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The root of the banking crisis in less developed countries (LDCs) can be traced to the late 1970s. In the late 1970s, OPEC raised oil prices. This was accompanied by inflation and high unemployment in developed countries. In response, developed countries tightened monetary policies and a global recession resulted.
As part of this global recession, the demand for oil and other commodities fell. The result of this change in demand and change in economic policies led to a rise in real interest rates, increasing the borrowing costs for LDCs. Since most of the LDCs debt was denominated in U.S. dollars and the rates were floating, the collapse of commodity prices on which LDC economies depended resulted in the LDCs being unable to service their debt.
In response to the LDC crisis, a secondary market for LDC debt developed in which LDC debt was purchased using debt-for-equity swaps. In this type of debt restructuring, creditor banks would sell their loans in U.S. dollars at significant discounts to multi-national corporations (MNCs). These MNCs would then sell the debt to a LDC central bank at a smaller discount and in local currency. The MNC would then use the local currency to invest in preapproved projects or firms in a way that was socially or economically beneficial to the LDC and its population. In this way, the LDC received debt relief and was the recipient socio-economic benefit from the MNC's investments.
In 1989, the Bush administration approved creation of the Brady Bond. As part of a long term solution to the problem, the U.S. Treasury designed a program by which creditor banks could convert loans to marketable bonds with a face value of 65% of the original loan amount, convert the loans into collateralized bonds with a rate reduced to 6.5% or lend additional funds to the LDCs to allow them to get on their feet. The majority of creditor banks chose the second option.
Brady Bonds, as they are called, are zero coupon U.S. Treasury bonds purchased by the debtor nation that extend the maturity date of LDC debt by 25-30 years and guarantee the marketability of LDC debt. This solution has provided an "out" to 12 of 16 debtor nations and by 1992, 92% of LDC debt had been refinanced. In total, $100 billion in debt has been refinanced with Brady Bonds.
Detroit Motors Mini-Case
Initial analysis shows that Detroit Motors should make their first sales pitch to Mexico.
Need to raise
Amount of Debt needed
Cost of debt to get $65M in capital
It will cost DM $35,035,000 to purchase $81,250,000 of Mexican debt. This debt can be redeemed for $65M in Mexican Pesos, which can then be used to build the plant. If Mexico is not a contender, the next best option is Venezuela, then Chile. The fact that Chile is redeeming the debt at 100% of face value and that debt is being sold at a price almost twice of the other two contenders keeps Chile a distant third.
There are a number of characteristics that distinguish foreign bonds from Eurobonds, but the main differentiation involves the currency denomination. A foreign bond is issued by a foreign borrower and is denominated in the investors' nation's currency. Foreign bonds often have specific names depending upon the country in which they are issued. A Eurobond is issued by a country, sold to investors in another country, but denominated in a currency other than that of the investors' country. These bonds are known by the currency in which they are denominated rather than the country that issued them. Eurobonds account for the majority of the international bond market due to regulations and ownership restrictions. Usually, Eurobonds are bearer bonds, meaning physical possession equates to ownership.
Investors favor these bonds because they value privacy and allow for tax evasion. Since investors will accept lower yields on these bonds, bearer bonds are usually less costly for the issuer. Foreign bonds are often registered bonds where the owner's name is recorded, making tax evasion unlikely. Finally, foreign bonds must meet security regulations of the issuing country, including registration and detailed financial disclosure. Because Eurobonds do not have to meet security regulations, have lower interest rates compared to foreign bonds, and are issued to the market quicker than foreign bonds, Eurobonds are more attractive to investors and therefore make up the majority of the market (Eun and Resnick, International Financial Management, Chapter 12).
In general, Standard & Poor's credit rating measures the country's financial capacity to pay its financial obligations. Standard & Poor determines credit ratings of sovereign governments based on a number of factors, including political risk, income and economic structure, growth prospects, and fiscal flexibility. Political risk includes the country's political institutions, processes, public security, and government leadership while the economic structure incorporates labor and the competitiveness of the nonfinancial private sector. S&P looks at the growth prospects of the country as well as the past rate of economic growth and the country's savings and investments. Fiscal flexibility includes revenue, expenditure and surplus or deficit trends, pension obligations, and financial reporting transparency. S & P also takes into consideration a government's debt burden, including capital market analysis and debt as a percent of GDP, offshore liabilities, external debt burden and liquidity, and monetary flexibility, including credit expansion, monetary policies, and financial institutions (Eun and Resnick, International Financial Management, Chapter 12).
A stock market is considered emerging if it is either located in a low or middle income economy or its market capitalization is relatively low. As an investor, I would consider a number of factors before investing in the stock market of a developing country, including capitalization, liquidity and market concentration. In order to indicate the ease with which stocks can be traded within an emerging stock market, I would measure the liquidity of the market. This turnover ratio is the ratio of stock market transactions over a period of time divided by the market size. In addition to liquidity measures, I would analyze market concentration since the more concentrated a market is in a few stock issues, the less opportunity investors have to internationally diversify their portfolios. As an investor, I would also take into account the market structure (or the marketability of the secondary market) as well as the domestic factors of the specific country, including exchange rates, interest rates, and expected inflation rates (Eun and Resnick, International Financial Management, Chapter 13)
Empirical studies have shown that domestic factors are more important than international factors in affecting equity returns. Domestic factors, of course, are closer to the country in question and can have direct and drastically impactful effects on equity returns. International monetary changes, for example, had weak influences on returns when compared with domestic changes because international changes may not affect certain countries in the same way or in the same degree as they affect other countries. Domestic changes in monetary policy, labor laws, and interest rates have more immediate effects on a country's returns and overall daily business transactions.
A firm's industrial membership is not significant in predicting the international correlation structure of international stocks mainly because industry factors do not necessarily coincide with domestic factors. Industry factors are based upon firms in a particular industry across the world and are often too general to apply to every firm within that industry. Assuming a company's equity return based solely on its industry would be poor decision making with incomplete information. The country in which the firm resides plays a huge role in determining the success, failure, and equity return of that firm; it is important to remember the country characteristics are partly responsible for shaping the industries of that country (Eun and Resnick, International Financial Management, Chapter 13).
One of the factors in the recent surge in international portfolio investment is the rapid globalization of modern financial markets. Recent technological advancements in computer and communication have dramatically reduced formidable costs associated with investments abroad. As a result of these advances and increased demand, banks (both commercial and investment) have helped to facilitate international investment by creating products such as country funds and ADRs. In addition, several countries that were previously cautious about letting foreign investors enter, have loosened and started to deregulate capital and forex markets, creating an international investor friendly climate. Finally, due to an increase in information available to the general public, individual investors are aware of the potential gains available outside of their countries that institutional investors may have only known previously.
The beta of a security measures the sensitivity of returns compared to the entire market portfolio. Beta can also be seen as a measure of the systematic risk associated with an individual security. If we were to define beta statistically it would be as follows: Cov(Ri, RM)/Var(RM), where Ri and RM are the expected returns of the individual investment and the market. The lower the beta, the lower the associated risk relative to the market performance.
[(135-120)/120]+[((1/1.06)-(1/1.15))/(1/1.15)]=Return of the Euro
.125+.085=Return of the Euro
.210=Return of the Euro
â‚¬10,000*.21=â‚¬2,100 Profit from this Investment
The rate of return is 21% in terms of Euros
The exchange rate movement is responsible for 8.5% of the return.
Maturity value US Dollar=(Â¥1,000,000,000/95)*1.06=$11,157,895
Dollars needed to pay loan=(Â¥1,000,000,000*1.028)/105=$9,790,476
A profit was realized because the dollar appreciated against the yen and the interest rate was substantially higher in the US than in Japan following the principles of uncovered interest arbitrage.
During a turbulent market phase, cross country correlations to equity returns have a tendency to increase. As a result, benefits from international diversification are mitigated in the short term.
Assuming an investor can wait out any short term turbulent market conditions and does not need to liquidate their investments, they can realize the long term benefits of international investments in the long run by holding onto their investment as opposed to selling in a panic.
IRP implied that F=(1.06/1.08)/(1/100)=$.010516/Â¥=Â¥95.09/$
Hind's expected forward rate is Â¥98/$ so clearly HFS can receive more dollars by shorting the Yen forward than by avoiding a hedge position at all. Relative to the IRP forward rate, Hind underestimates the future strength potential of the Yen.
There are several factors to consider when evaluating the political risk associated with making FDI in a foreign country. The host country's government system and frequency of changes in government policy is an important factor to consider. Also important is the number of political parties as well as their history, ideology and popularity. Another factor to consider is whether the country is a member of any of the major international organizations. A country is viewed as less risky and more likely to adhere to the rules if it has ties to a major international association such as the EU, OECD or WTO. The host country's religious stability and whether or not religious conflict is present is another important factor to consider when evaluating political risk. A country's relationship with its neighbors and whether they are peaceful and cooperative or hostile and aggressive with one another should be considered as well. Finally, there are certain economic factors that may influence the political risk of a country. Trade deficits, uneven income distribution and recessions are examples of economic factors that can cause governments to stop interest payments, freeze bank deposits and enact trade barriers, all of which can severely impact MNCs (Eun and Resnick, International Financial Management, Chapter 16).
Enron versus Bombay Politicians Mini Case
The biggest mistake that Enron made was not evaluating the political risk in India. Enron didn't take into account that the Bharatiya Janata Party (BJP) vehemently opposed foreign investments. Though the BJP openly announced that if elected, they'd cancel foreign projects that didn't meet their approval, Enron pushed forward and began construction on the project, acting as though they were immune to this potential obstacle. Enron also acted too hastily in closing the deal for its $2.9 billion dollar power project.
Enron should have given the political environment in India more serious consideration before finalizing its power project. Enron should have taken into account that the opposing political party, the BJP, did not approve of their project and intended to cancel it if elected. Enron could also have benefitted from taking its time to close the deal. If they'd waited for the outcome of the election before finalizing the project and beginning construction, they would not have risked losing money if the BJP party canceled the project.
Another option that Enron could have undertaken to minimize their exposure to India's political risk would have been to form a joint venture with an Indian company from the very beginning. By structuring the project so that it was partially owned by a local company, the odds of the BJP party canceling the project would have been greatly reduced. Also, Enron should have made the details of the project public from the onset. That would have served to ease the concerns of critics and others that opposed the project. Since there was already a strong aversion towards foreign investments by these groups, the fact that Enron kept the contract details confidential only ended up hurting them.
2. Mortgage Securitisation in Hong Kong and Asia
What are the benefits of securitisation?
Securitisation provides benefits to a country's economy, participating banks and investors. In terms of the economy, securitisation allows a country to raise cash while facilitating the development of its debt market. Securitisation provides the means to connect a countries capital market with its financial market by pooling financial assets and turning them into capital market commodities. Banks benefit from securitisation by using securitisation as an alternative funding tool by freeing up capital. This results in greater liquidity for the bank, which in turn can lower interest rates, allowing the bank to lend more and have greater financial flexibility. Securitisation is beneficial to investors because it provides an avenue to diversify which results in lower risk. Further benefits include the ability to invest in specific tranches which meet each investor's specific investment goals.
This does not mean that securitisation is without risks. Some of these risks include unreliable investment ratings, changes in tax codes which can affect income, and default risks. This risk is mitigated by insurance which guarantees payments of interest and principal to investors. There is also greater risk to the economy as a whole, when loans are packaged into securities a regional economic problem can impact the entire economy. This is due to the complex nature of these pooling agreements, which make it difficult to track who owns what loans. As seen in the U.S. 2007 credit crunch, if interest rates rise and borrowers begin defaulting on their loans, commercial paper investors become unwilling to finance Structured Investment Vehicles, which dries up liquidity worldwide (Eun & Resnick, Chapter 11, International Financial Management, 5th Ed.). Many investors found themselves forced to write down billions of dollars of subprime debt.
Ultimately, investing is a balance between risk and return. Securitisation lowers the risk and can guarantee a return for investors. The economy has a higher risk but more opportunity for growth which is provided for by the success of the securitisation market. Banks benefit and are able to grow, which in turn drives more lending, and in turn, more economic growth.
Discuss the preconditions required for developing an MBS market.
There are several preconditions that must be met before development of an MBS market can occur. These include having an established bond market, the establishment of regulations and a regulatory government agency, and strong tax and regulatory laws.
An established domestic bond market is vital to the success of the secondary mortgage market. Before an MBS market can take hold and be successful, a large investor pool is needed. To attract a larger more diversified investor base, a strong bond market needs to be established. Regulations and regulatory agencies are also needed to develop an MBS market. These agencies and regulations provide oversight and guidelines for the MBS process. Without these guidelines and regulations, investors would be hesitant to invest in the MBS market and skittish of fraud.
Finally, strong tax and regulatory laws are needed. Strong tax laws allow investors and lenders to easily purchase and sell securities. Regulatory laws, such as foreclosure laws, ensure that if default occurs, foreclosures are processed in accordance to the law as well as any security agreement guidelines. This provides peace of mind to investors, further lowering their risk and allowing the MBS market to take hold.
Was the HKMC's venture into MBS products a timely one?
HKMC's venture into MBS products was timely. In 1997 when the first MBS deal was brokered, inflation was trending upwards and unemployment was on the rise. HKMC helped to stimulate the emerging bond marketing and secondary mortgage market, which in turn benefited Hong Kong by promoting home ownership and improving banking and monetary stability (Ho, Mary. Mortgage Securitisation in Hong Kong and Asia. Case study. University of Hong Kong, 2001.) By 2001, Hong Kong unemployment was trending down and GDP recognizing growth year over year. However, if the government had established the HKMC when they first began issuing MBS in the late 1980's, the MBS market would have grown much faster and Hong Kong may have weathered the Asian financial turmoil much more successfully.
Since the publication of this article, many assumptions about MBS investments warrant a second look. It was thought that MBS investments reduced risk and were a sound investment. However, since 2007, many banks and investors have lost billions due to borrowers defaulting on subprime loans. One study performed by the American Enterprise Institute for Public Policy Research recommends privatizing the MBS marketing and only allowing prime loans to be bundled into securitsations (Wallison, Peter J. "Taking the Government Out of Housing Finance: Principles for Reforming the Housing Finance Market." Aei.org. 24 Mar. 2011. Web. 26 Mar. 2011). HKMC followed the model created by the U.S. to form their MBS market; however, their lending requirements were more stringent and their default rates were much lower than the US. While HKMC's venture was timely, the longevity of the market depends upon the stability of the loans which were used to create the securities.
3. Huaneng Power International Inc.: Raising Capital in Global Markets
1. What are the benefits to a non-U.S. firm from listing on a U.S. exchange?
A non-U.S. firm that lists on a U.S. exchange gains exposure to a broader pool of investors. With a larger pool of investors, an increase in demand could increase the market price. There may also be legal and political benefits to a foreign firm to list on a U.S. exchange. In the case of the PRC, the PRC courts would probably not enforce any judgments against one of its firms that were obtained in another country. This means that foreign shareholders have little to no recourse if they feel the board of directors is not acting in the best interest of the shareholders. Also in the case of the PRC and HPI, the PRC government passed laws which allowed power companies that were raising capital internationally to earn a guaranteed rate of return. The intent was to draw foreign investors who had concerns about investing in the PRC. Another reason that a non-U.S. firm may choose to list on a U.S. exchange is related to recent regulations and competition. With HPI, the U.S. exchange was very favorable, as U.S. utilities had been deregulated, which led to decreased profits. This would have made HPI a more attractive utility investment.
2. Will foreign investors be interested in investing in this company?
Foreign investors will likely be interested in investing in Huaneng Power International, Inc. (HPI). Because power requirements in the PRC are growing rapidly, there is a huge demand for new power plants, which HPI will provide. HPI has a great business plan for increasing installed capacity, using modern technology and equipment from foreign suppliers that is more efficient and reliable. Also, the company has a track record of success as a spinoff of Huaneng Power International Development Corporation (HPIDC). All of HPIDC's plants currently in operation had successfully used foreign equipment and technology. Additionally, the plants were all completed on time and within budget and are operating profitably.
Foreign investors also will be lured to this company based on guaranteed returns. The Ministry of Electrical Power influenced the government to pass legislation which allowed certain companies in high electricity growth areas to earn a guaranteed rate of return on electrical generating assets. This was done to entice foreign investors who might be concerned about the risks of investing in the PRC.
Another attraction for foreign investors has to do with the recent deregulation of utilities in the U.S., which decreased the profitability of U.S. utility companies. HPI's guaranteed returns would appear to be more desirable by comparison.
The fact that HPI chose to apply for a Level III American Depository Receipt is seen as promising to new investors. Although HPI was not accustomed to the strict regulatory and reporting requirements associated with this type of ADR, investors may view this as a sign that the company is making a move towards improved corporate governance.