Transcript Diapositiva 1 - Del Rosario University

Colegio Mayor de Nuestra
Señora del Rosario
International Finance
Professor: Alejandro José Useche Arévalo
Monitor: Daniela McAllister Harker
March 2013
© This Power Point presentation is an academic tool, intelectual property is owned
by its author, Alejandro José Useche Arévalo. It has been prepared as study guide
for the International Finance class at Faculty of Economics, Universidad del Rosario.
Data has been extracted from Bloomberg financial system, with academic purposes
only. Any reproduction is forbidden.
International money market
and interest rate parity
Money Market
The money market is a component of the
financial markets for assets involved in
short-term borrowing and lending with
original maturities of one year or shorter
time frames; it provides liquidity funding
for the global financial system.
Trading in the money markets involves
certificates of deposit, Treasury bills,
commercial paper, bankers' acceptances,
federal funds, and short-lived mortgageand asset-backed securities.
Common money market instruments
Certificate of deposit (CD): time deposit with a bank.
Treasury bills: Short-term debt obligations of a national
government that are issued to mature in three to twelve
months.
Commercial paper: Unsecured promissory notes with a fixed
maturity of one to 270 days; usually sold at a discount from
face value.
Repurchase agreements (repos or RPs): A dealer
government securities to an investor on an overnight basis,
an agreement to buy back those securities the next day
slightly higher price ; the dealer thus takes out a one-day
from the investor, and the securities serve as collateral.
sells
with
at a
loan
Common money market instruments
Bankers acceptance (BA): A negotiable money market
instrument issued to finance international trade. These are time
drafts in which a bank "accepts" as its financial responsibility to
pay the principal at maturity even if the importer does not.
These obligations are collateralized by goods being shipped
between an exporter and an importer.
Eurodollar deposit: Deposits made in USD at a bank located
outside the United States.
Foreign Exchange Swaps: Exchanging a set of currencies in
spot date and the reversal of the exchange of currencies at a
predetermined time in the future.
Short-lived mortgage and asset-backed securities.
International interest rate indexes
Prime rate: The lowest interest rate charged
to the biggest and the best borrowers (those
with the
least risk
of defaulting).
Overnight repurchase (or repo): agreement
that allows a borrower to use a financial
security as collateral for a cash loan at a fixed
rate of interest.
Discount rate: interest rate charged to banks
for borrowing short-term funds directly from
the US Federal Reserve.
Federal funds rate: is the interest rate at which private
depository institutions (mostly banks) lend balances
(federal funds) at the US Federal Reserve to other
depository institutions, usually overnight.
Freddie Mac & Fannie Mae are U.S. government-sponsored
enterprises (GSE) chartered by Congress with a mission to
provide liquidity, stability and affordability to the U.S.
housing and mortgage markets.
EURIBOR: Euro Interbank Offered Rate, is the rate at
which euro interbank term deposits are being offered by
one prime bank to another within the EMU zone.
LIBOR: London Interbank Offered Rate, is the rate at
which large banks in London are willing to lend money
among themselves.
HIBOR: for Hong Kong
PIBOR: for Paris
SIBOR: for Singapore
IBR: for Bogota
New York Funding Rate: three-month interbankfunding costs.
Interest rates
• Nominal annual rate or nominal interest rate:
periodic rate multiplied by the number of
compounding periods per year.
• Periodic rate: the interest that is charged (and
compounded) for each period.
• Effective annual rate: the total accumulated
interest that would be payable up to the end of
one year = annual percentage rate (APR).
Indexed rate: An interest rate that is
compounded by a benchmark index interest
rate and a specified margin: usually, Prime rate
= Federal Funds rate + 300 bp.
Annual percentage rate (APR): it is
what credit costs each year, expressed
as a percentage of the loan amount.
Annual percentage yield (APY): it is
the amount you earn on an investment in
a year, expressed as a percentage.
A basis point (denoted as bp or ‱) is a
unit relating to interest rates that is
equal to 1/100th of a percentage point
per annum: 1% annual = 100 basis
points.
Covered interest rate parity
In international money markets, the interest rate
differential between two currencies approximately equals
the percentage spread between the currencies’ forward
and spot rates. If this is not the case, traders have an
opportunity to earn arbitrage profits.
Investment and debt decisions must consider not
only the domestic market but also the international
market.
The availability of borrowing and lending
opportunities in differente currencies allows agents to
hedge foreign exchange risks with money market
transactions.
Let’s consider the situation of Kim Deal, a portfolio manager
at BNP Paribas, a French bank. Kim is trying to decide how
to invest € 10 million, and she must choose between 1-year
euro deposits and 1-year yen investments. In the latter case,
she knows she must worry about transaction foreign
exchange risk, but she also understands that she can use the
appropriate forward contract to eliminate it. Suppose Kim
has the following data:




EUR interest rate: 3.5200% per annum (p.a.)
JPY interest rate: 0.5938% p.a.
Spot exchange rate: 146.0300 ¥ / €
1-year forward exchange rate: 141.9021 ¥ / €
Which of these investments should Kim choose to get the
highest euro return?
To do the analysis, let’s first calculate the euro return from
investing in the euro denominated asset. If Kim invests €10 million
at 3.52%, after 1 year, she will have: 10,000,000 * 1.0352 = €
10,352,000
Next, let’s calculate the euro return if Kim invests her €10,000,000
in the yen denominated asset. This analysis requires three steps:
Step 1. Convert the euro principal into yen principal in the spot
foreign exchange market. The €10,000,000 buys €10,000,000 *
146.032 ¥/ € = ¥ 1,460,300,000 at the current spot exchange rate.
Step 2. Calculate yen-denominated interest plus principal. Kim can
invest her yen principal at 0.5938% for 1 year. Hence, Kim knows
that in 1 year, she will have a return of yen principal plus interest
equal 1,460,300,000 ¥ * 1.005938 = ¥ 1,468,971,261
Step 3. Hedge the transaction exchange risk with a 1-year forward
contract.
Initial investment: 10’000.000 EUR
10’000.000 EUR x 146,03 JPY/EUR = 1.460’300.000 JPY
1.460’300.000 JPY * (1+0,5938%) = 1.468’971.261 JPY
1.468’971.261 JPY / 141,9021 JPY/EUR = 10’352.005 EUR
% return = 3,5201%
Now, using the interest rate parity formula:
As our domestic currency is EUR, E/E =  EUR/JPY
Spot exchange rate= 146,03 JPY/EUR = 0,00684791 EUR/JPY
1-year forward exchange rate = 141,9021 JPY/EUR = 0,00704711 EUR/JPY
E/E = ( 0,00704711 / 0,00684791 ) – 1 = 2,908977%
idc = {( 1+ i* ) (1+ E/E )} - 1 =  (1,005938)(1,02908977)  - 1
= 3,5201%
Investment and debt decision through
the foreign exchang market
i* = foreign currency interest rate
idc = i* expressed in domestic currency
Et = Spot exchange rate (in European quotes)
Et+1 = F = forward exchange rate
E/E = ( Et+1 – Et ) / Et
= appreciation ( 0) or depreciation (> 0) rate

idc = { ( 1+ i* ) (1+ E/E ) } - 1
Investment and debt decision through
the foreign exchang market
i = domestic currency interest rate
If:
i = idc = { ( 1+ i* ) (1+ E/E ) } - 1
Interest rate parity: or international Fisher effect is an algebraic
identity that describes the non-arbitrage condition; the difference in
the nominal interest rates between two countries determines the
movement of the nominal exchange rate between their currencies.
Interest rate parity
It is a non-arbitrage relationship between
forward and spot exchange rates and the two
interest
rates
associated
with
these
currencies.
Interest rate parity will hold if markets are
efficient and governments allow arbitrage.
If this parity does not hold, “covered interest
rate arbitrage” can be done and the return
obtained is called “covered yield”.
Interest rate parity
Given: i = { ( 1+ i* ) (1+ E/E ) } - 1
i – i* = Et+1 – Et
1 + i*
Et
If i > i*:  capital inflows, E: we can
borrow on foreign currency and invest that
money at i: demand of foreign currency,
E and Et+1 > Et: parity is obtained again.
Interest rate parity
i – i* = Et+1 – Et
1 + i*
Et
If i > i*: Et+1 > Et = forward premium
If i  i*: Et+1  Et = forward discount
External currency market
It is the interbank market most closely related to the FX
market, defined as bank market for deposits and
loans in foreign currencies.
The first of these deposits were called “Eurodollars”.
Given its international nature, external currency
market seems more appropiate than Eurodollar market.
Main interbank rate: LIBOR
We have supposed that is possible to borrow and lend at
the same interest rate, but in practice, there is a different
rate for each transaction.
Transaction costs in the
External Currency Market
The Financial Times offers data on external currency interest rates in
the form of bid-ask spread, quoted in percentage points per annum.
Source: Financial Times. http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=EUR-040313
Financial Times, March 2013
Transaction costs in the
External Currency Market
For example:
3
15/32
–2
Borrowing rate
7/16
Deposit rate
both expressed as an annual percentage rate (APR)
Covered interest arbitrage
Example: If iCOP  i*EUR (when compared in
the same currency), we can make the next
covered interest rate arbitrage:
1.
2.
3.
4.
Borrow COP (at t)
Invest in EUR (at t)
Get EUR + i* (at t+1)
Repay COP + i (at t+1)
Covered interest arbitrage
1+ i*
3. EUR 1 year
2. EUR today
Et
COP/EUR
Et+1
COP/EUR
1. COP today
4. COP 1 year
1 / (1+ i)
Covered interest arbitrage: an example
USD interest rate = 8% p.a. = i
GBP interest rate = 12% p.a. = i*
Spot exchange rate = 1,60 USD per GBP
1-year forward exchange rate =
1,53 USD per GBP
In order to hedge this transaction, we will
borrow at the lowest rate and invest at the
highest rate.
We can find where to borrow and where to invest by using:
idc = { ( 1+ i* ) (1+ E/E ) } - 1
= { ( 1+ 0,12 ) ( 1 – 0,0438 ) } - 1
= 7,10% in USD
As i=8,00% and the equivalent from i* is 7,10%, we can
borrow in GBP (at 7,10%) and invest in USD (at 8%).
Covered interest arbitrage
Hedging transaction risk in the money market
When there is an open position in foreign
currency (account receivable or account
payable), there is transaction foreign
exchange risk.
There are two ways to hedge such risk:
1. Using forward contracts
2. Making a “synthetic forward”
Hedging transaction risk in the money market
Synthetic forward: «manufactured contract» through
a money market hedge.
It consists in borrowing or lending the foreign
currency coupled with making a transaction in the
spot market:
If the underlying transaction gives you a liability in
foreign currency, you need an equivalent asset in the
money market to provide a hedge.
If the underlying transaction gives you an asset in
foreign currency, you need an equivalent liability in
the money market to provide a hedge.
Synthetic forward for an importer
You have just contracted to import goods valued at
EUR 4’000.000. Payment of the money is
scheduled for 90 days in the future.
Spot exchange rate: USD 1,10 per EUR
90-day forward exchange rate: USD 1,08 per EUR
90-day dollar interest rate: 6% p.a.
90-day euro interest rate: 16% p.a.
Synthetic forward for an importer
As an importer, you are exposed to losses if there is a
depreciation of the USD against the EUR.
1st hedging strategy: the importer can agree to buy euros
forward and pay them in 90 days:
EUR 4’000.000 x (USD 1,08 per EUR) = USD 4’320.000
(The present value of this amount is equivalent to: USD 4’257.525,72)
2nd hedging strategy: Because the importer has an euro liability in
euros, she can acquire an equivalent asset in euros, buying the present
value of the euro liability at the spot exchange rate and
investing these euros in a money market asset:
EUR 4’000.000 / 1,16
(90/360)
= EUR 3’854.299,81
This amount of euros must be purchased in the spot market:
EUR 3’854.299,81 x 1,10 USD per EUR = USD 4’239.729,80
In other words: the importer can open today a 90-days CD for EUR
3’854.299,81. At a 16% annual percentage yield, she will have EUR
4’000.000 in 90 days, just enough to pay the import, avoiding the foreign
exchange rate risk.