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Lecture in International Finance

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					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”.
                  Outline
•   The FX market
•   Currency Forwards
•   Eurobond Market
•   Eurocurrency Market
•   Currency Swaps

• Strategies in FX
       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

• Exchange markets

                         FX Market




Spot Market               Forward Market          FX Swaps Market
Deals for delivery T +    Deals for delivery up   Deals with one spot
2                         to 12 months later      component and one
                          than T + 2              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
                                   Forwards
•   Spot Rates
•   Spot is the term used for standard settlement in the FX markets. The spot date is two business
    days after the trade date: T+2.
     – Spot rates are quoted as two way prices between the banks that populate the FX markets:




                                                                           Source: Bloomberg
            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
                     USD equiv   USD equiv   Currency per   Currency per
Country              Friday      Thursday    USD Friday     USD Thursday

Argentina (Peso)     0.3309      0.3292      3.0221         3.0377

Australia (Dollar)   0.7830      0.7836      1.2771         1.2762

Brazil (Real)        0.3735      0.3791      2.6774         2.6378

Britain (Pound)      1.9077      1.9135      0.5242         0.5226

1 Month Forward      1.9044      1.9101      0.5251         0.5235

          3 Months
           Forward   1.8983      1.9038      0.5268         0.5253

          6 Months
           Forward   1.8904      1.8959      0.5290         0.5275

Canada (Dollar)      0.8037      0.8068      1.2442         1.2395

1 Month Forward      0.8037      0.8069      1.2442         1.2393

          3 Months
           Forward   0.8043      0.8074      1.2433         1.2385

          6 Months
           Forward   0.8057      0.8088      1.2412         1.2364
                       Spot Rate Quotations

                     USD equiv   USD equiv   Currency per   Currency per
Country              Friday      Thursday    USD Friday     USD Thursday
Argentina (Peso)     0.3309      0.3292      3.0221         3.0377
Australia (Dollar)   0.7830      0.7836      1.2771         1.2762
                                                                           The direct quote for
Brazil (Real)        0.3735      0.3791      2.6774         2.6378         British pound is:
Britain (Pound)      1.9077      1.9135      0.5242         0.5226
                                                                           £1 = $1.9077
1 Month Forward      1.9044      1.9101      0.5251         0.5235
          3 Months
           Forward   1.8983      1.9038      0.5268         0.5253
          6 Months
           Forward   1.8904      1.8959      0.5290         0.5275
Canada (Dollar)      0.8037      0.8068      1.2442         1.2395
1 Month Forward      0.8037      0.8069      1.2442         1.2393
          3 Months
           Forward   0.8043      0.8074      1.2433         1.2385
          6 Months
                       Spot Rate Quotations

                     USD equiv   USD equiv   Currency per   Currency per   The indirect quote
Country              Friday      Thursday    USD Friday     USD Thursday   for British pound
Argentina (Peso)     0.3309      0.3292      3.0221         3.0377         is:
Australia (Dollar)   0.7830      0.7836      1.2771         1.2762         £.5242 = $1
Brazil (Real)        0.3735      0.3791      2.6774         2.6378
Britain (Pound)      1.9077      1.9135      0.5242         0.5226
1 Month Forward      1.9044      1.9101      0.5251         0.5235
          3 Months
           Forward   1.8983      1.9038      0.5268         0.5253
          6 Months
           Forward   1.8904      1.8959      0.5290         0.5275
Canada (Dollar)      0.8037      0.8068      1.2442         1.2395
1 Month Forward      0.8037      0.8069      1.2442         1.2393
          3 Months
           Forward   0.8043      0.8074      1.2433         1.2385
          6 Months
                       Spot Rate Quotations

                     USD equiv   USD equiv   Currency per   Currency per   Note that the
Country              Friday      Thursday    USD Friday     USD Thursday   direct quote is the
Argentina (Peso)     0.3309      0.3292      3.0221         3.0377         reciprocal of the
Australia (Dollar)   0.7830      0.7836      1.2771         1.2762         indirect quote:
Brazil (Real)        0.3735      0.3791      2.6774         2.6378
Britain (Pound)      1.9077      1.9135      0.5242         0.5226
1 Month Forward      1.9044      1.9101      0.5251         0.5235
          3 Months
           Forward   1.8983      1.9038      0.5268         0.5253
                                                                                        1
          6 Months
           Forward   1.8904      1.8959      0.5290         0.5275         1.9077 =
Canada (Dollar)      0.8037      0.8068      1.2442         1.2395
                                                                                      .5242
1 Month Forward      0.8037      0.8069      1.2442         1.2393
          3 Months
           Forward   0.8043      0.8074      1.2433         1.2385
          6 Months
         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

            big figure            small figure

                         Bid      Ask
         S($/£)          1.9072   1.9077
         S(£/$)          .5242    .5243
• A dealer would likely quote these prices as 72-
  77.
• It is presumed that anyone trading $10m
  already knows the “big figure”.
           Spot FX trading
• In the interbank market, the standard size
  trade is about U.S. $10 million.
• A bank trading room is a noisy, active
  place.
• The stakes are high.
• The “long term” is about 10 minutes.
              Cross Rates
• Suppose that S($/€) = 1.50
  – i.e. $1.50 = €1.00
• and that S(¥/€) = 50
  – i.e. €1.00 = ¥50
• What must the $/¥ cross rate be?
    $1.50 €1.00     $1.50
         ×       =
    €1.00 ¥50        ¥50
                                $1.00 = ¥33.33
                               $0.0300 = ¥1
                 Triangular Arbitrage

Suppose we observe
these banks posting                                    $
these exchange rates.
                                Barclays
                                                               Credit Lyonnais
                              S(¥/$)=120
                                                                  S(£/$)=1.50


                                   ¥       Credit Agricole
First calculate any implied                                             £
cross rate to see if an
arbitrage exists.                              S(¥/£)=85

                                   £1.50       $1.00            £1.00
                                           ×               =
                                   $1.00       ¥120              ¥80
                       Triangular Arbitrage
As easy as 1 – 2 – 3:
                                                 $
1. Sell our $ for £,           Barclays
2. Sell our £ for ¥,                                      Credit Lyonnais
                             S(¥/$)=120   3           1
3. Sell those ¥ for $.                                       S(£/$)=1.50
                                                 2

                                  ¥       Credit Agricole
                                                                £
                                              S(¥/£)=85
           Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
                                         receive £150,000
Sell our £150,000 for ¥ at S(¥/£) = 85
                                       receive ¥12,750,000
Sell ¥12,750,000 for $ at S(¥/$) = 120
                                          receive $106,250
 profit per round trip = $106,250 – $100,000 = $6,250
                  Triangular Arbitrage
Here we have to go “clockwise” to
make money—but it doesn’t
matter where we start.
                                                             $
                                      Barclays
                                                                       Credit Lyonnais
                                    S(¥/$)=120       2             3      S(£/$)=1.50
                                                            1

                                           ¥        Credit Agricole
                                                                              £
                                                         S(¥/£)=85
  If we went “counter clockwise” we would be the source of arbitrage profits, not
  the recipient!
                  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.
        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 = £1.00
While the 180-day forward rate is
               $1.8904 = £1.00
• What’s up with that?
                 USD
                 equiv    USD equiv   Currency per   Currency per
Country          Friday   Thursday    USD Friday     USD Thursday
Argentina
(Peso)           0.3309   0.3292      3.0221         3.0377
Australia
(Dollar)         0.7830   0.7836      1.2771         1.2762
Brazil (Real)    0.3735   0.3791      2.6774         2.6378         Clearly the market
Britain                                                             participants
(Pound)          1.9077   1.9135      0.5242         0.5226         expect that the
       1 Month                                                      pound will be
       Forward   1.9044   1.9101      0.5251         0.5235
                                                                    worth less in
      3 Months                                                      dollars in six
       Forward   1.8983   1.9038      0.5268         0.5253
                                                                    months.
      6 Months
       Forward   1.8904   1.8959      0.5290         0.5275
Canada
(Dollar)         0.8037   0.8068      1.2442         1.2395
       1 Month
       Forward   0.8037   0.8069      1.2442         1.2393
      3 Months
       Forward   0.8043   0.8074      1.2433         1.2385
      6 Months
       Forward   0.8057   0.8088      1.2412         1.2364
       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:
             gain           $1,890,400 – $1,907,700       –$17,300
  $HPR=              =                                =
             pain                  $1,907,700             $1,907,700



   $HPR = –0.0091

    Annualized dollar HPR = –1.81% = –0.91% × 2
               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:
             F180($/€) – S($/€)       360       1.30 – 1.25
f180,€v$ =                        ×         =                 ×2   = 0.08
                    S($/€)            180          1.25
     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
profit                  If you agree to sell anything in the future at a set
                        price and the spot price later falls then you gain.




                                                                   S180($/¥)
   0

                           F180($/¥) = .009524
         If you agree to sell anything in the future at a set
         price and the spot price later rises then you lose.

  loss                                                           Short position
             Payoff Profiles
   profit
                                        short position
                                            Whether the payoff
                                      profile slopes up or down
                                        depends upon whether
                                           you use the direct or
                                                  indirect quote:

       0                                 F (¥/$) = 105 or
                                 S180(¥/$)180
                                              F180($/¥) =
               F180(¥/$) = 105                  .009524.


-F180(¥/$)
      loss
             Payoff Profiles
   profit
                                            short position




                                              S180(¥/$)
       0

                F180(¥/$) = 105
             When the short entered into this forward
             contract, he agreed to sell ¥ in 180 days at
-F180(¥/$)
      loss   F180(¥/$) = 105
             Payoff Profiles
   profit
                                             short position

     15¥


                                               S180(¥/$)
       0
                                    120
                  F180(¥/$) = 105
             If, in 180 days, S180(¥/$) = 120, the short will
             make a profit by buying ¥ at S180(¥/$) = 120 and
-F180(¥/$)
      loss   delivering ¥ at F180(¥/$) = 105.
                      Payoff Profiles
   profit    Since this is a zero-sum game, the long position
F180(¥/$)           payoff is the opposite of the short.          short position




                                                                    S180(¥/$)
       0

                            F180(¥/$) = 105


-F180(¥/$)                                                      Long position
      loss
                Payoff Profiles
    profit
             The long in this forward contract agreed to BUY
-F180(¥/$)
             ¥ in 180 days at F180(¥/$) = 105
                      If, in 180 days, S180(¥/$) = 120, the long will
                          lose by having to buy ¥ at S180(¥/$) = 120
                                and delivering ¥ at F180(¥/$) = 105.
                                                     S180(¥/$)
       0
                                       120
                     F180(¥/$) = 105
   –15¥
                                               Long position
     loss
   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 $100,000:
• Invest in the U.S. at i$. Future value = $100,000 × (1
   + i $)
• Trade your $ for £ at the spot rate, invest
   $100,000/S$/£ in Britain at i£ while eliminating any
                            by selling             F$/£
   exchange rate risk$100,000(1 + i )× the future value of the
             Future value =          £
   British investment forward.                     S$/£
Since these investments have the same risk, they must have the same future value
(otherwise an arbitrage would exist)


                           (1 + i£) ×
                                          F   $/£
                                                    = (1 + i$)
                                          S $/£
    Alternative 2:                      $1,000                                    IRP
    Send your $ on
                                          S$/£
    a round trip to
                                                                             Step 2:
    Britain
                                                                         Invest those
                                                                         pounds at i£
                  $1,000                                              Future Value =
                                                                      $1,000
                                                                                 ´ (1+ i£)
                                                                         S$/£
                                       Step 3: repatriate
Alternative 1:                        future value to the
invest $1,000 at i$                                U.S.A.
                             $1,000
$1,000×(1 + i$)        =                ´ (1+ i£) × F$/£
                               S$/£
                       IRP




Since both of these investments have the same risk, they must have the same future value—
otherwise an arbitrage would exist
   Interest Rate Parity Defined
• The scale of the project is unimportant

                     $1,000
   $1,000×(1 + i$) =        ´ (1+ i£) × F$/£
                      S$/£

                      F$/£
           (1 + i$) =      × (1+ i£)
                      S$/£
    Interest Rate Parity Defined
Formally,       1+i               F
                                =
                            $         $/¥

                1+i         ¥     S
                                  $/¥




IRP is sometimes approximated as
               i$ – i             F–S
                        ¥       ≈
                                   S
                      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($/€) – S($/€)       360       $1.30 – $1.25
 f180,€v$   =                        ×         =                   × 2 = 0.08
                         S($/€)          180           $1.25
    Interest Rate Parity Carefully
               Defined
• Depending upon how you quote the
  exchange rate ($ per ¥ or ¥ per $) we
  have:
     1 + i¥   F                1+i      F
            =                         =
               ¥/$                   $      $/¥
                       or
     1 + i$   S¥/$
                               1+i   ¥  S $/¥




        …so be a bit careful about that
     IRP and Covered Interest
            Arbitrage
If IRP failed to hold, an arbitrage would
   exist. It’s easiest to see this in the form of
   an example.
Consider the following set of foreign and
   domestic interest rates and spot and
   forward exchange rates.
          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
• Exchange $1,000 for £800 at the prevailing spot
    rate,
• Invest £800 for one year at i£ = 11,56%; earn
    £892,48.
• Translate £892,48 back into dollars at the forward
    rate F360($/£) = $1,20/£, the £892,48 will be exactly
    $1,071.
Alternative 2:
                                                       Arbitrage I
buy pounds
                                £800
                      £1                                     Step 2:
   £800 = $1,000×
                     $1.25                              Invest £800 at
                                                        i£ = 11.56%
           $1,000                            £892.48 In one year £800
                                                          will be worth
                           Step 3: repatriate                 £892.48 =
                              to the U.S.A. at             £800 ´(1+ i£)
                                F360($/£) = $1.20/£

    Alternative 1:
    invest $1,000      $1,071                                       F£(360)
    at 7.1%                                    $1,071 = £892.48 ×
                                                                      £1
    FV = $1,071
          Interest Rate Parity
     & Exchange Rate Determination
According to IRP only one 360-day forward
  rate,
F360($/£), can exist. It must be the case that

             F360($/£) = $1.20/£
Why?
If F360($/£) ¹ $1.20/£, an astute trader could
   make money with one of the following
   strategies:
         Arbitrage Strategy I
If F360($/£) > $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÷$1.25/£) invest £800 at 11.56% (i£)
   for one year to achieve £892.48
   iii. Translate £892.48 back into dollars, if
    F360($/£) > $1.20/£, then £892.48 will be
   more than enough to repay your debt of
   $1,071.
Step 2:                                          Arbitrage I
buy pounds
                           £800
                  £1                                    Step 3:
£800 = $1,000×
                 $1.25                             Invest £800 at
                                                   i£ = 11.56%
      $1,000                            £892.48 In one year £800
                                                     will be worth
                                                         £892.48 =
                                                      £800 ´(1+ i£)
                         Step 4: repatriate
                              to the U.S.A.
Step 1:
borrow $1,000 More                                          F£(360)
Step 5: Repay    than $1,071          $1,071 < £892.48 ×
                                                              £1
your dollar loan
with $1,071.
If F£(360) > $1.20/£ , £892.48 will be more than enough to
repay your dollar obligation of $1,071. The excess is your profit.
          Arbitrage Strategy II

If F360($/£) < $1.20/£
  i. Borrow £800 at t = 0 at i£= 11.56% .
  ii. Exchange £800 for $1,000 at the
  prevailing spot rate, invest $1,000 at 7.1%
  for one year to achieve $1,071.
  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.
Step 2:
buy dollars                                   Arbitrage II
                           £800
                 $1.25
$1,000 = £800×                                    Step 1:
                  £1
                                                  borrow £800
    $1,000
                                       More        Step 5: Repay
                  Step 3:                            your pound
                    Invest $1,000      than
                                       £892.48         loan with
                    at i$
                                                       £892.48 .
                                                         Step 4:
                                                   repatriate to
                                                        the U.K.
 In one year $1,000
                                                   F£(360)
 will be worth    $1,071      $1,071 > £892.48 ×
                                                     £1


If F£(360) < $1.20/£ , $1,071 will be more than enough to repay
your dollar obligation of £892.48. Keep the rest as profit.
  IRP and Hedging Currency Risk
You are a U.S. importer of British woolens and have just
  ordered next year’s inventory. Payment of £100M is due in
  one year.
            Spot exchange rate        S($/£) = $1.25/£
            360-day forward rate    F360($/£) = $1.20/£
            U.S. discount rate            i$ = 7.10%
            British discount rate         i£ = 11.56%
IRP 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.
    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.
                                                  £100
                                 £89.64 =
                                                 1.1156

How many dollars will it take to acquire £89.64 million at the start of the year if S($/£) =
$1.25/£?


                                                               $1.00
                               $112.05 = £89.64 ×
                                                               £1.25
    Is the Forward Rate a good
      predictor of future spot?
• FORWARD RATES AS PREDICTORS OF
  FUTURE SPOT RATES
• 12 month forward rates from November
  ’05 to May ’06…
• …and the spot rate 12 month’s later
Forecasts
Forecasts
    Purchasing Power Parity and
    Exchange Rate Determination
• The exchange rate between two currencies
  should equal the ratio of the countries’ price
  levels:                 P$
                 S($/£) =
                            P£
l For example, if an ounce of gold costs $300 in
the U.S. and £150 in the U.K., then the price of
one pound in terms of dollars should be:
                   P$ $300
          S($/£) =    = £150 = $2/£
                   P£
USD/JPY PPP
    Purchasing Power Parity and
    Exchange Rate Determination
• Suppose the spot exchange rate is $1.25 =
  €1.00
• If the inflation rate in the U.S. is expected to be
  3% in the next year and 5% in the euro zone,
• Then the expected exchange rate in one year
  should be $1.25×(1.03) = €1.00×(1.05)


   F($/€) = $1.25×(1.03)       =   $1.23
            €1.00×(1.05)           €1.00
     Purchasing Power Parity and
     Exchange Rate Determination
• The euro will trade at a 1.90% discount in the forward
  market:
               $1.25×(1.03)
  F($/€)       €1.00×(1.05)       1.03   1 + p$
         =                      =      =
  S($/€)          $1.25           1.05   1 + p€
                  €1.00

Relative PPP states that the rate of change in the
exchange rate is equal to differences in the rates of
inflation—roughly 2%
      Purchasing Power Parity
      and Interest Rate Parity
• Notice that our two big equations today
  equal each other:

       PPP                      IRP
 F($/€)   1 + p$       1 + i$     F($/€)
        =          =            =
 S($/€)   1 + p€       1 + i€     S($/€)
     Expected Rate of Change in
     Exchange Rate as Inflation
            Differential
• We could also
  reformulate our            F($/€)    1 + p$
                                    =
  equations as inflation or  S($/€)    1 + p€
  interest rate
  differentials:
  F($/€) – S($/€)   1 + p$      1 + p$ 1 + p€
                  =        –1=        –
       S($/€)       1 + p€      1 + p€ 1 + p€

          F($/€) – S($/€)   p$ – p€
   E(e) =                 =         ≈ p$ – p€
              S($/€)        1 + p€
   Expected Rate of Change in
  Exchange Rate as Interest Rate
           Differential

         F($/€) – S($/€)     i$ – i€
E(e) =                   =             ≈ i$ – i€
             S($/€)          1 + i€
    Quick and Dirty Short Cut
• Given the difficulty in measuring expected
  inflation, managers often use

             p $ – p € ≈ i$ – i€
          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.
        Cross-Currency Swaps
              Positions
• Party A holds €
• Party B holds $

• 4 Possibilities:
   – A pays fixed rate on $ received and B pays fixed rate
     on € received.
   – A pays floating rate on $ received and B pays fixed
     rate on € received.
   – A pays fixed rate on $ received and B pays floating
     rate on € received.
   – A pays floating rate on $ received and B pays floating
     rate on € received.
        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
 •   From the perspective of A
Receive $20m       Receive            Receive         Receive              Receive
                    £0.8m              £0.8m           £0.8m               £10.8m




                                                                              Termination
                                                                                 date




 Pays                           Pay             Pay             Pay               Pay
 £10m                           $2m             $2m             $2m              $22m
                Contrary to
                IRS there is
                exchange of
               cash flows at
               initiation and
                termination
Other Instruments in International
            Finance
• EUROCURRENCY MARKETS

• EUROBOND MARKETS

				
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