Foreign exchange market conducted by mohammad ramzan cfa on behalf of l.jpg
This presentation is the property of its rightful owner.
Sponsored Links
1 / 60

Foreign Exchange Market Conducted BY: Mohammad Ramzan, CFA On Behalf of PowerPoint PPT Presentation


  • 143 Views
  • Uploaded on
  • Presentation posted in: General

Foreign Exchange Market Conducted BY: Mohammad Ramzan, CFA On Behalf of. Course Objectives. Understanding theoretical background of exchange rates History of Foreign Exchange Market Market Place Exchange Rate Regimes Fundamental Factors

Download Presentation

Foreign Exchange Market Conducted BY: Mohammad Ramzan, CFA On Behalf of

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


Foreign exchange market conducted by mohammad ramzan cfa on behalf of l.jpg

Foreign Exchange Market

Conducted BY:

Mohammad Ramzan, CFA

On Behalf of


Course objectives l.jpg

Course Objectives

  • Understanding theoretical background of exchange rates

  • History of Foreign Exchange Market

  • Market Place

  • Exchange Rate Regimes

  • Fundamental Factors

  • Structure and mechanism of the Foreign Exchange Market

  • Forward and Swap Rates

  • Theory of Determination of Exchange Rate: PPP


Foreign exchange l.jpg

Foreign Exchange

  • International Trade

    • Do we need International Trade?


Slide4 l.jpg

Gains from

Specialization and

International Trade


Slide5 l.jpg

Gains from Specialization and

Trade

  • International trade leads to mutual gain because it allows each country to specialize more fully in the production of those things that it does best according to the law of comparative advantage.

  • Trade permits each country to use more of its resources to produce those goods that it can produce at a relatively low cost.

  • With trade, it will be possible for the trading partners to consume a bigger bundle of goods that would be impossible for them to produce and consume domestically.


Gains from specialization trade l.jpg

Gains from Specialization, Trade

POPFOODSHIRTS

USAO,9100 x 2 = O,9 100 x 1 = 100

JAPAN 50 25 x 3 = 75 25 x 9 = 225

----------------- --------------

Total World Prod. 275 325

PRICES

USA1 Food = 0.5 Shirt

1 Shirt = 2.0 Foods

JAPAN1 Food = 3 Shirts

1 Shirt = 0.33 Food


Gains from specialization trade7 l.jpg

Gains from Specialization, Trade

POPFOODSHIRTS

USA O,9O,9 x 2 = 400 0 x 1 = 0

JAPAN 50 0 x 3 = 0 50 x 9 = 450

World Production400 450

Possibility of trade?

US should export food to Japan

Japan should export shirts to USA


Slide8 l.jpg

Production possibilities, Japan

R

Production possibilities, U.S.

J1

M

US1

S

N

Before Specialization and Trade

United States

Japan

Clothing(million units)

Clothing(million units)

450

450

400

375

350

300

300

250

225

O,9

150

150

100

75

50

Food(million units)

Food(million units)

100

O,9

300

400

75

150


Slide9 l.jpg

O

Consumption possibilitiesof Japan with trade

Consumption possibilitiesof U.S. with trade

T

Consumption Possibilities with

Trade

United States

Japan

Clothing(million units)

Clothing(million units)

R

450

450

400

375

350

300

300

250

M

225

J1

O,9

150

150

US1

100

75

50

S

N

50

Food(million units)

Food(million units)

400

100

O,9

300

400

75

150


Slide10 l.jpg

250

J2

US2

O,9

Consumption Possibilities with

Trade

United States

Japan

Clothing(million units)

Clothing(million units)

R

450

450

O

400

375

350

300

300

250

M

225

J1

O,9

150

150

US1

100

75

50

T

S

N

50

Food(million units)

Food(million units)

400

100

O,9

300

400

75

150


Foreign exchange11 l.jpg

Foreign Exchange

  • International Trade necessitates exchange of currencies

  • Movement of Capital creates another source of supply and demand

  • Definition: The price at which one currency is traded in exchange for another in FX market is the exchange rate between the two currencies.


Foreign exchange history l.jpg

Foreign Exchange: History

  • Bretton Woods: 1944 - 1971

    • Delegates from 45 Countries

    • Pegging of currencies with US Dollar

    • Margin of movement: 1% +/-

  • Dollar as a reserve currency

  • Dollar was convertible to gold (1/35 ounce)

  • Frequent adjustments took place

  • US ran a continuous Current A/c Deficit

  • Vietnam War worsened the US situation

  • Pressure for convertibility

  • 1971: US Unilaterally abandoned the convertibility


Foreign exchange history13 l.jpg

Foreign Exchange: History

  • Post Bretton Woods: Free float

  • Some regional treaties

  • EMU

    • European Monetary Unit

    • Currency pegs with 2.5% +/-

    • Some weak currencies were allowed 6% +/-

    • Frequent Adjustments

  • 1992: George Soros humbles BOE out of EMU

  • 1999: Euro created – Maastricht Treaty


Foreign exchange markets l.jpg

Foreign Exchange Markets


Foreign exchange market l.jpg

Foreign Exchange Market

  • US$ is the cornerstone of the foreign exchange market

  • Exchange Rates are quoted against US$

  • US Worlds biggest economy

  • Reserve currency status

  • Safe Haven status

  • Large amount of world trade in US$

  • Almost all commodities traded in US$


Factors that affect currency s value l.jpg

Factors that affect currency’s Value

  • National inflation rates – Imports/Exports

    • Inflation also affects the purchasing power of the currency

  • Changes in real interest rates – Debt securities Investment.

  • Differences in economic performance (GDP) – Equity and real asset Investment.

  • Current Changes in investment climate. Prospects of higher return but also low risk. (Political stability, Legal system, Fair taxation, Capital movement, stable prices policies, Law and Order, Judicial System)


Factors that affect currency s value17 l.jpg

Factors that affect currency’s Value

  • Trade and Current A/c Balance

  • GDP – Gross Domestic Product: Market Value of all good and services produced within a country during a specific period

  • Why is GDP important?

  • Higher GDP means higher value of the currency and vice versa


Slide18 l.jpg

Real and Nominal GDP

  • The term "real" means adjusted for inflation.

  • Price indexes are used to adjust income and output data for the effects of inflation.

    • A price index measures the cost of purchasing a market basket (or “bundle”) of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference (or base) period.


Slide19 l.jpg

GDP Deflator1

GDP Deflator2

Real GDP2=

Using the GDP Deflator to

Derive Real GDP

  • The formula for converting the nominal GDP into real GDP is:

Nominal GDP2 *

  • Data on both money GDP and price changes are essential for meaningful comparisons of output between two time periods.


Slide20 l.jpg

Nominal GDP

Price index

Real GDP

(billions of U.S. $)

(GDP deflator, 1996 = 100)

(billions of 1996 $)

100.0

109.4

9.4%

Source: U.S. Department of Commerce.

Using the GDP Deflator to

Derive Real GDP

  • Between 1996 and 2001, nominal GDP increased by 30.7%.

  • But, when the 2001 GDP is deflated to account for price increases, we see that real GDP increased by only 19.4%.

1996

$7,813

$7,813

2001

$10,208

$9,331

% increase

30.7%

19.4%


Government policies l.jpg

Government Policies

  • An expansionary monetary policy will lead to a depreciation of the home currency.

  • A restrictive monetary policy will lead to an appreciation of the home currency.

  • A more restrictive fiscal policy should also slow down economic activity and inflation, and real Interest rates. Lower Inflation and Lower real Int. rates may have conflicting affect.

  • A more expansionary fiscal policy has the reverse effect. Fiscal Policy is hard to judge.


Slide22 l.jpg

Exercises


Exchange quotes direct l.jpg

Exchange Quotes: Direct

  • A direct exchange rate is the domestic price of foreign currency.

  • Let “DC” be the domestic currency, and “FC” be the foreign currency.

  • A direct quote could be represented as:

    For example: 0.5 DC = 1 FC

    1.25DC = 1 FC


Indirect foreign exchange quotes l.jpg

Indirect Foreign Exchange Quotes

  • An indirect exchange rate is the amount of foreign currency equivalent to one unit of domestic currency.

  • For example, 2 FC: 1 DC

    • Note this conveys the same information as our previous example.

    • For example: 0.0067 $/Yen would be an indirect quote in Japan.


Quote conventions l.jpg

Quote Conventions

  • Internationally most currencies are quoted in terms of 1 US$ = ?.

  • There are two main exceptions:

    • British pound (has always been quoted as dollar price of one pound).

    • Euro (convention adopted to quote the foreign currency value of one euro).


Quote conventions26 l.jpg

Quote Conventions

  • Base Currency/Counter base (Quoted Currency)

  • Check: www.imf.org/external/np/fin/rates/rms_rep.cfm

  • Quotations are usually given with five digits. For example,

    • USD/JPY 118.55

    • GBP/US$ 1.7725

  • 1.77 = Big Fig; 25 = pips, points


  • Exercises l.jpg

    Exercises

    • Exercises on Quotes


    Cross rates l.jpg

    Cross Rates

    • A cross rate is the exchange rate between two countries inferred from each country’s exchange rate with a third country.

    • For example, bank A gives the following quotations:

      • $/CHF = 1.3110 – 20

      • $/JPY = 118.90 – 00

      • Calculate the CHF/JPY rate:

        • CHF/JPY bid rate = 118.90 and 1.3120 are relevant

        • 1.3120CHF = 1 US$ = 118.90

        • 118.90/1.3120 = 90.625

        • CHF/Yen ask rate =119.00/1.3110 = 90.770

        • Cross rate is: CHF/JPY = 90.625 – 90.770


    Cross rates29 l.jpg

    Cross Rates

    • GBP/USD: 1.8250-60

    • USD/JPY: 116.80-90

    • Calculate GBP/JPY?

    • For Bid: 116.80 and 1.8250 are relevant

      • 1 US$ = 116.80JPY

      • 1GBP = 1.8250 US$ = 116.80 x 1.8250 = 213.16

    • For Offer: 116.90 and 1.8260 are relevant

      • 1 US$ = 116.90

      • 1 GBP = 1.8260US$ = 1.8260 x 116.90


    Cross rates30 l.jpg

    Cross Rates

    • Rules of Thumb to remember:

      • If the rates of two currencies are quoted in same terms, the cross rates is really a X, i.e. bid to offer and offer to bid and it involves a division.

      • If the rates for two currencies are quoted in different terms, then the cross is a multiplication of bid to bid and offer to offer.


    Exercises31 l.jpg

    Exercises

    • Exercises for cross rate calculation


    Risks l.jpg

    Risks

    • Risk of a long position: Price may go down

      • Profit of a long position: When price goes up

    • Risk of a short position: Price may go up

      • Profit on a short position: When price goes down

    • Market Risk

    • Liquidity Risk

    • Credit Risk

    • Settlement Risk


    Forward rates l.jpg

    Forward Rates

    • Spot rates are quoted for immediate currency transactions (although in practice it takes place 48 hours later).

    • Forward exchange rates are contracted today but with delivery and settlement in the future.

    • In a forward, or futures, contract a commitment is irrevocably made on the transaction date, but delivery takes place later, on a date set in the contract.


    Forward premiums discounts l.jpg

    Forward Premiums/discounts

    • Base currency…$, Pound, Euro

    • Formula:

      F = spot {1+(Int Rate of counter-base*days/conventional year)/1+(Int Rate of Base currency*days/ conventional year)}

    • Use proper days’ convention


    Forward rates calculation l.jpg

    Forward Rates: Calculation

    • GBP/US$ = 1.6400 - 10

    • Assuming one can borrow/lend at market rates (6 Months)

    • Pound Interest Rate: 3.75 – 3.80%

    • US$ Interest Rate: 1.15 – 1.20%

    • P98,164.5 = $161,087.90 @ 1.6410

    • $161,087.90 @ 1.20% = $162,065.17

    • P98,164.5 @ 3.75% = P100,000

    • 162065.17/100,000 = 1.62065


    Forward rates calculation36 l.jpg

    Forward Rates: Calculation

    • Using the Formula

      1.6410 * {1+(0.012*182/360)/1+(0.0375*182/365)}

      =1.6410 * (1.006067/1.018699)

      =1.6410 * 0.9876

      =1.62065


    Forward rates calculation37 l.jpg

    Forward Rates: Calculation

    • GBP/US$ = 1.6400 – 10 (Spread: 10 points, 0.061%)

    • Assuming one can borrow/lend at market rates (6 Months)

    • Pound Interest Rate: 3.75 – 3.80%

    • US$ Interest Rate: 1.15 – 1.20%

    • P98,140.44 = $160,950.32

    • $160,950.32 @ 1.15% = $161,886.07

    • P98,140.44 @ 3.80% = P100,000

    • 161,886.07/100,000 = 1.61886


    Forward rates calculation38 l.jpg

    Forward Rates: Calculation

    • Using Formula

    • 1.6400 * {1+(0.0115*182/360)/1+(0.0380*182/365)}

    • 1.6400 * 1.005814/1.01895

    • 1.6400 * 0.9871

    • 1.61886


    Forward spread l.jpg

    Forward Spread

    • Spot 1.6400 – 10

    • Forward1.6189 – 07

    • Spread in Spot 10 points

    • Spread in forward18 points


    Forward premiums discounts40 l.jpg

    Forward Premiums/discounts

    • Spot 1.6400 – 10

    • Forward1.6189 – 07

    • Difference0.0211 - .0203

    • Also called Swap Points

    • Is GBP at discount/Premium?

    • Rule: Higher interest currency is always at discount in forward and lower interest currency always at premium


    Swaps l.jpg

    Swaps

    • In inter-bank market, forwards are quoted as under:

      Spot GBP 1.6400-10

      Swap

      1-month 35 – 32

      3-months 105 – 100

      6-months 211 – 203

      12-months 430 – 420


    Swaps revisited l.jpg

    Swaps Revisited

    • How to use swap points:

    • If the bid is higher than offer of swap points, the base currency is at discount

    • If the bid is lower than offer, the base currency is at premium


    Swaps revisited43 l.jpg

    Swaps Revisited

    • How to use swap points:

    • If the bid is higher than offer of swap points, Deduct swap points from spot rate

    • If the bid is lower than offer, Addswap points to spot rate


    Swaps revisited44 l.jpg

    Swaps Revisited

    • Make Outright forward rates

      Spot GBP 1.6400-10

      Swap

      1-month 35 – 32

      3-months 105 – 100

      6-months 211 – 203

      12-months 430 – 420


    Swaps revisited45 l.jpg

    Swaps Revisited

    • Make Outright forward rates

      Spot CHF 1.2760-70

      Swap

      1-month 12 - 10

      3-months 31 – 28

      6-months 60 – 55

      12-months 112 – 104


    Forwards revisited l.jpg

    Forwards Revisited

    • You can construct a forward (3-month) through spot market and swap market

    • Spot GBP 1.6400 - 10

      3-months swap 105 – 100

    • You want to buy GBP forward


    Forwards revisited47 l.jpg

    Forwards Revisited

    • You can buy spot first, let’s say 1 mio GBP at 1.6410

    • Then at 100 you sell/buy 1 mio pound

    • Swap Transaction:

    • You sell in spot and buy in forward

    • Rates: Spot 1.6410

      Forward1.6310


    Arbitrage l.jpg

    Arbitrage

    • Arbitrage involves the simultaneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio, in order to obtain a risk free profit on the price differential.

    • Arbitrage keeps exchange rates in line with each other and with risk free interest rates.

      • For example, the $/Euro rate must be the same, at a given instant, in Frankfurt, Paris and New York.


    Various arbitrage opportunities to consider l.jpg

    Various arbitrage opportunities to consider...

    • With respect to the exchange rate between two countries, the rate in one country should be aligned with the rate in the other. If not, a bilateral arbitrage opportunity exists.

    • A triangular arbitrage opportunity occurs if the quoted cross-rate between two currencies is higher or lower than the cross-rate implied by the exchange rates of the two currencies against a third currency.


    Triangular arbitrage l.jpg

    Triangular Arbitrage

    • Triangular arbitrage involves three steps:

      • Pick the cross-rate currency

      • Determine whether the cross-rate bid-ask quotes are in line with the direct quotes by determining whether it is cheaper to buy foreign currency directly or indirectly.

      • If the actual cross-rate quote is not in line with the quoted cross-rate quotes, an arbitrage opportunity exists.


    Covered interest rate arbitrage l.jpg

    Covered Interest Rate Arbitrage

    • The process of simultaneously borrowing the domestic currency, transferring it into foreign currency at the spot exchange rate, lending it, and buying a forward exchange rate contract to repatriate the foreign currency into domestic currency at a known forward exchange rate. The net result of such an arbitrage should be nil.


    Covered interest rate arbitrage52 l.jpg

    Covered Interest Rate Arbitrage

    • Spot rate = 1.6400 $/pound sterling

    • 6-month Forward rate = 1.6072 $/pound sterling

    • U.S. 6-m rate = 1.15%

    • UK 6-m rate = 3.75%

      • Annualized forward discount = – 4.0%

      • Interest rate parity is violated.

        • Dollar is stronger, pound weaker

        • Borrow in £ for 6 months, Sell GBP for $, Invest $ for 6 months

        • buy £ forward.


    Forwards l.jpg

    Forwards

    • Exercises


    Arbitrage on swaps l.jpg

    Arbitrage on Swaps

    • There is an active swap market in Karachi in $/PKR.

    • There is restriction on free movement of capital – exchange control.

    • Assume the fair $/PKR 6-m swap should be 95-100 (with spot at 60.25 it would mean fwd at 61.20/25) but for some reason swap comes down to 70-75 – by exporters or SBP b/s swap - (implying a fwd rate of 60.95/00).

    • In a free market condition, arbitrageur should buy the cheap dollar in forward, sell dollars in spot by borrowing them for 6-months. Is it possible and assured?

    • Can local banks can eliminate the inefficiency through arbitrage? Risk of further deterioration, loss on revaluation

    • Can foreign banks come in and arbitrage?


    Arbitrage on swaps55 l.jpg

    Arbitrage on Swaps

    • That anomaly leaves the swap misalignment in the market for considerable time, from where it could realign or get even worse.

    • This creates a phenomenon where swap market functions like a separate financial product which has it own dynamics with swaps points moving up and down depending on swap/fwd demand and supply.

    • However, over a medium term swap points should revert to their fair value.

    • This creates interesting trades in swap market


    Arbitrage on swaps56 l.jpg

    Arbitrage on Swaps

    • Some Trades in swap market

      • Arbitrage: Given sufficient resources

    • Anticipate next move of the Exporters, Importers or SBP and front-run them.

      • E.g.you expect exporters to sell dolls in fwd, which will compress swap points, you can sell swap in anticipation (b/s 6 months) and unwind when swap points drop.

    • You can gap-trade the swap. E.g, swap points came down to 60-65, you can sell/buy at 65 for 6 months and immediately b/s for 1 week.


    Slide57 l.jpg

    • Exercises


    Purchasing power parity ppp relation l.jpg

    Purchasing Power Parity (PPP) Relation

    • PPP states that the spot exchange rate adjusts perfectly to Price differentials between two countries. Law of one price.

    • There are two versions of PPP:

      • Absolute PPP

        • This claims that the exchange rate should be equal to the ratio of the average price levels in the two economies.

      • Relative PPP


    Purchasing power parity ppp relation59 l.jpg

    Purchasing Power Parity (PPP) Relation

    • Relative PPP

      • This claims that the percentage movement of the exchange rate should be equal to the inflation differential between the two economies

    • The PPP relation is presented as:

      • Exact

        S1/S0 = (1 + IFC)/(1 + IDC)


    Slide60 l.jpg

    Thank you!!


  • Login