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Fin 603 Week 3. Currencies, Gold Futures, and Commercial Paper. Some Online Sources for the Meanings of Finance Words Available for Free. Investopedia : Very comprehensive and designed for individual investors The Campbell Harvey glossary : A more academic collection of words

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fin 603 week 3

Fin 603 Week 3

Currencies, Gold Futures, andCommercial Paper

some online sources for the meanings of finance words available for free
Some Online Sources for the Meanings of Finance Words Available for Free
  • Investopedia: Very comprehensive and designed for individual investors
  • The Campbell Harvey glossary: A more academic collection of words
  • The Yahoo Finance glossary: A useful third source

Professor Ross Miller • Fall 2005

about class powerpoint slides
About Class PowerPoint Slides
  • Some slides will change from the time they are first posted
    • Significant changes can come during the day of the first class in which they are presented and immediately after that class
    • Minor changes can continue for the next week or two
  • Slides with answers
    • Posted after the material has been covered in all sections of both Fin 525 and 603

Professor Ross Miller • Fall 2005

slide4
Euro

Professor Ross Miller • Fall 2005

european central bank ecb
European Central Bank (ECB)
  • The European Union’s (EU) version of the Fed
  • The euro can be viewed as an experiment in which several European nations share a common currency and have a common central bank
  • Many EU countries have not adopted the Euro
    • United Kingdom (British pound)
    • Scandinavian Countries (Norway, Sweden, and Denmark each have their own currencies)
    • Switzerland (Swiss franc) is not part of the EU

Professor Ross Miller • Fall 2005

spot eur usd exchange rate
“Spot” EUR/USD Exchange Rate
  • “Spot” means the rate for an exchange of currencies right not, as opposed to “forward” which is an exchange in the future
  • The euro is generally quoted as a direct exchange rate(how many $US it is worth)
  • Most other currencies are quoted in terms of how many of them a dollar can purchase because then when the exchange rate goes up, the value of the dollar also goes up
  • Conversely, when the EUR/USD exchange rate goes up, the value of the dollar (relative to the euro) goes down

Professor Ross Miller • Fall 2005

foreign exchange
Foreign Exchange
  • The financial function of converting between currencies on either a spot or forward/futures basis is known as foreign exchange
  • Foreign exchange is often referred to as forex or f/x

Professor Ross Miller • Fall 2005

the spot rate of the euro from near its inception 1 1 1999 through 8 25 2005
The Spot Rate of the Euro From Near Its Inception (1/1/1999)Through 8/25/2005

Currency charts available here

Professor Ross Miller • Fall 2005

reasonably current spot exchange rates are easy to find on the internet bloomberg
Reasonably Current Spot Exchange Rates Are Easy to Find On the Internet (Bloomberg)

Professor Ross Miller • Fall 2005

more current rates from msn via excel
More Current Rates from MSN via Excel
  • In Excel, Type /DD followed by a carriage return (The Data Menu followed by “Import External Data”)
  • You can then open:

“MSN MoneyCentral Investor Currency Rates.iqy”

  • This will import MSN’s currency quotes, which are delayed 20 minutes (or more)

Professor Ross Miller • Fall 2005

not so current rates from google
Not-So-Current Rates from Google
  • To find the a somewhat stale EUR/USD rate, enter “1 euro in $” into Google
  • Enter other amounts to do quick (but not necessarily accurate) current translations
    • For example, “$800 in euros”

Professor Ross Miller • Fall 2005

let s focus on the bloomberg euro quote from the early afternoon of 9 8 2005
Let’s Focus On the Bloomberg Euro Quote from the early afternoon of 9/8/2005

IndirectEUR/USD rate

Direct EUR/USD rate

Professor Ross Miller • Fall 2005

what this means
What This Means
  • €1 (1 Euro) = $1.2399 (Direct rate)
  • $1 = €0.8065 (Indirect rate)
  • Is this correct?
    • For $1.2399 = 1.2399 x 0.8065 Euros

= €0.99997935

    • That’s pretty close, considering the rounding

Professor Ross Miller • Fall 2005

does this mean you can really get these rates
Does This Mean You Can Really Get These Rates?
  • No. Like any other market, there is a bid price and an ask price
  • The difference between ask and bid (the spread) is smaller for large institutional customers than for retail customers

Professor Ross Miller • Fall 2005

the bid and ask sides of spot currencies from australia s ozforex also 9 8 2005
The Bid and Ask Sides of Spot Currencies(From Australia’s Ozforex, also 9/8/2005)

Professor Ross Miller • Fall 2005

what does this quote mean
What Does This Quote Mean?
  • You can buy a euro for $1.2408
  • You can buy a Dollar for 1/1.2403 = €0.80626
  • Suppose you took $10,000, bought euros, and then converted back to dollars
    • $10,000 would get you 10,000/1.2408 euros or €8,059.32
    • Your € would then buy you 8,059.32/0.80626 dollars or $9,995.93
    • Hence, the spread comes to about 4 b.p.

Professor Ross Miller • Fall 2005

what would happen if you kept converting back and forth between euros and dollars long enough
What Would Happen If You Kept Converting Back and Forth Between Euros and Dollars Long Enough?

Professor Ross Miller • Fall 2005

what would happen if the bid price for euros in terms of dollars were higher than the ask price
What Would Happen if the Bid Price for Euros (in terms of Dollars) Were Higher Than the Ask Price?

Professor Ross Miller • Fall 2005

pure arbitrage
(Pure) Arbitrage
  • An opportunity for pure arbitrage exists when you can find a way to sell something for more than it costs you without taking on any risk
  • Cost should ideally include all appropriate costs
    • Commissions, spreads and market impact
    • Taxes
    • Labor and capital requirements
  • Banks would appear to be exploiting arbitrage opportunities by making a spread, but there are risks to being a market maker

Professor Ross Miller • Fall 2005

markets and arbitrage
Markets and Arbitrage
  • Market forces will quickly eliminate most opportunities for arbitrage
  • Simple opportunities (such as those in currency conversion) will be eliminated more quickly than complicated ones
  • Finance often uses no-arbitrage arguments to determine the relative values of financial instruments, especially derivative securities (forward/futures contracts, options, etc.)

Professor Ross Miller • Fall 2005

remember this from last week
Remember This From Last Week
  • Can a bank make big money borrowing in euros (at low interest rates), converting the euros to dollars, investing in dollars, and then converting back to pay off the loan?

Professor Ross Miller • Fall 2005

the problem with this attempt at arbitrage
The Problem With This Attempt at Arbitrage
  • It is not pure arbitrage because the value of the dollar can decline over the term of the loan and if it decline enough, the trade loses money
  • What if we can “lock in” a future exchange rate?
  • This is easy to do using forward and futures contracts in currency (we will concentrate of forward contracts, because they are easier to understand and quotes are more widely available)

Professor Ross Miller • Fall 2005

eur usd forward contract
EUR/USD Forward Contract
  • An agreement to exchange euros for dollars on a specified future date at a specified exchange rate
  • The counterparty (the financial institution on other side of the trade) is almost always a major bank (JP Morgan Chase, Citigroup, etc.)
  • Unlike currency futures contracts, currency forward contracts cannot be traded

Professor Ross Miller • Fall 2005

forward currency transactions are not just for banks
Forward Currency Transactions Are Not Just for Banks
  • Any company that uses foreign components or sells good abroad is exposed to the risk of currency fluctuations
  • A deal that is profitable at current forward rates, could become unprofitable if rates change
  • Forward contracts can “lock in” a profit
  • The use of forward (and futures) contracts to insure against changes in currency rates is one form of hedging

Professor Ross Miller • Fall 2005

the financial times publishes this comprehensive table of forward dollar rates
The Financial Times Publishes This Comprehensive Table of Forward Dollar Rates

Professor Ross Miller • Fall 2005

let s focus on the euro
Let’s Focus on the Euro

Spot Rate: 1.2412

1-Month Forward Rate 1.2428

3-Month Forward Rate 1.2465

1-Year Forward Rate 1.2651

  • The table shows that on an annual basis, the dollar drops by 1.5% vs. the euro over 1 month, by 1.7% over 3 months, and by 1.9% over 1 year

Professor Ross Miller • Fall 2005

interest rate parity
Interest-Rate Parity
  • The “financial law” that any extra interest that you can expect to make by switching into a currency with a higher interest rate will be exactly offset by a decline in the value of that currency is known as interest rate parity
  • Exceptions to interest-rate parity are small and fleeting

Professor Ross Miller • Fall 2005

the general form of the interest rate parity formula
The General Form of The Interest-Rate Parity Formula

F0 = direct exchange rate T years from now

E0 = spot direct exchange rate (the rate now)

rdomestic = interest rate in the “home currency” (usually U.S. dollars in this course)

rforeign= interest rate in the other currency, (usually euros in this course)

Professor Ross Miller • Fall 2005

how well does it work
How Well Does It Work?
  • The first question gives you an example to work through and we will go over it next week

Professor Ross Miller • Fall 2005

what does interest rate parity mean for financial markets currently
What Does Interest-Rate Parity Mean for Financial Markets Currently?
  • The value of the dollar has declined relative to other major currencies over the past year and markets expect it to continue to decline
  • In order for the return on dollar-denominated assets to be competitive in the international marketplace, interest rates for dollars must be higher than interest rates for holdings in other competitive currencies, most notably the euro and the Japanese yen.

Professor Ross Miller • Fall 2005

the other parity purchasing power parity
The Other Parity:Purchasing-Power Parity
  • Purchasing-power parity states that goods should cost the same in all currencies
  • Unlike interest rate parity, it is not an ironclad financial law
  • Consider the Big Mac

Professor Ross Miller • Fall 2005

the economist s big mac index
The Economist’s Big Mac Index

Professor Ross Miller • Fall 2005

what doesn t purchasing power parity work as well as interest rate parity
What Doesn’t Purchasing-Power Parity Work as Well as Interest-Rate Parity?

Professor Ross Miller • Fall 2005

how good are forward currency rates at predicting the future
How Good are Forward Currency Rates At Predicting the Future?
  • On average, not bad
    • They appear to conform to the unbiased expectations hypothesis
    • This means that when you look at forward currency rates, the market is giving you its best estimate of what a euro, yen, etc. will be worth in the future dollars
  • As a precise estimate, pretty bad
    • While forward rates are right on average, the dispersion around that average is enormous

Professor Ross Miller • Fall 2005

the problem with currencies
The Problem With Currencies
  • There are no accepted models for the future movements of currencies, because they depend on:
    • Politics
    • Trade policy
    • Global macroeconomics, etc.
  • Also, exchange rates are not “going anywhere” for “stable” economies
    • Stocks go up over long enough periods of time
    • U.S. risk-free interest rates tend toward 6%-8% over even longer periods of time

Professor Ross Miller • Fall 2005

gold spot price 448 60 ounce at 12 12 pm 9 14 2005
Gold (spot)Price = $448.60/ounce at 12:12PM 9/14/2005
  • Note technically a financial instrument, but a physical commodity

Professor Ross Miller • Fall 2005

new york mercantile exchange nymex
New York Mercantile Exchange (NYMEX)
  • The main exchange for petroleum products and precious metals in the U.S.
  • Includes COMEX (acquired in 1994)
  • Trades futures contracts and options on those futures

Professor Ross Miller • Fall 2005

comex gold futures symbol gc
COMEX Gold Futures (Symbol: GC)
  • Each contract is the delivery at a specified future date of 100 troy ounces of gold
  • Minimum price movement for futures (one tick) is $0.10, which is $10 per contract
  • Unlike fed funds futures, if a gold contract is held until the delivery date, the actual physical delivery of the gold takes place according the contract specifications
  • Unlike a forward contract, margin is posted and adjusted daily

Professor Ross Miller • Fall 2005

a brief history of gold
A Brief History of Gold
  • Known in antiquity
    • Mentioned in various religious texts
    • Archimedes, the bathtub, Eureka and the gold crown
  • Recent events
    • Dollar has been backed by gold (the gold standard) on several occasions during U.S. history
    • Ownership of gold bullion has been illegal at times
    • The U.S. last went off the gold standard in 1971

Professor Ross Miller • Fall 2005

why does the price of gold matter
Why Does the Price of Gold Matter?
  • It is considered an indicator of faith in the financial system
  • In particular, because it is “hard currency,” when concerns about inflation arise, the price of gold tends to go up
  • When investors get nervous, depending on the specific circumstances, gold and U.S. Treasury securities are where money goes in its “flight to safety”

Professor Ross Miller • Fall 2005

gold futures at 12 15 pm 9 14 2005
Gold Futures at 12:15PM 9/14/2005
  • Note that the price of gold is always higher in future months (additional quotes are available on the NYMEX site)

Professor Ross Miller • Fall 2005

do futures prices represent the market s prediction of what gold will be worth later
Do Futures Prices Represent the Market’s Prediction of What Gold Will Be Worth Later?
  • This was the case for the fed funds futures and we referred to this as the unbiased expectations hypothesis
  • However, the fed funds futures were not “real,” and gold is very real
  • It is easy to move gold into the future
    • Borrow money at the interest rate r
    • Purchase gold with the money
    • Lock in a future price with the futures contract

Professor Ross Miller • Fall 2005

let s compare the spot and october futures priced of gold just after noon on 9 14 2005
Let’s Compare the Spot and October Futures Priced of Gold Just After Noon on 9/14/2005
  • Spot price = $448.60
  • October futures price = $449.50 (delivery anytime during the month)
  • The return on buying gold now and selling in the futures market is: $449.50/$448.60 – 1 = 0.0020 or 20 b.p.

Professor Ross Miller • Fall 2005

is receiving 20 b p for holding onto gold for 17 days a good deal
Is Receiving 20 b.p. for Holding Onto Gold for 17 days a Good Deal?

Professor Ross Miller • Fall 2005

spot futures parity theorem
Spot-Futures Parity Theorem
  • In words, the futures price can exceed the spot price by at most an amount equal cost of “carrying” the item until the earliest time that delivery can be made
    • Cost of storing the item includes:
      • The cost of the money tied up in the item
      • Warehousing, insurance, etc.
      • Net out any benefits of holding the item (dividends for stocks)
  • A market where the futures price exceed the spot price by exactly the “cost of carry” is known as a full-carry market

Professor Ross Miller • Fall 2005

another way to think of the spot futures parity theorem when applied to gold
Another Way To Think of the Spot-Futures Parity Theorem When Applied to Gold
  • Gold is like a currency that pays either no interest or very slightly negative interest (the cost of storage, insurance, etc.)
  • Applying interest-rate parity with gold as the foreign currency and taking rforeign=0, we have (using S0 instead of E0):

Professor Ross Miller • Fall 2005

one loose end what to use for r domestic
One Loose End: What To Use For rdomestic
  • This was not a problem for currencies, because everything was Eurodeposits, which have the same risk (that associated with offshore banks)
  • Standard practice is to use a “risk-free rate” (an idea from the Capital Asset Pricing Model)
  • The prime candidate for the risk-free rate is the rate on the U.S. Treasury security that matures the same time as the futures contract is delivered

Professor Ross Miller • Fall 2005

example
Example
  • Spot gold: $448.60
  • Risk-free rate for 6 months (0.5 years): 3.74%
  • Then, the 6-month futures price should be:

F0= S0(1+r)0.5

= $448.60(1.0374)0.5

= $448.60(1.01852835) = $456.91

Professor Ross Miller • Fall 2005

most futures markets are not full carry markets consider nymex unleaded gasoline futures
Most Futures Markets are not Full-Carry Markets: Consider NYMEX Unleaded Gasoline Futures

Professor Ross Miller • Fall 2005

two big words to impress people with
Two Big Words to Impress People With
  • Contango
    • A market is in contango when prices are higher in the futures market the further into the future one goes
    • Some current examples: EUR/USD and gold
  • Backwardation
    • A market is in backwardation when prices are lower in the futures market the further into the future one goes
    • A current example: Unleaded gasoline

Professor Ross Miller • Fall 2005

ge capital commercial paper
GE Capital Commercial Paper
  • Commercial paper is the non-bank equivalent of non-negotiable bank certificates of deposit (CDs)
  • GE Capital, which is technically not a bank, is the largest issuer of commercial paper and its interest rate serve as the industry benchmark
  • By law, the term for commercial paper cannot exceed 270 days
  • Small companies rarely issue commercial paper directly; instead, they issue through dealers

Professor Ross Miller • Fall 2005

the rate for ge capital commercial paper is an important benchmark interest rate
The Rate for GE Capital Commercial Paper is an Important Benchmark Interest Rate

Numbers taken from wsj.com (subsciption required)

Professor Ross Miller • Fall 2005

commercial paper interest rates are not what they seem
Commercial Paper Interest Rates Are Not What They Seem
  • Commercial paper is quoted using “discount” yields and a 360-day year
  • Example: 180-day GE Capital paper quotes a yield of 3.86%
  • Based on a 360-day year, this means the buyer pays a discount of ½ of 3.86%, which is 1.93%
  • On $1,000,000 a 1.93% discount is $19,300, so paper that pays $1,000,000 in 180 days costs $1,000,000 – $19,300 = $980,700

Professor Ross Miller • Fall 2005

so what is the apy on 180 day paper with a stated yield of 3 86
So What Is the APY on 180-Day Paper With A Stated Yield of 3.86%
  • Cash in now: $980,700
  • Cash out in 180 days: $1,000,000
  • The return for 180 days is $19,300/$980,700 = 1.97%
  • However, 180 days is not ½ a year, it is 180/365 of a year
  • Pro rating to a full year 1.97% becomes 1.97(365/180) = 3.99%

Professor Ross Miller • Fall 2005

why the big difference between the stated interest rate 3 86 and the apy 3 99
Why the Big Difference Between the Stated Interest Rate (3.86%) and the APY (3.99%)?
  • Commercial paper is priced “at a discount”
    • The “right way” to compute returns or interest rates is to divide the interest by the invested amount (also known as the present value)
    • The “discounting way” uses the future value instead because it is generally a round number, like $1,000,000
  • The 360-day year overstates the fraction of a year and so understates the pro-rating factor

Professor Ross Miller • Fall 2005

coming up in week 4
Coming Up in Week 4
  • All we have left in the money part of the course is Treasury Bills, but they work the same way as commercial paper, except that the U.S. Treasury issues them and they are easily traded
  • We begin long-term debt with U.S. Treasury securities of all varieties

Professor Ross Miller • Fall 2005

for next time
For Next Time
  • Follow the links on the slides
  • Read BKM Ch. 14: Section 14.1: Bond Characteristics Section 14.2: Bond Pricing
  • Do the problems on the 6 slides that follow this one

Professor Ross Miller • Fall 2005

true false statements page 1 of 2
True-False Statements (Page 1 of 2)
  • The financial markets expect the Euro to rise relative to the dollar over the next year
  • According to purchasing-power parity it should cost fewer euros than dollars to buy a Gucci handbag.
  • Interest-rate parity means that the quoted interest rate for each currency should be the same.

Professor Ross Miller • Fall 2005

true false statements page 2 of 2
True-False Statements (Page 2 of 2)
  • Thirty-day commercial paper with a stated interest rate of 3.50% will have a higher APY than 60-day commercial paper that also has a stated interest rate of 3.50%.
  • If interest rates drop in the U.S. and are unchanged in Europe, it is likely that the value of the dollar will rise against the euro.
  • If you purchase spot gold and hold it for one month, you will always make money.

Professor Ross Miller • Fall 2005

these questions refer to today s forward interest rate and exchange rate slides
These Questions Refer to Today’s Forward Interest-Rate and Exchange-Rate Slides

Use the rates given on the slides, not the current rates found by following the links on those slides.

  • At current U.S.$ LIBOR, what will $10,000 invested in Eurodollars be worth in one year.
  • At current exchange rates, how many euros can $10,000 buy?
  • At current Euro LIBOR, what will the amount you found in the previous question be worth in one year if invested in Eurodeposits?

Professor Ross Miller • Fall 2005

questions on interest and exchange rates continued
Questions on Interest and Exchange Rates (continued)
  • Now, using the current one-year forward rates, convert the euros in the previous question back to dollars.
  • In order for interest-rate parity to hold, what must the one-year EUR/USD rate be?

Professor Ross Miller • Fall 2005

questions on gold futures and commercial paper
Questions on Gold Futures and Commercial Paper

Looking at your computer screen on the morning of September 15, 2005 you see the following quotes:

Spot Gold: $455.0090-Day “Risk-Free” rate: 3.43%90-Day GE Capital CP (in dollars): 3.77%90-Day GE Capital CP (in euros): 2.10%90-Day forward EUR/USD Exchange Rate: $1.2358

1. According to spot-futures parity, what will the price of gold futures for delivery in 90 days be?

Professor Ross Miller • Fall 2005

questions on gold futures and commercial paper continued
Questions on Gold Futures and Commercial Paper (continued)
  • What is the APY for the 90-Day GE Capital Commercial Paper that pays interest in dollars?
  • What is the APY for the 90-Day GE Capital Commercial Paper that pays interest in euro?
  • According to interest-rate parity, what should be the current (spot) EUR/USD exchange rate?

Professor Ross Miller • Fall 2005