Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University Economics of International Finance Econ. 315 Chapter 2 Foreign Exchange Markets

Economics of International Finance Economics of International Finance Prof. M. El-SaqqaProf. M. El-Saqqa CBA. Kuwait University CBA. Kuwait University

Economics of International FinanceEconomics of International FinanceEcon. 315Econ. 315

Chapter 2Chapter 2

Foreign Exchange Markets and Foreign Exchange Markets and Exchange RatesExchange Rates


The Foreign Exchange MarketThe Foreign Exchange Market

The market in which individuals, firms, and banks buy and The market in which individuals, firms, and banks buy and sell foreign currencies (sell foreign currencies (foreign exchangeforeign exchange).).

ExamplesExamples: London, Paris, Zurich, Frankfurt, Singapore, : London, Paris, Zurich, Frankfurt, Singapore, Hong Kong, Tokyo and New York. Hong Kong, Tokyo and New York.

These These centerscenters form a form a single internationalsingle international foreign exchange foreign exchange market. They are connected market. They are connected electronicallyelectronically and are in and are in constantconstant contact with each other contact with each other

What are the major world currencies?.What are the major world currencies?. The world have what is called a The world have what is called a vehiclevehicle currency, i.e., the currency, i.e., the

US Dollar which is used to pay for the transactions that do US Dollar which is used to pay for the transactions that do not involve USA. not involve USA.

Note that the Euro is also growing as a world vehicle Note that the Euro is also growing as a world vehicle currency. China and Russia are asking now for a new currency. China and Russia are asking now for a new vehicle currency.vehicle currency.


Figure 1: Daily Turnover of global foreign exchange transactions (Billions of US $)

Instrument 1998 2001 2004 2007 2010 2013

Foreign exchange instruments 1,527 1,239 1,934 3,324 3,971 5,345 Spot transactions 568 386 631 1,005 1,488 2,046 Outright forwards 128 130 209 362 475 680 Foreign exchange swaps 734 656 954 1,714 1,759 2,228 Currency swaps 10 7 21 31 43 54 Options and other products² 87 60 119 212 207 337 Memo: Turnover at April 2013 exchange rates3 1,718 1,500 2,036 3,376 3,969 5,345 Exchange-traded derivatives4 11 12 26 80 155 160 1 Adjusted for local and cross-border inter-dealer double-counting (ie “net-net” basis). 2 The category “other FX products” covers highly leveraged transactions and/or trades whose notional amount is variable and where a decomposition into individual plain vanilla components was impractical or impossible. 3 Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2013 exchange rates. 4 Sources: FOW TRADEdata; Futures Industry Association; various futures and options exchanges. Foreign exchange futures and options traded worldwide.

BIS “Triennial Central Bank Survey”Foreign exchange turnover in April 2013: preliminary global results


Currency distribution of global foreign exchange market turnover(Billions of US $)

Currency 1998 2001 2004 2007 2010 2013

Share Rank Share Rank Share Rank Share Rank Share Rank Share Rank

USD 86.8 1 89.9 1 88 1 85.6 1 84.9 1 87 1

EUR ... 32 37.9 2 37.4 2 37 2 39.1 2 33.4 2

JPY 21.7 2 23.5 3 20.8 3 17.2 3 19 3 23 3

GBP 11 3 13 4 16.5 4 14.9 4 12.9 4 11.8 4

AUD 3 6 4.3 7 6 6 6.6 6 7.6 5 8.6 5

CHF 7.1 4 6 5 6 5 6.8 5 6.3 6 5.2 6

CAD 3.5 5 4.5 6 4.2 7 4.3 7 5.3 7 4.6 7

OTH 66.9 20.9 21.1 27.6 24.9 26.4

Total 200 200 200 200 200 200



Instrument/ counterparty/ maturity

1998 2001 2004 2007 2010 2013

Amount % Amount % Amount % Amount % Amount % Amount %

Spot transactions 568 37.2 386 31.2 631 32.6 1,005 30.2 1,488 37.5 2,046 38.3

Outright forwards 128 8.4 130 10.5 209 10.8 362 10.9 475 11.9 680 12.7

Foreign exchange swaps 734 48.1 656 52.9 954 49.3 1,714 51.6 1,759 44.3 2,228 41.7

Currency swaps 10 1 7 0.6 21 1.1 31 0.9 43 1.1 54 1.0

FX options and other products² 87 6 60 4.8 119 6.2 212 6.4 207 5.2 337 6.3

Total 1,527 100.0 1,239 100.0 1,934 100.0 3,324 100.0 3,971 100.0 5,345 100.0

Global foreign exchange market turnover by instrument(Billions of US $)



Major foreign exchange centers (Major foreign exchange centers (by sizeby size) are:) are:

1.1. London (about 40% of daily transactions)London (about 40% of daily transactions)2.2. New YorkNew York3.3. TokyoTokyo4.4. SingaporeSingapore

Functions of the Foreign Exchange Markets:Functions of the Foreign Exchange Markets:

1. The principle function is to 1. The principle function is to transfer fundstransfer funds or purchasing power or purchasing power from one nation or currency into another.from one nation or currency into another.

How it is done:How it is done: If we need foreign exchange we usually go to a bank. A If we need foreign exchange we usually go to a bank. A

domestic bank will instruct its domestic bank will instruct its correspondentcorrespondent in a foreign in a foreign monetary center to pay the specified amount of its local monetary center to pay the specified amount of its local currency (currency (foreign exchangeforeign exchange) to a person, firm or an account.) to a person, firm or an account.


This is Usually accomplished by This is Usually accomplished by electronicelectronic transfers (the transfers (the internetinternet).).

Why we need foreign exchange (demand)Why we need foreign exchange (demand)

Source of demand for foreign exchange:Source of demand for foreign exchange: Imports of goods from abroadImports of goods from abroad Imports of services, e.g., travel abroadImports of services, e.g., travel abroad Invest abroadInvest abroad

Note that we also receive foreign exchange (supply)Note that we also receive foreign exchange (supply)

Source of supply of foreign exchange:Source of supply of foreign exchange: Exports of goods to abroadExports of goods to abroad Exports of services, e.g., insuranceExports of services, e.g., insurance Investments at homeInvestments at home

Note: these items are all recorded in the country’s Note: these items are all recorded in the country’s BOPBOP


All these transactions are mainly made through commercial All these transactions are mainly made through commercial banks which function as a banks which function as a clearinghouseclearinghouse for the foreign for the foreign exchange.exchange.

Banks may end up having:Banks may end up having: OversupplyOversupply of foreign exchange (will sell it to other banks) of foreign exchange (will sell it to other banks)

through a through a brokerbroker.. Excess demandExcess demand of foreign exchange (will buy it from other of foreign exchange (will buy it from other

banks) through a banks) through a brokerbroker..

In generalIn general: :

A country pays for its imports, investments ..etc. with its A country pays for its imports, investments ..etc. with its foreign exchange earnings from exports, services..etc.foreign exchange earnings from exports, services..etc.

What happens if the What happens if the nation’s demandnation’s demand for foreign exchange for foreign exchange exceeds exceeds the supplythe supply, or if the supply of foreign exchange , or if the supply of foreign exchange exceeds demand?exceeds demand?


If exchange rate is flexibleIf exchange rate is flexible; ; the exchange rate will have to the exchange rate will have to changechange to equilibrate supply and demand.to equilibrate supply and demand.

What if changes in exchange rates are What if changes in exchange rates are not allowednot allowed? (exchange ? (exchange rate is fixed), there will either berate is fixed), there will either be::

Excess demandExcess demand - banks will borrow foreign exchange from the banks will borrow foreign exchange from the central bankcentral bank

((lender of the last resortlender of the last resort).).- The central bank will The central bank will draw down its foreign reservesdraw down its foreign reserves ( (a BOP a BOP

deficitdeficit))

Excess SupplyExcess Supply - Banks will sell foreign exchange to the Banks will sell foreign exchange to the central bankcentral bank (exchange (exchange

the surplus into domestic currency)the surplus into domestic currency)- Foreign reserves in the CB will Foreign reserves in the CB will accumulateaccumulate ( (a BOP surplusa BOP surplus).).


There are There are four levelsfour levels of participants in the foreign of participants in the foreign exchange market that can be identified:exchange market that can be identified:

44thth level the central bank: seller or buyer of the level the central bank: seller or buyer of the last resortlast resort when the nations earnings and expenditures of when the nations earnings and expenditures of

foreign exchange are unequal, draw down its foreign exchange are unequal, draw down its foreign foreign reserves or adds to them reserves or adds to them

33rdrd level level foreign exchange brokers (foreign exchange brokers (wholesale marketwholesale market))

22ndnd level level commercial banks (clearing house between users commercial banks (clearing house between users and earners) and earners)

11stst level traditional users: tourists, importers, level traditional users: tourists, importers, exporters exporters (immediate users of foreign exchange)(immediate users of foreign exchange)


2. Another function is the 2. Another function is the credit functioncredit function. International . International transactions involve transactions involve credit facilitiescredit facilities, e.g., , e.g.,

An importer is usually given time to resell his imports and An importer is usually given time to resell his imports and make the payments. make the payments.

What the exporter do is to What the exporter do is to discountdiscount the “importer’s the “importer’s obligations to pay” at his bank, i.e., the exporter receives obligations to pay” at his bank, i.e., the exporter receives payments.payments.

The bank eventually collects the payments from the importer The bank eventually collects the payments from the importer when due.when due.

3. A third function is to provide facilities for 3. A third function is to provide facilities for hedging and hedging and speculationspeculation (explained later)(explained later)


Foreign exchange ratesForeign exchange rates

Equilibrium foreign exchange ratesEquilibrium foreign exchange rates: : Flexible exchange rates: Flexible exchange rates:

Consider the following caseConsider the following case (the Dollar and the Euro) (the Dollar and the Euro)

Rate Rate $/$/€€ Demand Demand

(daily)(daily)

Supply Supply

(daily)(daily)

NoteNote

0.50.5 350350 5050 The euro is cheapThe euro is cheap

11 200200 200200 Equilibrium RateEquilibrium Rate

1.51.5 100100 300300 The euro is expensiveThe euro is expensive

22 5050 350350 The euro is expensiveThe euro is expensive


The exchange rate is determined just like the price of any other The exchange rate is determined just like the price of any other good.good.

If the rate of the Euro is $ 0.5, the quantity of euros demanded If the rate of the Euro is $ 0.5, the quantity of euros demanded will exceed the quantity supplied will exceed the quantity supplied the rate will bid up towards the rate will bid up towards the equilibrium ratethe equilibrium rate

If the rate of the Euro is $ 1.5, the quantity of euros supplied will If the rate of the Euro is $ 1.5, the quantity of euros supplied will exceed the quantity demanded exceed the quantity demanded the rate will fall towards the the rate will fall towards the equilibrium rateequilibrium rate

What if the rate is fixed (fixed exchange rate system). What if the rate is fixed (fixed exchange rate system). In case of In case of excess demandexcess demand the central bank (Fed) will either: the central bank (Fed) will either:

- set restrictions on the demand for euro, orset restrictions on the demand for euro, or

- fill the gap between demand and supply out of its international fill the gap between demand and supply out of its international reservesreserves


FIGURE 3 The Exchange Rate Under a Flexible Exchange Rate System.

D€1

D€2

Demand shift

Demand shift

Free rates. Free rates. What if the rate is not free?What if the rate is not free? Fill the gap, orFill the gap, or Set restrictionsSet restrictions

Eq. rate

depreciationdepreciation

appreciationappreciation


Why the demand is negatively slopped? Why the demand is negatively slopped?

(note that the demand for foreign exchange is a (note that the demand for foreign exchange is a derived demandderived demand))

- At lower rates the demand for the euro increases: why?- At lower rates the demand for the euro increases: why?The lower the rate, the lower is the quantity of dollars required The lower the rate, the lower is the quantity of dollars required to buy one euro to buy one euro the cheaper it is for Americans to import and the cheaper it is for Americans to import and to invest in Europe to invest in Europe the greater is the demand for euros. the greater is the demand for euros.

Why the supply is positively slopped?Why the supply is positively slopped?

- At higher rates, European residents will receive more dollar for At higher rates, European residents will receive more dollar for each euro each euro they will find American goods and investments they will find American goods and investments cheaper and more attractive cheaper and more attractive they will spend more in USA and they will spend more in USA and the supply of euro will increase the supply of euro will increase


Changes in demand and supply of foreign exchangeChanges in demand and supply of foreign exchange

If the American demand for euros shifted up, e.g., as a result If the American demand for euros shifted up, e.g., as a result of increased US of increased US tastestastes for European goods and the US for European goods and the US quantity supplied for euros increased at point quantity supplied for euros increased at point G in figure 3G in figure 3, , the euro rate will be 1.5 and the equilibrium daily quantity the euro rate will be 1.5 and the equilibrium daily quantity will be € 300 mn. will be € 300 mn.

It requires now $ 1.5 (instead of $ 1) to buy one euro. This is a It requires now $ 1.5 (instead of $ 1) to buy one euro. This is a depreciationdepreciation of the US $, which is an of the US $, which is an increaseincrease in the in the domesticdomestic priceprice (US) of the foreign currency (euro). (US) of the foreign currency (euro).

If the American demand for euros shifted down to so as to If the American demand for euros shifted down to so as to intersect the US supply at point H intersect the US supply at point H in figure 3, in figure 3, the equilibrium the equilibrium exchange rate of the euro would fall to $ 0.5 and the daily exchange rate of the euro would fall to $ 0.5 and the daily equilibrium quantity would be € 50 mn. equilibrium quantity would be € 50 mn.


It requires now fewer dollars to buy one euro, It requires now fewer dollars to buy one euro, this is an this is an appreciationappreciation of the $ US, which is a of the $ US, which is a declinedecline in in

the the domestic pricedomestic price (US) of the euro. (US) of the euro.

Note that changes in supply of euros would similarly affect Note that changes in supply of euros would similarly affect the equilibrium exchange rate and quantity of euros.the equilibrium exchange rate and quantity of euros.

Another Definition of the Exchange Rate:Another Definition of the Exchange Rate:

The exchange rate can be defined as the foreign currency The exchange rate can be defined as the foreign currency price of a unit of domestic currency. If the Dollar price of price of a unit of domestic currency. If the Dollar price of the euro is $1.5 = the euro is $1.5 = € € 1 then the euro price of the dollar is 1 then the euro price of the dollar is (1/1.5) = .667, i.e., it takes 0.667 euros to buy one dollar.(1/1.5) = .667, i.e., it takes 0.667 euros to buy one dollar.

note: the conventional definition (no of domestic currency note: the conventional definition (no of domestic currency units to buy one unit of foreign currency) is (R), hence the units to buy one unit of foreign currency) is (R), hence the other definition is (1/R)).other definition is (1/R)).


Cross Exchange rates:Cross Exchange rates:

There are rates between the dollar and other There are rates between the dollar and other currencies, i.e., between the dollar and the euro, the currencies, i.e., between the dollar and the euro, the dollar and the Sterling…etc. once the rate between the dollar and the Sterling…etc. once the rate between the dollar and other two currencies is determined, the dollar and other two currencies is determined, the exchange rate between them (exchange rate between them (crosscross) can easily be ) can easily be calculated. calculated.

e.g., if the rate between the dollar and the Sterling is $ e.g., if the rate between the dollar and the Sterling is $ 2 = £ 1 and the rate between the dollar and the euro is 2 = £ 1 and the rate between the dollar and the euro is $ 1.25 = € 1, then the cross exchange rate between the $ 1.25 = € 1, then the cross exchange rate between the sterling and the euro is 1.60.sterling and the euro is 1.60.


R = €/£ = ($ value of the £)/(($ value of the €) = 2/1.25 R = €/£ = ($ value of the £)/(($ value of the €) = 2/1.25 = 1.6= 1.6

i.e., it takes € 1.6 to purchase £ 1.i.e., it takes € 1.6 to purchase £ 1.

Mathematical formMathematical form If you need the €/£, and you have the $/£ and $/€. You If you need the €/£, and you have the $/£ and $/€. You

need to manipulate these two rates such that you need to manipulate these two rates such that you ended up with € in the numerator and £ in the ended up with € in the numerator and £ in the denominatordenominator

Divide $/£ by $/€Divide $/£ by $/€ $/£ $/£ ÷÷ $/€ $/€ thethe $ cancels out and $ cancels out and you end up with €/£. Note that if you start with $/€ you end up with €/£. Note that if you start with $/€ ÷÷ $/£ you would end up with £/€.$/£ you would end up with £/€.


Effective Exchange Rate:Effective Exchange Rate:

A weighted average of the rate between the domestic currency A weighted average of the rate between the domestic currency and the nations most and the nations most important trade partnersimportant trade partners, with weights , with weights given by the relative importance of the given by the relative importance of the nation’s trade nation’s trade with each with each of these partners.of these partners.

Nominal and Real Exchange Rates:Nominal and Real Exchange Rates:

Nominal exchange rate is the domestic price of the foreign Nominal exchange rate is the domestic price of the foreign currency (direct or indirect rate). currency (direct or indirect rate).

The The realreal exchange rate is the nominal exchange rate divided by exchange rate is the nominal exchange rate divided by the ratio of the the ratio of the consumer price indicesconsumer price indices in the two countries. in the two countries.

e.g., the real exchange rate between the dollar and the Sterling e.g., the real exchange rate between the dollar and the Sterling is:is:

($/£)/(P($/£)/(PUSAUSA/P/PUKUK) = ($/£)(P) = ($/£)(PUK/UK/PPUSA)USA)


ArbitrageArbitrage

The purchase of a currency from the monetary center where it is cheaper The purchase of a currency from the monetary center where it is cheaper for immediate resale in the monetary center where it is more expensive in for immediate resale in the monetary center where it is more expensive in order to make a profit. order to make a profit.

Arbitrage keeps the exchange rate between two currencies the same in Arbitrage keeps the exchange rate between two currencies the same in different monetary centers. different monetary centers.

Two point arbitrageTwo point arbitrage

New YorkNew York LondonLondon $ 1.99 = £ 1$ 1.99 = £ 1 $ 2.01 = £ 1$ 2.01 = £ 1

* Buy here* Buy here * sell here* sell here

Arbitrageur profit = 2.01-1.99 = $ .02 per £ 1 (minus transactions cost)Arbitrageur profit = 2.01-1.99 = $ .02 per £ 1 (minus transactions cost)

As arbitrage continues, the exchange rate between the two currencies As arbitrage continues, the exchange rate between the two currencies equalizes. e.g.,equalizes. e.g.,

$ 2.00 = £ 1$ 2.00 = £ 1 $ 2.00 = £ 1$ 2.00 = £ 1

Eliminating thus the profitability of further arbitrage.Eliminating thus the profitability of further arbitrage.


Three point (triangular) arbitrageThree point (triangular) arbitrage

New YorkNew York London London FrankfurtFrankfurt $2 = £ 1$2 = £ 1 £ .625 = € 1 £ .625 = € 1 €.8 = $1€.8 = $1

Note: the cross rates are Note: the cross rates are consistentconsistent because: because: $2 $2 £ 1 £ 1 € 1.6 € 1.6 $2 $2

Why:Why:

R = €/£ = ($ value of the £)/(($ value of the €) = 2/1.25 = 1.6R = €/£ = ($ value of the £)/(($ value of the €) = 2/1.25 = 1.6

If this is the case there will be If this is the case there will be no profit out of arbitrageno profit out of arbitrage. To make sure lets start in . To make sure lets start in New York using $2 to buy £ 1, take the pound to London and exchange it for (1/.625) New York using $2 to buy £ 1, take the pound to London and exchange it for (1/.625) = € 1.6. Now if we take the euro to Frankfurt to exchange it into dollars we get = € 1.6. Now if we take the euro to Frankfurt to exchange it into dollars we get (1.6/.8) = $2, which is exactly what we started arbitrage with.(1.6/.8) = $2, which is exactly what we started arbitrage with.

But if:But if: New YorkNew York London London Frankfurt Frankfurt $1.96 = £ 1$1.96 = £ 1 £ .625 = € 1 £ .625 = € 1 €.8 = $1€.8 = $1

Again use $ 1.96 to buy £ 1 in New York to buy € 1.6 in London and exchange them Again use $ 1.96 to buy £ 1 in New York to buy € 1.6 in London and exchange them for $ 2 in Frankfurt, or for $ 2 in Frankfurt, or

The arbitrage profit is = $ 2 – $ 1.96 = $ .04.The arbitrage profit is = $ 2 – $ 1.96 = $ .04.


Now given the following informationNow given the following information::

New YorkNew York London London Frankfurt Frankfurt$2.04 = £ 1$2.04 = £ 1 £ .625 = £ .625 = €€ 1 1 € .8 = $1€ .8 = $1

What would you do:What would you do: (remember if you start in New York you would lose $ 0.4 (remember if you start in New York you would lose $ 0.4 for each two dollars you use in arbitrage!, how?: for each two dollars you use in arbitrage!, how?: Use $ 2.04 to buy £1 in New York, to be exchanged for Use $ 2.04 to buy £1 in New York, to be exchanged for €€ 1.6 in London and 1.6 in London and again to be exchanged into $ 2 in Frankfurt. Arbitrage profit = 2.04 – 2 = -.04)again to be exchanged into $ 2 in Frankfurt. Arbitrage profit = 2.04 – 2 = -.04)

Hence, to be profitable you should start the arbitrage in Hence, to be profitable you should start the arbitrage in FrankfurtFrankfurt using $ 2 using $ 2 to buy € 1.6, exchange them for £ 1 in London. Sell the £ 1 in New York for $ to buy € 1.6, exchange them for £ 1 in London. Sell the £ 1 in New York for $ 2.04. Therefore; 2.04. Therefore;

The arbitrage profit is = $ 2.04 – $ 2 = + $ .04.The arbitrage profit is = $ 2.04 – $ 2 = + $ .04.

Arbitrage increases the demand for currencies where they are Arbitrage increases the demand for currencies where they are cheapercheaper and and increases supply in the center where they are increases supply in the center where they are expensiveexpensive and quickly and quickly eliminates inconsistent cross rateseliminates inconsistent cross rates. .


The Exchange rate and the BOPThe Exchange rate and the BOP

Look at figure 4 and note the following:Look at figure 4 and note the following: DD€ € arises from imports of goods and services from and investment in arises from imports of goods and services from and investment in

Europe.Europe. SS€ € arises from exports of goods and services to Europe and European arises from exports of goods and services to Europe and European

investments in USinvestments in US Both are autonomousBoth are autonomous Equilibrium exchange rate is $1 = €1. and the equilibrium quantity is Equilibrium exchange rate is $1 = €1. and the equilibrium quantity is

200 million. 200 million.

If demand for € increases to DIf demand for € increases to D€’ €’ the effect will depend on the exchange the effect will depend on the exchange rate systemrate system

Fixed Exchange rate systemFixed Exchange rate system

If US wants to keep the euro rate at $1, it would have to satisfy the If US wants to keep the euro rate at $1, it would have to satisfy the excess demand TE (€ 250), out of official reserves, i.e. purchase $ and excess demand TE (€ 250), out of official reserves, i.e. purchase $ and sell €. sell €.


Figure 4.: Disequilibrium under a fixed and flexible exchange rate


Flexible Exchange Rate systemFlexible Exchange Rate system

The rate would rise to $1.5 to equilibrate demand and supply for The rate would rise to $1.5 to equilibrate demand and supply for €. €.

Use of reserves is unnecessary because the depreciation of the $ Use of reserves is unnecessary because the depreciation of the $ would eliminate excess demand for €.would eliminate excess demand for €.

Managed Floating systemManaged Floating system

Monetary authorities intervene in the market to moderate Monetary authorities intervene in the market to moderate depreciation of the $ to only $1.25 = €1. This can be done by depreciation of the $ to only $1.25 = €1. This can be done by supplying the market by WZsupplying the market by WZ

Part of the deficit is financed by loss of official reserves, Part of the deficit is financed by loss of official reserves, The other part is eliminated by the depreciation of the $.The other part is eliminated by the depreciation of the $. Loss of reserves indicates the degree of interventionLoss of reserves indicates the degree of intervention


Spot and forward, swaps, futures and options.Spot and forward, swaps, futures and options.

Spot and Forward Rate:Spot and Forward Rate:

A spot transactionA spot transaction involves the payment and receipt of foreign involves the payment and receipt of foreign exchange within two days after the day of transaction is agreed exchange within two days after the day of transaction is agreed upon. The rate is called spot rate. upon. The rate is called spot rate.

Forward Exchange Rate:Forward Exchange Rate:

A forward transactionA forward transaction involves an agreement to buy or sell a involves an agreement to buy or sell a specified amount of foreign exchange at a specified future date, at specified amount of foreign exchange at a specified future date, at a rate agreed upon today (a rate agreed upon today (forward rateforward rate). ).

The contract is for one, three or six months. The contract is for one, three or six months. Three months is the Three months is the most commonmost common..


Equilibrium forward rateEquilibrium forward rate is determined at the intersection of is determined at the intersection of the market demand and supply of foreign exchange for future the market demand and supply of foreign exchange for future deliverydelivery

This demand is derived in the course of hedging from foreign This demand is derived in the course of hedging from foreign exchange speculation and from covered interest arbitrage exchange speculation and from covered interest arbitrage (will explained later).(will explained later).

If the forward rate < the present spot rate, the foreign currency If the forward rate < the present spot rate, the foreign currency is said to be at a is said to be at a forward discountforward discount..

If the forward rate > the present rate, foreign currency is said If the forward rate > the present rate, foreign currency is said to be at a to be at a forward premiumforward premium. .


e.g., if R is $2 = £1, and the e.g., if R is $2 = £1, and the threethree monthmonth forward rate $1.98 forward rate $1.98 = £1= £1

The £ is at a forward The £ is at a forward discountdiscount of 2 cents (or 1% (2/200), or of 2 cents (or 1% (2/200), or the annual forward discount is 4% (8/200)). Same forward the annual forward discount is 4% (8/200)). Same forward premiumpremium if the three month forward rate is $ 2.02. if the three month forward rate is $ 2.02.

Hence, the annual forward discount or premium is calculated Hence, the annual forward discount or premium is calculated ((for a three month contractfor a three month contract) as:) as:

FD or FP = ((SFR – SR)/SR)FD or FP = ((SFR – SR)/SR)××4 4 ×× 100 100

i.e.,i.e., FD = ((1.98-2)/2) FD = ((1.98-2)/2) ×× 4 4 ×× 100 = -4% 100 = -4%andand FP = ((2.02-2)/2) FP = ((2.02-2)/2) ×× 4 4 ×× 100 = 4% 100 = 4%


Currency Swaps (combination of spot and forward)Currency Swaps (combination of spot and forward)

A currency swap refers to the A currency swap refers to the spot salespot sale of a currency combined with of a currency combined with a a forward purchaseforward purchase of the same currency - as part of a of the same currency - as part of a singlesingle transaction. transaction.

e.g., suppose that NBK receives a payment of $ 1 mn today that it e.g., suppose that NBK receives a payment of $ 1 mn today that it will need in three month but it wants to invest the sum in Sterling. It will need in three month but it wants to invest the sum in Sterling. It will swap the dollars into pounds with a British bank in a single will swap the dollars into pounds with a British bank in a single transaction. transaction.

This is cheaper (in terms of brokerage fees) than selling the dollars This is cheaper (in terms of brokerage fees) than selling the dollars in the spot market today and at the same time repurchasing dollars in in the spot market today and at the same time repurchasing dollars in the forward market for delivery in three month (the forward market for delivery in three month (two separatetwo separate transactionstransactions))

The swap rateThe swap rate is the difference between the is the difference between the spotspot and and forward rate forward rate in in

the currency swap.the currency swap.

The foreign exchange market is currently dominated by swaps, The foreign exchange market is currently dominated by swaps, about about 50% of foreign50% of foreign exchange contractsexchange contracts. .


Foreign Exchange Futures and Options.Foreign Exchange Futures and Options. Foreign exchange futureForeign exchange future is a forward contract for a standardized is a forward contract for a standardized

currency amounts and selected calendar dates traded in an organized currency amounts and selected calendar dates traded in an organized market. market.

e.g., in the International Monetary Market (IMM) in Chicago trading is e.g., in the International Monetary Market (IMM) in Chicago trading is done of standard size.done of standard size.

- £ 62500 £ 62500 C$ 100000C$ 100000 ¥ 12.5 million ¥ 12.5 million €125000€125000

- Four dates of the year are available, the Four dates of the year are available, the third Wednesdaythird Wednesday of :of :MarchMarch June June September September December December

1.1. The IMM imposes a The IMM imposes a daily limitdaily limit on exchange rate fluctuationson exchange rate fluctuations

2.2. Buyers have to pay a Buyers have to pay a brokerage commissionbrokerage commission

3.3. Buyers are required to Buyers are required to post a security depositpost a security deposit (margin) of 4% of the (margin) of 4% of the contract.contract.

____________________________________________________________________________________________________________________

* C$ = the Canadian Dollar* C$ = the Canadian Dollar ¥ = the Japanese Yen ¥ = the Japanese Yen


Futures market differs from the forward market. Futures market differs from the forward market.

In the futures marketIn the futures market: only few currencies are traded: : only few currencies are traded: - Trades occur in standardized contracts onlyTrades occur in standardized contracts only- For a few specific delivery datesFor a few specific delivery dates- Subject to limits on exchange rate fluctuationsSubject to limits on exchange rate fluctuations- Trading takes place only in a Trading takes place only in a few geographicalfew geographical locations locations

(Chicago, New York, London, Frankfurt, France and (Chicago, New York, London, Frankfurt, France and Singapore). Singapore).

- Future contracts are usually for Future contracts are usually for smaller amountssmaller amounts than than forward and thus useful for smaller companies, but forward and thus useful for smaller companies, but more more expensiveexpensive..

- Futures Futures can be soldcan be sold in any organized futures market until in any organized futures market until maturity. Forward contracts maturity. Forward contracts can notcan not be sold. be sold.


OptionsOptions

A foreign exchange option is a contract giving the purchaser the A foreign exchange option is a contract giving the purchaser the right, but not the obligation, to buy (a right, but not the obligation, to buy (a callcall option) or to sell (a option) or to sell (a putput option) a standard amount of traded currency on a stated option) a standard amount of traded currency on a stated date (date (the European optionthe European option) or at any time () or at any time (the American the American optionoption), and at a stated price (), and at a stated price (the strike or exercise pricethe strike or exercise price). ).

They are in They are in standard sizesstandard sizes equal to those of futures IMM equal to those of futures IMM contracts. contracts.

The buyer of the option has the The buyer of the option has the right to purchase or foregoright to purchase or forego the the purchase if it turns out to be purchase if it turns out to be unprofitableunprofitable. .

The The sellerseller of the option, however, of the option, however, must fulfillmust fulfill the contract if the the contract if the buyer desires so. buyer desires so.

For this privilege, the For this privilege, the buyer must pay the seller a premium buyer must pay the seller a premium (option price(option price) ranging from 1 to 5% of the value of the contract. ) ranging from 1 to 5% of the value of the contract.


Foreign Exchange Risk, Hedging and SpeculationForeign Exchange Risk, Hedging and Speculation

Foreign Exchange RiskForeign Exchange RiskOver time demand and supply for foreign exchange shifts due to Over time demand and supply for foreign exchange shifts due to changes in tastes, differences in inflation, changes in relative interest changes in tastes, differences in inflation, changes in relative interest rates, changing expectations ..etcrates, changing expectations ..etc

• Increasing demandIncreasing demand (tastes) by Kuwaitis for American goods raises (tastes) by Kuwaitis for American goods raises the US $ rate (depreciation of KD)the US $ rate (depreciation of KD)

• If domestic inflationIf domestic inflation in Kuwait decreases relative to US inflation the in Kuwait decreases relative to US inflation the US $ depreciates relative to the KD. US $ depreciates relative to the KD.

• If interest ratesIf interest rates on domestic currency (KD) deposits are greater than on domestic currency (KD) deposits are greater than the rate on US $ deposits, the KD will appreciate.the rate on US $ deposits, the KD will appreciate.

• If expectationsIf expectations of a stronger KD increases, the KD appreciates of a stronger KD increases, the KD appreciates relative to US $.relative to US $.

• Fluctuations in exchange rates impose Fluctuations in exchange rates impose risksrisks on individuals, firms, on individuals, firms, and banks that have to make or receive payments in the future and banks that have to make or receive payments in the future denominated in foreign exchange.denominated in foreign exchange.


e.g., e.g.,

• A local importerA local importer purchases $ 100,000 of goods to be paid in 3 purchases $ 100,000 of goods to be paid in 3 month time. month time.

• If the KD/$ rate is 0.300, He will have to pay KD 30,000 in three If the KD/$ rate is 0.300, He will have to pay KD 30,000 in three month time. month time.

• In 3 month time the rate could e.g., be 0.330, He will pay 33,000 In 3 month time the rate could e.g., be 0.330, He will pay 33,000 (extra KD 3000).(extra KD 3000).

• The rate could e.g., also be 0.270/1, He will only pay KD 27,000 The rate could e.g., also be 0.270/1, He will only pay KD 27,000 (KD 3000 less)(KD 3000 less)


The exporterThe exporter and investorand investor may face the same situation. may face the same situation.

Both the importer and exporter will have to Both the importer and exporter will have to insureinsure against the against the increase in the rates in 3 months. increase in the rates in 3 months.

In general, whenever a future payment must be made in a foreign In general, whenever a future payment must be made in a foreign currency, a foreign currency risk, or the so called currency, a foreign currency risk, or the so called open positionopen position, , occurs because the spot rate changes overtime. Most business occurs because the spot rate changes overtime. Most business people are people are risk averserisk averse..

Sources:Sources: The foreign exchange risk The foreign exchange risk arises from: arises from:

1.1. A transaction involving A transaction involving future payments or receiptsfuture payments or receipts in a foreign in a foreign currency (currency (transaction exposure)transaction exposure)

2.2. A need to A need to value inventories or assetsvalue inventories or assets abroad in local currency for abroad in local currency for inclusion in the firms consolidated balance sheet (inclusion in the firms consolidated balance sheet (the translation or the translation or accounting exposureaccounting exposure))

3.3. Estimation of the domestic currency value of the future Estimation of the domestic currency value of the future profitability of the firm (profitability of the firm (economic exposureeconomic exposure). ).


Hedging Hedging

Avoidance of “Avoidance of “foreign exchange riskforeign exchange risk” or the covering of an “open ” or the covering of an “open position”. position”.

How it is done? How it is done?

A- In the spot marketA- In the spot market

An importerAn importer purchases $100,000 goods. purchases $100,000 goods. The importer The importer could borrow could borrow domestic currency equals to the $100,000 and exchange it at the domestic currency equals to the $100,000 and exchange it at the present spot rate, and leave the sum on deposit in a bank for 3 present spot rate, and leave the sum on deposit in a bank for 3 months, when the payment is due. This way the importer avoids the months, when the payment is due. This way the importer avoids the risk.risk.

The cost of insuring against the foreign exchange risk is the positive The cost of insuring against the foreign exchange risk is the positive difference between the interest rate he pays on the loan and the difference between the interest rate he pays on the loan and the interest rate he earns on his depositinterest rate he earns on his deposit. .


An exporter An exporter exports $100,000 goods. exports $100,000 goods. The exporterThe exporter who expects who expects the rate to go down could also borrow the $100,000 (in foreign the rate to go down could also borrow the $100,000 (in foreign exchange) he expects to receive, exchange them into KDs, and exchange) he expects to receive, exchange them into KDs, and deposit the sum in a bank for 3 month. After 3 months, he will deposit the sum in a bank for 3 month. After 3 months, he will repay the loan using the payment he receives. repay the loan using the payment he receives.

The cost of avoiding the risk is the difference between the The cost of avoiding the risk is the difference between the borrowing and deposit interest rate. borrowing and deposit interest rate.

The problem with coverage of exchange risk in the spot market The problem with coverage of exchange risk in the spot market is that the exporter (importer)is that the exporter (importer) has to tie his funds for three has to tie his funds for three months.months.


B- In the forward marketB- In the forward market

The importerThe importer could could buybuy the $100,000 forward for delivery in three months at the $100,000 forward for delivery in three months at today’s 3 month forward rate. today’s 3 month forward rate.

If e.g., the 3 month forward premium is 4%, he would have to pay ((100000 If e.g., the 3 month forward premium is 4%, he would have to pay ((100000 +(100000 +(100000 ×× 0.04)/4) = $101000. 0.04)/4) = $101000.

The exporterThe exporter could also could also sellsell his $ 100,000 forward for delivery in 3 months. If his $ 100,000 forward for delivery in 3 months. If e.g., the 3 month forward discount is 4%, the exporter will get only $ 99 000.e.g., the 3 month forward discount is 4%, the exporter will get only $ 99 000.

C- In the futures or options market.C- In the futures or options market.

Another alternative for the importer is to buy an option to purchase the amount in Another alternative for the importer is to buy an option to purchase the amount in three month at option and pay now the premium 1% (KD 300) on the $100 000 three month at option and pay now the premium 1% (KD 300) on the $100 000 option. If the 3 month spot rate is 0.296/1. The importer could let the option option. If the 3 month spot rate is 0.296/1. The importer could let the option expires unexercised and get the $100 000 at a cost of KD 29600 on the spot expires unexercised and get the $100 000 at a cost of KD 29600 on the spot market. The 300 premium can be considered as the market. The 300 premium can be considered as the insurance policyinsurance policy and the and the importer will save KD 100 over the forward contract.importer will save KD 100 over the forward contract.

The option contract is better here than the forward contractThe option contract is better here than the forward contract


Ability of traders and investors to hedge greatly facilitates the Ability of traders and investors to hedge greatly facilitates the international flow of trade and investments.international flow of trade and investments.

Note that Note that multinationalsmultinationals have to make and receive a large number of have to make and receive a large number of transactions need only to transactions need only to hedgehedge their their net opennet open position. position.

Similarly Similarly banksbanks have an open position only in the have an open position only in the net balance net balance of of contracted future payments and receipts in each foreign currency at contracted future payments and receipts in each foreign currency at each future date. each future date.

SpeculationSpeculation

Opposite of hedging. Opposite of hedging. A speculator accepts and even seeks out a A speculator accepts and even seeks out a foreign exchange risk,foreign exchange risk, or an open position in the hope of making a or an open position in the hope of making a profit. profit.

A speculator can make profit or incurs a loss. A speculator can make profit or incurs a loss. Speculation can take place in spot, forward, futures and option Speculation can take place in spot, forward, futures and option

markets. markets.


A- Speculation in the spot marketA- Speculation in the spot marketIf a currency is believed to If a currency is believed to rise in three monthsrise in three months, the speculator will , the speculator will buybuy the currency at the spot rate now. the currency at the spot rate now. deposit the currency in a bank deposit the currency in a bank In the future if the rate is higher, he will sell it at the spot rate and In the future if the rate is higher, he will sell it at the spot rate and

earns profit.earns profit.

If a currency is believed to If a currency is believed to fall in three monthsfall in three months, the speculator will:, the speculator will: borrowborrow the currency and exchange it for domestic currency at the the currency and exchange it for domestic currency at the

spot rate, spot rate, deposit the domestic currency in a bank for three months. deposit the domestic currency in a bank for three months. After three months, if the rate is lower, he will purchase the After three months, if the rate is lower, he will purchase the

currency at the sport rate and repay the loan.currency at the sport rate and repay the loan.

Note: For a speculation to be profitable, the difference between the Note: For a speculation to be profitable, the difference between the two spot rates should be higher than the two spot rates should be higher than the difference between the difference between the interest rates on the domestic and foreign currencyinterest rates on the domestic and foreign currency


B- Speculation In the forward and options marketB- Speculation In the forward and options market

The problem with speculation in the spot market is that the The problem with speculation in the spot market is that the speculator has to speculator has to tie his funds or to borrow to speculatetie his funds or to borrow to speculate. To avoid . To avoid this speculation takes place in the forward market. this speculation takes place in the forward market.

Speculation in the forward marketSpeculation in the forward market

If a currency is believed e.g., to be If a currency is believed e.g., to be higherhigher than its present forward than its present forward rate in three months, the speculator will:rate in three months, the speculator will:

BuyBuy the currency forward for delivery in three months. the currency forward for delivery in three months. After three months he receives the foreign currency at the lower After three months he receives the foreign currency at the lower

agreed upon (agreed upon (forwardforward) rate and sells it immediately in the spot ) rate and sells it immediately in the spot market.market.


Speculation in the options marketSpeculation in the options marketAs an alternative, if the speculator believes that a currency will As an alternative, if the speculator believes that a currency will depreciatedepreciate (e.g., the dollar to fall form KD 0.300 (current forward (e.g., the dollar to fall form KD 0.300 (current forward rate) to KD 0.295) in three months, he could: rate) to KD 0.295) in three months, he could:

purchase an option to purchase an option to sellsell a specific amount of the currency a specific amount of the currency in three in three months at KD 0.300.months at KD 0.300.

If the speculator was right (after 3 months the spot rate is KD 0.295), If the speculator was right (after 3 months the spot rate is KD 0.295), he will exercise the option to make a profit of KD 0.005 for each he will exercise the option to make a profit of KD 0.005 for each dollar). dollar).

If the speculator is wrong, he will let the option If the speculator is wrong, he will let the option expireexpire unexercised unexercised and incurs only the option’s price.and incurs only the option’s price.

Long positionLong position: if a speculator purchase a foreign currency in the : if a speculator purchase a foreign currency in the expectation of reselling it at a expectation of reselling it at a higherhigher future spot rate. future spot rate.

Short positionShort position: if the speculator borrows or sells forward a currency : if the speculator borrows or sells forward a currency on the expectation of buying it at a future on the expectation of buying it at a future lowerlower rate to repay a foreign rate to repay a foreign exchange loan or honor a forward sale contract or option.exchange loan or honor a forward sale contract or option.


Stabilizing speculation:Stabilizing speculation: Refers to the purchase of a foreign currency when the domestic Refers to the purchase of a foreign currency when the domestic

price of it falls, on the expectation that it will rise thus leading to a price of it falls, on the expectation that it will rise thus leading to a profit. Or the sale of a currency when its rate rises in the profit. Or the sale of a currency when its rate rises in the expectation that it will soon fall. (expectation that it will soon fall. (i.e. in opposite directioni.e. in opposite direction))

Stabilizing expectations Stabilizing expectations moderatesmoderates fluctuations in exchange rates fluctuations in exchange rates over time and performs a useful functionover time and performs a useful function

Destabilizing speculation:Destabilizing speculation: Refers to the sale of a foreign currency when the exchange rate falls Refers to the sale of a foreign currency when the exchange rate falls

in the expectation that it will fall even more in the future. Or in the expectation that it will fall even more in the future. Or purchase a currency when its rate is rising on the expectation that it purchase a currency when its rate is rising on the expectation that it will rise even more in the future. (will rise even more in the future. (i.e. in the same directioni.e. in the same direction))

Destabilizing speculation Destabilizing speculation magnifiesmagnifies exchange rate fluctuations and exchange rate fluctuations and can disrupt international flow of trade and investment. can disrupt international flow of trade and investment.


Other speculation tactics.Other speculation tactics.

Any one who have to make payments in a foreign currency in the Any one who have to make payments in a foreign currency in the future can speculate by speeding up his payments if he expects the future can speculate by speeding up his payments if he expects the currency to rise, or delaying his payments if expects the currency currency to rise, or delaying his payments if expects the currency to fall. For example an importer expects exchange rate to rise he to fall. For example an importer expects exchange rate to rise he can place an order to pay for imports right away (leads). On the can place an order to pay for imports right away (leads). On the other hand, the exporter who expects the foreign exchange to rise other hand, the exporter who expects the foreign exchange to rise will want to delay deliveries and extend longer credit terms to will want to delay deliveries and extend longer credit terms to delay payments (lags)delay payments (lags)


Interest arbitrage and efficiency of foreign exchange marketsInterest arbitrage and efficiency of foreign exchange markets

Uncovered interest arbitrageUncovered interest arbitrage

Suppose that interest rate on 3 month T.B is 6% in New York and Suppose that interest rate on 3 month T.B is 6% in New York and 8% in Frankfurt.8% in Frankfurt.

The American investor may want to exchange $ for € and purchase The American investor may want to exchange $ for € and purchase EMU TBs, to earn an extra 2%. When the TBs matures the investor EMU TBs, to earn an extra 2%. When the TBs matures the investor exchange back his euros plus interest into dollars. By that time the exchange back his euros plus interest into dollars. By that time the euro may have depreciated so that he would get fewer dollars than euro may have depreciated so that he would get fewer dollars than he paid. If the euro depreciates by more than 2% the investor loses. he paid. If the euro depreciates by more than 2% the investor loses. (if the euro appreciates he would get an extra gain from the (if the euro appreciates he would get an extra gain from the appreciation of the euro) (appreciation of the euro) (this is an uncovered interest arbitragethis is an uncovered interest arbitrage) )

Covered interest arbitrageCovered interest arbitrage Investors of short term funds abroad generally want to avoid the Investors of short term funds abroad generally want to avoid the

foreign exchange risk by foreign exchange risk by covering interest arbitragecovering interest arbitrage. .


To do this the investor To do this the investor sells forwardsells forward the amount of foreign the amount of foreign exchange he invested plus interest with the maturity of the exchange he invested plus interest with the maturity of the investment.investment.

Covered interest arbitrage:Covered interest arbitrage: refers to the spot purchase of the refers to the spot purchase of the foreign currency to make the investment and the offsetting foreign currency to make the investment and the offsetting simultaneous forward sale of it (simultaneous forward sale of it (swapswap) to cover the risk. ) to cover the risk.

Since the currency with the higher interest rate is Since the currency with the higher interest rate is usually at a usually at a forward discount (why?),forward discount (why?), the the net return on investment is roughly net return on investment is roughly the interest differential minus the the interest differential minus the forward discountforward discount..


covered interest rate arbitrage parity (CIAP).covered interest rate arbitrage parity (CIAP).

As covered interest arbitrage continues, the possibility of gains As covered interest arbitrage continues, the possibility of gains diminishesdiminishes until it is completely until it is completely wiped outwiped out. This occurs for two . This occurs for two reasons:reasons:

1.1. As funds transferred from New York to Frankfurt, the interest As funds transferred from New York to Frankfurt, the interest rate rises in New York and falls in Frankfurt. Interest differentials rate rises in New York and falls in Frankfurt. Interest differentials diminishdiminish..

2.2. The purchase of euros in the spot market increases the rate and The purchase of euros in the spot market increases the rate and the sale of euro in the forward market reduces the forward rate. the sale of euro in the forward market reduces the forward rate. The forward discountThe forward discount on the euro on the euro risesrises. .

- Both reasons cause the net gain to fall until it becomes zero. Then Both reasons cause the net gain to fall until it becomes zero. Then the euro is said to be at the euro is said to be at covered interest rate arbitrage paritycovered interest rate arbitrage parity ((CIAPCIAP). The interest differential in favor of the foreign monetary ). The interest differential in favor of the foreign monetary center is equal to the forward discount on the foreign currency. center is equal to the forward discount on the foreign currency.


Covered interest arbitrage parity Covered interest arbitrage parity

Look at figure 5, where i = the domestic interest rate and i*= the Look at figure 5, where i = the domestic interest rate and i*= the foreign one. foreign one.

The vertical axis is interest rate differentials. The vertical axis is interest rate differentials. Negative valuesNegative values indicates that foreign interest rate is indicates that foreign interest rate is higherhigher than the domestic than the domestic one, and one, and positive positive indicates that the foreign interest is indicates that the foreign interest is lessless than than the domestic one. the domestic one.

The horizontal axis measures the forward discount (-) or forward The horizontal axis measures the forward discount (-) or forward premium (+). premium (+).

The solid diagonal line indicates all points ofThe solid diagonal line indicates all points of covered interest covered interest arbitrage parityarbitrage parity (CIAP), i.e., (CIAP), i.e., ((i-i*=FDi-i*=FD))


At At CIAPCIAP line, when (i-i*)=-1, the foreign currency is at a line, when (i-i*)=-1, the foreign currency is at a forward discount of 1% a year, and a positive differential of 1 forward discount of 1% a year, and a positive differential of 1 indicates a forward premium of 1%, finally when the interest indicates a forward premium of 1%, finally when the interest differential is zero, there is neither a forward discount nor a differential is zero, there is neither a forward discount nor a forward premium. forward premium.

Below the CIAP line, either the negative interest differentials (in Below the CIAP line, either the negative interest differentials (in favor of the foreign currency) favor of the foreign currency) exceedsexceeds the forward discount on the forward discount on the foreign currency, or forward premium the foreign currency, or forward premium exceedsexceeds the positive the positive interest differentials. In either case there will be a net gain from interest differentials. In either case there will be a net gain from covered interest arbitrage (CIA) outflow, e.g., point A. covered interest arbitrage (CIA) outflow, e.g., point A. where where interest differential is 2, in favor of the foreign currency, while the interest differential is 2, in favor of the foreign currency, while the forward discount is 1%forward discount is 1% CIA margin is 1%CIA margin is 1% in favor of the foreign in favor of the foreign nation leading to capital outflow. Similarly point A’ involves a nation leading to capital outflow. Similarly point A’ involves a forward premium of 2% on the foreign currency and a positive forward premium of 2% on the foreign currency and a positive interest differential of only 1% in favor of the domestic currencyinterest differential of only 1% in favor of the domestic currency investors have an incentive to invest abroad. investors have an incentive to invest abroad.


Figure 5

i-i* = FD (FP)

No CIA

At A’: i-i*<FP +ve CIA

At A: i-i*>FD +ve CIA

At B’: i- i*<FD -ve CIA

At B: i-i*>FP -ve CIA

Note CIA ends up here before reaching the CIA line

In favor of the nation

In favor of the foreign nation


As arbitrage outflow continues, the net gain diminishes and As arbitrage outflow continues, the net gain diminishes and tends to disappear. Starting from A, the transfer of funds tends to disappear. Starting from A, the transfer of funds reduces interest differentials in favor of the foreign currency, reduces interest differentials in favor of the foreign currency, and increases forward discount on it (e.g., from 1 – 1.5), and and increases forward discount on it (e.g., from 1 – 1.5), and reduces the premium (say from 2 to 1.5) so as to reach again reduces the premium (say from 2 to 1.5) so as to reach again the CIAP line.the CIAP line.

Above the interest parity line, either the positive interest Above the interest parity line, either the positive interest differential exceeds the forward premium on the foreign differential exceeds the forward premium on the foreign currency (point B) or the negative interest differential is currency (point B) or the negative interest differential is smaller than the forward discount on the foreign currency smaller than the forward discount on the foreign currency (point B’). In both cases it pays off for foreigners to invest in (point B’). In both cases it pays off for foreigners to invest in our country our country an arbitrage inflow. an arbitrage inflow.


As arbitrage continues, the As arbitrage continues, the gain diminishesgain diminishes and then and then disappears when the CIAP is reached. disappears when the CIAP is reached.

Note that in reality interest arbitrage will come to an end when Note that in reality interest arbitrage will come to an end when the net gain reaches about ¼ of 1% a year (white area between the net gain reaches about ¼ of 1% a year (white area between dashed line and the diagonal).dashed line and the diagonal).

Covered interest arbitrage marginCovered interest arbitrage margin

CIAP line indicates either that the negative interest differential CIAP line indicates either that the negative interest differential (in favor of the foreign center) equals the forward discount FD (in favor of the foreign center) equals the forward discount FD on the foreign currency, or the positive interest differentials (in on the foreign currency, or the positive interest differentials (in favor of the domestic center) equals the forward premium FP favor of the domestic center) equals the forward premium FP on the foreign currency, i.e.,on the foreign currency, i.e.,


i-i* = FD if i-i* = FD if or;or;CIAPCIAP

i-i* = FP i-i* = FP But since FD(FP) = (FR-SR)/SR measures the FD if SR>FR or the But since FD(FP) = (FR-SR)/SR measures the FD if SR>FR or the

FP if SR<FR, the foregoing condition for CIAP can be written as:FP if SR<FR, the foregoing condition for CIAP can be written as:

i-i* = (FR-SR)/SRi-i* = (FR-SR)/SR The covered interest arbitrage margin CIAM or the margin gain The covered interest arbitrage margin CIAM or the margin gain

from covered interest arbitrage can be written asfrom covered interest arbitrage can be written as

CIAM =(i-i*)-FD or FPCIAM =(i-i*)-FD or FP

More precisely as:More precisely as:

CIAM = (i-i*) / (1+i*) – (FR-SR)/SRCIAM = (i-i*) / (1+i*) – (FR-SR)/SR

Where(1+i*) is a weighting factor. Where(1+i*) is a weighting factor.


Example: Example:

If the interest rate on a three month TB is 6% in New York (on an If the interest rate on a three month TB is 6% in New York (on an annual basis), and 8% in Frankfurt. annual basis), and 8% in Frankfurt.

The spot rate of the € is $1/ €1. The spot rate of the € is $1/ €1.

The three month forward rate is $.99/€1 on an annual basis.The three month forward rate is $.99/€1 on an annual basis.

CIAM CIAM = (0.06-0.08)/(1+0.08)-(0.99-1)/1= (0.06-0.08)/(1+0.08)-(0.99-1)/1

= (-.02)/1.08-(-.01)/1= (-.02)/1.08-(-.01)/1

= -.01852+.01= -.01852+.01

= = -.00852 (per year) -.00852 (per year)

The negative sign (The negative sign (in favor of the foreign centerin favor of the foreign center) refers to a CIA ) refers to a CIA outflow or outflow or investing in Frankfurtinvesting in Frankfurt. .


The extra return per dollar invested in Frankfurt is .852% The extra return per dollar invested in Frankfurt is .852% per year or per year or .213% per quarter.213% per quarter, i.e., for a $ 10 million , i.e., for a $ 10 million invested in Frankfurt, means an invested in Frankfurt, means an extra return of $21300extra return of $21300 for investing in three month EMU TB with the foreign for investing in three month EMU TB with the foreign exchange risk covered. exchange risk covered.

Deduct from that the transactions costs. If these are ¼ % Deduct from that the transactions costs. If these are ¼ % a year (i.e., 1/16 % per quarter), i.e. 1/16 of 1% i.e., a year (i.e., 1/16 % per quarter), i.e. 1/16 of 1% i.e., 0.000620 times the $10 million which is $6250. 0.000620 times the $10 million which is $6250.

The net gain = $21300 - $6250 = $15050 for three The net gain = $21300 - $6250 = $15050 for three monthsmonths


In reality Covered interest arbitrage margins are In reality Covered interest arbitrage margins are sometimes observed, not because the covered interest sometimes observed, not because the covered interest arbitrage does not work, but it may be due to other arbitrage does not work, but it may be due to other forces. For example:forces. For example:

1.1. High tax rate abroad may exceedHigh tax rate abroad may exceed the CIAM in favor of the CIAM in favor of the foreign monetary center so that no arbitrage the foreign monetary center so that no arbitrage outflows takes placeoutflows takes place

2.2. Investors may not take advantage of a CIAM in favor of Investors may not take advantage of a CIAM in favor of a foreign monetary center if they fear that the a foreign monetary center if they fear that the foreign foreign government might defaultgovernment might default or impose restriction on or impose restriction on foreign capital repatriation.foreign capital repatriation.

3.3. Large and persistent CIAM may exist because of Large and persistent CIAM may exist because of lack of lack of informationinformation on foreign investment opportunities in on foreign investment opportunities in LDCs’ financial market.LDCs’ financial market.


Efficiency of foreign exchange marketsEfficiency of foreign exchange markets

In general a market is efficient if it reflects all available In general a market is efficient if it reflects all available information.information.

A foreign exchange market is efficient if forward rates accurately A foreign exchange market is efficient if forward rates accurately predict the future spot rates. predict the future spot rates.

If forward rates reflect all available information and quickly If forward rates reflect all available information and quickly adjust to any new information so that investors can not earn adjust to any new information so that investors can not earn consistent and unusual profits by utilizing any available consistent and unusual profits by utilizing any available information, then the market is efficient. information, then the market is efficient.

Tests of efficiency are difficult to formulate and interpret. Tests of efficiency are difficult to formulate and interpret.


Key TermsKey Terms

AppreciationAppreciation ArbitrageArbitrageCovered interest arbitrageCovered interest arbitrage Covered interest arbitrage margin Covered interest arbitrage margin

(CIAM)(CIAM)Covered interest arbitrage parity (CIAP)Covered interest arbitrage parity (CIAP) Cross Exchange rateCross Exchange rateCurrency swapsCurrency swaps DepreciationDepreciationDestabilizing speculationDestabilizing speculation Effective exchange rateEffective exchange rateEfficiency of foreign exchange marketsEfficiency of foreign exchange markets Exchange rateExchange rateForeign exchange futuresForeign exchange futures Foreign exchange marketForeign exchange marketForeign exchange optionsForeign exchange options Foreign exchange risk Foreign exchange risk Forward discountForward discount Forward premiumForward premiumOffshore depositsOffshore deposits Forward rateForward rateHedgingHedging Interest arbitrageInterest arbitrageSpeculationSpeculation Spot rateSpot rateStabilizing speculationStabilizing speculation Uncovered interest arbitrageUncovered interest arbitrageVehicle currencyVehicle currency

Documents

Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University Economics of International Finance Econ. 315 Chapter 2 Foreign Exchange Markets