Table Of ContentInternational Financial
Operations
Arbitrage, Hedging, Speculation, Financing and
Investment
Imad A. Moosa
International Financial
Operations
Arbitrage, Hedging, Speculation,
Financing and Investment
IMAD A. MOOSA
©ImadA.Moosa2003
Softcover reprint of the hardcover 1st edition 2003 978-0-333-99859-5
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Contents
ListofFigures ix
ListofTables xiii
CurrencySymbols xv
ListofAbbreviations xvi
NotationandConventions xviii
Preface xx
1 Two-Currency,Three-Currencyand Multi-CurrencyArbitrage 1
1.1 DefinitionofArbitrage 1
1.2 Two-CurrencyArbitrage 2
1.3 Three-CurrencyArbitrage 12
1.4 Multi-CurrencyArbitrage 15
1.5 Examples 17
2 Covered and Uncovered Interest Arbitrage 19
2.1 CoveredInterestArbitrageWithoutDistortions 19
2.2 TheNo-ArbitrageConditionWithBid–OfferSpreads 24
2.3 DeviationsFromtheCIPNo-ArbitrageCondition 26
2.4 CombiningCoveredArbitrageWithThree-CurrencyArbitrage 36
2.5 UncoveredInterestArbitrage 39
3 Other KindsofArbitrageand SomeExtensions 44
3.1 CommodityArbitrage 44
3.2 ArbitrageUndertheGoldStandard 47
3.3 ArbitrageBetweenEurocurrencyandDomesticInterestRates 49
3.4 Eurocurrency–EurobondArbitrage 51
3.5 ArbitrageBetweenCurrencyFuturesandForwardContracts 52
3.6 RealInterestArbitrage 53
3.7 UncoveredArbitrageWhentheCrossRatesAreStable 54
3.8 UncoveredInterestArbitrageWhentheBaseCurrencyIs
PeggedtoaBasket 57
3.9 MisconceptionsAboutArbitrage 60
v
vi CONTENTS
4 Hedging Exposureto Foreign ExchangeRisk:TheBasicConcepts 65
4.1 DefinitionandMeasurementofForeignExchangeRisk 65
4.2 ValueatRisk 69
4.3 DefinitionandMeasurementofExposuretoForeign
ExchangeRisk 73
4.4 TransactionExposure 82
4.5 EconomicandOperatingExposure 84
4.6 AFormalTreatmentofOperatingExposure 93
4.7 TranslationExposure 100
5 Financialand OperationalHedging ofExposureto Foreign
ExchangeRisk 105
5.1 WhyDoFirmsHedgeExposuretoForeignExchangeRisk? 105
5.2 ToHedgeorNottoHedge? 106
5.3 TheDesignofaHedgingStrategy 110
5.4 TheBasicPrinciplesofHedging 110
5.5 MoneyMarketHedgingofShort-TermTransactionExposure 118
5.6 ForwardandFuturesHedgingofShort-Term
TransactionExposure 124
5.7 OptionsHedgingofShort-TermTransactionExposure 128
5.8 FinancialHedgingofLong-TermTransactionExposure 137
5.9 OtherFinancialandOperationalTechniquesof
HedgingTransactionExposure 138
5.10 HedgingOperatingExposure 147
5.11 HedgingTranslationExposure 149
5.12 WhatDoFirmsDoinPractice? 150
6 Measuring theHedgeRatio 156
6.1 TheConceptoftheHedgeRatio 156
6.2 MeasuringtheOptimalHedgeRatio 158
6.3 EmpiricalModelsoftheHedgeRatio 160
6.4 EvaluatingtheEffectivenessofHedging 167
6.5 StaticandDynamicHedging 172
6.6 AnIllustrationUsingCrossCurrencyHedging 174
7 Speculation in theSpot and CurrencyDerivativeMarkets 183
7.1 DefinitionofSpeculation 183
7.2 SpotSpeculation 184
7.3 SpotSpeculationBasedonSpecialEvents 191
7.4 Spot–ForwardSpeculation 193
7.5 ForwardSpeculation 194
7.6 SpeculationWithCurrencyOptions 195
7.7 CombiningSpeculationWithArbitrageandHedging 197
7.8 HedgingasaSpeculativeActivity 203
CONTENTS vii
7.9 StabilisingandDestabilisingSpeculation 204
7.10 SpeculativeBubbles 206
8 Speculation:Generating Buyand SellSignals 209
8.1 SpeculationontheBasisofExpectationFormation 209
8.2 SpeculationontheBasisofTechnicalAnalysis 218
8.3 SpeculationontheBasisofTradingRules 226
8.4 SpeculationontheBasisofFundamentals 231
8.5 HeterogeneityofSpeculatorsasaSourceofExchange
RateVolatility 237
8.6 AnIllustration 243
9 InternationalShort-TermFinancing and Investment 249
9.1 WhyForeignCurrencyFinancingandInvestment? 249
9.2 SourcesofFinancingandInvestmentOutlets 250
9.3 InternationalCashManagement 253
9.4 TheEffectiveFinancingRateandtheEffectiveRateofReturn 258
9.5 IntroducingtheBid–OfferSpreads 261
9.6 ImplicationsofCIPandUIP 263
9.7 TheProbabilityDistributionoftheEffectiveFinancing
RateandtheEffectiveRateofReturn 265
9.8 UsingCurrencyPortfoliosforShort-TermFinancing
andInvestment 267
10 InternationalLong-TermFinancing,CapitalStructureand the
Cost ofCapital 271
10.1 InternationalBankLoanFinancing 271
10.2 InternationalBondFinancing 274
10.3 InternationalEquityFinancing 277
10.4 OtherSourcesofFinancing 279
10.5 TheCostofCapital 280
10.6 VariationsintheCostofCapitalandCapitalStructure 283
10.7 DebtandEquityExposure 287
11 InternationalLong-TermPortfolio Investment 294
11.1 Overview 294
11.2 InvestmentinBonds 295
11.3 InvestmentinEquities 299
11.4 InternationalEquityReturnsandDiversification 303
11.5 InternationalCapitalAssetPricingModel 308
11.6 ManagingForeignExchangeRiskinInternationalPortfolios 312
12 Foreign Direct Investment 318
12.1 DefinitionandClassification 318
viii CONTENTS
12.2 ExplainingForeignDirectInvestment 321
12.3 InternationalCapitalBudgeting 328
12.4 ProjectEvaluationCriteria 331
12.5 AdjustingProjectAssessmentforRisk 336
References 341
Index 357
List of Figures
1.1 Theeffectoftwo-currencyarbitrage.
1.2 Theno-arbitrageline(two-currencyarbitrage).
1.3 Theeffectoftwo-currencyarbitrageinthepresenceofbrokeragefees.
1.4 Theno-arbitragelineinthepresenceofbrokeragefees.
1.5 Theno-arbitragezoneinthepresenceofprogressivebrokeragefees.
1.6 Theeffectoftwo-currencyarbitrageinthepresenceofpartialcapital
controls.
1.7 Theeffectoftwo-currencyarbitrageinthepresenceofbid–offerspread.
1.8 Theno-arbitrageconditioninthepresenceofbid–offerspread.
1.9 Theeffectofthree-currencyarbitrage.
2.1 Theno-arbitrageconditionimpliedbyCIP.
2.2 Theeffectofcoveredarbitrage.
2.3 Theno-arbitragelineinthef–(i –i )space.
x y
2.4 Thecoveredmargin(percentagepoints).
2.5 Coveredarbitrageinthepresenceoftransactioncosts.
2.6 Coveredarbitrageinthepresenceofpoliticalrisk.
2.7 Coveredarbitrageinthepresenceoftaxdifferentials.
2.8 Coveredarbitrageinthepresenceoftransactioncosts,politicalrisk
andtaxdifferentials.
2.9 Theeffectofcoveredarbitrageinthepresenceofinelasticsupplyand
demandandsimilarfactors.
2.10 Theeffectofcoveredarbitrageinthepresenceofinelasticsupplyand
demandandsimilarfactors(theCIPdiagram).
2.11 Theuncoveredmargin(percentagepoints).
3.1 Theeffectofcommodityarbitrage.
3.2 Thepurchasingpowerparityrelationship.
3.3 ActualandPPPexchangerates.
3.4 Exchangeratedeterminationunderthegoldstandard.
3.5 DeterminationofdomesticandEurocurrencyinterestrates.
3.6 Uncoveredarbitragewhenthebasecurrencyispeggedtoabasket.
ix
