The “Domestic Fisher Effects” implies that the nominal rate of interest is equal to the sum of real interest rate and the expected inflation rate. K = Re + Onf. Where: K = Nominal Rate of Interest Re = Real Rate of Interest (roughly which is the same across the world) Onf. = Inflation Rate The real interest rate is defined as the global economy growth rate, which comes out to be approximately 3%. The nominal interest rate is determined by inflation in a country. That explains why the nominal interest rates differ in two countries. The underlying principle is that investors should be compensated to accommodate for inflation. For example, suppose if you invest in Brazil and you expect to get a 3% real return on your investment and suppose the inflation rate in Brazil is 20%, and then you must get at least 23% nominal rate of return. Otherwise it is really not worth investing.
Foreign Exchange Risk
The Purchasing Power Parity theory implies that the prices of goods, in the nonexistence of restrictions of trade and costs of transportation, should be the same in 2 countries. In short, this leads to the Law of One Price that stands all across the globe. In language of exchange rates, this implies that the exchange rate between two countries should be equal to the ratio of the price level of a fixed basket of goods and services respectively in the two countries. S$/£ = P$/P£ For example, this means that a purse in the US should cost the same as a purse in Canada once you take into account the exchange rate. If the purse cost $5 in the U.S. and let say the exchange rate is 1US$ = 1.50 CAN$, then the purse should cost CAN$7.5 in Canada, otherwise then arbitrage could be possible.
Political risk associated with investment in foreign country: Nationalization of natural resources (e.g. mines, oil deposits) Limits on repatriation of funds Expropriation Currency controls (e.g. manipulation of exchange rate) Non-tariff barriers design to protect domestic producers (e.g. stringent health or labeling requirements, excessive documentation and ‘red tape’) Country of origin and local content rules, Rules about having local’s nationals form a significant part of senior management. Government or private domestic equity in multinational subsidiary Economic Risk associated with investment in foreign country: Tax regulations and their effect on expected profitability Exchange rate fluctuations Social Risk associated with investment in foreign country: Labor laws Religious differences Cultural differences
The portfolio manager wants to fully hedge the primary risks associated with bonds. The primary risk involved is inflation risk and foreign exchange risk. Inflation risk will affect the yield associated with the bonds whereas foreign exchange risk will affect the conversion from foreign currency to UK currency. To hedge against the above two primary risks, hedging instruments that will be affective are bond futures and FX options. As it has been stated in the case that there is some possibility that currency markets could move in their favor and hence FX options will provide flexibility of participation in any favorable move, whilst being fully protected against adverse moves. Bond futures will provide hedge against elevated risk of extreme volatility in the markets during the next three months and also will help cater to the mandate that they remain fully invested at all times.
Hedge strategy using FX Options:-
A portfolio manager can use option derivatives to have the right (not obligation) to buy or sell an asset at a specified price before a given date in the future. There are two types of options: Call Option: When someone buys a call option then he is actually buying the right to call or purchase that underlying asset at a specific price which is known as the “strike price,” but before a specified point in time which is known as the “expiration date.” Put Option: When an investor buys a put option then he is actually buying the right to put or sell that underlying asset for a specific price to the writer of the option but before the expiration date. In order to receive the opportunity to buy/sell an option, an investor needs to pay a “premium.” It should be noted that if the market is not able to reach the strike price of the option, then that option will eventually expire worthless on the expiration date. But if incase the market does actually reach the strike price of the option on the expiration date then in that case the investor will be assigned the underlying future at that strike price. The advantages of buying a call or a put option are as follows: Leverage: It means that an investor could gain leverage in a stock without actually committing to the trade Hedging: It means that options allow investors to protect their positions against price fluctuations in the case when it’s not attractive to change the underlying position: Buyer of option can never lose more than the premium of the option Seller of option can never win more than the premium of the option The costs associated with option are as follows: Costs. The costs of trading options, which includes both commissions and the bid or ask spread is usually significantly higher than trading the underlying stock when calculated on percentage basis; and these costs can drastically reduce your profits. Complexity. Options are very complex and thus require a great deal of observation and maintenance. Time decay. The time-sensitive nature of options actually makes most options expire worthless after expiration time. In the case of the FX options case, let us assume that the Portfolio Manager is presented with the following possibilities for put options. He has an alternative to buy these put options to actually restrict his loss in the event of a market downturn. Option # Strike Price Value Premium 1 $1,450 $50M 2 $1,400 $40M 3 $1,375 $20M 4 $1,350 $15M Let’s suppose that the market drops to $1,200. Following are the losses sustained by the Portfolio Manager based on the option purchased. Option Description Loss in Portfolio Loss in Premium Overall Loss Option 1: Buy Put Option #1: ($1,500 – $1,450) = $50M $50M $100M Option 2: Buy Put Option #2 ($1,500 – $1,400) = $100M $40M $140M Option 3: Buy Put Option #3 ($1,500 – $1,375) = $125M $20M $145M Option 4: Buy Put Option #4 ($1,500 – $1,350) = $150M $15M $165M Option 5: Do nothing ($1,500 – $1,200) = $300M 0 $300M Hedge strategy using Bond Futures:-
On 1/10/2010, the notional 10-year bond (from zero coupon yield curve) was Rs.45.43. You think the long rate will go up, so you short three futures contracts (12,000 bonds) @ Rs.49. On 31/12/2010, the notional 10-year bond is at Rs.39. You gain a profit of Rs.10/bond or Rs.120, 000 overall.
On 19 Feb 1994, the notional 10-year bond was at Rs.32. The 31/10/1994 futures were trading at Rs.33. You thought interest rates would go down, so you purchased two futures contracts (8000 bonds) @ Rs.33. Interest rates went up On expiration; the notional bond was at Rs.21.4. Thus resulting in a loss of Rs.92, 800.
Q-4 Short report
There are various risk associated with investing in multiple countries. The risks can be categorized in two forms. The primary risks that can be hedged against via various hedging instruments. The secondary risks such as social, political and economic risks which needs to be borne by the portfolio manager and which cannot be completely hedged against even with help of hedging financial instruments. They can be taken care of adequate fundamental analysis of the countries where the portfolio manager chooses to invest. The primary risks associated are inflation risk and foreign exchange risk. Inflation risk will affect the yield associated with the bonds whereas foreign exchange risk will affect the conversion from foreign currency to UK currency. To hedge against the above two primary risks, hedging instruments that will be affective are bond futures and FX options. As it has been stated in the case that there is some possibility that currency markets could move in their favor and hence FX options will provide flexibility of participation in any favorable move, whilst being fully protected against adverse moves. Bond futures will provide hedge against elevated risk of extreme volatility in the markets during the next three months and also will help cater to the mandate that they remain fully invested at all times.