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FIN 40500: International Finance Introduction to Currency Markets
“Sherman, set the way-back machine for 1850!” Prior to the late 1800 s, international transactions were made with gold and silver coins…no exchange rate was necessary!! The most prominent coins were Spanish One Peseta =. 8465 ounces of Silver One Doubloon =. 88 ounces of Gold (one Doubloon = 16 Pesetas) US Coins were modeled after Spanish coins One US Dollar =. 8465 ounces of Silver One US Dollar = 0. 056 ounces of Gold
1 Dollar =. 86 oz. silver 1 Dollar = 0. 056 oz. gold Note that if, for example, the US was running a trade deficit with Britain, Gold and Silver would flow out of the US and into Britain (price-specie flow mechanism)…. when this happens, what happens to prices? 1 Pound = 3. 98 oz. silver 1 Sovereign =. 2354 oz. gold
As countries moved to paper currency in the late 1860 s, governments would regulate the value of that currency by fixing the price of gold VS $20. 67 Per Ounce $1 =. 0483 oz gold 4. 40 Per Ounce 1 Pound =. 227 oz gold These two prices imply an exchange rate between the US Dollar and the British Pound $20. 67 Per Ounce = $4. 70 Per 4. 40 Per Ounce
Suppose that the exchange rate were $4. 00 per (The British Pound is Undervalued) $20. 67 Per Ounce 1 Start with $1, convert it to Pounds ( = . 25 ) 4. 40 Per Ounce 2 Buy Gold in England (. 0658 oz ) 3 Ship the gold back to the US and sell it ( = $1. 17 ) The gold standard era saw very stable exchange rates!
The Gold Standard maintained the price-specie flow mechanism $20. 67 Per Ounce $4. 70 Per 4. 40 Per Ounce Note that if, for example, the US was running a trade deficit with Britain, Excess demand for British pound notes would cause the Pound to appreciate – arbitrage would cause gold to flow out of the US and into England
In July 1944, delegates from 44 nations gathered at the Mount Washington hotel in Bretton Woods New Hampshire. The result was the Bretton Woods Agreement $1 = 360 JPY $1 =. 2481 GBP $1 = 3. 33 DEM 1 oz = $35 $1 = 119 FRF $1 = 575 ITL
The British Pound is attacked – The Bank of England devalues by 14% Johnson’s Great Society programs and the Vietnam war create large US deficits 1966 1965 1968 1967 August 15, 1971: Nixon is forced to suspend convertibility of dollars to gold 1971 1970 1972 Bretton Woods collapses and the currency boom begins!
From 1971 until 1987 the US followed a policy of managed floating (market based exchange rate with periodic “re-alignments”). USD/JPY The Plaza Accord (1985) purposely devalued the dollar against the Yen and Deutschmark by 51% The Louvre Accord (1987) ended the dollar devaluation policy of the plaza accord The Smithsonian Agreement (1971 -1973) attempted to return to the Bretton Woods system but without dollar/gold convertibility
In the meantime, the Europeans were developing an exchange rate system of their own. Called the ERM (European exchange rate mechanism), this system involved member countries to peg to an artificial currency called a European Currency Unit Currency Weight (%) Belgian Franc 8. 183 German Mark 31. 915 Danish Krone 2. 653 Spanish Peseta 4. 138 French Franc 20. 306 British Pound 12. 452 Greek Drachma . 437 Irish Punt 1. 086 Italian Lira 7. 84 Luxembourg Franc . 322 Dutch Guilder 9. 87 Portuguese Escudo . 695 The ECU was the original recipe for the Euro
GBP/USD In 1992, George Soros (Quantum Fund) believed the British pound was overvalued and began selling. On September 19, 1992 the British government was forced to withdraw from the ERM and devalue the pound. George Soros made a profit of $1 B!!!
Political turmoil and economic weaknesses led to a collapse of the Mexican Peso in 1994. This currency problem eventually spread through Latin America through what has become knows as the “Tequila Effect” (Not to be confused with the other “Tequila Effect”)
1998 1997 2000 1999 2002 2001 Currency markets have had a turbulent decade!!! 2003
In January, 2002, the Euro officially entered circulation in Europe. Since the emergence of the Euro in 1999, the dollar has had a bumpy ride! USD/EUR Will the Euro survive as a major currency?
The foreign exchange market is unique not just because of its geographic dispersion, but also because of its extreme liquidity and tremendous volume – around $1. 9 T PER DAY!! Name % of Volume v$600 B in Spot market Transactions Deutsche Bank 17 v$1. 3 T in Derivative Market Transactions UBS 12. 5 Citigroup 7. 5 HSBC 6. 4 Barclays 5. 9 Ø $200 B in Forwards Ø $1 T in Swaps Merrill Lynch 5. 7 Ø $100 B in Options JP Morgan Chase 5. 3 Goldman Sachs 4. 4 ABN Amro 4. 2 Morgan Stanley 3. 9 The ten most active traders account for 73% of the volume
With trading centers in New York City, London, Tokyo and Sydney, currency markets operate 24 hours a day, 5 days a week. Eastern Standard Time 12 AM 3 AM 8 AM 12 PM 5 PM 9 PM Australia: 5 PM - 2 AM 8 PM - 5 AM Tokyo London: 3 AM -11 AM New York City: 8 AM -5 PM 11 PM
Unlike other asset markets, England dominates foreign exchange trading Why is this?
The “Majors” The six “Majors” are: The US Dollar (USD), Japanese Yen (JPY), Euro (EUR), British Pound (GBP), Swiss Franc (CHF), Australian Dollar (AUD), and the Canadian Dollar (CAD)
Spot transactions are executed immediately (delivery usually takes place two days after the transaction date). A spot exchange rate is simply the price of one currency in terms of another currency. VS USD/JPY = 110. 49 (1 USD = 110. 49 JPY) The dollar appreciated against the Yen in the early eighties (USD/JPY increased ) Overall, the trend is a dollar depreciation (A decrease in USD/JPY)
In currency markets you need to PAY ATTENTION TO THE UNITS!!!! VS EUR/USD = 1. 2885 (1 EUR = 1. 2885 USD) The dollar has been depreciating against the Euro since 2001 (an increase in EUR/USD) The dollar appreciated sharply against the Euro after its 1999 release (a decrease in EUR/USD)
Calculating Profits/Losses Suppose that you took a long position in dollars @ 110. 00 and then reversed it @ 110. 10 Long: $10, 000 USD/JPY 110. 00 Short: $10, 000 USD/JPY 110. 10 These prices are in terms of Yen per dollar!! Profit =. 10 ( $10, 000) = Y 1, 000, 000 = $9, 082. 65 110. 10 Again…pay attention to the units!!!
As a currency dealer, you need to decide where to buy, where to sell and at what prices USD/CHF = 1. 2050 – 1. 2055 Bid Price for Dollars (the price in which the market maker is willing to buy dollars) Spread = 5 “Pips” Offer Price for Dollars (the price the market maker is willing to sell dollars) . 0005 CHF Profits (Per dollar traded) = $1 (. 0005) = 1. 2050 = $0. 0000415 What influences the spread? Liquidity News/Announcements Trade Size Why can’t we increase the spread to increase profits?
Unlike other assets, there is no centralized exchange that determines currency prices. The “market” is a network of dealers. As an individual dealer, you “skew” your price relative to the market USD/AUS Market = 1. 2884 – 1. 2890 You: 1. 2882 – 1. 2888 ? You: 1. 2884 – 1. 2890 ? You: 1. 2886 – 1. 2892 ? What affects your price? Economic Fundamentals Technical Analysis Order Flow Your Position We will talk about both of these methods this semester
Market: EUR/USD = 1. 2882 – 89 Current Order: Buy 10 Million Euro What price will you quote? Scenario #1: Your current position is long 25 M Euro Scenario #2: Your current position is short 25 M Euro Scenario #3: Your current position is square; order to sell 20 M Euro if 1. 2881 deals stop loss Scenario #4: Your current position is long 25 M Euro; order to sell 20 M Euro if 1. 2881 deals stop loss Scenario #5: You’re short 20 M Euros. NEWS: FED SEEN BUYING EUROS IN THE MARKET
Market: EUR/USD = 1. 2882 – 89 Current Order: 10 Million Euro What price will you quote? Scenario #1: German unemployment soars to 8. 9%, much higher than expected Scenario #2: Fed raises Fed Funds 50 Basis Points Scenario #3: S&P downgrades Japanese debt to A from Aa Scenario #4: Rice’s trip to the Middle East ends with no resolution. Violence continues Scenario #5: US department of labor announces 350, 000 new jobs created in July. Much higher than the expected number of 100, 000
Suppose that a dealer were offering Euro at $1. 22 in New York City while a dealer in London was offering Euro at $1. 24 1 Sell Euro short in London 3 2 Use the proceeds to buy Euro in New York Use your newly acquired Euro to pay off your short position Arbitrage insures that currency prices will be the same at different locations around the world. (Arbitrage will raise the price in NYC and lower the price in London)
Suppose that a dealer in New York City was offering the following prices: Euro/USD = $1. 25 USD/JPY = Y 115 Euro/JPY = Y 135 2 1 Use the dollars to buy Yen at Y 115 3 Sell Euro short at $1. 25 Use the Yen to buy Euro at Y 135 Repay your short position The USD/JPY, and Euro/JPY rates imply a Euro/USD rate (Cross Rates) USD/JPY = Y 115 Euro/JPY = Y 135 Euro/USD = Y 135 Y 115 = $1. 17
Voice Brokers Direct Market Offer Bid/Offer Bid Banks contact brokers through dedicated phone lines. The broker quotes a bid or offer Bid/Offer Traders contact market makers via phone or computer. Each trader is given a bid and offer and can accept either (or both) Electronic Exchange Bid Offer Traders submit orders to a computer network which automatically match up buys and sells
Since the early nineties, trading in currency markets have shifted towards electronic trading platforms. Any trade less than $10 M will almost definitely be handled by computer ØPrices have become more transparent ØSpreads collapsing ØVolume, Volume!!! 1994 2000 2002
Forward contracts involve transactions to be made at a later date. CAD/USD 1 month forward 3 months forward 6 months forward Contract signed . 9063. 9065. 9075. 9090 Transaction Made (Spot Rate =. 9087) Long position in CAD earns. 0012 CAD profit per CAD of contract size
Derivative markets offer a variety of ways to hedge currency risk n Futures are standardized forward contracts, many futures are traded in centralized markets (Chicago Mercantile Exchange) n JPY: 12, 500, 000 Yen n GBP: 62, 500 Pounds n Euro: 125, 000 Euro n CAD: 100, 000 Canadian Dollars n Options give the buyer the right to buy/sell currency, but not the requirement n Call: The right to buy at a specific “strike price” n Put: The right to sell at a specific “strike price” Currency Swaps represent agreements to exchange one currency for another at multiple pre-specified prices/dates. n
How do Multinational Corporations deal with exchange rate risk? What causes exchange rates to change? How can we detect overvalued/undervalued currencies? Questions to be Answered What causes currency crashes? What underlying conditions make them more likely?