foreign exchange l.
Download
Skip this Video
Loading SlideShow in 5 Seconds..
Foreign Exchange PowerPoint Presentation
Download Presentation
Foreign Exchange

Loading in 2 Seconds...

play fullscreen
1 / 37

Foreign Exchange - PowerPoint PPT Presentation


  • 740 Views
  • Uploaded on

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

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Foreign Exchange' - niveditha


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

Foreign Exchange

Chapter 17

Chapter 17: Foreign Exchange

background
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

common markets and economic unions
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

foreign exchange rate fluctuations
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

foreign exchange rate fluctuations5
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

economic unions
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

european monetary union emu
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

european monetary union emu8
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

european monetary union emu9
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

spot and forward markets
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

spot and forward markets11
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

spot and forward markets12
Spot and Forward Markets
  • An example of spot prices for different currencies are listed below

Chapter 17: Foreign Exchange

expected foreign exchange rate
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

analysis of foreign exchange risk
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

the domestic investor
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

the foreign investor
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

the foreign investor17
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

components of investor s total return
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

risks undertaken by international investors
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

worldwide currency trading
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

three foreign exchange parity relationships
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

relative purchasing power parity ppp
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

relative purchasing power parity ppp23
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

relative purchasing power parity ppp24
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

critique of ppp
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

fisher s inflation based theories
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

fisher s inflation based theories27
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

fisher open model
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

interest rate parity
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

uncovered interest rate parity
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

covered interest rate parity
Covered Interest Rate Parity
  • Forward contracts can be used to earn arbitrage profits if the relationships do not hold

Chapter 17: Foreign Exchange

example covered arbitrage
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

example covered arbitrage33
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

example covered arbitrage34
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

simplified summary of equilibrium conditions
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

the bottom line
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

the bottom line37
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