ecn 160b lectures 3 and 4 international macroeconomics
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ECN 160B Lectures 3 and 4 International Macroeconomics. Galina A. Schwartz Department of Economics University of CA, Davis. FOREX market . How does it work? (What rules govern it?) By and large As any other market – ForEx market

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ecn 160b lectures 3 and 4 international macroeconomics

ECN 160B Lectures 3 and 4International Macroeconomics

Galina A. Schwartz

Department of Economics

University of CA, Davis

Lecture 3 ECN160B

forex market
FOREX market
  • How does it work? (What rules govern it?) By and large
    • As any other market – ForEx market
  • DefinitionVehicle currency is one widely used to denominate international contracts of parties not residing in the country issuing the vehicle currency. KO, p. 331
  • Means of exchange rate formation
    • Supply-demand (as for any other market price)
    • Arbitrage as a tool to reach equilibrium
    • Presence of vehicle currency

Lecture 3 ECN160B

forex market same as lecture 2 slide 7
FOREX market (same as Lecture 2, slide 7)
  • Major Actors (Players or Participants)
    • Commercial Banks
      • Interbank Trading
    • Corporations
    • Non-Bank Financial Institutions
    • Central Banks
    • ? Individuals ?
  • Why KO mentions individuals only briefly?
    • they transact via intermediaries
    • volume is an insignificant fraction of total volume

Lecture 3 ECN160B

forex market characteristics
FOREX Market Characteristics
  • Arbitrage – buy low, sell high KO, p. 330
  • Today: Global Markets
    • Communications (fast and cheap)
    • Laws: have to be compatible why?
      • Arbitrage argument (if laws differ, market participants will choose a location with most favorable laws)
  • Why prices differ? [for example with location]
    • Imperfect market competition (supply side)
    • Price discrimination (demand side)
    • Differences in market conditions (ex. Risk Characteristics)
  • Prices (exchange rates) are close or not, and why?
    • Arbitrage, arbitrage, arbitrage

Lecture 3 ECN160B

exchange rates as prices
Exchange Rates as Prices
  • Why there are so many different exchange rates?
    • Wholesale (interbank trading), KO, p. 329
    • Retail, KO, p. 329
    • Spot, KO, p. 331
    • Forward, KO, p. 332
    • Off-shore versus On-shore (regulated versus unregulated), later -- KO, Ch. 21
  • It is no mystery: exchange rate is just a price
    • As any market, FOREX market has price dispersion
    • What limits price dispersion? -- Arbitrage (i.e. competition)

Lecture 3 ECN160B

forex market6
FOREX market
  • How does it work? (What rules govern it?) By and large
    • As any other market exchange market
  • Factors and means of price formation
    • Supply-demand
    • Arbitrage
    • Presence of vehicle currency

Lecture 3 ECN160B

forex transactions
ForEX transactions
  • Exchange rates:
    • Spot (but really 2 days) (clearing)
    • Forward (30, 90, 180 days) rate quoted in forex deals with value date of > 2 days
  • Types of ForEx contracts

● Spot ● Forward

● Swap [spot sale +forward repurchase]

● Futures ● Options

Lecture 3 ECN160B

forex market characteristics8
ForEX Market Characteristics
  • Rate of Return (+ we will relate this to arguments about Interest Rate Parity)
    • Expected
    • real (savers care of exp. Real rate)
  • All else equal, returns should be equal, but
  • Risk (variability of returns)
  • Liquidity (cost (ease) & speed to sell the asset)
    • What affects liquidity? Ex. Market volume

Lecture 3 ECN160B

hedging
Hedging
  • Hedge:engage in a financial transaction that reduces or eliminates risk
  • Basic hedging principle:
  • Hedging risk involves engaging in a financial transaction that offsets a long position by taking a short position, or offsets a short position by taking a additional long position
  • Question: What is short/long position?

Lecture 3 ECN160B

forward markets exchange rates interest rates
Forward Markets (exchange rates & interest rates)
  • Long position = agree to buy securities at future date

Hedges by locking in future interest rate if funds coming in future

  • Short position = agree to sell securities at future date

Hedges by reducing price risk from change in interest rates if

holding bonds

  • Pros
    • 1. Flexible
  • Cons
    • 1. Lack of liquidity: hard to find counterparty
    • 2. Subject to default risk: requires information to screen good from bad risk

Lecture 3 ECN160B

ltcm events gcm regulation
LTCM events & GCM regulation
  • LTCM Marks a New Era of
    • Technical Trading
    • LTCM manifests GCM regulatory problems
  • Should Hedge Funds be regulated? How?
  • Could Hedge Funds be regulated?
  • Fed rescue: would it be more rescues?
  • Who really paid for the rescue: Banks, Taxpayers or … ?

Lecture 3 ECN160B

next lecture
Next Lecture
  • More about Exchange Rates
    • Expectations
    • Expected rate of return
    • Equilibrium
    • Connection with interest rates
  • Interest Rates Parity
    • Covered (uses forward rate)
    • Uncovered (uses expectations)
  • Your preparation: Read KO Ch. 13

Lecture 3 ECN160B

summary of today
Summary of Today
  • ForEx Markets Characteristics (Parameters)

●Liquidity ●Risk ●Rate of Return

  • Concepts:
    • Vehicle currency
    • Arbitrage
    • ForEx Contracts

●Spot ●Forward ●Future ●Option ●Swap

  • Have a Nice Day

Lecture 3 ECN160B

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