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 countrys (her citizens and her governments 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

Theres 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

Canadas Balance of Payments

40000 30000 20000 10000 0 -10000 -20000 -30000 -40000 BCA BKA BCA+BKA

Source: CANSIM

1960

1965

1970

1975

1980

1985

1990

1995

2000

Page 7

2005

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 Shoes Watches Surfboards Australia (AUD) 20 40 80 HK (HKD) 80 180 550

Page 13

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 0.80000-20 0.79985-05 0.79995-15

Page 21

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 banks 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 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

Calculate cross-rates and compare with the rates

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 ________.

you are ________. are short.

If you have agreed to buy anything (forward or spot)

If you have agreed to

If you have agreed to

________ forex forward, you

________ forex forward, you

are long.

Page 37

Payoff Profiles
profit

0 F180($/) = .009524

S180($/)

loss
Page 38

Short position

Payoff Profiles
profit F180(/$) short position

0 F180(/$) = 105

S180(/$)

Page 39

-F180(/$) loss

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?

Page 40

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?

Page 41