available information in their forecast of future exchange rates, and (c) economic agents subsequent forecasts should contain no persistent errors. If the FOREX market is efcient, the forward rate will reect economic agents expectations of what the future spot exchange rate is likely to be and thus the FERE theorem will hold. To illustrate the last point, assume that the forward exchange rate between Euro and USD for delivery in one year is 1 F = 1.0000. If FERE holds then one year from now the spot exchange rate will also be E ( 1 S) = 1.0000. However, if market participants think that the future spot exchange rate will be higher than 1.0000 (say 1.1000) then they will not buy USD today in the forward market, but wait to buy it cheaper in a years time directly from the spot market. As a result the demand (and subsequently the price) for the forward contract will reduce until the expectation (and consequently the price) of the future spot exchange rate and the forward exchange rate are equal During this process, market participants could benet from the above-mentioned price discrepancies between the forward and the future spot exchange rates by performing arbitrage as follows. Sell EUR forward at EUR/USD = 1.0000; i.e. for each EUR sold you will get in a years time 1 USD. In a years time buy EUR in the spot market. For each EUR bought you will pay 0.91 (=1/1.1) USD. Exercise your forward contract and earn 0.09 USD per EUR sold forward. Thus, if you had 100000 USD to invest in this strategy, then your total prot would be USD 9000 just enough for a brand new laptop! This type of arbitrage will continue until all price discrepancies between the forward and the future spot USD/EUR exchange rate disappear and the FERE equation N F = E (N S) holds.
6.3.3.1 Expressing FERE through forward discounts/premiums It is easy to show how FERE theory is related to forward premiums or discounts; simply subtract 0 S (i.e. the current spot exchange rate) from both sides of the original FERE expression:
NF
- 0 S = E (N S) - 0 S
Alternative FERE: E (N S) = 0 S + (N F - 0 S) Notice that the right hand side ( N S - 0 S) of the above expression is the approximation of a forward premium (if positive) or discount (if negative). The above expression indicates that the expected spot exchange rate in future time N is the same as the current spot exchange rate plus the forward premium (or discount) of the same maturity.
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Example The current EUR/USD spot exchange rate is 0 S = 1.0000 and the one-year EUR/USD forward discount is 3%. What will the EUR/USD spot exchange rate be oneyear from now? Solution = 0 S - forward discount S 1 = 1.000 - 0.03 1 S = 0.9700 EUR/USD
1S
The EUR/USD spot exchange rate one year from now will be:
Example The current GBP/CAD spot exchange rate is 0 S = 2.0000 and the one-year GBP/CAD forward premium is 0.07 Canadian dollars per British pound. If FERE holds, what is the expected GBP/CAD spot exchange rate one-year from now? Solution = 0 S - forward discount 1 S = 2.000 - 0.07 1 S = 2.0700 GBP/CAD
1S
6.3.3.2 Forecast accuracy of FERE The Foreign Exchange Rate Expectations theory is one of the most widely examined theories in nancial economics. Numerous studies have attempted to discern whether the forward exchange rate is a good, or at least unbiased, predictor of the future spot exchange rate. Some studies found that the current spot exchange rate is a better predictor of the future than the forward rate, but others support FERE and show that the forward rate is an unbiased predictor. In general, however, the results of these studies are not conclusive support of one view or the other. Consequently, although the FOREX market participants may be willing to invest based on the FERE theorem, their forecasts may or may not be accurate depending on which currencies are considered, the quality of the data used, the time period under study and the methodology employed.
6.3.4
Interest Rate Parity (IRP)
Interest Rate Parity theorem relates exchange rates on forward contracts of specied maturities to interest rate differentials between two countries. IRP states that an appreciation (depreciation) of one currency against another currency must be neutralized by a change in the interest rate differential. For example, if UK interest Heriot-Watt University Securities Markets 1
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rates exceed European interest rates, then GBP should depreciate against the Euro by an amount which prevents riskless arbitrage. In its mathematical formulation, the theory holds that the ratio of forward and spot exchange rates will be proportional to the interest rate differential between the two countries as follows: IRP:
NF 0S
1 + ND 1 + NF
where:
NF 0S
is the forward exchange rate of specied maturity N. is the current spot exchange rate of domestic currency per one unit of foreign currency. is the nominal interest rate in the domestic country. is the nominal interest rate in the foreign country.
ND NF
If IRP holds, the countries will correctly set the forward exchange rate and thus arbitrage is not possible. In this case, the domestic investors will receive the same rate of return from investing in the foreign currency as they would have received if they had invested domestically.
Example To illustrate the IRP theorem, by example, consider a situation in which the one-year foreign interest rate is 5% and the one-year domestic interest rate is 11%. Suppose that the spot exchange rate between the two countries is 7.55 Danish krone (DKK) per British pound (GBP). What is the current one-year forward exchange rate according to IRP theorem? Solution 1 + ND NF 1 + NF 0S 1.11 F 7.55 1.05 1 F = 7.9814 DKK per GBP So according to IRP theorem the current one-year forward GBP/DKK exchange rate must be 7.9814 DKK per GBP. If this is the case, investors - as is illustrated next - will be indifferent between investing in Denmark (Scenario 1) or Britain (Scenario 2). Example continued: Suppose that an investors initial capital is 1 million DKK. Show that, if IRP holds, the investor will be indifferent between investing in her home country or abroad. Scenario 1: She invests the 1 million DKK domestically (i.e. in Denmark) at 11% per annum. In one year she will have 1.11 million DKK. Heriot-Watt University Securities Markets 1
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Scenario 2: She invests the 1 million DKK in Britain as follows. a) She converts the 1 million DKK to GBP at the current spot exchange rate of 7.55 GBP/DKK to give her 132450 GBP (i.e. 1m/7.55). b) She invests (i) the 132 450 GBP at the British interest rate of 5% and (ii) buys a one-year forward contract which xes the GBP/DKK exchange rate at 7.9814 DKK per GBP. In a years time: i ii The 132450 GBP at 5% will give her 139 073 GBP. Convert the 139073 GBP to DKK at the exchange rate she xed a year ago to get (139073 7.9814) 1.11 million DKK.
Consequently, Scenarios 1 and 2 give the same result, so the investor will be indifferent between them.
Example Let us now consider the case in which the forward exchange rate differs from the one set by IRP theorem. Suppose that 1 F = 8.1000 DKK per GBP instead of 7.9814 previously estimated. Scenario 1: For Scenario 1, that is investing domestically, nothing changes. Calculations stay as before. Scenario 2: a) This part remains as calculated before. b) She invests (i) the 132450 GBP at the British interest rate of 5% and (ii) buys a one-year forward contract, which xes the GBP/DKK exchange rate at 8.1000 DKK per GBP. In a years time: i ii The 132450 GBP at 5% will give her 139073 GBP. Convert the 139 073 GBP to DKK at the exchange rate she xed a year ago to get (1390738.1000) 1.13 million DKK.
Consequently, if the forward exchange rate is different from the one estimated by IRP theorem, the investor will no longer be indifferent between the two scenarios, since one of them gives extra prot.
In the example, Scenario 2 gives an extra 0.2 million DKK approximately. This is an attractive free-meal by anybodys standards, especially considering the lack of risk. Heriot-Watt University Securities Markets 1
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Therefore, if exchange rates differ from the ones indicated by IRP, then investors will take advantage of this situation, driving the UK-Denmark interest rate differential down or reducing the GBP/DKK forward exchange rate*. Until this arbitrage situation is eliminated - which usually happens very quickly - informed investors could make some prot.
Example Suppose you have noticed a bank on the Internet which quotes the one-year forward ROL/EUR exchange rate at 0.54 EUR per ROL. The interest rate in Euroland is 3.85% per annum, the correspondent one in Romania is 10.30% p.a. and the spot EUR/JPY exchange rate is 0.56 ROL per Euro. a) Use the IRP to check whether the EUR/JPY forward exchange rate is correctly set. b) Describe the strategy you would follow to grab any arbitrage opportunity were it to appear and calculate the prot you would make in the absence of any transaction and commission costs. Your bank can lend you up to 200 000 EUR for a year at 4% p.a. Solution a) The forward EUR/ROL exchange rate is not correctly set. According to IRP it should be: F 0.56 F = 0.5272 ROL per EUR Thus an arbitrage opportunity exists. b) The arbitrage strategy is as follows: i ii Borrow the 200000 EUR from the bank and convert it to ROL at the current spot exchange rate of 0.56. It will give you 357143 ROL. Invest the 357143 ROL at the Romanian interest rate of 10.30% p.a. and at the same time x the ROL/EUR exchange rate in one-year at 0.54 EUR .per ROL
By the end of the year: Your capital has grown by 10.30% to 393929 ROL. The forward contract bought in (ii) is now exercised, so you can convert the 393929 ROL to 212722 EUR Pay back your bank the capital and interest due. Prot from arbitrage = Final capital - (borrowed capital + interest) = 212722 EUR - 208000 EUR = 4722 EUR
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Example The current spot exchange rate between CNY and USD is 0.146 USD per CNY. The Chinese and American annual interest rates are given in the table below: Period of lending/ borrowing (Years) 1 2 3 Chinese Interest Rates (Annualised) 5% 5.75% 6.25% American Interest Rates (Annualised) 0.25% 0.50% 0.75%
What are the one-year, two-year and three-year CNY/USD forward exchange rates? Solution Current CNY/USD exchange rate is 0S = 0.146
1F
= 0S
1 + ID 1 + IF
1.05 1.0025
Thus, according to the IRP the one-year forward CNY/USD exchange rate is 0.153. This means that the American dollar is expected to depreciate in value over the Chinese Yuan by approximately 4.6%. Similarly, the two-year forward CNY/USD exchange rate is:
2F
= 0S
(1 + ID 2 (1 + IF 2
1.0575 1.005 1.0625 1.0075
Finally, the three-year forward CNY/USD exchange rate is:

3F
= 0S
(1 + ID 3 (1 + IF 3
3 3
6.3.4.1 Forecast accuracy of IRP The Interest Rate Parity theorem is found to hold up in the Eurocurrency markets and in other nancial markets before the 1990s. However, IRP showed no proof of working in other nancial markets after the 1990s, giving FOREX market participants opportunities for arbitrage. The main advantage of IRP is that unlike the PPP, IFP and FERE theories, FOREX market participants need not make any forecasts on exchange rates to anticipate a prot. Every number in the IRP formula is a number they can get simply from looking in the nancial press or calling a broker. However, traders and investors are not the only ones that use the IRP to search for exchange rate mis-pricing. The forward exchange rates themselves are set by banks which also utilize the IRP to hedge forward contracts. Therefore, exchange rate differences rarely appear and if they do, they vanish quickly as large scale arbitrage drives away any such prot opportunities.
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6.4
Determining foreign exchange prices using Technical Analysis
Technical analysis looks at the past price behaviour of a currency and its volume data to discover trends and to determine if they are expected to continue as such in the future. The technical analysis can be further divided into two major forms: the quantitative analysis and the chartism. Quantitative analysis uses various statistical properties to help assess the extent of an overbought/oversold currency. Chartism uses graphs, lines and gures to identify recognisable trends and patterns in the formation of currency exchange rates. The technical analysis attempts to forecast future price movements by examining past market data. Most traders use the technical analysis to get the big picture on a currencys price history. Even fundamental traders will glance at a chart to see if theyre buying at a fair price, selling at a cyclical top or entering a choppy, sideways market. The goal of the technical analyst is simple: to make protable FOREX trades by identifying past patterns that have historically led to a predictable outcome. The methodology is relatively simple based on extrapolation of past price trends and ignores underlying economic variables. Therefore, the FOREX technical analysis is concerned with what has actually happened in the foreign exchange market rather than what should happen. However, the potential risk should always be considered, because a recurring pattern does not guarantee a desirable or expected currency price movement.
6.4.1
The technical analysis is based on three underlying principles:

This means that the actual price is a reection of everything that is known to the market that could affect it, for example, supply and demand, political factors, and market sentiment. The pure technical analyst is only concerned with price movements, not with the reasons for any changes.
a) Market action discounts everything
b) Prices move in trends Technical analysis is used to identify patterns of market behaviour which have long been recognised as signicant. For many given patterns there is a high probability that they will produce the expected results. Also there are recognised patterns which repeat themselves on a consistent basis. c) History repeats itself Chart patterns have been recognised and categorised for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little with time.
6.4.2
Commonly used technical analysis methods are:
Trading rules Analysis of repeating patterns Analysis of chart formations
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Trading rules Applying a concrete trading rule is an investment tool based on certain algorithms with the conditions dening signals for the transactions (up or down).
Example Buy when the price goes down by x%over the period of last n days. Sellwhen the price goes up by x% over the period of last n days.
Analysis of repeating patterns There is some evidence in the nancial literature on the cyclical behaviour of the stock prices. For example, some interesting calendar effects have been identied such as the January effect, the Monday effect etc. However there is mixed evidence about their persistence over time and existence in various markets. This type of analysis can be also used for predicting foreign exchange price movements. Analysis of chart formations By plotting a currencys price history one may observe various patterns indicating either continuation or reversal of the current trend of a currencys price. FOREX analysts may glance at this type of analysis to form ideas about possible future trends. However, it should be noted that this is a very subjective and informal method of analysis. There is a tendency to pigeonhole FOREX traders into two distinct schools: fundamental or technical. In fact, most smart traders favour a blended approach versus being a purist of either type. Fundamentalists need to keep an eye on signals derived from price charts, while few technicians can afford to completely ignore impending economic data, critical political decisions or pressing societal issues that inuence price action.
6.4.3
Pros and Cons of Technical Analysis:
Benets of technical analysis helps to identify a trend, allowing investors to make prediction on future trends; allows investors to judge the direction of the current trend and enables them to gauge the best time to take a position in the market; when it is used in conjunction with fundamental analysis and company and industry related news, it minimizes the chances of an investor incurring losses. Drawbacks of technical analysis it draws heavily on a persons opinion or interpretation it is more a study of probabilities than an actual value it is useful only for a short-term investment strategies. Heriot-Watt University Securities Markets 1
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6.5
6.5.1
Determining foreign exchange prices using other approaches

Balance of Payment Approach
The Balance of Payment approach is an additional method which helps us to forecast the future exchange rate. This approach focuses on the relationship between the balance of payments ows and the exchange rate. According to this method, any trade decit has to be matched by surplus in the capital account (i.e. inow of capital from abroad). The Balance of Payments account (BoP) records all transactions between a given country and the rest of the world. Inows of currency, for example those that result from exports of goods and services, are recorded as positive items, while outows, such as those that result from imports of goods and services, are recorded as negative items. The BoP balance for a given country in any period must be zero. The following accounts make up the BoP: Current Account Balance + Capital Account Balance + Ofcial Reserve Balance = BoP or CA + KA + FXB = BoP where: A. The Current Account (CA) is made up of the following elements: Trade Balance TB (i.e. value of exports of goods (X) minus value of imports of goods (M) within a given period) BS (i.e. value of exports of services (X) minus value of imports of services (M) within a given period) NI (i.e. interest and other investment income within a given period)
Balance of services Net income received
Thus, based on the above notation the CA is quickly expressed as follows: CA = (X-M) + NI CA = TB + BS + NI B. The Capital Account (KA) is made up of the following elements: The KA includes all short-term and long-term capital transactions except those transactions made by or through the Central Bank. It therefore comprises the following:
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Direct Investment Portfolio Investment Other Capital Flow Net Errors and Omissions
DI (i.e. value of capital inows (CI) minus value of capital outows (CO) within a given period) PI (i.e. value of nancial inows such as equity ows, bond ows etc. (FI) minus value of nancial outows (FO) within a given period) OK (e.g. short-term capital ows, long term bank debt) NE (note: NE is an important parameter which ensures that everything balances as it should, so that the nal BoP measurement within a given period is zero)
Based on the above notications the KA is quickly expressed as follows: KA = (CI-CO) + (FI-FO) + OK + NE KA = DI + PI + OK + NE C. The Ofcial Reserve Account (FXB) is made up of the following elements: The FXB reects changes in the governments holdings of foreign currency or loans to foreign governments within a given period. The balance in this account is denoted as FXB (i.e. ofcial foreign exchange reserves balance) Interpreting the FXB account often causes confusion. For example for the UK, if the government has to sell foreign currency to accommodate a decit in the trade account (TB), there is an outow of foreign currency and this is recorded as a positive contribution to FXB. Thus a fall in reserves of foreign currency is recorded as an increase in FXB. The increase in FXB is actually a bad outcome for a countrys foreign exchange reserves. D. Finally, it must always be the case that for a given country in any period the BoP must be zero. I.e.: BoP = 0 CA + KA + FXB = 0 TB + BS + NI + DI + PI + OK + NE + FXB = 0 X - M + NI + CI - CO + FI - FO + OK + NE + FXB = 0 This relation holds as an accounting identity denoting that the BoP is always in balance. Some countries try to estimate their international accounts by recording all transactions within a given period of time, while others use a sampling approach. Both approaches are subject to error, especially in regard to the measurement of capital ows (CI-CO), nancial ows (FI-FO), services transactions (X-M) etc. Hence the need for the term NE.
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6.5.1.1 Links between BoP and the exchange rate movements If the exchange rate is xed in a country, the government is responsible for ensuring that the BoP is zero. In order to manage this, it has to intervene in the foreign market by buying or selling domestic currency whenever there is an account imbalance. More specically, if there is a decit in a countrys trade balance (TB) which cannot be covered by inows of capital by the private sector, then the central bank will intervene in the FOREX market selling foreign currency and thus avoiding its currency to devalue. If there is a trade surplus not offset by the outows of capital, then the central bank will intervene in the FOREX market buying foreign currency in order to prevent its currency from appreciating. In a oating exchange rate regime, currency prices are dened in the free markets. For example, if there is a decit in a countrys trade balance (TB) which cannot be covered by other accounts inows, then its currency is expected to drop in value in the FOREX market. However, a cheaper domestic currency will probably encourage more exports and make imports more expensive which may result to a nal recovery of the countrys BoP.
6.5.1.2 Forecast accuracy of BoP approach Although we understand moderately well how a devaluation or appreciation of the currency inuences trade ows in the short term, in the long term, the connection between trade ows and the exchange rate seems to be quite weak. In practice, the study of trade ows (i.e.the BoP approach) turns out not to help much in explaining exchange rates movements. For this reason we usually use it as a complimentary approach to fundamental and technical analyses for determining exchange rate movements.
6.5.2
The Asset Market Approach
Current trade ows have trivial effect on exchange rates, in contrary to the news about future economic prospects which are more important in the foreign exchange determination. Therefore, according to the Asset Market approach, exchange rates are determined by expectations about future ows of capital. Sophisticated investors decide how to invest their money by comparing the rates of return of foreign investments with those of domestic investments. Consequently, they will shift their funds abroad in case that the rates of return from foreign investments are larger, in order to benet from higher yields. Additionally, they will be willing to hold securities and undertake foreign direct investment in developed countries or emerging markets based on the relative real interest rates and on the outlook for economic growth and protability. The experience of the U.S. dollar during the years 1981-85, 1990 and 2000 denotes exactly such an investment behavior. The U.S. dollar strengthened during these periods despite growing current account decits in the US. The US exchange rate appreciation was the outcome of low ination, relatively high real returns and low political risk in the
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US which attracted sophisticated investors.
Example Suppose you have US$100,000 and want to decide if you will invest in a US dollar-dominated asset or Euro-dominated asset for a year. To see which asset you should buy today, you need to calculate the rate of return for both assets. You will then choose the asset with the highest rate of return. Lets rst calculate the rate of the return to the dollar-dominated asset. Suppose that the interest rate for the dollar-denominated asset is 10%. This implies that if you invest your money into the dollar-denominated asset this will be worth $100.000*(1 + 0.1) = $110.000 in a year. In other words, the rate of return to the dollar-denominated asset will equal to the U.S. interest rate. Next, you calculate the rate of return to the Euro-denominated asset. The rate of return on the Euro-denominated asset will not only depend on the interest rate of the eurodenominated asset (assume 8%), but also on the expected change in the currency exchange rate. To demonstrate this, we need to proceed with the following actions: 1. Convert $100000 into Euros at the current exchange rate of USD/Euro. Assume USD/Euro=0.769. This will give us $100000*0.769$/Euro= 76900 2. With an interest rate of 8% the Euro-dominated asset will be worth 76900*(1 + 0.08) = 83052 after a year 3. The nal worth of Euro-dominated asset needs to be converted back into dollars. Suppose that the dollar is expected to depreciate from 1.3 to 1.354 in a year (depreciation of 4%) in that case, the Euro-dominated asset will be worth 83.052*Euro/$1.354= $112452.4 Thus, investing in the Euro asset is clearly more protable than investing in dollar assets, since we receive $112452.4 - $110000=$2452.4 more from doing so. The above investment strategy is similar to an arbitrage one. This means that if investors start investing massively to Euro denominated nancial assets the demand for the Euro currency will go up and the Euro will appreciate over time over the US dollar, in which case arbitrage opportunities will quickly disappear. In addition, you should always keep in mind that investors assume a risk when investing abroad as when their investment proceeds are converted back into US dollars their investment value may fall due to a depreciation of the Euro (or appreciation of the US dollar).
6.5.3
The Market Microstructure Approach
The Market Microstructure approach is used to explain the exchange rates movements in a very short horizon (usually intraday or at most a few days ahead). According to this methodology what drives the exchange rates is the order ow generated by the investors. Heriot-Watt University Securities Markets 1
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The order ow is a record of all transactions, which investors want to make in the nearest future in a specic currency. In the market microstructure approach long term is not relevant. Therefore all the variables used in the other exchange rate theories and parities, which hold in the long run, are ignored. Instead, the market microstructure approach is focused on the demand and supply of currencies as indicated by the order ow data. A number of studies that use the market microstructure approach for exchange rate determination report widespread evidence that order ow is strongly positively correlated with short-term exchange rate movements. This evidence makes the market macrostructure approach a very successful methodology for predicting exchange rate movements in the nearest future. Problems when applying this methodology: Both inter-dealer order ow data and order ow data from customers are not publicly disclosed; Order ow data is a proprietary information of individual banks and market dealers; Because of its very short-term nature, the data can not be easily used for forecasting future exchange rate movements especially in the longer run.
6.6
Summary
The various fundamental theories discussed in this chapter are linked together in a fourway equivalence model known as the Fisherian framework. Purchasing Power Parity (PPP), International Fisher Parity (IFP), Interest Rate Parity (IRP) and Foreign Exchange Rate Expectations (FERE) are linked together through common parameters such as ination rate differentials, interest rate differentials and forward exchange rates. The four theories are linked diagrammatically as follows.
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Figure 6.4: The PPP equates the expected spot exchange rate to the ination rate differential. The ination rate differential equals the interest rate differential in IFP. Interest rate differentials dene the forward exchange rate in IRP. And, nally, forward exchange rates equal expected spot exchange rates in FERE. All four theories main aim is to price currencies correctly and to determine future spot exchange rates. Empirical evidence has shown that this aim tends to be fullled in the long run. For this reason, international exchange rate parity theories provide a very useful tool in nance and one of the most widely used tool by practitioners in nancial markets. Other methods for forecasting exchange rates which are used, usually complementarily with the international exchange rate parity theories, are the technical analysis, the balance of payments approach, the asset market approach and the market microstructure approach. The technical analysis is based on the premises that price discounts every aspect and information in the market. Moreover, it is based on the belief that price movements are never completely arbitrary and follow a trend. A technical analyst believes that it is possible to identify an ongoing trend and generate prots as a trend unfolds. The balance of payments approach uses data from the current account and the capital account. Although its forecasting power is limited in the long run it help us to understand moderately well how a devaluation or appreciation of the currency inuences trade ows in the subsequent 2-3 years. In the asset market approach, the exchange rate is determined by expected ows of capital. News about the future economic prospects seems to be more important in the foreign exchange rate determination and prediction. Finally, in the market microstructure approach, the order ow drives the exchange rates. Empirical evidence suggests that the order ow is a very good predictor of the exchange rates movements in the very short term.
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6.7
Further Reading
Solnik, B. (1996), International Investments, (3rd edition), Addison-Wesley. Chapters 2 and 3. Rutterford, J. (1993), Introduction to Stock Exchange Investment, (2nd edition) MacMillan. Chapter 11. Rogoff, K.(1996), The Purchasing Power Parity Puzzle, Journal of Economic Literature, 34(2), pages 647-668. Madura, J. (1998), International Financial Management (5th edition), SW press. Chapters 7, 8 and 9. Joint OECD-Eurostat PPP program, http://www.oecd.org/std/ppp
6.8
Q1:
Review Questions
a) A television set costs 1 000 Euros in Greece. The current spot exchange rate between Greece and Great Britain is EUR/GBP = 0.6377. What is the price of this television set in Britain given that Absolute PPP holds? (Suppose Britain is the domestic country). b) The annual rate of ination in the UK is 4% and in Turkey 12%. i What is the current spot GBP/TLR exchange rate according to Relative PPP? ii If the current spot GBP/TLR exchange rate is 1.0000 by how much should the TLR depreciate/appreciate so that the relative PPP holds? Q2: In a similar way to the BIG MAC Index table, create your DIET COKE Index table using the following information: Diet Coke Index Diet Coke prices in local currency United States Britain China Germany Indonesia Mexico Singapore Sweden Switzerland $0.60 pounds 0.40 Yuan 2.25 marks 1.45 roupiah 4500 peso 6.05 S$0.76 Skr 6.75 Sfr 1.50 Actual exchange rate (foreign currency per 1 USD) 0.65 4.28 2.17 6855 8.33 1.65 8.84 2.70
a) Calculate the implied PPP with the USD and ll the column Implied PPP with USD. b) Compare the Actual exchange rates with the ones calculated in (a) and ll the column Under(-)/Over(+) valuation against the USD. Heriot-Watt University Securities Markets 1
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c) Explain in words what the numbers in the last column imply for the future of each quoted foreign currency against the USD. Q3: You are a global travel agent who wants to recommend cheap holidays to a group of Greek travellers. How do you think that the Joint OECD Eurostat Program report will be of use to you? Q4: a) Ination differentials between the UK and industrialised countries have typically been a few percentage points in any given year. Yet, there have been many years in which annual exchange rates between the corresponding currencies have changed by 10% or more. What does this information suggest about the Purchasing Power Parity? b) What are the implications of the International Fisher Parity to rms with excess cash that consistently invest in foreign Treasury bills? Q5: The current (spot) exchange rate between Brazilian Real (BRR) and British Pound (GBP) is 5 BRR per GBP. The Brazilian and British annual interest rates are given in the table below. British Interest Rates Brazilian Interest Rates Period of lending/borrowing (Annualised) (annualised) (Years) 1 2 3 10.00% 10.75% 11.25% 15.00% 18.00% 22.00%
a) What are the one-year, two-year and three-year GBP/BRR forward exchange rates, according to the Interest Rate Parity (IRP)? b) If the current rate of ination in Brazil is 10%, what is the current real rate of interest in Brazil, according to the Fisher Closed theory? c) If the current real rates of interest are the same in Brazil and in the UK, what is the current rate of ination in the UK, according to IFP? d) Using the Purchasing Power Parity (PPP) as a guide, is the BRR expected to appreciate or depreciate against the GBP? (Assume that British real rates of interest will remain constant throughout the period). Give your reasons. Q6: The current CAD/ARS spot exchange rate is 0 S =2.1575 and the one year CAD/ARS forward premium is 1.85 Argentinean pesos (ARS) per Canadian dollar (CAD). a) If the Foreign Exchange Rate Expectations theory (FERE) holds, what is the expected spot CAD/ARS exchange rate one year from now? b) What do your calculations in (a) imply for the future of ARS?
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Q7: A British shoe retailer enters into a contract with an Italian shoe manufacturer to buy 250 pairs of shoes at 50 EUR per pair. The contract was agreed on 1st July 2000 when the exchange rate was 1.63 EUR per GBP. The shoes will be delivered and paid 6 months later, on 1st January 2001. The Italian interest rate is 5% per annum, while the British interest rate is 4% per annum. a) If Interest Rate Parity (IRP) holds, what is the GBP/EUR exchange rate expected to be on 1st January 2001? b) In order to eliminate the exchange rate risk the British shoe retailer wants to exchange a sufcient number of GBP into EUR when the contract is signed (1/7/00) and deposit the EUR in an Italian bank account until the payment and delivery of shoes are due (1/1/01). Ignoring transaction costs, how many GBPs would need to be changed into EUR on the 1.1.01? Q8: a) Explain what the Purchasing Power Parity, Interest Rate Parity and Foreign Exchange Expectations theories are about. b) How are the international exchange rate theories linked among them? Q9: a) How the Technical Analysis is attempting to determine foreign exchange prices? b) On which underlying principles the technical analysis is based? c) Describe at least two technical analysis methods. Q10: a) On which assumptions the fundamental analysis is based when used in forecasting exchange rates movements? b) Discuss the advantages and disadvantages of using the technical analysis in forecasting exchange rate movements. Q11: a) Which accounts consist the BoP accounting identity? b) Discuss the role of the following elements in the BoP estimation: NE FXB c) How changes in the BoP balance are associated with exchange rate movements? Q12: a) On which assumptions the Asset Market approach is based and what is its forecasting power in determining exchange rate movements? b) Briey discuss the Market Microstructure approach and its forecasting capacity. Are there any problems associated with this methodology?
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Chapter 7
International Portfolio Diversication

Contents
7.1 7.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk and return in portfolios: the core principles . . . . . . . . . . . . . . . 7.2.1 Returns and risks of portfolios with two securities . . . . . . . . . 7.2.2 A portfolio of more than two investments . . . . . . . . . . . . . . 7.2.3 Market and unique risk . . . . . . . . . . . . . . . . . . . . . . . . 7.3 7.4 7.5 Risk diversication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diversifying risk in world markets . . . . . . . . . . . . . . . . . . . . . . . Other factors to consider when investing in international markets . . . . . 7.5.1 Efcient markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5.2 Fluctuations in exchange rates . . . . . . . . . . . . . . . . . . . 7.5.3 International regulations . . . . . . . . . . . . . . . . . . . . . . . 7.5.4 Taxes and transaction costs . . . . . . . . . . . . . . . . . . . . . 7.6 The efcient frontier and a world market portfolio . . . . . . . . . . . . . . 7.6.1 Investing in a world market portfolio . . . . . . . . . . . . . . . . 7.6.2 The changing efcient frontier . . . . . . . . . . . . . . . . . . . . 7.7 7.8 7.9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 147 147 148 150 151 152 155 155 156 156 156 157 157 160 161 162 162
Learning Objectives On completion of this chapter students should be able to understand: the extension of risk-return principles to international investment, the potential for investors to take advantage of investing in assets with different correlation coefcients of return, how the efcient frontier changes with the extension of a portfolio to include international investments, new investors can achieve risk diversication benets by tracking a world portfolio through indexed funds, and
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Chapter 7. International Portfolio Diversication
the additional factors necessary for an investor in international markets to consider.
7.1. Introduction
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7.1
Introduction
You should by now be familiar with the basic principles of measuring risk and return for nancial investments. The next two chapters focus on the application of nance theory to international investment and measuring the performance of fund managers and international portfolios. In todays world there is an increasingly global market for capital, with stock markets listing foreign securities and reduced barriers to the movement of capital between countries. In this chapter we will begin with a reminder of the measurement of risk and return of the efcient frontier. We will then look at the risk diversication possibilities through the extension of investment opportunities beyond domestic securities to international investments. As the choice of investments increases, the impact on the risk-return trade-off will become more marked and the efcient frontier will change its shape. You will notice therefore, that in so doing, we will be progressing towards the market portfolio identied by Sharpe, Treynor and Lintner in the Capital Asset Pricing Model (CAPM). Towards the end of this chapter we will consider how an investor can meaningfully achieve a world market portfolio together with some of the issues and misconceptions surrounding the risks associated with international investment.
7.2
Risk and return in portfolios: the core principles
Although you should by now be familiar with the core principles of modern portfolio theory, it is useful to have a recapitulation of the main points.
7.2.1
Returns and risks of portfolios with two securities
The range of investment possibilities open to an investor in choosing the proportion of invested funds in two possible securities will be dened by the correlation coefcient of their returns. Exhibit illustrates the investment frontiers based on correlation coefcients ranging from -1.0 to +1.0. You will notice from Figure 7.1 that the maximum risk reduction possibilities occur when the two securities have returns which are perfectly negatively correlated.
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Figure 7.1: Risks and Returns from a portfolio of two securities
7.2.2
A portfolio of more than two investments
In each of the developed stock markets around the world there are typically several thousand ordinary shares and xed interest securities traded daily by investors. The UK Stock Exchange contains listings of over 7000 securities. This means that an investor is faced with a far wider choice than we have considered so far. Before we consider a portfolio consisting of many thousand securities, lets consider how enlarging the number of possible investments to three can change the investment frontier. Figure 7.2 illustrates the number of possible constituents in portfolios containing three possible investments. Possible combinations of three investments (A, B and C) in a portfolio: A B C A, B A, C B, C A, B, C Number of covariances (correlation coefcients): A, B B, C A, C Portfolio(A, B, C) = (XA)2 ( A)2 + (XB)2 ( B)2 + (XC)2 ( C)2 + 2XAXB (CovA, B) + 2XA XC (CovA, C) + 2XB XC (CovB, C) Figure 7.2: Calculating the risk of portfolios containing up to three investments There are of course many alternative portfolios of different weighted combinations of the three investments. When we extend the range of possible investments to greater than three, the number of covariance calculations increases. For additional investments covariance terms need to be calculated for each investment pair. In other words if we Heriot-Watt University Securities Markets 1
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assume there are only three possible investments and we become aware of a fourth (investment D), three further covariance calculations are required (cov A,D; cov B,D, cov, C,D) before a new investment frontier can be calculated for a new set of possible portfolios. Figure 7.3 illustrates the calculations required to calculate the standard deviation for any number (N) and combination of investment possibilities.
Portfolio
where
sum of the weights of i investments

by their standard deviation
the sum of the covariances for each investment pair
The double summation term encapsulates the two times the weights of each investment multiplied by each covariance term. Figure 7.3: Calculating the standard deviation of a portfolio of N investments The formula in Figure 7.3 looks really daunting! The reality is that the more possible investments, the greater the number of covariance terms which need to be calculated. In other words, the way in which investments move in relationship to one another will affect increasingly the shape of the investment frontier facing an investor constructing a multi-investment portfolio. Figure 7.4 illustrates the typical clustering of risk-return possibilities of investments in alternative sized portfolios. A frontier is shown around the upper and lower bands of the possible portfolio investment set.
Figure 7.4: Returns and risks of portfolios and the efcient frontier The shape of the diagram in Figure 7.4 has been referred to as a broken egg or umbrella shape. Look again at the diagram as if you are an investor choosing from the alternative investment opportunities shown. Hopefully you should be focussing your
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attention on the upper boundary of the frontier, the points on which all dominate the portfolios marked within the broken egg shape. The portfolios on the upper boundary of the frontier are efcient in terms of providing more return for the same risk and/or lower risk for the same return as the portfolios within the broken egg shape. The upper boundary therefore becomes the efcient frontier as shown in the diagram. The available investments and their relationship with one another, set the shape of the frontier which affects the risk reduction possibilities of combining them in different sized portfolios.
7.2.3
Market and unique risk
When we considered portfolios with larger numbers of ordinary shares we noticed that the important factor affecting the risk of the portfolio was the relationship between the returns of each security in the portfolio. In particular, we have observed that ordinary shares with negative correlation coefcients offer the best prospect for minimising the risk of a portfolio. As more combinations of ordinary shares become possible, an efcient frontier of portfolios emerges. The opportunity to reduce risk by investing in ordinary shares that are not perfectly positively correlated will mean that investors should diversify their shareholdings. If we assume that investors will hold diversied portfolios of shares, when an investor considers additional investments it will be the relationship between the expected returns of the additional investment and the portfolio which will be important in assessing risk. In other words, it will be the incremental volatility of returns of a portfolio from investing in an additional shareholding rather than the volatility of returns from holding the share on its own. We assume therefore that the shareholder will be concerned with the incremental risk to his portfolio rather than the total risk from holding the share on its own. Figure 7.5 illustrates the relationship between unique risk and market risk.
Figure 7.5: Unique risk and market risk Unique risk refers to the volatility of returns from ordinary shares caused by factors that are related directly to the company issuing the shares. Market risk is the volatility of returns caused by the wider economic factors affecting the returns from all shares listed on the capital market. In Figure 7.6 there are some examples of factors contributing to Heriot-Watt University Securities Markets 1
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unique and market risk. Market risk Interest rates Ination rates Foreign exchange rates Oil prices Taxation rates Unique risk Company policy on industrial relations with employees Capital investment strategy Pricing strategy Research and development policy Management skills
Figure 7.6: Factors affecting unique risk and market risk Market risk cannot be diversied. In other words an investor should expect some volatility when investing in a portfolio containing ordinary shares, caused by the movement of general market factors.
7.3
Risk diversication
Portfolio theory makes a compelling case for the reduction of risk through investment in larger portfolios of nancial securities. It has been demonstrated that much of the unique risk is diversied away with relatively small numbers of shares. Shares which have correlation coefcients of zero to -1.0 provide the investor with the greatest opportunity to reduce risk. Can we apply this theory to international investment? In principle of course the answer is yes. The principle is even more persuasive as investors have the choice of a wider range of nancial securities with different riskreturn proles. Most important of all, foreign shares open the possibilities for different correlation coefcients. What then happens to an investors portfolio risk as international investments become potential investments? Figure 7.7 illustrates the impact on unique and market risk.
Figure 7.7: Market risk International diversication
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The risk that an investor is most concerned about now becomes the market risk (international); in other words the risk that cannot be diversied away by investing in shares from any international market. What then should the message be for an investor? You will recall that the capital asset pricing model (CAPM) relies on a market portfolio lying on the efcient frontier (see Figure 7.8).
Figure 7.8: The capital market line The market portfolio consists of all types of investment including nancial (such as bonds and shares) commodities (such as gold and tin), ne art and vintage cars. Looking at the composition of the market portfolio from the viewpoint of ordinary shares, it follows that there should be combinations of shares from all international capital markets (under the CAPM perfect capital markets assumption). An investor will naturally seek to reduce risk as far as possible, without sacricing return. We must therefore explore how an investor should approach the search for his/her optimum portfolio in world markets.
7.4
Diversifying risk in world markets
Extending the principles of portfolio theory from investor choices in a domestic market to the incorporation of international stocks and shares into his or her portfolio requires certain conditions to exist. An investor will need to derive some reduction of risk or increased expectation of return given the risk-return opportunities available in his or her domestic market. For this condition to be achieved, investments on international markets need to have cash ow movements which differ from the movements of stocks and shares on domestic markets. You will recall that the correlation coefcient term is a standard measure of how returns on investments co-vary. Remember that the investor will gain maximum risk reduction to his or her portfolio, through zero or negatively correlated investments. The case for international diversication should therefore be gauged by the observation of returns on international investments co-varying to allow risk reduction possibilities for an investor.
7.4. Diversifying risk in world markets
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Figure 7.9 shows the annualised standard deviations for emerging markets and world indices (2000-2005). When we look at returns and risk from world stock markets the correlation coefcients become the key to identifying risk reduction opportunities (see Figure 7.10).
Source: Parametric Portfolio Associates Figure 7.9: Annualised Standard Deviations: 5 years ending 31/12/05
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Figure 7.10: Market capitalisation; weightings; returns and risk of world markets
7.5. Other factors to consider when investing in international markets
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It is always worth remembering that an investor is concerned with what will happen in the future, and not the past. Ex-post analysis however does provide insight into opportunities that existed. This needs to be taken further to look at the correlation coefcients between investments in different world markets, in order to identify the maximum risk reduction for an investor over the same period. Remember the rst principles of the measurement of risk and correlation coefcients. Returns from ordinary shares are measured by share price movements and dividends paid, which in turn will be based on the company performance. Company earnings will be derived in part from movement in general economic factors (such as interest rates and ination), industry-specic factors and company specic factors. Returns from investments subject to the same risk exposure, we can expect to co-vary together (ie have a positive correlation coefcient close to 1.0). Likewise a company whose earnings were in the opposite direction to another company will have a negative correlation coefcient because of the relative impact of economic, industry-specic and companyspecic factors. Countries such as the US and UK are closely linked, in terms of economic factors through trade. Other countries, such as Argentina and Malaysia have less closely linked economies (in terms of industry and consumers), which yields a low correlation coefcient. Figure 7.7 illustrates the impact of risk reduction through international investment in terms of the unique and market risk distinction. You will see that from the widening of the market, domestic market risk has been reduced. The diagram illustrates that this can be achieved with a relatively small number of randomly selected international stocks and shares.
7.5
Other factors to consider when investing in international markets
The case for international diversication, based on the existence of risk reduction opportunities, is well-founded and good news for investors. It is however important to consider factors prevalent in international investment that may require consideration by an investor. We shall look at each in turn before summarising the impact of international diversication and how it can be practically achieved by an investor.
7.5.1
Efcient markets
For a capital market to be efcient, there must be a timely ow of information about share prices made available investors. The information relevant to the value of the ordinary share needs to be quickly absorbed into share prices. Stock markets categorised as developing (or emerging) will not, by denition, be efcient in the semi-strong form (ie speedily incorporating all publicly available information into the value of ordinary shares). For the market to be efcient it also requires there to be large numbers of buyers and sellers available in the markets. A common measure of the liquidity of a market is the market turnover. Relatively illiquid markets means that share prices become less reliable. It has the same impact as imperfect or relatively costly information, which can Heriot-Watt University Securities Markets 1
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also lead to a share price being stale. Developed stock markets include the Western European markets (eg UK, France and Germany), the US markets, Japan and Hong Kong. The reliability of stock market prices is higher in developed markets. Categories of developing or recently developed markets, such as the Malaysian, may have weak form but not semi-strong efciency.
7.5.2
Fluctuations in exchange rates
When a domestic investor invests in foreign securities he or she is exposed to exchange rate movements between his or her own currency and the currency of the foreign investment. Returns on the foreign stocks and shares will be earned in the local currency and therefore any gain or loss from the movement in the exchange rate will be realised at the time the return is received. Developing or emerging markets are likely to have, on average, a more volatile exchange rate than more developed markets. You are, however, aware from the previous chapters in this text of how currency risk can be hedged and hence reduce an investors exposure. Currency options and futures may be used to hedge exposure to exchange rate movements. Also, a well-diversied international portfolio will, by its very nature, contain a natural diversication of exchange rate risk.
7.5.3
International regulations
Some countries around the world impose constraints on the amount of foreign exchange undertaken by individuals and institutions. This places a limit on investment in international capital markets. In the UK exchange controls were removed in 1979, though some developed, as well as developing, countries exercise limits on foreign investment. The powerful pension fund institutions in the US still have limits on the proportion of foreign investments they hold in their portfolio providing a demand-side constraint, therefore limiting some of the benets of international diversication. Some countries continue to impose restrictions on the proportion of foreign investment in the stocks and shares in their domestic market. This supply side constraint to international diversication is particularly the case for emerging stock markets.
7.5.4
Taxes and transaction costs
In a perfect capital market you will recall that there are no taxes and transaction costs connected with buying and selling ordinary shares. As we know that both are in existence in the real world, the impact of each needs to be considered when investing in foreign stocks and shares. The impact of taxes and transaction costs is to reduce the returns to investors. They can also have the effect of making markets less liquid. An investor may also be liable for withholding taxes from his or her foreign investments. Mostly withholding taxes may be reclaimed, provided that there is a mutual recognition by means of the relevant countries taxation treaties. An investor should consider carefully the impact of such costs on his or her overall return, ensuring that the risk-return trade-off incorporates the net return.
7.6. The efcient frontier and a world market portfolio
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7.6
The efcient frontier and a world market portfolio
You will recall the key message of modern portfolio theory for the investor is to diversify the unique risk of individual stocks and shares by holding a diversied portfolio. The capital asset pricing model identies a market portfolio that all investors should hold in proportions together with the risk free asset (short-term government bonds or gilts). The problem with dening the market portfolio has caused much debate and criticism (Fama and French 1992). Although it includes a wider representation of investments than nancial securities, we will explore in this section how an internationally representative portfolio can be achieved, consisting solely of nancial securities.
7.6.1
Investing in a world market portfolio
In todays developed capital markets the range of securities with different risk-return proles provides a wide choice to the investor. You should by now be familiar with the case for a passive well diversied portfolio in efcient capital markets. In an efcient domestic capital market, this modern portfolio and efcient market theory tells us this should include all shares listed on the market. How does an individual investor achieve this? There are many fund management institutions operating in todays markets offering the opportunity for investment in an indexed fund. In many cases the fund will consist of the fund managers choice of winners (with the losers omitted from the fund). Increasingly tracker funds became popular in times when the domestic market was performing well. A tracker fund, as its name suggests tracks a market index. For the UK Stock Market this is normally the FT All Share Index (FT, stands for Financial Times). Investments in the FT All Share Index tracker fund will yield a return commensurate with the movement of the market index. The fund manager invests several millions of s, an individual investor will share a return in proportion to his or her investment (which may be say 1000). Through this mechanism a UK investor can passively hold the FT All Share Index and avoid the pitfalls and costs of picking winners in efcient markets. Figure 7.10 illustrates the annual returns over a 31 year period and the respective standard deviations. Remember that it is the correlation coefcients that illustrate the degree of risk reduction. Figure 7.10 demonstrates that on average 45 out of every 100 invested in a value weighted world portfolio would be in US stocks. Around 6 would be in emerging markets (not shown on this exhibit) and 9 in the UK. Figure 7.11 and Figure 7.12 illustrate the efcient frontier based on historic returns from 1970 to 2006 and the impact of risk reduction prospects (from the viewpoint of an American investor).
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Source: Morgan Stanley MSCI indexes, Datastream. Figure 7.11: Average returns and volatility of returns of investments in US stocks and in foreign industrial countries stocks, 1970-2006 Portfolios Share of foreign equity (percent) 0 8 12 41 100 Average annualised returns (percent) 10.24 10.28 10.30 10.44 10.74 Standard deviation of returns (percent) 15.12 14.67 14.47 13.78 16.35
100% US (point A in Figure 7.11) 1997 US stocks allocation (point D) 2004 US stocks allocation (point E) Minimum variance portfolio (point C) 100% foreign industrial countries (point B)
Source: MSCI equity returns available in Datastream Figure 7.12: Mean and standard deviation of stock returns, January 1970-March 2006 What about constructing an international portfolio? How can we extend the rationale for investment in world markets? In most developed and developing markets there are funds set up to invest in shares in each market. In the US the Standard and Poor and NASDAQ indexed funds will mirror movements in American markets and in Hong Kong it is the Hong Kong indexed funds. It is therefore possible for a relatively modest investment to track the movement of shares world-wide by investing a weighted proportion of funds in each indexed fund tracking individual stock markets. Of course as share prices change the weights will also move over time. A number of misconceptions about investing in a world market portfolio is that it will be more risky than a domestic market portfolio. This view tends to be based on concerns over the volatility of emerging markets. Examples include the Mexican Market Collapse in the early 1990s, the Far Eastern crisis in the late 1990s (causing sharp falls in the Thai, Singaporean and Malaysian markets). The important message to an investor is that the smaller emerging market will be a relatively small proportion of his or her world
7.6. The efcient frontier and a world market portfolio
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portfolio. Figure 7.11 and Figure 7.12 demonstrates the potential benets to an investor in the allocation of funds across wider foreign investments. Notice how the standard deviation falls based on the addition of foreign equities to US stocks. Figure 7.13 and Figure 7.14 illustrate the returns and risks of alternative strategies over selected periods during the last century, from investing in the US and internationally.
Source: Ibbotson Associates Figure 7.13: Average returns and risks on the US stock market 1926-2004
Source: ABN AMRO/LBS Global Investment Returns Yearbook 2007. Figure 7.14: Real returns on equities and bonds internationally, 1900-2006 Figure 7.15 shows the risk premium achieved by investing in equity investment worldwide, over investment in government bonds and treasury bills in the last century. Dimson, Marsh and Staunton have shown that, while the US risk premium has been 5.6% over the last 106 year period, the world index has been smaller at 4.8%, based on annualised geometric means. Heriot-Watt University Securities Markets 1
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Based on: Dimson, Marsh and Staunton (ABN AMRO) and Triumph of the Optimists, Princeton University Press, 2002. Figure 7.15: The worldwide equity risk premium relative to bills and bonds, 1900-2006
7.6.2
The changing efcient frontier
You will recall how quickly the efcient frontier emerges as securities are combined in different sized portfolios. You can appreciate that, given the correlation coefcients of international stock markets, the efcient frontier changes shape. The shape of the frontier can look quite different depending on the period chosen, when compared to the efcient frontier based only on domestic securities. It is important to remember, however, that a positive investment in the world market portfolio will not enable an investor to gain abnormal returns but will give him or her maximum benets of risk diversication. There are of course many investors and fund managers who try to select markets, to outperform average historic performance, and also to give more efcient risk reduction benets. In the next chapter we will look at how the performance of such funds can be properly measured. The efcient frontier for an international investor can also be improved by incorporating bonds into a portfolio. Bonds provide a low risk, low return option which helps pull the efcient frontier from right to left. Figure 7.16 illustrates this effect.
7.7. Summary
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Figure 7.16: The changing efcient frontier In summary, the efcient frontier with international stocks and bonds improves the riskreturn trade-off for an investor from that which he or she faces from investments in a domestic market. All investors, whatever their domestic market (UK, US, Japan or South East Asia) will be able to benet. Aggressive investors (ie those not holding a passive weighted portfolio) can nd potentially higher abnormal returns, in international markets. The extent of the benet gained by international investment will of course vary between countries. If an investor is faced with signicant zero or negatively correlated international stocks, he or she can gain the most effective means of risk reduction.
7.7
Summary
In this chapter we have looked at the relevance and application of the core messages of modern portfolio theory to international investment. We have found that the efcient frontier drawn from the availability of domestic nancial securities shifts signicantly when international bonds and shares become available. The shape of the frontier will differ according to the country of domicile for each investor. An investor needs to consider carefully the impact of currency risk, based on expected exchange rates with alternative currencies. An investor needs also to be aware, when investing internationally, of the efciency of the capital market, taxes, transaction costs and exchange rates applicable. Each factor can impact on the rate of return realised. As has been demonstrated, the correlation coefcient between world markets provides the best indicator of risk reduction opportunities for international investments. Investors should consider the expected future correlations rather than relying on historic relationships. Investors seeking to maximise risk reduction benets from international investment can achieve most effective results through use of the correlation coefcient relationship. Exchange rate exposure can be managed through hedging techniques (such as forward rate and currency swap arrangements), though a well diversied portfolio can provide its own currency hedge. Alternatively, adopting a passive buy and hold approach can efciently reduce risk, reducing the necessity and cost of picking winners (from either a return or correlation point of view). Heriot-Watt University Securities Markets 1
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Fund Managers investing internationally are increasingly under pressure to nd riskreturn payoffs for investors. In the next chapter we will look at how such payoffs can be achieved.
7.8
Further Reading
Text books Dimson, E, Marsh, P. Staunton, M. (2002) Triumph of the Optimists: 101 Years of Global Investment Returns, Princeton University. Solnik, B. International Investments, Addison-Wesley (4th Edition, 1999) Ibbotson, R. and Brinson, G., Global Investing, McGraw Hill (1993) Journal Articles Erb, C.B., Harvey, C.R. and Viskanta, T.E., Forecasting International Correlations, Financial Analysts Journal (November/ December 1994) Levy, H. and Sarnat, M., International Diversication of Investment Portfolios, American Economic Review (September 1970) Odier, P. and Solnik, B., Lessons for International Asset Allocation, Financial Analysts Journal (March/April 1993) Solnik, B., Boucrelle, C. and Le Fur, Y., International Market Correlation and Volatility, Financial Analysts Journal (September/October 1996) Websites International Finance Corporation http://www.ifc.com Financial Times http://www.FT.com
7.9
Review Questions
Short problems Q1: Identify three key issues for an international investor in overseas capital markets. Q2: Describe how an indexed fund can be used by an individual investor to assist international risk diversication. Q3: If an investor is risk averse should he/she be investing in international shares?
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Tutorial questions Q4: Consider Figure 7.10 containing the historic correlation coefcients of different capital market investments. Discuss how you might approach using this information to adapt an investment strategy. What other information would you require to assist your judgement? Q5: Does modern portfolio theory suggest that a passive investment policy of holding a world Market Portfolio (weighted by market capitalisation) is best? Q6: Discuss the proposition that emerging markets provide the best opportunity for an investor to diversify his or her risk.
Practical assignment
From the perspective of your country of domicile, consider which international markets provide the maximum benets for diversifying risk. You may use the web sites listed to nd articles and nancial statistics.
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Chapter 8
Measuring Portfolio Risk, Return and Performance

Contents
8.1 8.2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Portfolio returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.2.1 What is responsible for the portfolio return? . . . . . . . . . . . . 8.2.2 Internal rate of return (IRR) . . . . . . . . . . . . . . . . . . . . . 8.2.3 Money-weighted rate of return (MWR) . . . . . . . . . . . . . . . 8.2.4 Time weighted rate of return (TWR) . . . . . . . . . . . . . . . . 8.3 Portfolio risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.3.1 What is responsible for the portfolio risk . . . . . . . . . . . . . . 8.3.2 Total, Market and Unique risk . . . . . . . . . . . . . . . . . . . . 8.4 Benchmarking performance . . . . . . . . . . . . . . . . . . . . . . . . . . 8.4.1 Controlling for currency uctuations 8.5 8.6 8.7 . . . . . . . . . . . . . . . . 8.4.2 Identifying components of performance . . . . . . . . . . . . . . Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 167 167 168 168 169 170 170 170 171 171 173 175 175 175
Learning Objectives On completion of this chapter students should be able to understand: the purpose of measuring performance of a portfolio of nancial securities; the key factors affecting the return on a portfolio; how to calculate the internal rate of return of a portfolio; how to calculate money-weighted rate of return of a portfolio; how to calculate the time-weighted rate of return of a portfolio; the distinction between total, unique and market risk in relation to portfolio performance; the importance of benchmarking a portfolio when assessing performance;
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Chapter 8. Measuring Portfolio Risk, Return and Performance
how to deal with currency in terms of assessing performance; and how to adjust performance measures for risk.
8.1. Introduction
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8.1
Introduction
In the last chapter we looked at the benets of international diversication and in particular how an investor can reduce his or her exposure to risk. Managers of funds are employed to manage a portfolio of investments, within the objectives of an institution. Examples of nancial institutions managing large international portfolios include life assurance, pension and investment trust companies. On behalf of the members of the institutions, a fund manager has the task of yielding the highest return for a given level of risk for a portfolio of investments. In the last chapter we identied the types of risk in an international environment. You should be aware by now of the danger in looking purely at historic returns in isolation as a guide to the performance of an investment. Understanding how an investor is exposed to risk during the period of return is crucial to assessing performance. Part of the performance of the portfolio will be attributable to factors associated with the selections of the fund manager and part with market movements (such as exchange rate and other general economic factors). Performance assessment, therefore, becomes important to an investor in assessing the effectiveness of the investment of his or her funds. We will consider in this chapter how to adjust for the measures of risk and return and how to benchmark performance.
8.2
Portfolio returns
You will be aware by now of the alternative ways in which returns on investment can be expressed. In assessing the performance of a portfolio of investments therefore it is important to be aware of the basis on which the return is calculated. We will look at three common ways of calculating returns on portfolios: internal rate of return (IRR); money-weighted rate of return (MWR) and time-weighted rate of return (TWR).
8.2.1
What is responsible for the portfolio return?
Before assessing the different methods of calculating portfolio returns it is worth reecting on how factors which create these returns can be classied. Figure 8.1 illustrates the different components of returns on a portfolio. rp where rp the total return on the portfolio j = the weight of each component part (n) of the portfolio C = the capital gain or loss of each component part (n) of the portfolio D = the income return from each component part (n) of the portfolio X = the currency gain or loss of each component part (n) of the portfolio Figure 8.1: The component parts of total returns from a portfolio The return on a portfolio will normally be expressed in the currency of the investor and therefore, the total return expressed will be adjusted for the exchange rate movements Heriot-Watt University Securities Markets 1 jn Cn jn Dn jn Xn
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of each segment of the portfolio. We will return to this expression later in the chapter. Now let us look at the different means of expressing rates of return.
8.2.2
Internal rate of return (IRR)
Many of you will be familiar with the IRR calculation, in relation to capital investment projects. The formula is shown in Figure 8.2. 0 = C0 where C0 Cn the initial cash investment the total cash ows received/paid in period n Figure 8.2: Formula for the IRR of a portfolio You may recall, if you have used IRR for capital investment decision making that it suffers from inherent aws to the calculation. The calculation may result in multiple IRRs if there are changes in the sign of cash ows during the investment period. The calculation of IRR is shown in example 1. C1
IRR)
1
C2
IRR)
2
Cn IRR)n
IRR = the discount rate for the capital investment opportunity with NPV of 0
Example : 1: An example of IRR A single security portfolio (Portfolio XXX) has a value of 1000 (at the start of the year). At the end of the year the price had increased to 1100. There was a dividend paid of 60 after six months. The IRR calculation is as follows: 50 1100 1000 = 1 (1 + r) (1 + r)2 The IRR (six-monthly rate) = 7.92 %
The IRR does take account of the time value of money, but due to its inherent aws it is not a foolproof method.
8.2.3
Money-weighted rate of return (MWR)
You will be familiar with the rate of return which calculates a holding period rate of return. This rate of return normally uses the initial investment as the denominator. When an investment has released some income return over its life, the rate can be made more meaningful by taking account of the time of the income being released. Figure 8.3 shows the formula of the MWR.
8.2. Portfolio returns P1 Dt P0 t D t P0 365
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MWR = Where:
P1 = The value of the investment in period 1 P0 = The value of the investment in period 0 Dt = The dividend paid at time t Figure 8.3: Formula for the MWR Example 2 uses the MWR formula to calculate the rate of return for Portfolio XXX.
Example : 2: An example of MWR

365
Dt
The MWR method does not suffer from the same aws as IRR. While it is simple to use, if there are many dividend payments it can require a fairly lengthy process.
8.2.4
Time weighted rate of return (TWR)
Where the MWR measure focuses on the return per capital invested over a holding period, the time weighted rate of return (TWR) provides a what if measure of return for comparison of returns over different time periods. As with the MWR it is important to identify the dividend income received and its timing. The formula for the TWR is shown in Figure 8.4. (1 + r) = (1 + rn )(1 + r n + 1 ) = Where: Rn = the TWR for the rst period (n) Pn = the value of the portfolio at period n P0 = the value of the portfolio at period 0 Dn = the dividend paid at period n Figure 8.4: Formula for the TWR Using the formula in Figure 8.4, an example of calculating the TWR for Portfolio XXX is shown in Example 3. P1 P1 P0 Pn Dn
Example : 3: Calculating TWR First we need to split the two 6 month periods (before and after) the cash is paid out.
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First 6 month period Pn rn P0
Second 6 month period P1 rn Pn Dn Second 6 month period 1100 rn + 1 1010 - 60
For Portfolio XXX:
First 6 month period 1010 rn or 1000 TWR (Total)

r = 16.7%
or
You will notice from Example 3 that the TWR calculation compounds the two rates of return from the two six month periods producing a quite different rate for Portfolio XXX during the period under consideration. The MWR and TWR as you can see are two different calculations and it is therefore crucial in assessing portfolio performance that the two are not confused or used interchangeably.
8.3
Portfolio risk
We now turn to risk, having identied different rates of return for portfolios. You will recall from the previous chapter that CAPM relies on a market portfolio that constitutes combinations of risky assets and the risk free asset. We established that through an indexed fund an investor can track world stock markets, and by combining investments in indexed funds an investor can achieve a world market portfolio. An investor can therefore adopt a sit and hold passive investment strategy or adopt an aggressive policy by identifying maximum risk reduction opportunities by selecting based on correlation coefcients.
8.3.1
What is responsible for the portfolio risk
Managers of funds attempting to beat the market will invest in a portfolio that will be a subset of the market, and therefore have a different risk. Managers who attempt to track the market are required to buy and sell securities based on market movements to ensure the portfolio continues to reect the weighted index. Tracking errors occur when a manager under performs the market index he or she is intending to track. Let us look a little further at the components of risk.
8.3.2
Total, Market and Unique risk
Within the context of a domestic capital market, you will recall that total risk of a portfolio (as measured by the standard deviation) is composed of market and unique risk. The standard deviation calculation is reproduced in Figure 8.5.
Portfolio =
XX
8.4. Benchmarking performance
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where
sum of the weights of investments
by their standard deviation
XX

the sum of the covariances for each investment pair
The double summation encapsulates the two times the weights of each investment multiplied by each covariance term. Figure 8.5: Total risk of a portfolio A fund manager attempting to beat the market will undertake greater unique risk in a search for excess returns. A passive investment fund manager may simply track the market as closely as possible, diversifying away the unique risk, linking exposure to only the market risk. Taking a similar analysis of an international portfolio, unique risk of different countries can be diversied when held as a world indexed fund. The market risk becomes the general world economic movements rather than those affecting individual countries. In assessing performance of fund managers, therefore, it is important to be aware not simply of the total portfolio risk in isolation but to compare performance with a suitable alternative portfolio with a similar risk prole. This is commonly referred to as benchmarking.
8.4
Benchmarking performance
Benchmarks are commonly used in many areas of performance measurement in todays world. Schools, universities and other education providers in the UK, (and many other countries worldwide), have key learning outcomes matched against institutions with similar aims and objectives. Airlines are often assessed in terms of key performance indicators (such as ight arrival times, number of complaints) benchmarked against key competitors. For fund managers of international portfolios it is important to adjust for risk. Benchmarking against portfolios from similar markets and risk categories can help achieve this. We would not normally expect an FT-All share index tracker fund to have the same performance as a fund investing solely in stocks and shares from emerging economies. In this section we will look at how we can breakdown the components of return from a portfolio to assess a managers performance. We will also look at adjusting performance measurements to take account of risk.
8.4.1
Controlling for currency uctuations
A UK investor in a portfolio containing US shares knows that he or she could gain or lose through the movement in the US$/ exchange rate. If the portfolio contains Japanese shares, the Yen/ exchange rate movement will also affect the portfolio return. The return on a portfolio may therefore be expressed as shown in Figure 8.6.
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Chapter 8. Measuring Portfolio Risk, Return and Performance wi pn p0 di ci
rp Where:
wi ri0
rp = the return on a portfolio i = one slice in the portfolio w = the weight of each slice in the portfolio (pn - p0 ) = the capital gain of each slice d = the income return of each slice c = the currency gain or loss from each slice Figure 8.6: Total return of a portfolio It is important to note that the capital gains and dividends are expressed in the base currency of the investor. The formula of Figure 8.6 shows that the return of a portfolio consists of the weighted average of the slices. A slice consists of a separate investment, for example, by country. The return on each slice consists of a capital gain component, a dividend component and a currency component. Figure 8.7 shows an example of a two-investment portfolio, one slice relates to an investment in Hong Kong shares and the other slice is in an investment in US shares.
Figure 8.7: Portfolio returns You will notice from Figure 8.7 that the capital gain and dividend income returns are calculated based on the local currency. The currency factor is based on the total investment, capital gains and dividends over the period.
8.4. Benchmarking performance
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8.4.2
Identifying components of performance
To assess a fund managers performance we need to take our analysis a step further. It is important to identify not only the income, capital gain and currency factor, but to assess whether the return is attributable to the manager beating the market. Remember that a fund manager may take a broadly passive strategy, leading to an allocation of investment in one market portfolio. Alternatively a manager may aggressively aim to beat the market through picking winners. The manager can therefore beat the market index in one of two basic ways: allocating funds in a different way to the market index weights, or by picking winners. Broadly of course, the two methods amount to much the same thing. An aggressive policy will mean excluding losers and increasing the relative weight of winners. In terms of performance measurement, we will look for a breakdown of each relevant factor. Figure 8.8 illustrates the breakdown in performance for a portfolio. rp =
wn dn +
wn (Sn - Mn ) +
(wn - Wn )Mn +
(wn cn - Wn Cn ) +
Wn Mnb
where rp = return on a portfolio wn dn = Yield (d) on the portfolio slice n, weighted (w) wn (Sn - Mn ) = The security selection n premium, measured by the capital gain (Sn ) of the portfolio slice (n) less the return on the market index (M n ), for the portfolio slice over the same period. (wn - Wn )Mn = The weight of the portfolio slice(wn) less the world market benchmark weighting (Wn) (wn cn - Wn Cn ) = The weighted proportion of the currency element (wncn) less the market benchmark weighting (c n Cn ) Wn Mnb = The return on the benchmarked World Market Portfolio (M nb ) for the portfolio slice at the benchmarked weight (W n ) Figure 8.8: Measuring performance of a portfolio Figure 8.8 looks daunting. Let us recap on what we are trying to achieve. A fund manager will be allocating funds in international securities on world markets. A standard World Market Portfolio benchmark (ie an index of shares from world capital markets, weighted by market capitalisation) is the IFC (International Finance Corporation) World Index, the MSCI (Morgan Stanley Capital International). Bear in mind that the benchmark used should be appropriate to the fund. If the portfolio fund in question is a Far East Emerging Markets Fund, then the appropriate benchmark should be a weighted index of Far-Eastern Capital Markets. The portfolio return is therefore broken down (in the Figure 8.8 formula) to show the relative strength of each portfolio slice and the contribution of each component part. The term portfolio slice refers typically to the investment in one sector of the world market (eg by country). A portfolio investing in the S+P 500 index; FT All Share; Hang Seng and CAC indices will have four portfolio slices for which the components shown in Figure 8.8 will be calculated. Heriot-Watt University Securities Markets 1
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Let us see how we can use the formula to assess the portfolio; the results are shown in Figure 8.9.
Figure 8.9: Components of portfolio performance Let us consider what Figure 8.8 tells us about the performance of the portfolio. The American shares did not perform as well as the index. The same applies to the Hong Kong shares, which were also outperformed by the index. The portfolio, however, did benet from the currency movement in the Hong Kong $. This movement more than offset the adverse change in the US $ exchange rate. The allocation between American and Hong Kong Stocks also meant that the poor American returns made less of an impact, relative to the Hong Kong returns, leading to a positive market allocation contribution. Use of the analysis method in Figure 8.9 can assist investors and fund managers alike in the review of asset allocation decisions.
8.5. Summary
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8.5
Summary
We have focused on the alternative measures of portfolio returns, and performance measurement tools in this chapter. The assessment of portfolio performance needs to be based on both risk and return. Fund managers investing in international capital markets are exposed to currency uctuations as they strive to achieve maximum risk diversication. We have looked at how a fund managers performance on security selection and asset allocation can be broken down between general market movements, and that specic to security selection. We have shown how, with the benet of an identied benchmark performance, a portfolios return can be decomposed.
8.6
Further Reading
Solnik, B.M., International Investments (4th Edition, 1999), Addison-Wesley
8.7
Q1:
Review Questions
Discuss the difference between the Money Weighted Rate of Return (MWR) and the Time Weighted Rate of Return (TWR) Q2: Identify the different categories of risk in an international portfolio of nancial securities. Q3: Discuss the need for a benchmark when measuring the performance of international portfolios.
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ANSWERS: Chapter 1
Answers to questions and activities

1 Bonds
Answers from page 21. Q1: a) The principal amount of a bond is the amount that will be repaid when the bond is redeemed. This amount is specied on the face of the bond. In the UK the amount is usually 100. The principal amount does not change throughout the life of the bond. (It is usually close to the amount that was paid for the bond when it was rst issued). The price of a bond is determined in an open market. It is the price at which the willingness of some investors to sell is balanced by the willingness of other investors to buy. It will vary from day to day throughout the life of the bond. b) Bonds are normally issued in units with a principal amount of 100 (the principal amount can also be called the nominal amount or the face value or the par value of the bond). If a company issues 350 000 such units, the amount of the bond issue will be 350 000 100 = 35 000 000 This is the total face value of all the bonds being issued at a particular point in time. A bond issuer is likely to have several different bond issues outstanding at any time. These bond issues will generally have different coupon rates and redemption dates. A large business organisation will be redeeming old bond issues and making new bond issues on a fairly frequent basis. c) A coupon is an amount of money paid each year by the bond issuer to the holder of a bond. Usually, the coupon is paid in two equal half-yearly instalments. The coupon rate is the coupon amount expressed at a percentage of the principal amount of the bond. Since the principal amount in the UK is generally 100, a coupon rate of 7% would equate to a coupon amount of 7.00 on each bond per year. Q2: The protection system for bondholders is quite different from the system for shareholders. Shareholders elect the board of directors. If they are dissatised with the directors, they can replace them. They also vote on other matters related to the management of the company. Bondholders do not have votes. Their investment can be protected in three main ways 1. The bond agreement may contain indentures (also known as covenants) which restrict the freedom of management in running the business. The indentures might specify that the debt/equity ratio of the company may not go above a specied level, and that net working capital must not fall below a certain amount. If the company fails to comply with the bond indenture, the bondholders are entitled to immediate repayment of the bond. 2. The bond agreement may offer bondholders security. Security is often consists of land or buildings. If the company fails to make payments of interest or principal the bondholders can sell the assets which have been offered as security and take the money which is due to them from the proceeds. Heriot-Watt University Securities Markets 1
ANSWERS: Chapter 1
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3. The bond agreement may offer bondholders seniority. The debts of the company are ranked from most senior to least senior - the seniority of any debt is determined by the debt agreement. If the company fails and is liquidated, the most senior debt is paid rst, then the second most senior, and so on until all the money from the liquidation has gone. Bondholders are protected if their bond has a high ranking in terms of seniority. Q3: Five major types of bond issuer are 1. Sovereign bonds, issued by national governments. 2. International Agency bonds, issued by agencies such as the World Bank and the International Monetary Fund. The leading developed countries are members of these organisations and agree their nancial structure, so these bonds are viewed as very low risk. 3. Local and Regional government bonds. Different countries have different constitutional arrangements. Some allow states/ provinces/regions/cities to issue their own bonds. 4. Bonds issued by Government Agencies and para-statal bodies. Many governments have set up government-owned bodies (national electricity organisations for example) which issued bonds under their own name, backed by their own revenues. The bonds are not explicitly guaranteed by the government, so these bonds do not have the status of sovereign credits. 5. Corporate bonds. These are private sector organisations. The bonds are backed by the assets and the potential cash to be generated by the business. Q4: a) A zero-coupon bond offers no interest payments during its life. The only cash-ow received by the bondholder is the principal amount paid at redemption. To make the bond attractive to investors, the bond must originally be issued at a substantial discount to the principal amount. By contrast, most bonds are issued at a price close to the principal amount. b) An exchangeable bond can be exchanged, at the option of the bondholder, for a specic quantity of another nancial asset on a specic date or dates in the future. The nancial asset usually consists of shares in another company. (If the bond can be converted into shares of the issuing company, it is a convertible bond). Company A may have acquired shares in company B as a result of a take-over or acquisition. If company A issues a bond which can be exchanged into company Bs shares, that would be an exchangeable bond. c) A oating-rate note (FRN) is a bond whose coupon varies from period to period, linked to some measure of current interest rates. For example, the bond might bear a coupon rate for each half-yearly period equal to LIBOR plus 0.65%. d) A puttable bond is one which allows the bondholder, at his option, to sell the bond back to the organisation that issued it. There will be specied dates and prices at which this option can be exercised. Puttable bonds can be very risky for the issuer. If the issuer gets into nancial difculty, the price of its bonds will fall, the bondholders will decide to exercise their put option, the issuer will have to nd the cash to buy back the bonds - and this will make the issuers nancial difculties even worse. Heriot-Watt University Securities Markets 1
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ANSWERS: Chapter 1
Q5: A rating agency categorises bonds according to its degree of condence that the bond will not default. The two best known agencies are Moodys and Standard and Poors. For S&P, the ratings (from the top) are AAA, AA, A, BBB, BB, B, CCC, CC, C, D. A bond rated BBB or above is investment grade. Generally corporate issuers pay the agencies to rate their bonds. The rating will be based, not just on the accounts and other published information relating to the bond and the issuer, but also on the outcome of meetings between the agency and company management at which management explains the companys policies and prospects. Most major companies want their bonds to qualify for, at least, an investment grade. For these companies, the rating agencies effectively limit the amount of bonds they can issue. Also, the higher the rating of a bond, the lower the coupon rate that the company has to offer. So ratings are very important to bond issuers. A junk bond is one which, at the time it is issued, has a rating below investment grade. Major international companies generally do not want to issue such bonds - but there are other companies which are so keen to raise money that they will issue bonds with junk status. A fallen angel is a bond which qualied for an investment grade at the time it was issued, but which has been re-rated during its life to a level below investment grade. This can happen if the company issuing the bond gets into a nancially weak position.
ANSWERS: Chapter 2
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2 Bond Yields, Prices and Bond Swaps

Answers from page 36. Q1: a) First we make a very rough estimate of the yield of this bond. At the current price of 110.20, the coupon gives an annual return of 10/110.20 = 9.1%, but the investor will suffer a capital loss of 10.20/110.20 = 0.067 or 9.3% over the three remaining years before the bond is redeemed. So the capital loss is about 3.1% per year. So an estimate of the yield on the bond is 9.1% - 3.1% = 6.0% per year or, roughly, 3% per half year. The bond pays interest half-yearly. We need to nd the (halfyearly) interest rate at which the NPV of the cash ows from buying the bond and holding it to maturity equals zero. The cash ows, which are received at half-yearly intervals, are (110.20) 5 5 5 5 5 105 We proceed by trial and error. Try 3%. At this rate 5 5 5 5 105 105 + + + + + NPV (3% ) + 1.03 1.03 1.03 1.03 1.03 1.03 0.63 Note: It is possible to evaluate each of the terms in this expression and sum them. But a quicker method is to value an annuity of 5 for 6 periods at 3% using the annuity tables; add in the present value of 100 in 6 periods time using the discounted value table; and then subtract the initial investment. This gives (5 5.417) + (100 0.8375) - 110.20 = 0.63 Note that, if the price of the bond was 110.83 the return would have been exactly 3.0% per half year. Actually it can be bought more cheaply than that (110.20) and at a lower price it will give a slightly higher return. Try 4%. Using the tables NPV(4%) = (5 5.242) + (100 0.7903)- 110.20 = -4.96 Clearly the rate is much closer to 3% than 4%. Going from 3% to 4% would lower the price by 0.63 - (-4.96) = 5.59 (). We want to nd the interest rate which lowers the price by 0.63 (relative to the price that yields 3%). So by interpolation, the interest rate is 3 + 1.0 0.63 5.59 We have now found the interest rate per half year. To convert this to an annual rate using the US/UK convention, simply multiply by 2. Yield to maturity (US/UK convention) = 3.11 2 = 6.22(%) b) The US/UK convention is an inaccurate measure of the true yield because it ignores the fact that interest rates operate in a compound manner. If wealth increases by a factor of 1.0311 over a half year period, over a whole year it will grow by 1.03112 = 1.0632 and the true annual yield to maturity is 6.32% Q2: a) The yield to maturity of a bond is the interest rate which gives zero net present value from buying the bond today and holding it to maturity. We calculate the yield to maturity of bond A by trial and error and interpolation. At 5% the NPV is = 1.85() Heriot-Watt University Securities Markets 1
180
ANSWERS: Chapter 2
At 6% the NPV is = -1.53() The yield to maturity (at which NPV would be zero) is clearly between 5% and 6%. It is a bit closer to 6% than 5%. By interpolation, the yield to maturity is 5% + 1%
1.85 (1.85 + 1.53)
b) The interest yield is the coupon amount divided by the current market price. For bond A this is 4/ 94.60 = 0.0414 or 4.14% c) The real yield (R) is calculated from the yield to maturity (N) and the ination rate (I) using the relationship + N) 1 + R = (1 (1 + I) in this case 1 + R = 1.0555 1.03 so the real yield is 0.0248 or 2.48%. Q3: a) When a bondholder receives interest, he generally has to pay income tax on the money received. If a bondholder makes a capital gain (by selling a bond for a higher price than he paid) the gain is usually subject to a lower tax rate, or no tax at all. A bondholder can avoid paying any income tax by buying a bond just after it goes ex-dividend and selling it six months later just before the next ex-dividend date. The bondholder makes a capital gain but does not receive any income. This can save tax for the bondholder. It is called bond-washing. In the gilts market, investors are quoted a clean price, but, in addition, the buyer must pay (and the seller must receive) any accrued interest since the last exdividend date. In this way all bond investors have to receive interest for the period of time that they hold the bond, and bond-washing becomes impossible. b) In addition to the quoted price, the purchaser must pay accrued interest. Accrued interest is usually a positive amount (and it is positive in this example), but it can be negative if a bond is purchased between the ex-dividend date and the actual payment date for the dividend. In this example, 125 days interest is 125 365 So the actual price paid by the purchaser is 115.60+ 3.77 = 119.37 Q4: The price at which gilt-edged securities are sold is set by auction. The only buyers allowed to participate in the auction are the primary dealers appointed by the Bank of England. In return for the privilege of being allowed to bid, the primary dealers agree that they will always participate in the auction - so the Bank of England is certain that all the bonds it offers will be sold. The price of a eurobond is generally agreed between the issuing company and an investment bank which acts as a lead manager for the issue. The eurobond issue will be underwritten and the lead manger will have found a group of banks to do the underwriting. Because the eurobond has been underwritten, the issuing company can be sure that the bonds will be sold and that cash will be raised. But this system is expensive, because underwriters charge a substantial fee.
ANSWERS: Chapter 2
181
Q5: a) An interest rate swap is benecial for a pair of companies if i ii one of them prefers to borrow at a xed rate and the other prefers a oating rate the company that prefers the oating rate has a comparative advantage in the xed rate market.
In this example, Benbow has an absolute advantage in both xed and oating debt. But its advantage is greater in the xed rate market, so it has a comparative advantage in xed borrowing. In an interest rate swap, each company borrows in the market where it has a comparative advantage. They agree to make side payments between themselves so that the company which wanted a oating rate effectively pays a oating rate (even though it has borrowed on a xed basis), and the company that wanted a xed rate effectively gets a xed rate. The side payments are set at a level which ensures that both parties gain from the swap - compared to borrowing directly in the market that they preferred. b) If the two companies borrow in the markets they prefer, then Benbow pays LIBOR + 0.3% and Hawkins pays 7.20% - a total of LIBOR + 7.50%. If the companies borrow in the markets where they have a comparative advantage, then Benbow pays 5.80% and Hawkins pays LIBOR + 0.8% - a total of LIBOR + 6.60%. So the total interest rate saving that can be made is the difference between the two totals, which is 0.90%. c) i Benbow pays LIBOR to Hawkins and receives 6.10% in return. And Benbow has borrowed in the xed market at 5.80%. So the effective cost to Benbow is LIBOR + 5.80% - 6.10% which is LIBOR - 0.30%. This is a gain of 0.6% compared to borrowing directly at a oating rate. Hawkins pays 6.10% to Benbow and receives LIBOR in return. And Hawkins has borrowed in the oating market at LIBOR + 0.8%. So the effective cost to Hawkins is LIBOR + 0.8% + 6.10% - LIBOR which is 6.90%. This is a gain of 0.3% compared to borrowing directly at a xed rate. Hawkins pays 6.10% to Benbow and gets LIBOR in return. Only the net amount is exchanged between the two parties. If LIBOR is 5.20%, then Hawkins pays 6.10% - 5.20% = 0.90%. For a half-yearly period on a loan of 50m, the amount paid by Hawkins is 50m 0.5 0.0090 = 225000
ii
182
ANSWERS: Chapter 3
3 Bond Price Sensitivity

Answers from page 53. Q1: Three different types of risk are:
1. Credit risk. This is the risk that the bond will default and will fail to make the promised payments of interest and principal. Even if a bond is not currently in default, the price of the bond will reect the probability that the bond will default in the future. The price of the bond will rise and fall as the likelihood of default decreases or increases. A sovereign bond issued by a major developed economy will have a very low level of credit risk. 2. Ination risk. Even if the bond makes all the promised payments, a bond investor can still suffer if unforeseen ination has eroded the purchasing power of those payments. 3. Interest rate risk. The market price of a bond is the value of the promised payments discounted at the appropriate current market interest rate. If interest rates rise, the market price of the bond will fall. An investor who holds the bond to maturity will receive the yield-to-maturity that he was promised when he bought the bond (assuming no default). But the return received by an investor who buys the bond and sells before maturity will be subject to interest rate risk. There are bonds that are almost completely risk-free as far as credit risk is concerned. But all bonds are subject to ination risk and interest rate risk. Q2: 1. The price of the bond if it offers a yield to maturity of 4% is 6 6 6 6 6 + + + + P= 2 3 4 1.04 (1.04) (1.04)5 (1.04) (1.04)

2. The duration is the weighted average period of time before the cash ow from the bond is received. In this calculation, each cash ow is measured by its present value. If the present value of the cash ow to be received t years in the future is PV(t), then the duration formula is
t.PV (t) PV (t)
The denominator of this expression is simply the current market price of the bond. The duration calculation is as follows t PV (t) t. PV (t) 1 2 3 4 5 5.77 5.55 5.33 5.13 87.12 108.90 So the duration of Bond X is
488.98 / 108.90
5.77 11.10 15.99 20.52 435.60 488.98
= 4.49 (years) Heriot-Watt University Securities Markets 1
ANSWERS: Chapter 3
183
3. Modied duration = Duration* 1 1 / 1+ yield So in the case of Bond B Modied duration = 4.49 1 /1.04 = 4.32 (years) 4. Measures of duration are useful to investors because they measure the sensitivity of a bonds price to changes in its yield to maturity. They therefore help to measure the interest rate risk associated with the bond. - % change in bond price Duration measures % change in (1 + y) where y is the yield to maturity. - % change in bond price Modied duration measures % change in yield 5. Using the relationship % change in bond price = -Modied duration change in yield we have % change in Bond X price= -4.32 -0.25 (since the yield has fallen by 1/4 per cent) = 1.08 So the new price is 108.90 (100 +1.08) /100 = 110.08 () 6. Using Modied duration to estimate the new bond price after a change in the yield will not be entirely accurate. The calculation using Modied duration assumes that the relationship between bond price and yield is a straight line. In fact the relationship is not linear - it is convex. For this reason, a calculation of the new price based on Modied duration will always be a slight underestimate of the true value. The larger the change in yield, the greater the underestimation will be. For small changes in yield, calculations using Modied duration work well. Q3: a) The duration of a bond is the average number of years that a bondholder has to wait to receive his money. The money in the formula is measured as the present value of each of the future cash ows. So the general relationship is that the longer the remaining life of the bond, other things equal, the greater the bond duration (in certain cases, for bonds with very unusual characteristics, this relationship may not hold). b) The coupon payments are received throughout the life of the bond. The principal repayment is only received at the end of the bonds life. The larger the coupon, the more cash ow is received before the end of the bonds life and the shorter the duration. For a zero-coupon bond, duration is equal to the number of years to maturity. For a coupon bond, the duration is less than this. The higher the coupon, the more the duration is shortened. c) Duration is the link between price volatility and yield volatility. If yields were equally volatile for all bonds the price volatility of any bond would be directly proportional to its duration. A bond with a Modied duration of 6 years would have twice the price volatility of one with a Modied duration of 3 years. However, yields on short term bonds tend to uctuate more than those of long term bonds. For this reason, the price volatility of bonds is not strictly proportional to their duration.
184
ANSWERS: Chapter 3
Q4: a) Bond immunisation is an investment strategy followed by many major nancial institutions. Life insurance companies are a good example. They have written a lot of insurance policies and they can forecast with a considerable degree of accuracy how much money they will have to pay out on the policies in each future year. To cover these liabilities, they will invest in bonds. But bonds are subject to interest rate risk. The life insurance company wants to make sure that, even if interest rates change unexpectedly, the value of their assets will cover their liabilities. Immunisation helps to achieve this objective. The cash outows and their dates are known, so it is possible to calculate the duration of the liabilities. Then a portfolio of bonds is purchased with a weighted average duration that just matches the duration of the liabilities. If all interest rates (short term/ medium term/longterm) all go up or down by X%, the change in value of the bond portfolio will exactly match the change in the present value of the liabilities. The life insurance company has carried out an immunisation strategy. This strategy will work perfectly as long as there are parallel shifts in interest rates - short rates and long rates move by equal amounts. If interest rates do not move in this way, then the immunisation strategy will not be completely effective. b) Bond convexity refers to the fact that the relationship between bond yield and bond price is not a straight line. The line curves as shown in the diagram below.
Duration and Modied duration numbers are usually used to calculate how a bond price will respond to a change in its yield. However, this technique assumes a linear relationship. The true bond price (after a change in yield) will always be a little higher than the duration formula predicts. The greater the convexity of a bond or bond portfolio, the higher the price will be. Professional bond investors calculate the convexity of their portfolios. Other things equal, the higher the convexity the better.
ANSWERS: Chapter 4
185
4 Yield Curves and the Term Structure of Interest Rates

Answers from page 78. Q1: A yield curve is a diagram showing how yield-to-maturity varies with life-to-maturity for any specic category of bonds. The bonds included in the yield curve must be of equal credit standing (often the bonds are all government guaranteed), denominated in the same currency and paying the same coupon (the curve is often drawn for zerocoupon bonds). A yield curve can be upward sloping or downward sloping. It can be humped or U shaped. In general, the short end of the yield curve is likely to be more sloped (either upward or downward) and the long end is likely to be atter. The government (or other policy-making body) can determine the short term interest rate, but the market determines the long term rate. A high short-term interest rate and a downward sloping yield curve is usually associated with an economic boom which the government is trying to restrain by setting a high short-term rate. An upward sloping yield curve is usually associated with a depressed economy that the government is trying to stimulate. This model assumes that governments can set short term interest rates. Some governments peg the value of their currencies. For example, the Hong Kong government has pegged the value of its currency to the US dollar. In this case, Hong Kong will have interest rates linked to US rates, and the Hong Kong government cannot use interest rate policy to stimulate or slow down the local economy. Q2: a) A spot rate is an interest rate for a loan which starts immediately. The symbol 0 s3 , for example, refers to the interest rate for a loan which is made now and which is repaid (in one lump sum) in three years time. A forward rate is an interest rate which can be agreed today for a loan which which will not start until some time in the future. The rate 1f2 is the interest rate for a loan which is arranged today, but where the loan does not start until 1 year from now the loan is repaid 2 years from now. b) We use the relationship (1 + 0 s2 )2 (1 + 2 f3 ) = (1+ 0 s3 )3 In this example 1.0382 (1 + 2 f3 ) = 1.0363 1 + 2 f3 = 1.112 /1.077 = 1.0320 2 f3 = 3.20% This calculation is not based on any theory of the yield curve. It is simply based on the denitions of spot rates, forward rates and the relationship between them. (1 + 0 s4 )4 (1 + 4 f5 ) = (1+ 0 s5 )5 In this example 1.0354 1.041 = (1 + 0 s5 )5 1.1475 1.041= 1.1946 = (1 + 0 s5 )5 1 + 0 s5 = 1.0362
c) We use the relationship
186
ANSWERS: Chapter 4
= 3.62% This calculation is not based on any theory of the yield curve. d) According to the Pure Expectations Theory of the yield curve, the forward rate for any time period is the markets expectation of the spot rate that will exist over that same period of time. E2 s4 = 2 f4 The answer to this question is therefore found by calculating 2 f4 - the interest rate that covers a two year period starting two years from now. We use the relationship (1 + 0 s2 )2 (1 + 2 f4 )2 = (1+ 0 s4 )4 In this example 1.0382 (1 + 2 f4 )2 = 1.0354 1.0774 (1 + 2 f4 )2 = 1.1475 1 + 2 f4 = 1.0320 2 f4 = 3.20% Q3: The UK investor will have to choose between investing his money in short-dated, medium-dated or long- dated bonds. He is investing over a six year horizon. So possible investment strategies are 1. He could buy a bond that matured in 6 years time. 2. He could buy a sequence of one year bonds, rolling-over his investment whenever a bond matured. 3. He could buy a long-term bond - for example a 20 year bond - and sell it when his contract ends in six years time. With strategy 1, the investor knows how much money he will get in 6 years time. There is no default risk and no interest rate risk. However, the bonds will suffer from ination risk. The outcome of strategy 2 depends on future movements in interest rates. If interest rates rise, then the overall return over the six years will exceed the return from investing in a six-year bond. If interest rates fall, the return will be worse than the six year bond. However, since interest rates tend to move with ination, this strategy would reduce the ination risk. The outcome of strategy 3 also depends on future interest rates. This strategy will work well if interest rates fall (so that the 20-year bond can be sold at a high price at the end of year 6), but it will be unsuccessful if interest rates rise. There will be substantial interest risk and ination risk. So the best strategy to follow would depend on the investors forecast of future interest rates. If a rise is forecast - go for strategy 2. If a fall is forecast - go for strategy 3. The Pure Expectations Hypothesis states that the expected returns from strategies 1, 2 and 3 will all be the same. If the yield curve is at, this means that interest rates are expected to remain at their current level. In this case, strategy 1 will have the advantage of avoiding interest rate risk. The Liquidity Preference theory suggests that long-dated bonds will, on average, give a slightly higher return. The investor could benet from this return premium by choosing strategy 3 - but this strategy also involves substantial interest rate risk.
0 s5
ANSWERS: Chapter 4
187
The Preferred Habitat theory suggests that investors have preferences for particular maturities, and that, depending on the balance of supply and demand at specic maturities, some bond strategies will offer higher returns than others. If the investor could identify that the bond demand was low relative to supply for, say, 20 year bonds, he could take advantage of that fact by following strategy 3. Q4: a) The Pure Expectations Hypothesis states that forward interest rates are the best possible forecast of future spot rates over any specic time period. If this is true, the yield curve today can be used to forecast future interest rates, and the yield curve today can be used to forecast future yield curves. If this hypothesis is true, all bond investment strategies over a specic investment horizon will offer the same expected return. The evidence suggests that the PEH does have forecasting power. Forecasts of future interest rates based on PEH are more accurate than the nave assumption that the yield curve will not change. However, the PEH also predicts that, on average, the yield curve will be at. This is not the case. Upward-sloping yield curves are more common than downward-sloping ones. b) Liquidity Preference suggests that, because long-bonds exhibit more price volatility, they should offer, on average, a higher return. Investors in long bonds should receive a risk-premium compared to investors in shorts. This model predicts that the yield curve should, on average, slope upward - and this prediction is supported by the evidence. c) The Preferred Habitat Theory states that bond issuers and bond investors have specic maturities that they prefer. They require an extra return to tempt them away from their preferred maturity. It follows that some maturities (where the natural demand exceeds the natural supply) will offer low returns. Maturities where supply exceeds demand will offer high returns. The theory does not predict the maturities at which these high and low returns can be obtained. The model is therefore consistent with any shape of the yield curve. If the theory is correct, a very large issuer (such as a government) could alter the shape of the yield curve depending on the pattern of short, medium and long bonds that it issued. Some governments clearly act on the basis that this is true, but the Preferred Habitat theory is difcult to test. d) The Market Segmentation theory is an extreme case of the Preferred Habitat model. It states that the different maturity sectors of the market are entirely separate markets each with their own supply and demand. There is no logical link between the interest rates at different points on the yield curve. The fact that current long interest rates do have some forecasting power for future short rates (see Pure Expectations above) is evidence against the strong Market Segmentation theory.
188
ANSWERS: Chapter 5
5 Currency Exchange Rates

Answers from page 108. Q1: a) The dealers in the FOREX realize prot from the following sources. The Bid-Offer spread, where Bid is the highest price a prospective buyer is prepared to pay at a particular time for a trading unit of a given security or currency, and Offer is the lowest price acceptable to a prospective seller of the same security or currency. The difference between the two prices is the spread, which constitutes a source of revenue for the dealers in the FOREX. Commissions charged on all foreign exchange transactions (such as buying, selling or trading currency). Legal trading prots occuring when the dealers hold a long position in currencies that appreciate or a short position in currencies which depreciate in value. b) Exchange rate arrangements between markets are ofcially classied into 3 major categories. The exchange rate is xed to a number of currencies or to gold. An example was Argentina in 1991. The exchange rate is adjusted daily according to a set of macroeconomic indicators such as ination, interest rate. and other market trends. Examples: the EURO, the American dollar, the Japanese Yen. The exchange rate is pegged to a single currency or to a basket of currencies. Examples: the Brazilian Reals, the Canadian dollar and each currency joining the EURO. c) (i) The number of units of local currency exchangeable for one unit of a foreign currency is called a direct quote. (ii) An indirect quote is the reciprocal of a direct quote; i.e. the number of units of foreign currency exchangeable for one unit of local currency. (iii) Cross exchange rates are exchange rates computed by referral to a third currency. (iv) Arbitraging to take advantage of any cross exchange rates mispricing is called triangular arbitrage since it involves dealing with three currencies. Q2: a) Direct Quotes. (How many $ cost one unit of foreign currency?) b) USD/DM = 1/0.6874 = 1.45475 (i.e. 1 USD buys 1.4575 DM) USD/JPY = 1/0.00779 = 128.369 (i.e. 1 USD buys 128.369 JPY) USD/GBP = 1/1.9905 = 0.5024 (i.e. 1 USD buys 0.5024 GBP) c) i DM/JPY = 128.369/1.45475 = 88.24 (i.e. 1 DM buys 88.24 JPY) ii GBP/DM = 1.45475/0.5024 = 2.8956 (i.e. 1 GBP buys 2.8956 DM) iii GBP/JPY = 128.369/0.5024 = 255.51 (i.e. 1 GBP buys 255.51 JPY)
ANSWERS: Chapter 5
189
Q3: Yes, triangular arbitrage is possible. True Cross rate : 0.9116/1.5802 = 0.577 i.e. 1 Euro = 0.577 Since the true (as calculated above) cross rate is different from the one quoted by ABN bank, triangular arbitrage is possible 1. You have $5 000 000. First, buy Euros with this money. The amount you buy is:
($ 5 000 000) 0.9116
= Euros 5484861.78
2. Then convert the European currency in British Pounds: Euros 5484861.78 0.5877 = 3223453.27 3. Finally, sell your British currency and buy back American dollars: 3223453.27 $ 1.5802 = $ 5093700.86 4. You started with $5000000 and you now have $5093700.86 Prot: $93700.86 Q4: Yes, triangular arbitrage is possible, since the true cross rate differs from the one quoted: True Cross rate :
CAD/USD DM/USD
= CAD/DM = 3
3.02 (quoted CAD/DM)
1. You have $1000000. First, buy Canadian dollars with this money. The amount you buy is: ($ 1000000) = CAD 1111111 0.9 2. Then convert the Canadian currency to German Marks: CAD 1111111 3.02 = DM 3355555.2 3. Finally, sell your German currency and buy back American dollars DM 355555.2 0.30 = $ 1006667 4. You started with $1000000 and you now have $1006667. Prot: $6667 Q5: Q6:
190
ANSWERS: Chapter 6
6 International Exchange Rate Parity Theories

Answers from page 141. Q1: a) b) i ii
0S 0S
Price level UK Price level GREECE
Price level UK = 0.677

= 1.0769 GBP/TLR
1000 = 677 GBP
1 + ID 1 + IF
1.12 1.04
According to PPP, since the reported spot GBP/TLR exchange rate is lower than the one estimated in (i), then the TLR must depreciate by: % change in GBP/TLR exchange rate = 1.12 /1.04 - 1 = 0.0769 p.a. or 7.69% per annum.
Q2: a) Diet Coke Index
b) If the Implied PPP is higher than the reported (actual) exchange rate, the foreign currency is expected to appreciate relative to the USD. The British Pound, DeutcheMark, Indonesian Roupiah etc. belong in this category. If the Implied PPP is lower than the reported (actual) exchange rate, the foreign currency is expected to depreciate relative to the USD. The Chinese Yuan, Singapore dollar and Swiss franc belong in this category. Q3: The JOEP table is useful as it compares the cost of living between countries. So, in the case of Greece the basket of goods and services costs 100 (intersection of 17th row and 16th column in the JOEP table). Going down the 16th column (Greece) we can nd the countries in which this basket costs less than 100 and recommend them as cheap holiday resorts for Greek citizens. Korea, New Zealand, Czech Republic, Hungary, Poland, Portugal, Slovak Republic and Turkey belong in this category. Q4: a) This information suggests that other factors besides ination differentials inuence exchange rate movements. These factors may be interest rate differentials, gross domestic product (GDP) growth levels, level of country borrowing, budget decit Heriot-Watt University Securities Markets 1
ANSWERS: Chapter 6
191
etc. Thus, exchange rate changes will not necessarily conform exclusively to ination differentials and therefore the Purchasing Power Parity will not necessarily hold. b) The International Fisher Parity states that any currencys value will adjust in accordance with the interest rate differential between the two countries. Consequently, a rm that consistently buys foreign Treasury Bills (T-Bills) will on average earn a similar return to that if it had bought domestic T-Bills. Q5: a) We know that the current GBP/BRR exchange rate is 0 S = 5. Thus, according to IFP the one-year forward exchange rate is: 1 + ID 1.15 5.23 1 F = 0 S 1 + IF = 5 1.1 Similarly, the two-year forward exchange rate is:
2F
= 0S = 0S
(1 + ID )2 (1 + IF )2 (1 + ID )3 (1 + IF )3
=5 =5
1.182 1.10752 1.223 1.11253
= 5.68 = 6.59
Finally, the three-year forward exchange rate is:

3F
b) Current real rate of interest in Brazil:

+ N) (1 + R) = (1 (1 + I) where: R = Real interest rate = unknown I = Ination rate = 10% N = Nominal interest rate = 15% 1.15 = 1.04545 (1 + R) = 1.10
Brazilian real rate of interest = 4.545% c) Current rate of ination in the UK: (1 + N) (1 + I) = (1 + R) 1.10 I) = 1.04545 Annual rate of ination in the UK = 5.22% d) If real interest rates are equal, differences in interest rates between the UK and Brazil must be due to differences in expected rates of ination. With higher ination in Brazil and for the Purchasing Power Parity to hold, the BRR must be expected to depreciate against the GBP. Q6: a) The expected spot CAD/ARS exchange rate: 1 S = 0 S + forward premium 1 S = 2.1575 + 1.85 1 S = 4.0075 CAD/ARS b) Since the expected spot CAD/ARS exchange rate calculated in (a) is higher than the current one, the Argentinean peso (ARS) is expected to depreciate against the Canadian dollar (CAD). Heriot-Watt University Securities Markets 1
192
ANSWERS: Chapter 6
Q7: a) If the Interest Rate Parity holds, the GBP/EUR exchange rate expected in 6 months time (1st July 2000 . 1st January 2001) is: 1 + ID 1.04 1.63 1.6222 GBP/ EUR 1F = 0S 1 + IF You can calculate the 6-month interest rate either by taking the square root of the annual interest rate as above, or by dividing the annual interest rate by 2 as follows: 1 + ID 1.02 1 F = 0 S 1 + IF = 1.63 1.025 = 1.6220 GBP/EUR In the rst case we assume that the interest rate is compounded; in the second that the interest rate is simple. b) Total amount of EUR required on 1.1.2001, is: 250 pairs 50 EUR = 12500 EUR On the 1.7.00, the total amount of EUR to be deposited in an Italian Bank in order to have 12500 EUR at the end of the 6 month period, is: EUR The amount of GBP needed to be exchanged into 12199 EUR is: GBP (i.e. 12199 EUR at todays exchange rate of 1.63 GBP/EUR equal 7484 GBP) So, we will need today 7484 GBP which we will convert to EUR and immediately deposit it in an Italian bank account at 5% p.a. for 6 months, in order 6 months later (i.e. on the 1.1.01) to have the exact amount of EUR (i.e. 12 500) to pay the Italian shoe manufacturer. Q8: a) Compare your answer to the relevant parts of the chapter. b) Refer to Summary. Q9: Q10: Q11: Q12:
ANSWERS: Chapter 7
193
7 International Portfolio Diversication

Answers from page 162. Q1: Typically the following are issues for investors in international capital markets: Efciency of the market The importance of information availability and liquidity of the market will affect the reliability of share values. Taxes and Transaction Costs Both factors will be a cost to the investor, in particular withholding taxes on returns from shares that cannot be reclaimed through a double taxation treaty. Exchange rates The volatility of exchange rates of the domestic currency with the currency of the dividend or capital gain can have a signicant impact on an investor. Currency hedging can reduce the impact of this factor. Q2: Indexed funds provide an investor with the ability to achieve signicant diversication across a market or sector, for a relatively low level of investment. Tracker funds of markets mean that an investor can spread his or her investment across world markets as well as domestic sectors. Figure 7.11 illustrates the weighted world market portfolio that can guide an investor as to the scale required to invest in tracker funds, for worldwide markets (based on GDP). Q3: It may seem paradoxical but as has been illustrated in Figure 7.9, there are risk reduction benets from spreading investments in emerging markets. Always remember that volatility can be good for an investor. What becomes important, as an investor diversies, is the market not the unique risk. In a world portfolio, the general international market risk dominates the portfolio volatility, rather than individual emerging market uctuations.
Answers from page 163. Q4: The key is to know whether the investor is passive or aggressive. If passive, the objective will be to combine each of the indexed shares from each market in a market capitalized weighted portfolio. An aggressive approach would use the information provided to reduce the overall risk of a portfolio and focus investment on the negative and zero correlated markets to his or her own domestic market. Considerations will include: Volatility of currency uctuations and cost of hedging, Efciency of capital markets, Expected returns in the future (for non-semi-strong form efcient markets), Expected returns and risks from international bond investments, Expected differences to future correlation coefcients (ie Figure 7.10 shows historic calculations), and The scale of transactions and tax costs. Heriot-Watt University Securities Markets 1
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ANSWERS: Chapter 7
Q5: Passive investment reduces transaction costs and management costs of an investors portfolio. You will recall that the capital asset pricing model found that a market portfolio dominated all other portfolios. It is more complex when taking the analysis into international markets, as the simplifying assumptions of the CAPM become unrealistic (eg homogeneous expectations and the impact of exchange rates). Remember also that the analysis of the benets of international diversication discussed in this chapter relates to nancial securities. CAPM assumes the market portfolio consisting of wider types of investment. A more rigorous analysis is required to explore this issue. This chapter has explored some of the benets in terms of the efcient frontier. Q6: The proposition that emerging markets provide the most effective means of risk diversication is dependent upon the uctuations with an investors market of domicile. This will be affected by the political and economic risk that affects returns in the respective countries. So, for example, countries that are exporters of oil will generally have returns moving in different directions to countries that are generally net importers of oil. Returns also move in generally opposite directions when considering two countries; eg Country A (that is a net exporter of goods and services to Country B), when there is a change in exchange rate between Country A and Country B. Of course, there may also be general economic factors such as interest rates and ination, that also mean returns from shares in different countries move in generally the same direction also. Emerging markets often provide the greatest risk reduction possibilities because returns are generally more volatile than developed markets.
ANSWERS: Chapter 8
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8 Measuring Portfolio Risk, Return and Performance

Answers from page 175. Q1: The money weighted rate of return refers to the return over the relevant holding period. The time weighted rate of return expresses the return to enable comparison across time periods. Q2: The types of risk referred to in an international portfolio of nancial securities include: Total (market and unique) Market, and Unique. Q3: To analyse performance of investments it is important to compare BOTH Risk and Return. To do this it is necessary, when controlling for risk, to establish a suitable category of risk for an international portfolio, to ensure that the return can be compared. Standard deviation is the traditional means with which to compare. It is important in doing so to control for the uctuation of currency of the benchmarked investment.

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Heriot-Watt Management Programme

Ian Hirst Michael A Kerrison Alexandra Berketti

4.9 4.10 4.11 4.12 4.13

Heriot-Watt University Securities Markets 1

176 176 179 182 185 188 190 193 195

Heriot-Watt University Securities Markets 1

The size and growth of the bond markets

Securitisation - the case of the Rock dinosaurs

1.3. Basic bond characteristics

Basic bond characteristics

1.4. Bond issuers

Heriot-Watt University Securities Markets 1

1.4. Bond issuers

1.6. Types of bond

1.6. Types of bond

Heriot-Watt University Securities Markets 1

Heriot-Watt University Securities Markets 1

1.6. Types of bond

1.7. Bond default

Heriot-Watt University Securities Markets 1

Heriot-Watt University Securities Markets 1

1.8. Bond rating agencies

Bond rating agencies

Heriot-Watt University Securities Markets 1

1.8. Bond rating agencies

Heriot-Watt University Securities Markets 1

Bond ratings and efcient markets

Heriot-Watt University Securities Markets 1

Bond Yields, Prices and Bond Swaps

Chapter 2. Bond Yields, Prices and Bond Swaps

Bond yields with annual coupon payments

7 7 7 7 107 + + + + 1.06 1.06 1.06 1.06 1.06

2.3. Bond yields with semi-annual coupon payments

7 7 7 7 107 + + + + 1.05 1.05 1.05 1.05 1.05

Bond yields with semi-annual coupon payments

1.68 (1.68 + 3.83)

per half - year

Chapter 2. Bond Yields, Prices and Bond Swaps

In our example, this is

Heriot-Watt University Securities Markets 1

2.6. Bond price quotations

7 7 7 107 7 + + + + 1 + N 1 + N 1 + N 1 + N 1 + N 7 7 107 7 7 + + + (1 + I)(1 + R) + (1 + I)(1 + R) (1 + I)(1 + R) (1 + I)(1 + R) (1 + I)(1 + R)

Bond price quotations

Heriot-Watt University Securities Markets 1

Chapter 2. Bond Yields, Prices and Bond Swaps

2.6. Bond price quotations

Heriot-Watt University Securities Markets 1

Chapter 2. Bond Yields, Prices and Bond Swaps

Bond issuance and bond trading

2.8. Bond swaps (Interest rate swaps)

Bond swaps (Interest rate swaps)

Chapter 2. Bond Yields, Prices and Bond Swaps

2.8. Bond swaps (Interest rate swaps)

Chapter 2. Bond Yields, Prices and Bond Swaps

X borrows at a xed rate of X effectively pays a oating rate of

5.75% LIBOR + 0.10%.

Risk in interest-rate swap

Heriot-Watt University Securities Markets 1

2.8. Bond swaps (Interest rate swaps)

Banks and swaps

Heriot-Watt University Securities Markets 1

Chapter 2. Bond Yields, Prices and Bond Swaps

2.10. Review Questions