IFMGT

INTERNATIONAL FINANCIAL MANAGEMENT

LONDON SCHOOL OF BUSINESS AND FINANCE PHILIP FOJU SATIA A4040572 13/04/2012

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IFMGT EXECUTIVE SUMMARY International financial management is of increasing importance in the current global economy given the magnitude of corporations extending trading into different markets. Gilles, (2012) stated that corporations seek raw materials, skills, labour and political safety as the reasons why companies extend trading into foreign markets. This process of extension is further facilitated by recent developments in information technology/systems. However exciting the adventure of discovering new markets may seem it is immediately confronted with draw backs or risk factors such as exchange rate risk, trade barriers, quotas and cultural differences. These risk factors can be specific to the company such as governance risk, country specific such as war and global specific such as terrorism (Carbaugh, 2008). Entering into forward contracts, mergers and acquisitions and exploiting various derivative features can thus hedge these risk variables. It is no doubt that the overall aim of investing is to maximise returns preferably in cash flows, corporations are therefore interest in the returns they will get from taking on foreign ventures cognisant of the risk factors associated with it. A widely used tool to determine the returns of an investment is the Capital Asset Pricing Model (CAPM). The CAPM simply measure the returns of an investment, this model has been extended to the international scene in the form International CAPM (ICAPM). The CAPM has however been criticised by academics for its many assumptions but the model is still used today to determine the return on investments. Part A of this report examines the application of ICAPM, using its formula to calculate the risk free rate its beta and the market return. It also examines the strategies of international diversification focusing on the methods multi-national corporations use in selecting a currency and its choice of market to invest in; it further makes a comparison between the ICAPM and the CAPM capitalising on the differences in using domestic market figures and foreign market figures in their respective calculations and also evaluates the limiting assumptions of the models considering certain works of other academicians contradicting the CAPM model and finally, calculating the possibilities of investing in euro-denominated bonds or US-denominated bonds of a US investment bank. Part B of the report examines the reasons why a fixed interest rate swap is more desirable for MNC; it illustrates the advantages of swapping a floating interest rate for a fixed one. Arguments here will centre on managing interest rate risk exposure, reduced risk in international trade, the elimination of destabilising speculation and a comparative advantage. It further considers a case study with a demonstration of the benefit of holding a fixed interest rate swap and finally it considers sovereign debts and the criteria utilised by credit rating agencies in their ratings of sovereign debts.

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IFMGT TABLE OF CONTENTS TITLE.1 EXECUTIVE SUMMARY2 TABLE OF CONTENTS...3 INTRODUCTION..5 1). EXAMINING THE STRATEGY OF INTERNATIONAL DIVERSIFICATION.6 a). CURRENCY SELECTION.6 b). MARKET SELECTION...7 APPLICATION OF THE ICAPM.8 A COMPARISON BETWEEN ICAPM AND CAPM...8 LIMITING ASSUMPTIONS OF THE CAPM AND ICAPM...10 EVALUATING WHETHER TO INVEST IN EURO BONDS OR US BONDS..11 PART B SUMMARY. 12 BENEFITS OF FIXED INTEREST RATE SWAP...13 Managing interest rate risk...13 Planning13 Hedging risk.14 Arbitrage arguments.14 CALCULATIONS OF A QUARTERLY SWAP PAYMENT..15 ALTERNATIVE HEDGING POSSIBILITIES FOR ABC LTD15 Forward contracts.15 Future contracts15 SOVEREIGN DEBT16 DETERMINANTS OF SOVEREIGN CREDIT RATING...17 CONCLUSION20 PHILIP FOJU SATIA 3 A4040572

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REFERENCES.20 LIST OF TABLES...21

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INTRODUCTION

Multi-national corporations (MNC) trade across borders and are thus exposed to international risk factors such as exchange rates, quotas, and trade barrier and interest rates. Strategising, planning and forecasting is thus an essential part of MNC in other to hedge the risk variables associated with trading in foreign markets. Differences in the nationality of parties involved, relatively less mobility of factors of production, customer heterogeneity across markets, variations in business practices and political systems, varied business regulations and policies, use of different currencies are the key aspects that differentiate international businesses from domestic business (Madura, 2010). The crux of the matter is therefore to cogitate about the returns, strategies of diversification and hedging the risk variables which MNC encounter as they expand into foreign markets. Investors need additional compensation when they invest in riskier ventures, the Capital asset pricing model (CAPM) was developed by a financial economist (and Nobel Laureate in economics) William Sharpe, (1970). In his book Portfolio Theory and Capital Markets, Sharpe, (1970) stated that organisations are faced with two types of risks; systematic and unsystematic. Systematic risk are market risk that cannot be diversified away such as interest rates, wars and natural disaster while unsystematic risk also known as specific risk represents the component of a stock return that is not correlated with the general markets. CAPM therefore describes the relationship between risk and expected return; it calculates the return, risk free rate, beta of an investment and expected market return. Financial planners use the CAPM to decide whether the additional risk of a stock is worth adding to a clients portfolio, CAPM also examines how diversification reduces risk. Beta used in the CAPM formula as a measure of the volatility of a security in comparison to the market as a whole (Fox & Madura, 2007). International Capital Asset Pricing Model (ICAPM) is an international extension of the CAPM, whilst the CAPM addresses a single currency area; a single market with no restrictions on financial transactions the ICAPM extends this analysis to multiple currency areas and multiple financial markets (Fox & Madura, 2007). This report examines the portfolio of a USA international investment bank with foreign investments, its strategy of international diversification, how the bank incorporates the ICAPM. It further compares the ICAPM with the CAPM of its investment portfolio and the limiting assumptions of the models. Finally, it evaluates whether to invest the foreign allocation in euro-denominated bonds or reallocate its money to US bonds.

1). EAMINING THE STRATEGY OF INTERNATIONAL DIVERSIFICATION AND THE APPLICATION OF ICAPM.

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The common phrase in business is the higher the risk the greater the returns and vice versa, MNC investing in foreign markets are exposed to many risk factors such as exchange rates and the choice of the market to invest in. A USA investment bank must thus develop strategies to diversify its portfolio on the international scheme. Its strategy should therefore cover two main categories: its currency selection and its market selection. a) CURRENCY SELECTION; There is little debate that exploiting foreign markets is mate with exchange rate fluctuations, so by reducing exposure to adverse exchange rate movements MNC can maximise returns. This can be achieved principally by choosing the right currency of their foreign markets. Hunt & Kennedy, (2004) report currency risk contributed to 1015% of the risk associated with internationally diversified stock portfolios. Kaplanis and Schaefer, (1991) report exchange rate fluctuations may erode part or sometimes all, of the benefits of international diversification. A strategy to hedge exchange rate risk is the carry and trade strategy. The carry and trade strategy involves borrowing low interest rate currencies and lending high interest rate currencies without hedging the exchange rate risk (Burnside al, 2006). For example, suppose the interest rate on the Great British Pound was 4.75% whilst the Japanese Yen only yielded 0.25%. Since interest rates are effectively the amount of money you are paid for owning a currency, the 4.5% difference between the pair's interest rates could be taken advantage of. One could take advantage of this by selling the Yen in favour of the Pound, i.e. going long on the GBP/JPY pair - most brokers would pay for holding a higher yielding currency against a lower yielding one.

Figure 1: Source: FXwords.com

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Source: FXwords.com The above diagrams illustrates the use of the carry-trade strategy were the pound GDP is bought against the Yen for 204.73 and sold for 221.25 on interest rates of 4.50% and 0.52% respectively to make a total profit of $22,067.59. An alternative strategy as demonstrated by Fama, (1984) involves selling (buying) the pound forward when the payoff predicted by the recession is positive (negative). This means a MNC can exchange one currency for another at some specified future date at the spot exchange rate. The forward exchange rate is determined by the relationship between the spot exchange rate and differences in interest rates between two countries. Forward exchange rates have important theoretical implications in forecasting future spot exchange rates. MNC can lock spot rates in a forward contract in foreign markets or use the carry and trade method to diversify their portfolio and avoid potential looses.

b). MARKET SELECTION; As a general rule it is never good to invest in a single asset class. MNC investing in foreign markets must thus consider diversifying their portfolio into different areas. Choosing bonds/stocks from different issuers protects MNC from the possibility that any one issuer will be unable to meet its obligations to pay interest and principal. Choosing bonds/stocks of different types (government, agency, corporate, municipal, mortgage-backed securities, etc.) creates protection from the possibility of losses in any particular market sector. Because stock market returns are usually more volatile or changeable than bond market returns, combining the two asset classes can help create an overall investment portfolio that generates more stable performance over time (Shapiro, 2009). Often but not always, the stock and bond markets move in different directions: the bond market rises when the stock market falls and vice versa (Shapiro, 2009). Therefore in years when the stock market is down, the performance of bond investments can sometimes help compensate for any losses. It is thus a useful tool for MNC to select their markets choosing different types of interest in other to avoid risk of default by one principal.

APPLICATION OF THE ICAPM

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IFMGT A business needs to know how a foreign investment translates its returns in their domestic currency and how likely they are to be affected by changes in the value of a foreign currency. The international capital asset pricing model (ICAPM) seeks to answer the question what discount rate should be applied to the future cash flows of a particular investment? The expected return of investing in foreign markets is calculated with the CAPM, the formula used in determining the ICAPM is: Kj=Rf + j (Rw-Rf) Where; Kj is the expected return of the investment Rf is the risk free rate of return Bj is the beta of a particular asset and Rw is the return on the world index The application of this model possess considerable problem for MNC. In particular, Fama and French (1992) announced the death of beta based on the fact that it does a poor job of explaining the cross-section variation of average returns, as opposed to the book-tomarket ratio and market capitalization. It is problematic were the MNC carries out different projects in different economies, market and completely different industrial sector, thus to what extend does the market return represent the return on all investments. In applying the ICAPM the MNC first has to find a like project of similar risk class to identify an appropriate beta (Fox and Madura, 2007). It is difficult to find other firms with identical operating characteristics.

2). A COMPARISON BETWEEN THE ICAPM AND THE CAPM AND THEIR LIMMITING ASSUMPTIONS. Investors are more concern with the return of taking on a particular risk. The CAPM refers to the anticipated investment risk and return for domestic projects while the ICAPM extends to foreign markets. The CAPM and the ICAPM suggest that the return on an investment should equal the cost of capital and the only way to earn higher returns is to take more risk (Damodaran, 2007). Both CAPM and ICAPM address the main features discussed below. They calculate the return, risk free rate, beta of an investment and the expected market return. They are also used to judge the total portfolios risk and decide if changes are necessary, they further suggest that beta is the only relevant measure of a stock risk. It measures a stocks relative volatility; it shows how much the price of a particular stock jumps up and down compared with how much the stock market as a whole moves. For example if a share price moves exactly in line with the market then the beta is 1. A stock with a beta of 1.5 would rise by 15% if a market rose 10% and vice versa. The ICAPM on the other hand covers multiple currencies, different markets and considers exchange rate risk, trade barriers and a global market index while the CAPM simply considers only the domestic market. Consider therefore that a US international investment bank has the following betas in its foreign stock investments, 1.1, 0.95 and 1.3. The risk free rate of return is 4.5% and the average annual return on the market could be assumed to be 6.5%. Using the ICAPM formula mentioned above;

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Kj = Rf + j (Rm Rf)

ICAPM Kj = 0.045 + 0.95 (6.5% 0.045) = 0.0199 = 0.045 + 1.3 (6.5% 0.045) = 0.0269 = 0.045 + 1.1 (6.5% - 0.045) = 0.0229 CAPM Its been stated that the domestic markets are efficient, thus the market return is equal to the return on the domestic portfolio, which indicates that the beta will be 1, where the risk free rate of return is 2.9% we can thus calculate the CAPM assuming the market rate of return is 6.5%. 2.9% + 1.0 (6.5% - 2.9%) = 0.029(0.036) = 0.001044 We could now find the average figure for the ICAPM in an attempt to compare the return on both investments Average of the ICAPM = 0.0199+0.0269+0.0229 = 0.0697/3 = 0.0232 Observing the figures above the ICAPM is greater than the CAPM, which suggest that the returns on the foreign investments are more than that of the domestic one. Note that a positive beta means that the assets beta follows the markets return while a negative beta means the assets beta moves opposite the market returns (Damodaran, 2007). A beta of 1 indicates that the security's price will move with the market. A beta less than 1 means, that, the security will be less volatile than the market, while a beta greater than 1 indicates that the security's price will be more volatile than the market (Damodaran, 2007).

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IFMGT LIMITING ASSUMPTIONS OF THE CAPM AND ICAPM MODEL The attributes of the CAPM are that it presents distinctive and numerated predictions about how to measure risk and the link between expected return and risk. Investors use the model to determine the risk and return of an investment, they form decisions on the basis of the results derived from calculating the CAPM. Unfortunately, the empirical record of the model has been criticized for difficulties in its implementation. The model assumes that the markets are efficient; this limits the extent which corporations are able to eliminate unsystematic risk from their portfolios. Fama and French, (2004) pointed out that the CAPM measures the risk of a stock relative to comprehensive market portfolios, that in principle can include not just traded financial assets but could infer consumer durables and real estate. The measure of the market return as a determinant for the actual return of a stock will be inaccurate as the markets trade in a variety of commodities and assets. Beta is a measure of the non-diversifiable risk for any asset; it can be measured by the covariance of its returns with returns on a market Index, which is defined to be the asset's beta (Apte, 2006). Beta values are usually in the past and will not give an accurate value of a corporation portfolio risk if it engages into a recent project. In applying the beta formula MNC will need to find other firms with operating on the same wavelength and this is a difficult process. The CAPM also assumes that portfolios are well diversified and so it doesnt take into account the systematic risk involved. In the CAPM model the only factor that affect the calculation of an asset's expected return is that asset's co-movement with the market (i.e. its systematic risk). The ICAPM doesnt take into considerations taxes, inflation and transaction cost. Investing in foreign markets is mate with trade route barriers, quotas and taxes, which affect the investment of a portfolio. The application of beta to determine the return of the investing avoids the effects of taxes and other variables such as exchange rate risk associated with trading in foreign markets and trade barriers. Research carried out by Bujang and Nasirr, (1977) on sorted stock by earning price characteristics were that stocks with higher earning yields tend to have better returns than the CAPM would have predicted. Merton's (1973) intertemporal capital asset pricing model (ICAPM) was another attempt to replace the CAPM model. In the CAPM, investors care only about the wealth their portfolios produce at the end of the current period while in the Intertemporal CAPM, investors are concerned not only with their end-of-period payoff, but also with the opportunities they will have to consume or invest the payoff.

3). Evaluating whether to invest foreign allocation of stocks in euro-denominated bonds or in the US given the figures below;

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IFMGT TOTAL ASSETS TOTAL FOREGIN ASSETS FOREGIN STOCKS FOREGIN BONDS EURO-DENOMINATED BONDS INTEREST RATE US DENOMINATED BONDS INTEREST RATE CURRENT EXCHANGE RATE 1YEAR FORWARD EXCHANGE RATE $25Billion 15% 60% (betas: 1.1, 0.95, 1.3) 40% 4.5% 2.9% $1.4 per euro $1.5per euro

Total foreign assets ($) = percentage of total foreign assets * total assets 0.15 * 25b = $3.75billion Foreign Stocks ($) = total foreign assets in dollars * percentage of foreign stocks $3.75b * 60% (0.6) = $2.25billion Foreign Bonds ($) = total foreign assets in dollars * percentage of foreign bonds $3.75b * 40% (0.4) = $1.5billion Current euro-denominated bonds in dollars; where $1.4: 1euro = $1.5b/1.4 = 1.07414 Interest on euro bonds = 1.0714 * 4.5% = 0.0482 =0.0482*1.5 =$0.72315 Interest on US bonds = if the money stays in the US $1.5b * 2.9% = $0.0435 The interest on euro denominated bonds is $0.72315 while that of the US bonds is $0.0435, euro bonds earn higher than US bonds, so it is better for the US investment bank to allocate its investments in the euro denominated bonds.

PART B SUMMARY PHILIP FOJU SATIA 11 A4040572

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Multi-national corporations engage in trading across different time zones, cultures and political habits, this platform exposes MNC to various risk factors such as interest rate risk, exchanges rate risk and natural causes. A pertinent issue to be addressed by MNC is the interest rate risk that they face, an interest rate is a rate, which is charged or paid for the use of money. An interest rate is often expressed as an annual percentage of the principal (Hunt & Kennedy, 2004). Raising capital to finance projects by MNC can be obtained through loans or other methods such as debt securities, the loan is issued to these corporations for an interest rate, it could either be a fixed interest rate or a floating interest rate. A fixed interest rate is a loan or mortgage with an interest rate that will remain at a predetermined rate for the entire term of the loan while a floating interest rate is a loan with an interest rate that is allowed to move up and down with the rest of the market or along with an index (Hunt & Kennedy, 2004). A fixed interest is predetermined for the whole term of the loan contract while a floating interest rate alternates to the markets. In an article by Verick & Islam, (2010) they stated that interest rates were a cause to the 2008 economic recession arguing that they were far to low. This illustrates the magnitude, which interest rates have on the economy, which is correlated with operations of MNC. The LIBOR (London Interbank Offer rate) is used as a benchmark for short-term interest rate. The LIBOR is the rate at which banks are willing to lend funds to other bank in the interbank market. The British Bankers Association fixes the LIBOR on a daily basis. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year. The LIBOR rate is used to determine interest rates around the world. Corporations that get into a fixed interest rate can however swap this liability for a floating one; this process is referred to as SWAPS. A swap is an agreement between two or more parties to exchange a sequence of cash flows over a period in the future (Kolb, 2011). . This part examines the reasons why a fixed interest rate swap is more desirable for MNC; it illustrates the advantages of swapping a floating interest rate for a fixed one. Arguments here will centre on managing interest rate risk exposure, reduced risk in international trade, the elimination of destabilising speculation and a comparative advantage. It further considers a case study with a demonstration of the benefit of holding a fixed interest rate swap and finally it considers sovereign debts and the criteria utilised by credit rating agencies in their ratings of sovereign debts.

A). BENEFITS OF A FIXED INTEREST RATE SWAP LIBOR RATES 2011 (GREAT BRITISH POUND)

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Month / LIBOR rate 2011

First

Last

High

Low

Average

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IFMGT January February March April May June July August September October November December 0.559 % 0.557 % 0.559 % 0.557 % 0.557 % 0.556 % 0.562 % 0.581 % 0.568 % 0.568 % 0.569 % 0.556 % 0.561 % 0.581 % 0.568 % 0.671 % 0.571 % 0.584 % 0.558 % 0.561 % 0.581 % 0.581 % 0.671 % 0.571 % 0.584 % 0.556 % 0.556 % 0.562 % 0.564 % 0.566 % 0.564 % 0.569 % 0.558 % 0.557 % 0.557 % 0.568 % 0.572 % 0.572 % 0.565 % 0.577 % 0.584 % 0.584 % 0.583 % 0.581 %

0.581 % 0.624 % 0.624 % 0.581 % 0.589 % 0.582 % 0.589 % 0.582 % 0.582 % 0.582 % 0.585 % 0.582 % 0.582 % 0.583 % 0.583 % 0.580 %

Figure 1: -Source: Global-rates.com The above diagram shows the LIBOR rate of the Great British Pound for the year 2011, the first observation is the constant rate at which interest rates change. In August 2011 the opening LIBOR rate was 0.569% while the closing rate was 0.584% the variance in the month of August is thus 0.015%. This is a significant change in interest rate; a MNC that had a loan on a floating interest rate on the GBP will be exposed to a rise in interest rate on its loan and will have to pay more. Also the average interest rate in January 2011 was 0.558% and in December it was 0.581% this is an average increase of 0.023%. In other for MNC to avoid this constant increase in interest rate they will have to enter into a fixed interest rate loan. Managing Interest Rate Risk: having a fixed interest rate loan help MNC manage interest rate risk. As illustrated above interest rates are changing and due to high inflation they are moving upwards. A fixed interest rate swap will thus protect MNC from the changes in interest rates. Planning; The International Swaps and Derivatives Association Inc. (ISDA) indicates that the outstanding notional principal of interest rate swaps has grown consistently during the years 1987 through 1995 from $682.8 billion to $12.81 trillion. This illustrates the constant increase in the use of swaps by organizations as a tool in various economic ventures and most importantly in planning. Planning is an unequivocal part in the success of MNC, swapping will provide a platform for accurate financial planning and a heads on control in cash flows. A fixed interest rate swap as opposed to a floating one provides a constant cash flow and MNC can forecast future economic turnover and plan its financials. Hedging Risk; Consider a U.S. company (Party A) that is looking to open up a plant in Germany where its borrowing costs are higher in Europe than at home. Assuming a 0.6 Euro/USD exchange rate, the U.S. Company needs 3 million euros to complete an PHILIP FOJU SATIA 14 A4040572

IFMGT expansion project in Germany. The company can borrow 3 million euros at 8% in Europe, or $5 million at 7% in the U.S. The company borrows the $5 million at 7%, and then enters into a swap to convert the dollar loan into euros. The counter party of the swap may likely be a German company that requires $5 million in U.S. funds. Likewise, the German company will be able to attain a cheaper borrowing rate domestically than abroad let's say that the Germans can borrow at 6% within from banks within the country's borders. Subsequently, every six months for the next three years (the length of the contract), the two parties will swap payments. The German bank pays the U.S. Company the product of $5 million (the notional amount paid by the U.S. company to the German bank at initiation), 7% (the agreed upon fixed rate), and .5 (180 days / 360 days). This payment would amount to $175,000 ($5 million x 7% x .5). The U.S. Company pays the German bank the product of 3 million euros (the notional amount paid by the German bank to the U.S. company at initiation), 6% (the agreed upon fixed rate), and .5 (180 days / 360 days). This payment would amount to 90,000 euros (3 million euros x 6% x .5). There are several advantages to the swap arrangement for the U.S. Company. First, the U.S. Company is able to achieve a better lending rate by borrowing at 7% domestically as opposed to 8% in Europe. The more competitive domestic interest rate on the loan, and consequently the lower interest expense, is most likely the result of the U.S. Company being better known in the U.S. than in Europe. Arbitrage arguments; the terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible. Consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments as mentioned above. Where this is not true, an arbitrageur could similarly short sell the overpriced instrument, and use the proceeds to purchase the correctly priced instrument, pocket the difference, and then use payments generated to service the instrument, which he is short.

B). CALCULATIONS OF THE QUARTERLY SWAP PAYMENTS DUE FROM ABC LIMITED. ABC Ltd enters into a one year quarterly pay of = 2,000,000 Fixed rate = 6% Floating rate = LIBOR + 1% Period = 90days Quarterly payments: from ABC to Trust Invest = 2000000 * 0.06 = 120.000 * 3/12 = 30,000

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Trust Invest. To ABC Quarter 1: 2,000,000 * (0.05+0.01) = 120,000*3/12 = 30,000 Quarter 2: 2,000,000 * (5.4%+1%) = 128,000*3/12 = 32,000 Quarter 3: 2,000,000 * (5.8%+1%) = 136,000*3/12 = 34,000 Quarter 4: 2,000,000 * (7% * 3/12) = 31,000 ALTERNATIVE HEDGING POSSIBILITIES

A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment (Shapiro, 2009). Hedging is managing the risk factors associated with an investment; it reduces or eliminates risk either by taking a long or short position. Forward contracts; a Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future. No cash or assets are exchanged until expiry, or the delivery date of the contract. On the delivery date, forward contracts can be settled by physical delivery of the asset or cash settlement. The price agreed upon for the maturity date is known as the strike/exercise price. ABC Ltd could therefore enter into a forward contract where it locks in the price (strike price) to be paid at redemption day and avoid floating interest rates. Futures contracts; a futures contract is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets. Futures contracts do not refer to future values. ABC Ltd has the alternative possibility to enter into a futures contract where it signs to deliver a service or commodity at a predetermined date and price, this will hedge risk variables of floating exchange rates since the price/product has been determined. C). SOVEREIGN DEBT For more than 2000 years governments have had to borrow money just like corporations to finance projects or stimulate the growth of their economy. This usually takes the form of a bond issue (Government bond), generally promising to pay a certain amount on a certain date as well as periodic interest. The English government in 1693 issued the first government bond, to raise money to fund a war against France (Kolb, 2011). Since then governments have issued bonds to raise capital, Kolb, (2011) advanced the argument that sovereign governments want to maintain a reputation as good as credit risk to assure future access to international funds so they repay the debts

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IFMGT they owe now, as a result lenders feel sufficient confidence to extend funds. A sovereign debt is a debt that is issued by a national government. It is theoretically considered to be risk-free, as the government can employ different measures to guarantee repayment, e.g. increase taxes or print money (Financial Times). A government bond has the main characteristics as a corporate bond, its face value, and maturity date and coupon rate. Face value; is the amount that the issuer agrees to repay the bondholder at or by the maturity date, also referred to as par value, principal value or redemption value. Maturity date; is the number of years the debt is outstanding or the number of years remaining prior to the final principal payment. Coupon rate; is the interest rate the issuer agrees to, either annually or on a semiannual basis. Government bonds are considered less risky than corporate bonds, however certain governments are considered more credit worthy than others. The Oxford Advanced Learners dictionary defines a credit rating as an estimate of the ability to fulfil financial commitments, based on previous dealings. This however takes a broader perspective when dealing with sovereign debts. The credit worthiness of a country is determined by credit rating agencies such as Standard & Poors, Fitch and Moodys. G7 FINANCIAL LIABILITIES

General government net financial liabilities - PUBLIC DEBT Country United States Japan Germany France Italy United Kingdom Canada

% of GDP

% of GDP

% of GDP

% of GDP

% of GDP

% of GDP

% of GDP

2005 42.7 84.6 49.8 43.2 93.7 27.1 31.0

2006 41.8 84.3 47.9 37.2 90.6 27.7 26.2

2007 42.3 80.4 42.9 34.0 87.1 28.8 23.1

2008 47.2 84.4 45.0 44.3 89.6 33.1 22.4

2009 56.4 96.5 50.2 53.1 97.4 46.9 28.6

2010 65.2 104.6 54.7 60.7 100.8 59.0 32.6

2011 72.2 112.7 58.1 67.3 103.4 69.9 35.7

Figure 2: Source: Adopted from guardian.co.uk Figure 2 highlights the national debt of the G7 economies; an immediate observation is that Japan has the highest national debt in 2011 of 112.7% of GDP. Another insightful matrix is the constant increase of national debt between 2008 and 2011, government borrowing definitely increased, we could make allusion to the fact this was caused by the financial crisis, which started in 2008. UNITED KINGDOM PUBLIC NET DEBT

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Figure 3: Source: ukpublicspending.co.uk The above diagram illustrates the United Kingdom debt from 2000-2010, we immediately notice how it increases over the years from about 35% of GDP to approximately 60%+ of GDP. Government debt is an important part of a countrys economy; it affects economic growth in both a positive and negative ways. Also, the increasing debt here indicates that creditors are constantly lending out money to the UK, what are thus the factors considered by credit rating agencies in determining the credit worthiness of a country. DETERMINANTS OF SOVEREIGN CREDIT RATING

Credit rating business began in the United States in the early 1900s and has grown to take a wider role in America and across the world. Credit ratings provide individual and institutional investors with information that assists them in determining whether issuers of debt obligations and fixed-income securities will be able to meet their obligations with respect to those securities. There are three major credit rating agencies in the world; Fitch Ratings, Standard and Poors and Moodys investor Service. A credit rating is an assessment of the credit worthiness of individuals and corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities (Apte, 2006). Credit rating is a very important tool, a New York Time columnist, Thomas L. Friedman in an interview likened credit rating agencies to the American military might. What are the key factors used by these credit rating agencies in their rating of sovereign economies is the crux of the matter. Rating agencies assign a grade to a borrower according to its degree of relative creditworthiness. Credit rating agencies provide sovereign rating in grades, the grades range from AAA, the highest rate, (Fitch and S&P) or Aaa (Moodys) too respectively D and Caa, the lowest rate. For example, a credit rating between AAA and BBB- is used to denote an investment grade debt, while a debt rated BB+ to D is considered as speculative or high yield. Figure 4 illustrates.

RATING SYMBOLS FOR LONG TERM DEBT

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INTERPRETATION Highest quality High quality MOODY'S Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 S&P AAA AA+ AA AAA+ A ABBB+ BBB+ BBB-

Strong payment capacity

Adequate payment capacity

Figure 4: Source: Cantor & Packer, (1996).

Figure 5: Adopted from Cantor & Packer, (1996). Figure 5 highlights the main determinants of sovereign rating used by the three major rating agencies; per capita income, gross domestic product, inflation rate, fiscal balance and corruption index (Cantor & Packer, 1996). Per Capita Income refers to the measure of mean income within an economic aggregate. It is calculated by taking a measure of all sources of income in a country and dividing it by the total population. An increase in per capita income demonstrates a larger potential tax base. This is one of the mechanisms used by credit rating agencies. Gross Domestic Product represents the total dollar value of all goods and services produced over a specific time period. An increase thus illustrates the country can service its debt.

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IFMGT Inflation rate is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Low inflation indicates wellmanaged economic policies. Fiscal balance is the balance of a government's tax revenues, plus any proceeds from asset sales, minus government spending. If the balance is positive the government has a surplus that is an economically healthy. Corruption index shows the level of corruption in a country were there is low corruption it most likely to be attractive to investors. Theses are the key factors used by the credit rating agencies in the rating of sovereign debt. Figure 6 below shows the ratings of a few countries. CREDIT RATING BY COUNTRY

ISO code AL AO AR CA GR GB LT FR CM

Country Albania Angola Argentina Canada Greece United Kingdom Lithuania France Cameroon

MOODYS RATING B1 Ba3 B3 Aaa Ca Aaa Baa1 Aaa

MOODYS OUTLOOK STABLE STABLE STABLE STABLE DEVELOPING NEGATIVE STABLE NEGATIVE

Fitch RATING BBB AAA CCC AAA BBB AAA B

FITCH OUTLOOK STABLE STABLE STABLE

S and P RATING B+ BBB AAA SD AAA BBB AA+ B

S and P OUTLOOK STABLE STABLE STABLE STABLE NEGATIVE STABLE STABLE NEGATIVE STABLE

STABLE POSITIVE STABLE STABLE

Figure 6: Source: guardian.com Drawing from figure 6 Canada is quite stable with A ratings from all three rating agencies. A very poor rated country here is Greece with C and a negative outlook.

CONCLUSIONS SWAP has developed to be an essential tool for many MNC in recent years; it provides a basis for corporations to hedge exchange rate risk and avoids the ever-increasing interest rates on loans. Coupled with the recent 2008 recession interest rates are at it PHILIP FOJU SATIA 20 A4040572

IFMGT highest. Swapping floating interest rate for a fixed one is definitely advantageous to MNC. Swapping a floating interest rate for a fixed one is more advantageous than holding a floating interest rate. Governments issue bonds to raise capital to finance their projects or stimulate their economy, over the years government bonds have proven to have very low default features and its often refereed to as risk free bonds. The trusted nature of government bonds is embedded in their credit ratings. Credit ratings are carried out by credit rating agencies that consider main factors such as inflation rate of an economy, its fiscal balance and corruption index among other things. Lenders use these ratings to determine if a government will be able to pay back its debts. Credit rating is an important tool and the purpose, which it fulfils, is justified. REFRENCES Apte, P. G. (2006). International financial management. 4th Ed. New York: McGrawHill. Burnside, C. Eichenbaum, M. Kleschelski, I. Rebelo, S. (2006). The return on currency speculation. Available at< http://www.4.gsb.columbia.edu/null/download? &exclusive=filemgr.download&file_id=611926 [accessed 23/03/2012]. Carbaugh, R. J. (2008). International economics. New York: Cenage learning. Cantor, R. Packer, F. (1996). Determinants & impact of sovereign credit rating. Economic policy review, Vol 2,No 2. Damodaran, A. (2002). Investment Valuations: tools and techniques for determining the value of any asset. 2nd Ed. America: John Wiley & Sons. Fox, R. & Madura, J. (2007). International financial management. United Kingdom Thomson learning. Fama, E. F. & French, K. R. (1992). The cross section of expected stock returns. Volume 22, issue 6. Center for Research in Security Prices, Graduate School of Business, The University of Chicago. Hunt, P. G. & Kennedy, J. E. (2004). Financial derivatives in theory and practice. England: John Wiley & Sons Ltd. Kolb, R. W. (2011). Sovereign debt: from safety to default. Canada: John Wiley & Sons. Shapiro, A. C., (2009). Multinational Financial Management. 9th Ed. England: John Wiley & Sons. Global rates (2012). GBP LIBOR interest rates. [Online] Available at>http://www.global-rates.com/interest-rates/libor/british-pound-sterling/britishpound-sterling.aspx> [Accessed 27/03/2012].

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IFMGT Guardian, (2012). Credit ratings: how Fitch, Moodys and S&P rate each country. Available at<http://www.guardian.co.uk/news/datablog/2010/apr/30/credit-ratingscountry-fitch-moodys-standard [Accessed 04/04/2012]. Gilles, G. (2012). Trans-national corporations and international production: concepts, theories and effects. England: Edward Elgar Publishing Ltd. LIST OF TABLES Figure 1: LIBOR rates 2011 (GBP) Figure 2: G7 Financial Liabilities Figure 3: United Kingdom Public Net Debt Figure 4: Rating Symbols for long term debt. Figure 5: Determinants of Sovereign ratings. Figure 6: Credit rating by country.

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