1.How would the Chilean trader speculate on the Argentine peso? Spell out his

2. exchange rate forecast and how and when he would earn a profi t.

Do you believe that trading rooms within large commercial banks should be

forbidden to engage in directional trades? Under what conditions would you

allow trading rooms to engage in directional trades?

CASE STUDY 5.1 as Banco Mercantil Internacional's Forex Losses sh is s a Co re tud ur d v y se ia re so H er ur o. c ew co m This case study accompanies Chapter 5 of International Corporate Finance. A speculator is a man who observes the future and acts before it occurs. Bernard Baruch ROGUE TRADER Th On March 19, 2001, in the heyday of the Argentine currency board of fixed exchange rates, Banco Mercantil Internacional (BMI)the second-largest Mexican commercial bank with 177 offices in 11 Latin American countriesannounced a loss of US$80 million. The loss was attributed to unauthorized forward speculation on the Argentine peso (ARS) by a Chilean trader in the bank's Buenos Aires branch. The amount of the underlying transactions was rumored to be close to US$1.8 billion, and initial reports indicated that the losses could be traced to short sales of the U.S. dollar for the Argentine peso. Preliminary accounts indicated that the trader was betting the Argentine peso would not devalue and that the fiscal situation would stabilize. Accordingly, the trader had purchased Argentine pesos for six and nine months' delivery at respective forward rates of ARS 1.15 and ARS 1.25 = US$1, fully expecting that as Argentina restored economic growth, the forward discounts on the peso would narrow.1 Banco Mercantil's officials stated that the trader involved had violated corporate guidelines when he persisted in maintaining an uncovered position in his trading accounts. For 1 Forward rates are linked to interest rate differentials between the U.S. dollar and Argentine peso through the theorem of interest rate parity. The higher the interest rates in Argentina, the deeper the discount on the peso. Tighter fiscal policy in Argentina meant higher interest rates. An IMF-led rescue package would allow the Argentine government to relax its high interest rate policy, which would in turn narrow the discount on the ARS. One-month and threemonth forward contracts were available at ARS 1.05 and ARS 1.08. 1 https://www.coursehero.com/file/11889647/Case-Study-51/ 2 CASE STUDY Banco Mercantil the year 2001 had commenced with a two-for-one stock split and ended with record operating profit of $94 million in spite of this one-time loss of US$80 million. How could a single employee fool one of the largest and most sophisticated Latin American commercial banks? How could such a large speculative bet go undetected by the firm's back office and lose so much money for the bank whenfor all practical purposesthe Argentine peso peg to the U.S. dollar had been enacted into a law? as TRIALS AND TRIBULATIONS OF THE ARGENTINE ECONOMY AFTER A DECADE-LONG HARD PEG Th sh is s a Co re tud ur d v y se ia re so H er ur o. c ew co m In 1991, Argentina ended decades of hyperinflation by instituting a rigid one-to-one peg of the peso to the U.S. dollar known as the Convertibility Plan. In effect, Argentina adopted a currency board whereby its central bank committed itself to tying the money supply to its holding of foreign exchange (forex) reservesprimarily U.S. dollars. More specifically, Argentina's money supply could grow only if the country accumulated additional foreign exchange reserves. Monetary policy had become an automatic and unbending rule (reminiscent of the gold standard), and politicians or bureaucrats were no longer in charge. As inflation abated and the Peronist Menem government pushed through ambitious privatizations, the Argentine economy grew rapidly until 1997growth that was fueled in part by large borrowing in world capital markets at low interest rates. The 1997 Asian financial crisis, followed by the 1998 debacles of the Russian and Brazilian economies, resulted in emerging market risk premiums,2 which burdened the Argentine budget deficit. The sharp devaluation of the Brazilian real in 1999 and the appreciation of the U.S. dollar against the euro dragged along3 the Argentine peso, which had become increasingly overvalued vis--vis its major trading partners. Argentina's economic situation began to unravel as the recession worsened an already bad public deficit and deepened the balance-of-payments currentaccount deficit. National debt, which had stood at 41 percent of gross domestic product (GDP) in 1997, reached 64 percent of GDP in 2001, while risk premiums on long-term Argentine government debt more than doubled from 3 or 4 percent in 1997 to 7 or 8 percent in late 2000 as compared with U.S. Treasury bonds of similar maturities. With monetary policy and foreign exchange rate policy off the table, Argentina was left with fiscal and wage policy as the only active policy instruments. Unfortunately, with tepid or mildly negative economic growth, tax revenues increasingly lagged projections. Attempts to tighten fiscal policy further 2 The emerging market risk premium refers to the high interest rate at which the Argentine government could borrow on international capital markets to finance its budget deficit. The benchmark against which the market risk premium is calculated is the interest rate on U.S. Treasury bonds at which the U.S. government finances its budget deficit. 3 Twenty-five percent of Argentina's exports are destined to the euro-zone. https://www.coursehero.com/file/11889647/Case-Study-51/ 3 Banco Mercantil Internacional's Forex Losses sh is s a Co re tud ur d v y se ia re so H er ur o. c ew co m CURRENCY TRADING IN THE TRANQUIL DAYS OF ARGENTINA'S CURRENCY BOARD as by increasing taxes and slashing expenditures merely postponed economic recovery. Thus the burden of restoring growth fell squarely on wage policya form of internal devaluation: Workers had to accept lower wages to enable Argentina to compete in international markets. Indeed, the consumer price index started to fall in 1998 but not enough or soon enough to restore Argentina's exports' competitiveness. In spite of a new International Monetary Fund (IMF) financing package and a stabilizing balance of trade deficit, rumors of a peso devaluation were increasingly circulating in banking circles. The cost of unpegging the Argentine peso from the U.S. dollar, however, was considered exorbitant and dimmed the probability of such an occurrence. Forward rates, however, reflected a tightening of the monetary situation. Although forex trading is often shrouded in secrecy, there is a widespread consensus that forex trading profits at commercial banks come primarily from trades carried out on behalf of corporate customers (so-called agency trading); for example, when IBM-USA repatriates ARS 50 million of dividends from its Argentine subsidiary, it purchases the amount on the spot market through the Buenos Aires branch of Banco Mercantil. Indeed, banks' currency trading desks, for the most part, earn a living by buying and selling foreign currencies at slightly different ratesalso known as the bid/ask spreadprimarily on a spot basis and to a lesser extent on a forward basis for corporate customers (and more recently on options, swaps, and other derivative products). This is indeed a relatively safe way to make a living, as it does not entail outright speculative positions on currencies coming from directional trades through the spot or forward currency market based on forecasting of exchange rates (socalled proprietary trading). In 2001 the Argentine peso had been pegged (tied) to the U.S. dollar by its par value at the price of US$1.00 = ARS 1.00 and backed by a currency board since 1991. Th HOW BANKS KEEP A LID ON THEIR FOREIGN EXCHANGE TRADING OPERATIONS Banco Mercantil puts overnight limits on its currency traders, though the actual amount varies from branch to branch depending upon the volume of business transacted. Traders are required to observe trading limits for a single transaction; for example, the bank may mandate that no single forex trade be in excess of $10 million and that the aggregate limit of a trader's net position be no more than $25 million during the day and very close to zero by the end of the business day in order to avoid unwelcome overnight surprises. Banco Mercantil, however, kept track of its foreign exchange transactions only on a net basis. For example, overall U.S. dollar sales and purchases of either a spot or a forward nature would be toted up and only the balanceplus or minuswould be shown. Thus, Banco Mercantil, like most banks, had set in place control systems https://www.coursehero.com/file/11889647/Case-Study-51/ 4 CASE EXHIBIT 5.1 CASE STUDY Selected Macroeconomic Statistics for Argentina (1996-2000) Argentina 1997 1998 2000a Annual Indicators 1996 1999 GDP at market prices (ARS bn) 272.2 292.9 298.9 283.3 282.3 GDP (US$ bn) 272.2 293.0 299.1 283.4 282.5 5.5 8.1 3.9 -3.4 -0.3 Consumer price inflation (av., %) 0.2 0.5 0.9 -1.2 -0.9b Population (mn) 35.2 35.7 36.1 36.1 37.0 24,043.0 26,430.0 26,441.0 23,333.0 sh is s a Co re tud ur d v y se ia re so H er ur o. c ew co m Exports of goods FOB (US$ mn) as Real GDP growth (%) 26.251 Imports of goods FOB (US$ mn) 22,283.0 28,554.0 29,558.0 24,103.0 Current-account balance (US$ mn) -6,842.0 -12,498.0 -14,602.0 -12,312.0 Foreign-exchange reserves gold (US$ mn) 18,104.0 22,320.0 24,752.0 26,252.0 25,147.0 Total external debt (US$ bn) 111.4 128.4 141.5 147.9 156.3 Debt-service ratio, paid (%) 39.4 50.0 57.5 75.8 76.2 Exchange rate (ARS per US$) a 1.00 1.00 1.00 1.00 24,002.9 -11,121 1.00 March 2, 2001: ARS 1.00 = US$1. U.S. interest rate = 3.00% for three-month deposit, 3.25% for six-month bank deposit, and 3.60% for nine-month deposit. Argentine interest rate = 12.00% for three-month deposit, 13.25% for six-month bank deposit, and 13.60% for nine-month deposit. Th aimed at keeping its traders honest by implementing the square position requirement, which is nothing more than requiring that each trader keep his or her trades in balance and that for each currency the amount sold forward would equal the amount purchased forward. Thus, in all likelihood, the Chilean trader must have entered into shorter-term speculative positions to offset and mask his speculative gamble. HASTY CONCLUSION According to Mr. Santiago Munoz, the manager of the Buenos Aires branch, he didn't become aware of the trader's positions until September, at which point he moved to have the trader close his position expeditiously. The losses thus had come https://www.coursehero.com/file/11889647/Case-Study-51/ 5 Banco Mercantil Internacional's Forex Losses QUESTIONS FOR DISCUSSION as in two waysfrom the trading itself that had accumulated since March and from liquidating the large outstanding positions. The bulk of the losses apparently had come from trading itself. The trader was betting that the large forward premium on the U.S. dollar would shrink as Argentina won a reprieve on its international debt burden and was able to stave off a devaluation of the peso. But as Argentina's international debt position continued to deteriorate, the premium on the U.S. dollar only increased across all maturities. Banco Mercantil also took a loss in closing the position, as it had to purchase forward dollars that had previously been sold forwardjust the reverse of what the trader had done to build his position. And yet the Argentine peso still had not devalued! Th sh is s a Co re tud ur d v y se ia re so H er ur o. c ew co m Refer to Case Exhibit 5.1 to answer questions 1 through 6. 1. How would the Chilean trader speculate on the Argentine peso? Spell out his exchange rate forecast and how and when he would earn a profit. 2. Why would an outright speculative position be easily found out and exposed by the BMI's branch back office? How was the currency trader able to hide his trades? 3. Given that the Argentine peso did not devalue until January 2002, explain what would have been the end result of the Chilean trader's speculative scheme if the bank had let it ride until maturity. Detail timing and amount of cash flows. 4. Why were forward exchange rates trading at significant discounts or premiums from the spot price when the latter was fixed at ARS 1 = US$1 and backed by a currency board? 5. What are the control systems that Banco Mercantil should institute to prevent the recurrence of such a speculative scheme? 6. Do you believe that trading rooms within large commercial banks should be forbidden to engage in directional trades? Under what conditions would you allow trading rooms to engage in directional trades? https://www.coursehero.com/file/11889647/Case-Study-51/ Powered by TCPDF (www.tcpdf.org)