“International Finance and Payments” Lecture VI “International FX Markets” Lect. Cristian...
-
Upload
david-pitts -
Category
Documents
-
view
223 -
download
2
Transcript of “International Finance and Payments” Lecture VI “International FX Markets” Lect. Cristian...
“International Finance and Payments”
Lecture VI
“International FX Markets”
Lect. Cristian PĂUNLect. Cristian PĂUN
Email: Email: [email protected]
URL: http://www.finint.ase.roURL: http://www.finint.ase.ro
Academy of Economic Studies
Faculty of International Business and Economics
Lecture 6: International FX Markets 2
Risks in international financing - review
• risks mean potential losses caused by different factors in case of a specific transaction
• in international financing we have: environmental risks, company risks and project risks;
• country risk: describe the economic and political environment of a country
• interest risk: is determined by an unfavorable evolution of interest rates on international financial markets
• currency exposure: affects financing denominated in different currencies;
• default risk: expresses the capacity of a company to pay-back its debt in terms of liquidity, solvability and profitability;
Lecture 6: International FX Markets 3
FX Markets – basic concepts
• Foreign currency: money from abroad circulated within
an economy, including coins and paper notes.
• Exchange rate: the exchange rate is the price of one
country’s currency in terms of another country’s currency
• FX Market: the place where brokerage firms and banks
are connected over an electronic network that allows
them to convert the currencies of most countries.
• Exchange rate regime: the legal environment about FX
transactions and FX market.
Lecture 6: International FX Markets 4
FX Markets – main characteristics
• The FX market is a highly active, highly decentralized market for currency conversions that operates almost 24 hours per day around the world (see the next slide).
•The vast majority of foreign exchange (FX) trading is done over-the-counter (OTC)
• Most transactions have the USD on one side (USD is a vehicle currency)
• FX Market is a Wholesale Market- Interbank Market and Retail--Client Market too;
• About 700 banks worldwide stand ready to make a market in Foreign exchange.
• Non-bank dealers account for about 20% of the market.
• The FX market is the most active market in the world ($1,210 trillion turnover per day, worldwide, in April 2001)
Lecture 6: International FX Markets 5
Around-the-clock FX trading
Average Electronic Conversions Per Hour
Greenwich Mean Time
0
5,000
10,000
15,000
20,000
25,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Tokyoopens
Asiaclosing
10 AMIn Tokyo
Afternoonin America
Londonclosing
6 pmIn NY
Americasopen
Europeopening
LunchIn Tokyo
Lecture 6: International FX Markets 6
Size of the FOREX Market
0
100
200
300
400
500
600
700
1989 1992 1995 1998 2001
United States
United Kingdom
Japan
Singapore
Germany
Geographic Distribution of Foreign Exchange Turnover (daily averages in April, billions of US dollars)
Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001,” October 2001, www.bis.org.
Lecture 6: International FX Markets 7
World inter-bank FX transactions
By currency pairs -- 2001
$/euro25%
$/yen20%
$/pound10%
$/other28%
non-$17%
Lecture 6: International FX Markets 8
Forex swap53%
Forward11%
OTC Options
5%
Spot31%
World FX transactions$1.2 trillion/day (2001)
Lecture 6: International FX Markets 9
FX Markets – Direct quote vs. Indirect quote
Quoted exchange rates can be either direct or indirect, one method
is usually the convention
Direct: home currency per unit of foreign currency
Examples from US perspective:
1.676 US Dollars (USD) per British
Pound (GBP)
1.152 US Dollars (USD) per Euro
(EUR)
Indirect: foreign currency per unit of home currency
Examples from ROL perspective:
109.58 Japanese Yen (JPY) per
US Dollar (USD)
1.3664 Swiss Francs (CHF) per US
Dollar (USD)
Pound, CAD, AUD, NED - Indirect Quote
USD, Euro, ROL – Direct Quote
Lecture 6: International FX Markets 10
FX Markets – The Bid / Ask Spread
bid price--the price a dealer (NOT you) is willing to pay you for a currency.
ask price--the amount the dealer wants you to pay for a currency.
The bid-ask spread is the difference between the bid and ask prices
1 USD = 30.500 – 550 ROL
1 USD = 30.500 – 30.550 ROL
The spread = 0.050 ROL / 1 USD
Lecture 6: International FX Markets 11
Exchange rates
- Nominal Exchange Rate: the price between the local currency and a
foreign currency
- Real Exchange Rate: the nominal exchange rate adjusted with prices
differential:
RFX=NFX x (PROM-PUS)/(1+PUS)
- Effective Exchange Rate: the nominal exchange rate between a currency
basket (simple or weighted):
EFX=1/n (NFXUSD+NFXyen+NFXpound)
• Effective Exchange Rate: the effective exchange rate between a currency
basket (simple or weighted):
EFX=1/n (RFXUSD+RFXyen+NFXpound)Calculated by IMF, Morgan Guaranty Trust Company, Federal Reserve Bank
Lecture 6: International FX Markets 12
Cross exchange Rates
Suppose that S($/€) = .50 i.e. $1 = 2 €
and that S(¥/€) = 50 i.e. €1 = ¥50
What must the $/¥ cross rate be? What must the ¥/$ cross rate be?
The use of cross exchange rate:
- To determine exchange rate between two different foreign currencies;
- in arbitrage transaction (buy and sell on different FX markets)
Lecture 6: International FX Markets 13
Depreciation and Appreciation of a currency
A depreciation of the local currency means that it takes more local currency to buy a unit of foreign currency An appreciation of the local currency is the opposite
Example: If the $/€ exchange rate goes up from 1.20 to 1.30 the dollar has
depreciated against the euro but, the euro has appreciated against the dollar.
Valuation / Devaluation of a currency-When a government interviews on FX market to manage (to fix) the exchange rate at a specific level (value)
- Specific in the case of fixed exchange regimes
The relationship between depreciation of local currency and export development !!!
Lecture 6: International FX Markets 14
Currency regimes
Define the regulations related to the FX Rate mechanism (Central Bank intervention on FX Market, official exchange rate, exchange rate control)
Fixed Exchange Regime Hybrid Exchange Regimes
Dirty Float or Managed Float Fixed Band Crawling Band Fixed Peg Crawling Peg Currency Board.
Free Floating Exchange Regimes
Lecture 6: International FX Markets 15
“Dirty” or managed float
Central Bank Intervention
A
B
Exchange Rate
Central Bank Intervention
Lecture 6: International FX Markets 16
Fixed Band
Central Bank Intervention
Central Bank Intervention
Anchor
Lecture 6: International FX Markets 17
Crawling Band
T1 T2 T3
Fixed Anchor
Adjustable Margins
Fixed Margins
Adjustable Anchor
Lecture 6: International FX Markets 19
Currency Regimes and FX Rate Control
Currency Regimes Low Medium HighFixed Exchange Rate
Currency Board
Fixed Peg
Crawling Peg
Narrow Band
Oblique Band
Wide Band
Crawling Band
Mixed Currency Regime
Managed Float
Free Floating
FX Rate C
ontrol
Lecture 6: International FX Markets 20
Convertibility of a currency
Full convertible currency: no restrictions in terms of transactions volume, capital transfers and FX Market access for residents and non-residents;
Partial convertible currency:Current Account ConvertibilityCapital Account Convertibility
No Convertibility: FX Market is very restrictive
Lecture 6: International FX Markets 21
Spot transactions
In the inter-bank market, the standard size trade for a
spot transaction is about U.S. $10 million;
Private information is an important determinant of spot
exchange rates.
Bid-Ask spreads in the spot FX market: increase with FX exchange rate volatility and
decrease with dealer competition.
The settlement or value date for a spot transaction (the
date on which the parties actually exchange assets)
occurs two business days after the deal is made ;
Lecture 6: International FX Markets 22
Forward Transactions
A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.
Main characteristics: Usual maturity: 30, 90 and 180 days; It is not a stock exchange contract; Implies a direct negotiations with the bank It is not standardized; It has a fixed value established in the initial moment; It has not a secondary market; Can be finished only at the maturity; It is considered a money market instrument
Lecture 6: International FX Markets 23
Forward transactions
Long ForwardShort Forward
Profit
Loss
Exchange Rate at the Maturity
Initial Spot Exchange Rate
Lecture 6: International FX Markets 24
Forward Contracts and Risk Management
Position in a credit
Currency Exposure
Forward Strategy
Debtor Local currency will increase
Long Forward
Creditor Local currency will decrease
Short Forward
Lecture 6: International FX Markets 25
Forward and Spot Quotations
Spot 1,6325 - 35 ($) 2,30 - 2,30 3 / 4 (€) 263,15 - 25 ¥
Forward 1 m 0,75 - 0,73 cents 5/8 - 1/2 cents 0.15 ¥ premium0.10 ¥ discount
Forward 2 m 1,35 - 1,32 cents 1 1/8 - 1 cents 0.17 ¥ premium0.8 ¥ discount
Forward 3 m 2,03 - 2,00 cents 1 5/8 - 1 1/2 cents 0.19 ¥ premium0.6 ¥ discount
Pound against USD, Euro and Yen
Rule for pips:
- If the pip for bid is higher than pip for ask then –
- If the pip for bid is lower than pip for ask then +
Lecture 6: International FX Markets 26
FX Rate Determinants
Traditional Approach (Keynes) Purchasing Power Parity (PPP) Monetary Approach (Friedman) Interest Power Parity General Equilibrium Theory Mundell – Fleming Model Rudiger Dornbush Model
Lecture 6: International FX Markets 27
Traditional Approach The foreign trade is the most important factor for FX Rate The current account deficit or surplus should be taken into
consideration If M > X than the local currency will depreciate against foreign currency If M < X than the local currency will appreciate against foreign currency
The Model Equation:
CSV = F (p-p*, Y-Y*, R-R*)
Prices
GDP Growth
Interest rates
Lecture 6: International FX Markets 28
Purchasing Power Parity Low of one price: we can write an equation for the law of one price
as:
PiLC = Pi
FC * Ewhere
PiLC is the local currency price of good i
PiFC is the foreign currency price of good i
E is the dollar to euro exchange rate
Or we can rearrange the equation to get
E = PiLC / P
iFC
USD
lei
0 p
ps
)p (1 x p
)p(1 x ps
USDUSD
leilei_
lei
USD
USD
lei
USD
lei
0
0
_
p
p x 1
)p (1
)p(1 x
p
p
s
s s
)p (1
)p-(p
s
s s
USD
USDleu
0
0
_
Lecture 6: International FX Markets 29
Monetary Approach
M x V = P x T
M = k x P x Y
americana piatapentru - Y x k
MP
romaneasca piatapentru Y x k
MP
**
*
*
ROL
USDFX Rate = (M - M*) + (Y - Y*) + (k - k*)
Lecture 6: International FX Markets 30
Interest Power Parity
General Equilibrium Theory
(p - p*) / (1+p*) = (d - d*)/ (1+ d*) = (f - s) / (1 + s) = (s1 – s0) / (1 + s0)
Real Market Money Market Spot and Forward FX Market
(i - i*)/ (1+ i*) = (s1 – s0) / (1 + s0)
i – interest rate (i* - interest rate from abroad)
s0 – initial spot exchange rate
s1 – predicted spot
Lecture 6: International FX Markets 31
FX Determinants - conclusion
Changing of FX Rate for a particular currency can be determined by the action of the following variables:
• current account deficits
• real economic growth
• inflation differential
• interest rate differential
• economic structure
• monetary aggregates (M1 and M2)