International Finance

International FinanceFIN456

Michael Dimond

Michael DimondSchool of Business Administration

The Trade Relationship

• Trade financing shares a number of common characteristics with traditional value chain activities conducted by all firms– All companies must search out suppliers for goods and services– Must determine if supplier can provide products at required

specifications and quality– All must be at an acceptable price and delivered in a timely manner

• Understanding the nature of the relationship between the exporter and the importer is critical to understanding the methods for import-export financing utilized in industry

• Three categories of relationships:– Unaffiliated unknown party– Unaffiliated known party– Affiliated party


The Trade Dilemma

• International trade must work around a fundamental dilemma:– Imagine an importer and an exporter who would like to do business

with one another– Because of the distance between the two, it is not possible to

simultaneously hand over goods and receive payments in person– How do participants in international trade mitigate the risks associated

with conducting business with a stranger?


Financing Trade: The Flow of Goods and Funds


Key Documents

• As we will see in the following exhibits, letters of credit, order bills of lading and sight drafts are critical in conducting international trade– An example of a letter of credit occurs when an importer obtains a

bank’s promise to pay on its behalf, knowing the exporter will trust the bank

– When the exporter ships the merchandise to the importer’s country, title to the merchandise is given to the bank on a document called an order bill of lading

– The exporter asks the bank to pay for the goods using a sight draft

– The bank, having paid for the goods, now passes title to the importer who eventually reimburses the bank


The Mechanics of Import and Export


The Bank as the Import/Export Intermediary


The Trade Transaction Time-Line and Structure


Letter of Credit (L/C)

• Letter of Credit (L/C) is a bank’s conditional promise to pay issued by a bank at the request of an importer in which the bank promises to pay an exporter upon presentation of documents specified in the L/C

• The essence of an L/C is the promise of the issuing bank to pay against specified documents, which means that certain elements must be present for the bank– Issuing bank must receive a fee for issuing L/C– Bank’s L/C must contain specified maturity date– Bank’s commitment must have stated maximum amount– Bank’s obligation must arise only on presentation of specific

documents and bank cannot be called on for disputed items– Bank’s customer must have unqualified obligation to reimburse

bank on same condition of bank’s payment


Letter of Credit (L/C)

• Commercial L/C’s are classified as follows– Irrevocable Vs. Revocable – irrevocable letters of credit are non-

cancelable while its opposite can be cancelled at any time– Confirmed Vs. Unconfirmed – An L/C issued by one bank can be

confirmed by another bank

• Advantages of L/Cs are that it reduces risk of default and a confirmed L/C helps secure financing

• Disadvantages of L/Cs are the fees charged and that the L/C reduces the available credit of the importer


Parties to a Letter of Credit (L/C)


Essence of a Letter of Credit (L/C)


Draft

• A draft, sometimes called a bill of exchange (B/E), is the instrument normally used in international commerce to effect payment– It is a written order by an exporter instructing an importer or its agent

to pay a specified amount at a specified time– The party initiating the draft is the maker, drawer, or originator while

the counterpart is the drawee– In a commercial transaction where the buyer is the drawee it is a

trade draft, or the buyer’s bank when it is called a bank draft


Draft

• If properly drawn, drafts can become negotiable instruments– As such they provide a convenient instrument for financing the

international movement of merchandise– To become a negotiable instrument, there are four requirements

• Must be written and signed by buyer

• Must contain unconditional promise to pay

• Must be payable on demand or at a fixed date

• Must be payable to bearer


Draft

• Types of drafts include– Sight drafts which is payable on presentation to the drawee– Time drafts, also called usance draft, allows a delay in payment. It is

presented to the drawee who accepts it with a promise to pay at some later date

• When a time draft is drawn on a bank, it becomes a banker’s acceptance

• When drawn on a business firm it becomes a trade acceptance


• Banker’s Acceptance– When a draft is accepted by a bank, it becomes a banker’s

acceptance– Example: Acceptance of $100,000 for exporter

– Exporter may discount the acceptance note in order to receive the funds up-front

Face amount of acceptance $100,000Less 1.5% p.a. commission for 6 months - 750Amount received by exporter in 6 months $ 99,250Less 7% p.a. discount rate for 6 months - 3,500Amount received by exporter at once $95,750

Banker’s Acceptances


Bill of Lading

• Bill of Lading (B/L) is issued to the exporter by a common carrier transporting the merchandise– It serves the purpose of being a receipt, a contract and a document of

title• As a receipt the B/L indicates that the carrier has received the

merchandise

• As a contract the B/L indicates the obligation of the carrier to provide certain transportation

• As a document of title, the B/L is used to obtain payment or written promise of payment before the merchandise is released to the importer


Bill of Lading

• Characteristics of the Bill of Lading– A straight B/L provides that the carrier deliver the merchandise to the

designated consignee only– An order B/L directs the carrier to deliver the goods to the order of a

designated party, usually the shipper– A B/L is usually made payable to the order of the exporter


Steps in a Typical Trade Transaction


Government Programs to Help Finance Exports• Governments of most export-oriented industrialized countries

have special financial institutions that provide some form of subsidized credit to their own national exporters

• These export finance institutions offer terms that are better than those generally available from the competitive private sector

• Thus, domestic taxpayers are subsidizing lower financial costs for foreign buyers in order to create employment and maintain a technological edge


Government Programs to Help Finance Exports• Export Credit Insurance

– Provides assurance to the exporter or the exporter’s bank that an insurer will pay should the foreign customer default

– In the US the Foreign Credit Insurance Association (FCIA) provides this type of insurance

• Export-Import Bank– Known as the Eximbank, it facilitates the financing of US exports

through various loan guarantee and insurance programs


Trade Financing Alternatives

• In order to finance international trade receivables, firms use the same financing instruments as they use for domestic trade receivables including;– Banker’s Acceptances– Trade Acceptances– Factoring– Securitization– Bank Credit Lines Covered by Export Credit Insurance– Commercial Paper


Forfaiting: Medium and Long Term Financing• Forfaiting is a specialized technique to eliminate the risk of

nonpayment by importers in instances where the importing firm and/or its government is perceived by the exporter to be too risky for open account credit

• The essence of forfaiting is the non-recourse sale by an exporter of bank-guaranteed promissory notes, bills of exchange, or similar documents received from an importer in another country

• The following exhibit outlines a typical forfaiting transaction


Typical Forfaiting Transaction


Parity Conditions & Currency Forecasting


International Parity Conditions

• The economic theories which link exchange rates, price levels, and interest rates together are called international parity conditions

• These theories may not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted


P$ S = P¥

Where the price of the product in US dollars (P$), multiplied by the spot exchange rate (S, yen per dollar), equals the price of the product in Japanese yen (P¥)

Prices and Exchange Rates

• The Law of one price states that all else being equal (no transaction costs) a product’s price should be the same in all markets

• Even if prices for a particular product are in different currencies, the law of one price states that


P

PS

¥

$

Prices and Exchange Rates

• Conversely, if the prices were stated in local currencies, and markets were efficient, the exchange rate could be deduced from the relative local product prices


Purchasing Power Parity & The Law of One Price• If the Law of One Price were true for all goods, the

purchasing power parity (PPP) exchange rate could be found from any set of prices

• Through price comparison, prices of individual products can be determined through the PPP exchange rate

• This is the absolute theory of purchasing power parity• Absolute PPP states that the spot exchange rate is

determined by the relative prices of similar basket of goods


Relative Purchasing Power Parity

• If the assumptions of absolute PPP theory are relaxed, we observe relative purchasing power parity– This idea is that PPP is not particularly helpful in determining what the

spot rate is today, but that the relative change in prices between countries over a period of time determines the change in exchange rates

– Moreover, if the spot rate rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot rate


Relative Purchasing Power Parity (PPP)


Relative Purchasing Power Parity

• Empirical tests of both relative and absolute purchasing power parity show that for the most part, PPP tends to not be accurate in predicting future exchange rates

• Two general conclusions can be drawn from the tests:– PPP holds up well over the very long term but is poor for short term

estimates– The theory holds better for countries with relatively high rates of

inflation and underdeveloped capital markets


Exchange Rate Indices: Real and Nominal• In order to evaluate a single currency’s value against all other

currencies in terms of whether or not the currency is “over” or “undervalued,” exchange rate indices were created– These indices are formed by trade-weighting the bilateral exchange

rates between the home country and its trading partners

• The nominal exchange rate index uses actual exchange rates to create an index on a weighted average basis of the value of the subject currency over a period of time


FC

$$N

$R C

C x E E

Exchange Rate Indices: Real and Nominal• The real effective exchange rate index indicates how the

weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period– Example: The real effective rate for the US dollar (E$ ) is found by

multiplying the nominal rate index (E$ ) by the ratio of US dollar costs (C$) over foreign currency costs (CFC)

R

N


Exchange Rate Indices: Real and Nominal

– If changes in exchange rates just offset differential inflation rates – if purchasing power parity holds – all the real effective exchange rate indices would stay at 100

– If a rate strengthened (overvalued) or weakened (undervalue) then the index value would be ± 100


S x PP BMW$BMW

€ €/$

Exchange Rate Pass-Through

• Incomplete exchange rate pass-through is one reason that country’s real effective exchange rate index can deviate from it’s PPP equilibrium point– The degree to which the prices of imported & exported goods

change as a result of exchange rate changes is termed pass-through

– Example: assume BMW produces a car in Germany and all costs are incurred in euros. When the car is exported to the US, the price of the BMW should be the euro value converted to dollars at the spot rate

– Where P$ is the BMW price in dollars, P€ is the BMW price in euros and S is the spot rate


14.29%or ,1429.1000,35$

000,40$

P

P$

1 BMW,

$2 BMW,

The degree of pass-through in this case is partial, 14.29% ÷ 20.00% or approximately 0.71. Only 71.0% of the change has been passed through to the US dollar price


– Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium level

– If the euro appreciated 20% against the dollar, but the price of the BMW in the US market rose to only $40,000, and not $42,000 as is the case under complete pass-through, the pass-through is partial

– The degree of pass-through is measured by the proportion of the exchange rate change reflected in dollar prices


• Prices between countries are related by exchange rates and now we discuss how exchange rates are linked to interest rates

• The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. As a formula, The Fisher Effect is

i = r + + r

Where i is the nominal rate, r is the real rate of interest, and is the expected rate of inflation over the period of timeThe cross-product term, r , is usually dropped due to its relatively minor value

Interest Rates and Exchange Rates


• Applied to two different countries, like the US and Japan, the Fisher Effect would be stated as

i = r + ; i = r + $ $ $ ¥ ¥ ¥

It should be noted that this requires a forecast of the future rate of inflation, not what inflation has been, and predicting the future can be difficult!



i i 100 x S

S S $

2

21 ¥


• The international Fisher effect, or Fisher-open, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries– if we were to use the US dollar and the Japanese yen, the

expected change in the spot exchange rate between the dollar and yen should be (in approximate form)



• Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates

• The international Fisher effect predicts that with unrestricted capital flows, an investor should be indifferent between investing in dollar or yen bonds, since investors worldwide would see the same opportunity and compete it away



• The Forward Rate– A forward rate is an exchange rate quoted today for settlement at

some future date– The forward exchange agreement between currencies states the rate

of exchange at which a foreign currency will be bought or sold forward at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days)

– The forward rate is calculated by adjusting the current spot rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies


36090

x i 1

36090

x i 1

x S F$

FC

FC/$FC/$90


• The Forward Rate


• The Forward Rate example with spot rate of Sfr1.4800/$, a 90-day euro Swiss franc deposit rate of 4.00% p.a. and a 90-day euro-dollar deposit rate of 8.00% p.a.

$Sfr1.4655/ 1.02

1.01 x Sfr1.4800

360

90 x 0.0800 1

360

90 x 0.0400 1

xSfr1.4800 Sfr/$90F



100 x days

360 x

Foward

Foward -Spot f FC

For direct quotes ($/FC), then (F-S)/S should be applied


• The forward premium or discount is the percentage difference between the spot and forward rates stated in annual percentage terms– When stated in indirect terms (foreign currency per home

currency units, FC/$) then formula is


Currency Yield Curves and the Forward Premium


p.a. 3.96% 100 x 90

360 x

Sfr1.4655

Sfr1.4655 - Sfr1.4800 f Sfr

100 x days

360 x

Foward

Foward -Spot f FC

The positive sign indicates that the Swiss franc is selling forward at a premium of 3.96% per annum (it takes 3.96% more dollars to get a franc at the 90-day forward rate)


– Using the previous Sfr example, the forward discount or premium would be as follows:


Interest Rate Parity (IRP)

• Interest rate parity theory provides the linkage between foreign exchange markets and international money markets

• The theory states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite sign to, the forward rate discount or premium for the foreign currency, except for transaction costs


Interest Rate Parity (IRP)

– In this diagram, a US dollar-based investor with $1 million to invest, is shown indifferent between dollar-denominated securities for 90 days earning 8.00% per annum, or Swiss franc-denominated securities of similar risk and maturity earning 4.00% per annum, when “cover” against currency risk is obtained with a forward contract


Covered Interest Arbitrage (CIA)

• Because the spot and forward markets are not always in a state of equilibrium as described by IRP, the opportunity for arbitrage exists

• The arbitrageur who recognizes this imbalance can invest in the currency that offers the higher return on a covered basis

• This is known as covered interest arbitrage (CIA)• The following slide describes a CIA transaction in much the

same way as IRP was transacted



• A deviation from CIA is uncovered interest arbitrage, UIA, wherein investors borrow in currencies exhibiting relatively low interest rates and convert the proceeds into currencies which offer higher interest rates

• The transaction is “uncovered” because the investor does not sell the currency forward, thus remaining uncovered to any risk of the currency deviating



• Rule of Thumb: – If the difference in interest rates is greater than the forward

premium (or expected change in the spot rate), invest in the higher yielding currency.

– If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.


UIA: The Yen Carry Trade


Interest Rate Parity (IRP) and Equilibrium


Forward Rates as an Unbiased Predictor• If the foreign exchange markets are thought to be “efficient”

then the forward rate should be an unbiased predictor of the future spot rate

• This is roughly equivalent to saying that the forward rate can act as a prediction of the future spot exchange rate, and it will often “miss” the actual future spot rate, but it will miss with equal probabilities (directions) and magnitudes (distances)


Forward Rate as an Unbiased Predictor


Prices, Interest and Exchange Rates in Equilibrium

• (A) Purchasing power parity – forecasts the change in the spot rate on the basis of differences in expected rates of

inflation

• (B) Fisher effect – nominal interest rates in each country are equal to the required real rate of return (r)

plus compensation for expected inflation ()

• (C) International Fisher effect – the spot exchange rate should change in an amount equal to but in the opposite

direction of the difference in interest rates between countries

• (D) Interest rate parity – the difference in the national interest rates should be equal to, but opposite in sign to,

the forward rate discount or premium for the foreign currency, except for transaction costs

• (E) Forward rate as an unbiased predictor – the forward rate is an efficient predictor of the future spot rate, assuming that the foreign

exchange market is reasonably efficient


International Parity Conditions in Equilibrium


Foreign Exchange Markets

• Provide the physical and institutional structure to – Exchange the money of one country for that of another– Determine the rate of exchange between currencies– Physically complete foreign exchange transactions

• A foreign exchange transaction is an agreement between a buyer & seller that a set amount of one currency will be delivered for some other currency at a specified rate

• Six main characteristics of the FOREX markets:– The geographic extent– The three main functions– The market’s participants– Its daily transaction volume– Types of transactions including spot, forward and swaps– Methods of stating exchange rates, quotations, & changes in rates


• Geographically, the FOREX market spans the globe with prices moving and currencies trading every hour of every business day

• Major world trading starts each morning in Sydney and Tokyo, then moves west to Hong Kong and Singapore & finishes on the West Coast of the U.S.

Geographic Extent of the Market


Geographic Extent of the Market


Functions of the FOREX Market

• The FOREX market is the mechanism by which participants– Transfer purchasing power between countries

• This is necessary as international trade and capital transactions normally involve parties living in countries with different national currencies

– Obtain or provides credit for international trade transactions• Inventories in transit must be financed

– Minimize exposure to exchange rate risk• FOREX markets provide instruments utilized in “hedging” or transferring

risk to more willing parties


Market Participants

• The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retail market

• Five broad categories of participants operate within these two tiers– Bank and non bank foreign exchange dealers– Individuals and firms conducting commercial or investment

transactions– Speculators and Arbitrageurs– Central banks and treasuries– Foreign exchange brokers


Bank and Non-bank Dealers

• These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price

• Competition among dealers narrows the spread between the bid and offer rate contributing to the market’s efficiency

• Dealers on behalf of large int’l banks often act as market makers, buy or sell these currencies without necessarily having a counterpart with which to unload the “inventory”

• They trade amongst other banks and dealers in order to keep their inventory levels at manageable levels

• Currency trading is profitable and often contributes between 10% - 20% of a banks’ average net income

• Small- to medium-sized banks participate in the interbank market but rarely act as market makers


Individuals and Firms

• Individuals and firms conduct transactions for commercial and investment purposes. For example:– Importers– Exporters– Portfolio investors– MNCs– Tourists

• Some of these participants use the market to hedge foreign exchange rate risk


Speculators and Arbitrageurs

• Speculators and arbitrageurs seek to profit from trading in the market itself

• They operate for their own interest, without need or obligation to serve clients or ensure a continuous market

• Speculators seek all their profit from exchange rate changes• Arbitrageurs try to profit from simultaneous differences in

exchange rates in different markets• A large proportion of speculation and arbitrage is conducted

on behalf of major banks by traders employed by those banks


Central Banks and Treasuries

• Central banks and treasuries use the market to acquire or spend their country’s currency reserves as well as to influence the price at which their own currency trades

• They may act to support the value of their currency because of their government’s policies or obligations or because of commitments entered through joint float agreements such as the European Monetary System (EMS)

• Consequently their motive is not to profit but rather influence the foreign exchange value of their currency in a manner that will benefit their interests


Continuous Linked Settlement

• Continuous Linked Settlement (CLS) system (since 2002) eliminates losses if either party unable to settle

• CLS links with Real-Time Gross Settlement (RTGS) systems in seven major currencies

• Eventually we expect same-day settlement instead of the current lag of two days

• The U.S. Commodity Futures Trading Commission (CFTC) regulates foreign exchange trading


Foreign Exchange Settlement in Europe


Transactions in the Interbank Market

• Transactions within this market can be executed on a spot, forward, or swap basis– A spot transaction requires almost immediate delivery of foreign

exchange– A forward transaction requires delivery of foreign exchange at some

future date– A swap transaction is the simultaneous exchange of one foreign

currency for another


Spot Transactions

• A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day– The settlement date is often referred to as the value date– This is the date when most dollar transactions are settled through the

computerized Clearing House Interbank Payment Systems (CHIPS) in New York


Outright Forward Transactions

• This transaction requires delivery at a future value date of a specified amount of one currency for another

• The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed

• Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months– Terminology typically used is buying or selling forward– A contract to deliver dollars for euros in six months is both buying

euros forward for dollars and selling dollars forward for euros


Swap Transactions

• A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

• Both purchase and sale are conducted with the same counterpart

• A common type of swap is a spot against forward– The dealer buys a currency in the spot market and simultaneously

sells the same amount back to the same bank in the forward market– Since this transaction occurs at the same time and with the same

counterpart, the dealer incurs no exchange rate exposure


Swap Transactions

• Forward-forward swaps – A dealer sells £20,000 forward for dollars for delivery in two months at $1.8420/£ and simultaneously buys £20,000 forward for delivery in three months at $1.8400/£– The difference between the buying and selling price is equivalent to

the interest rate differential– Thus a swap can be viewed as a technique for borrowing another

currency on a fully collateralized basis


Swap Transactions

• Non-deliverable forwards (NDFs) – NDFs possess the same characteristics as traditional forward contracts except that they are settled only in US dollars and the foreign currency being sold or bought forward is not delivered– The dollar-settlement feature reflects the fact that NDFs are

contracted offshore and are beyond the reach and regulatory frameworks of the home country governments

– Pricing of NDFs reflects basic interest rate differentials


Size of the FOREX Market

• The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be USD 3.7 trillion in April 2010– Spot transactions at $1,495 bn/day– Outright forward transactions at $475 bn/day– Swaps at $1,765 bn/day


Size of the FOREX Market

• The United Kingdom (London) and the United States (New York) make up roughly 55% of the foreign exchange market

• The London trade alone makes up 36.7% of daily transactions in the foreign exchange market, followed by the US (17.9%), Japan (6.2%), Singapore (5.3%), Switzerland (5.2%) and Hong Kong (4.2%)

• Asian markets growing more rapidly than European markets

Currency exchanges paired with the U.S. Dollar


Foreign Exchange Rates & Quotations• A foreign exchange quote is a statement of willingness to buy

or sell at an announced rate– In the retail market (newspapers and exchange booths), quotes are

often given as the home currency price of the foreign currency• Currency Traditional Symbol ISO 4217 Code

– U.S. dollar $ USD

– European euro € EUR

– Great Britain pound £ GBP

– Japanese yen ¥ JPY

– Mexican peso Ps MXN


Foreign Exchange Rates & Quotations• Interbank quotes – professional dealers or brokers may state

quotes in one of two ways– The foreign currency price of one dollar

• Sfr1.6000/$, read as 1.600 Swiss francs per dollar

– The dollar price of a unit of foreign currency• $0.6250/Sfr, read as 0.625 dollars per Swiss franc

• The former quote is considered to be in “European terms” and the latter is considered to be “American terms”

• Almost all European currencies, except two, are quoted the European way– The Pound Sterling and the Euro are the exceptions– Additionally, Australian and New Zealand dollars are also quoted in

American terms


Foreign Exchange Rates & Quotations

• Direct and Indirect Quotes– A direct quote is a home currency price of a unit of a foreign currency

• Sfr1.6000/$ is a direct quote in Switzerland

– An indirect quote is a foreign currency price in a unit of the home currency

• Sfr1.600/$ is an indirect quote in the US,

• $0.625/Sfr is a direct quote in the US and an indirect quote in Switzerland


Foreign Exchange Rates & Quotations• Interbank quotes are given as a bid and ask

– The bid is the price at which a dealer will buy another currency– The ask or offer is the price at which a dealer will sell another

currency

• For example the bid and ask for spot euros would probably be shown “1.2170/78” on a video screen.

• In some cases between professional traders, they may only quote the last two digits of both the bid and ask, “70-78” because they know what the other figures are.


Bid, Ask, and Mid-Point Quotations


Foreign Exchange Rates & Quotations• Expressing Forward Quotations on a Points Basis

– The previously mentioned rates for yen were considered outright quotes

– Forward quotes are different and typically quoted in terms of points– A point is the last digit of a quotation, with convention dictating the

number of digits to the right of the decimal• Hence a point is equal to 0.0001 of most currencies


Bid Ask

Outright spot: ¥118.27 ¥118.37

Outright forward: ¥116.84 ¥116.97

Plus points (3 months) -1.43 -1.40


• Expressing Forward Quotations on a Points Basis– The yen is quoted only to two decimal points– A forward quotation is not a foreign exchange rate, rather the

difference between the spot and forward rates– Example:


100 x days

360 x

Foward

Foward -Spot f FC


• Forward Quotations in Percentage Terms– Forward quotations may also be expressed as the percent-per-

annum deviation from the spot rate• This is similar to the forward discount or premium calculated earlier

– The important thing to remember is which currency is being used as the home or base currency

• For indirect quotes (i.e. quote expressed in foreign currency terms), the formula is


100 x days

360 x

Spot

Spot - Forward f H

Foreign Exchange Rates & Quotations• Forward Quotations in Percentage Terms

– For direct quotes (i.e. quote expressed in home currency terms), the formula is


p.a. 2.32% 100 x 90

360 x

105.04

105.04 - 105.65 f ¥

p.a. 2.32% 100 x 90

360 x

50.00946521

50.00946521-30.00952018 f $

Foreign Exchange Rates & Quotations• Forward Quotations in Percentage Terms

– Example: Indirect quote

– Example: Direct quote


Exchange Rates: New York Closing Snapshot


Exchange Rates: New York Closing Snapshot (cont.)


• Cross Rates– Many currencies pairs are inactively traded, so their exchange rate is

determined through their relationship to a widely traded third currency– Example: A Mexican importer needs Japanese yen to pay for

purchases in Tokyo. Both the Mexican peso (MXP) and Japanese yen (¥) are quoted in US dollars

• Assume the following quotes:

– What is the cross rate of yen to pesos?

Japanese yen ¥110.73/$Mexican peso MXP 11.4456/$



Key Currency Cross Rates, Tuesday, January 4, 2011


Citibank $1.2223/€Barclays Bank $1.8410/£Dresdner Bank €1.5100/£


• Intermarket Arbitrage– Cross rates can be used to check on opportunities for intermarket

arbitrage– Example: Assume the following exchange rates are quoted


£ £

€ € 1.5062/

$1.2223/

$1.8410/

Foreign Exchange Rates & Quotations• Intermarket Arbitrage

– The cross rate between Citibank and Barclays is

– This cross rate is not the same as Dresdner’s rate quote of €1.5100/£– Therefore, an opportunity exists for risk-less profit or arbitrage


Triangular Arbitrage by a Market Trader


Foreign Exchange Rate Determining/Forecasting• Three basic approaches

– Parity conditions– Balance of Payments – Asset market

• These are not competing theories but are in fact complementary theories

• Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost


Determinants of Foreign Exchange Rates


Foreign Exchange Rate Determining/Forecasting• Along with an understanding of the theories, an understanding of

the complexities of international political economy, societal and economic infrastructures, and random political and social events is needed when viewing the foreign exchange markets– Infrastructure weaknesses were among the major causes of the exchange

rate collapses in emerging markets in the late 1990s

– Speculation contributed greatly to the emerging market crises. Uncovered interest rate arbitrage caused by extremely low interest rates in Japan coupled with high real interest rates in the US was a problem in the 1990s

– Cross-border foreign direct investment and international portfolio investment into emerging markets dried up during the recent crises

– Foreign political risks have been much reduced in recent years as capital markets became less segmented from each other and more liquid

– Finally, note that most determinants of spot exchange rates are also in turn affected by changes in the spot rate – in other words, they are not only linked but mutually determined


Purchasing Power Parity Approach

• PPP is the oldest and most widely followed of the exchange rate theories

• PPP is embedded within most theories of exchange rate determination

• PPP calculations and forecasts have structural differences across countries and significant data challenges in estimation

• Many versions of PPP (see chapter 7) but perhaps the relevant for explaining exchange rate values is Relative Purchasing Power Parity which explains that changes in relative prices between countries drive the change in exchange rates over time


Balance of Payments (Flows) Approach• Essentially BOP approach says equilibrium exchange rate is

achieved when current account inflows match current account outflows

• BOP transactions are widely appealing, captured, and reported

• Criticism of the BOP approach is that it focuses on flows rather than stocks of money or financial assets

• Relative stocks of money or financial assets do not play a role in the theory

• Practitioners use BOP but academics largely dismiss it


Monetary Approaches

• Changes in supply and demand for money largely determine inflation which in turn alter exchange rates

• Prices are flexible in both the short and long-run thus, the transmission impact is immediate

• Real economic activity influences exchange rates through any alterations in demand for money

• Omits a number of important factors for exchange rate determination including:– The failure of PPP to hold in the short to medium term– Money demand appears to be relatively unstable over time– The level of economic activity and the money supply do not

appear to be independent


Asset Market Approach (Relative Prices of Bonds)• AKA relative price of bonds or portfolio balance approach• argues that exchange rates are determined by supply and

demand for a wide variety of assets– Shifts in supply and demand alter exchange rates– Changes in monetary and fiscal policy alter expectations and thus

exchange rates– Theories of currency substitution follow the same basis premises of

portfolio rebalance framework


Asset Market Approach (Relative Prices of Bonds)• The Asset market approach assumes that whether

foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (as per the previous exhibit)

• In highly developed countries, foreign investors are willing to hold securities and undertake foreign direct investment based primarily on relative real interest rates and the outlook for economic growth and profitability

• Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment


Asset Market Approach (Relative Prices of Bonds)• Capital market liquidity is particularly important to foreign

institutional investors. Cross-border investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired

• A country’s economic and social infrastructure is an important indicator of its ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment

• Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a country’s securities and for purposes of evaluating foreign direct investment in that country


Asset Market Approach (Relative Prices of Bonds)• The credibility of corporate governance practices is important

to cross-border portfolio investors. A firm’s poor corporate governance practices can reduce foreign investors 'influence and cause subsequent loss of the firm’s focus on shareholder wealth objectives

• Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries with similar characteristics—at least in the eyes of cross-border investors. Contagion can cause an “innocent” country to experience capital flight with a resulting depreciation of its currency

• Speculation can both cause a foreign exchange crisis or make an existing crisis worse


Currency Market Intervention

• Foreign currency intervention, the active management, manipulation, or intervention in the market’s valuation of a country’s currency, is a component of currency valuation and forecast that cannot be overlooked.

• Central bank’s driving consideration – inflation or unemployment?

• “beggar-thy-neighbor,” policy to keep currency values low to aid in exports, may prove inflationary if some goods MUST be imported … e.g. oil

• Direct Intervention - This is the active buying and selling of the domestic currency against foreign currencies. This traditionally required a central bank to act like any other trader in the currency market


Currency Market Intervention

• Coordinated Intervention - in which several major countries, or a collective such as the G8 of industrialized countries, agree that a specific currency’s value is out of alignment with their collective interests

• Indirect Intervention - This is the alteration of economic or financial fundamentals which are thought to be drivers of capital to flow in and out of specific currencies

• Capital Controls - This is the restriction of access to foreign currency by government. This involves limiting the ability to exchange domestic currency for foreign currency– The Chinese regulation of access and trading of the Chinese yuan is

a prime example over the use of capital controls over currency value.


Forecasting in Practice

• In addition to the three approaches to forecasting discussed earlier (Parity Conditions, Balance of Payments, Asset Approach) forecasting practitioners also utilize technical analysis

• These analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future

• The longer time horizon of the forecast, the more inaccurate the forecast is likely to be

• The following summarizes the various forecasting periods, regimes and preferred forecasting methods for each


Exchange Rate Forecasting Methods



• Decades of theoretical and empirical studies show that exchange rates do adhere to the fundamental principles and theories outlined in the previous sections – fundamentals do apply in the long term

• Therefore, there is something of a fundamental equilibrium path for a currency’s value

• In the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long term fundamental path – this is sometimes referred to as noise


• Although the various theories surrounding exchange rate determination are clear and sound, it may appear on a day-to-day basis that the currency markets do not pay much attention to the theories

Short-Term Noise Versus Long-Term Trends



• The difficulty is understanding which fundamentals are driving markets at which points in time

• One example of this relative confusion over exchange rate dynamics is the phenomenon known as overshooting

International Finance

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