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 l.jpg

ECN 160B Lectures 3 and 4International Macroeconomics

Galina A. Schwartz

Department of Economics

University of CA, Davis

Lecture 3 ECN160B


Forex market l.jpg
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


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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 l.jpg
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


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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


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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


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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


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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 l.jpg
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 l.jpg
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


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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


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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


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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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