International Finance

1
International Finance

• Lecture 2

2
Foundations of International Financial Management

• Globalization and the Multinational Firm
• International Monetary System
• Balance of Payments
• The Market for Foreign Exchange
• International Parity Relationships

3
Balance of Payments

• The Balance of Payments is the statistical
  ________ of a countrys (her citizens and her
  governments international transactions over a
  certain period of time.
• Every country prepares and publishes ________
  balance of payment statements.
• They are composed of the following
• The Current Account
• The Capital/Financial Account
• Statistical Discrepancy
• View actual Canadian, US, French, Russian,
  Ukrainian Balance of Payments statements

4
The Current and Capital Accounts

• Current Account
• Includes all ________ and ________ of goods and
  services.
• Includes unilateral transfers of foreign aid.
• If the debits gt credits, then trade deficit.
• If the credits gt debits, then trade surplus.
• Capital Account
• The capital account measures the difference
  between home country sales of ________ to
  foreigners and home country purchases of foreign
  ________.
• Composed of Foreign Direct Investment (FDI),
  portfolio investments and other investments.

5
Statistical Discrepancy and Official Reserve
Account

• Theres going to be some ________ and misrecorded
  transactions
• we use a plug figure to get things to balance.
• Official reserves assets include gold, foreign
  currencies, SDRs, reserve positions in the IMF.

6
The Balance of Payments Identity

• BCA BKA BRA 0
• where
• BCA balance on ________ account
• BKA balance on ________ account
• BRA balance on the ________ account
• Under a pure flexible exchange rate regime,
• BCA BKA 0

7
Canadas Balance of Payments
Source CANSIM
8
Balance of Payments and the Exchange Rate

• Current account Capital account Reserves
• Balance gt 0
• inflow of capital, quantity ________ of home
  currency gt quantity supplied, ________ pressure
  on home currency value
• Balance lt 0
• Outflow of capital, quantity demanded of home
  currency lt quantity supplied, ________ pressure
  on home currency value
• Equilibrium can continue __________,
  disequilibrium cannot.
• If the balance is not zero for long time, it is a
  disequilibrium and will be corrected by the
  market in the long run
• several scenarios possible, material for
  international economics course
• Price of home currency is the exchange rate
• Units of local currency / 1 unit of foreign
  currency (direct)
• Units of foreign currency / 1 unit of local
  currency (indirect)

9
Foundations of International Financial Management

• Globalization and the Multinational Firm
• International Monetary System
• Balance of Payments
• The Market for Foreign Exchange
• International Parity Relationships

10
The FOREX Market
11
The FOREX Market

• Structure
• Place of trading
• ________
• Volume
• Wholesale (________) and retail
• Timing
• ________ deal now, deliver now (up to 2
  business days)
• ________ (deal now, deliver in the future)

12
Spot Rate Quotations

• Direct quotation
• the Canadian ________ equivalent
• e.g. a Japanese Yen is worth about a penny
• Indirect Quotation
• the price of a Canadian dollar in the foreign
  currency
• e.g. you get 100 ________ to the dollar
• View daily foreign exchange rate updates from the
  US Federal Reserve System or the Bank of Canada

13
Exchange rates and trade

• The following table provides domestic prices for
  three items in Australia and Hong Kong. If AUD 1
  6 HKD, then what is the likely flow of goods?
  Ignore transaction costs.

14
Exchange rates and trade

• Over the past 5 years the CHF/USD exchange rate
  has changed from 1.20 to 1.60. Did the Swiss
  goods become more or less expensive for the US
  customers?

15
Spot FX trading

• Bid-ask spread
• The bid price is the price a dealer is ________
  to pay to buy the currency.
• The ask price is the amount the ________ wants to
  sell you the currency.
• The bid-ask spread is the difference between the
  bid and ask prices.
• 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.
• Cross- rates view major cross-rates _at_ Bloomberg

16
Bid-ask spread

• Direct ask (DC/FC) 1 / Indirect bid (FC/DC)
• Direct bid (DC/FC) 1 / Indirect ask (FC/DC)
• Notation DCdomestic currency, FCforeign
  currency

17
Example

• If the direct quotation for the exchange rate is
  USD/EUR0.9825-0.9829, then what is the indirect
  EUR/USD quote?

18
Bilateral arbitrage

• Assume no transaction costs for now. (ignore
  bid-ask spread)
• Domestic currency is DC, foreign currency is FC,
  exchange rate is DC/FC
• You observe two rates at ________ banks
  DC/FCbank1 and DC/FCbank2
• No-arbitrage DC/FCbank1 FC/DCbank2 must
  ________ Reason Law of One Price
• the price of the same item should be the same
  regardless of where it is sold, otherwise there
  will be arbitrage opportunities
• Mathematically, DC/FC FC/DC 1

19
Bilateral arbitrage

• You observe the following spot rates in two
  banks
• In Frankfurt EUR/GBP 1.4959 and in London
  GBP/EUR0.6695. Is there an arbitrage opportunity
  and if yes, what is it? Ignore transaction costs.

20
Bilateral arbitrage

• You observe the following spot rates in two
  banks
• In Canada JPY/CAD 122.30-122.35 and in Japan
  JPY/CAD122.15-122.25. Is there an arbitrage
  opportunity and if yes, what is it?

21
Exchange rates and investment

• A Canadian portfolio manager is planning to buy
  15 million worth of German bonds. The manager
  calls several banks to find out spot rates. The
  quotes that she gets is below. How many Euros
  will the manager invest in German bonds?

22
Exchange rates and investment

• A foreign exchange trader at a US bank took a
  short position of GBP 5,000,000 when the USD/GBP
  rate was 1.45. After that the exchange rate
  changed to 1.51. (a) Is this movement beneficial
  for the FX trader in question? (b) How did the US
  banks liability change as a result of this FX
  rate move?

23
Cross Rates

• Suppose that S(/SFr) .50
• i.e. 1 2 SFr
• and that S(/SFr) 50
• i.e. SFr1 50
• What must the / cross rate be?

24
Cross Rates

• You find the following rates in the newspaper.
  USD/EUR0.9119, CHF/USD1.5971, JPY/USD128.17
• Compute all cross-rates.

25
Cross Rates and Bid-Ask Spread

• Notation DCdomestic currency, FC1foreign
  currency 1, FC2foreign currency 2
• Cross-rates FC1/FC2
• (FC1/FC2)ask(FC1/DC)ask (DC/FC2)ask
• (FC1/FC2)bid(FC1/DC)bid (DC/FC2)bid
• Cross-rates FC2/FC1
• (FC2/FC1)ask(DC/FC1)ask (FC2/DC)ask
• (FC2/FC1)bid(DC/FC1)bid (FC2/DC)bid

26
Cross Rates and Bid-ask Spread

• A bank is quoting the following exchange rates
  USD/EUR1.1610-15, CHF/USD1.4100-20. What is the
  CHF/EUR cross-rate?

27
Cross Rates and Bid-ask Spread

• A bank is quoting the following exchange rates
  CHF/CAD1.5960-70, AUD/CAD1.8225-35. An
  Australian firm asks for CHF/AUD rate. What
  cross-rate will the bank quote?

28
Triangular Arbitrage

• Idea look for the quoted cross-rates FC1/FC2
  (between two foreign currencies FC1 and FC2)
• And see if they differ from the implied rates
  suggested by the DC/FC1 and DC/FC2 (domestic
  currency rates against the two foreign
  currencies)
• If any of the three currencies is
  over/underpriced, all cross-rates will present
  arbitrage opportunities.
• If transaction costs are ignored
• Check whether (DC/FC1)(FC1/FC2)(FC2/DC)
  ________
• Transaction costs
• Check whether quoted and cross-rate bid-ask
  spreads overlap for any currency out of our three
  currencies.
• If you have rate 1 bid1, ask1 and rate 2 bid2,
  ask2 such that ask2ltbid1, buy at ask2 and sell
  at bid1.

29
Triangular Arbitrage Example

• You observe these rates
• Tokyo / 120.00, NYC SF/ 1.6000, Zurich
  /SF80.00

30
Triangular Arbitrage Example

• You observe these quotes below. Is any
  currency arbitrage possible?

Calculate cross-rates and compare with the quoted
rates
31
Spot Foreign Exchange Microstructure

• Market Microstructure refers to the ________ of
  how a marketplace operates.
• Bid-Ask spreads in the spot FX market
• increase with FX exchange rate volatility and
• decrease with dealer competition.
• Private information is an important determinant
  of spot exchange rates.

32
The Forward Market

• A forward contract is an ________ to buy or sell
  an asset in the future at prices agreed upon
  today.
• If you have ever had to order an out-of-stock
  textbook, then you have entered into a forward
  contract.
• The forward market for FOREX involves agreements
  to buy and sell foreign currencies in the
  ________ at prices agreed upon today.
• Bank quotes for 1, 3, 6, 9, and 12 month
  maturities are readily available for forward
  contracts.
• Longer-term contracts are available.

33
The Forward Market

• Transactions
• ________ forward transaction do a regular
  forward contract
• ________ simultaneous sale (or purchase) of
  spot foreign exchange and corresponding purchase
  (or sale) of approximately equal amount of
  foreign currency
• View rates at BMO Economics or Federal Reserve of
  New York

34
The Forward Market

• You observe the spot rate EUR/USD0.92000 and the
  1-month forward EUR/USD0.92200, what does it
  mean? is the dollar trading at premium or
  discount? Is the dollar weak or strong?

35
The Forward Market

• Annualized forward premium/discount

36
The Forward Market

• You observe the following. Spot
  USD/GBP1.4570-76, and 6-months forward
  USD/GBP1.4408-34. Is GBP trading at a premium or
  discount relative to the USD? Compute the
  annualized forward discount/premium.

37
Long and Short Forward Positions

• If you have agreed to sell anything (spot or
  forward) you are ________.
• If you have agreed to buy anything (forward or
  spot) you are ________.
• If you have agreed to ________ forex forward, you
  are short.
• If you have agreed to ________ forex forward, you
  are long.

38
Payoff Profiles
profit
S180(/)
0
F180(/) .009524
Short position
loss
39
Payoff Profiles
profit
short position
F180(/)
S180(/)
0
F180(/) 105
-F180(/)
Long position
loss
40
Forward Speculation

• Today the 3-month forward rate is USD/CHF0.7476.
  A currency trader decides to bet on depreciation
  of the Swiss franks by selling CHF short. He
  contracts now to sell Swiss franks in 3 months
  anticipating that at that time the spot rate will
  change to USD/CHF0.7400. Suppose 3 months later
  the actual spot rate is USD/CHF0.7500.
• Is this a short sale and why? What is the
  expected payoff for the trader and his
  counterparty? What is the actual payoff?

41
Forward Speculation

• The counterparty
• On the actual spot market the same amount
  ________
• Savings
• If the rate dropped to 0.7400 instead of rising
  to 0.7500, would overpay
• _______________
• What if a trader decides to ignore the contract
  and not deliver when not profitable?