Appendix A: Cases CASE 1 (LN V) : Exchange Rate Projections. Casullo Financial Services (CFS)
Appendix A: Cases CASE 1 (LN V) : Exchange Rate Projections. Casullo Financial Services (CFS)
Appendix A: Cases CASE 1 (LN V) : Exchange Rate Projections. Casullo Financial Services (CFS)
CASE 1 (LN V): Exchange Rate Projections. Casullo Financial Services (CFS).
Ricardo Casullo, president of CFS, has been contacted by Nike Inc. to forecast exchange rates for
the next five year. Ricardo Casullo assigned to the project Mr. Walter Ritz, Vice President of CFS
and manager of the Forecasting Department. Mr. Ritz is an expert on currency forecast who is often
quoted in the financial press and who is a regular on CNBC's Power Lunch. Mr. Ritz first task was
to review several Nike's annual reports and industry reports.
Nike Inc.
Nike Inc. (NKE) likes its maverick image. In 1994, the giant footwear giant, based on Beaverton,
Oregon, paid the legal bills for figure skater Tonya Harding. More controversy ensued when Nike
outfitted tennis contender Mary Price in a provocative halter dress during her surprise loss at the
French Open on May 31, 1996. But Nike's most shocking move may have come earlier in 2007,
when Chief Executive Mark Parker brashly forecasted that Nike would grow by more than 50% in
size -from USD 15 billion to USD 23 billion in revenues- by 2011. By the end of 2010, this bold
prediction seemed to be a bit of track, with USD 20.9 billion in revenues. But this shortfall in the
2007 prediction did not stop Nike from another bold prediction. Last June, Nike projected fiscal
year 2015 revenue of USD 28 to 30 billion. The fuel of this growth has been Nikes international
markets. Today, worldwide revenues represent more than 65% of total revenues.
Nike is heavily counting on overseas sales for revenue growth. In 2003, international sales were
52% of the brand total, the first time international sales have surpassed U.S. sales. After spending
hundreds of millions of dollars on endorsement contracts with such high-profile U.S. athletes as
Jordan, Agassi, Bo Jackson, and, more recently, Tiger Woods, LeBron James, Kobe Bryant,
Michael Vick, and Roger Federer, as well as on overseas deals including the Brazilian national
soccer team and European teams Manchester United and Barcelona FC, track and field athletes in
Kenya, and almost all the Chinese Olympic teams, its name and logo are recognized around the
world.
Industry experts say Nike's massive global expansion, coupled with its entry into new products,
such as electronics, dress and casual footwear and apparel, and extreme sports (surfing,
skateboarding, and snowboarding), raises questions about whether the company is losing focus.
Objective and Methodology
Mr. Ritz wants to forecast exchange rates using the following models:
(a) PPP.
(b) Forward exchange rates.
(c) Monetary approach.
(d) Ad-hoc economic models.
A.1
Data
CFS subscribes to the International Financial Statistics (IFS). The IFS is published by the
International Monetary Fund (IMF) and contains economic and financial data for all member
countries (including nominal exchange rates and nominal interest rates).
Assignment
Mr. Ritz instructed you, his Research Assistant, to prepare a 12-month currency outlook from
2011:III through 2012:II for the GBP, JPY, MXN, and KOW (Korean Won). "Just do it," said Mr.
Ritz. You joined CFS two months ago following your graduation from the University of Houston,
where you earned an MBA, with a major in finance.
1. Test the forecasting skills of Mr. Ritz's models. Estimate Mr. Ritzs models, on the basis of
information that was available at the end of 2010:II. Evaluate the in-sample performance of the
models by evaluating the signs, the t-statistics, and the R-squared coefficients.
2. Prepare quarterly out-of-sample forecasts for each currency during 2010:III2011:II i.e., four
quarters. Check the quality of the forecasts by examining the Mean-squared error (MSE) of your
forecasts and the ability to predict the direction of exchange rates.
3. Compare your models out-of-sample performance with the out-of-sample performance of the
random walk model.
4. Select the "best" model among Mr. Ritzs models in (2). Using the best model, project the
exchange rate for the GBP and JPY through 2012:II.
5. Briefly discuss your results and evaluate your forecasts.
A.2
Class Assignment
(1) Get the data. Go to my homepage and download the data set datacase1.xls. In datacase1.xls, you
have inflation rates, 3-mo. interest rates, and GDP growth rates for the U.K. and the U.S,
respectively. In addition, column 5 gives you the exchange rate USD/GBP.
(2) You work for Mr. Ritz and you want to predict the USD/GBP exchange rate. Mr. Ritz believes
that the inflation rate differential, the interest rate differential and the income differential help to
explain exchanges rates. Since it is easier to work with changes, Mr. Ritz's model has as the
dependent variable the percentage change in exchange rates -i.e, 0.01 (1%), 0.025 (2.5%), etc.
Using data from 1978:II to 2010:III, Mr. Ritz asks you to estimate the following regression:
st,T = + 1 (Id,t-If,t) + 2 (id,t-if,t) + 3 (yd,t-yf,t)
+ t
1. Do the estimated signs make sense? (i.e., are there any theories that justify the signs?)
2. Given the t-statistics and the R2, a priori, would you recommend this model to Nike Inc.?
3. In 2010:III, St = 1.5811 USD/GBP. Using the data in Table C1, forecast St for 2010-:IV to
2011:IV. Recall that St+T = St (1+st,T).
4. The last column of Table C1 presents the actual St during 2010:IV to 2011:IV. Evaluate your
forecasts using the mean absolute error (MAE) metric.
5. Calculate the 3-mo USD/GBP forward rates, using IRPT, for the period 2010:IV to 2011:IV. Do
forward rates predict better than Mr. Ritzs prediction? That is, calculate the forward rates MAE
and compare this MAE with the MAE in question 4.
6. Briefly discuss the failure/success of Mr. Ritz's regression.
TABLE C1
Year
2010:III
2010:IV
2011:I
2011:II
2011:III
2011:IV
Id-If
-0.1727
-0.7779
-0.2179
0.2315
-0.1534
-1.1716
id-if
yd-yf
-0.630
-0.680
-0.650
-0.790
-0.800
-0.990
1.0789
1.1178
0.5107
0.1681
0.0494
0.0000
A.3
St
1.5811
1.5466
1.5654
1.6031
1.6046
1.5477
CASE 2 (LN VIII): Hedging Transaction Exposure. Popescu, Hagi & Associates
Georgi Popescu defected from the Romanian delegation in 1972 while he was participating in the
Olympic Games of Munich. He was a 20-year old gymnast, who was promptly offered a
scholarship at Columbia University. He chose business as his major. "I thought it was the easiest
subject," he says in his office, based in Hartford, Connecticut. Soon he found that his Romanian
education, with a strong emphasis on mathematics, was very helpful in the new field of derivatives.
"Not everything was bad in Romania," he says, when he talks about his Romanian high school
education. After finishing his B.A. at Columbia, he enrolled in the MBA program at MIT. At MIT
he met Sorin Hagi, the only son of two Romanian immigrants, who was also interested in
derivatives. In 1982, three years after getting their MBA degrees, Mr. Popescu and Mr. Hagi
founded a consulting firm that specialized in derivatives, Popescu, Hagi & Associates (PHA).
In July 2011, Len Mirman, founder and president of DW Inc., approached PHA with a very specific
problem. DW is a ten-year old, fast growing company, dubbed by many analysts "the next Wang."
DW manufactures computers in Los Angeles, California. DW computers are primarily sold in
California, under different labels. DW has a problem of mismatch outflows and inflows. Inflows are
denominated in USD. Outflows, however, are mainly denominated in foreign currency: all parts are
imported, 50% of them from Japan, and the rest from Korea, China and Malaysia. DW has never
hedged and has taken the fluctuations of its cost structure as a given. Mr. Mirman is planning to
take DW public next year. He has been told that Wall Street analysts value a predictable cost
structure. DW's revenue in 2011 was 105 USD million. Last year, due to the strengthening of the
JPY against the USD, DW's total expenditures were up 10% to USD 7 million.
PART I
In June 2011, DW ordered Japanese parts valued at JPY 200,000,000. Delivery usually takes two
months. Payment is due within 30 days of delivery. This morning, June 6, DW received a
confirmation notice that the Japanese parts would be delivered in October. The exact delivery date
could not be guaranteed, but an informal telephone call from Japan stated the expected delivery date
to be October 17.
The Assignment
PHA assigns you to solve DW's hedging problem associated with the June transaction. You have
the data in Table C2 available to make your decision.
1. Using different scenarios, evaluate the risk associated with the open position. Do the following:
a.- Calculate range using a worst/best case scenario; a normal, a simulation.
b.- Calculate the VaR (99%)
2. Suppose you decide to use the PHLX options market. How many contracts would you buy?
Estimate the total premium cost.
3. How does the cost of using the traded option compare to the OTC option?
4. How does the forward alternative compare to the cost of using options? Graph the expected net
cash flows for DW in October 17.
5. Which method would you recommend to Mr. Mirman?
PART II
A.4
It is now, November 6. The Japanese parts arrived on October 11 and payment is due in five days.
The exchange rate is .01304 USD/JPY. The 1-mo. and 3-mo. forward USD/JPY rates are .0130464,
and .0130593, respectively. U.S. short interest rates for two months or less are .2909-0.3165. The
CME Dec futures trades at .013062. The PHLX Dec options have the following prices (in USD
cents):
JPY Dec .011
JPY Dec .012
JPY Dec .013
JPY Dec .011
JPY Dec .012
JPY Dec .013
p
p
p
0.00004
0.00117
0.02342
0.20465
0.10592
0.02827
The Assignment
What would be the effective total cost (in USD) of the Japanese parts if you had advised:
1. Using three months forward? (You need the value of the three months forward in September.)
2. Using six months forward?
3. Using Dec futures?
4. Using the OTC JPY option?
5. Using JPY Dec options?
6. Left the position open?
DATA
TABLE C2
Foreign exchange rates (June 6, 2011)
Spot rate (USD/JPY)
.012470
Forward rate
1mo
.012485
3mo
.012494
6mo
.012561
CME Futures
Sep
.01250
Dec
.01257
Interest rates
3-month
USD (%)
0.78105-0.79230
JPY (%)
0.50100-0.50850
PHLX options (premium in cents per unit)
JPY Dec .011 p
0.00707
JPY Dec .012 p
0.03052
JPY Dec .013 p
0.03425
JPY Dec .011
0.15830
JPY Dec .012
0.08255
JPY Dec .013
0.08142
6-month
1.53080-1.56205
0.70158-0.71205
A.5
Class Assignment
1. Go to the CME website, www.cmegroup.com. What is the volume of JPY/USD futures at the
CME? Go to the NASDAQ-PHLX website, www.nasdaq.com. What is the volume of JPY/USD
PHLX calls? Which strategy do you think would be easier to close?
2. Go to my homepage to get the JPY/USD exchange rate. Using 5 years of past data, calculate the
VAR associated with DWs open position (use a 97.5% confidence interval). (Recall that you need
to adjust the monthly returns to the correct frequency i.e., 4-mo (June-October) frequency.)
3. Using the past five years of data, calculate the best case and worst case scenarios for DW.
(Again, recall that you need to adjust the monthly returns to the correct frequency i.e., 4-mo (JuneOctober) frequency.)
4. In the past, your Japanese counterpart has not been reliable with respect to delivery dates. Thus,
you decide, on June 5, 2011, to do a 6-mo futures hedge. DW buys the JPY Dec futures contract.
Value this contract on November 6, 2011.
5. On June 6, 2011, you decide to do a 6-mo. money market hedge, calculate the cost of this
alternative on November 6, 2011. (Remember to discount the cash flows back to November 6,
2011.)
6. Briefly describe and compare the advantages and disadvantages of alternatives (4) and (5).
A.6
The Assignment
You should evaluate Templeton's international portfolio management and performance by using
standard portfolio management theory. More specifically, please address the following question:
1. Determine whether Templeton, in February 2011, has provided U.S. investors with an optimal
portfolio. More specifically, review Templeton's portfolio composition on the basis of the data
provided below. Utilize the data on risk and return per country as reflected by the MSCI Indexes.
Calculate the RVAR, beta, and RVOL of the Templeton Growth Fund. Assume that MSCI data set
was available to you prior to the investment. (Get the data from my homepage or from
mscibarra.com.)
2. Construct an internationally diversified portfolio by identifying countries to be invested in, and
determine the amount to be allocated to each country. Calculate the RVAR, beta, and RVOL of the
optimal portfolio.
3. Many economists believe that observed (ex-post) returns are measured with error. Many
institutions do not feel comfortable with the mean-variance allocation determined using historical
(ex-post) data. It is common to observe that money managers are faced with caps and floors. For
example, money managers cannot allocate more than a given percentage (the cap) in a foreign
market. These caps and floors try to minimize the effects on the asset allocation of measurement
error in ex-post returns. Now, you face a cap of 6.5% for each foreign market and a floor of 45% for
the U.S. Incorporate these restrictions (the caps and floors) in the construction of your
internationally diversified portfolio. That is, you build an optimal constrained portfolio. Calculate
the RVAR, beta, and RVOL of the optimal constrained portfolio.
4. Compare the performance of your constructed portfolios, in (2) and (3), in terms of beta, RVOL,
RVAR and the rate of return and with the performance of Templeton's Growth Fund, the MSCI
USA, and the MSCI World Index.
A.7
5. Answer 4, but with 2010 data. Use the same weights you obtained in (2) and (3), but the new data
on returns. That is, compare the out-of-sample performance of your portfolios.
Class Assignment
1. Go to my website (database3.xls) or to the Morgan Stanley Web Site (www.mscibarra.com) to
obtain the MSCI's USD annualized returns on the U.S., U.K., France, Switzerland, Spain, Hong
Kong, Singapore, South Korea, and Brazil during the 20-year period 1991-2010. Estimate the return
on an equally weighted portfolio. Using the rf and is provided below, calculate the RVOL for this
equally weighted portfolio.
2. For the nine countries mentioned in (1), use the 1991-2010 annualized returns from MSCI,
calculating also the variances and correlations coefficients, to estimate the return of an optimal
portfolio. Calculate the RVOL for this portfolio. Determine the optimal weights for your portfolio
using the Elton and Gruber approach. (See Exercise XVII.3 Remember to first order the countries
according to their RVOLs.)
3. Assume you need to invest 50% in the U.S. market. Recalculate the optimal weights. Calculate
the return and RVOL for this constrained optimal portfolio. Does the performance of the portfolio
improve? Does it make sense to impose caps and floors to fund managers?
4. Compare the performance of the optimal portfolio in (2) and the performance of your equally
weighted portfolio in (1). Which one would you select for next year?
5. For the same eight countries obtain the 2011 annual USD returns. Calculate the ex-post
performance of the equally weighted portfolio, the optimal portfolio from (2), and the constrained
optimal portfolio from (3). Has your answer in (4) changed? Briefly discuss the results.
A.8
Data
Investment Portfolio February 2011 Geographic Distribution (percent)
TABLE C3
MSCI Indexes: Performance and Risk Measures (annualized, 1970-2011)
Weight
WORLD
SD
World
U.S.
41.5
0.76
15.5
0.77
U.K.
14.0
0.63
22.4
0.91
France
7.9
0.65
23.0
0.96
Switzerland
5.2
0.74
18.5
0.93
Germany
5.3
0.67
22.3
0.96
Netherlands
3.8
0.74
19.4
0.93
South Korea
4.3
0.53
38.5
1.31
Italy
2.2
0.55
25.0
0.92
Singapore
2.6
0.53
29.2
0.99
Japan
2.2
0.64
21.7
0.89
Spain
1.5
0.61
23.4
0.60
Hong Kong
1.8*
0.48
36.1
1.18
Sweden
1.3
0.63
24.4
1.00
Taiwan
1.1
0.41
36.1
0.95
Ireland
0.9
0.73
22.7
1.09
Russia
0.7
0.52
55.2
1.85
India
0.6
0.50
31.5
1.02
Norway
0.6
0.59
28.6
1.09
Turkey
0.5
0.35
58.9
1.31
Total Equity
Cash & Notes
98.00
2.00
A.9
MSCI
USD SDt
15.5
17.9
23.3
15.7
10.9
Beta-W
1.00
0.92
0.94
0.80
-0.02
A.10
Country reports
.Review of Brazil's energy sector
.Analysis of the project, including investment and cash flow analysis for 2011-2017.
Mr. Fields agreed to make a presentation to the board with preliminary findings next month.
The Assignment
You work for Mr. Fields. During his flight to Sao Paulo, Mr. Fields faxed you the following list of
issues that he plans to present to the Board of Directors:
1. Do a brief country report. Based on the country report and using the checklist method, determine
the country risk.
2. Determine the project's risk by calculating the "beta" and/or standard deviation (of comparable
firms if necessary) to access the systematic and unsystematic risk.
3. Determine the feasibility of the project, on the basis of the Projected Income Statement. (You can
calculate the NPV or the IRR of the project. You will need to forecast the USD/BRL exchange rate
according to PPP. You should use Vale's weighted average cost of capital or the yield on long-term
government securities plus 2.75% as the discount rate.) Based on your calculations, you will advise
HAC to invest USD 10 million in the modernization of Vale's power plant.
4. Propose a funding policy for HAC with the objective of minimizing funding cost and economic
exposure.
5. Formulate a foreign currency hedging policy for HAC. (Be aware that HAC exposure consists of
two parts: (i) the initial international bidding process requires a 5% deposit of the proposed
investment, and (ii) in case HAC's bid is accepted it needs to make a substantial investment in BRRdenominated assets.)
6. Calculate the value of the option (use Black-Scholes formula) that is offered to HAC.
Class Assignment
Answer 3. Do not add back depreciation to your cash flows -i.e., assume depreciation matches
changes in working capital and capital expenditures. Assume that the estimated USD 160 million
investment is proportionately spent throughout the seven-year period. (Note that the investment is in
USD, but the cash flows generated by the project are in BRL.) You will probably use as the
discount rate the yield on government securities plus 375 basis points (get the rate from the IFS or
the Internet). Assume the Brazilian tax rate for this project is 20%. (Hint: What is an appropriate
discount rate for this project: a Brazilian discount rate or a U.S. discount rate?)
Answer 4. Hint: You should take into account currency risk considerations.
A.11
Data
Projected Income Statement, 2011-2017
(millions of BRL)
2011
2012
2013
2014
Operating revenue
Operating expenses
Depreciation
Operating income
48.00
4.75
1.25
42.00
86.20
6.45
2.75
77.00
120.00
8.60
5.00
106.40
Interest cost
Interest income
Net interest cost
34.50
1.00
33.50
56.70
1.20
55.50
8.50
21.50
Net income
2015
2016
2017
163.00
19.75
11.50
131.75
217.50 300.50
21.00 49.00
20.00 35.00
176.50 216.50
348.00
66.60
50.00
231.40
73.20
1.40
71.80
93.00
1.85
91.25
109.10 121.50
2.00
2.40
107.10 119.10
130.10
2.80
127.30
34.60
40.50
69.40
97.40
104.10
208.3
231.4
216.0
251.5
223.8
276.2
231.9
303.4
240.4
335.7
0.5785
196.0
199.8
201.4
213.2
160
130
30
40-60
40-50
40-50
10-15
(Debt in USD)
(Debt and Equity in BRL)
(Debt in BRL)
(Equity in USD and BRL)
A.12
PART I
It is 1994. Ms. Amichi has asked her research assistants to answer the following questions:
1. The USD has been very volatile in the past 5 years. Is investing in non-USD bonds a good idea?
(Draw an efficient portfolio frontier for the expanded GE bond portfolio, with non-USD bonds.)
2. Does the currency exposure need to be managed? (Draw two efficient portfolio frontiers for the
expanded GE bond portfolio, with hedging and no-hedging exchange rate exposure.)
3. Is diversification in non-USD bonds a "bond market play" or rather a "currency play," or both?
4. From GE's overall perspective, is diversification advantageous?
Based on the answers to the above questions, Ms. Amichi has to determine the optimal allocation
for non-USD and USD bonds. Hints: Calculate the efficient frontier for U.S. bonds plus the
international bonds. Calculate the efficient frontier in USD and in local currency. Compare the
unhedged (in USD) and the hedged (using forward rates) frontiers.
PART II
It is 2005. Ms. Amichi convinced GE Capital to invest in international bonds. By now, you know
that GE Capital has heavily invested in Europe: over the past six years GE Capital has taken over 34
European businesses. Moreover, GE Capital has recently been buying Eastern European banks.
A.13
1. You should evaluate ex-post the short-term and long-term risk-adjusted returns of the bond
portfolio of GE Capital. (Calculate RVARs and RVOLs for your constructed optimal portfolio.
Report the ex-ante and ex-post i.e., 1994-2005- results. Compare your results with an equally
weighted portfolio. You should take into consideration hedging issues.)
2. Suppose GE is only using the Government bonds Ms. Amichi suggested. Should GE Capital
expand its bond portfolio to incorporate Eastern European government bonds? What about Latin
American government bonds? What about African and Chinese government bonds? (Draw different
efficient frontiers, incorporating the different Emerging Market bonds.)
3. It is 2012. Evaluate the ex-post performance of GEs bond portfolio with and without Emerging
Market bonds.
Class Assignment
1. It is 2012. You are a U.S. investor and you have available the data for Long-term Government
Bonds presented in Table C4 (also downloadable from my homepage: datacase5.xls).You are
planning to invest 50% of your bond portfolio in foreign long-term government bonds. Using the
techniques discussed in Chapter XVII, construct an optimal portfolio. (Assume a risk free rate of
3.5%.)
2. Should you hedge your currency exposure?
A.14
Data
Table C4
Annual Returns of Government Bond Indexes (JP Morgan)
A. In local currency
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
USD
8.92
16.99
-0.44
-1.51
-1.16
0.39
-7.31
44.96
0.15
15.01
30.45
26.58
14.75
6.78
13.97
8.64
14.8
0.72
10.06
3.23
-9.23
-3.51
3.15
3.65
-8.82
7.07
0.56
6.55
-2.25
-0.69
-1.45
-2.30
4.19
9.54
-7.16
2.98
7.02
CAD
4.18
16.28
6.5
3.02
0.01
3.68
-0.33
36.06
9.8
14.11
21.74
15.26
-6.43
-0.97
2.42
-3.10
10.18
0.28
7.25
-12.03
11.06
3.93
2.20
2.77
-7.64
3.74
1.16
2.19
0.43
1.81
2.27
0.89
0.13
7.40
-5.27
2.88
6.56
JPY
18.69
13.38
36.36
2.99
-14.67
8.82
13.52
9.6
13.22
18.36
12.87
22.92
-0.30
0.64
-6.93
-5.23
7.16
5.37
8.01
-7.78
9.21
1.56
3.26
-2.91
1.85
-0.49
1.47
1.69
-2.19
-0.03
-0.44
-1.22
1.23
2.36
-0.56
1.06
0.88
FRF
19.11
23.88
28.43
-6.88
-5.9
-3.71
4.64
27.76
3.28
21.13
13.8
10.19
-4.67
6.22
-4.75
-1.96
6.62
2.45
12.75
-12.57
9.22
4.32
1.17
6.44
-8.36
1.39
-0.08
4.11
-1.05
2.61
0.92
-3.58
-2.61
7.32
-1.10
1.64
1.38
A.15
DEM
19.94
3.3
10.8
20.8
-9.28
1.33
1.9
22.85
25.02
23.04
23.46
23.78
-1.38
-1.28
-5.39
-6.02
3.97
5.15
7.44
-9.45
9.58
0.80
0.11
5.37
-7.49
1.68
-0.16
5.27
-0.78
2.96
1.12
-3.15
-2.22
7.94
-1.98
2.85
6.51
ITL
0.91
-0.96
1.30
3.75
-2.50
18.64
-12.68
7.00
13.71
5.98
5.85
-8.06
1.38
1.22
5.20
-1.01
3.73
2.15
-3.53
-2.84
1.11
3.75
-4.68
-10.06
GBP
34.26
9.65
47.45
-6.09
5.22
19.55
0.29
53.33
16.86
7.16
9.36
11.97
5.05
-3.25
-2.50
-1.71
5.66
8.12
12.32
-14.57
7.42
-0.93
6.53
12.03
-7.62
2.44
-2.86
2.77
-3.61
0.80
2.66
-1.14
-0.02
8.22
-5.34
3.10
12.47
Global
-1.18
0.54
-1.76
6.01
1.45
7.00
-10.24
9.57
0.80
2.89
3.90
-6.53
2.82
0.41
4.18
-1.70
1.13
0.21
-2.34
0.29
5.56
-2.44
1.27
3.53
B. In USD
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
USD
8.92
16.99
-0.44
-1.51
-1.16
0.39
-7.31
44.96
0.15
15.01
30.45
26.58
14.75
6.78
13.97
8.64
14.8
0.72
3.23
-9.23
9.96
-3.51
3.15
3.65
-8.82
7.07
0.56
6.55
-2.25
-0.69
-1.45
-2.30
4.19
9.54
-7.16
2.98
7.02
CAD
1.54
16.89
-1.57
-4.93
1.59
1.33
0.39
31.3
8.42
7.47
15.04
16.69
-0.61
7.94
5.47
-3.27
10.61
-8.86
2.98
-16.97
14.22
3.42
-2.11
-4.25
-2.25
0.24
-4.82
3.26
22.77
9.80
4.89
6.57
18.06
-14.13
-4.60
-
JPY
17.05
18.16
66.31
27.71
-31.19
28.67
4.78
2.63
14.68
8.92
42.13
55.4
30.14
-2.46
-19.26
0.81
16.22
5.32
20.83
3.16
5.62
-9.74
-7.83
11.92
12.24
-10.81
-11.58
12.31
8.30
4.55
-13.57
-13.55
7.97
26.15
-8.48
-
FRF
19.25
-7
16.85
35.59
-5.46
-10.03
-18.94
4.02
0.92
6.16
59.69
45.05
15.43
-6.59
-0.39
11.78
4.31
-3.69
5.30
-3.27
19.19
-1.87
-12.57
14.63
-21.78
-5.04
-5.23
22.70
18.94
10.58
-12.42
-4.21
7.98
2.04
-10.59
-
A.16
DEM
9.61
37.6
44.27
7.03
-0.49
-15.85
-7.68
20.23
-9.94
4.7
47.2
39.75
20.70
-12.42
-1.09
6.72
2.08
-1.51
0.20
1.45
18.67
-6.38
-14.20
13.75
-21.04
-4.77
-5.31
24.07
19.26
10.95
-12.25
-3.78
8.41
2.62
-9.94
-
ITL
-10.54
2.11
13.85
1.84
-24.27
2.58
-7.85
9.41
18.65
-8.86
13.49
-21.52
-5.04
-4.00
23.99
18.99
11.78
-11.36
-4.16
7.72
-3.87
-9.64
-
GBP
15.7
-8.84
66.33
-0.57
14.59
29.01
-19.77
29.89
4.72
-14.34
36.58
14.64
33.78
-7.13
-13.09
17.82
2.09
-12.60
9.98
-9.66
6.60
9.19
2.43
13.28
-10.51
-5.05
-5.36
13.68
7.18
8.11
-8.21
0.48
1.69
-21.83
-4.42
-
Global
19.27
13.79
5.00
6.80
11.76
15.45
4.55
12.27
1.28
19.32
4.40
1.40
15.31
-5.08
2.34
-0.79
19.37
14.51
10.10
-6.53
0.25
10.81
12.00
1.90
6.42
7.22
A.17
The Venezuelan par and discount bonds were issued in December 1990 with an initial maturity of
thirty years. The debt conversion terms were similar to those associated with the Mexican bonds,
with a conversion of bank debt to discount bonds occurring at 70% of original face value and the
par bond carrying a coupon rate of 6.75%. The principal guarantee, rolling fourteen months interest
rate guarantee, and oil price recapture clause are also similar to those attached to the Mexican
bonds.
The Costa Rican fixed and floating-rate Brady bonds are called the Principal Series A and Interest
Series A bonds, respectively. The bonds come with no collateral guarantee but both have rolling
interest guarantees. The Principal Series A bond was issued in May 1990 with an initial maturity of
20 years, pays a coupon 6.25% and has a rolling interest guarantee of eighteen months of interest.
The Interest Series A bond was also issued in May 1900. The initial maturity was 15 years and the
bond pays a coupon of LIBOR plus 13/16%. A rolling guarantee covers thirty-six months of
interest.
The Mexican issues began trading at the end of March 1990 with prices around USD 40 for the par
bond and USD 60 for the discount bond. Both prices showed a sharp increase in 1991. In 1991, the
relative price of the par bond exhibited a simultaneous rise. Since then, the two prices have moved
more or less in parallel. Trading in the Venezuelan issues began in December 1990, with the
discount bond priced around USD 70 and the par bond priced around USD 50. The price of the
Venezuelan issues have shown a similar behavior to the price of the Mexican issues.
In 2003, Mexico became the first country to retire its Brady debt. The Philippines bought back all
of its Brady bonds in May 2007, joining Colombia, Brazil, Venezuela, and Mexico as countries
that have retired the bonds.
The Assignment
1.- It is March 1990. You work for Citibank. Bill Rhodes has personally asked you for advice:
should Citibank buy the Mexican par or discount bonds? What would be your advice?
2.- In December 1990, you are faced with the same question, but for Venezuela.
3.- It is May 1990. What should be a fair opening price for the Costa Rican Principal Series A
bonds?
4.- It is November 6, 1996. Assume Citibank still holds Mexican Brady bonds. Should Citibank sell
the Mexican bonds? Have they been useful diversification tools?
5.- Mexico retired the Brady Bond debt in 2003. The Mexican government has issued different
international bonds. Among them is the UMS 11.375% bond, maturing in February 2016. Can you
provide a method and an estimate of country risk for Mexico using the UMS 11.375% bonds?
6.- Assume Citibank holds USD 600 million of UMS 11.375%. How can Citibank hedge its
Mexican exposure?
7.- Looking forward, do you think the probability of a Mexican default is substantial?
Class Assignment
A.18
1.- It is November 1996. Describe how you would value the Mexican par bond.
2.- Value the Mexican Brady par bond in November 1996. (Do not just get the value from the
newspaper or the Internet! But you should get the YTMs from newspapers or the internet). Show
your calculations.
3.- Assume Citibank holds USD 600 million of Mexican USD bonds. How would you hedge this
position? (You can visit the CME website or BradyNet.com to check available instruments).
4.- Ignoring liquidity and speculative trades, who buys Mexican USD bonds and who sells Mexican
USD bonds?
Data
Summary Statistics of Mexican Brady Bonds - Historical Weekly Returns
Par
Discount
State Variable
Mean
0.001486
0.000545
0.001210
S.D.
0.02394
0.02530
0.11895
par
1.00
0.76
0.71
US Rate DBVP: The price rise (fall) of the bond for a 100 basis point shift downward in the U.S.
yield curve.
Note: the state variable provides an estimate of country risk embedded in the bond -the higher the
state value, the lower the risk of the bond.
A.19
Class Assignment
Answer questions 1 and 4.
A.20
Euro-USD -3 mo.
2 1/4 - 2 3/8
2 11/32 - 2 14/32
2 3/8 - 2 1/2
2 13/32 - 2 17/32
2 7/16 - 2 9/16
2 7/16 - 2 9/16
2 15/32 - 2 19/32
2 17/32 - 2 21/32
FRA -3 mo.
1X4 2.35 - 2.41
2X5 2.45 - 2.52
3X6 2.46 - 2.53
4X7 2.52 - 2.60
5X8 2.53 - 2.61
6X9 2.58 - 2.64
9X12 2.71 - 2.77
FRA -6 mo
1X7 2.52 - 2.58
2X8 2.55 - 2.61
3X9 2.57 - 2.63
4X10 2.62 - 2.68
5X11 2.65 - 2.71
6X12 2.68 - 2.74
A.21
Eurodeposits
1MO 2.41 - 2.44
2MO 2.44 - 2.47
3MO 2.48 - 2.51
6MO 2.52 - 2.56
9MO 2.55 - 2.60
12MO 2.60 - 2.63