International Finance FIN 456 Michael Dimond Foreign

International Finance FIN 456 Michael Dimond

Foreign Exchange Markets • Provide the physical and institutional structure to – Exchange the money of one country for that of another – Determine the rate of exchange between currencies – Physically complete foreign exchange transactions • A foreign exchange transaction is an agreement between a buyer & seller that a set amount of one currency will be delivered for some other currency at a specified rate • Six main characteristics of the FOREX markets: – – – The geographic extent The three main functions The market’s participants Its daily transaction volume Types of transactions including spot, forward and swaps Methods of stating exchange rates, quotations, & changes in rates Michael Dimond School of Business Administration

Geographic Extent of the Market • • Geographically, the FOREX market spans the globe with prices moving and currencies trading every hour of every business day Major world trading starts each morning in Sydney and Tokyo, then moves west to Hong Kong and Singapore & finishes on the West Coast of the U. S. Michael Dimond School of Business Administration

Functions of the FOREX Market (FX Market) • The FOREX market is the mechanism by which participants – Transfer purchasing power between countries • This is necessary as international trade and capital transactions normally involve parties living in countries with different national currencies – Obtain or provides credit for international trade transactions • Inventories in transit must be financed – Minimize exposure to exchange rate risk • FOREX markets provide instruments utilized in “hedging” or transferring risk to more willing parties • The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retail market – Five broad categories of participants operate within these two tiers • • • Bank and non bank foreign exchange dealers Central banks and treasuries Foreign exchange brokers Individuals and firms conducting commercial or investment transactions Speculators and Arbitrageurs Michael Dimond School of Business Administration

Size of the FOREX Market • The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be USD 3. 7 trillion in April 2010 – Spot transactions at $1, 495 bn/day – Outright forwards at $475 bn/day – Swaps at $1, 765 bn/day • The London trade alone makes up 36. 7% of daily transactions in the foreign exchange market, followed by the US (17. 9%), Japan (6. 2%), Singapore (5. 3%), Switzerland (5. 2%) and Hong Kong (4. 2%) • Asian markets growing more rapidly than European markets Michael Dimond School of Business Administration

Continuous Linked Settlement • • Continuous Linked Settlement (CLS) system (since 2002) eliminates losses if either party unable to settle CLS links with Real-Time Gross Settlement (RTGS) systems in seven major currencies Eventually we expect same-day settlement instead of the current lag of two days The U. S. Commodity Futures Trading Commission (CFTC) regulates foreign exchange trading Michael Dimond School of Business Administration

Transactions in the Interbank Market • Transactions within this market can be executed on a spot, forward, or swap basis – A spot transaction requires almost immediate delivery of foreign exchange – A forward transaction requires delivery of foreign exchange at some future date – A swap transaction is the simultaneous exchange of one foreign currency for another Michael Dimond School of Business Administration

Spot Transactions • A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day – The settlement date is often referred to as the value date – This is the date when most dollar transactions are settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York Michael Dimond School of Business Administration

Outright Forward Transactions • This transaction requires delivery at a future value date of a specified amount of one currency for another • The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed • Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months – Terminology typically used is buying or selling forward – A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros Michael Dimond School of Business Administration

Foreign Exchange Rates & Quotations • A foreign exchange quote is a statement of willingness to buy or sell at an announced rate – In the retail market (newspapers and exchange booths), quotes are often given as the home currency price of the foreign currency • Currency Traditional Symbol ISO 4217 Code – – – U. S. dollar European euro Great Britain pound Japanese yen Mexican peso $ € £ ¥ Ps USD EUR GBP JPY MXN Michael Dimond School of Business Administration

Foreign Exchange Rates & Quotations • Interbank quotes – professional dealers or brokers may state quotes in one of two ways – The foreign currency price of one dollar • Sfr 1. 6000/$, read as 1. 600 Swiss francs per dollar – The dollar price of a unit of foreign currency • $0. 6250/Sfr, read as 0. 625 dollars per Swiss franc • The former quote is considered to be in “European terms” and the latter is considered to be “American terms” • Almost all European currencies, except two, are quoted the European way – The Pound Sterling and the Euro are the exceptions – Additionally, Australian and New Zealand dollars are also quoted in American terms Michael Dimond School of Business Administration

Foreign Exchange Rates & Quotations • Direct and Indirect Quotes – A direct quote is a home currency price of a unit of a foreign currency • Sfr 1. 6000/$ is a direct quote in Switzerland – An indirect quote is a foreign currency price in a unit of the home currency • Sfr 1. 600/$ is an indirect quote in the US, • $0. 625/Sfr is a direct quote in the US and an indirect quote in Switzerland Michael Dimond School of Business Administration

Foreign Exchange Rates & Quotations • Interbank quotes are given as a bid and ask – The bid is the price at which a dealer will buy another currency – The ask or offer is the price at which a dealer will sell another currency • For example the bid and ask for spot euros would probably be shown “ 1. 2170/78” on a video screen. • In some cases between professional traders, they may only quote the last two digits of both the bid and ask, “ 70 -78” because they know what the other figures are. Michael Dimond School of Business Administration

Bid, Ask, and Mid-Point Quotations Michael Dimond School of Business Administration

Foreign Exchange Rates & Quotations • Expressing Forward Quotations on a Points Basis – The previously mentioned rates for yen were considered outright quotes – Forward quotes are different and typically quoted in terms of points – A point is the last digit of a quotation, with convention dictating the number of digits to the right of the decimal • Hence a point is equal to 0. 0001 of most currencies Michael Dimond School of Business Administration

Foreign Exchange Rates & Quotations • Expressing Forward Quotations on a Points Basis – The yen is quoted only to two decimal points – A forward quotation is not a foreign exchange rate, rather the difference between the spot and forward rates – Example: Bid Outright spot: Plus points (3 months) Outright forward: Ask ¥ 118. 27 ¥ 118. 37 -1. 43 -1. 40 ¥ 116. 84 ¥ 116. 97 Michael Dimond School of Business Administration

Exchange Rates: New York Closing Snapshot Michael Dimond School of Business Administration

Exchange Rates: New York Closing Snapshot (cont. ) Michael Dimond School of Business Administration

Cross Rates • Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency • Key Currency Cross Rates, Tuesday, January 4, 2011 Michael Dimond School of Business Administration

Foreign Exchange Rate Determining/Forecasting • Three basic approaches – Parity conditions – Balance of Payments – Asset market • These are not competing theories but are in fact complementary theories • Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost Michael Dimond School of Business Administration

Determinants of Foreign Exchange Rates Michael Dimond School of Business Administration

Foreign Exchange Rate Determining/Forecasting • Along with an understanding of theories, an understanding of the complexities of international political economy, societal and economic infrastructures, and random political and social events is needed when viewing the foreign exchange markets – Infrastructure weaknesses were among the major causes of the exchange rate collapses in emerging markets in the late 1990 s – Speculation contributed greatly to the emerging market crises. Uncovered interest rate arbitrage caused by extremely low interest rates in Japan coupled with high real interest rates in the US was a problem in the 1990 s – Cross-border foreign direct investment and international portfolio investment into emerging markets dried up during the recent crises – Foreign political risks have been much reduced in recent years as capital markets became less segmented from each other and more liquid – Finally, note that most determinants of spot exchange rates are also in turn affected by changes in the spot rate – in other words, they are not only linked but mutually determined Michael Dimond School of Business Administration

Purchasing Power Parity Approach • PPP is the oldest and most widely followed of the exchange rate theories • PPP is embedded within most theories of exchange rate determination • PPP calculations and forecasts have structural differences across countries and significant data challenges in estimation • Many versions of PPP (see chapter 7) but perhaps the relevant for explaining exchange rate values is Relative Purchasing Power Parity which explains that changes in relative prices between countries drive the change in exchange rates over time Michael Dimond School of Business Administration

Balance of Payments (Flows) Approach • Essentially BOP approach says equilibrium exchange rate is achieved when current account inflows match current account outflows • BOP transactions are widely appealing, captured, and reported • Criticism of the BOP approach is that it focuses on flows rather than stocks of money or financial assets • Relative stocks of money or financial assets do not play a role in theory • Practitioners use BOP but academics largely dismiss it Michael Dimond School of Business Administration

Monetary Approaches • Changes in supply and demand for money largely determine inflation which in turn alter exchange rates • Prices are flexible in both the short and long-run thus, the transmission impact is immediate • Real economic activity influences exchange rates through any alterations in demand for money • Omits a number of important factors for exchange rate determination including: – The failure of PPP to hold in the short to medium term – Money demand appears to be relatively unstable over time – The level of economic activity and the money supply do not appear to be independent Michael Dimond School of Business Administration

Asset Market Approach (Relative Prices of Bonds) • AKA relative price of bonds or portfolio balance approach • argues that exchange rates are determined by supply and demand for a wide variety of assets – Shifts in supply and demand alter exchange rates – Changes in monetary and fiscal policy alter expectations and thus exchange rates – Theories of currency substitution follow the same basis premises of portfolio rebalance framework • The Asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers • In highly developed countries, foreign investors are willing to hold securities and undertake foreign direct investment based primarily on relative real interest rates and the economic outlook of growth & profitability • Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment Michael Dimond School of Business Administration

Asset Market Approach (Relative Prices of Bonds) • • • Capital market liquidity is particularly important to foreign institutional investors. Cross-border investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired A country’s economic and social infrastructure is an important indicator of its ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a country’s securities and for purposes of evaluating foreign direct investment in that country The credibility of corporate governance practices is important to cross-border portfolio investors. A firm’s poor corporate governance practices can reduce foreign investors 'influence and cause subsequent loss of the firm’s focus on shareholder wealth objectives Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries with similar characteristics—at least in the eyes of cross-border investors. Contagion cause an “innocent” country to experience capital flight with a resulting depreciation of its currency Speculation can both cause a foreign exchange crisis or make an existing crisis Michael Dimond worse School of Business Administration

Currency Market Intervention • Foreign currency intervention, the active management, manipulation, or intervention in the market’s valuation of a country’s currency, is a component of currency valuation and forecast that cannot be overlooked. • “beggar-thy-neighbor, ” policy to keep currency values low to aid in exports, may prove inflationary if some goods MUST be imported … e. g. oil • Direct Intervention - This is the active buying and selling of the domestic currency against foreign currencies. This traditionally required a central bank to act like any other trader in the currency market • Coordinated Intervention - in which several major countries, or a collective such as the G 8 of industrialized countries, agree that a specific currency’s value is out of alignment with their collective interests • Indirect Intervention - This is the alteration of economic or financial fundamentals which are thought to be drivers of capital to flow in and out of specific currencies • Capital Controls - This is the restriction of access to foreign currency by government. This involves limiting the ability to exchange domestic currency foreign currency Michael Dimond School of Business Administration

Forecasting in Practice • In addition to the three approaches to forecasting discussed earlier (Parity Conditions, Balance of Payments, Asset Approach) forecasting practitioners also utilize technical analysis • These analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future • The longer time horizon of the forecast, the more inaccurate the forecast is likely to be • The following summarizes the various forecasting periods, regimes and preferred forecasting methods for each Michael Dimond School of Business Administration

Exchange Rate Forecasting Methods Michael Dimond School of Business Administration

Forecasting in Practice • Decades of theoretical and empirical studies show that exchange rates do adhere to the fundamental principles and theories outlined in the previous sections – fundamentals do apply in the long term • Therefore, there is something of a fundamental equilibrium path for a currency’s value • In the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long term fundamental path – this is sometimes referred to as noise Michael Dimond School of Business Administration

Short-Term Noise Versus Long-Term Trends • Although the various theories surrounding exchange rate determination are clear and sound, it may appear on a day-to -day basis that the currency markets do not pay much attention to theories Michael Dimond School of Business Administration

Forecasting in Practice • The difficulty is understanding which fundamentals are driving markets at which points in time • One example of this relative confusion over exchange rate dynamics is the phenomenon known as overshooting Michael Dimond School of Business Administration

International Parity Conditions • The economic theories which link exchange rates, price levels, and interest rates together are called international parity conditions • These theories may not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted Michael Dimond School of Business Administration

Prices and Exchange Rates • The Law of one price states that all else being equal (no transaction costs) a product’s price should be the same in all markets • Even if prices for a particular product are in different currencies, the law of one price states that P$ S = P ¥ Where the price of the product in US dollars (P$), multiplied by the spot exchange rate (S, yen per dollar), equals the price of the product in Japanese yen (P¥) Michael Dimond School of Business Administration

Prices and Exchange Rates • Conversely, if the prices were stated in local currencies, and markets were efficient, the exchange rate could be deduced from the relative local product prices ¥ $ Michael Dimond School of Business Administration

Purchasing Power Parity & The Law of One Price • If the Law of One Price were true for all goods, the purchasing power parity (PPP) exchange rate could be found from any set of prices • Through price comparison, prices of individual products can be determined through the PPP exchange rate • This is the absolute theory of purchasing power parity • Absolute PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods Michael Dimond School of Business Administration

Relative Purchasing Power Parity • If the assumptions of absolute PPP theory are relaxed, we observe relative purchasing power parity – This idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between countries over a period of time determines the change in exchange rates – Moreover, if the spot rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot rate Michael Dimond School of Business Administration

Relative Purchasing Power Parity (PPP) Michael Dimond School of Business Administration

Relative Purchasing Power Parity • Empirical tests of both relative and absolute purchasing power parity show that for the most part, PPP tends to not be accurate in predicting future exchange rates • Two general conclusions can be drawn from the tests: – PPP holds up well over the very long term but is poor for short term estimates – The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets Michael Dimond School of Business Administration

Exchange Rate Indices: Real and Nominal • In order to evaluate a single currency’s value against all other currencies in terms of whether or not the currency is “over” or “undervalued, ” exchange rate indices were created – These indices are formed by trade-weighting the bilateral exchange rates between the home country and its trading partners • The nominal exchange rate index uses actual exchange rates to create an index on a weighted average basis of the value of the subject currency over a period of time Michael Dimond School of Business Administration

Exchange Rate Indices: Real and Nominal • The real effective exchange rate index indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period – Example: The real effective rate for the US dollar (E$ ) is found by multiplying the nominal rate index (E$ ) by the ratio of US dollar costs (C$) over foreign currency costs (CFC) – If changes in exchange rates just offset differential inflation rates – if purchasing power parity holds – all the real effective exchange rate indices would stay at 100 R – If a rate strengthened (overvalued) or weakened (undervalue) then the index value would be ± 100 N Michael Dimond School of Business Administration

Exchange Rate Pass-Through • Incomplete exchange rate pass-through is one reason that country’s real effective exchange rate index can deviate from it’s PPP equilibrium point – The degree to which the prices of imported & exported goods change as a result of exchange rate changes is termed passthrough – Example: assume BMW produces a car in Germany and all costs are incurred in euros. When the car is exported to the US, the price of the BMW should be the euro value converted to dollars at the spot rate – Where P$ is the BMW price in dollars, P€ is the BMW price in euros and S is the spot rate € €/$ Michael Dimond School of Business Administration

Exchange Rate Pass-Through – Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index can deviate for lengthy periods from its PPPequilibrium level – If the euro appreciated 20% against the dollar, but the price of the BMW in the US market rose to only $40, 000, and not $42, 000 as is the case under complete passthrough, the pass-through is partial – The degree of pass-through is measured by the proportion of the exchange rate change reflected in dollar prices The degree of pass-through in this case is partial, 14. 29% ÷ 20. 00% or approximately 0. 71. Only 71. 0% of the change has been passed through to the US dollar price Michael Dimond School of Business Administration

Exchange Rate Pass-Through Michael Dimond School of Business Administration

Interest Rates and Exchange Rates • Prices between countries are related by exchange rates and now we discuss how exchange rates are linked to interest rates • The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. As a formula, The Fisher Effect is i = r + + r Where i is the nominal rate, r is the real rate of interest, and is the expected rate of inflation over the period of time The cross-product term, r , is usually dropped due to its relatively minor value Michael Dimond School of Business Administration

Interest Rates and Exchange Rates • Applied to two different countries, like the US and Japan, the Fisher Effect would be stated as $ i = r $ $ + ; ¥ i = r ¥ ¥ + It should be noted that this requires a forecast of the future rate of inflation, not what inflation has been, and predicting the future can be difficult! Michael Dimond School of Business Administration

Interest Rates and Exchange Rates • The international Fisher effect, or Fisher-open, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries – if we were to use the US dollar and the Japanese yen, the expected change in the spot exchange rate between the dollar and yen should be (in approximate form) ¥ • Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates • The international Fisher effect predicts that with unrestricted capital flows, an investor should be indifferent between investing in dollar or yen bonds, since investors worldwide would see the same opportunity and compete it away Michael Dimond School of Business Administration

Interest Rates and Exchange Rates • The Forward Rate – A forward rate is an exchange rate quoted today for settlement at some future date – The forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought or sold forward at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days) – The forward rate is calculated by adjusting the current spot rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies Michael Dimond School of Business Administration

Interest Rates and Exchange Rates • The Forward Rate example with spot rate of Sfr 1. 4800/$, a 90 -day euro Swiss franc deposit rate of 4. 00% p. a. and a 90 -day euro-dollar deposit rate of 8. 00% p. a. • Is Sfr 1. 4800/$ a direct quote or an indirect quote? • What is the forward premium or discount (in percent) on the swiss franc? Michael Dimond School of Business Administration

Interest Rates and Exchange Rates • The forward premium or discount is the percentage difference between the spot and forward rates stated in annual percentage terms – When stated in indirect terms (foreign currency per home currency units, FC/$) then formula is – The positive sign indicates that the Swiss franc is selling forward at a premium of 3. 96% per annum (it takes 3. 96% more dollars to get a franc at the 90 -day forward rate) – NOTE: For direct quotes ($/FC), then (F-S)/S should be applied Michael Dimond School of Business Administration

Currency Yield Curves and the Forward Premium Michael Dimond School of Business Administration

Interest Rate Parity: Linkage between FX markets • • Interest rate parity theory states the difference in the national interest rates for securities of similar risk and maturity should be equal, with opposite sign, to the forward discount or premium for the foreign currency (except for transaction costs) A US dollar-based investor can “cover” risk with a forward contract to become indifferent between dollar-denominated securities and Swiss franc-denominated securities of similar risk and maturity but different nominal rates Michael Dimond School of Business Administration

Covered Interest Arbitrage (CIA) • Because the spot and forward markets are not always in a state of equilibrium as described by IRP, the opportunity for arbitrage exists • The arbitrageur who recognizes this imbalance can invest in the currency that offers the higher return on a covered basis • This is known as covered interest arbitrage (CIA) • CIA can be described in much the same way as IRP was transacted: Michael Dimond School of Business Administration

Covered Interest Arbitrage (CIA) • Rule of Thumb: – If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher yielding currency. – If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency. Michael Dimond School of Business Administration

What if the trader doesn’t cover his position? • A deviation from CIA is to leave the position uncovered (ie, to not use a forward contract). Investors borrow in currencies with relatively low interest rates and convert the proceeds into currencies with higher rates • The transaction is “uncovered” because the investor does not sell the currency forward, thus remaining uncovered to any risk of the currency deviating. Consider this example of Yen Carry Trade: Michael Dimond School of Business Administration

Forward Rates as an Unbiased Predictor • If the foreign exchange markets are thought to be “efficient” then the forward rate should be an unbiased predictor of the future spot rate • This is roughly equivalent to saying that the forward rate can act as a prediction of the future spot exchange rate, and it will often “miss” the actual future spot rate, but it will miss with equal probabilities (directions) and magnitudes (distances) Michael Dimond School of Business Administration

International Parity Conditions in Equilibrium Michael Dimond School of Business Administration

Prices, Interest and Exchange Rates in Equilibrium • (A) Purchasing power parity – forecasts the change in the spot rate on the basis of differences in expected rates of inflation • (B) Fisher effect – nominal interest rates in each country are equal to the required real rate of return (r) plus compensation for expected inflation ( ) • (C) International Fisher effect – the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries • (D) Interest rate parity – the difference in the national interest rates should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs • (E) Forward rate as an unbiased predictor – the forward rate is an efficient predictor of the future spot rate, assuming that the foreign exchange market is reasonably efficient Michael Dimond School of Business Administration

Foreign Exchange Rates & Quotations • Intermarket Arbitrage – Cross rates can be used to check on opportunities for intermarket arbitrage – Example: Assume the following exchange rates are quoted Citibank Barclays Bank Dresdner Bank $1. 2223/€ $1. 8410/£ € 1. 5100/£ Michael Dimond School of Business Administration

Foreign Exchange Rates & Quotations • Intermarket Arbitrage – The cross rate between Citibank and Barclays is $1. 8410/ £ $1. 2223/ € = € 1. 5062/ £ – This cross rate is not the same as Dresdner’s rate quote of € 1. 5100/£ – Therefore, an opportunity exists for risk-less profit or arbitrage Michael Dimond School of Business Administration

Intermarket (Triangular) Currency Arbitrage Michael Dimond School of Business Administration