Foreign Exchange Market

Conducted BY:Mohammad Ramzan, CFA

On Behalf of

Course ObjectivesCourse Objectives• Understanding theoretical background of exchange rates• History of Foreign Exchange Market• Market Place• Exchange Rate Regimes• Fundamental Factors• Structure and mechanism of the Foreign Exchange Market• Forward and Swap Rates• Theory of Determination of Exchange Rate: PPP

Foreign ExchangeForeign Exchange

• International Trade– Do we need International Trade?

Gains from Specialization and International Trade

Gains from Specialization and Trade

• International trade leads to mutual gain because it allows each country to specialize more fully in the production of those things that it does best according to the law of comparative advantage.

• Trade permits each country to use more of its resources to produce those goods that it can produce at a relatively low cost.

• With trade, it will be possible for the trading partners to consume a bigger bundle of goods that would be impossible for them to produce and consume domestically.

Gains from Specialization, TradeGains from Specialization, Trade

POP FOOD SHIRTSUSA O,9 100 x 2 = O,9 100 x 1 = 100JAPAN 50 25 x 3 = 75 25 x 9 = 225

----------------- --------------Total World Prod. 275 325PRICESUSA 1 Food = 0.5 Shirt

1 Shirt = 2.0 FoodsJAPAN 1 Food = 3 Shirts

1 Shirt = 0.33 Food

Gains from Specialization, TradeGains from Specialization, Trade

POP FOOD SHIRTS

USA O,9 O,9 x 2 = 400 0 x 1 = 0

JAPAN 50 0 x 3 = 0 50 x 9 = 450

World Production 400 450

Possibility of trade?

US should export food to Japan

Japan should export shirts to USA

United States Japan

150

150

300

450

375

225

75

75Food(million units)

Before Specialization and Trade

Food(million units)

Production possibilities, U.S.

Production possibilities, Japan

Clothing(million units)

Clothing(million units)

100 O,9 300 400

100

O,9

300

250

150

50

M

350

400

450

N

US1

J1

S

R

United States Japan

Food(million units)

Consumption Possibilities with Trade

Food(million units)

Clothing(million units)

Clothing(million units)

Consumption possibilitiesof U.S. with trade

100 O,9 300 400

100

O,9

300

M250

150

50

US1

N

350

400

450O

150

150

300

450

375

225

75

75

J1

R

400

T

Consumption possibilitiesof Japan with trade

S50

United States

100 O,9 300 400

100

O,9

300

M

Japan

150

150

300

450

S

250

150

50

375

225

75

75

US1

J1

NFood(million units)

R

Consumption Possibilities with Trade

Food(million units)

350

400

450

Clothing(million units)

Clothing(million units)

400

O

T

J2

O,9

250

US2

50

Foreign ExchangeForeign Exchange

• International Trade necessitates exchange of currencies• Movement of Capital creates another source of supply

and demand• Definition: The price at which one currency is traded in

exchange for another in FX market is the exchange rate between the two currencies.

Foreign Exchange: HistoryForeign Exchange: History

• Bretton Woods: 1944 - 1971– Delegates from 45 Countries– Pegging of currencies with US Dollar– Margin of movement: 1% +/-

• Dollar as a reserve currency• Dollar was convertible to gold (1/35 ounce)• Frequent adjustments took place• US ran a continuous Current A/c Deficit• Vietnam War worsened the US situation• Pressure for convertibility• 1971: US Unilaterally abandoned the convertibility

Foreign Exchange: HistoryForeign Exchange: History

• Post Bretton Woods: Free float• Some regional treaties• EMU

– European Monetary Unit– Currency pegs with 2.5% +/-– Some weak currencies were allowed 6% +/-– Frequent Adjustments

• 1992: George Soros humbles BOE out of EMU• 1999: Euro created – Maastricht Treaty

Foreign Exchange MarketsForeign Exchange Markets

Foreign Exchange MarketForeign Exchange Market• US$ is the cornerstone of the foreign exchange market• Exchange Rates are quoted against US$• US Worlds biggest economy• Reserve currency status• Safe Haven status• Large amount of world trade in US$• Almost all commodities traded in US$

Factors that affect currency’s ValueFactors that affect currency’s Value

• National inflation rates – Imports/Exports– Inflation also affects the purchasing power of the currency

• Changes in real interest rates – Debt securities Investment.• Differences in economic performance (GDP) – Equity and

real asset Investment. • Current Changes in investment climate. Prospects of

higher return but also low risk. (Political stability, Legal system, Fair taxation, Capital movement, stable prices policies, Law and Order, Judicial System)

Factors that affect currency’s ValueFactors that affect currency’s Value

• Trade and Current A/c Balance• GDP – Gross Domestic Product: Market Value of all good

and services produced within a country during a specific period

• Why is GDP important?• Higher GDP means higher value of the currency and vice

versa

Real and Nominal GDP

• The term "real" means adjusted for inflation. • Price indexes are used to adjust income and output data

for the effects of inflation. – A price index measures the cost of purchasing a market basket

(or “bundle”) of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference (or base) period.

Real GDP2 =Nominal GDP2 * GDP Deflator1

GDP Deflator2

Using the GDP Deflator to Derive Real GDP

• Data on both money GDP and price changes are essential for meaningful comparisons of output between two time periods.

• The formula for converting the nominal GDP into real GDP is:

Source: U.S. Department of Commerce.

1996 2001 % increase

Nominal GDP(billions of U.S. $)

Real GDP(billions of 1996 $)

$7,813 $10,208 30.7%

Price index (GDP deflator, 1996 = 100)

100.0 109.4 9.4%

$7,813 $9,331 19.4%

Using the GDP Deflator to Derive Real GDP

• Between 1996 and 2001, nominal GDP increased by 30.7%.

• But, when the 2001 GDP is deflated to account for price increases, we see that real GDP increased by only 19.4%.

Government PoliciesGovernment Policies

• An expansionary monetary policy will lead to a depreciation of the home currency.

• A restrictive monetary policy will lead to an appreciation of the home currency.

• A more restrictive fiscal policy should also slow down economic activity and inflation, and real Interest rates. Lower Inflation and Lower real Int. rates may have conflicting affect.

• A more expansionary fiscal policy has the reverse effect. Fiscal Policy is hard to judge.

Exercises

Exchange Quotes: DirectExchange Quotes: Direct

• A direct exchange rate is the domestic price of foreign currency.

• Let “DC” be the domestic currency, and “FC” be the foreign currency.

• A direct quote could be represented as:For example: 0.5 DC = 1 FC

1.25DC = 1 FC

Indirect Foreign Exchange QuotesIndirect Foreign Exchange Quotes

• An indirect exchange rate is the amount of foreign currency equivalent to one unit of domestic currency.

• For example, 2 FC: 1 DC– Note this conveys the same information as our previous

example.– For example: 0.0067 $/Yen would be an indirect quote in Japan.

Quote ConventionsQuote Conventions

• Internationally most currencies are quoted in terms of 1 US$ = ?.

• There are two main exceptions:– British pound (has always been quoted as dollar

price of one pound).– Euro (convention adopted to quote the foreign

currency value of one euro).

Quote ConventionsQuote Conventions • Base Currency/Counter base (Quoted Currency)

• Check: www.imf.org/external/np/fin/rates/rms_rep.cfm

• Quotations are usually given with five digits. For example,

• USD/JPY 118.55 • GBP/US$ 1.7725

• 1.77 = Big Fig; 25 = pips, points

ExercisesExercises• Exercises on Quotes

Cross RatesCross Rates• A cross rate is the exchange rate between two countries inferred from each

country’s exchange rate with a third country.

• For example, bank A gives the following quotations:

• $/CHF = 1.3110 – 20

• $/JPY = 118.90 – 00

– Calculate the CHF/JPY rate:

• CHF/JPY bid rate = 118.90 and 1.3120 are relevant• 1.3120CHF = 1 US$ = 118.90• 118.90/1.3120 = 90.625• CHF/Yen ask rate =119.00/1.3110 = 90.770• Cross rate is: CHF/JPY = 90.625 – 90.770

Cross RatesCross Rates• GBP/USD: 1.8250-60• USD/JPY: 116.80-90• Calculate GBP/JPY?• For Bid: 116.80 and 1.8250 are relevant

– 1 US$ = 116.80JPY

– 1GBP = 1.8250 US$ = 116.80 x 1.8250 = 213.16

• For Offer: 116.90 and 1.8260 are relevant– 1 US$ = 116.90

– 1 GBP = 1.8260US$ = 1.8260 x 116.90

Cross RatesCross Rates• Rules of Thumb to remember:

– If the rates of two currencies are quoted in same terms, the cross rates is really a X, i.e. bid to offer and offer to bid and it involves a division.

– If the rates for two currencies are quoted in different terms, then the cross is a multiplication of bid to bid and offer to offer.

ExercisesExercises• Exercises for cross rate calculation

RisksRisks

• Risk of a long position: Price may go down– Profit of a long position: When price goes up

• Risk of a short position: Price may go up– Profit on a short position: When price goes down

• Market Risk• Liquidity Risk• Credit Risk• Settlement Risk

Forward RatesForward Rates

• Spot rates are quoted for immediate currency transactions (although in practice it takes place 48 hours later).

• Forward exchange rates are contracted today but with delivery and settlement in the future.

• In a forward, or futures, contract a commitment is irrevocably made on the transaction date, but delivery takes place later, on a date set in the contract.

Forward Premiums/discountsForward Premiums/discounts• Base currency…$, Pound, Euro• Formula:

F = spot {1+(Int Rate of counter-base*days/conventional year)/1+(Int Rate of Base currency*days/ conventional year)}

• Use proper days’ convention

Forward Rates: CalculationForward Rates: Calculation• GBP/US$ = 1.6400 - 10• Assuming one can borrow/lend at market rates (6

Months)• Pound Interest Rate: 3.75 – 3.80%• US$ Interest Rate: 1.15 – 1.20%• P98,164.5 = $161,087.90 @ 1.6410• $161,087.90 @ 1.20% = $162,065.17• P98,164.5 @ 3.75% = P100,000• 162065.17/100,000 = 1.62065

Forward Rates: CalculationForward Rates: Calculation

• Using the Formula1.6410 * {1+(0.012*182/360)/1+(0.0375*182/365)}

=1.6410 * (1.006067/1.018699)

=1.6410 * 0.9876

=1.62065

Forward Rates: CalculationForward Rates: Calculation• GBP/US$ = 1.6400 – 10 (Spread: 10 points, 0.061%)• Assuming one can borrow/lend at market rates (6 Months)• Pound Interest Rate: 3.75 – 3.80%• US$ Interest Rate: 1.15 – 1.20%• P98,140.44 = $160,950.32• $160,950.32 @ 1.15% = $161,886.07• P98,140.44 @ 3.80% = P100,000• 161,886.07/100,000 = 1.61886

Forward Rates: CalculationForward Rates: Calculation

• Using Formula• 1.6400 * {1+(0.0115*182/360)/1+(0.0380*182/365)}• 1.6400 * 1.005814/1.01895• 1.6400 * 0.9871• 1.61886

Forward SpreadForward Spread• Spot 1.6400 – 10• Forward 1.6189 – 07• Spread in Spot 10 points• Spread in forward 18 points

Forward Premiums/discountsForward Premiums/discounts• Spot 1.6400 – 10• Forward 1.6189 – 07• Difference 0.0211 - .0203• Also called Swap Points• Is GBP at discount/Premium?• Rule: Higher interest currency is always at discount

in forward and lower interest currency always at premium

Swaps Swaps • In inter-bank market, forwards are quoted as under:

Spot GBP 1.6400-10

Swap

1-month 35 – 32

3-months 105 – 100

6-months 211 – 203

12-months 430 – 420

Swaps Revisited Swaps Revisited • How to use swap points:• If the bid is higher than offer of swap points,

the base currency is at discount• If the bid is lower than offer, the base

currency is at premium

Swaps Revisited Swaps Revisited • How to use swap points:• If the bid is higher than offer of swap points, Deduct

swap points from spot rate

• If the bid is lower than offer, Add swap points to spot rate

Swaps Revisited Swaps Revisited • Make Outright forward rates Spot GBP 1.6400-10

Swap

1-month 35 – 32

3-months 105 – 100

6-months 211 – 203

12-months 430 – 420

Swaps Revisited Swaps Revisited • Make Outright forward rates Spot CHF 1.2760-70

Swap

1-month 12 - 10

3-months 31 – 28

6-months 60 – 55

12-months 112 – 104

Forwards Revisited Forwards Revisited • You can construct a forward (3-month)

through spot market and swap market• Spot GBP 1.6400 - 10

3-months swap 105 – 100

• You want to buy GBP forward

Forwards Revisited Forwards Revisited • You can buy spot first, let’s say 1 mio GBP at 1.6410• Then at 100 you sell/buy 1 mio pound• Swap Transaction:• You sell in spot and buy in forward• Rates: Spot 1.6410

Forward 1.6310

ArbitrageArbitrage

• Arbitrage involves the simultaneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio, in order to obtain a risk free profit on the price differential.

• Arbitrage keeps exchange rates in line with each other and with risk free interest rates.– For example, the $/Euro rate must be the same, at

a given instant, in Frankfurt, Paris and New York.

Various arbitrage opportunities to considerVarious arbitrage opportunities to consider......• With respect to the exchange rate between two countries, the

rate in one country should be aligned with the rate in the other. If not, a bilateral arbitrage opportunity exists.

• A triangular arbitrage opportunity occurs if the quoted cross-rate between two currencies is higher or lower than the cross-rate implied by the exchange rates of the two currencies against a third currency.

Triangular ArbitrageTriangular Arbitrage• Triangular arbitrage involves three steps:

– Pick the cross-rate currency

– Determine whether the cross-rate bid-ask quotes are in line with the direct quotes by determining whether it is cheaper to buy foreign currency directly or indirectly.

– If the actual cross-rate quote is not in line with the quoted cross-rate quotes, an arbitrage opportunity exists.

Covered Interest Rate ArbitrageCovered Interest Rate Arbitrage• The process of simultaneously borrowing the

domestic currency, transferring it into foreign currency at the spot exchange rate, lending it, and buying a forward exchange rate contract to repatriate the foreign currency into domestic currency at a known forward exchange rate. The net result of such an arbitrage should be nil.

Covered Interest Rate ArbitrageCovered Interest Rate Arbitrage • Spot rate = 1.6400 $/pound sterling• 6-month Forward rate = 1.6072 $/pound sterling• U.S. 6-m rate = 1.15%• UK 6-m rate = 3.75%

– Annualized forward discount = – 4.0%– Interest rate parity is violated.

• Dollar is stronger, pound weaker• Borrow in £ for 6 months, Sell GBP for $,

Invest $ for 6 months • buy £ forward.

Forwards Forwards • Exercises

Arbitrage on SwapsArbitrage on Swaps • There is an active swap market in Karachi in $/PKR. • There is restriction on free movement of capital –

exchange control. • Assume the fair $/PKR 6-m swap should be 95-100

(with spot at 60.25 it would mean fwd at 61.20/25) but for some reason swap comes down to 70-75 – by exporters or SBP b/s swap - (implying a fwd rate of 60.95/00).

• In a free market condition, arbitrageur should buy the cheap dollar in forward, sell dollars in spot by borrowing them for 6-months. Is it possible and assured?

• Can local banks can eliminate the inefficiency through arbitrage? Risk of further deterioration, loss on revaluation

• Can foreign banks come in and arbitrage?

Arbitrage on SwapsArbitrage on Swaps • That anomaly leaves the swap misalignment in the

market for considerable time, from where it could realign or get even worse.

• This creates a phenomenon where swap market functions like a separate financial product which has it own dynamics with swaps points moving up and down depending on swap/fwd demand and supply.

• However, over a medium term swap points should revert to their fair value.

• This creates interesting trades in swap market

Arbitrage on SwapsArbitrage on Swaps • Some Trades in swap market

– Arbitrage: Given sufficient resources

• Anticipate next move of the Exporters, Importers or SBP and front-run them.– E.g.you expect exporters to sell dolls in

fwd, which will compress swap points, you can sell swap in anticipation (b/s 6 months) and unwind when swap points drop.

• You can gap-trade the swap. E.g, swap points came down to 60-65, you can sell/buy at 65 for 6 months and immediately b/s for 1 week.

• Exercises

Purchasing Power Parity (PPP) RelationPurchasing Power Parity (PPP) Relation

• PPP states that the spot exchange rate adjusts perfectly to Price differentials between two countries. Law of one price.

• There are two versions of PPP:– Absolute PPP

• This claims that the exchange rate should be equal to the ratio of the average price levels in the two economies.

– Relative PPP

Purchasing Power Parity (PPP) RelationPurchasing Power Parity (PPP) Relation

• Relative PPP– This claims that the percentage movement of the

exchange rate should be equal to the inflation differential between the two economies

• The PPP relation is presented as:

• Exact

S1/S0 = (1 + IFC)/(1 + IDC)

Thank you!!