Team 8HW_2

.docx

School

Arizona State University *

*We aren’t endorsed by this school

Course

MISC

Subject

Economics

Date

Feb 20, 2024

Type

docx

Pages

Uploaded by PresidentAardvark2617

Group Homework Assignment #2 Leila Bandringa Branden Garbin Brad Johnson Shana Lear Janna Rowell Part I: Chapter 11, Question 8: How did the credit crunch become a global financial crisis? The inability for borrowers to easily obtain credit, also known as the ‘credit crunch,’ began in 2007. Three factors contributed to the crunch:  The liberalization of banking and securities regulation,  A global savings glut and  The low interest rate environment created by the Federal Reserve As the credit crunch worsened, many collateralized debt obligations (CDOs: a corporate entity constructed to hold a portfolio of fixed-income assets as collateral) found themselves stuck in various tranches of mortgage-backed securities (MBS) debt which they had not yet placed or were unable to place as countrywide foreclosure rates escalated. Commercial and investment banks were forced to write down billions of subprime debt. As the U.S. economy slipped into recession, banks also started to set aside billions for credit card debt and other consumer loans they feared would go bad. Credit rating firms lowered their ratings on many CDOs after realizing the models they used to evaluate the risk of the various tranches were mis-specified. Additionally, the credit rating firms downgraded many MBS, especially those containing subprime mortgages, as foreclosures around the country increased. An unsustainable problem arose for bond insurers who sold credit default swap (CDS) contracts and the banks that purchased this credit insurance. As bond insurers were hit with claims from bank-sponsored structured investment vehicles (SIVs: a virtual bank, frequently operated by a commercial bank or investment bank, but which operates off the balance sheet) as the MBS debt in their portfolios defaulted, downgrades of the bond insurers by the credit agencies required the insurers to put up more collateral with the counterparties who had purchased the CDSs. This put stress on their capital base and prompted additional credit rating downgrades, which in turn triggered more margin calls. By September 2008, a worldwide flight to quality investments – primarily short-term U.S. Treasury Securities – ensued. In October 2008, the spread between the three-month Eurodollar

rate and the three-month U.S. Treasury bill, frequently used as a measure of credit risk, reached a record level of 543 basis points. The demand for safety was so great, that in November 2008, the one-month U.S. Treasury bill was yielding just one basis point. Investors were essentially willing to accept zero return for a safe place to put their funds. Detroit Motors Mini Case It is September 1990 and Detroit Motors of Detroit, Michigan, is considering establishing an assembly plant in Latin America for a new utility vehicle it has just designed. The cost of the capital expenditures has been estimated at $65,000,000. There is not much of a sales market in Latin America, and virtually all output would be exported to the United States for sale. Nevertheless, an assembly plant in Latin America is attractive for at least two reasons. First, labor costs are expected to be half what Detroit Motors would have to pay in the United States to union workers. Since the assembly plant will be a new facility for a newly designed vehicle, Detroit Motors does not expect any hassle from its U.S. union in establishing the plant in Latin America. Secondly, the chief financial officer (CFO) of Detroit Motors believes that a debt-for-equity swap can be arranged with at least one of the Latin American countries that have not been able to meet its debt service on its sovereign debt with some of the major U.S. banks. The September 10, 1990, issue of Barron’s indicated the following prices (cents on the dollar) on Latin American bank debt: Brazil 21.75 Mexico 43.12 Argentina 14.25 Venezuela 46.25 Chile 70.25 The CFO is not comfortable with the level of political risk in Brazil and Argentina, and has decided to eliminate them from consideration. After some preliminary discussions with the central banks of Mexico, Venezuela, and Chile, the CFO has learned that all three countries would be interested in hearing a detailed presentation about the type of facility Detroit Motors would construct, how long it would take, the number of locals that would be employed, and the number of units that would be manufactured per year. Since it is time consuming to prepare and make these presentations, the CFO would like to approach the most attractive candidate first. He has learned that the central bank of Mexico will redeem its debt at 80 percent of face value in a debt-for-equity swap, Venezuela at 75 percent, and Chile 100 percent. As a first step, the CFO decides an analysis based purely on financial considerations is necessary to determine which country looks like the most viable candidate. You are asked to assist in the analysis. What do you advise? No matter where Detroit Motors builds its new facility, the company will still need $65,000,000 in that country’s currency to build the plant. The company must complete an analysis –

comparing the dollar cost of the less-developed country’s debt from a creditor bank to provide $65,000,000 in local currency upon redemption with the country’s central bank. To build in Mexico: $65,000,000/.80 = $81,250,000 Detroit Motors must purchase $81,250,000 in Mexican sovereign debt to have $65,000,000 in pesos after redeeming it from the Mexican central bank. $81,250,000 x .4312 = $35,035,000 The cost in dollars will be $35,035,000. To build in Venezuela: $65,000,000/.75 = $86,666,667 Detroit Motors must purchase $86,666,667 in Venezuelan sovereign debt to have $65,000,000 in bolivars after redeeming it from the Venezuelan central bank. $86,666,667 x .4625 = $40,083,333 The cost in dollars will be $40,083,333 To build in Chile: $65,000,000/1.00 = $65,000,000 Detroit Motors must purchase $65,000,000 in Chilean sovereign debt to have $65,000,000 in pesos after redeeming it with the Chilean central bank. $65,000,000 x .7025 = $45,662,500 The cost in dollars will be $45,662,500. Considering the above numbers, Detroit Motors should build its facility in Mexico, as the cost in dollars is the lowest. Chapter 12, Question 1: Describe the differences between foreign bonds and Eurobonds. Also discuss why Eurobonds make up the lion’s share of the international bond market. The international bond market is made up of two basic market segments: foreign bonds and Eurobonds. A foreign bond issue is offered by a foreign borrower to investors in a national capital market and denominated in that nation’s currency. A Eurobond issue is denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency. Roughly 80% of new international bonds are likely to be Eurobonds. Eurobonds are known by the currency in which they are denominated – for example, U.S. dollar Eurobonds, yen Eurobonds, etc. Foreign bonds frequently have fun names that designate the country in which they are issued – like Yankee bonds – dollar-denominated foreign bonds originally sold to U.S. investors. Bringing a Eurodollar bond issue to market requires a shorter length of time, which is part of why the Eurobond segment of the international bond market is roughly four times the size of

the foreign bond segment. Also, borrowers pay a lower rate of interest for Eurodollar bond financing in comparison to Yankee bond financing. Eurobonds also do not have to meet national security regulations. Chapter 12, Question 4: What factors does S&P Global Ratings analyze in determining the credit rating it assigns to a sovereign government? In rating a sovereign government, S&P’s analysis centers around five factors: institutional assessment, economic assessment, external assessment, fiscal assessment and monetary assessment. The institutional assessment comprises an analysis of how a government’s institutions and policymaking affect a sovereign’s credit fundamentals by delivering sustainable public finances, promoting balanced economic growth and responding to economic or political shocks. The key drivers of a sovereign’s economic assessment are income levels, growth prospects and economic diversity and volatility. The external assessment reflects a country’s ability to obtain funds from abroad to meet its public and private sector obligations to non-residents. The external assessment refers to the transactions and positions of all residents, vis-a-vis those of non-residents, because it is the totality of these flows and stocks that affects a country’s level of reserves and exchange rate developments. The fiscal assessment reflects the sustainability of a sovereign’s deficits and debt burden. A sovereign’s monetary assessment reflects the extent to which its monetary authority can fulfill its mandate while supporting sustainable economic growth and decreasing major economic or financial shocks. Chapter 13, Question 2: As an investor, what factors would you consider before investing in the emerging stock market of a developing country? As an investor, one should consider market capitalization and market liquidity. A liquid stock market is one in which investors can buy and sell stocks quickly at close to the current quoted prices. A measure of liquidity is the turnover ratio. The turnover ratio is the ratio of stock market transactions over a period of time divided by the size (or market capitalization) of the stock market. The higher the turnover ratio, the more liquid the secondary stock market – indicating ease in trading. The company's culture, corporate governance structure, and protections for investors are a few other considerations. An investor should also consider market consideration, if it is high then the diversification is limited creating more risk while low concentration would allow for more portfolio diversity.

Chapter 13, Question 6: Why do you think empirical studies about factors affecting equity returns basically showed that domestic factors were more important than international factors, and, secondly, the industrial membership of a firm was of little importance in forecasting the international correlation structure of a set of international stocks? Domestic factors, like economic conditions, vary between countries – which in turn leads to different monetary and fiscal policies. Economic conditions impact the way stocks are traded in one country, whereas stocks traded elsewhere will behave differently. The way businesses operate in a country is influenced by the government’s economic rules. Even if companies are in the same type of business and from different countries, they won’t necessarily act the same everywhere. When these companies sell securities, we should not expect them to perform identically either. Chapter 15, Question 1: What factors are responsible for the recent surge in international portfolio investment? The rapid growth in international portfolio investments reflects the globalization of financial markets. Many governments began to deregulate foreign exchange and capital markets in the late 1970s. In addition, recent advancements in telecommunication and computer technologies contributed to the globalization of investments by facilitating cross-border transactions and rapid dissemination of information across national borders. Chapter 15, Question 3: Explain the concept of the world beta of a security. The world beta measures the sensitivity of a national market to world market movements. World beta measures the risk of a stock in relation to the global market. A higher world beta means the security is riskier, and vice versa. The world beta is defined as Bi = σiw / σw 2 , where σiw is the covariance between returns to the ith market and the world market index, and σw 2 is the variance of the world market return. Chapter 15, Problem 1: Suppose you are a euro-based investor who just sold Microsoft shares that you had bought six months ago. You had invested 10,000 euros to buy Microsoft shares for $120 per share; the exchange rate was $1.15 per euro. You sold the stock for $135 per share and converted the dollar proceeds into euros at the exchange rate of $1.06 per euro. First, determine the profit from this investment in euro terms. Second, compute the rate of return on your investment in euro terms. How much of the return is due to the exchange rate movement? ((135-120)/120) + ((1/1.06)-(1/1.15)/(1/1.15)) (15/120) + (.94340-.86957/.86957) .12500 + (.07383/.86957) .12500+.08490 .2099 x 100 = 20.99 --> 21% rate of return in euro terms

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version