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Chapter 9 Notes - Chapter 9 Interest Rate and Currency...

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Chapter 9 Interest Rate and Currency Swaps Questions 9-1. Triumvirate of Risks. Define and explain the three main financial risks facing a multinational enterprise. The three financial price risks facing all MNEs are exchange rate risk, interest rate risk, and commodity price risk. The first, exchange rate risk, was the subject of prior chapters and focused on transaction exposure, operating exposure, and accounting exposure. The second financial price risk, interest rate risk, can be subdivided into debt service (MNE liabilities) and interest-bearing securities (MNE assets). The third risk, commodity price risk, is the risk and exposure of the firm to key commodity input price changes such as oil, metals, agricultural inputs, etc. 9-2. Reference Rates. What is an interest “reference rate” and how is it used to set rates for individual borrowers? Whether it is on the left or right side, the reference rate of interest calculation merits special attention. A reference rate —for example, U.S. dollar LIBOR—is the rate of interest used in a standardized quotation, loan agreement, or financial derivative valuation. LIBOR, the London Interbank Offered Rate, is by far the most widely used and quoted. It is officially defined by the British Bankers Association (BBA). U.S. dollar LIBOR is the mean of 16 multinational banks’ interbank offered rates as sampled by the BBA at approximately 11 A . M . London time in London. Similarly, the BBA calculates the Japanese yen LIBOR, euro LIBOR, and other currency LIBOR rates at the same time in London from samples of banks. The interbank interest rate market is not, however, confined to London. Most major domestic financial centers construct their own interbank offered rates for local loan agreement purposes. These rates include PIBOR (Paris Interbank Offered Rate), MIBOR (Madrid Interbank Offered Rate), SIBOR (Singapore Interbank Offered Rate), and FIBOR (Frankfurt Interbank Offered Rate), to name but a few. 9-3. Risk and Return. Some corporate treasury departments are organized as service centers (cost centers), while others are set up as profit centers. What is the difference and what are the implications for the firm? Before they can manage interest rate risk, treasurers and financial managers of all types must resolve a basic management dilemma: the balance between risk and return. Treasury has traditionally been considered a service center (cost center) and is therefore not expected to take positions that incur risk in the expectation of profit. Treasury activities are rarely managed or evaluated as profit centers. Treasury management practices are, therefore, predominantly conservative, but opportunities to reduce costs or actually earn profits are not to be ignored. History, however, is littered with examples in which financial managers have strayed from their
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38 Eiteman/Stonehill/Moffett • Multinational Business Finance, Twelfth Edition fiduciary responsibilities in the expectation of profit. Unfortunately, much of the time they have realized only loss.
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