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Lecture in International Finance Chinese University of Technology Foued Ayari, Ph. D Lecture in International Finance Chinese University of Technology Foued Ayari, Ph. D

About Dr Ayari • Assistant Professor of Finance in New York • President & 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 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 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: 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 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 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 + 2 Deals for delivery up to 12 months later than T + 2 Deals with one spot component and one forward component

Spot & Forward • A spot contract is a binding commitment for an exchange 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 How Factors Can Affect Exchange Rates

Forwards • • Spot Rates Spot is the term used for standard settlement in 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 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. 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 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 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 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 Canada (Dollar)

Spot Rate Quotations Country USD equiv Friday USD equiv Thursday Currency per USD Friday 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 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 The direct quote for British pound is: £ 1 = $1. 9077

Spot Rate Quotations Country USD equiv Friday USD equiv Thursday Currency per USD Friday 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 The indirect quote for British pound 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 Country USD equiv Friday USD equiv Thursday Currency per USD Friday 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 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 Note that the direct quote is the reciprocal of the indirect quote: 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 1. 9077 = 1. 5242

The Bid-Ask Spread • The bid price is the price a dealer is willing 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 The Bid-Ask Spread • A dealer could offer – bid price of $1. 25 per € – ask price of $1. 26 per € – While there 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($/£) 1. 9072 1. 9077 The Bid-Ask Spread big figure small figure Bid Ask S($/£) 1. 9072 1. 9077 S(£/$) . 5242 . 5243 • A dealer would likely quote these prices as 7277. • It is presumed that anyone trading $10 m already knows the “big figure”.

Spot FX trading • In the interbank market, the standard size trade is about 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. $1. 50 Cross Rates • Suppose that S($/€) = 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 $1. 00 = ¥ 33. 33 $0. 0300 = ¥ 1

Triangular Arbitrage Suppose we observe these banks posting these exchange rates. $ Barclays Credit Triangular Arbitrage Suppose we observe these banks posting these exchange rates. $ Barclays Credit Lyonnais S(¥/$)=120 First calculate any implied cross rate to see if an arbitrage exists. ¥ S(£/$)=1. 50 Credit Agricole £ S(¥/£)=85 £ 1. 50 $1. 00 × $1. 00 ¥ 120 = £ 1. 00 ¥ 80

Triangular Arbitrage As easy as 1 – 2 – 3: $ 1. Sell our Triangular Arbitrage As easy as 1 – 2 – 3: $ 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $. Barclays S(¥/$)=120 Credit Lyonnais 3 1 S(£/$)=1. 50 2 ¥ Credit Agricole S(¥/£)=85 £

Triangular Arbitrage Sell $100, 000 for £ at S(£/$) = 1. 50 receive £ 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 Triangular Arbitrage Here we have to go “clockwise” to make money—but it doesn’t matter where we start. $ Barclays S(¥/$)=120 Credit Lyonnais 2 3 S(£/$)=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 three rates Triangular Arbitrage • As a quick spot method for triangular arbitrage, write 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 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 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 forward contracts. • Non Deliverable Forwards

Forward Rate Quotations • Consider the example from above: for British pounds, the spot 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?

Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD 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 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 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 Canada (Dollar) Clearly the market participants expect that the pound will be worth less in dollars in six months.

Forward Rate Quotations • Consider the (dollar) holding period return of a dollar-based investor 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: $HPR= gain pain = $1, 890, 400 – $1, 907, 700 $HPR = – 0. 0091 Annualized dollar HPR = – 1. 81% = – 0. 91% × 2 = –$17, 300 $1, 907, 700

Forward Premium • The interest rate differential implied by forward premium or discount. • Forward Premium • The interest rate differential implied by forward premium or discount. • For example, suppose the € is appreciating from S($/€) = 1. 25 to F 180($/€) = 1. 30 • The 180 -day forward premium is given by: f 180, €v$ = F 180($/€) – S($/€) × 360 180 = 1. 30 – 1. 25 × 2 = 0. 08

Long and Short Forward Positions • If you have agreed to sell anything (spot 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 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. S 180($/¥) 0 F 180($/¥) =. 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 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 180(¥/$) = 105 -F 180(¥/$) loss F (¥/$) = 105 or S 180(¥/$)180 F 180($/¥) =. 009524.

Payoff Profiles profit short position S 180(¥/$) 0 F 180(¥/$) = 105 -F 180(¥/$) Payoff Profiles profit short position S 180(¥/$) 0 F 180(¥/$) = 105 -F 180(¥/$) loss When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F 180(¥/$) = 105

Payoff Profiles profit short position 15¥ S 180(¥/$) 0 F 180(¥/$) = 105 -F Payoff Profiles profit short position 15¥ S 180(¥/$) 0 F 180(¥/$) = 105 -F 180(¥/$) loss 120 If, in 180 days, S 180(¥/$) = 120, the short will make a profit by buying ¥ at S 180(¥/$) = 120 and delivering ¥ at F 180(¥/$) = 105.

Payoff Profiles profit F 180(¥/$) Since this is a zero-sum game, the long position Payoff Profiles profit F 180(¥/$) Since this is a zero-sum game, the long position payoff is the opposite of the short position S 180(¥/$) 0 F 180(¥/$) = 105 -F 180(¥/$) loss Long position

Payoff Profiles profit -F 180(¥/$) The long in this forward contract agreed to BUY Payoff Profiles profit -F 180(¥/$) The long in this forward contract agreed to BUY ¥ in 180 days at F 180(¥/$) = 105 If, in 180 days, S 180(¥/$) = 120, the long will lose by having to buy ¥ at S 180(¥/$) = 120 and delivering ¥ at F 180(¥/$) = 105. S 180(¥/$) 0 F 180(¥/$) = 105 120 – 15¥ loss Long position

Interest Rate Parity Defined • IRP is an arbitrage condition. • If IRP did 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. 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 F$/£ exchange rate risk$100, 000(1 + i )× the future value of the by selling Future value = £ British investment forward. S$/£ Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist) (1 + i£) × F S $/£ = (1 + i$)

Alternative 2: Send your $ on a round trip to Britain $1, 000 S$/£ Alternative 2: Send your $ on a round trip to Britain $1, 000 S$/£ $1, 000 IRP Step 2: Invest those pounds at i£ Future Value = $1, 000 Alternative 1: invest $1, 000 at i$ $1, 000×(1 + i$) = $1, 000 Step 3: repatriate future value to the U. S. A. (1+ i£) S$/£ (1+ i£) × F$/£ IRP S$/£ 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 Interest Rate Parity Defined • The scale of the project is unimportant $1, 000 (1+ i ) × F $1, 000×(1 + i$) = £ $/£ S$/£ F$/£ × (1+ i£) (1 + i$) = S$/£

Interest Rate Parity Defined Formally, 1+i $ ¥ F = S $/¥ IRP is Interest Rate Parity Defined Formally, 1+i $ ¥ F = 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 Forward Premium • It’s just the interest rate differential implied by forward premium or discount. • For example, suppose the € is appreciating from S($/€) = 1. 25 to F 180($/€) = 1. 30 • The forward premium is given by: f 180, €v$ = F 180($/€) – S($/€) × 360 180 = $1. 30 – $1. 25 × 2 = 0. 08

Interest Rate Parity Carefully Defined • Depending upon how you quote the exchange rate Interest Rate Parity Carefully Defined • Depending upon how you quote the exchange rate ($ per ¥ or ¥ per $) we have: 1+i 1 + i¥ F F or = = 1+i 1 + i$ S S ¥/$ $ $/¥ ¥/$ ¥ $/¥ …so be a bit careful about that

IRP and Covered Interest Arbitrage If IRP failed to hold, an arbitrage would exist. 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($/£) = $1. 25/£ 360 -day forward rate F 360($/£) = $1. 20/£ U. S. discount rate i$ = 7. 10% British discount rate i£ = 11. 56%

IRP and Covered Interest Arbitrage A trader with $1, 000 could invest in the 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 $1, 000 for £ 800 at the prevailing spot rate, 2. Invest £ 800 for one year at i£ = 11, 56%; earn £ 892, 48. 3. Translate £ 892, 48 back into dollars at the forward rate F 360($/£) = $1, 20/£, the £ 892, 48 will be exactly $1, 071.

Alternative 2: Arbitrage I buy pounds £ 800 = $1, 000× $1, 000 £ Alternative 2: Arbitrage I buy pounds £ 800 = $1, 000× $1, 000 £ 1 £ 800 Step 2: $1. 25 Invest £ 800 at i£ = 11. 56% £ 892. 48 In one year £ 800 will be worth Step 3: repatriate £ 892. 48 = to the U. S. A. at £ 800 (1+ i£) F 360($/£) = $1. 20/£ Alternative 1: invest $1, 000 at 7. 1% FV = $1, 071 = £ 892. 48 × F£(360) £ 1

Interest Rate Parity & Exchange Rate Determination According to IRP only one 360 -day Interest Rate Parity & Exchange Rate Determination According to IRP only one 360 -day forward rate, F 360($/£), can exist. It must be the case that F 360($/£) = $1. 20/£ Why? If F 360($/£) $1. 20/£, an astute trader could make money with one of the following strategies:

Arbitrage Strategy I If F 360($/£) > $1. 20/£ i. Borrow $1, 000 at Arbitrage Strategy I If F 360($/£) > $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÷$1. 25/£) invest £ 800 at 11. 56% (i£) for one year to achieve £ 892. 48 iii. Translate £ 892. 48 back into dollars, if F 360($/£) > $1. 20/£, then £ 892. 48 will be more than enough to repay your debt of $1, 071.

Step 2: buy pounds £ 800 = $1, 000× $1, 000 Arbitrage I £ Step 2: buy pounds £ 800 = $1, 000× $1, 000 Arbitrage I £ 1 $1. 25 £ 800 Step 3: Invest £ 800 at i£ = 11. 56% £ 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 than $1, 071 Step 5: Repay your dollar loan with $1, 071 < £ 892. 48 × F£(360) £ 1 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 F 360($/£) < $1. 20/£ i. Borrow £ 800 at Arbitrage Strategy II If F 360($/£) < $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 $1, 071 back into pounds, if F 360($/£) < $1. 20/£, then $1, 071 will be more than enough to repay your debt of £ 892. 48.

Step 2: buy dollars $1, 000 = £ 800× $1, 000 $1. 25 £ Step 2: buy dollars $1, 000 = £ 800× $1, 000 $1. 25 £ 1 £ 800 Arbitrage II Step 1: borrow £ 800 Step 5: Repay More Step 3: your pound loan than Invest $1, 000 with £ 892. 48 at i$ Step 4: repatriate to the U. K. In one year $1, 000 F£(360) will be worth $1, 071 > £ 892. 48 × $1, 071 £ 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 IRP and Hedging Currency Risk You are a U. S. importer of British woolens and have just ordered next year’s inventory. Payment of £ 100 M is due in one year. Spot exchange rate 360 -day forward rate S($/£) = $1. 25/£ F 360($/£) = $1. 20/£ U. S. discount rate i$ = 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 £ 100 M in one year—a long forward contract on the pound. You will pay (£ 100 M)(1. 2/£) = $120 M 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. 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 £ 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. £ 89. 64 = £ 100 1. 1156 How many dollars will it take to acquire £ 89. 64 million at the start of the year if S($/£) = $1. 25/£? $112. 05 = £ 89. 64 × $1. 00 £ 1. 25

Is the Forward Rate a good predictor of future spot? • FORWARD RATES AS 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 • …and the spot rate 12 month’s later

Forecasts Forecasts

Forecasts Forecasts

Purchasing Power Parity and Exchange Rate Determination • The exchange rate between two currencies 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£ 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£ l

USD/JPY PPP USD/JPY PPP

Purchasing Power Parity and Exchange Rate Determination • Suppose the spot exchange rate is 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) $1. 25×(1. 03) F($/€) = € 1. 00×(1. 05) = $1. 23 € 1. 00

Purchasing Power Parity and Exchange Rate Determination • The euro will trade at a Purchasing Power Parity and Exchange Rate Determination • The euro will trade at a 1. 90% discount in the forward market: F($/€) = S($/€) $1. 25×(1. 03) € 1. 00×(1. 05) $1. 25 € 1. 00 1. 03 1 + $ = = 1. 05 1 + € 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 Purchasing Power Parity and Interest Rate Parity • Notice that our two big equations today equal each other: PPP F($/€) 1 + $ = 1 + € S($/€) IRP = 1 + i$ 1 + i€ F($/€) = S($/€)

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

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

Quick and Dirty Short Cut • Given the difficulty in measuring expected inflation, managers Quick and Dirty Short Cut • Given the difficulty in measuring expected inflation, managers often use $ – € ≈ i$ – i€

Currency Strategies • Momentum trading seeks to take advance of market trends, purchasing currencies 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 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 $ • 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 £ Example of a Currency Swap • • • Below are cash flows for £ 10 m 4 year swap 5% fixed for fixed £ / $: US Interest Rates: 10% UK Interest Rates 8% Party A holds £ 10 m From the perspective of A Receive $20 m Receive £ 0. 8 m Receive £ 10. 8 m Termination date Pays £ 10 m Contrary to IRS there is exchange of cash flows at initiation and termination Pay $2 m Pay $22 m

Other Instruments in International Finance • EUROCURRENCY MARKETS • EUROBOND MARKETS Other Instruments in International Finance • EUROCURRENCY MARKETS • EUROBOND MARKETS