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Foreign Exchange Chapter 17 Background About 170 different foreign currencies in the world Traded in a global currency market Most trading occurs in only a few currencies Euro, U.S. dollar Currencies market is the largest financial market in the world

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Foreign exchange l.jpg

Foreign Exchange

Chapter 17

Chapter 17: Foreign Exchange


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Background

  • About 170 different foreign currencies in the world

    • Traded in a global currency market

      • Most trading occurs in only a few currencies

        • Euro, U.S. dollar

  • Currencies market is the largest financial market in the world

    • Decentralized—most transactions occur via telephone

      • Over $1 trillion U.S. dollars of transaction occur daily

        • Most of the trading occurs between larger international banks in London, New York City, Tokyo and Singapore

  • Chapter 17: Foreign Exchange


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    Common Markets and Economic Unions

    • For many years countries tried to maintain a gold exchange standard

      • The exchange rate between currencies determined by the ratio of the weights of gold defining the currencies

    • However, since 1970 most national governments have abandoned the gold standard

      • Makes it easier for government to create money

        • If a country’s money supply expands too rapidly, inflation generally results

    Chapter 17: Foreign Exchange


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    Foreign Exchange Rate Fluctuations

    • Exchange rate movements occur when

      • Economic relations between countries change

      • Market participants’ expectations change

    • Governments often intervene in foreign exchange markets

      • Attempt to affect their currency values

        • Dirty float—while exchange rates are determined by the financial markets, governments are free to intervene

          • Happens in U.S., U.K., Japan, Germany, France, Canada

    Chapter 17: Foreign Exchange


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    Foreign Exchange Rate Fluctuations

    • In long run, currencies interaction is shaped by political and economic conditions

      • Germany and U.S. have had stable political systems for the last several decades

        • Thus, these currencies are viewed as ‘safe’

    • Some countries (Brazil, Israel, Mexico) have experienced hyperinflation

      • Thus, their currencies lost purchasing power

    Chapter 17: Foreign Exchange


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    Economic Unions

    • Economic unions occur when countries band together and adopt a common currency

      • Attempt to foster cross-border trade

    • Expected benefits of forming an economic union

      • Will reduce the number of foreign exchange transactions

      • Increase competition by making price comparisons easier

      • Form a bond between the countries in the union

    Chapter 17: Foreign Exchange


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    European Monetary Union (EMU)

    • European Monetary Union composed of

      • Austria

      • Belgium

      • Finland

      • France

      • Germany

      • Ireland

      • Italy

      • Luxembourg

      • Netherlands

      • Portugal

      • Spain

    Adopted the euro on 1/1/1999. Euro and original countries’ currencies are still acceptable. However, after 7/1/2002 only the euro will be used.

    Chapter 17: Foreign Exchange


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    European Monetary Union (EMU)

    • Will the EMU work?

      • It is easy to argue that a common currency will facilitate cross border trade

      • Economic unions prior to EMU did not fare well

        • Latin Monetary Union, Scandinavian Monetary Union and East African Community all fell apart

      • Cultural differences between nations will remain

      • Administrative costs may exceed benefits of a common currency

    Chapter 17: Foreign Exchange


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    European Monetary Union (EMU)

    • Member nations created the European Central Bank (www.ecb.int) to replace member countries’ separate central banks

      • Reason for failure of other unions was different monetary policies pursued by separate member countries’ banks

      • ECB has power over inflation, deficit spending and currency stability

    Chapter 17: Foreign Exchange


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    Spot and Forward Markets

    • Some nations’ currency trades at a fixed rate relative to a popular currency

    • Other currencies have freely fluctuating exchange rates

    • The spot market is the current exchange rate for immediate delivery

    Chapter 17: Foreign Exchange


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    Spot and Forward Markets

    • A transaction of foreign currency with a future delivery date occurs in the forward market

      • Only a few currencies are traded in the forward market

        • Unprofitable to make a forward market in a currency that does not have an active market

    Chapter 17: Foreign Exchange


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    Spot and Forward Markets

    • An example of spot prices for different currencies are listed below

    Chapter 17: Foreign Exchange


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    Expected Foreign Exchange Rate

    • The expected spot rate during the next time period is equal to the value of today’s forward rate for delivery during that time period, or:

    • Currencies can sell at a premium or a discount in the forward market

    If value < (>) 0,

    currency is

    selling at a

    forward discount

    (premium).

    Chapter 17: Foreign Exchange


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    Analysis of Foreign Exchange Risk

    • Two people simultaneously invest in an Indian security

      • Domestic investor in India—domestic currency to purchase domestic security

      • Foreign investor in U.S.—uses U.S. dollars to buy an equivalent amount (500 rupees) of the same Indian security

        • Must purchase the rupee with U.S. dollars to make the investment

          • If the exchange rate fluctuates, the two investors can earn different rates of return

            • Even though they owned the same security over the same holding period

    Chapter 17: Foreign Exchange


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    The Domestic Investor

    • If the Indian investment returned 550 rupees after a one-year period (with no cash income during the period), the domestic investor has earned 10%:

    Chapter 17: Foreign Exchange


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    The Foreign Investor

    • The return to the foreign investor hinges on the exchange rate fluctuation

      • Suppose at the beginning of the investment period, the spot rate was 40 rupees for $1 or

        • SPt-1 = $1/Rs40 = $0.025

          • Thus, the American paid $12.50 for the Indian investment

            • $0.025 x 500 rupees = $12.50

      • If the exchange rate remains at $0.025, the American earns the same return as the Indian investor

    Chapter 17: Foreign Exchange


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    The Foreign Investor

    • However, most governments allow exchange rates to fluctuate

      • American investor has actually made two risky investments

        • In the risky Indian security

        • In the risky rupee

    • If the exchange rate has fluctuated to $0.0275 (a 10% gain) per rupee by the end of the investment period, the American investor’s return is:

    Chapter 17: Foreign Exchange


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    Components of Investor’s Total Return

    • The return to the foreign investor can be simplified as:

      rforeign = rdomestic + rforeign exchange gain + rforeign exchange gainrdomestic

      • This can be approximated by:

        rforeign rdomestic + rforeign exchange gain

  • Any investor undertaking a foreign investment faces three risk factors

    • Total risk = foreign currency risk + foreign security risk + covariance risk

      • Covariance risk can be negative or positive

  • Chapter 17: Foreign Exchange


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    Risks Undertaken by International Investors

    • Estimates of the risks undertaken by U.S. and domestic investors, 1993-1999 inclusive:

    When correlation > 0 the American investor’s risk is greater than the domestic investor’s risk—causing the last column to exceed 1.0.

    Chapter 17: Foreign Exchange


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    Worldwide Currency Trading

    • A large international bank may make a market in 50 currencies

      • Responsibility for the bank’s electronic trading book may pass daily from New York to London to Tokyo and back to New York

        • Allows the currency market to operate around the clock

    Chapter 17: Foreign Exchange


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    Three Foreign Exchange Parity Relationships

    • In long run exchange rates are determined by fundamental economic relationships

      • Relative purchasing power parity

      • Inflation-based theories

      • Interest rate parity

    Chapter 17: Foreign Exchange


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    Relative Purchasing Power Parity (PPP)

    • Law of one price—identical goods should sell for the same price

      • Tends to equalize prices around the world

        • More applicable to financial goods because there are essentially no transportation costs

    • Relative PPP generalizes law of one price

      • A basket of identical goods should sell at the same price around the world

        • If goods are priced in a common currency and no barriers to trade exist

          • Adjusts for different countries’ inflation rates

    Chapter 17: Foreign Exchange


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    Relative Purchasing Power Parity (PPP)

    • Implies that if countries have different inflation rates, the exchange rate should fluctuate to compensate

      • Example: If inflationUS = 4% and inflationU.K.=8%, the U.S dollar should appreciate by 1.08/1.04 – 1 = 3.8% relative to the British pound

        • If this doesn’t happen, U.K. exports to the U.S. will become overpriced and U.S. exports to U.K. will become underpriced

          • Demand for pounds would decrease

          • Demand for U.S. dollar would increase

            • Until new equilibrium is reached

    Chapter 17: Foreign Exchange


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    Relative Purchasing Power Parity (PPP)

    • Thus, the relationship between inflation and exchange rates is:

    • In a world without restrictions, foreign exchange rates would reflect inflation differentials between countries

    Chapter 17: Foreign Exchange


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    Critique of PPP

    • PPP lacks the ability to explain day-to-day (or even month-to-month) changes in foreign exchange rates

      • One of the main problems is our inability to measure inflation

        • Consumers’ baskets of goods change continuously

          • Difficult to alter the basket of goods used in calculating a CPI

        • Different baskets of goods apply for different countries

        • Most inflation measures are based on historical data, not on expected future price changes

    Chapter 17: Foreign Exchange


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    Fisher’s Inflation-Based Theories

    • During 1930s Irving Fisher states that nominal interest rates could be divided into:

      • Constant real rate

      • Fluctuating expected rate of inflation

      • (1 + nominal rate) = (1 + real rate) x ( 1 + expected inflation)

        • Can be approximated by

          • Nominal rate  real rate + expected inflation

    • Critics argue Fisher’s model is too simple

      • Assumes the real rate remains constant

    Chapter 17: Foreign Exchange


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    Fisher’s Inflation-Based Theories

    • Fisher extended his model to an open economy

      • Allows trading between countries and multiple currencies

        • Differences between countries’ nominal interest rates can be explained by

          • Differences in real rates

          • Differences in inflation rates

      • Known as the Fisher open model

    Chapter 17: Foreign Exchange


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    Fisher Open Model

    • If two countries have the same real rate, the differences in their nominal rates can be explained by differences in their expected inflation rates

    • More useful for analyzing long-run than short-run relationships

    • Also, differences in countries’ real rates causes problems

    Chapter 17: Foreign Exchange


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    Interest Rate Parity

    • Occurs when market returns in two countries are equal when they are denominated in the same currency

    • Applies law of one price to nominal interest rates

      • Adjusts to remove exchange rate effects

    • Uncovered interest rate parity involves no offsetting ‘cover’ to hedge the position

    Chapter 17: Foreign Exchange


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    Uncovered Interest Rate Parity

    • Not useful for predicting because

      • Comparison must be made across countries on assets of equal risk

        • Can be troublesome if different levels of sovereign risk exist

      • The expected spot price1 is difficult to measure

      • Foreign exchange adjustments needed to derive the model make the model cumbersome

    • The covered interest rate parity model is easier to use

    Chapter 17: Foreign Exchange


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    Covered Interest Rate Parity

    • Forward contracts can be used to earn arbitrage profits if the relationships do not hold

    Chapter 17: Foreign Exchange


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    Example: Covered Arbitrage

    • Given information:

      • FP1 = C$/US$ = 1.17

      • SP0= C$/US$ = 1.16

      • Nominal rateU.S. (domestic) = 10%

      • Nominal rateCanada (foreign) = 13%

    • Substituting these values into the covered interest rate parity equation yields the following inequality:

    Chapter 17: Foreign Exchange


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    Example: Covered Arbitrage

    • Arbitrage profits could be earned by

      • Borrowing U.S. dollars for 10%

      • Converting the U.S.$ to Canadian$ at the current spot price of 1.16

      • Investing the Canadian$ in an investment returning 13%

      • Buying a foreign exchange forward contract guaranteeing the exchange rate in 1 year of C$1.17 per U.S.$

    Chapter 17: Foreign Exchange


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    Example: Covered Arbitrage

    • If this were done with $100,000 U.S., the result would be:

    • If this inequality existed arbitrage would lead to

      • Increase in demand for Canadian dollars

        • Lead to a reduction in the C$/US$ exchange rate

      • Increase in supply of Canadian dollars in the forward market

        • Lead to an increase in the C$/US$ foreign exchange rate

    Chapter 17: Foreign Exchange


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    Simplified Summary of Equilibrium Conditions

    • Profit seekers can use the covered interest rate parity equation to determine if profitable currency trading opportunities exist

      • However, profitable trading opportunities will not exist for long

    • Arbitrageurs must be prepared to transact quickly

      • In less liquid markets, covered interest rate parity is more likely to be violated

    Chapter 17: Foreign Exchange


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    The Bottom Line

    • When buying a foreign currency-denominated asset an investor faces foreign exchange risk and foreign investment risk

    • Several European nations are trying to reduce international trade barriers by executing transactions in a single currency (the euro)

      • While similar unions have been unsuccessful, supporters hope it will lead to trade stimulation

    Chapter 17: Foreign Exchange


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    The Bottom Line

    • Parity relationship exist to explain foreign exchange rates

      • Purchasing power parity

        • Identical goods should sell for the same price, regardless of the currency

      • Interest rate parity—applies law of one price to nominal interest rates

      • Covered interest rate parity

    Chapter 17: Foreign Exchange


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