ECO802 International Finance and Banking
1 Corporate Budgeting Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its current capital structure has a 10% weight in equity, 20% in preferred stock, and 70% in debt. The cost of equity capital is 16%, the cost of preferred stock is 10%, and the pretax cost of debt is 8%. What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?
2 Options Suppose a stock is priced at $50. You are bullish on the stock and are considering buying March calls with an exercise price of $45 and $55, respectively. The 45 call is priced at $8.50 and the 55 call is quoted at $2.75. What is the time value for a $45 call and what is time value for a $55 call?
1 Currency Manipulation
Very often governments seek to alter the market's valuation of their currency by influencing relative interest rates, thus influencing the economic fundamentals of exchange rate determination rather than through direct intervention in the foreign exchange markets. Analyze how this strategy works.
2 Carry Trade
The authors develop an application of uncovered interest arbitrage (UIA) known as "yen carry trade." Analyze how does yen carry trade work. (10 marks) Why would an investor engage in the practice of yen carry trade and is there any risk of loss or lesser profit from this investment strategy?
3 American Deposit Receipts
ADRs are a popular investment tool for many U.S. investors. In recent years several alternatives for investing in foreign equity securities have become available for U.S. investors, yet ADRs remain popular. Define what an ADR is (5 marks) and provide at least three examples of the advantages they may hold over alternative foreign investment vehicles for U.S. investors.
1 KiKos and the South Korean Won
That possibility arises from a fundamental tenet of international law that is not written down in any law book: In extremis, the locals win.
—“Bad Trades, Except in Korea,” by Floyd Norris, The New York Times, April 2, 2009 South Korean exporters in 2006, 2007, and into 2008 were not particularly happy with exchange rate trends. The South Korean won (KRW) had been appreciating, slowly but steadily, for years against the U.S. dollar. This was a major problem for Korean manufacturers, as much of their sales was exports to buyers paying in U.S. dollars. As the dollar continued to weaken, each dollar resulted in fewer and fewer Korean won—and nearly all of their costs were in Korean won. Korean banks, in an effort to service these hedging needs, became the sale and promotion of Knock-In Knock-Out option agreements (KiKos). Knock-In Knock-Outs (KiKos)
Many South Korean manufacturers had suffered falling margins on sales for years. Already operating in highly competitive markets, the appreciation of the won had cut further and further into their margins after currency settlement. The won had traded in a narrow range for years. But that was little comfort as the difference between KRW1,000 and KRW 930 to the dollar was a big chunk of margin
South Korean banks had started promoting KiKos as a way of managing this currency risk. The Knock-In Knock-Out (KiKo) was a complex option structure, which combined the sale of call options on the KRW (the knock-in component) and the purchase of put options on the USD (the knock-out component). These structures then established the trading range seen that the banks and exporters believed that the won would stay within. In one case the bank salesman told a Korean manufacturer “we are 99% sure that the Korean won will continue to stay within this trading range for the year.”
But that was not the entirety of the KiKo structure. The bottom of the range, essentially a protective put on the dollar, assured the exporter of being able to sell dollars at a set rate if the won did indeed continue to appreciate. This strike rate was set close-in to the current market and was therefore quite expensive. In order to finance that purchase the sale of calls on the knock-in rate was a multiple (sometimes call the turbo feature) meaning that the exporter sold call options on a multiple, sometimes two or three times, the amount of the currency exposure. The exporters were “over-hedged.” This multiple yielded higher earnings on the call options that financed the purchased puts and provided added funds to be contributed to the final KiKo feature. This final feature was that the KiKo assured the exporter a single “better-than-market-rate” on the exchange of dollars for won as long as the exchange rate stayed within the bounds. Thus, the combined structure allowed the South Korean exporters to continue to exchange dollars for won at a rate like KRW 980 = USD when the spot market rate might have only been KRW 910.
This was not, however, a “locked-in rate.” The exchange rate had to stay within the upper and lower bounds to reap the higher “guaranteed” exchange rate. If the spot rate moved dramatically below the knock-out rate, the knock-out feature would cancel the agreement. This was particularly troublesome because this was the very range in which the exporters needed protection. On the upper side, the knock-in feature, if the spot rate moved above the knock-in rate the exporter was required to deliver the dollars to the bank at that specific rate, although movement in this direction was actually in the exporter’s favor. And the potential costs of the knock-in position were essentially unlimited, as a multiple of the exposure had been sold, putting the exporter into a purely speculative position
It did not take long for everything to go amiss. In the spring of 2008, the won started falling—rapidly—against the U.S. dollar. The spot exchange rate of the won blew through the typical upper knock-in rate boundary quickly. By March of 2008 the won was trading at over KRW 1,000 to the dollar. The knock-in call options sold were exercised against the Korean manufacturers. Losses were enormous. By the end of August, days before the financial crisis broke in the United States, it was estimated there were already more than KRW 1.7 trillion (USD 1.67 billion) in losses by Korean exporters
The magnitude of losses quickly resulted in the filing of hundreds of lawsuits in Korean courts. Korean manufacturers who had purchased the KiKos sued the Korean banks to avoid the payment of losses, losses that in many cases would cause the bankruptcy of their businesses.
Exporters argued that the Korean banks had sold them complex products, which they did not understand. The lack of understanding was on at least two different levels. First, many of the KiKo contracts were only in English, and many Korean buyers did not understand English. The reason they were in English was that the KiKos were not originally constructed by the Korean banks. They were created by a number of major Western hedge funds that then sold the products through the Korean banks, the Korean banks earning more and more fees for selling more and more KiKos. The Korean banks, however, were responsible for payment on the KiKos; if the exporting companies did not or could not pay-up, the banks would have to pay. Secondly, exporters argued that the risks associated with the KiKos, particularly the knock-in risks of multiple notional principals to the underlying exposures, were not adequately explained to them. The exporters argued that the Korean banks had a duty to adequately explain to them the risks—and even more importantly—only sell them products that were suitable for their needs. (Under U.S. law this would be termed a fiduciary responsibility.)
The Korean banks argued that they had no such specific duty, and regardless, they had explained the risks sufficiently. The banks also argued that this was not a case of an unsophisticated buyer not understanding a complex product; both buyer and seller were sufficiently sophisticated to understand the intricate workings and risks of these structures. The banks had in fact explained in significant detail how the exporters could close-out their positions and then limit the losses, but the exporters had chosen not to do so. In the end the Korean courts found in favor of the exporters in some cases, in favor of the banks in others. One principle that the courts followed was that the exporters found themselves in “changed circumstances” in which the change in the spot exchange rate was unforeseeable, and the losses resulting—too great. But some firms, for example GM Daewoo, lost $1.11 billion. Some Korean banks suffered significant losses as well, and may have in fact helped transmit the financial crisis of 2008 from the United States and the European Union to many of the world’s emerging markets.
1, What leads to the lack of understanding between exporters and Korean banks?
2, The exporters argued that the Korean banks had a fiduciary duty to adequately explain to them the risks—and even more importantly— only sell them products that were suitable for their needs. Analyze whether exporter’s argument is legitimate or not?
3, If you are exporters and learn about the risk of derivative contracts, what will you do differently to proceed with those contracts?