Lecture in international finance

The Foreign Exchange Market• TYPES OF EXCHANGE MARKETS AND CONVENTIONS to 12 months later than T + 2 FX Swaps MarketDeals with one spot component and one forward component... • An FX sw

Lecture in International

Finance

Chinese University of Technology

Foued Ayari, PhD

About Dr Ayari

• Assistant Professor of Finance in New York

• President & CEO of Bullquest LLC, a financial training company.

• Partner at Goldstone Property Group Inc

• Author of a recently published book:

“Credit Risk Modeling: An Empirical Analysis on

Pricing, Procyclicality and Dependence

• Author of a forthcoming book published with Wiley &

Sons,

“Understanding Credit Derivatives: Strategies & New

Market Developments”.

Foreign Exchange Markets

• BACKGROUND

• Foreign Exchange markets come under Global Markets

Division within Banks It features are as follows:

– OTC market

– Major international banks

– Spot market and forward market

– London is the largest centre

• 7/24 Market with daily Turnover of more than $3,200 Billions (BIS, 2007)

• All currencies are primarily valued against the USD dollar:

– USD 1 = JPY 112.26 (in this quote, the most common type, the

USD is the base currency)

– EUR 1 = USD 1.2594 (in this quote the USD is the variable

currency)

Correspondent Banking

Relationships

• International commercial banks communicate with one another with:

– SWIFT: The Society for Worldwide Interbank Financial

Telecommunications.

– CHIPS: Clearing House Interbank Payments System

– ECHO Exchange Clearing House Limited, the first global clearinghouse

for settling interbank FX transactions

Spot Market Participants and

Trading

• FX MARKET STRUCTURE

• The foreign exchange spot markets are QUOTE DRIVEN

markets with international banks as the wholesale

participants This market is also known as the FX inter-bank market.

• International banks act as MARKET MAKERS They make each other two-way prices on demand:

– The bank MAKING the quote bids for the BASE currency on the left and offers (ask) it on the right e.g:

• GBP 1 = USD 1.8850 (Bid), GBP 1 = USD 1.8860 (Ask)

Becomes:

• 1.8850/60

or even

• 50/60

The Foreign Exchange Market

• TYPES OF EXCHANGE MARKETS AND CONVENTIONS

to 12 months later

than T + 2

FX Swaps MarketDeals with one spot component and one forward component

Spot & Forward

• A spot contract is a binding commitment for an exchange of funds,

with normal settlement and delivery of bank balances following in two business days (one day in the case of North American

currencies).

• A forward contract, or outright forward, is an agreement made today

for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months).

• Forward contracts typically involve a bank and a corporate

counterparty and are used by corporations to manage their

exposures to foreign exchange risk.

• An FX swap (not to be confused with a cross currency swap) is a contract that simultaneously agrees to buy (sell) an amount of

currency at an agreed rate and to resell (repurchase) the same

amount of currency for a later value date to (from) the same

counterparty, also at an agreed rate.

• Non Deliverable Forwards

How Factors Can Affect Exchange Rates

The Spot Market

• Spot Rate Quotations

• The Bid-Ask Spread

• Spot FX trading

• Cross Rates

Spot Rate Quotations

• Direct quotation

– the U.S dollar equivalent

– e.g “a Japanese Yen is worth about a penny”

• Indirect Quotation

– the price of a U.S dollar in the foreign currency

– e.g “you get 100 yen to the dollar”

Spot Rate Quotations

Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Spot Rate Quotations

The direct quote for

British pound is:

£1 = $1.9077

Country

USD equiv Friday

USD equiv Thursday

Currency per USD Friday

Currency per USD Thursday Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Spot Rate Quotations

The indirect quote

for British pound is:

£.5242 = $1

Country

USD equiv Friday

USD equiv Thursday

Currency per USD Friday

Currency per USD Thursday Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Spot Rate Quotations

Note that the direct quote is the reciprocal of the indirect quote:

5242

1 9077

.

Country

USD equiv Friday

USD equiv Thursday

Currency per USD Friday

Currency per USD Thursday Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

The Bid-Ask Spread

• The bid price is the price a dealer is willing to pay you for something

• The ask price is the amount the dealer wants you to pay for the thing.

• The bid-ask spread is the difference between the bid and ask prices

The Bid-Ask Spread

• A dealer could offer

– bid price of $1.25 per €

– ask price of $1.26 per €

– While there are a variety of ways to quote that,

• The bid-ask spread represents the dealer’s expected profit.

The Bid-Ask Spread

• A dealer would likely quote these prices as 72-77.

• It is presumed that anyone trading $10m already knows the “big figure”.

1.9072 5242

S($/£) S(£/$)

1.9077 5243

big figure small figure

Spot FX 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.

Credit Agricole S(¥/£)=85

Barclays S(¥/$)=120

Suppose we observe

these banks posting

these exchange rates

First calculate any implied

cross rate to see if an

Triangular Arbitrage

$

Credit Lyonnais S(£/$)=1.50

Credit Agricole S(¥/£)=85

Barclays S(¥/$)=120

As easy as 1 – 2 – 3:

1 Sell our $ for £,

2 Sell our £ for ¥,

3 Sell those ¥ for $.

12

3

$

Triangular Arbitrage

$

Credit Lyonnais S(£/$)=1.50

Credit Agricole S(¥/£)=85

Barclays S(¥/$)=120

Here we have to go “clockwise” to

make money—but it doesn’t

matter where we start

Triangular Arbitrage

• As a quick spot method for triangular arbitrage, write the three rates out with

a different denominator in each:

– 1.3285 CHF / USD

– 0.00851 USD / JPY

– 88.20 JPY / CHF

• If there is parity:

– If this is greater, or less than, 1 an arbitrage opportunity exists.

– An answer < 1 means that one of the component rates (fractions) is too low An

answer > 1 mean that one of the rates is too high.

– If the total is less than one, assume that any of the fractions is too low, e.g CHF/USD This would imply that CHF is too low (overvalued vs USD) or USD is too high

(undervalued vs CHF); this tells us to either buy the undervalued or sell the overvalued currency.

USD USD

CHF

The Forward Market

• A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today

Forward Rate Quotations

• The forward market for FX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today

• Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts

• Non Deliverable Forwards

Forward Rate Quotations

• Consider the example from above:

for British pounds, the spot rate is

$1.9077 = £1.00While the 180-day forward rate is

$1.8904 = £1.00

• What’s up with that?

Clearly the market participants

expect that the pound will be

worth less in

dollars in six months

Country

USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina

Forward Rate Quotations

• Consider the (dollar) holding period return of a dollar-based investor who buys

£1 million at the spot and sells them forward:

Forward Premium

• The interest rate differential implied by forward premium or discount.

• For example, suppose the € is appreciating from S($/€) = 1.25 to F180($/€) = 1.30

• The 180-day forward premium is given by:

= 0.08

1.30 – 1.251.25 × 2

Long and Short Forward

Positions

• If you have agreed to sell anything (spot or forward), you are “short”

• If you have agreed to buy anything (forward or spot), you are “long”.

• If you have agreed to sell FX forward, you are short

• If you have agreed to buy FX forward, you are long.

Payoff Profiles

F180($/¥) = 009524

Short position loss

profit If you agree to sell anything in the future at a set

price and the spot price later falls then you gain

If you agree to sell anything in the future at a set

price and the spot price later rises then you lose

indirect quote:

F180(¥/$) = 105 or

F180($/¥) = 009524 short position

When the short entered into this forward

contract, he agreed to sell ¥ in 180 days at F180(¥/

$) = 105 profit

short position

If, in 180 days, S180(¥/$) = 120, the short will make

a profit by buying ¥ at S180(¥/$) = 120 and

delivering ¥ at F180(¥/$) = 105

15¥

profit

short position

If, in 180 days, S180(¥/$) = 120, the long will

and delivering ¥ at F180(¥/$) = 105

120 –15¥

Interest Rate Parity Defined

• IRP is an arbitrage condition.

• If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity

• Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds

Interest Rate Parity Carefully

Defined

Consider alternative one year investments for $100,000:

1 Invest in the U.S at i$ Future value = $100,000 × (1 + i$)

2 Trade your $ for £ at the spot rate, invest $100,000/S $/£ in

Britain at i£ while eliminating any exchange rate risk by selling the future value of the British investment forward

(otherwise an arbitrage would exist)

Interest Rate Parity Defined

• The scale of the project is unimportant

Interest Rate Parity Defined

Forward Premium

• It’s just the interest rate differential implied by forward premium or discount.

• For example, suppose the € is appreciating from S($/€) = 1.25 to F180($/€) = 1.30

• The forward premium is given by:

F180($/€) – S($/€)

360180

$1.25 × 2 = 0.08

Interest Rate Parity Carefully

IRP and Covered Interest

Spot exchange rate S($/£) = $1.25/£

360-day forward rate F360($/£) = $1.20/£

U.S discount rate i$ = 7.10%

British discount rate i£ = 11.56%

IRP and Covered Interest

Arbitrage

A trader with $1,000 could invest in the U.S at 7.1%, in

one year his investment will be worth

$1,071 = $1,000 × (1+ i$) = $1,000 × (1,071) Alternatively, this trader could

1 Exchange $1,000 for £800 at the prevailing spot rate,

2 Invest £800 for one year at i£ = 11,56%; earn

£892,48

3 Translate £892,48 back into dollars at the forward

rate F360($/£) = $1,20/£, the £892,48 will be exactly

$1,071.

£892.48 = £800 × (1+ i£)

Interest Rate Parity

& Exchange Rate Determination

According to IRP only one 360-day forward rate,

F360($/£), can exist It must be the case that

F360($/£) = $1.20/£

Why?

If F360($/£) ≠ $1.20/£, an astute trader could make money with one of the following strategies:

Arbitrage Strategy I

If F360($/£) > $1.20/£

i Borrow $1,000 at t = 0 at i$ = 7.1%

ii Exchange $1,000 for £800 at the prevailing spot rate, (note that £800 =

$1,000÷$1.25/£) invest £800 at 11.56% (i£) for one year to achieve £892.48iii Translate £892.48 back into dollars, if

F360($/£) > $1.20/£, then £892.48 will be more than enough to repay your debt

of $1,071

£892.48 = £800 × (1+ i£)

repay your dollar obligation of $1,071 The excess is your profit.

iii Translate $1,071 back into pounds, if

F360($/£) < $1.20/£, then $1,071 will be more than enough to repay your debt

of £892.48

the U.K.

your dollar obligation of £892.48 Keep the rest as profit.

£892.48

IRP and Hedging Currency Risk

You are a U.S importer of British woolens and have just ordered next year’s inventory Payment of £100M is due in one year.

IRP implies that there are two ways that you fix the cash outflow to a

certain U.S dollar amount:

a) Put yourself in a position that delivers £100M in one year—a long

forward contract on the pound

You will pay (£100M)(1.2/£) = $120M in one year.

b) Form a forward market hedge as shown below.

Spot exchange rate S($/£) = $1.25/£

360-day forward rate F360($/£) = $1.20/£

U.S discount rate i$ = 7.10%

British discount rate i£ = 11.56%

IRP and a Forward Market

Hedge

To form a forward market hedge:

Borrow $112.05 million in the U.S (in one year you will owe $120 million).

Translate $112.05 million into pounds at the spot

rate S($/£) = $1.25/£ to receive £89.64 million Invest £89.64 million in the UK at i£ = 11.56% for one year.

In one year your investment will be worth £100 million—exactly enough to pay your supplier.

Forward Market Hedge

Where do the numbers come from? We owe our

supplier £100 million in one year—so we know that

we need to have an investment with a future value

of £100 million Since i£ = 11.56% we need to invest

£89.64 million at the start of the year.

How many dollars will it take to acquire £89.64 million at the start of the year if S($/£) =

Is the Forward Rate a good predictor of future spot?

• FORWARD RATES AS PREDICTORS OF FUTURE SPOT RATES

• 12 month forward rates from November ’05 to May ’06…

• …and the spot rate 12 month’s later

Forecasts

Forecasts

Purchasing Power Parity and Exchange Rate Determination

• The exchange rate between two currencies should equal the ratio of the countries’ price levels:

USD/JPY PPP

Purchasing Power Parity and Exchange Rate Determination

• Suppose the spot exchange rate is $1.25 =

Purchasing Power Parity and Exchange Rate Determination

• The euro will trade at a 1.90% discount in the forward

Purchasing Power Parity and Interest Rate Parity

• Notice that our two big equations today equal each other:

Expected Rate of Change in Exchange Rate as Inflation

Differential

• We could also reformulate our equations as

inflation or interest rate differentials:

Expected Rate of Change in Exchange Rate as Interest Rate

Quick and Dirty Short Cut

• Given the difficulty in measuring expected inflation, managers often use

≈ i$ – i€

π$ – π€

Currency Strategies

• Momentum trading seeks to take advance of

market trends, purchasing currencies with the

best recent performance and selling the weakest performers

• Mean reversion strategies in are some ways

the opposite of momentum strategies It is based

on the idea that currencies are prone to move too far too fast and then are reversed in part or in full.

• Carry trades seek to take advantage of interest

rate differentials, selling low yielding currencies

and buying higher yielding currencies

Currency Swaps

• In a plain vanilla cross-currency swap transaction, one party

typically holds one currency and desires a different currency

• Each party will then pay interest on the currency it receives in the swap and the interest payment can be made at either a fixed or a floating rate.

• Contrary to the Interest Rate Swap there is an actual exchange of cash flow at initiation

• Frequent bond issuers often issue bonds in currencies demanded

by investors.

Example of a Currency Swap

• Below are cash flows for £10m 4 year swap 5% fixed for fixed £ / $:

• US Interest Rates: 10% UK Interest Rates 8% Party A holds £10m

Pays

£10m

Contrary to IRS there is exchange of cash flows at initiation and termination

Other Instruments in International

Finance

• EUROCURRENCY MARKETS

• EUROBOND MARKETS