Lecture 4 International finance Readings: Chapter 3: ESM Balance of payments Chapter 5: The FX Market Exchange rate markets - Bid-ask -spread - Cross-rates - Calculating exchange rate changes The currency markets: - Largely facilitated by banks and investment banks - 24-hour - Most liquid time of the day – New York and London time - Participants and products FX Participants: - Buy side - Corporations - Real money accounts – money managers/cash flow available - Leverage accounts - Retail accounts - Governments - Central banks - Sovereign wealth funds - Sell side: - Large dealing banks - Financial institutions Bid and ask - Currency markets are (mostly) dealer-based, dealers earn the bid-ask-spread or dealer’s spread - Dealers take a position in the asset - Dealer’s earn the bid-ask spread - Bid price – rate at which the dealers buy a currency - Ask price – rate at which they sell a currency - Buy low - Sell high - Difference – spread - Wholesale markets – bid-ask spread is small - Higher currency pairs with greater volatility and bid ask spread will increase if volatility increases - Higher for more thinly traded pairs – not as frequent – higher spread - Calculating spread: EXAM QUESTION - Percentage = (ask price-bid price )/ask pricex100 - - mid-point quote – average of bid and ask quotes Dealers make money on currency exchanges by the difference between the bid price, or the price they will offer to pay, and the ask price, or the price at which they offer to sell the currency. John Rusnack trader Bid-ask-spread $31.4762-31.4778 16 pips Cross rates many currency pairs are inactively traded So, the convention is quotation against the dollar US dollar – most liquid currency A cross exchange rate – any rate between a currency pair in which neither is the USD 80% of forex trading involves the dollar the most liquid dollar cross rates example use example from notes from France arbitrage – using cross rates to make money – triangular arbitrage forward premium/discount If it costs more to buy a currency for forward delivery than for spot delivery, then we can say that it is traded at a forward premium Current euro-pound spot rate is S(E/#) = 1.6 and a one year forward of 1.5 Premium/discount = 1.5-1.6/1.6 x360/360 x 100 = -6.25% Pound Is trading at a forward discount of 6.25% When is a base currency at a forward discount? When the forward rate is below the spot rate Defining terms – currency movements: - Weakening/deterioration/depreciation of a currency - Strengthening/appreciation of a currency: use these terms when referring to floating exchange rate systems - Devaluation of a currency/revaluation – fixed/pegged exchange - Soft/weak – expecting depreciation - Hard/strong – expecting appreciation Appreciation/Depreciation Depreciation - Domestic currency - Rise in exchange rate – implies depreciation of domestic currency - Domestic currency is weaker and foreign currency is stronger - EURO/A$ = 0.7627 – euro price per 1 AUS$ - 3 months later: EUR/A$ = 0.8130 – it takes more EUR to buy 1AUS$ - Euro depreciated against the Aussie $ - It takes more EUR to buy 1 Aussie $ - Euro is the domestic currency - Domestic currency is weaker if it takes more to buy the foreign currency - Foreign currency is stronger Appreciation - Decline in the exchange rate - implies appreciation of the domestic currency - Takes less domestic currency to buy one unit of foreign currency - EUR/AUS$ = 0.8130 - 4-months later EUR/AUS$ = 0.6757 - EUR appreciated against the AUS$ Calculating exchange rates: - If the EUR/USD$ rate goes 1EUR =$0.93 TO 1EUR =$1.09 e0 = old dollar value of EUR = 0.93 e1 = new dollar value of EUR = 1.09 appreciation of EUR = (NEW DOLLAR VALUE OF EUR – OLD DOLLAR VALUE OF EUR)/OLD DOLLAR VALUE OF EUR = (e1-e0)/e0 Euro appreciation = (e1-e0)/e0 = (1.09-0.93) / 0.93 = 17.20% EURO APPRECIATION = 17.2% Yen Example: S($/Y) = 0.010817 to S($/Y) = 0.0123265 - Costs more $ to buy 1 yen Depreciation of dollar to yen Appreciation of yen to dollar By how much has the yen appreciated? (e1-e0)/e0 = (0.0123265-0.0108170/0.0108017 = 14.12% YEN APPRECIATED 14.12% How much has dollar depreciated? Reciprocal 1/x $/Y = dollar value per 1 Yen to find Y/$ = yen value per 1 USD you must use reciprocal 1/0.0108170 = 92.477 YEN 1/0.0123265 = 81.126 YEN e0 = 92. 477 e1 = 81.126 e1-e0/e0 = 81.126-92.477/92.477 = -12.37% Dollar depreciated 12.37% Equilibrium spot exchange: - Exchange rates are determined by supply and demand - The markets for currencies are a bit more complex than standard financial assets - Euro-US Dollar exchange rate: - If trader demands (buys) EUR, the by definition he/she is supplying (selling) dollars If trader supplies (sells) in EUR, then by definition he/she is demanding (buying) in dollars Example: what transactions create demand for euro? 1.European exporters to the US earn revenues in US dollars To bring revenue home, the exporter must sell dollars/buy euros 2. Investors from the US in euro denominated financial assets Need to buy euro to invest in European assets 3. Tourists visiting Europe need euro 4. Speculation What transactions increase supply of euro? - European importers pay US suppliers in dollars - They must convert EUR to USD - Buy USD/sell EUR – INCREASE SUPPLY OF EUR - Europeans investing in the US in dollar denominated financial assets – need to buy dollars to invest in American assets – sell euro - Tourists visiting the US – sell euro for USD - Speculation Euro will strengthen if ( other things equal) - European exports more than imports (current account surplus) - There are more capital inflows than outflows - If demand exceeds supply, its price will rise - D > S = currency appreciation - Euro will weaken if - - we import more than we export (current account deficit) - there are more capital outflows than inflows - if supply exceeds demand, the price will fall. - S > D = currency depreciation Factors effecting the exchange rate equilibrium - Differentials in inflation rates - Differentials in interest rates - Differentials in economic growth rates - Political and economic risk - Trade and current account deficits (BoP) Turkish Lira fall - Turkey raises interest rate to tackle lira’s fall - Bank increased its main rate to 10.25% from 8.25% - Turkish company example: borrowed 10,000,000 dollars - Paying back interest – as currency depreciates – becomes more expensive - Increase interest rate to curb inflation - Encourage inflows into turkey Balance of Payments: set of accounts showing all economic transactions between residents of the home country and the rest of the world in any one year Important for government policymakers and MNE’s as it is a gauge of a nation’s competitiveness or health For an MNE, both home and host country BOP data is important as: - An indication of pressure on a country’s foreign exchange rate - A signal of the imposition or removal of controls in various sorts of payments - A forecast of a country’s market potential BOP: 1. 2. 3. 4. 5. The current account Capital account Financial account Official reserve accounts – tracks government currency transactions The net errors and omissions account is produced to preserve the balance of the BOP The BOP must balance It cannot be in disequilibrium unless something has not been counted or has been counted improperly Exchange rate formula: The Current Account: - Current Account includes all international economic transactions with income or payment flows occurring within one year Difference between net exports and imports of goods (cars/computers/textiles)/services(banking/travel) Net income from abroad (income associated with previous investments If US firm has subsidiary in S.K. net income paid to parent company – wages, salaries Net current transfers Financial settlements associated with changes in ownership (foreign aid) Service exports Ireland Capital and Financial Accounts - The capital and financial accounts of the balance of payments measure all international economic transactions of financial assets. - At a high level the accounts = (the change in foreign ownership of domestic assets – change in domestic ownership of foreign assets) - Breaking it down – the subcategories include - FDI - Portfolio investment - Other-asset investment Net Errors AND Omissions/Official Reserves Accounts - Net errors and omissions account ensures that the BOP actually balances - The official reserves Account is the total reserves held by the official monetary authorities within the country - These reserves are normally composed of the major currencies used in international trade and financial transactions - Significance of official reserves – depends on whether the country is operating under a fixed exchange regime or a floating-exchange system VIDEO: Why are emerging markets concurrencies failing - Big debt in dollars - As dollar strengthens it becomes more difficult to pay back China’s Current Account – Article - Undervalued Yuan/frugal people – china selling a lot abroad and buying very little back - Current Account surplus reached 10% of GDP in 2007 - Current account balance is the difference between a country’s investment and savings - Data on savings are patchy in China - Its savings outweighed its colossal investment - Savings has dropped – big increase in consumption - Current account deficit in 1st quarter was exaggerated - Likely to return to a surplus in the coming months - Surplus will be just 1% of GDO this year and 0.5% next year - Exchange rate will become more volatile Chinas door is creaking open: - Foreign participation in China’s domestic capital markets has reached unprecedented levels over the past 2 years - Foreign investors say Chinese markets still need to enhance access, ensure greater liquidity and improve hedging mechanisms to evolve up to the standards of developed nations - Decision by MSCI to add Chinese stocks – A shares to their flagship emerging markets index had been a catalyst for foreign inflows - Stock connect PROGRAMME – allows foreign investors to purchse stocks through Hong Kong brokers TUTORIAL BASED ON LECTURE 4 (WEEK 5) QUESTIONS: Mexican Pesos MXN/USD = MXN pesos per 1 USD - 3.2 pesos per 1 USD - to - 5.5 pesos per 1 USD initial rate : 3.2 new exchange rate : 5.5 percentage change = beginning rate-ending rate/ending rate 3.2-5.5/5.5 = -41.82% direct method – Mexican pesos is the domestic currency Mexican pesos is depreciating against the USD Anytime a government sets or resets the value of its currency, it is a managed or fixed exchange rate QUESTION 2: HK $7.8/USD Yuan 8.28/USD TO 8.11/USD Original Chinese yuan peg to dollar: 8.28 Revalued yuan to dollar: 8.11 HK$ PEG TO USD: 7.8 Original HK$/Yuan cross rate HK$/Yuan 7.8 x 1/8.28 = 0.9420 New HK$/Yuan cross rate: HK$/Yuan7.8 x 1/8.11 = QUESTION 3: Spot rate GTO/EUR cross rate = GTQ 10.5799/EUR Pot rate on the EUR/REAIS cross rate = 0.4462EUR/REAIS A. what is the Guatemalan quetzal/Brazilian reais cross rate? B. How many quetzals will Isaac get for his reais? Reais amount from parents: 4,500.00 Spot rate GTQ/EUR: 10.5799 Spot rate EUR/REAIS: 0.4462 What is the GTQ/REAIS? 4.72 GTQ/REAIS = GTQ/EUR X EUR/REAIS 10.5799 x 0.4462 = 4.72 how many quetzals? GTQ/REAIS = GTQ/EUR X EUR/REAIS 4.72 x 45000 = 21,240 quetzals QUESTION 5: Triangular Arbitrage question Fuji Y92/$ U.S.A SF 1.02/$ SWISS Y90/SF SF12,000,000 1. BUY DOLLARS WITH SF IN U.S.A. SF 1.02/$ = 11,764,705.88 $ 2. USE DOLLARS TO BUY YEN IN FUJI Y92/$ = 1,082,352,941 YEN 3. USE YEN TO BUY SF IN SWISS Y90/SF = 12,026,143.79 SF INCREASE IN WEALTH = 12,026,143.79 – 12,000,000 = 26,143.79 SF PROFIT