Transcript International Finance Lecture 2 Page 1

International Finance
Lecture 2
Page 1
Foundations of International
Financial Management
• Globalization and the Multinational
Firm
• International Monetary System
• Balance of Payments
• The Market for Foreign Exchange
• International Parity Relationships
Page 2
Balance of Payments
• The Balance of Payments is the statistical ________
of a country’s (her citizens and her government’s
international transactions over a certain period of
time.
• Every country prepares and publishes ________
balance of payment statements.
• They are composed of the following:
– The Current Account
– The Capital/Financial Account
– Statistical Discrepancy
• View actual Canadian, US, French, Russian, Ukrainian
Balance of Payments statements
Page 3
The Current and Capital Accounts
• Current Account
– Includes all ________ and ________ of goods and
services.
– Includes unilateral transfers of foreign aid.
– If the debits > credits, then trade deficit.
– If the credits > debits, then trade surplus.
• Capital Account
– The capital account measures the difference between
home country sales of ________ to foreigners and
home country purchases of foreign ________.
– Composed of Foreign Direct Investment (FDI), portfolio
investments and other investments.
Page 4
Statistical Discrepancy and
Official Reserve Account
• There’s going to be some ________ and misrecorded
transactions
– we use a “plug” figure to get things to balance.
• Official reserves assets include gold, foreign currencies,
SDRs, reserve positions in the IMF.
Page 5
The Balance of Payments Identity
• BCA + BKA + BRA = 0
where
– BCA = balance on ________ account
– BKA = balance on ________ account
– BRA = balance on the ________ account
• Under a pure flexible exchange rate regime,
•
BCA + BKA = 0
Page 6
Canada’s Balance of Payments
40000
Source: CANSIM
30000
20000
-10000
-20000
-30000
-40000
BCA
Page 7
BKA
BCA+BKA
2005
2000
1995
1990
1985
1980
1975
1970
1965
0
1960
10000
Balance of Payments
and the Exchange Rate
• Current account + Capital account + Reserves
– Balance > 0
• inflow of capital, quantity ________ of home currency >
quantity supplied, ________ pressure on home currency value
– Balance < 0
• Outflow of capital, quantity demanded of home currency <
quantity supplied, ________ pressure on home currency value
– Equilibrium can continue __________, disequilibrium cannot.
– If the balance is not zero for long time, it is a disequilibrium
and will be corrected by the market in the long run
• several scenarios possible, material for international economics
course
– Price of home currency is the exchange rate
• # Units of local currency / 1 unit of foreign currency (direct)
• # Units of foreign currency / 1 unit of local currency (indirect)
Page 8
Foundations of International
Financial Management
• Globalization and the Multinational
Firm
• International Monetary System
• Balance of Payments
• The Market for Foreign Exchange
• International Parity Relationships
Page 9
The FOREX Market
Page 10
The FOREX Market
• Structure
– Place of trading
• ________
– Volume
• Wholesale (________) and retail
– Timing
• ________ : deal now, deliver now (up to 2
business days)
• ________ (deal now, deliver in the future)
Page 11
Spot Rate Quotations
• Direct quotation
– the Canadian ________ equivalent
– e.g. “a Japanese Yen is worth about a penny”
• Indirect Quotation
– the price of a Canadian dollar in the foreign
currency
– e.g. “you get 100 ________ to the dollar”
• View daily foreign exchange rate updates from the
US Federal Reserve System or the Bank of Canada
Page 12
Exchange rates and trade
• The following table provides domestic prices for three
items in Australia and Hong Kong. If AUD 1 = 6 HKD,
then what is the likely flow of goods? Ignore transaction
costs.
Item
Page 13
Australia (AUD)
HK (HKD)
Shoes
20
80
Watches
40
180
Surfboards
80
550
Exchange rates and trade
• Over the past 5 years the CHF/USD exchange rate
has changed from 1.20 to 1.60. Did the Swiss goods
become more or less expensive for the US
customers?
Page 14
Spot FX trading
• Bid-ask spread
– The bid price is the price a dealer is ________ to pay to buy the
currency.
– The ask price is the amount the ________ wants to sell you the
currency.
– The bid-ask spread is the difference between the bid and ask
prices.
• Trading
– In the interbank market, the standard size trade is about U.S.
$10 million.
– A bank trading room is a noisy, active place.
– The stakes are high.
– The “long term” is about 10 minutes.
• Cross- rates: view major cross-rates @ Bloomberg
Page 15
Bid-ask spread
• Direct ask (DC/FC) = 1 / Indirect bid (FC/DC)
• Direct bid (DC/FC) = 1 / Indirect ask (FC/DC)
– Notation: DC=domestic currency, FC=foreign
currency
Page 16
Example
• If the direct quotation for the exchange rate
is USD/EUR=0.9825-0.9829, then what is the
indirect EUR/USD quote?
Page 17
Bilateral arbitrage
• Assume no transaction costs for now. (=ignore bid-
ask spread)
• Domestic currency is DC, foreign currency is FC,
exchange rate is DC/FC
• You observe two rates at ________ banks:
DC/FCbank1 and DC/FCbank2
• No-arbitrage: DC/FCbank1 * FC/DCbank2 must ________
Reason: Law of One Price
– the price of the same item should be the same regardless of
where it is sold, otherwise there will be arbitrage
opportunities
– Mathematically, DC/FC * FC/DC = 1
Page 18
Bilateral arbitrage
• You observe the following spot rates in two banks:
• In Frankfurt: EUR/GBP =1.4959 and in London:
GBP/EUR=0.6695. Is there an arbitrage opportunity and
if yes, what is it? Ignore transaction costs.
Page 19
Bilateral arbitrage
• You observe the following spot rates in two banks:
• In Canada: JPY/CAD =122.30-122.35 and in Japan:
JPY/CAD=122.15-122.25. Is there an arbitrage
opportunity and if yes, what is it?
Page 20
Exchange rates and investment
•
A Canadian portfolio manager is planning to buy $15 million worth
of German bonds. The manager calls several banks to find out
spot rates. The quotes that she gets is below. How many Euros
will the manager invest in German bonds?
Bank
A
B
C
EUR/CAD
Page 21
0.80000-20
0.79985-05
0.79995-15
Exchange rates and investment
•
A foreign exchange trader at a US bank took a short position of
GBP 5,000,000 when the USD/GBP rate was 1.45. After that the
exchange rate changed to 1.51. (a) Is this movement beneficial
for the FX trader in question? (b) How did the US bank’s liability
change as a result of this FX rate move?
Page 22
Cross Rates
• Suppose that S($/SFr) = .50
– i.e. $1 = 2 SFr
• and that S(¥/SFr) = 50
– i.e. SFr1 = ¥50
• What must the $/¥ cross rate be?
Page 23
Cross Rates
• You find the following rates in the newspaper.
USD/EUR=0.9119, CHF/USD=1.5971, JPY/USD=128.17
• Compute all cross-rates.
Page 24
Cross Rates and Bid-Ask Spread
• Notation: DC=domestic currency, FC1=foreign
currency #1, FC2=foreign currency #2
• Cross-rates FC1/FC2
– (FC1/FC2)ask=(FC1/DC)ask * (DC/FC2)ask
– (FC1/FC2)bid=(FC1/DC)bid * (DC/FC2)bid
• Cross-rates FC2/FC1
– (FC2/FC1)ask=(DC/FC1)ask * (FC2/DC)ask
– (FC2/FC1)bid=(DC/FC1)bid * (FC2/DC)bid
Page 25
Cross Rates and Bid-ask Spread
• A bank is quoting the following exchange rates:
USD/EUR=1.1610-15, CHF/USD=1.4100-20. What is
the CHF/EUR cross-rate?
Page 26
Cross Rates and Bid-ask Spread
•
A bank is quoting the following exchange rates:
CHF/CAD=1.5960-70, AUD/CAD=1.8225-35. An Australian firm
asks for CHF/AUD rate. What cross-rate will the bank quote?
Page 27
Triangular Arbitrage
•
Idea: look for the quoted cross-rates FC1/FC2 (between two foreign
currencies FC1 and FC2)
– And see if they differ from the implied rates suggested by the DC/FC1
and DC/FC2 (domestic currency rates against the two foreign currencies)
– If any of the three currencies is over/underpriced, all cross-rates will
present arbitrage opportunities.
•
If transaction costs are ignored
– Check whether (DC/FC1)*(FC1/FC2)*(FC2/DC)= ________
•
Transaction costs
– Check whether quoted and cross-rate bid-ask spreads overlap for any
currency out of our three currencies.
– If you have rate 1 [bid1, ask1] and rate 2 [bid2, ask2] such that
ask2<bid1, buy at ask2 and sell at bid1.
Page 28
Triangular Arbitrage Example
• You observe these rates:
– Tokyo ¥/$ 120.00, NYC SF/$ 1.6000, Zurich
¥/SF80.00
Page 29
Triangular Arbitrage Example
You observe these quotes below. Is any currency arbitrage possible?
Frankfurt
London
New York
bid
ask
bid
ask
bid
ask
USD/EUR
0.9836
0.9839 EUR/GBP
1.5373
1.5380 GBP/USD
0.6566
0.6571
EUR/USD
1.0164
1.0167 GBP/EUR
0.6502
0.6505 USD/GBP
1.5219
1.5231
Calculate cross-rates and compare with the
rates
QUOTED
CROSS-RATES
quoted
bid
ask
bid
ask
USD/EUR
0.9836
0.9839
0.9895
0.9908
EUR/GBP
1.5373
1.5380
1.5469
1.5485
GBP/USD
0.6566
0.6571
0.6609
0.6614
Page 30
Spot Foreign Exchange Microstructure
• Market Microstructure refers to the
________
of how a marketplace operates.
• Bid-Ask spreads in the spot FX market:
– increase with FX exchange rate volatility and
– decrease with dealer competition.
• Private information is an important determinant
of spot exchange rates.
Page 31
The Forward Market
• A forward contract is an ________ to buy or sell an
•
•
•
•
asset in the future at prices agreed upon today.
If you have ever had to order an out-of-stock
textbook, then you have entered into a forward
contract.
The forward market for FOREX involves agreements
to buy and sell foreign currencies in the ________ at
prices agreed upon today.
Bank quotes for 1, 3, 6, 9, and 12 month maturities
are readily available for forward contracts.
Longer-term contracts are available.
Page 32
The Forward Market
• Transactions
– ________ forward transaction: do a regular
forward contract
– ________ : simultaneous sale (or purchase) of
spot foreign exchange and corresponding
purchase (or sale) of approximately equal amount
of foreign currency
• View rates at BMO Economics or Federal Reserve of
New York
Page 33
The Forward Market
• You observe the spot rate EUR/USD=0.92000 and the
1-month forward EUR/USD=0.92200, what does it
mean? is the dollar trading at premium or discount?
Is the dollar weak or strong?
Page 34
The Forward Market
• Annualized forward premium/discount
Page 35
The Forward Market
•
You observe the following. Spot USD/GBP=1.4570-76, and 6-months
forward USD/GBP=1.4408-34. Is GBP trading at a premium or
discount relative to the USD? Compute the annualized forward
discount/premium.
Page 36
Long and Short Forward Positions
• If you have agreed to sell anything (spot or forward)
you are “________”.
• If you have agreed to buy anything (forward or spot)
you are “________”.
• If you have agreed to
are short.
• If you have agreed to
are long.
Page 37
________ forex forward, you
________ forex forward, you
Payoff Profiles
profit
S180($/¥)
0
F180($/¥) = .009524
loss
Page 38
Short position
Payoff Profiles
profit
F180(¥/$)
short position
S180(¥/$)
0
F180(¥/$) = 105
-F180(¥/$)
loss
Page 39
Long position
Forward Speculation
•
•
Today the 3-month forward rate is USD/CHF=0.7476. A currency trader
decides to bet on depreciation of the Swiss franks by selling CHF short. He
contracts now to sell Swiss franks in 3 months anticipating that at that time
the spot rate will change to USD/CHF=0.7400. Suppose 3 months later the
actual spot rate is USD/CHF=0.7500.
Is this a short sale and why? What is the expected payoff for the trader and
his counterparty? What is the actual payoff?
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Forward Speculation
•
The counterparty
–
– On the actual spot market the same amount ________
– Savings
– If the rate dropped to $0.7400 instead of rising to $0.7500, would
overpay
–
•
_______________
What if a trader decides to ignore the contract and not deliver when not
profitable?
–
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