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INTERNATIONAL INTERNATIONAL FINANCEFINANCE

LECTURE NOTESLECTURE NOTES

MM IPMI

Prof. Roy Sembel, Ph.DOctober 2009 – February 2010

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Last week’s (January 16) AGENDA

Review of course outline, assignments, and last-week materials

Book Review presentation, 25-30 minutes per group

USD forecast results

Simulation: temporary results

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Forecasting Rp/US$

Group Dates11 12 13 14 15 comments

1 9250 9250 9250 9250 9250 TA2 9260 9280 9315 9290 9280 TA3 9276 9224 9241 9163 9206 TA4 9279 9275 9274 9276 9275 TA (MA-3)Average 9266 9257 9270 9245 9253Random walk == Exch Rate on 10/1Actual 9233 9157 9174 9165 9165

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Error of Forecast

Group Dates11 12 13 14 15 Total

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AverageRd Wk

17 93 76 85

27 123 141 125

43 67 67 2

46 118 100 111

33,25 100,25 96 80,75

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January 23 AGENDA Course Review

Simulation: temporary results

Currency Risk Exposure: Transaction, Translation, Economic Exposure

Managing Currency Risk with Derivatives

Discussion: Barings, SocGen

Case: Vogl

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‘Students’ Active learners:• Read reading materials• Discuss within group (articles, hot issues, investment simulation, solution for cases, book

review, preparing presentation)• Participate actively in class discussion

‘Lecturer’ Facilitator:• Structure syllabus• Prepare reading materials, cases, simulation rules & template• Invite guest lecturers• Facilitate discussion, presentation

3-stage learning:• Individual learning• Group discussion• Class discussion

Grading policy: • Individual efforts (class participation & quiz) 35%• Group efforts (case summary & group presentation) 40%• Final examination 25%

STUDENT CENTERED APPROACH

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COURSE OUTLINE

Projects / Cases:1. Event analysis: (Financial) Crises of the world2. International Portfolio Investment Simulation3. Book Review4. Analysis of one Multi National Company (MNC)5. Exchange rate forecasting

Final Examination

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1. Oct 10 Choose one of the crises: Indonesia 1966, Indonesia 1997, Sub-prime mortgage 2007, Jerome Kerviel (Societe Generale 2007), DotCom Bubble 2000, The Great Depression 1929

2. Nov 14 1-page description of the crises3. Nov 28 Analysis of the causes of the crises4. Dec 19 What happened after the crises5. Jan 23 Lessons learned from the crises6. Jan 30 Submit complete report 7. February 625-minute presentation of the crises

Project 1: Crises of the world

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1. Nov 14 5-minute presentation of criteria, reasons, and fund allocation

2. Nov 28 – Jan 30 weekly performance report

3. February 6 5-minute presentation of final results and lessons learned

Project 2: SimulationInternational Portfolio Investment

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Project 3: Book Review

1. Nov 14 Choose one book

2. Jan 9 Submit Report (10 pages, A4, times roman 12, line spacing1.5)

3. Jan 16 Book review presentation

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Project 4: Analysis of one Multi National Company (MNC)

1. Oct 10 Choose one MNC2. Nov 14 Describe briefly the MNC3. Nov 28 Analyze historical (weekly: last 52

weeks, yearly: last 5 years) performance of MNC’s stock

4. Dec 19 Analyze MNC’s funding and investment strategy

5. Jan 30 Analyze MNC’s financial risk management strategy

6. Feb 6 Submit complete report on MNC

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Project 5: Exchange Rate Forecasting

1. Nov 14, 2009 to January 9, 2010 Visit www.oanda.com, play around with Rp/$ data (average daily return, volatility, etc), download monthly data January 2007 – January 2010

2. January 9, 2010 Forecast the Rp/$ (closing) exchange rates for 11/1, 12/1, 13/1, 14/1, 15/1.

3. January 16 Record your forecast error

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Final Examination

1. Group take-home examination [40% of total final examination score]: Complete report on Investment simulation, EVENT, MNC

2. Individual in-class examination [60% of total final examination score]: Questions on projects, hot issues, guest lecture, articles, etc.

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Assignment agenda January 23:

Readings: ICF Ch 5, 10, 11, 12 Managing Derivatives Risks: BaringsSeveral articles on Risk Management

Project/Case:¤ Case: Vogl Co¤ EVENT: Lessons learned¤ Investment Simulation: weekly performance

report

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Assignment agenda January 30:

Readings: ICF Ch 16, 19, Appendix 3 p 87-97Articles: Emerging Market Risk;

Measuring Long Term Performance

Project/Case:¤ EVENT: Submit complete report on the crises ¤ MNC: Financial Risk Management in MNC¤ Investment Simulation: weekly performance report

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Assignment agenda February 6:

Project/Case:¤ EVENT: Complete 25-minute presentation of

the crises ¤ Simulation: 5 minute presentation of

International Portfolio Investment Simulation Results and Lessons learned

¤ MNC: Complete report on MNC

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January 23 AGENDA Course Review

Simulation: temporary results

Currency Risk Exposure: Transaction, Translation, Economic Exposure

Managing Currency Risk with Derivatives

Discussion: Barings, SocGen

Case: Vogl

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Investment Simulation Results

Group Portfolio value Main contributor 19/12 9/1 16/1 23/1

1 105,4 106,3 106,6 105.1 Mexico, Indonesia 2 100,8 102,1 101,2 100.1 South Kor, Hong Kong

3 97,9 100,4 99,8 98.7 China, Indonesia4 101,2 103,1 98,8 100.6 Indonesia, DJIA

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January 23 AGENDA Course Review

Simulation: temporary results

Currency Risk Exposure: Transaction, Translation, Economic Exposure

Managing Currency Risk with Derivatives

Discussion: Barings, SocGen

Case: Vogl

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Currency risk exposure

• Exchange rate exposure may affect financing costs¤ volatile cash flow from exchange rate

changes increases risk

• Transaction exposure¤ reflects the exposure of an MNC’s future

cash transactions to exchange rate movements

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Currency risk exposure

• Economic exposure¤ measures the direct and indirect risks to

cash flows from exchange rate movements

• Translation exposure¤ focuses on consolidated financial

statements

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January 23 AGENDA Course Review

Simulation: temporary results

Currency Risk Exposure: Transaction, Translation, Economic Exposure

Managing Currency Risk with Derivatives

Discussion: Barings, SocGen

Case: Vogl

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DERIVATIVE SECURITIESDERIVATIVE SECURITIES

SECURITIES WHOSE VALUES DEPEND SECURITIES WHOSE VALUES DEPEND ON OTHER MORE ELEMENTARY ASSET.ON OTHER MORE ELEMENTARY ASSET.

USES OF DERIVATIVE:USES OF DERIVATIVE:

SPECULATIONSPECULATION

ARBITRAGEARBITRAGE

HEDGINGHEDGING

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DERIVATIVES:

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FORWARDS

CONTRACT BETWEEN TWO PARTIESCONTRACT BETWEEN TWO PARTIESTO BUY/SELL AN UNDERLYING ASSETTO BUY/SELL AN UNDERLYING ASSETWITH PRESPECIFIED AMOUNT, PRICE,WITH PRESPECIFIED AMOUNT, PRICE,AND DELIVERY TIME IN THE FUTURE.AND DELIVERY TIME IN THE FUTURE.

LONG VS SHORTLONG VS SHORT

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FORWARDS

EXAMPLES OF FORWARDS:EXAMPLES OF FORWARDS:

PRE-HARVEST SALE (IJON)PRE-HARVEST SALE (IJON)PRE-ARRANGED MARRIAGEPRE-ARRANGED MARRIAGE(KAWIN SITI NURBAYA)(KAWIN SITI NURBAYA)

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FORWARDS

LONG VS SHORTLONG VS SHORT

Long positionLong position

Spot Price Spot Price at maturityat maturity

Short positionShort position

PayoffPayoff

Delivery priceDelivery price

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HEDGING

A shoe manufacturer in Indonesia has just received an order to export several containers of shoes to Japan as soon as possible and will receive payment of 100 million yen six months from now. She estimates that the total cost (including insurance and transportation costs) of the exported shoes is Rp 8 billion rupiah. Yen may appreciate or depreciate against rupiah. Now, the spot price is Rp 100 / yen and six-month forward price is Rp 102 / yenWhat should she do ?

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HEDGING

SITUATION:Long yen position (will receive yen)

RISK: Yen depreciate against rupiah

SOLUTION:Concentrate on shoe business Hedge the currency risk: take short yen position (sell yen forward) to cover the long yen position

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FORWARDSHEDGING YEN RECEIVABLESHEDGING YEN RECEIVABLES

Long yen positionLong yen positionin shoe businessin shoe business

Rp / yen Rp / yen in six monthsin six months

Short yen positionShort yen positionin derivative marketin derivative market

PayoffPayoff

Rp 102 /yenRp 102 /yen

Net resultNet result::Currency fluctuation will not affect profitCurrency fluctuation will not affect profitThe Rp 2.2 billion profit is locked in from the shoe business, i.e.,The Rp 2.2 billion profit is locked in from the shoe business, i.e.,Rp 10.2 billion (or yen 100 million x Rp 102/yen) - Rp 8 billion Rp 10.2 billion (or yen 100 million x Rp 102/yen) - Rp 8 billion

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FORWARDS VS FUTURES

FORWARDS: FORWARDS: TAILOR MADE BETWEEN TWO PARTIESTAILOR MADE BETWEEN TWO PARTIES

FUTURES:FUTURES: STANDARDIZED, TRADED ON ORGANIZED EXCHANGESTANDARDIZED, TRADED ON ORGANIZED EXCHANGE

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OPTIONSCONTRACT THAT GIVES ITS HOLDER A RIGHTCONTRACT THAT GIVES ITS HOLDER A RIGHT TO BUY TO BUY

((CALLCALL) OR SELL () OR SELL (PUTPUT))A CERTAIN AMOUNT OF A CERTAIN UNDERLYING A CERTAIN AMOUNT OF A CERTAIN UNDERLYING

ASSETASSET WITH A CERTAIN PREDETERMINED PRICE WITH A CERTAIN PREDETERMINED PRICE (STRIKE/EXERCISE PRICE)(STRIKE/EXERCISE PRICE)

AT A CERTAIN TIME IN THE FUTUREAT A CERTAIN TIME IN THE FUTURE

AMERICAN VS EUROPEAN OPTIONSAMERICAN VS EUROPEAN OPTIONS

PRICE (PREMIUM) OF OPTIONS PRICE (PREMIUM) OF OPTIONS VS PRICE OF UNDERLYING ASSETVS PRICE OF UNDERLYING ASSET

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CALL VS PUT

CALL OPTIONSRight to BUY

• S• At a price X• At time T

PUT OPTIONSRight to SELL

• S• At a price X• At time T

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How does it work? CALL

NOWMATURITYSellerShort SELL SWriter

Rp Premium S Rp X

Buyer BUY S Long Taker

Expired

CALL OPTIONSRight to BUY

• S• At a price X• At time T

Right to BUY•S•At price X•At time T

Hak digunakan

Hak tidak digunakan

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How does it work? PUT

NOW MATURITYSeller Short BUY SWriter

Rp Premium S Rp X

Buyer SELL S Long Taker

PUT OPTIONSRight to SELL

• S• At a price X• At time T

Right to SELL•S•At price X•At time T

Hak digunakan

Hak tidak digunakanExpired

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INTRINSIC VS TIME VALUE

• INTRINSIC VALUE:¤ MAX (0, | S – X | )

• TIME VALUE:¤ PREMIUM ABOVE INTRINSIC VALUE

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OPTIONSPAY-OFFPAY-OFF

X=30X=30Price of asset at Price of asset at maturity of optionsmaturity of options

Strike priceStrike price

Pay-off Long Pay-off Long Call OptionsCall Options

Pay-off Short Pay-off Short Call OptionsCall Options

-C-C

Profit Long Profit Long Call OptionsCall Options

CC

Profit Short Profit Short Call OptionsCall Options

BEPBEP = X + C= X + C

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OPTIONSPAY-OFFPAY-OFF

X=30X=30Strike PriceStrike Price

Pay-off Long Pay-off Long Put OptionsPut Options

Pay-off Short Pay-off Short Put OptionsPut Options

-P-P

Profit Long Profit Long Put OptionsPut Options

PP

Profit Short Profit Short Put OptionsPut Options

BEPBEPPrice of asset at Price of asset at maturity of optionsmaturity of options

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CASE STUDY

PT Bank Bangkrut plans to expand its operation to the USPT Bank Bangkrut plans to expand its operation to the USand offer to buy a US bank at US$ 10 million. The US bankand offer to buy a US bank at US$ 10 million. The US bankneeds 3 months to consider the offer. Bank Bangkrut givesneeds 3 months to consider the offer. Bank Bangkrut givesthe US Bank 3 months to decide.the US Bank 3 months to decide.

1. WHAT FINANCIAL RISKS ARE FACED BY BB ?1. WHAT FINANCIAL RISKS ARE FACED BY BB ?2. WHAT SHOULD IT DO TO HEDGE THE RISK ?2. WHAT SHOULD IT DO TO HEDGE THE RISK ?

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CASE STUDYRISK EXPOSURERISK EXPOSURE::

PayoffPayoff

Rp/$Rp/$10,00010,000

HEDGINGHEDGING

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January 23 AGENDA Course Review

Simulation: temporary results

Currency Risk Exposure: Transaction, Translation, Economic Exposure

Managing Currency Risk with Derivatives

Discussion: Barings, SocGen, Local Disputes

Case: Vogl

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CASE: BARINGS

• What caused Barings’ debacle?

• Explain the risks of Leeson’s transactions!

• What lessons we learned from Barings?

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January 23 AGENDA Course Review

Simulation: temporary results

Currency Risk Exposure: Transaction, Translation, Economic Exposure

Managing Currency Risk with Derivatives

Discussion: Barings

Case: Vogl

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VOGL

• Currency exposure?

• Tools: Forwards? Options? Why?

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THANK YOU VERY MUCH FOR YOUR ATTENTION

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Assignment agenda January 30:

Readings: ICF Ch 16, 19, Appendix 3 p 87-97Articles: Emerging Market Risk;

Measuring Long Term Performance

Project/Case:¤ EVENT: Submit complete report on the crises ¤ MNC: Financial Risk Management in MNC¤ Investment Simulation: weekly performance report

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LEARNING LOG

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PREMIUM OPTIONS

FACTORFACTOR EFFECT ONEFFECT ONCALLCALL PUT PUT

SS ++ --

++ ++XX -- ++TT ++ ++DD -- ++rr ++ --

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OPTION VALUATION

BINOMIAL MODEL BINOMIAL MODEL

BLACK-SCHOLESBLACK-SCHOLES

C = N(d1) S - N(d2) X eC = N(d1) S - N(d2) X e(-Rf * T)(-Rf * T)

SIMULATIONSIMULATION

d1 = [ log(S/X) + Rf * T + d1 = [ log(S/X) + Rf * T + 22 * T/2] / [ * T/2] / [ * T * T0.50.5]]d2 =d2 = d1 - d1 - * T * T0.50.5