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Lecture in International Finance

Lecture in International Finance. Chinese University of Technology Foued Ayari, PhD. About Dr Ayari. Assistant Professor of Finance in New York President & CEO of Bullquest LLC, a financial training company. Partner at Goldstone Property Group Inc Author of a recently published book:

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Lecture in International Finance

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  1. Lecture in International Finance Chinese University of Technology Foued Ayari, PhD

  2. About Dr Ayari • Assistant Professor of Finance in New York • President & CEO of Bullquest LLC, a financial training company. • Partner at Goldstone Property Group Inc • Author of a recently published book: “Credit Risk Modeling: An Empirical Analysis on Pricing, Procyclicality and Dependence • Author of a forthcoming book published with Wiley & Sons, “Understanding Credit Derivatives: Strategies & New Market Developments”.

  3. Outline The FX market Currency Forwards Eurobond Market Eurocurrency Market Currency Swaps Strategies in FX

  4. Foreign Exchange Markets BACKGROUND Foreign Exchange markets come under Global Markets Division within Banks. It features are as follows: OTC market Major international banks Spot market and forward market London is the largest centre 7/24 Market with daily Turnover of more than $3,200 Billions (BIS, 2007) All currencies are primarily valued against the USD dollar: USD 1 = JPY 112.26 (in this quote, the most common type, the USD is the base currency) EUR 1 = USD 1.2594 (in this quote the USD is the variable currency)

  5. Correspondent Banking Relationships International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions.

  6. Spot Market Participants and Trading FX MARKET STRUCTURE The foreign exchange spot markets are QUOTE DRIVEN markets with international banks as the wholesale participants. This market is also known as the FX inter-bank market. International banks act as MARKET MAKERS. They make each other two-way prices on demand: The bank MAKING the quote bids for the BASE currency on the left and offers (ask) it on the right. e.g: GBP 1 = USD 1.8850 (Bid), GBP 1 = USD 1.8860 (Ask) Becomes: 1.8850/60 or even 50/60

  7. The Foreign Exchange Market TYPES OF EXCHANGE MARKETS AND CONVENTIONS Exchange markets FX Market Spot Market Deals for delivery T + 2 FX Swaps Market Deals with one spot component and one forward component Forward Market Deals for delivery up to 12 months later than T + 2

  8. Spot & Forward A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies). A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months). Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk. An FX swap (not to be confused with a cross currency swap) is a contract that simultaneously agrees to buy (sell) an amount of currency at an agreed rate and to resell (repurchase) the same amount of currency for a later value date to (from) the same counterparty, also at an agreed rate. Non Deliverable Forwards

  9. How Factors Can Affect Exchange Rates

  10. Forwards Spot Rates Spot is the term used for standard settlement in the FX markets. The spot date is two business days after the trade date: T+2. Spot rates are quoted as two way prices between the banks that populate the FX markets: Source: Bloomberg

  11. The Spot Market Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

  12. Spot Rate Quotations Direct quotation the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny” Indirect Quotation the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar”

  13. Spot Rate Quotations

  14. Spot Rate Quotations The direct quote for British pound is: £1 = $1.9077

  15. Spot Rate Quotations The indirect quote for British pound is: £.5242 = $1

  16. Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote: 1 = 1 . 9077 . 5242

  17. The Bid-Ask Spread The bid price is the price a dealer is willing to pay you for something. The ask price is the amount the dealer wants you to pay for the thing. The bid-ask spread is the difference between the bid and ask prices.

  18. The Bid-Ask Spread A dealer could offer bid price of $1.25 per € ask price of $1.26 per € While there are a variety of ways to quote that, The bid-ask spread represents the dealer’s expected profit.

  19. The Bid-Ask Spread A dealer would likely quote these prices as 72-77. It is presumed that anyone trading $10m already knows the “big figure”. big figure small figure Bid Ask S($/£) 1.9072 1.9077 S(£/$) .5242 .5243

  20. Spot FX trading In the interbank market, the standard size trade is about U.S. $10 million. A bank trading room is a noisy, active place. The stakes are high. The “long term” is about 10 minutes.

  21. Cross Rates Suppose that S($/€) = 1.50 i.e. $1.50 = €1.00 and that S(¥/€) = 50 i.e. €1.00 = ¥50 What must the $/¥ cross rate be? $1.50 €1.00 $1.50 × = €1.00 ¥50 ¥50 $1.00 = ¥33.33 $0.0300 = ¥1

  22. Triangular Arbitrage £1.50 $1.00 £1.00 × = $1.00 ¥120 ¥80 Suppose we observe these banks posting these exchange rates. $ Barclays S(¥/$)=120 Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 ¥ £ First calculate any implied cross rate to see if an arbitrage exists.

  23. Triangular Arbitrage As easy as 1 – 2 – 3: $ $ 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $. Barclays S(¥/$)=120 Credit Lyonnais S(£/$)=1.50 3 1 2 Credit Agricole S(¥/£)=85 ¥ £

  24. Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 Sell our £150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 Sell ¥12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $106,250 – $100,000 = $6,250

  25. Triangular Arbitrage Here we have to go “clockwise” to make money—but it doesn’t matter where we start. $ $ Barclays S(¥/$)=120 Credit Lyonnais S(£/$)=1.50 2 3 1 Credit Agricole S(¥/£)=85 ¥ £ If we went “counter clockwise” we would be the source of arbitrage profits, not the recipient!

  26. Triangular Arbitrage As a quick spot method for triangular arbitrage, write the three rates out with a different denominator in each: 1.3285 CHF / USD 0.00851 USD / JPY 88.20 JPY / CHF If there is parity: If this is greater, or less than, 1 an arbitrage opportunity exists. An answer < 1 means that one of the component rates (fractions) is too low. An answer > 1 mean that one of the rates is too high. If the total is less than one, assume that any of the fractions is too low, e.g. CHF/USD. This would imply that CHF is too low (overvalued vs USD) or USD is too high (undervalued vs CHF); this tells us to either buy the undervalued or sell the overvalued currency.

  27. The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.

  28. Forward Rate Quotations The forward market for FX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Non Deliverable Forwards

  29. Forward Rate Quotations Consider the example from above: for British pounds, the spot rate is $1.9077 = £1.00 While the 180-day forward rate is $1.8904 = £1.00 What’s up with that?

  30. Clearly the market participants expect that the pound will be worth less in dollars in six months.

  31. Forward Rate Quotations Consider the (dollar) holding period return of a dollar-based investor who buys £1 million at the spot and sells them forward: gain $1,890,400 – $1,907,700 –$17,300 $HPR= = = pain $1,907,700 $1,907,700 $HPR = –0.0091 Annualized dollar HPR = –1.81% = –0.91% × 2

  32. Forward Premium The interest rate differential implied by forward premium or discount. For example, suppose the € is appreciating from S($/€) = 1.25 to F180($/€) = 1.30 The 180-day forward premium is given by: F180($/€) – S($/€) 360 1.30 – 1.25 f180,€v$ = × = × 2 S($/€) 180 1.25 = 0.08

  33. Long and Short Forward Positions If you have agreed to sell anything (spot or forward), you are “short”. If you have agreed to buy anything (forward or spot), you are “long”. If you have agreed to sell FX forward, you are short. If you have agreed to buy FX forward, you are long.

  34. Payoff Profiles profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain. S180($/¥) 0 F180($/¥) = .009524 If you agree to sell anything in the future at a set price and the spot price later rises then you lose. loss Short position

  35. Payoff Profiles profit short position Whether the payoff profile slopes up or down depends upon whether you use the direct or indirect quote: F180(¥/$) = 105 or F180($/¥) = .009524. 0 S180(¥/$) F180(¥/$) = 105 -F180(¥/$) loss

  36. Payoff Profiles profit short position S180(¥/$) 0 F180(¥/$) = 105 When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F180(¥/$) = 105 -F180(¥/$) loss

  37. Payoff Profiles 15¥ 120 profit short position S180(¥/$) 0 F180(¥/$) = 105 If, in 180 days, S180(¥/$) = 120, the short will make a profit by buying ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105. -F180(¥/$) loss

  38. Payoff Profiles profit Since this is a zero-sum game, the long position payoff is the opposite of the short. short position F180(¥/$) S180(¥/$) 0 F180(¥/$) = 105 -F180(¥/$) Long position loss

  39. Payoff Profiles 120 –15¥ profit The long in this forward contract agreed to BUY ¥ in 180 days at F180(¥/$) = 105 -F180(¥/$) If, in 180 days, S180(¥/$) = 120, the long will lose by having to buy ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105. S180(¥/$) 0 F180(¥/$) = 105 Long position loss

  40. Interest Rate Parity Defined IRP is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds.

  41. Interest Rate Parity Carefully Defined Consider alternative one year investments for $100,000: Invest in the U.S. at i$. Future value = $100,000 × (1 + i$) Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£ while eliminating any exchange rate risk by selling the future value of the British investment forward. F$/£ Future value = $100,000(1 + i£)× S$/£ F$/£ (1 + i£) × = (1 + i$) S$/£ Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist)

  42. IRP $1,000 S$/£ $1,000 $1,000  (1+ i£)  (1+ i£) × F$/£ S$/£ S$/£ IRP Alternative 2: Send your $ on a round trip to Britain Step 2: Invest those pounds at i£ $1,000 Future Value = Step 3: repatriate future value to the U.S.A. Alternative 1: invest $1,000 at i$ $1,000×(1 + i$) = Since both of these investments have the same risk, they must have the same future value—otherwise an arbitrage would exist

  43. Interest Rate Parity Defined The scale of the project is unimportant $1,000  (1+ i£) × F$/£ = $1,000×(1 + i$) S$/£ F$/£ × (1+ i£) = (1 + i$) S$/£

  44. Interest Rate Parity Defined Formally, 1 + i$ F$/¥ = 1 + i¥ S$/¥ F – S i$ – i¥ ≈ S IRP is sometimes approximated as

  45. Forward Premium It’s just the interest rate differential implied by forward premium or discount. For example, suppose the € is appreciating from S($/€) = 1.25 to F180($/€) = 1.30 The forward premium is given by: F180($/€) – S($/€) 360 $1.30 – $1.25 f180,€v$ = × = × 2 = 0.08 S($/€) 180 $1.25

  46. Interest Rate Parity Carefully Defined Depending upon how you quote the exchange rate ($ per ¥ or ¥ per $) we have: 1 + i¥ F¥/$ = 1 + i$ S¥/$ 1 + i$ F$/¥ = 1 + i¥ S$/¥ or …so be a bit careful about that

  47. IRP and Covered Interest Arbitrage If IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.

  48. IRP and Covered Interest Arbitrage A trader with $1,000 could invest in the U.S. at 7.1%, in one year his investment will be worth $1,071 = $1,000  (1+ i$) = $1,000  (1,071) Alternatively, this trader could Exchange $1,000 for £800 at the prevailing spot rate, Invest £800 for one year at i£ = 11,56%; earn £892,48. Translate £892,48 back into dollars at the forward rate F360($/£) = $1,20/£, the £892,48 will be exactly $1,071.

  49. Arbitrage I £800 £1 £800 = $1,000× $1.25 $1,000 F£(360) $1,071 = £892.48 × £1 Alternative 2: buy pounds Step 2: Invest £800 at i£ = 11.56% In one year £800 will be worth £892.48 = £892.48 Step 3: repatriate to the U.S.A. at F360($/£) = $1.20/£ £800 (1+ i£) Alternative 1: invest $1,000 at 7.1% FV = $1,071 $1,071

  50. Interest Rate Parity & Exchange Rate Determination According to IRP only one 360-day forward rate, F360($/£), can exist. It must be the case that F360($/£) = $1.20/£ Why? If F360($/£)  $1.20/£, an astute trader could make money with one of the following strategies:

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