Transcript Exchange rates.eve.ppt

BA 543
The Market for Foreign Exchange
Rate Risk Control Instruments
By: Gurjot Dhaliwal
Foreign Currency Markets
► Largest
Trading Market in the World
► $1.2 Trillion average daily trading volume
► Open 24/7
Exchange Rates
► The
amount of US dollars necessary to
acquire one unit of foreign currency, and
this is the dollar price of one unit of foreign
currency; or
► The number of units of foreign currency
necessary to acquire one US dollar, or the
foreign currency price of one dollar.
Direct Quotes
► The
number of units of a local currency
exchangeable for one unit of a foreign
currency.
► $1/.8152 Euro
Indirect Quotes
► The
number of units of a foreign currency
that can be exchanged for one unit of a
local currency.
► 1 Euro / $1.2268
Bid – Ask Spread
► In
the floating market currencies are traded
just as in the open market with a bid price
and an ask price. The difference between
the two is the bid ask spread. The bid is
always given first.
► An example of a bid ask spread is 1 Euro =
$1.33-42. This means that there is a bid
price of $1.33 and the sellers are asking
$1.42 per Euro.
Currency Risk
► Is
the risk that a currency’s value may
change adversely
► Also termed foreign exchange risk
Exchange Rate Regimes
► Fixed
Rates – A country establishes a fixed band in
which a currency is allowed to trade relative to
another countries currency.
► Floating Rates – A country allows its currency to
move according to market conditions.
► Managed Floating Rates – A country allows its
currency limited movement according to the
market but actively purchases currency to control
where its currency moves.
Purchasing Power Parity
Consumer Price Index
Brief Explanation of the CPI The Consumer Price Index (CPI) is a measure of the average change in prices over time of
goods and services purchased by households. The Bureau of Labor Statistics publishes CPIs for two population
groups: (1) the CPI for Urban Wage Earners and Clerical Workers (CPI-W), which covers households of wage earners
and clerical workers that comprise approximately 32 percent of the total population and (2) the CPI for All Urban
Consumers (CPI-U) and the Chained CPI for All Urban Consumers (C-CPI- U), which cover approximately 87 percent of
the total population and include in addition to wage earners and clerical worker households, groups such as
professional, managerial, and technical workers, the self- employed, short-term workers, the unemployed, and retirees
and others not in the labor force. The CPIs are based on prices of food, clothing, shelter, and fuels, transportation
fares, charges for doctors' and dentists' services, drugs, and other goods and services that people buy for day-to-day
living. Prices are collected in 87 urban areas across the country from about 50,000 housing units and approximately
23,000 retail establishments- department stores, supermarkets, hospitals, filling stations, and other types of stores
and service establishments. All taxes directly associated with the purchase and use of items are included in the index.
Prices of fuels and a few other items are obtained every month in all 87 locations. Prices of most other commodities
and services are collected every month in the three largest geographic areas and every other month in other areas.
Prices of most goods and services are obtained by personal visits or telephone calls of the Bureau's trained
representatives. In calculating the index, price changes for the various items in each location are averaged together
with weights, which represent their importance in the spending of the appropriate population group. Local data are
then combined to obtain a U.S. city average. For the CPI-U and CPI-W separate indexes are also published by size of
city, by region of the country, for cross-classifications of regions and population-size classes, and for 27 local areas.
Area indexes do not measure differences in the level of prices among cities; they only measure the average change in
prices for each area since the base period. For the C-CPI-U data are issued only at the national level. It is important to
note that the CPI-U and CPI-W are considered final when released, but the C-CPI-U is issued in preliminary form and
subject to two annual revisions. The index measures price change from a designed reference date. For the CPI-U and
the CPI-W the reference base is 1982-84 equals 100.0. The reference base for the C-CPI-U is December 1999 equals
100. An increase of 16.5 percent from the reference base, for example, is shown as 116.5. This change can also be
expressed in dollars as follows: the price of a base period market basket of goods and services in the CPI has risen
from $10 in 1982-84 to $11.65.
►
Purchasing Power Parity
► Consumer
Price Index
► Brief Explanation of the CPI - The Consumer
Price Index (CPI) is a measure of the
average in prices over time of goods and
services purchased by households.
CPI
► It
is a price index which tracks the prices of a
specified set of consumer goods and services,
providing a measure of inflation
Purchasing Power Parity
► Consumer
Price Index
► Big Mac Index
Purchasing Power Parity
Big Mac Index
As of publication a Big Mac in
the United States cost $2.90.
A Big Mac in China cost $1.26.
Therefore the implied PPP
3.59. This can be compared
against the current differences
in currency valuations and
showed that the Chinese Yuan
was undervalued by 57%.
This is an example of why
most countries are pressuring
China to allow the Yuan to
float.
Purchasing Power Parity
► Consumer
Price Index
► Big Mac Index
► Starbucks Latte Index
Cross Rates
► Comparison
of two foreign currencies via a
third currency such as the dollar
Triangular Arbitrage
► An
arbitrage strategy employed to take
advantage of cross rate mispricing between
the U.S. dollar and the two foreign
currencies
Triangular Arbitrage Example
► Euro
dollar Rate: .8 Euro / $
► Yen dollar Rate: 122 Yen / $
► Implied Cross Rate: 122 Yen / .8 Euro =
152.5 Yen/Euro
► Yen Euro Rate: 140
► Because there is a difference between the
actual rate of 140 and the implied rate of
152.5 there exists an opportunity for
arbitrage
Triangular Arbitrage Example Cont.
►A
US investor borrows
$100 million. This
would be used to buy
12.2 billion Yen.
$100 Million US
122 Yen / $
12.2 billion Yen
Triangular Arbitrage Example Cont.
►
►
A US investor borrows
$100 million. This would
be used to buy 12.2 billion
Yen.
Trade the 12.2 billion Yen
for Euro’s at the market
rate of 140 Yen / Euro
yielding 87.14 million
Euro’s.
$100 Million US
122 Yen / $
87.14 Million Euro
140 Euro / Yen
12.2 billion Yen
Triangular Arbitrage Example Cont.
►
►
►
A US investor borrows
$100 million. This
would be used to buy
12.2 billion Yen.
Trade the 12.2 billion
Yen for Euro’s at the
market rate of 140 Yen
/ Euro yielding 87.14
million Euro’s.
The 87.14 million Euros
would then be traded
back to US dollars at .8
Euro / $ yielding
$108.93 Million
$108.93 Million
$100 Million US
122 Yen / $
.8 Euro
/$
87.14 Million
Euro
12.2 billion Yen
140 Euro / Yen
Triangular Arbitrage Example Cont.
►
►
►
►
A US investor borrows $100
million. This would be used
to buy 12.2 billion Yen.
Trade the 12.2 billion Yen
for Euro’s at the market rate
of 140 Yen / Euro yielding
87.14 million Euro’s.
The 87.14 million Euros
would then be traded back
to US dollars at .8 Euro / $
yielding $108.93 Million.
The investor would then
repay the $100 million. The
investor keeps the $8.93
Million profit, or 8.93%.
$8.93 Million Profit
$108.93 Million
$100 Million US
.8 Euro
/$
122 Yen / $
87.14 Million
Euro
12.2 billion Yen
140 Euro / Yen
Triangular Arbitrage Example
Cont.
► This
can be double checked by measuring
the difference between the implied and
actual cross rates.
► (152.5 – 140)/ 140 = 8.93%
► $100 Million * 8.93% = $8.93 Million Profit