BUSI 163 Notes
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Transcript of BUSI 163 Notes
7/29/2019 BUSI 163 Notes
http://slidepdf.com/reader/full/busi-163-notes 1/22
Chapter 1 2/2/2013 11:23:00 AM
3 Kinds of FX Markets:
Spot Market - By and sell based on current price
Forward Market – By currency today at pre-determined price, but
complete transaction at a time specified in the future
Swap Market – Return to this topic later in class
FX Market has no physical location (trade in OTC market)
Open 24 hours on weekdays (flexible)
How money – invest for speculative returns vs. long-run return
If you do not have regulations in place, you should not open your
market to speculators (East Asian Crisis of 1998)
Indirect quote => foreign currency/home currency
Direct quote => home currency/foreign currency
Banks or airports
Easier for a domestic person to understand
Cross-rate => foreign currency/foreign currency
0.0001 = 1 basis point = .01%
Spot Market
Cross-rate example: Derive CAD/EUR cross-rate
$0.98 USD/CAD
$1.22 USD/EUR
(1.22 USD/EUR) / (0.98 USD/CAD)
= 1.2449 CAD/EUR
Sometimes in the business world, it is possible to find cross-rate that does
not match the mathematical derivative
Way to make profit by taking advantage of the difference
Arbitrage = risk-free profit
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Now that trading is done by computer, arbitrage is no longer
possible
Currency change given a direct quote:
(Ending Price – Opening Price) / Opening Price If given an indirect quote, convert to direct quote first
o 1 / indirect quote
If given a cross-rate, ensure that your are consistent
FX Currency Change Example 1:
Day 1: 0.98 USD/CAD
Day 2: 1.02 USD/CAD
(1.02-0.98)/0.98 = .0408 (4 decimal places)
CAD appreciated against USD by 4.08%
FX Currency Change Example 2 (cross-rate):
Day 1: 1.23 CAD/EUR
Day 2: 1.19 CAD/EUR
(1.19-1.23)/1.23 = -.0325
EUR depreciated against CAD by 3.25%
Absolute Bid-Ask Spread Example: Dealer buys at 1.2000 USD/EUR (Bid Price)
Dealer sells at 1.2200 USD/EUR (Ask Price)
1.22 – 1.20 = $0.02 USD profit (Absolute Bid-Ask Spread)
If turnover/volume is low, the dealer will charge higher commission to make
profit
If currency is very liquid, profit margin is small but turnover/volume is high
(allowing them to make profits)
Relative Bid-Ask Spread
(Ask price – Bid price) / Ask price
Used to standardize the bid-ask spread because it gives a
percentage value
Allows you to measure transaction cost
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Relative Bid-Ask Spread Example:
Dealer buys at 1.2000 USD/EUR (Bid Price)
Dealer sells at 1.2200 USD/EUR (Ask Price)
(1.22-1.2)/1.22 = 1.64% (Relative Bid-Ask Spread) If trading $1000 USD,
o $1000 * 1.64% = $16.40 (Transaction Cost)
Relative Bid-Ask Spread (transaction cost) Example:
Buy EUR, sell 1000 USD to the dealer
1000 USD / (1.22 USD/EUR) = 819.67 EUR
Sell 819.67 EUR back to the dealer and buy USD
819.67 EUR * 1.20 USD/EUR = $983.60 USD
$983.60 - $1000 = -$16.40 (transaction cost)
Transaction cost is round trip
OANDA FX Game
Example: EUR/USD
o EUR = primary currency
o USD = secondary currency
Buying/selling the primary currency for/with the secondary currency
XAU = gold XAG = silver
Short sell – selling an asset that you do not have
Borrow from the dealer
Sell acquired asset in the market for current (market) price
(Hopefully) when the asset drops in the market, you buy back the
asset and return it to the dealer (plus interest)
Margin Account
Only have to pay a portion of the price (borrow the rest)
Have to put more into your account (margin call) if you losses
exceed the amount you put in
o If you do not put more money into your account, the dealer
will close it
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Dealer charges interest for the time you buy on margin
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Goal of financial management?
Maximize Cash flow
Maximize Profit
Maximize Market share
Corporate company structure
Assets (controlled by mangers/employees)
Debt holders (liability)
Shareholders (equity)
Must act in the best interest of shareholders
Shareholder’s value
Stock price * #shares outstanding
Firm value = CF1 /(1+i) + CF2 /(1+i)2+…+CFn /(1+i)n
i=discount rate
discount rate reflects rate of return you are expecting given the risk
of the company
Increase firm value by increasing cash flows and/or decreasing risk
Reason’s for going abroad
Develop new markets Cheap labor
Outsourcing (costs, strengths of labor force)
Regulation at home
Risk diversification
Natural resources
International risks
Political risk
Foreign market risk
Cultural difference
Natural disaster
Differing management style
Control
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Corporation benefits
Limited liability
Easier to raise capital
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Current Account
Trade Balance = Export – Import
Surplus (if positive) or Deficit (if negative) GDP = Consumption + Investment + Government Spending +
Trade Balance
1) Inflation
Inflation of U.S.
o Inversely related with U.S. export
o Directly related with U.S. import
Inflation of foreign country
o Directly related with U.S. export
o Inversely related with U.S. import
2) FX Rate
US FX Rate
o Inversely related with U.S. export
o Directly related with U.S. import
Depreciation alone is an ineffective policy
o Competitors cut their own price/depreciate their own currencyo Transfer price / Inter-firm trade
International trade between subsidiaries of single MNC
Not effected by external exchange rate
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J-curve
Negative in short run due to delays
o Contract signed 2-3 months before shipping products
o Shipping takes another 2-3 months
o 90 days for accounts receivable period
Trade balance = (USD price * # units exporting) – (foreign price *
# units importing)
o Even if FX rates change, short term demand is already set by
contract (# units)
o Adjustment occurs in the long run
3) US National Income
Inversely related with U.S. export
Directly related with U.S. import
Wealth Effect
Tariff (only US) or Quota (only US) or Dumping or Government Subsidies
US Export up, US Import down, Trade Balance up
Harder to see effect if trade partners also introduce tariffs
o Hurt international trade
Known as trade frictions
Financial Account
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Foreign Direct Investment Economic growth/strength
Institutions (government/culture)
Tax
Government PolicyInternational Portfolio Investment
Interest rate
o Attracts “Hot money” – not good for economy
Tax
Government Policy
Others
Fixed exchange regime All countries fix their exchange rates to USD
After WWII
o US had the gold to support the currencies
Bretton Woods Agreement
Ends in 1971
o France first to say USD is overvalued
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Unholy Trinity – Can only achieve 2 at once
Currency stability
Open capital market
Independent monetary policy
Effects of having a fixed rate currency
Exporting inflation
o Hong Kong rate fixed to USD
Inflation in US goes up
Demand for Hong Kong products go up
Prices in Hong Kong go up
Exporting unemployment
o US unemployment goes up
Imports go down
o Demand for Hong Kong products goes down
Hong Kong job cuts up
Unemployment up
Examples of FX Markets (Japan Perspective)
Spot market
o Sell yeno Buy dollar
Forward market
o Buy yen
o Sell dollar
Swap market
o Selling today
o Repurchase in the future at a fixed price
Currency Inventory Cost
Opportunity cost of keeping cash in banks
The higher the interest rate on currency, the higher the opportunity
cost
Euro prefix – describe offshore currencies
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Eurodollar – name to describe offshore US dollars
Euroeuro – name to describe offshore euros
Syndicator
Group of banks that share risk/loans given to client Lead bank to organize administration between banks
International bond market
Loan maturity generally greater than 5 years
o Due to large size of the bond
2 Types of bonds
o Eurobond – currency denomination of bond is different from
the issuing county’s currency
Bearer form – anonymous owner / amount of bond
Attractive for investors looking to avoid taxes on
income generated from investment
o Foreign bond - currency denomination of bond is same as the
domestic market’s currency
Capital Reserve
Amount that banks have on hand
Focus on standardization reserve requirementso Basel Accord – 8%
ADR – American Depository Receipt
Foreign firm -> US Depository Bank -> ADR -> US Investors
ARD I only traded in OTC market
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Financial Derivatives 2/2/2013 11:23:00 AM
Hedging strategy to reduce risk
Foreign exchange rate risk
o Exporting
Receive foreign currency
If FX rate depreciates, revenue goes downo Importing
Pay foreign currency
If FX rate appreciates, cost to import goes up
Forward Contract
o Example:
Forward Contract for 3 months later at $1.00/euro
Current FX rate $1.00/euro
Future FX rate $1.50/euro
($1.50/euro - $1.00/euro) * 10,000 euro = $5,000 =
price of contract
Buy 10,000 euro at $1.00/euro using contract for
$10,000
Sell 10,000 euro in the market and get $15,000
$5,000 profit
o Both buyer and seller are bound to the contract
Hedging Strategies Payable of foreign currency (import)
o Buy forward
o Buy futures
o Buy call option
Receivable of foreign currency (export)
o Sell forward
o Sell futures
o Buy put options
Need to make payment of Euros in three months (hedge against
euro rising)
o Buy euro forward (for large institutional investors)
o Buy euro futures
o Buy call option
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Forwards & Futures 8/30/2012 4:57:00 PM
Parts of a Forward Contract
1. Quantity
2. Future Date
3. Type of Assets
4. Price of Assets5. Buyer and Seller
i. Obligation to buy and sell at agreed upon date in the future at
agreed upon price
ii. Can only be traded OTC
Forward rate = rate 3 months in the future
Forward premium (When Forward rate > Spot rate)
Expectation of how much the currency will appreciate in the future
Forward discount (When Forward rate < Sport rate)
Expectation of how much the currency will depreciate in the future
(Forward rate – Spot rate) / Spot rate = Forward premium or discount
Annualized forward premium or discount
Multiple by 4
Calculate Profit/Loss in Forward Contract
Buyer: (Forward rate – Spot rate) * Contract Size
Seller: (Spot rate – Forward rate) * Contract Size
Assuming no transaction cost
Futures contract is similar to a forward contract, but can be traded publically
on an organized securities exchange
Very liquid (can buy/sell in secondary market)
Highly structured
Mark-to-Market
Margin account – do not need to pay 100% of amount for the trade
Margin call if your account balance drops below maintain amount
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o Your account will be closed if you fail to pay
Cannot accumulate gains/losses like with a forward account
Buyer of Futures/Forward
Make money when FX futures go upSeller of Futures/Forward
Make money when FX futures go down
Forward contracts are only between individuals with very high credit ratings
since there is no oversight to avoid default
Held until maturity date
o Physical delivery
Illiquid market
Privately negotiated contract
Gains and losses calculated at the end of contract
The futures market is better for smaller traders, because the margin
accounts has measures to monitor/prevent default
Usually sell before maturity date in the market
o Cash settlement
Very liquid market
Highly standardized contract Gains and losses calculated on a daily basis using margin account
(mark-to-market)
Buyers/sellers of both forward and futures contracts are obligated to buy/sell
the assets in the contract at the agreed upon price at maturity date
Example: Futures Contract
Buyer
o Maintainer’s Margin: $2,240
o Day 1
AUD futures: 100,000 AUD
.98 USD/AUD
Initial margin: $2450/contract
o Day 2
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1.00 USD/AUD
(1.00 – 0.98) * 100,000 * 100 = $200,000
Margin = 200,000 + (2,450*100) = $445,000
o Day 3
.97 USD/AUD (0.97 – 1.00) * 100,000 *100 = -$300,000
Margin = -300,000 + $445,000 = $145,000
(Margin Call)
$224,000 - $145,000 = $79,000 to margin
account to maintain
Cross-hedging (in futures contract)
Due to standardization, you may not be able to find the exact asset
you are looking to hedge against
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Options 8/30/2012 4:57:00 PM
Buyer has the right to choose if they want to buy at maturity date
Seller has the obligation to sell at maturity date
Call Option
Give the buyer the right to buy underlying assetsPut Option
Give the buyer the right to sell underlying assets
Time t = future time when contract reaches maturity
Buyer Seller
Call Option - Have the right to buy
underlying asset at a fixed price
at time t (when you expect price
to go up)
- Pay premium to the seller
- Have the obligation to sell
underlying asset at a fixed price
at time t
- Receive premium from buyer
Put Option - Have the right to sell
underlying asset at a fixed price
at time t (when you expect price
to go down)
- Pay premium to the seller
- Have the obligation to buy
underlying asset at a fixed price
at time t
- Receive premium from buyer
Call Option contract
Exercise/Strike Price
Quantity
Time (date)
Asset Type
Premium
European Options vs. American Options American Option has a higher premium because it has more
flexibility
o Can buy the underlying asset at any date vs. only at
expiration for European option
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Example: European call option
100,000 euros
Strike price = $1.20/euro
Premium = $.02/euro Buyer: If euro FX rate (St) = $1.30/euro
o Exercise call option because strike price <St
o (100,000 euro * $1.20/euro) + (100,000 euro * $.02/euro) =
$122,000 USD = cost of euros
Profit on option of $8,000
Buyer: If euro FX rate (St) = $1.10/euro
o Do not exercise call option because strike price > St
o (100,000 euro * $1.10/euro) + (100,000 euro * $.02/euro) =
$112,000 USD = cost of euros
Loss on option of $2,000
Call Option Generalizations
Strike price (X) < Market price (St)
o Exercise the call
o “In the money”
(St – X – premium) * Contract Size
Strike price (X) > Market price (St)o Do not exercise the call
o “Out of the money”
premium * contract size
Call option premium determinants
Risk of underlying asset price positively related positively related to
option value premium
Time to maturity positively related to option value premium
Market price(St) positively related to option value premium
Strike price(s) negatively related to option value premium
Option Pricing Boundaries
Lower Bounds
o Call option premium > Max (0, S-X)
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o Put option premium > Max (0, X-S)
Upper Bounds
o Call option premium < S
o Put option premium < X
Where S is the underlying spot exchange rate; X is the exerciseprice of the option
Option Strategies
Long Straddle
o Buy both a call option and a put option
o o Expect volatility
o Profit on upside and downside
o Expensive Short straddle
o Sell both a call option and a put option
o Long Strangle
o Buy 1 out of the money call and 1 out of the money put
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o Short Strangle
o Sell 1 out of the money call and 1 out of the money put
o
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Swaps 8/30/2012 4:57:00 PM
Exchange cash flows at periodic intervals
Interest rate swap
Decide you want to switch between fixed or floating rate without
refinancing
Currency swap Switch currencies based on specific exchange rates an fixed or
floating interest rates
Example
US firm wants to finance 1000000 euro plant in UK
British firm wants to borrow $1.6 million
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International Parity Conditions 8/30/2012 4:57:00 PM
F = S0 * (1+i$) / (1+if )
Fisher Effect
Nominal Interest Rate= Real Interest Rate+ Inflation Rate
Higher interest rate = higher spot rate
Higher interest rate = lower exchange rate
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Risk Exposure 8/30/2012 4:57:00 PM
USD FX Rate Up
Company A Net Income Down 2%
Company B Net Income Down 2%
o More exposed to risk
3 Types of Exposure in FX Market
Transactional Exposure
o Hedge with Contracts
o Amount and Timing
o Receivable (Fear depreciation of foreign currency)
Buy put option to lock rate at fixed price at future time
Sell futures of foreign currency
Sell forward of foreign currency
o Payable (Fear appreciation of foreign currency)
Buy call option to lock rate at fixed price at future time
Buy futures of foreign currency
Buy forward of foreign currency
o Translation Exposure
FX Rates affect numbers on accounting statements