page 1 international finance lecture 2. page 2 foundations of international financial management...

International Finance

Lecture 2

Foundations of International Financial Management

• Globalization and the Multinational Firm

• International Monetary System• Balance of Payments• The Market for Foreign Exchange• International Parity Relationships

Balance of Payments • The Balance of Payments is the statistical

________ of a country’s (her citizens and her government’s international transactions over a certain period of time.

• Every country prepares and publishes ________ balance of payment statements.

• They are composed of the following:– The Current Account– The Capital/Financial Account– Statistical Discrepancy

• View actual Canadian, US, French, Russian, Ukrainian Balance of Payments statements

The Current and Capital Accounts• Current Account

– Includes all ________ and ________ of goods and services.

– Includes unilateral transfers of foreign aid.– If the debits > credits, then trade deficit.– If the credits > debits, then trade surplus.

• Capital Account– The capital account measures the difference

between home country sales of ________ to foreigners and home country purchases of foreign ________.

– Composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

Statistical Discrepancy and Official Reserve Account

• There’s going to be some ________ and misrecorded transactions– we use a “plug” figure to get things to

balance.• Official reserves assets include gold, foreign

currencies, SDRs, reserve positions in the IMF.

The Balance of Payments Identity

• BCA + BKA + BRA = 0where– BCA = balance on ________ account– BKA = balance on ________ account– BRA = balance on the ________ account

• Under a pure flexible exchange rate regime,• BCA + BKA = 0

Canada’s Balance of Payments

-40000

-30000

-20000

-10000

0

10000

20000

30000

40000

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

BCA BKA BCA+BKA

Source: CANSIM

Balance of Payments and the Exchange Rate

• Current account + Capital account + Reserves– Balance > 0

• inflow of capital, quantity ________ of home currency > quantity supplied, ________ pressure on home currency value

– Balance < 0• Outflow of capital, quantity demanded of home currency <

quantity supplied, ________ pressure on home currency value– Equilibrium can continue __________, disequilibrium cannot.– If the balance is not zero for long time, it is a disequilibrium

and will be corrected by the market in the long run• several scenarios possible, material for international economics

course– Price of home currency is the exchange rate

• # Units of local currency / 1 unit of foreign currency (direct)• # Units of foreign currency / 1 unit of local currency (indirect)

Foundations of International Financial Management

• Globalization and the Multinational Firm

• International Monetary System• Balance of Payments• The Market for Foreign Exchange• International Parity Relationships

The FOREX Market

The FOREX Market• Structure

– Place of trading• ________

– Volume• Wholesale (________) and retail

– Timing• ________ : deal now, deliver now (up to 2

business days)• ________ (deal now, deliver in the future)

Spot Rate Quotations• Direct quotation

– the Canadian ________ equivalent– e.g. “a Japanese Yen is worth about a

penny”• Indirect Quotation

– the price of a Canadian dollar in the foreign currency

– e.g. “you get 100 ________ to the dollar”• View daily foreign exchange rate updates from

the US Federal Reserve System or the Bank of Canada

Exchange rates and trade• The following table provides domestic prices for

three items in Australia and Hong Kong. If AUD 1 = 6 HKD, then what is the likely flow of goods? Ignore transaction costs.

Item Australia (AUD) HK (HKD)

Shoes 20 80

Watches 40 180

Surfboards 80 550

Exchange rates and trade• Over the past 5 years the CHF/USD exchange

rate has changed from 1.20 to 1.60. Did the Swiss goods become more or less expensive for the US customers?

Spot FX trading• Bid-ask spread

– The bid price is the price a dealer is ________ to pay to buy the currency.

– The ask price is the amount the ________ wants to sell you the currency.

– The bid-ask spread is the difference between the bid and ask prices.

• Trading– In the interbank market, the standard size trade is about

U.S. $10 million.– A bank trading room is a noisy, active place.– The stakes are high.– The “long term” is about 10 minutes.

• Cross- rates: view major cross-rates @ Bloomberg

Bid-ask spread• Direct ask (DC/FC) = 1 / Indirect bid (FC/DC)• Direct bid (DC/FC) = 1 / Indirect ask (FC/DC)

– Notation: DC=domestic currency, FC=foreign currency

Example• If the direct quotation for the exchange

rate is USD/EUR=0.9825-0.9829, then what is the indirect EUR/USD quote?

Bilateral arbitrage• Assume no transaction costs for now. (=ignore

bid-ask spread)• Domestic currency is DC, foreign currency is

FC, exchange rate is DC/FC• You observe two rates at ________ banks:

DC/FCbank1 and DC/FCbank2

• No-arbitrage: DC/FCbank1 * FC/DCbank2 must ________ Reason: Law of One Price – the price of the same item should be the same

regardless of where it is sold, otherwise there will be arbitrage opportunities

– Mathematically, DC/FC * FC/DC = 1

Bilateral arbitrage• You observe the following spot rates in two banks:• In Frankfurt: EUR/GBP =1.4959 and in London:

GBP/EUR=0.6695. Is there an arbitrage opportunity and if yes, what is it? Ignore transaction costs.

Bilateral arbitrage• You observe the following spot rates in two banks:• In Canada: JPY/CAD =122.30-122.35 and in Japan:

JPY/CAD=122.15-122.25. Is there an arbitrage opportunity and if yes, what is it?

Exchange rates and investment

• A Canadian portfolio manager is planning to buy $15 million worth of German bonds. The manager calls several banks to find out spot rates. The quotes that she gets is below. How many Euros will the manager invest in German bonds?

Bank A B C

EUR/CAD 0.80000-20 0.79985-05 0.79995-15

Exchange rates and investment• A foreign exchange trader at a US bank took a short position

of GBP 5,000,000 when the USD/GBP rate was 1.45. After that the exchange rate changed to 1.51. (a) Is this movement beneficial for the FX trader in question? (b) How did the US bank’s liability change as a result of this FX rate move?

Cross Rates• Suppose that S($/SFr) = .50

– i.e. $1 = 2 SFr • and that S(¥/SFr) = 50

– i.e. SFr1 = ¥50• What must the $/¥ cross rate be?

Cross Rates• You find the following rates in the newspaper.

USD/EUR=0.9119, CHF/USD=1.5971, JPY/USD=128.17• Compute all cross-rates.

Cross Rates and Bid-Ask Spread

• Notation: DC=domestic currency, FC1=foreign currency #1, FC2=foreign currency #2

• Cross-rates FC1/FC2– (FC1/FC2)ask=(FC1/DC)ask * (DC/FC2)ask– (FC1/FC2)bid=(FC1/DC)bid * (DC/FC2)bid

• Cross-rates FC2/FC1– (FC2/FC1)ask=(DC/FC1)ask * (FC2/DC)ask– (FC2/FC1)bid=(DC/FC1)bid * (FC2/DC)bid

Cross Rates and Bid-ask Spread• A bank is quoting the following exchange rates:

USD/EUR=1.1610-15, CHF/USD=1.4100-20. What is the CHF/EUR cross-rate?

Cross Rates and Bid-ask Spread• A bank is quoting the following exchange rates:

CHF/CAD=1.5960-70, AUD/CAD=1.8225-35. An Australian firm asks for CHF/AUD rate. What cross-rate will the bank quote?

Triangular Arbitrage• Idea: look for the quoted cross-rates FC1/FC2 (between two

foreign currencies FC1 and FC2) – And see if they differ from the implied rates suggested by the

DC/FC1 and DC/FC2 (domestic currency rates against the two foreign currencies)

– If any of the three currencies is over/underpriced, all cross-rates will present arbitrage opportunities.

• If transaction costs are ignored– Check whether (DC/FC1)*(FC1/FC2)*(FC2/DC)= ________

• Transaction costs– Check whether quoted and cross-rate bid-ask spreads overlap

for any currency out of our three currencies. – If you have rate 1 [bid1, ask1] and rate 2 [bid2, ask2] such that

ask2<bid1, buy at ask2 and sell at bid1.

Triangular Arbitrage Example

• You observe these rates:– Tokyo ¥/$ 120.00, NYC SF/$ 1.6000, Zurich

¥/SF80.00

Triangular Arbitrage Example You observe these quotes below. Is any currency arbitrage possible?

bid ask bid ask bid askUSD/EUR 0.9836 0.9839 EUR/GBP 1.5373 1.5380 GBP/USD 0.6566 0.6571EUR/USD 1.0164 1.0167 GBP/EUR 0.6502 0.6505 USD/GBP 1.5219 1.5231

bid ask bid askUSD/EUR 0.9836 0.9839 0.9895 0.9908EUR/GBP 1.5373 1.5380 1.5469 1.5485GBP/USD 0.6566 0.6571 0.6609 0.6614

Frankfurt London New York

QUOTED CROSS-RATESCalculate cross-rates and compare

with the quoted rates

Spot Foreign Exchange Microstructure

• Market Microstructure refers to the ________ of how a marketplace operates.

• Bid-Ask spreads in the spot FX market:– increase with FX exchange rate

volatility and – decrease with dealer competition.

• Private information is an important determinant of spot exchange rates.

The Forward Market• A forward contract is an ________ to buy or sell an

asset in the future at prices agreed upon today.• If you have ever had to order an out-of-stock

textbook, then you have entered into a forward contract.

• The forward market for FOREX involves agreements to buy and sell foreign currencies in the ________ at prices agreed upon today.

• Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

• Longer-term contracts are available.

The Forward Market• Transactions

– ________ forward transaction: do a regular forward contract

– ________ : simultaneous sale (or purchase) of spot foreign exchange and corresponding purchase (or sale) of approximately equal amount of foreign currency

• View rates at BMO Economics or Federal Reserve of New York

The Forward Market• You observe the spot rate EUR/USD=0.92000 and

the 1-month forward EUR/USD=0.92200, what does it mean? is the dollar trading at premium or discount? Is the dollar weak or strong?

The Forward Market

• Annualized forward premium/discount

The Forward Market• You observe the following. Spot USD/GBP=1.4570-76, and 6-

months forward USD/GBP=1.4408-34. Is GBP trading at a premium or discount relative to the USD? Compute the annualized forward discount/premium.

Long and Short Forward Positions

• If you have agreed to sell anything (spot or

forward) you are “________”.• If you have agreed to buy anything (forward or

spot) you are “________”.

• If you have agreed to ________ forex forward, you are short.

• If you have agreed to ________ forex forward, you are long.

Payoff Profiles

0 S180($/¥)

F180($/¥) = .009524

Short positionloss

profit

Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

Long position-F180(¥/$)

F180(¥/$)short position

profit

Forward Speculation• Today the 3-month forward rate is USD/CHF=0.7476. A currency trader

decides to bet on depreciation of the Swiss franks by selling CHF short. He contracts now to sell Swiss franks in 3 months anticipating that at that time the spot rate will change to USD/CHF=0.7400. Suppose 3 months later the actual spot rate is USD/CHF=0.7500.

• Is this a short sale and why? What is the expected payoff for the trader and his counterparty? What is the actual payoff?

Forward Speculation• The counterparty

–

– On the actual spot market the same amount ________– Savings

– If the rate dropped to $0.7400 instead of rising to $0.7500, would overpay

– _______________• What if a trader decides to ignore the contract and not deliver when not

profitable?

–

page 1 international finance lecture 2. page 2 foundations of international financial management...

Documents