Cross Exchange Rates • The exchange rate between 2 currencies where neither currency is the US dollar (domestic currency) • We know the dollar rates. What if we want to know other rates, i. e. S(€/£) ? – Calculate cross-rates from dollar rates – S($/€)=1. 5000 and S($/£)=2. 0000. What is S(€/£), i. e. the € price of £? 1
Cross-Exchange Rates • Cross-rates must be internally consistent; otherwise arbitrage profit opportunities exist. • Suppose that: • A profit opportunity exists. Either S(€/£) is too high or S(€/$) or S($/£) is too low. • How does this work? • Sell high and buy low. 2
Cross-Exchange Rates Example • Bank 1: S($/¥)=0. 0084; Bank 2: S($/€)=1. 0500; Bank 3: S(€/¥)=0. 0081. • The implied cross rate between Bank 1 and 2 is: S(€/¥)=0. 0080. • You have ¥ 1, 250, 000. What should you do? – Go to Bank 3. Convert ¥ 1, 250, 000 to € 10, 125. 00 @ 0. 0081 – Go to Bank 2. Convert € 10, 125 to $10, 631. 25 @ 1. 0500. – Go to Bank 1. Convert $10, 631. 25 to ¥ 1, 265, 625. 00 @ (1/0. 0084) Sell ¥ high! Buy ¥ low! – The initial ¥ 1, 250, 000 becomes ¥ 1, 265, 625. You earn a risk-free profit of ¥ 15, 625, or 1. 25%. 3
Cross Rate and Triangular Arbitrage • Arbitrage defined – Riskless arbitrage is a situation in which one can lock in a sure profit with no investment and no risk. – Economics Professor Hal Varian and the Yankee farmer • Triangular arbitrage – It is the process of trading out of the domestic currency into a second currency, then trading it for a third currency, which is in turn is traded for domestic currency again. – The purpose is to earn an arbitrage profit via trading into a second currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate.
Triangular Arbitrage Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage opportunity exists. $ Barclays Credit Lyonnais S(¥/$)=120 S(£/$)=0. 60 ¥ £ Credit Agricole S(¥/£)=210
Triangular Arbitrage The implied S(¥/£) cross rate is S(¥/£) = 200 $ S(¥/£)=210 so there is an arbitrage opportunity. Credit Lyonnais S(¥/$)=120 Credit Agricole has posted a quote of Barclays S(£/$)=0. 6 ¥ £ Credit Agricole S(¥/£)=210 So, how can we make money?
Triangular Arbitrage As easy as 1 – 2 – 3: $ 1. Sell our $ for £, Barclays 2. Sell our £ for ¥, S(¥/$)=120 Credit Lyonnais S(£/$)=0. 6 3. Sell those ¥ for $. ¥ £ Credit Agricole S(¥/£)=210
Triangular Arbitrage Sell $100, 000 for £ @ S(£/$) = 0. 60 receive £ 60, 000 Sell our £ 60, 000 for ¥ @ S(¥/£) = 210 receive ¥ 12, 600, 000 Sell ¥ 12, 600, 000 for $ @ S(¥/$) = 120 receive $105, 000 profit per round trip = $ 105, 000 - $100, 000 = $5, 000
Triangular Arbitrage Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage opportunity exists. Tk. Prime S(¥/Tk. )=1. 76 HSBC S(£/Tk. )=. 00714 ¥ £ Dhaka Bank S(¥/£)=250
Triangular Arbitrage Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage opportunity exists. Tk. Prime S(¥/Tk. )=1. 76 HSBC S(£/Tk. )=. 00714 ¥ £ Dhaka Bank S(¥/£)=250
Triangular Arbitrage The implied S(¥/£)cross rate is S(¥/£)= 246. 5 Tk. Prime S(¥/Tk. )=1. 76 Dhaka Bank has posted a quote of S(¥/£)=250 so there is HSBC S(£/Tk. )=. 00714 ¥ an arbitrage opportunity. £ Dhaka S(¥/£)=250 So, how can we make money?
Triangular Arbitrage As easy as 1 – 2 – 3: 1. Sell our Tk for £, Tk. Prime 2. Sell our £ for ¥, S(¥/Tk. )=1. 76 HSBC S(£/Tk. )=. 00714 3. Sell those ¥ for Tk. ¥ £ Dhaka S(¥/£)=250
Triangular Arbitrage Sell Tk. 100, 000 for £ at S(£/Tk. )=. 00714 receive £ 714 Sell our £ 714. for ¥ at S(¥/£) = 250 receive ¥ 178500 Sell ¥ 178500 for Tk. at S(¥/Tk. )=1. 76 receive Tk. 101420 profit per round trip = Tk. 101420 - Tk. 100, 000 = Tk. 1420
No Arbitrage Condition for Triangular Arbitrage • S(j/k)*S(k/l)*S(l/j) =1, i. e. the product of the spot rates is equal to 1, indicating zero profit • The no-arbitrage condition implies that when the arbitrager starts with one unit of a particular currency, s(he) ends up with one unit of the same currency after exchange
No Arbitrage Condition for Triangular Arbitrage • Suppose the following exchange rates hold: – S($/ ¥) = $0. 00960984 – S(¥/DM) = ¥ 60. 750 – S(DM/$) = DM 1. 7125 • See if there is an opportunity for triangular arbitrage? • Which rate is misaligned? • Calculate arbitrage profit.
The Forward Market • Forward market involves contracting today for the future purchase or sale of foreign exchange • Forward prices are quoted the same way as spot prices • Denote the forward price maturing in N days as FN – i. e. F 30($/£), F 180($/€), F 90(€/ ¥), etc. – F 30($/£) = 1. 558 – F 180($/€) =1. 051 – F 90(€/ ¥) = 0. 0081 16
Premium and Discount • The forward dollar price of the euro can be: – Same as the spot price – Higher than the spot price (euro at a premium) – Lower than the spot price (euro at a discount) • Examples: – S($/ €)= 1. 0051 – F 30($/ €)= 1. 0062 – F 90($/ €)= 1. 0070 – F 180($/ €)=1. 0075(in American terms the Euro is trading at a premium) – S(€ /$)=. 6653 – F 30(€ /$)=. 6645 – F 90(€ /$)=. 6635 – F 180(€ /$)=. 6630(in European terms the dollar is trading at a discount) 17
Spot Rate Quotations Clearly the market participants expect that the yen will be worth MORE in dollars in six months.
Forward Rate Quotations • Consider the example from above: for Japanese yen, the spot rate is ¥ 115. 75 = $1. 00 While the 180 -day forward rate is ¥ 112. 80 = $1. 00 • What’s up with that?
Wrap-Up • The foreign exchange market is by far the largest financial market in the world. • Currency traders trade currencies for spot and forward delivery. • Exchange rates are by convention quoted against the U. S. dollar/domestic currency, but cross-rates can easily be calculated from bilateral rates. • Triangular arbitrage forces the cross-rates to be internally consistent. • The euro has enhanced trade within Europe, and the currency has the potential of becoming a major world currency. 20
Corporate Governance 21
Home De(s)pot • Bob Nardelli took the helm at Home Depot in 2000, and sales soared from $46 billion in 2000 to $81. 5 billion in 2005. • Profits more than doubled… • Stock price has lagged the market • Bob Nardelli was paid $38. 1 million from his last yearly contract. • He refused to accept even a reduction in his current stock package, and only agreed to give up a guarantee that he would receive a minimum $3 million bonus each year. • Board members asked him to more closely tie his future stock awards to shareholder gains, but he refused. • Nardelli claims that he cannot control the stock price, so his compensation should not be tied to it… • Shareholders threatened to riot at annual meeting in May, 2007. • Nardelli was asked to leave on January 2, 2007, with a $210 million retirement package!!! 22
Agenda • • Governance of the Public Corporation Agency Problem Law and Corporate Governance Reform in the US – Sarbanes Oxley • Corporate Governance Reform in the UK – Cadbury Code 23
Governance of the Public Corporation • Corporate Governance – the economic, legal, and institutional framework in which corporate control and cash flow rights are distributed among shareholders, managers, and other stakeholders of the company. • Corporate scandals: Enron, World. Com, Global Crossing, Daewoo Group, Parmalat, and Satyam. • American executives “treat their companies like automated teller machines (ATMs), awarding themselves millions of dollars in corporate perks. ” (Harvard Business Review, 2003) • Corporate governance failures have detrimental effects on corporate valuations and the functioning of capital markets. 24
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Governance of the Public Corporation • Public ownership is associated with efficient risk sharing, access to low-cost capital, and the pursuit of risky investment projects. • Conflicts of interest between managers (agents) and shareholders (principals). – Shareholders elect the board of directors, who in turn hire and monitor managers. – Board composition (insiders/outsiders) – Shareholder monitoring (free-rider) • Conflicts of interest between controlling shareholders and outside shareholders. 26
The Principal-Agent Problem • Shareholders (principals) want profit • Managers (agents) want leisure & security • Conflicting motivations between these groups are called agency problems. – Professor Yunus blasts Telenor ethics in Bangladesh – Stock brokers and investors – Physicians and patients – Auto mechanics and car owners
Solutions to Agency Problems • Compensation as incentive • Extending to all workers stock options, bonuses, and grants of stock – It helps to make workers act more like owners of firm (but not always – Citibank and Managers) • Incentives to help the company, because that improves the value of stock options and bonuses • Good legal contracts that can be effectively enforced
The Agency Problem • Incomplete contracts create room for agency problems, and managers often grab the residual control rights. – Perquisites – Steal funds – Divert funds – Waste funds – Managerial entrenchment • Free cash flows, Payout problems 29 – Retain cash to avoid future capital raising – Size Higher compensation – Size Higher prestige
Remedies for Agency Problem • Board of directors – Outside directors on board – CEO and chairman of board different people – Europe – union representation, two-tier boards • Incentive contracts – Stocks and stock options – Independent compensation committee • Concentrated ownership – Germany, France, Japan, China, Latin America – Morck, Shleifer, and Vishny (1988): Effect of managerial ownership (%) on firm value is likely non-linear and entrenchment dominates in 5 -25% range for the US. 30
Firm Value Morck, Shleifer, and Vishny (1988) Alignment Entrenchment x 31 Alignment y Manager Ownership (%)
Remedies for Agency Problem • Accounting Transparency – Accurate accounting information in a timely fashion • Debt – Less managerial discretion with respect to payouts – Less flexibility for financing investment projects • Overseas Stock Listings – Credible bond to provide better investor protection (Doidge, Karolyi, and Stulz (2002)) • Market for Corporate Control – Disciplinary effect on managers and enhance company efficiency (US and UK) – Developing also in Germany, Japan, etc. 32
Law and Corporate Governance • La Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLSV) • Sharp differences among countries with respect to: – Corporate ownership structure – Depth and breadth of capital markets – Access of firms to external financing – Dividend policies • Explained by how well investors are protected from expropriation by managers and controlling shareholders and the origin of the country’s legal system. – English common law – discrete rulings, judicial precedent – French civil law – codification of legal rules (Roman) – German civil law – codification of legal rules (Roman) – Scandinavian civil law – codification/precedent 33
Law and Corporate Governance • LLSV (1998) Invented the: Shareholder Rights Index and the Rule of Law Index • English common law countries rank highest on shareholder rights, while Scandinavian and German civil law countries rank highest on enforcement. • Why are they so different? • Glaesser and Shleifer (2002) argue the explanation dates back to the Middle Ages. – France – power of adjudication to the center (King) – England - power of adjudication to a local jury 34
Consequences of Law • LLSV (1998) find that corporate ownership tends to be more concentrated in countries with weaker investor protection. Legal Origin Ownership Concentration External Cap/GNP Domestic Firms/Population English common law 0. 43 0. 60 35. 45 French civil law 0. 54 0. 21 10. 00 German civil law 0. 34 0. 46 16. 79 Scandinavian civil law 0. 37 0. 30 27. 26 35
Consequences of Law • Dominant investor may seek to acquire control rights in excess of cash flow rights – Shares with superior voting rights – Pyramidal ownership structure • Li Ka-Shing Family (Hutchison Whampoa) • Lee Keun-Hee (Samsung Electronics) • Robert Bosch Gmb. H (Daimler-Benz) – Interfirm cross-holdings • Private Benefits of Control that are not shared by other shareholders or pro rata basis – Nenova (2001) premium for voting shares: US 2. 0%, Canada 2. 8%, Brazil 23%, Germany 9. 5%, Italy and Korea 29% and Mexico 36%. . . – Dyck and Zingales (2003) block premium: Canada US and UK 1%, Australia and Finland 2%, Brazil 65%, Czech Republic 58%, Israel 27%, Italy 37%, Korea 16%, and Mexico 34%. 36
Consequences of Law • Capital Markets and Valuation – LLSV (1997) find that countries with strong shareholder protection tend to have more valuable stock markets and more companies listed on stock exchanges per capita than countries with weak protection. – Studies (e. g. , Lins (2002)) show that higher insider cash flow rights are associated with higher valuations, while higher insider control rights are associated with lower valuations. – Johnson, Boon, Breach and Friedman (2000) find that stock markets declined more in countries with weaker investor protection during the Asian financial crisis 1997 -1998. – Lemmon and Lins (2003) find that crisis period returns of firms in which managers have high levels of control rights, but have separated their control and cash flow ownership, are 10 -20 percentage points lower than those of other firms. – Financial market development also promotes growth. 37
Consequences of Law • Doidge, Karolyi, and Stulz (2004) – Almost all of the variation in governance ratings across firms in less developed countries is attributable to country characteristics rather than firm characteristics typically used to explain governance choices. – Firm characteristics explain more of the variation in governance ratings in more developed countries. – Access to global capital markets sharpens firm incentives for better governance, but decreases the importance of home-country legal protections of minority investors. 38
Corporate Governance Reform • Late 1990 s – Internal corporate governance mechanisms, auditors, regulators, banks, and institutional investors failed… • Strengthen the protection of outside shareholders against expropriation of managers and controlling shareholders 39 – Strengthening the independence of boards of directors with more outsiders – Enhancing the transparency and disclosure standard of financial statements – Energize the regulatory monitoring role of the stock market regulator and the exchanges – Modernize the legal framework
Sarbanes Oxley • Accounting regulation – Public accounting oversight board – Restricting consulting/auditing • Audit committee – Independent financial experts • Internal control assessment – Assessment by auditors and company (Section 404) – Deemed costly and contested – Cross-listing elsewhere… • Executive responsibility – CEOs and CFOs must sign off on the company’s quarterly and annual financial statements. If fraud causes an overstatement of earnings, these officers must return any bonuses. 40
Sarbanes Oxley • Many argue that SOX is hurting U. S. capital markets. – SOX undermines CEO’s appetites for risk – SOX is a full employment act for Accountants (404) • The Committee on Capital Markets Regulation, set up by U. S. Treasury Secretary Hank Paulson, advocates rolling back the Sarbanes-Oxley Act. • New York Governor-elect Eliot Spitzer, New York City Mayor Michael Bloomberg and U. S. Sen. Charles Schumer of New York have weighed in too, saying SOX is wrecking New York’s standing as the world’s financial markets. 41
Sarbanes Oxley • Many propose: – Section 404 attestation provisions should be rolled back for small companies, with an internal control review every two years. – The bar should be raised on what constitutes a “material weakness” in internal controls. – It is particularly foreign companies that are balking at SOX. • New markets are appearing… – Chi-X a London-based joint venture that claims it will offer cheaper trading in European stocks – Equiduct, and all-electronic, Pan-European exchange based in Belgium – Goldman Sachs, Merrill Lynch, Morgan Stanley, Citigroup, Credit Suisse, UBS, and Deutsche Bank reportedly will form a consortium to trade equities across Europe (already announced the same for US…) 42
Sarbanes Oxley • U. S. is losing out on new international listings… – London is beating the U. S. in the number of IPOs it draws. – Last year, the NYSE drew 192 IPOs and Nasdaq 126. – The LSE, often cited as the example of how SOX is chasing companies away, attracted a robust 617 IPOs, 510 of which were on the AIM, the exchanges small-cap market. – However, the U. S. IPOs are larger. • Of a total of $118. 2 billion raised through IPOs in 2006 – – 43 $17. 5 billion occurred on the LSE, $4. 2 billion on AIM $16. 9 billion on the NYSE $9. 4 billion on Nasdaq $0. 2 billion on AMEX, according to Thomson Financial.
NYSE Corporate Governance • Listed companies to have boards of directors with a majority of independents • The compensation, nominating, and audit committees to be entirely composed of independent directors • The publication of corporate governance guidelines and reporting of annual evaluation of the board and CEO 44
Cadbury Code of Best Practice • Corporate scandals in the 1980 s and 1990 s – Bankruptcy of Ferranti, Colorol Group, BCCI, and Maxwell Group • Cadbury Code – Boards of directors of public companies include at least three outside (non-executive) directors – The positions of CEO and chairman of the board of these companies be held by two different individuals • Cadbury Code is not legislated into law • LSE requires companies to “comply or explain. ” • Empirical research suggests the code has been effective despite not being enforceable in courts… 45
Corporate Governance Indices • • • FTSE ISS Corporate Governance Index Series (CGI) Quantifying the risk of corporate governance across international markets has posed a challenge for investors trying to deal with the increased recognition of the issue. The new FTSE ISS Corporate Governance Index (CGI) Series assists you with company analysis, portfolio management and stock selection against selected companies with a proven standard in corporate governance. The series is the result of a collaboration between FTSE and corporate governance experts ISS, two market leaders in their respective fields. The design incorporates ISS corporate governance ratings into a financial index. You will now be able to track the financial performance of companies against the universal themes in corporate governance practice of: – Compensation systems for Executive and Non – – – Executive Directors Executive and Non-Executive stock ownership Equity Structure and independence of the Board Independence and integrity of the audit process The series consists of six regional and country equity indices covering 24 developed countries as defined by the FTSE Global Equity Index Series. http: //www. issproxy. com/institutional/cgi/index. jsp 46
FTSE ISS CGI 47
Corporate Governance Around the World • European Corporate Governance Institute • http: //www. ecgi. org/codes/all_codes. php 48
Parmalat • How was it possible for Parmalat managers to “cook the books” and hide it for so long? • Investigate and discuss the role that international banks and auditors might have played in Parmalat’s collapse. • Study and discuss Italy’s corporate governance regime and its role in the failure of Parmalat. 49
Satyam Systems • A global IT company based in India • Satyam's CEO, Ramalingam Raju, took responsibility for broad accounting improprieties that overstated the company's revenues and profits and reported a cash holding of approximately $1. 04 billion that simply did not exist. • They usually start by fudging the number a little--and then it grows • What started as a marginal gap between actual operating profits and ones reflected in the books of accounts continued to grow over the years.
Satyam Systems • World Council for Corporate Governance awarded Satyam its Golden Peacock Award for Corporate Governance in 2008 • When an accounting fraud involves reporting cash that is not there, it is typically the result of adding fraudulent transactions, such as cash sales, to customers that never happened. These types of transactions should have been audited to assure their legitimacy. In the case of Satyam, the auditors signed off on the financial reports • We also need stiffer penalties. Simply put, "white collar" crime cannot be viewed as less of an evil than any other form of crime • If there isn't sufficient belief in the notion that business will act in good faith, then the capitalist system is itself at risk.
Conclusions • Agency conflicts may arise between managers and controlling shareholders on the one hand outside shareholders on the other hand. • Corporate governance: protecting shareholders against expropriation by managers and controlling shareholders. • Mechanisms to control agency problems: strengthening the independence of boards of directors, providing managers with incentive contracts, concentrating ownership, using debt, crosslisting to bond to better investor protection, and facilitating the market for corporate control. • The legal origin influences shareholder protection and enforcement of laws, and this in turn has consequences for corporate valuations. • Tradeoff concentrated ownership and lack of investor protection. • Corporate governance reform is an uphill battle… 52
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