Ch' 8: Intl Equity Markets

1
Ch. 8 Intl Equity Markets

• Approximately 90 of global equity market
  capitalization is in the developed world.
• Remaining 10 of global equity market
  capitalization is in emerging markets.
• Emerging markets are growing faster but have
  greater volatility.

2
Emerging Equity Markets

• Most global equity funds allocate 5 of total
  assets to emerging markets.
• But, this is quite sizeable in relation to the
  market capitalization of emerging stock markets.
• Example In 2001 total emerging market exposure
  of global equity funds was approximately US108bn
  or about the size of Koreas total market
  capitalization!

Source IMF Global Financial Stability Report,
June 2002
3
Emerging Markets Overview
Notes (1) Sharpe Ratio (portfolio return
risk-free rate)/portfolio standard deviation.
Indicates whether returns reflect wise
investments or excess risk. (2) Why divide data
at 94? Mexico crisis.
Source http//www.imf.org/external/pubs/ft/GFSR/2
002/02/pdf/chp4.pdf
4
How do we measure liquidity?

• Turnover ratio ratio of stock market
  transactions over a period of time divided by the
  size, or market capitalization , of the market.
• Higher ratio ? more liquid market, easier to
  trade equities.
• Liquidity refers to how quickly an asset can be
  sold without a major price concession.

5
Liquidity

• The equity markets of the developed world tend to
  be much more liquid than emerging markets.
• Turnover ratio varies markedly over time and
  across markets (e.g. US 71 in 94 98 in 98)
• Sharp swings might reflect external macro or
  political factors that influence local demand for
  equities.
• Example Hong Kong was 55 in 94, 35 in 95,
  37 in 96, 118 in 97 and then 60 in 98!

6
Market Concentration

• Concentration ratio ratio of 10 largest stocks
  traded as a fraction of total market
  capitalization of all equities traded.
• When this is high, it may be harder to diversify
  a portfolio within the country as there are fewer
  investment opportunities.
• Emerging markets tend to be much more
  concentrated. A small of firms have greater
  impact on local market.
• Example China was 18 in 98 but the Philippines
  was 55 at same time.

7
International Equity Market Benchmarks

• Morgan Stanley Capital International Perspective
  (MSCI) the main benchmark.
• Monthly index covering 23 national stock market
  indices from developed countries.
• Includes 85 of market cap of each industry
  within the country. All stocks are market-value
  weighted. (Effective since 2002 book says 60.)
• Also publishes regional and global indices.
• Used by most funds/banks to recommend
  international investment strategy. Overweight
  relative to MSCI.
• http//www.msci.com/equity/index.html

8
World Equity Benchmark Shares

• Each fund is designed to approximate the return
  pattern of a designated MSCI country benchmark
  index.
• Country-specific baskets of stocks designed to
  replicate the country indexes of 14 countries.
• WEBS are subject to U.S. SEC and IRS
  diversification requirements. Trade as shares on
  the American Stock Exchange.
• Low cost, convenient way for investors to hold
  diversified investments in several different
  countries.
• Trading since March 1996.

9
Cross-Listing of Shares

• A firm has its equity shares listed on one or
  more foreign exchanges.
• The number of firms doing this has exploded in
  recent years.

10
Why would a firm cross-list?

• Expanded investor base
• Increased demand for stock ? raise price ?
  increase market liquidity.
• Make hostile takeovers more difficult and less
  likely.
• Increases name recognition in a market ?
  stimulate local demand for companys services.
• Increases name recognition in other markets to
  other customer groups ? easier for the firm to
  raise capital in the future.

11
American Depository Receipts

• An ADR is issued by a U.S. Bank, consisting of a
  bundle of shares of a foreign corporation that
  are being held in custody overseas. The foreign
  entity must provide financial information to the
  sponsor bank.
• Offers U.S. investors a convenient way to add
  global exposure to their portfolios.
• Lower administrative costs.
• Avoid foreign taxes on each transaction.

12
ADRs more!

• ADRs can be bought or sold just like the stocks
  of U.S. companies, and ADR trades clear and
  settle just like U.S. stock trades.
• ADRs are listed on either the NYSE, AMEX, or
  Nasdaq.
• ADRs do not eliminate the currency and economic
  risks for the underlying shares in another
  country.
• In early 90s about 60 of intl equity issues
  were in the form of ADRs closer to 80 in
  00-02.

13
Types of ADRs

• Sponsored ADRs
• Created by a bank at the request of the foreign
  company that issued the underlying security.
• Largely a historical anomaly now.
• (Not important to us.)
• Unsponsored ADRs
• Levels I, II and III

14
Unsponsored ADRs

• Created at the request of a US investment bank
  without direct involvement by the foreign issuing
  firm.
• Level I Most basic type of ADR. Foreign
  companies either dont qualify or dont wish to
  list on an exchange. Trade on the OTC market.
  Does not have to comply with US GAAP or full SEC
  disclosure.
• Level II Listed on an exchange or quoted on
  Nasdaq. Slightly more requirements from the SEC.
• Level III Most prestigious! Issuer floats a
  public offering on a US exchange.

15
Factors Affecting International Equity Returns

• Macroeconomic factors
• Imperfect correlation of international business
  cycles (not all countries experience ups/downs at
  same time).
• Weak influence.
• Exchange rates
• Cross-correlation of equity and forex markets is
  low but positive.
• Industrial Structure
• Some countries are more similar ? greater
  correlation of equity market movement
• Politics and sentiment

16
Trends in Equity Issuance

• Intl equity issuance has far exceeded domestic
  issuances in recent years.
• Enables top-quality emerging market companies to
  raise capital at lower cost.
• But, might dampen efforts to develop local equity
  markets.

Source http//www.imf.org/external/pubs/ft/GFSR/2
002/02/pdf/chp4.pdf
17
Ch. 9 Futures Options on Forex

• Why do we study these tools?
• Provide a more comprehensive understanding of the
  foreign exchange markets.
• Risk-management.
• Potential profit-making tool.

18
Futures vs. Forwards

• A futures contract is like a forward contract
• It specifies that a certain currency will be
  exchanged for another at a specified time in the
  future at prices specified today.
• A futures contract is different from a forward
  contract
• Futures are standardized contracts trading on
  organized exchanges with daily resettlement
  through a clearinghouse.

Source McGraw/Hill
19
Timing Spot Transaction
20
Timing Forward
21
Timing Futures
? Implies daily changes in margin account.
22
Standard Features of Futures Contracts

• Standardizing Features
• Contract Size (varies across exchanges and
  currencies but is constant over time look at
  p.211)
• Delivery Month (March, June, Sept, Dec.)
• Daily resettlement ? marked-to-market daily at
  the settlement price (closing price).

23
Initial Margin Requirements

• Margin requirements are complex and are not the
  same for writers of options on different types of
  contracts.
• Margin requirements are subject to change, and
  may vary between brokerage firms.
• Held as collateral by broker.
• Usually 2-4 of contract value paid in cash or
  T-bills.
• Account balance fluctuates because of daily
  resettlement.
• Margin amount is the same for short long
  positions.

24
Settlement Terminology

• Buyer holds a long position (seller short).
• If todays settlement price is higher than
  yesterdays, the buyer has a positive settlement
  for the day. This means the futures price of the
  underlying asset has increased. A long position
  in the contract is now worth more.
• Exact opposite for the seller.
• Thus, this is a zero-sum game.

25
Daily Resettlement An Example

• Suppose you want to speculate on a rise in the
  / exchange rate (specifically you think that
  the dollar will appreciate).

Currently 1 140. The 3-month forward price is
1150.
Source McGraw/Hill
26
Daily Resettlement An Example

• Currently 1 140 and it appears that the
  dollar is strengthening.
• If you enter into a 3-month futures contract to
  sell at the rate of 1 150 you will make
  money if the yen depreciates. The contract size
  is 12,500,000
• Your initial margin is 4 of the contract value

Source McGraw/Hill
27
Daily Resettlement An Example

• If tomorrow, the futures rate closes at 1
  149, then your positions value drops.
• Your original agreement was to sell 12,500,000
  and receive 83,333.33
• But now 12,500,000 is worth 83,892.62

You have lost 559.28 overnight.
Source McGraw/Hill
28
Daily Resettlement An Example

• The 559.28 comes out of your 3,333.33 margin
  account, leaving 2,774.05
• This is short of the 3,355.70 required for a new
  position.
• Your broker will let you slide until you run
  through your maintenance margin. Then you must
  post additional funds (variation margin) or your
  position will be closed out. This is usually done
  with a reversing trade.

Source McGraw/Hill
29
Basic Futures Terminology

• Open Interest refers to the number of contracts
  outstanding for a particular delivery month.
• Open interest is a good proxy for demand for a
  contract.
• Some refer to open interest as the depth of the
  market. The breadth of the market would be how
  many different contracts (expiry month, currency)
  are outstanding.

30
Open Interest

• When a contract month first starts trading, open
  interest is technically zero.
• Open interest increases over time, until
  positions are liquidated heading into expiration.
  
• Total open interest is the total number of
  outstanding positions in all the delivery months
  of a futures market.
• Liquidity implies at least 5,000 outstanding
  contracts.

http//www.activetradermag.com/futuresbasics.htm
31
Reversing Trades

• Rare in forward markets about 90 of all
  contracts lead to eventual delivery of the
  underlying assets.
• Commonplace in futures markets only about 1 of
  all contracts lead to delivery!
• This reflects the regularity of buyers purchasing
  offsetting positions and high liquidity.

32
Interest Rate Parity

• FT(/) S0(/) (1rUS)/(1r)T
• This theory worked for forwards (remember chapter
  5?). And now we can use it again!
• Why? If it doesnt hold then there exists an
  opportunity to arbitrage differences between the
  futures and forwards markets.

33
Eurodollar Interest Rate Futures Contracts

• Widely used futures contract for hedging
  short-term U.S. dollar interest rate risk.
• The underlying asset is a hypothetical 1,000,000
  90-day Eurodollar depositthe contract is cash
  settled.
• This means profits/losses are realized in the
  margin account based on the final settlement
  price on the last day of trading.

Source McGraw/Hill
34
Reading Eurodollar Futures Quotes
Eurodollar futures prices are stated as an index
number of three-month LIBOR calculated as F
100-LIBOR.
The closing price for the June contract is 94.68
thus the implied yield is 5.32 percent 100
94.68
 
The change was .01 percent of 1 million (1 basis
point) representing 100 on an annual basis.
Since it is a 3-month contract one basis point
corresponds to a 25 price change.
Source McGraw/Hill
35
Futures Contracts vs. Options

• Futures Contract youve agreed to purchase/sell
  the contract. No backing out but you can offset
  or exit a position by buying/selling to someone
  else.
• Buy long sell short.
• Option contract that gives you the right but
  not the obligation to purchase/sell something at
  pre-specified terms. No commitment.

36
Options

• An option gives the holder the right, but not the
  obligation, to buy or sell a given quantity of an
  asset in the future, at prices agreed upon today.
• Calls vs. Puts
• Call options right to buy an asset at some time
  in the future at prices agreed upon today.
• Put options right to sell an asset at some
  time in the future at prices agreed upon today.

Source McGraw/Hill
37
Currency Futures Options

• Are an option on a currency futures contract.
• Exercise of a currency futures option results in
  a long futures position for the holder of a call
  or the writer of a put.
• Exercise of a currency futures option results in
  a short futures position for the seller of a call
  or the buyer of a put.
• If the futures position is not offset prior to
  its expiration, foreign currency will change
  hands.

Source McGraw/Hill
38
Examples of Terminology

• Long on futures contract buy futures contract.
  (can also go short)
• Commitment guarantees you a certain quantity of
  a certain currency on a specific date.
• Intuition
• Similar to forward in many respects.
• Lower transaction costs because it is a
  standardized commodity.
• Easy to re-sell.

39
Examples of Terminology (2)

• Long call on futures option buy option to
  purchase a pre-specified amount of a
  pre-specified foreign currency at a pre-set price
  on an agreed upon date. (can also go short)
• Intuition
• Preserve flexibility.
• Leeway to change your opinion about a currencys
  trajectory over a specified time-frame.
• Limits downside potential.

40
Options Contracts Preliminaries

• Intrinsic Value
• The difference between the exercise price of the
  option and the spot price of the underlying
  asset.
• Speculative Value
• The difference between the option premium and the
  intrinsic value of the option.

Option Premium
Intrinsic Value
Speculative Value


Source McGraw/Hill
41
Currency Options Markets

• PHLX Philadelphia Stock Exchange
• HKFE Hong Kong Futures Exchange
• 20-hour trading day.
• OTC volume is much bigger than exchange volume.
  ( 46x) Why? Regulatory restrictions great
  explanation on p. 217.
• Trading is in six major currencies against the
  U.S. dollar. (Australian dollar, British pound,
  Canadian dollar, Japanese yen, Swiss franc, Euro)

42
European vs. American options

• With an American option, you can do everything
  that you can do with a European optionthis
  option to exercise early has value.
• CaT gt CeT MaxST - E, 0
• PaT gt PeT MaxE - ST, 0

Source McGraw/Hill
43
Basic Option Pricing Relationships at Expiry

• At expiry, an American call option is worth the
  same as a European option with the same
  characteristics.
• If the call is in-the-money, it is worth ST E.
• If the call is out-of-the-money, it is worthless.
• CaT CeT MaxST - E, 0

Source McGraw/Hill
44
Basic Option Profit Profiles Long Call

• CaT CeT MaxST - E, 0

profit
Long call
ST
EC
E
loss
Source McGraw/Hill
45
Basic Option Profit Profiles Short Call

• CaT CeT MaxST - E, 0

profit
ST
E
EC
short call
loss
Source McGraw/Hill
46
Basic Option Pricing Relationships at Expiry

• At expiry, an American put option is worth the
  same as a European option with the same
  characteristics.
• If the put is in-the-money, it is worth E - ST.
• If the put is out-of-the-money, it is worthless.
• PaT PeT MaxE - ST, 0

Source McGraw/Hill
47
Basic Option Profit Profiles Long Put

• PaT PeT MaxE - ST, 0

profit
long put
ST
E - p
E
loss
Source McGraw/Hill
48
Basic Option Profit Profiles Short Put

• PaT PeT MaxE - ST, 0

profit
ST
Short put
E
E - p
loss
Source McGraw/Hill
49
Currency Futures Options
The s in the call and put columns denote the
premium for a call or put expiring in the
specified months. So a call expiring in March
with a strike price of 8500 hundredths of a cent
(or 0.85 per 100) sells for a premium of 0.83
but the premium is substantially higher for the
April and May expiry dates.
Source WSJ
50
Test Theory Expiration Value of an American Call
Option (Ex 9.4)

• CaT CeT MaxST - E, 0
• Given that the strike price 8500, we have
  locked in a rate of 0.85/100 yen ? 10.625 mn.
• Suppose the exercise price 8400.
• CaT Max 8500-8400, 0 100.
• This means we have the option to buy 12.5mn yen
  at the current price of 0.84 per 100 yen ?
  profit of 125,000! ?
• Suppose the exercise price 8600.
• CaT Max 8500-8600, 0 0.
• Now, wed choose not to exercise the call because
  the exercise value is negative.

51
Currency Futures Options
The s in the call and put columns denote the
premium for a call or put expiring in the
specified months. So a put expiring in March
with a strike price of 8500 hundredths of a cent
(or 0.85 per 100) sells for a premium of 0.45
but the premium is substantially higher for the
April and May expiry dates.
Source WSJ
52
Test Theory Expiration Value of an American Put
Option (Ex 9.5)

• PaT PeT MaxE - ST, 0
• Given that the strike price 8500, we have
  locked in a rate of 0.85/100 yen ? 10.625 mn.
• Suppose the exercise price 8400.
• PaT Max 8400-8500, 0 0.
• This means we have the option to sell 12.5mn yen
  at the current price of 0.84 per 100 yen (when
  we paid 0.85!). Now, wed choose not to exercise
  the call because the exercise value is negative.
• Suppose the exercise price 8600.
• PaT Max 8600-8500, 0 100.
• This means we have the option to sell 12.5mn yen
  at the current price of 0.86 per 100 yen ?
  profit of 125,000! ?

53
Market Value, Time Value and Intrinsic Value for
an American Call

• CaT gt MaxST - E, 0

Profit
ST - E
Market Value
Time value
Intrinsic value
ST
E
Out-of-the-money
In-the-money
loss
We can draw similar pictures for puts. This is
just an example to illustrate the existence of a
premium.
Source McGraw/Hill
54
Interpretation of Graph

• Intrinsic Value you only care about it when you
  make a profit. Hence, this line was truncated at
  zero.
• Time Value reflects a gamble that the option
  might be more profitable (more in-the-money) as
  time passes (i.e. before time of expiry).

55
How is a call (or put) priced?

• Given that CaT gt MaxST - E, 0, the market value
  of this call will be greater or equal to this
  amount. Why?
• CaT intrinsic value of the call. Translation
  when you actually make a profit, this is
  positive. Otherwise you dont care.
• Premium time-value of money. You expect that
  the call will be worth more at date of expiry.
  This reflects private information or beliefs.
  This will be largest when date of collection is
  most distant.
• Market value Time value Intrinsic Value

56
One Very Important Caveat

• When we discuss whether to exercise a call or put
  at expiration we examine only the marginal value
  of exercising the option at that date.
• When we discuss profit we look at the relative
  values of strike and exercise price.
• But what happened to the initial premium we paid
  to purchase the option? That is an up-front cost
  that we have already absorbed in its entirety.
• Therefore we should really look at profits
  realized at time of option expiration net of
  initial costs.

57
Sailing in Uncharted Waters?

• How do you decide to go long/short a call/put or
  to buy a contract vs. an option?
• Hire PhD economists! ?
• Purchase research reports and follow their
  recommendations (e.g. each bank publishes
  forecasts).
• Take a guess and pray your intuition is good.
• Use 2 or 3 of these methods simultaneously. Most
  common is 1 2 together.
• Which method is best? Depends!
• Note the banks hire PhD economists too but the
  marginal cost to an individual company is lower.

58
Hedging Your Bets

• Suppose you arent sure which way an exchange
  rate will move. Could go up or down. If you
  guess wrong, you could lose big.
• So, try to protect yourself by using a
  complicated scheme.
• Instead of counting only on the future income
  generated by the futures contract (1),
• you borrow and lend the present value of the
  expected value at time of expiration (2).
• If your expectations are not fulfilled, you will
  have protected yourself via this hedge.

59
European Option Pricing Relationships

• Consider two investments
• Buy a call option on the British pound futures
  contract. The cash flow today is -Ce
• Replicate the potential upside payoff of the
  call
• Borrowing the present value of the exercise price
  of the call in the U.S. at i The cash flow today
  is E /(1 i)
• Lending the present value of ST at i The cash
  flow is - ST /(1 i)

Source McGraw/Hill
60
European Option Pricing Relationships

• When the option is in-the-money both strategies
  have the same payoff.
• When the option is out-of-the-money the borrowing
  and lending strategy has a higher payoff.
• Thus

Source McGraw/Hill
61
European Option Pricing Relationships

• Using a similar portfolio to replicate the upside
  potential of a put, we can show that

Source McGraw/Hill
62
Option Value Determinants
Call Put 1. Exchange rate (S)
2. Exercise price (E) 3. Interest
rate in U.S. (i) 4. Interest rate in
other country (i) 5. Variability in
exchange rate 6. Expiration date
7. Interest rate spread (i - i)
The value of a call option C0 must fall
within max (S0 E, 0) lt C0 lt S0. The precise
position will depend on the above factors.
63
Portfolio Evaluation (1)

• Imagine a simple world where the dollar-euro
  exchange rate is S0(/ ) 1 today and in the
  next year, S1(/ ) is either 1.10 or .90.

S0(/ )
S1(/ )
1.10
1
.90
Source McGraw/Hill
64
Portfolio Evaluation (2)

• A call option on the euro with exercise price
  S0(/ ) 1 will have the following payoffs.
  
• We can replicate the payoffs of the call option
  with a levered position in the euro.

Source McGraw/Hill
65
Portfolio Evaluation (3)
debt
portfolio
-.90
.20
-.90
.00
Source McGraw/Hill
66
Portfolio Evaluation (4)

• In this example, the portfolio has twice the
  options payoff so the portfolio is worth twice
  the call option value.
• The portfolio value today is todays value of one
  euro less the present value of a .90 debt
• We can value this option as half of the value of
  the portfolio

67
Portfolio Evaluation (5)

• The most important lesson to draw from this is
  that a position can be replicated by building a
  portfolio. The replicating portfolio
  intuition.
• Many derivative securities can be valued by
  valuing portfolios of primitive securities when
  those portfolios have the same payoffs as the
  derivative securities.

Source McGraw/Hill
68
Technical Extension

• Weve determined the lower bounds on call put
  premiums but have not figured out exact pricing.
• To derive the exact pricing scheme, youd need to
  adjust for all possible scenarios
• volatility of exchange rate movements,
• probabilities of appreciation and depreciation,
  and
• the risk-free hedge ratio.
• If youre really gung-ho about this, read pages
  225-227 very carefully. Otherwise, spend just a
  few minutes on that section enough time for
  your eyes to glaze over and youre done.