Week2:InternationalFinancialMarkets&ExchangeRateDeterminants

Ch3:InternationalFinancialMarkets

ForeignExchangeMarket• Allowsfortheexchangeofonecurrencyforanother• Exchangeratespecifiestherateatwhichonecurrencycanbeexchangedforanother

HistoryofForeignExchange

• GoldStandard(1876–1913)o Eachcurrencywasconvertibleintogoldataspecifiedrateo SuspendedwhenWW1beganin1914

• AgreementsonFixedExchangeRateso BrettonWoodsAgreement1944-1971o SmithsonianAgreement1971-1973

• FloatingExchangeRateSystemo Widelytradedcurrencieswereallowedtofluctuateinaccordancewith

marketforcesForeignExchangeTransactions

• Theoverthecountermarketisthetelecommunicationsnetworkwherecompaniesnormallyexchangeonecurrencyforanother

• FOREIGNEXCHANGEDEALERSo Intermediariesintheforeignexchangemarket

• SPOTMARKETo Aforeignexchangetransactionsforimmediateexchangeissaidtotradein

SPOTMARKETatSPOTRATE• SpotMarketStructure:

o Tradingbetweenbanksoccurintheinterbankmarket• UseoftheUSDinspotmarkets

o USDiscommonlyacceptedmediumofexchangeinthespotmarket• SPOTMARKETTIMEZONES

o Conductedonlyduringnormalbusinesshoursinagivenlocationo Atanygiventimeonaweekday,somewhereintheworldabankisopenand

readytoaccommodateforeignexchangerequests• SPOTMARKETLIQUIDITY

o MorebuyersandsellersmeansmoreliquidtyForeignExchangeQutations

• Atanygivenpointintime,abank’sbid(buy)quoteforaforeigncurrencywillbelessthanitsask(sell)quote

• Bid/Askspreadofbanks;thebid/askspreadcoversthebank’scostofconductingforeignexchangetransactions

• ComparisonofBid/AskSpreadamongcurrencies;

•

• FactorsthataffecttheSpread

• Ordercostso Costsofprocessingorders,includingclearingcostsandthecostsofrecording

transactions• Remuneration

o Forprovisionofservice• Inventorycosts

o Costsofmaintaininganinventoryofaparticularcurrency• Competition

o Themoreintensethecompetition,thesmallerthespreadquotedbyintermediaries

• Volumeo Currenciesthathavealargetradingvolumearemoreliquidbecausethere

arenumerousbuyersandsellersatanygiventime• CurrencyRisk

o Economicorpoliticalconditionsthatcausethedemandforandsupplyofthecurrencytochangeabruptly

InterpretingForeignExchangeQuotationsDirectvsIndirectquotationsatonepointintime

• DirectQuotationo Representsthevalueoftheforeigncurrencyindollars(numberofdollarsper

currency)o Example:$1.40perEuro

• IndirectQuotationo Representsthenumberofunitsofaforeigncurrencyperdollaro Example:Euro0.7143/Dollaro IndirectQuotation=1/DirectQuotation

Directvsindirectexchangerateovertime

• WhentheEUROisappreciatingagainstthedollar(basedonupwardmovementofthedirectexchangerateoftheeuro),theindirectexchangerateoftheeuroisdeclining

• WhentheEUROISDEPRECIATING(basedonadownwardmovementofthedirectexchangerate)againstthedollar,theindirectexchangerateisrising

Sourceofexchangeratequotations

• YahooFinance• Onlinesources(oanda.com)

CrossExchangeRates

• Crossexchangerateo Theamountofoneforeigncurrencyperunitofanotherforeigncurrency

• Example:o ValueofPeso=$0.07o ValueofCanadianDollar=$0.70

o ValueofpesoinC$=(ValueofPesoin$/ValueofC$in$)o =$0.07/$0.70=C$0.10

HowFinancialMarketsServeMNCsCorporatefunctionsthatrequireforeignexchangemarkets

• foreigntradewithbusinessclients• directforeigninvestment,ortheacquisitionofforeignrealassets• short-terminvestmentorfinancinginforeignsecurities• longer-termfinancingintheinternationalbondorstockmarkets

TheForeignExchangeMarket• “Traditional”turnover5.3trillionUSDperday(April2013)• 5primaryFXtradingcentres:

o UK(41%)o US(19%)o Singapore(6%)o Japan(6%)o HongKongSAR(4%)

• Dealerso FinancialinstitutionsthatactivelyparticipateinFXmarkets(tradingFXfor

themselvesortheircustomers)• OtherFinancialInstitutions

o Non-dealerinstitutions• Non-financialcustomers

o EveryoneelseReportedFXTurnover

• Dealer->Dealer(InterbankMarket)39%• Dealer->OtherFinancialInstitution53%

o Small/RegionalBanks24%o InstitutionalInvestors11%o HedgeFunds11%o OtherInstitutions6%o Centralbanks1%

• Dealer->Non-financialcustomers9%FXExecution

• Voice-directo Phone/notintermediated

• Voice-indirecto Phone,intermediatedbya3rdparty

• Electronic-Directo Executedoveranelectronicmedium,notintermediated

§ Singlebankelectronictradingsystem

§ Otherdirectelectronicmeans• ElectronicIndirect

o Executedoveranelectronicmedium,intermediated§ Interdealermarket;ReutersEikon/EBS§ Multibankdealingsystems

ForeignExchangeMarketTurnover

• MajorCurrencies(173%/200%)o USD87%o EUR33%o JPY23%o GBP11%o AUD9%o CHF5%o CAD5%

• OtherCurrencieso 2%;MXN,CNY,NZD,SEK,RUBo 1%:HKD,NOK,SGD,TRY,KRW,ZAR,BRL,INR,DKK,PLN

• Remainingcurrencies<0.5%

ExchangeRateQuotations• Noorganisationdecidesforeignexchangetradingstandards.• However,particularmarketconventionsarefollowed:

o ISO4217(Currencycode)o ASpotQuotation

§ UNIT*/CURRENCY§ AUD/USD§ 1AUD=??USD

o (*itismarketconventionforthecurrencybeforetheslashtorepresenttheunit(basecurrency))

• Currencybeforetheslashistheunit• CannotreadUNITDIVIDEDBYCURRENCY• AUD/USDtellsyouthatAUDistheunit• UNITWRITTENFIRST

ExchangeratequotationsineconomictextbooksandCFA

• AlleconomictextbookspresentquotationsinaformwhereA/B(representsAdividedbyB)

• CFALevel1,Book2,Reading21:o A/BreferstothenumberofunitsofcurrencyAthatoneunitofcurrencyB

willbuy• FINA3326=USEMARKETCONVETIONofUnit/Currency• PotentialStrategytoeliminateconfusion1) Thinkwhatisthesourceofthequotation(A/BtypicallymeansBdivA,butitcan

meanAdivB)

2) Converttoamathematicalformof

• What1Aussieisworth• 1AUDisworth=0.7534

• Buypricefirst,sellpricesecond• Buyquoteshouldbelowerthansellquote

o 0.7874isactuallylower(INDIRECTFORM)o Actualquote(buy)=1/0.7874=1.27o Actualquote(sell)=1/0.7142=1.40

• YoucantellitsINDIRECTifBUY>SELL• (remember;buyLOW,sellHIGH)• Pricethedealerispreparedtobuy

GOLDisquoteddirectly(Buy<Sell)

BidandAskQuotes

• TheBID–pricetheMARKETMAKERofferstoBUYcurrencyfromtheCUSTOMER• TheASK–pricetheMARKETMAKERofferstoSELLcurrencytothecustomer

o IfyouarebuyingthenyouhavetousetheASKpriceo Pricetheyarewillingtoselltoyou

• Point

o ThelastsignificantdigitBid/AskSpread

• 0.7874/0.7142• Thebid/askspreadis732points(pips)

o Representsdealersprofit• Acommissionisnotnormallycharged(largetrades)• Smalltransactions

o Chargearetailfee• Dealersprofitfromthebid/askspread

o Thebid/askspreadrepresentstheCOSTOFIMMEDIACYo Quotesareadjustedveryquicklyinresponsetonews,expectationsand

tradingstrategies• Determinantsofthebid/askspread

o Liquidityo Breadthanddepth(howmuchtradingisgoingonforthatcurrency)

DirectvsIndirect• DirectQuote

o AmountofHOMECURRENCYNEEDEDtoBUYaUNITOFFOREIGNCURRENCYo Foreigncurrency=thecurrencythedealerisofferingtobuyandsell

• Indirecto AmountofFOREIGNCURRENCYBOUGHTWITHaunitofHOMECURRENCY

• AustraliaisquotedinINDIRECTTERMS• Note:$1.0876/78iscommonlyused

o Thisnotationhasasimplicityadvantagewhenthespreadissmallo Eg1.0216/26or0.7827/30

IndirectQuotation Indirect(UnitnotFC)AUD/USD 0.7874/0.7142

USD=FC• ThemarketmakerofferstobuyUSDatarateof

o 0.7874USD=1AUDo 1USD=1.2700AUD

• ThemarketmakerofferstosellUSDatarateof

o 0.7142USD=1AUDo 1USD=1.4002AUD

DirectQuotation Direct(Unit=FC)USD/AUD 1.2700/1.4002

USD=FC• ThemarketmakerofferstobuyUSDatarateof

o 1.2700AUD=1USDo 1AUD=0.7874

• ThemarketmakerofferstosellUSDatarateofo 1.4002AUD=1USDo 1AUD=0.7142USD

DirectvsIndirect Direct IndirectAUD/USD 0.7142/0.7874

AUD=FC0.7874/0.7142USD=FC

USD/AUD 1.2700/1.4002USD=FC

1.4002/1.2700AUD=FC

• Equivalentquotations• Locationofthequotation–unimportant

AmericanvsEuropeanterms• Americanterms

o NumberofUSdollarsperunitofforeigncurrency• EuropeanTerms

o NumberofforeigncurrencyunitsperUSDUsingtheQuotation

• 1.YouhaveAUD1millionandwantUSdollarso 0.7874/0.7142

• 2.Doyouusethebidorask?o Whatdoyouendupwith?o Whattypeofquotationdowehave?

• ThemarketmakerofferstobuyUSDatarateofexchangeofo 1AUD=0.7874USD

• ThemarketmakerofferstosellUSDatarateofexchangeofo 1AUD=0.7142USD

• 3.AUD1mx0.7142=USD714,200Aroundtrip

• 1.YouhaveUSD714,200andwanttocovertitbacktoAussiedollars o 0.7874/0.7142

• 2.Doyouwantthebidortheask?o WhatdoIwanttodowiththequotedcurrency?o ThemarketmakerofferstobuyUSDatarateofexchangeof

§ 1AUD=0.7874o ThemarketmakerofferstosellUSDatarateofexchangeof

§ 1AUD=0.7142USD• 3.USD714,200/0.7874=AUD907,036

-You’vejustcompleteda‘roundtrip’andlost>9%onthisretailtransaction-Reality:With1mUSDyoucouldachievemorecompetitiverates

CrossRates

• Crossexchangerates:o Expresstherelationbetweentwocurrenciesthateachdifferfromone’s

basecurrency• IntheUS,thetermcrossexchangeratereferstotherelationshipbetweentwonon-

dollarcurrencies• TheUSDistradedin87%ofallFXtransactions(volumemeasure)

o Thiswas90%in2001• INTERBANKMARKET

o Notallpairsaretraded(increasedliquidity)o IwanttoconvertAUDtoSGD,viaUSD

§ 1AUD->USD->SGDo (ifnotdirectlyofferedintheinterbankmarket)o usethisbecauseofliquidity

CrossRateExample

• AUD/USD0.7293/0.7297• USD/SGD1.3700/1.3701• (DIRECTQUOTEONTHEAUDandSDG)

1AUD->0.7293USD-> (0.7293)(1.3700)SGD 0.9991SGD

• AUD/SGD• BidorAsk?Dependsonhowwewanttowritethisquotation

o DirectQuotation->Bid(thedealerisbuyingtheunitinourseriesoftransactions)

o Ifwewantedtowritethisasanindirectquotation,wecouldcallthisanaskquote(thedealerissellingyouthecounter).DealerSell=Ask

• Or,ConvertingSGDtoAUDviaUSD1SGD->(1/1.3701)USD-> (1/1.3701)(1/0.7297)AUD 1.0002AUD

• SGD/AUD(Direct=BID)DirectCrossRate

Chapter4:ExchangeRateDetermination

MeasuringExchangeRatemovements• Depreciation:declineinacurrency’svalue• Appreciation:increaseinacurrency’svalue• Comparingforeigncurrencyspotratesovertwopointsintime,SandSt-1

o o ApositivepercentchangeindicatesthatthecurrencyhasAPPRECIATEDo Anegativepercentchangeindicatesthatithasdepreciation

ExchangeRateEquilibrium• Theexchangeraterepresentsthepriceofacurrency,ortherateatwhichone

currencycanbeexchangedforanother• DEMANDFORACURRENCYincreaseswhenthevalueofthecurrencydecreases,

leadingtoadownwardslopingdemandschedule(SeeExhibit4.2)• SUPPLYOFACURRENCYFORSALEincreaseswhenthevalueofthecurrency

increases,leadingtoanupwardslopingsupplyschedule(EXHIBIT4.3)• EQUILIBIRUMequatesthequantityofpoundsdemandedwiththesupplyofpounds

forsale(EXHIBIT4.4)

FactorsthatInfluenceexchangerates• Theequilibriumexchangeratewillchangeovertimeassupplyanddemandschedule

changes

• RELATIVEINFLATIONRATESo IncreasesinUSinflationleadstoincreaseinUSdemandforforeigngoods,an

increaseindemandforforeigncurrency,andanincreaseintheexchangeratefortheforeigncurrency

o Morepurchasingofimports->requiremoreforeigncurrency->increasedemandofforeigncurrency->increaseintheexchangerate

o Supplywillmovetotheleft

o Valueofthepoundhasincreased(notasmanyUSDbeingbought)o ImpactofRisingUSInflationontheEquilibriumvalueoftheBritishPound:

• Relative Interest Rates

o Increase in US rates leads to increase in demand for US deposits and a decrease in demand for foreign deposits, leading to an increase in demand for dollars and an increased exchange rate for the dollar

o Invest those funds domestically o Not much demand to buy pounds (shift in demand to the left) – more attractive

to invest domestically o If you’re in the UK (UK interest rates the same), more attractive to buy USD

and invest at higher rate o Sell pound and buy USD o More supply of pound o Price of pound has fallen o Impact of rising US interest rates on the equilibrium value of the British

Pound

• Real Interest Rates o Fisher Effect o Real Interest Rate = Nominal Interest Rate – Inflation Rate

Argument that high interest rates pushes up the value of the currency today, but adds pressure in the future market when repayments/returns are being paid out.

• RELATIVEINCOMELEVELSo IncreaseinUSincomeleadstoincreasedinUSdemandforforeigngoodsand

increaseddemandforforeigncurrencyrelativetothedollarandanincreaseintheexchangeratefortheforeigncurrency

o ImpactofrisingUSincomelevelsonequilibriumvalueoftheBritishPound

• • GOVERNMENT CONTROLS via:

o Imposing foreign exchange barriers o Imposing foreign trade barriers o Intervening in foreign exchange markets o Affecting macro variables such as inflation, interest rates and income levels

Expectations

• IMPACTOFFAVOURABLEEXPECTATIONSo Ifinvestorsexpectinterestratesinonecountrytorise,theymayinvestin

thatcountryleadingtoariseinthedemandforforeigncurrencyandanincreaseintheexchangerateforforeigncurrency

• IMPACTOFUNFAVOURABLEEXPECTATIONSo Speculatorscanplacedownwardpressureonacurrencywhentheyexpectit

todepreciate• IMPACTOFSIGNALSONCURRENCYSPECULATION

o Speculatorsmayoverreacttosignalscausingcurrencytobetemporarilyovervaluedorundervalued

• InteractionofFactors:o Somefactorsplaceupwardpressurewhileotherfactorsplacedownward

pressure

• INFLUENCEOFFACTORSACROSSMULTIPLECURRENCYMARKETS

o CommonforEuropeancurrenciestomoveinthesamedirectionagainstthedollar

• INFLUENCEOFLIQUIDITYONEXCHANGERATEADJUSTMENTo Ifacurrency’sspotmarketisliquidthenitsexchangeratewillnotbehighly

sensitivetoasinglelargepurchaseorsale

MovementsinCrossExchangeRates• IfcurrenciesAandBmoveinthesamedirection,thereisnochangeinthecross

exchangerate• WhencurrencyAappreciatesagainstthedollarbyagreater(smaller)degreethan

currencyB,thencurrencyAappreciates(depreciates)againstB• WhencurrencyAappreciates(depreciates)againstthedollar,whilecurrencyBis

unchangedagainstthedollar,currencyAappreciates(depreciates)againstcurrencyBbythesamedegreeasitappreciates(depreciates)againstthedollar

Howforcesaffectthecrossexchangerate

CapitalisingonExpectedExchangeRateMovements• INSTITUTIONALSPECULATIONBASEDONEXPECTEDAPPRECIATION

o Whenfinancialinstitutionsbelievethatacurrencyisvaluedlowerthanitshouldbeintheforeignexchangemarket,theymayinvestinthatcurrencybeforeitappreciates

• INSTITUTIONALSPECULATIONBASEDONEXPECTEDDEPRECIATIONo Iffinancialinstitutionsbelievethatacurrencyisvaluedhigherthanitshould

beintheforeignexchangemarket,theymayborrowfundsinthatcurrencyandconvertittotheirlocalcurrencynowbeforethecurrency’svaluedeclinestoitsproperlevel

• SPECULATIONBYINDIVIDUALSo Individualscanspeculateinforeigncurrencies

Summary• Exchangeratemovementsarecommonlymeasuredbythepercentagechangein

theirvaluesoveraspecifiedperiod,suchasamonthorayear.MNCscloselymonitor

exchangeratemovementsovertheperiodinwhichtheyhavecashflowsdenominatedintheforeigncurrenciesofconcern.

• Theequilibriumexchangeratebetweentwocurrenciesatanytimeisbasedonthedemandandsupplyconditions.Changesinthedemandforacurrencyorthesupplyofacurrencyforsalewillaffecttheequilibriumexchangerate.

• Thekeyeconomicfactorsthatcaninfluenceexchangeratemovementsthroughtheireffectsondemandandsupplyconditionsarerelativeinflationrates,interestrates,andincomelevels,andgovernmentcontrols.Whenthesefactorsleadtoachangeininternationaltradeorfinancialflows,theyaffectthedemandforacurrencyorthesupplyofcurrencyforsaleandthustheequilibriumexchangerate.

• Therearedistinctinternationaltradeandfinancialflowsbetweeneverypairofcountries.Theseflowsdictatetheuniquesupplyanddemandconditionsforthecurrenciesofthetwocountries,whichaffecttheequilibriumcrossexchangeratebetweentheircurrencies.Movementintheexchangeratebetweentwonon-dollarcurrenciescanbeinferredfromthemovementineachcurrencyagainstthedollar.

• Financialinstitutionscanattempttobenefitfromtheexpectedappreciationofacurrencybypurchasingthatcurrency.Analogously,theycanbenefitfromexpecteddepreciationofacurrencybyborrowingthatcurrencyandexchangingitfortheirhomecurrency.