FIN 40500: International
Finance
Introduction to International Finance
“Sherman, set the way-back machine for
1850!”
Prior to the late 1800s, international
transactions were made with gold and silver
coins…no exchange rate was necessary!!
The most prominent coins were
Spanish
One Peseta = .86
ounces of Silver
One Doubloon = .88 ounces of
Gold (one Doubloon = 16
Pesetas)
US Coins were modeled after
Spanish coins
One US Dollar = .86
ounces of Silver
Twenty US Dollars =
1.07 ounces of Gold
1 Dollar = .86 oz. silver
20 Dollars = 1.07 oz. gold
1 Pound = 16 oz. silver
Note that if, for example, the US was running a
trade deficit with Britain, Gold and Silver would
flow out of the US and into Britain (price-specie
flow mechanism)….when this happens, what
happens to prices?
1 Sovereign = .5 oz. gold
As countries moved to paper currency in the late 1860s, governments
would regulate the value of that currency by fixing the price of gold
VS
$20.67 Per Ounce
4.40 Per Ounce
These two prices imply an exchange rate between
the US Dollar and the British Pound
$20.67 Per Ounce
= $4.70 Per
4.40 Per Ounce
Suppose that the exchange rate were $4.00 per
(The British Pound is Undervalued)
$20.67 Per Ounce
1
Start with $1, convert it to Pounds ( =
.25 )
4.40 Per Ounce
2
Buy Gold in England ( .0658 oz )
3
Ship the gold back to the US and sell it ( = $1.17 )
The gold standard era saw very stable exchange rates!
The Gold Standard maintained the
price-specie flow mechanism
$20.67 Per Ounce
$4.70 Per
4.40 Per Ounce
Note that if, for example, the US was running a trade deficit
with Britain, Excess demand for British pound notes would
cause the Pound to appreciate – arbitrage would cause gold
to flow out of the US and into England
In July 1944, delegates from 44 nations gathered at the Mount
Washington hotel in Bretton Woods New Hampshire. The result was the
Bretton Woods Agreement
$1 = 360 JPY
$1 = .2481 GBP
$1 = 3.33 DEM
1 oz = $35
$1 = 119 FRF
$1 = 575 ITL
The British
Pound is
attacked – The
Bank of
England
devalues by
14%
Johnson’s Great
Society programs
and the Vietnam
war create large US
deficits
1966
1965
1968
1967
August 15, 1971:
Nixon is forced to
suspend
convertibility of
dollars to gold
1971
1970
1972
Bretton Woods
collapses and
the currency
boom begins!
From 1971 until 1987 the US followed a policy of managed floating (market
based exchange rate with periodic “re-alignments”).
USD/JPY
The Plaza Accord
(1985) purposely
devalued the dollar
against the Yen and
Deutschmark by
51%
400.00
350.00
300.00
250.00
200.00
The Louvre Accord
(1987) ended the
dollar devaluation
policy of the plaza
accord
150.00
100.00
50.00
0.00
Jan-71
Jan-75
Jan-79
Jan-83
Jan-87
The Smithsonian Agreement (1971-1973) attempted to return to
the Bretton Woods system but without dollar/gold convertibility
In the meantime, the Europeans were developing an exchange rate system
of their own. Called the ERM (European exchange rate mechanism), this
system involved member countries to peg to an artificial currency called a
European Currency Unit
Currency
Weight (%)
Belgian Franc
8.183
German Mark
31.915
Danish Krone
2.653
Spanish Peseta
4.138
French Franc
20.306
British Pound
12.452
Greek Drachma
.437
Irish Punt
1.086
Italian Lira
7.84
Luxembourg Franc
.322
Dutch Guilder
9.87
Portuguese Escudo
.695
The ECU was the original
recipe for the Euro
In 1992, George Soros (Quantum Fund) believed the British pound was
overvalued and began selling. On September 19, 1992 the British
government was forced to withdraw from the ERM and devalue the pound.
2.05
1.95
GBP/USD
1.85
1.75
1.65
1.55
George
Soros made
a profit of
$1B!!!
1.45
1.35
1.25
8/1/90
8/1/91
8/1/92
8/1/93
8/1/94
8/1/95
Political turmoil and economic weaknesses led to a
collapse of the Mexican Peso in 1994.
This currency problem
eventually spread through Latin
America through what has
become knows as the “Tequila
Effect”
(Not to be confused with the
other “Tequila Effect”)
1998
1997
2000
1999
2002
2001
Currency markets have had a turbulent decade!!!
2003
In January, 2002, the Euro officially
entered circulation in Europe. Since the
emergence of the Euro in 1999, the
dollar has had a bumpy ride!
1.40
USD/EUR
1.30
Will the Euro
survive as a
major
currency?
1.20
1.10
1.00
0.90
0.80
Jan-99
Jan-01
Jan-03
Jan-05
The foreign exchange market is unique not just because of its geographic
dispersion, but also because of its extreme liquidity and tremendous
volume – around $1.9T PER DAY!!
Name
% of Volume
$600B in Spot market
Transactions
Deutsche Bank
17
UBS
12.5
$1.3T in Derivative Market
Transactions
Citigroup
7.5
HSBC
6.4
Barclays
5.9

$200B in Forwards

$1T in Swaps
Merrill Lynch
5.7

$100B in Options
JP Morgan Chase
5.3
Goldman Sachs
4.4
ABN Amro
4.2
Morgan Stanley
3.9
The ten most active traders account for 73% of the volume
With trading centers in New York City, London, Tokyo and Sydney, currency
markets operate 24 hours a day, 5 days a week.
Eastern Standard Time
12
AM
3
AM
8
AM
12
PM
5
PM
9
PM
Australia: 5PM - 2AM
8PM - 5AM
30000
Tokyo
London: 3AM -11AM
New York City: 8AM -5PM
Transactions/Hour
25000
20000
15000
10000
5000
0
12:00AM
4:00AM
8:00AM
12:00AM
4:00PM
8:00PM
11
PM
Unlike other asset markets, England dominates foreign
exchange trading
Germany
Switzerland 5%
4%
France Singapore
3%
6%
Canada
3%
Australia
3%
Japan
9%
Other
19%
US
16%
UK
32%
Why is
this?
The “Majors”
USD/GBP
11%
USD/CHF
5%
USD/CAD
4%
USD/AUD
4%
USD/Other
17%
EUR/All
8%
USD/JPY
20%
USD/EUR
31%
The six “Majors” are: The US Dollar (USD), Japanese Yen (JPY), Euro (EUR),
British Pound (GBP), Swiss Franc (CHF), Australian Dollar (AUD), and the
Canadian Dollar (CAD)
Spot transactions are executed immediately. A spot exchange rate is
simply the price of one currency in terms of another currency.
VS
USD/JPY = 110.49 (1 USD = 110.49 JPY)
400.00
350.00
The dollar appreciated against
the Yen in the early eighties
(USD/JPY increased )
USD/JPY
300.00
250.00
200.00
150.00
100.00
50.00
0.00
Jan-71
Jan-76
Jan-81
Jan-86
Jan-91
Jan-96
Jan-01
Jan-06
Overall, the trend is a dollar
depreciation (A decrease in
USD/JPY)
In currency markets you need to PAY ATTENTION TO THE UNITS!!!!
VS
EUR/USD = 1.2885 (1 EUR = 1.2885 USD)
The dollar has been depreciating
against the Euro since 2001 (an
increase in EUR/USD)
1.4000
1.3000
1.2000
1.1000
1.0000
The dollar appreciated sharply
against the Euro after its 1999
release (a decrease in EUR/USD)
0.9000
0.8000
Jan-99
Jan-01
Jan-03
Jan-05
Suppose that you take a long position and a short position in
Japanese Yen.
Long: $10,000,000 USD/JPY 110.00
Short: $10,000,000 USD/JPY 110.10
These prices are in terms of
Yen per dollar!!
Profit = .10 ( $10,000,000) = Y 1,000,000
Y 1,000,000
= $9,082.65
110.10
Again…pay attention to the units!!!
As a currency dealer, you need to decide where to buy,
where to sell and at what prices
USD/CHF = 1.2050 – 1.2055
Bid Price for Dollars
Spread = 5 “Pips”
Offer Price for
Dollars
.0005 CHF
Profits (Per dollar traded) = $1 (.0005) = 1.2055
= $0.0000417
What influences the spread?
Liquidity
News/Announcements
Trade Size
Why can’t we increase
the spread to increase
profits?
Unlike other assets, there is no centralized exchange that determines
currency prices. The “market” is a network of dealers.
As an individual dealer, you “skew” your price relative
to the market
USD/AUS
Market = 1.2884 – 1.2890
You: 1.2882 – 1.2888 ?
You: 1.2884 – 1.2890 ?
You: 1.2886 – 1.2892 ?
What affects your price?
Economic Fundamentals
Technical Analysis
Order Flow
Your Position
We will talk about both of these
methods this semester
Market: EUR/USD = 1.2882 – 89
Current Order: Buy 10 Million Euro
What price will you quote?
Scenario #1: Your current position is long 25M Euro
Scenario #2: Your current position is short 25M Euro
Scenario #3: Your current position is square; order to sell 20M Euro if
1.2881 deals stop loss
Scenario #4: Your current position is long 25M Euro; order to sell 20M
Euro if 1.2881 deals stop loss
Scenario #5: You’re short 20M Euros. NEWS: FED SEEN BUYING EUROS
IN THE MARKET
Market: EUR/USD = 1.2882 – 89
Current Order: 10 Million Euro
What price will you quote?
Scenario #1: German unemployment soars to 8.9%, much higher than
expected
Scenario #2: Fed raises Fed Funds 50 Basis Points
Scenario #3: S&P downgrades Japanese debt to A from Aa
Scenario #4: Rice’s trip to the Middle East ends with no resolution.
Violence continues
Scenario #5: US department of labor announces 350,000 new jobs created
in July. Much higher than the expected number of 100,000
Suppose that a dealer were offering Euro at $1.22 in New York City
while a dealer in London was offering Euro at $1.24
1
Sell Euro short in London
3
Use your newly acquired
Euro to pay off your short
position
2
Use the proceeds to buy
Euro in New York
Arbitrage insures that currency prices will be the same at different
locations around the world. (Arbitrage will raise the price in NYC and
lower the price in London)
Suppose that a dealer in New York City was offering the following
prices:
Euro/USD = $1.25
USD/JPY = Y115
Euro/JPY = Y135
2
1
Use the
dollars to
buy Yen at
Y115
3
Sell Euro
short at $1.25
Use the Yen
to buy Euro
at Y135
Repay your short position
The USD/JPY, and Euro/JPY rates imply a Euro/USD rate (Cross Rates)
USD/JPY = Y115
Euro/JPY = Y135
Y135
Euro/USD =
Y115
= $1.17
Voice Brokers
Direct Market
Offer
Bid/Offer
Bid/Offer
Bid
Banks contact brokers through
dedicated phone lines. The broker
quotes a bid or offer
Bid/Offer
Traders contact market makers via phone
or computer. Each trader is given a bid
and offer and can accept either (or both)
Electronic Exchange
Bid
Offer
Offer
Traders submit orders to a
computer network which
automatically match up
buys and sells
Since the early nineties, trading in currency markets have shifted towards
electronic trading platforms. Any trade less than $10M will almost definitely
be handled by computer
Prices have become more transparent
Spreads collapsing
Volume, Volume, Volume!!!
Voice
Brokers
5%
Electronic
30%
Direct
Market
60%
1994
Voice
Brokers
5%
Direct
Market
10%
Voice
Brokers
40%
Electronic
85%
2000
Electronic
95%
2002
Forward contracts involve transactions to be made at a later date.
CAD/USD
1 month forward
3 months forward
6 months forward
.9063
.9065
.9075
.9090
0.91
0.909
0.908
0.907
0.906
0.905
0.904
0
8
Contract signed
14
20
26
30
36
Transaction Made
(Spot Rate = .9087)
42
Long position in CAD
earns .0012 CAD profit
per CAD of contract size
Derivative markets offer a variety of ways to hedge
currency risk



Futures are standardized forward contracts, many futures are traded
in centralized markets (Chicago Mercantile Exchange)
 JPY: 12,500,000 Yen
 GBP: 62,500 Pounds
 Euro: 125,000 Euro
 CAD: 100,000 Canadian Dollars
Options give the buyer the right to buy/sell currency, but not the
requirement
 Call: The right to buy at a specific “strike price”
 Put: The right to sell at a specific “strike price”
Currency Swaps represent agreements to exchange one
currency for another at multiple pre-specified prices/dates.
How do Multinational
Corporations deal with
exchange rate risk?
What causes exchange rates to
change? How can we detect
overvalued/undervalued
currencies?
Questions to be
Answered
What causes currency
crashes? What
underlying conditions
make them more likely?