1/9/2020
International Finance
Assoc. Prof. Dr. Mai Thu Hien
hien.mai@ftu.edu.vn
Faculty of Banking and Finance
Foreign Trade University
1
Course description
• This course is designed to provide students of all majors with a
comprehensive introduction and overview of international finance
with emphasis upon monetary and macroeconomic relations as well
as capital mobility between countries to explain the real issues in the
world and Vietnam relating to the causes of exchange rate
movements, the monetary and exchange rate issues and policies
between countries, the implications of monetary and
macroeconomic linkages between countries, the balance of
payments problems, the capital mobility, the international financial
markets, the international financial institutions, the financial and
banking services integration, and the international monetary
system’s issues.
• The course will be conducted in lecture-discussion over 8 weeks.
• The primary reference materials are from the text books and power
point notes designed to cover important aspects of international
finance.
• Read the textbook material before and after the lecture covering
that material.
Course objectives
Upon completion of the course, the student should be able to:
• Express knowledge of the basic determinants of exchange rates
between different currencies;
• Explain the international parity theories and their implications
for policy decisions;
• Analyze the balance of payments;
• Develop knowledge of international financial markets as well as
foreign exchange markets;
• Interpret roles of international financial institutions in
international financial markets;
• Assess the international monetary system and its issues
(financial crises).
3
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Major Textbooks
• Daniels, Joseph P. and David D. VanHoose, 2005, International
Monetary and Financial Economics, 3rd edition, SouthWestern/Thomson.
• Eiteman, David K., Stonehill, Arthur I., and Moffett, Michael H.,
2013, Multinational Business Finance, 13th edition, Pearson.
• Eun, Cheol S., Resnick, Bruce G., and Sabherwal, Sanjiv, 2015,
International Financial Management, 7th edition, McGraw-Hill.
• Levi, Maurice D., 2009, International Finance, 5th edition,
Routledge.
• Madura, Jeff, 2015, International Financial Management, 12th
edition, Cengage Learning.
• Pilbeam, Keith, 2006, International Finance, 3rd edition, Palgrave
Macmillan.
Required readings
• Mai Thu Hien, 2016, International Finance: Questions and
Exercises, Bach Khoa Publishing House.
• Mai Thu Hien, 2013, Exchange Rate Policy for Transition
Economy of Vietnam, Bach Khoa Publishing House.
Optional Readings
• Copeland, Laurence, 2014, Exchange rate and International
Finance, 6th edition, Pearson.
• Gandolfo, Giancarlo, 2016, International Finance and OpenEconomy Macroeconomics, 2nd edition, Springer.
• Krugman, Paul R., Maurice Obstfeld and Marc J. Melitz, 2018,
International Finance Theory and Policy, 11th edition, Pearson.
• Rødseth, Asbjørn, 2000, Open Economy Economics, Cambridge
University Press.
• Sarno, Lucio, and Mark P. Taylor, 2002, The Economics of Exchange
rate, Cambridge University Press.
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Website
• http://www.abyznewslinks.com/
• http://www.ecb.int/
• http://www.econstats.com/
• http://www.dbresearch.com/
• https://www.federalreserve.gov/
• http://www.fedstats.gov/
• http://www.iie.com/
• http://www.imf.org
• https://www.sbv.gov.vn/
Course outline
Particular emphasis is placed on the following five issues:
• Exchange rate: determination, theory, evidence and policy;
• The balance of payments;
• International financial markets with focus on foreign
exchange market and foreign exchange derivatives;
• International monetary system: past, present and future;
and international financial institutions
• International financial crises.
8
Chapter 1. An overview of international finance
Teaching
activities
Lecture
Assessment
Students’
Content
preparation
1.1. The formation and development of Ch1[1]; Ch1[3];
international finance
Ch1[4]; Ch1[7]
1.2. The roles of international finance
1.3. The content of the course
- What is international finance?
- Characteristics of international finance?
- Factors affecting the development of international finance?
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Chapter 2. The fundamentals of exchange rates
Teaching
activities
Lecture
Content
Practice,
Seminar
Assessment
Students’ preparation
2.1. Exchange rate fundamentals
Ch2 (34-50)[1]; Ch6
2.1.1. Definition
(148-156)[2]; Ch4[5];
2.1.2. Exchange rate quotation
Ch1[6]; Ch2[7]; Ch1,
2.1.3. Exchange rate classification 2[8]; Ch1 (1.1)[9]
- Using the exchange rate policy management in Vietnam, China
and other countries to clarify exchange rate definitions.
- The process of becoming the reserve and international of the
Chinese yuan.
- Exercises for cross rates and EER.
- What is appreciation? Depreciation? Its effects on export,
import, and investment?
- What is revaluation? Devaluation? Take examples?
- What is overvaluation? Undervaluation? Take examples?
- Differentiate between real and nominal exchange rate?
- Differentiate between real and nominal effective exchange rate?
- Exercises for cross rates and EER.
Chapter 2. The fundamentals of exchange rates
Teaching
activities
Lecture
Practice,
Seminar
Assessment
Students’
preparation
Ch2 (52-58), 8 (267273)[1]; Ch8[4];
Ch4, 6 (195-201)[5];
Ch1[6]; Ch2[7]
Factors affecting the supply of and demand for foreign currency in
Vietnam foreign exchange market.
- According to simple model of exchange rate determination, what are
factors affecting the supply of and demand for foreign currency in the
foreign exchange market?
- Foreign exchange managements according to current and
capital/financial account transacations?
Content
2.2. Exchange rate theories
2.2.1. Supply-and demand view of exchange
rates
Chapter 2. The fundamentals of exchange rates
Teaching
activities
Lecture
Practice,
Seminar
Assessment
Content
Students’ preparation
2.2.2. Purchasing power parity
Ch2 (59-63)[1]; Ch 7[2];
Ch5[4]; Ch6[6]; Ch2[7];
Ch2, 3[9]; Ch15 (15.1)[10]
Exercises for PPP.
- State the law of one price?
- State purchasing power parity and its application?
- Exercises for PPP.
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Chapter 2. The fundamentals of exchange rates
Teaching
activities
Lecture
Content
Students’ preparation
2.2.3. Interest rate parity
Ch4 (106-123)[1]; Ch
2.2.4. The relationship between interest 7[2]; Ch6[4]; Ch2[7];
rates, inflation rates and exchange rates Ch3[9]; Ch4[10]
Exercises for IPR and IFE.
Practice,
Seminar
Assessment - Covered and uncovered interest rate arbitrage?
- Covered and uncovered interest rate parity?
- The meaning of forward margin (forward discount and
primium)?
- The meaning of International Fisher effect?
- Analyze the relationship between the exchange rates, interst rates
and inflation rates?
- Exercises for IPR and IFE.
Chapter 2. The fundamentals of exchange rates
Teaching
activities
Lecture
Practice,
Seminar
Assessment
Content
Students’ preparation
2.3. Models of exchange rate determination Ch 9[1]; Ch9[4];
2.3.1. The monetary approach to the
Ch7[6]; Ch2[7];
exchange rate
Ch5[9]; Ch15
(15.3)[10]
Explore the relationship between the money supply and the exchange
rate in Vietnam and other countries.
- Characteristics of MA?
- MA under flexible exchange rate regimes: fundamental factors?
Effects of a money supply increase on the nominal exchange rate?
Why does not an increase in government expenditure affect the
nominal exchange rate?
Chapter 2. The fundamentals of exchange rates
Teaching
activities
Lecture
Practice,
Seminar
Assessme
nt
Content
Students’ preparation
2.3.2. The portfolio balance model Ch 9-12[1]; Ch9[4]; Ch4,
2.3.3. Mundell-Fleming model
8[6]; Ch2[7]; Ch4, 6-8[9];
Ch10, 11, 15 (15.3)[10]
Apply Mundell-Fleming Model to explain the management of
the monetary and exchange rate policy of the State Bank of
Vietnam.
- Characteristics of PA and MFM?
- Analysis of PA in the long run and short run?
- MFM under flexible exchange rate regimes: effects of an
expansionary monetary and fiscal policy on the exchange rate?
Effects of an increase in the price level, output and foreign
interest rate on the exchange rate?
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Chapter 2. The fundamentals of exchange rates
Teaching
activities
Lecture
Practice,
Seminar
Assessment
Students’
Content
preparation
2.4. Exchange rate policies and management
Ch3 (71)[1];
2.4.1. Definition
Ch10[6];
2.4.2. Objectives
Ch2[7]; Ch1,
2.4.3. Management of exchange rate policies 2[8]; Ch17[9]
2.5. Exchange rate regimes
2.5.1. Fixed exchange rates
2.5.2. Floating exchange rates
2.5.3. Intermediate exchange rate regimes
2.5.4. Determinants in choice of exchange
rate regimes
2.6. Factors affecting exchange rates
The monetary and exchange rate policy of Vietnam, China and
other countries.
- What is the objetive of the exchange rate policy?
- The central bank management under flexible and fixed exchange
rate regimes?
- The exchange rate management of the central bank?
- The foreign exchange management of the central bank?
- Differentiate between sterilised and unsterilised intervention?
- Advantages, disadvantages of flexible, intermediate and fixed
exchange rate regimes?
Chapter 3. The balance of payments
Teaching
activities
Lecture
Practice,
Seminar
Assessment
Students’
Content
preparation
3.1. Introduction to the balance of payments Ch 1 (12-29)[1];
3.1.1. Definition
Ch4[2]; Ch3[3];
3.1.2. BOP accounts
Ch7[4]; Ch2[5];
3.1.3. BOP accounting
Ch2[6]; Ch3[7];
3.1.4. Surplus, deficit and balance of
Ch1 (1.3)[9];
BOP accounts
Ch5[10]
The balance of payments of Vietnam, China and other
countries.
- What are residents and nonresidents?
- Why is the balance of payments balanced?
- Structure of the balance of payments?
- Why is the foreign exchange market in equilibrium when the
balance of payments is balanced?
Chapter 3. The balance of payments
Teaching
activities
Lecture
Practice,
Seminar
Assessment
Students’
Content
preparation
3.2. Approaches to the balance of payments
Ch8 (2743.2.1. Elasticity approaches to the BOP
288), 9[1];
3.2.2. Absorption approaches to the BOP
Ch7[4]; Ch3,
3.2.3. The monetary approach to the BOP
5[6]; Ch3[7];
3.3. The BOP interaction with key macroeconomic variables Ch7, 12[10]
- Apply elasticity approach to explain the effect of the exchange rate
devaluation on China balance of payments.
- Exercises on the elasticity and the balance of payments.
- The relationship between the exchange rate and the balance of payments?
- Analyse the effects of exchange rate devaluation on the balance of
payments acording to elasticity approach? Absorption approach?
Monetary approach?
- Why does the trade balance deteriorate initially and improve eventually
following the exchange rate depreciation?
- What does Marshall-Lerner condition state?
- The macroeconomic combination to get internal and external balance
under flexible and fixed exchange rate regimes?
- Exercises on the elasticity and the balance of payments.
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Chapter 4. International financial markets
Teaching
activities
Lecture
Students’
Content
preparation
4.1. The formation of international financial Ch6, 8[2];
markets
Ch4, 6-9[3];
4.2. The definition of international financial
Ch3[5];
markets
Ch12[6];
4.3. Roles of international financial markets
Ch4[7]
4.4. Classification of international financial
markets
4.5. The development trends of international
financial markets
What should investors pay attention to when planning to
Practice,
invest in the stock market of a developing country? Take the
Seminar
case Vietnam stock market.
Assessment - The history of Eurocurrency markets?
- Differentiate between Euronote and Euro commercial paper?
- Differentiate between dosmetic, foreign, international and
global bonds?
- Differentiate between registered and unregistered Eurobond?
- International bond market instruments?
- International stock market instruments?
Chapter 4. International financial markets
Teaching
activities
Lecture
Practice,
Seminar
Assessment
Content
Students’ preparation
4.6. Introduction to some international Ch6, 8[2]; Ch4, 6-9[3]; Ch3,
financial markets
5[5]; Ch12, 13[6]; Ch4[7]
Exercises for currency derivatives and international financial markets.
- Purposes of currency derivatives?
- Differentiate between arbitrage, speculation and hedging?
- Differentiate between currency derivatives?
- Exercises for currency derivatives and international financial markets.
Chapter 5. International monetary
systems and financial institutions
Teaching
activities
Lecture
Practice,
Seminar
Students’
Content
preparation
5.1. International monetary systems
Ch3[1]; Ch3[2];
5.1.1. Gold Standard
Ch2[3]; Ch10, 11[4];
5.1.1. The Bretton Woods System
Ch2[5]; Ch5[7];
5.1.2. Eurocurrency market
Ch11, 14, 16[6]; Ch1
5.2. Financial institutions
(1.5), 11[9]; Ch3, 205.2.1. The International Monetary Fund 22[10]
5.2.2. The World Bank
5.2.3. The Asian Development Bank
5.2.4. Other financial institutions
- Roles of international financial institutions
- EU and Brexit issues.
- Asian Infrastructure Investment Bank (AIIB) and its impacts on the
world economy.
- WB, ADB and their roles on developing economies.
- Roles of the IMF in early warning financial crisis.
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Chapter 5. International monetary systems
and financial institutions
Assessment
- What is Gresham’s law?
- Advantages and disadvantages of the gold standard?
- How was the exchange rate determined under the gold standard?
- The cause of the collapse of the gold standard?
- Objectives of Bretton Woods system?
- Why was Bretton Woods system described as a dollar-based goldexchange system?
- The cause of the collapse of Bretton Woods system?
- How was SDR established?
- What are the legal framework and operational mechanism of EMS?
- Impacts of Euro on EMU members?
- EU and Brexit issues?
- What is the optimal currency area?
- Prospects of Asian Monetary Union or ASEAN Monetary Union?
- What is the exchange arrangement of Japan, US, Thailand, and
Hongkong under IMF exchange rate classification in 2009?
- Establishment and organization of the IMF? Its main activities in
money and credit area?
- What kind of bank is BIS? IBRD? WB?
- Activities of institutions of the WB group?
- Objectives, roles and supports of the WB?
- Credit activities of ADB?
- What is about AIIB?
Chapter 6. International financial crises
Teaching
activities
Lecture
Practice,
Seminar
Assessment
Students’
Content
preparation
6.1. Definition
Ch5[2]; Ch15,
6.2. Classification
17[6]; Ch6[7];
6.2.1. Currency crises
Ch18[9]; Ch16,
6.2.2. Bank crises
24[10]
6.2.3. Debt crises
6.2.4. Twin crises
6.3. Early warning systems of financial crises
Roles of the IMF and credit rating agencies (Big Three) to warn early
financial crisis.
- Differentiate between currency crisis, banking crisis and twin crisis?
- What is the signals of debt crisis? Name some major debt crisis?
- Present the first generation models of currency crisis? Advantages and
disadvantages of the models? Take example currency crisis?
- How does the second generation models of currency crisis explain the
currency speculation attack? Advantages and disadvantages of the
models? Take example of currency crisis?
- How is the twin crisis (currency and banking crisis) explained by the third
generation models of currency crisis? Take example of currency crisis?
- How does the impossible trinity (or trilemma) explain the causes of recent
currency crisis?
- What causes bank panic?
- What happens during bank run?
- Why is banking crisis associated with a large number of depositors
withdraw cash from banks?
- Explain contagion effects of crisis spread within the banking system?
- What types of twin crisis are there?
Chapter 6. International financial crises
Teaching
activities
Lecture
Content
Students’ preparation
6.4. The financial crises in recent times
Ch5[2]; Ch15, 17[6];
6.4.1. The Japanese Banking crisis 1990
Ch6[7]; Ch18[9]
6.4.2. The European currency crisis 19921993
6.4.3. Mexican currency crisis 1994
6.4.4. East Asian financial crisis 1997 – 1998
6.4.5. Russian crisis 1998
6.4.6. Argentina crisis 2001 – 2002
6.4.7. US financial crisis 2007 – 2008
6.4.8. Vietnamese financial crisis
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Chapter 6. International financial crises
Assessment
- Causes of the East Asian financial crisis 1997-1998 and countries’ responses? Impacts on
Vietnam economy? Lessons for Vietnam? Why did not Vietnam suffer a severe crisis like East
Asian countries?
- Causes of the Russian financial crisis 1998 and experience lessons?
- What were the Argentine government’s measures to overcome the economic and financial crisis
2001-2002?
- The roles of the IMF during crisis of Argentina, Indonesia and South Korea?
- Compare the Argentina’s crisis 2001-2002 with the East Asia’s financial crisis 1997-1998?
- Present Mexican crisis 1994-1995 and experience lessons?
- How did Krugman and Flood Gerber models explain the Mexican crisis 1994?
- Compare Japan’s banking crisis in 1991-2005 with the US financial crisis 2007-2008?
- Why did Japan’s banking crisis persist for more than two decades?
- What is liquidity trap in Japan’s banking crisis?
- What was the problem of EMS which led to the crisis 1992-1993? What were the consequences
of the crisis?
- Causes of the US financial crisis 2007-2008? How did countries’ governments respond to
recover from crisis?
- The Latin American debt crisis in the 1980s: causes, consequences and cures?
- Causes of the European sovereign debt crisis 2010?
- Sovereign debt crisis 2010 in PIIGS countries?
- Vietnam’s public debt situation and management?
Course policy
•
•
•
•
•
•
•
The course policy is under the current training regulations.
All students are expected to attend classes, prepared for and actively involved in
the discussions during the lecture, practice and seminar time.
Student attendance in classes is compulsory. Students must attend class
regularly and on time, participate actively and proactively in discussions, and do
homework.
Students, who do not attend class or do not do in-class exercise, will get zero for
class attendance assessment each time.
Students, who do not do homework or do not prepare at home for presentation
about the topic assigned by the instructor during the lectures, practices, and
seminars, will get zero for class attendance assessment each time.
Students, who do not submit mid-term assignments by the due date, will get
zero.
Students, who participate actively, make presentation, do homework well, and
respond well to the instructor’s questions and exercises during the lectures,
practices, and seminars, can be given an extra credit (bonus point) of maximum
0.5 to summative assessments for each time (mid-term exam). The maximum
bonus in total is 1.5 (Instructors decide to add points).
Course assessment
• Formative assessment (10%)
Formative assessments are conducted in the
form of class attendance checking, homework
assignments, oral presentation, and/or in-class
assignments, etc.
• Summative assessment (90%)
No.
1
2
Assessment
Group assignment
Final exam
Rate
30%
60%
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Formative assessment
Each class attending or workout is counted as 1
attendance point.
• Class attendance checking: maximum to 10 times.
• Doing homework checking: maximum to 1 time
– Doing homework: 1 attendance point
– Not doing homework: 0 attendance point
• Oral presentation checking: maximum to 1 time
– Preparing for presentation by giving their answers to
the instructor’s questions or analyzing the topic
straight to the point: 1 attendance point
– Not preparing for presentation: 0 attendance point
Formative assessment
• In-class assignments: maximum to 3 times.
– Format: In-class assignment can be in form of short answer test,
essay questions, or exercises.
– Content: Both theoretical and practical knowledge of the topics
have been studied which will be assigned by the instructor.
– Evaluation criteria
 Short answer test, essay questions: A clear and deep analysis will be given a
maximum of 10 points.
 Exercises: Correct answers and good written presentation will be given a
maximum of 10 points.
– Generic creteria:
 The assignment, which is given from 8.5 to 10, will get 1 attendance point.
 The assignment, which is given 7 to under 8.5, will get 0.5 attendance
points.
 The assignment, which is given 5.5 to under 7, will get 0.25 attendance
points.
 The assignment, which is given under 5.5, will get 0 attendance point.
Summative assessment
(1) Extra credit
• Students, who participate actively, make
presentation, do homework well, and respond well
to the instructor’s questions and exercises during the
lectures, practices, and seminars, can be given an
extra credit (bonus point) of maximum 0.5 to
summative assessments for each time (mid-term
exam). The maximum bonus in total is 1.5
(Instructors decide to add points).
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Summative assessment
(2) Mid-term exam:
• Format: At-home assignment.
• Content: Both theoretical and practical knowledge of the topics have been
studied which will be assigned by the instructor.
• At-home assignment can be in form of an essay:
– Format: A 6,000-10,000-words essay will be printed in A4 using Times New Roman
font, size 14, 1.5 space, margins of 2.5cm top and bottom, 3.5cm left, 2cm right.
– Students will be asked to form groups of max 5.
– Content: The essay provides an opportunity for the students to demonstrate their
general understanding on topics covered during the course with focus on chapter 5
ad 6. It will also enable students to get into more practical issues such as collecting
data and carrying out some basic quantitative estimation. The topic will be assigned
by the instructor or suggested by the student with the instructor’s acceptance.
– Evaluation criteria
 Appropriate structure and consistency/logic:1 point
 Good presentation:
1 point
 Reasoned argument and conclusion:
3 points
 Scope of research:
1 point
 Critical analysis:
3 points
 Good referencing:
1 point
Total
10 points
Summative assessment
(3) Final exam
• Format: In-class written exam in 60 minutes. The in-class written exam can be in
form of 30-40 multiple-choice questions and/or 02-04 essay/exercise questions
(in which, 01-02 theory-based question and 01-02 practical question). Students
are not allowed to use any material during the exam, but are allowed to bring a
calculator with you.
• Content: All the learning outcomes will be assessed in the written examination.
Both theoretical and practical knowledge of the topics have been studied which
will be assigned by the instructor.
• Evaluation criteria for the exam including 2 parts (multiple-choice questions and
essay questions):
– For multiple-choice questions: Correct answers of multiple-choice questions will be
given maximum of 6 points.
– For essay questions: A clear and deep analysis will be given a maximum of 4 points,
specifically for each question:
 Understand the issue
 Solving the issue
 Analyze the issue
 Giving example
 Expression
Total
20%
20%
20%
20%
20%
100%
Summative assessment
• Evaluation criteria for the multiple-choice questions exam:
Correct answers of multiple-choice questions will be given
maximum of 10 points.
• Evaluation criteria for the essay/exercise questions exam:
– Exercises: Concise answers and good written presentation will
be given a maximum of 5 points.
– Essay questions: A clear and deep analysis will be given a
maximum of 5 points, specifically for each question:
 Understand the issue
 Solving the issue
 Analyze the issue
 Giving example
 Expression
Total
20%
20%
20%
20%
20%
100%
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4/16/2018
Chapter 1
The Exchange rate
Assoc. Prof. Dr. Mai Thu Hien
maithuhien712@yahoo.com
Faculty of Banking and Finance
Foreign Trade University
Foreign exchange rate
1.
• Foreign exchange rate (foreign currency exchange rate,
exchange rate) is the price of one country‘s currency in units
of another currency.
• A foreign exchange quotation (or quote) is a statement of
willingness to buy or sell at an announced rate.
• Exchange rates are quoted as foreign currency per unit of
domestic currency or domestic currency per unit of foreign
currency.
 How much can be exchanged for one dollar? JPY102/USD1
 How much can be exchanged for one yen?
USD0.0098/JPY1
• Exchange rate allows us to denominate the cost or price of a
good or service in a common currency.
 How much does a Honda cost? JPY3,000,000
 Or, JPY3,000,000 x USD0.0098/JPY1 = USD29,400
Tỷ giá hối đoái (Foreign Exchange Rate):
•
Tỷ giá hối đoái là giá của một đồng tiền quốc gia được biểu thị
bằng đơn vị của một đồng tiền khác.
•
Ví dụ: Tỷ giá JPY102/USD1 có nghĩa là 1 USD có thể đổi được
102 Yên Nhật.
2.
Báo giá ngoại tệ (Foreign Exchange Quotation):
•
Là việc công bố tỷ giá mà người mua/bán sẵn sàng giao dịch.
•
Tỷ giá này có thể được trích dẫn theo hai cách:
•
Số đơn vị ngoại tệ trên một đơn vị nội tệ (foreign currency per
unit of domestic currency).
•
Số đơn vị nội tệ trên một đơn vị ngoại tệ (domestic currency per
unit of foreign currency).
3.
Ví dụ minh họa:
•
Honda giá JPY3,000,000:
•
Với tỷ giá USD0.0098/JPY1, giá Honda là:
JPY3,000,000 \times USD0.0098/JPY1 = USD29,400 .
•
Điều này cho thấy việc quy đổi tỷ giá giúp định giá sản phẩm
trong một đơn vị tiền chung (ở đây là USD).
4.
Vai trò của tỷ giá hối đoái:
•
Tỷ giá hối đoái giúp định giá hàng hóa hoặc dịch vụ trong một
loại tiền tệ chung, tạo điều kiện cho giao thương quốc tế.
2
Direct and indirect quotations
Direct quotation
(a home currency price of a
unit of foreign currency)
Indirect quotation
(a foreign currency price of a
unit of home currency)
CHF0.9133/USD
USD1.0949/CHF
JPY82.95/USD
USD0.01206/JPY
EUR0.7578/USD
USD1.3196/EUR
VND20,855/USD
USD0.00004795/VND
1/SF0.9133/$ = $1.0949/SF
3
5.
Các cách báo giá tỷ giá hối đoái (Direct
and Indirect Quotation):
•
Báo giá trực tiếp (Direct Quotation):
•
Giá của một đơn vị ngoại tệ tính bằng
nội tệ.
•
Ví dụ: VND20,855/USD có nghĩa là
cần 20,855 VND để mua 1 USD.
•
Báo giá gián tiếp (Indirect Quotation):
•
Giá của một đơn vị nội tệ tính bằng
ngoại tệ.
•
Ví dụ: USD0.00004795/VND có nghĩa
là cần 0.00004795 USD để mua 1 VND.
1
4/16/2018
European and American quotations
Swiss/Japaness/European terms
(foreign currency price of one
USD)
CHF0.9133/USD
American terms
(USD price of one unit
of foreign currency)
USD1.0949/CHF
JPY82.95/USD
USD0.01206/JPY
EUR0.7578/USD
USD1.3196/EUR
VND20,855/USD
USD0.00004795/VND
6.
Các thuật ngữ báo giá (European
and American Terms):
•
European Terms:
•
Giá ngoại tệ trên một USD (USD1
= X ngoại tệ).
•
Ví dụ: USD1 = JPY82.95.
•
American Terms:
•
Giá USD trên một đơn vị ngoại tệ
(X USD = 1 ngoại tệ).
•
Ví dụ: JPY1 = USD0.01206.
4
•
USD/CHF:
•
Báo giá trực tiếp: CHF0.9133/USD (1
USD = 0.9133 CHF).
•
Báo giá gián tiếp: USD1.0949/CHF (1
CHF = 1.0949 USD).
•
JPY/USD:
•
Báo giá trực tiếp: JPY82.95/USD (1
USD = 82.95 JPY).
•
Báo giá gián tiếp: USD0.01206/JPY (1
JPY = 0.01206 USD).
•
EUR/USD:
•
Báo giá trực tiếp: EUR0.7578/USD (1
USD = 0.7578 EUR).
•
Báo giá gián tiếp: USD1.3196/EUR (1
EUR = 1.3196 USD).
Exchange rate quotations in practice
Quote
Meaning
USD/CHF = 0.9133 (European terms) USD1 = CHF0.9133
CHF/USD = 1.0949 (American terms) CHF1 = USD1.0949
EUR/USD = 1.3196 (American
terms)
EUR1 = USD1.3196
EUR/GBP = 0.8345 (American
terms)
EUR1 = GBP0.8345
EUR, GBP, AUD, NZD, and SDR are always quoted in American terms.
6
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Foreign exchange rate convention
throughout this course
•
•
•
Slide 1: Foreign Exchange Rate Convention Throughout This Course (Quy ước tỷ giá
hối đoái trong khóa học này)
1.
Tỷ giá hối đoái là một loại giá tài sản:
•
Là giá tương đối giữa hai loại tiền tệ (tiền pháp định) của hai
quốc gia, được biểu diễn dưới dạng:
Số đơn vị của tiền tệ I / 1 đơn vị tiền tệ J.
2.
Cách định nghĩa tiền tệ:
•
Tử số (Numerator): Tiền tệ I được gọi là “Domestic Currency”
(tiền tệ nội địa).
•
Mẫu số (Denominator): Tiền tệ J được gọi là “FOREX” (ngoại
tệ).
3.
Quy ước sử dụng trong khóa học này:
•
Tỷ giá trực tiếp: Giá của một đơn vị ngoại tệ (FOREX) tính bằng
nội tệ (Domestic Currency).
•
Tỷ giá được biểu diễn dưới dạng: Domestic Currency / FOREX.
An exchange rate is an asset price.
It is the relative price of the currencies (fiat money) of two
countries, namely: Units of currency I per unit of currency J.
Currency J is the asset (currency) being priced, and the price
is quoted in terms of units of currency I
–
–
NUMERATOR: Currency I is termed “domestic currency”
DENOMINATOR: Currency J is termed “FOREX” (foreign exchange)
• Convention is used throughout this course
– Domestic Currency per unit of FOREX: I/J
– So whatever currency is in the numerator (denominator) of the
exchange rate expression is termed the domestic currency (FOREX)
7
Foreign exchange rate convention
throughout this course
•
1.
This convention of quoting the exchange rate as the domestic
currency price of a unit of FOREX (the direct quote
convention), means that:
–
An increase in the exchange rate implies that the domestic currency
has depreciated in value relative to the foreign currency (FOREX is
more expensive).
–
A fall in the exchange rate means that the domestic currency has
appreciated in value relative to the specified FOREX
–
It has the big advantage that all exchange rates are quoted in
domestic currency units, so are easily compared.
Quy ước báo giá tỷ giá dưới dạng giá tiền nội địa trên mỗi đơn vị ngoại tệ:
•
Tăng tỷ giá:
•
Điều này có nghĩa là tiền tệ nội địa mất giá so với ngoại tệ
(ngoại tệ đắt hơn).
•
Giảm tỷ giá:
•
Điều này có nghĩa là tiền tệ nội địa tăng giá so với ngoại tệ
(ngoại tệ rẻ hơn).
2.
Lợi ích của quy ước này:
•
Tất cả tỷ giá được báo giá bằng đơn vị tiền nội địa, do đó dễ so
sánh hơn.
8
Bid and Ask quotations
• A bid is the price in one currency at which a dealer will buy
another currency.
• An ask (offer) is the price at which a dealer will sell the other
currency.
• Dealers bid (buy) at one price and ask (sell) at a slightly higher
price, making their profit from the spread between the buying
and selling prices.
• The bid/ask spread is normally larger for those currencies that
are less frequently traded.
• The spread is also larger for “retail” transactions than for
“wholesale” transactions between banks or large
corporations.
1.
Quy ước báo giá tỷ giá dưới dạng giá tiền nội địa trên mỗi đơn vị ngoại tệ:
•
Tăng tỷ giá:
•
Điều này có nghĩa là tiền tệ nội địa mất giá so với ngoại tệ
(ngoại tệ đắt hơn).
•
Giảm tỷ giá:
•
Điều này có nghĩa là tiền tệ nội địa tăng giá so với ngoại tệ
(ngoại tệ rẻ hơn).
2.
Lợi ích của quy ước này:
•
Tất cả tỷ giá được báo giá bằng đơn vị tiền nội địa, do đó dễ so
sánh hơn.
9
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4/16/2018
Bid - Ask spread
• Bid - Ask Spread = Ask – Bid
$/€ = 1.2011 - 1.2014
Spread = 1.2014 – 1.2011 = 3 pips (price interest point)
Midpoint price = (Ask + Bid)/2
• The pip is an abbreviation of "Price Interest Point", and this is
why another name used for pips is points
• A pip is the smallest change of price for any foreign currency.
Because currencies are usually quoted to four decimal places,
the smallest change in a currency pair would be in the last
digit. The currency quotes appear as numbers with either two
or four decimal places. This would make one pip equal to
1/100th of a percent, or one basis point (=0.0001)
1.
Công thức tính Bid - Ask Spread:
•
\text{Spread} = \text{Ask} - \text{Bid}
•
Ví dụ:
\text{Tỷ giá } $/€ = 1.2011 - 1.2014
Spread = 1.2014 - 1.2011 = 0.0003 (3 pips).
2.
Midpoint Price (Giá trung bình):
•
Công thức:
\text{Midpoint Price} = \frac{\text{Ask} + \text{Bid}}{2}
•
Ví dụ:
Giá trung bình = (1.2014 + 1.2011) / 2 = 1.20125.
3.
Pip (Price Interest Point):
•
Là sự thay đổi nhỏ nhất của giá trong giao dịch tiền tệ.
•
Thông thường tỷ giá được biểu thị đến 4 chữ số thập
phân, 1 pip = 0.0001.
1.
Bid - Ask spread in percentage terms
• Percent spread = (Ask – Bid)/Ask
Bid – Ask Spread as percentage of ask rate (also called bid-ask
margin or trading/profit margin) represents the discount in the
bid rate as a percentage of the ask rate or percentage cost of
transaction in forex market.
Spread(%) = (1.2014-1.2011)/1.2014 = 0.00025 = 0.025% = 2.5
basis points
1 basic point = 0,01%
• Percent spread = (Ask – Bid)/Bid
Bid – Ask Spread as percentage of bid rate shows the percentage
markup of the ask rate above the bid rate.
• Percent spread = (Ask – Bid)/(Ask + Bid)/2
Bid – Ask Spread as percentage of mid rate
Công thức tính phần trăm Spread:
•
\text{Percent Spread} = \frac{\text{Ask} - \text{Bid}}{\text{Ask}} \times 100
•
Ví dụ:
Với Ask = 1.2014, Bid = 1.2011:
\text{Percent Spread} = \frac{1.2014 - 1.2011}{1.2014} \times 100 =
0.025\% = 2.5 \text{ basis points.}
2.
•
Các cách tính khác:
Dựa trên giá Bid:
\text{Percent Spread} = \frac{\text{Ask} - \text{Bid}}{\text{Bid}} \times 100
•
Dựa trên giá Midpoint:
\text{Percent Spread} = \frac{\text{Ask} - \text{Bid}}{\frac{\text{Ask} +
\text{Bid}}{2}} \times 100
Factor affecting the spread
• Order cost (+)
• Inventory cost (+)
• Competition (-)
• Volume (-)
• Currency risk (+)
1.
•
•
•
•
•
Các yếu tố làm tăng hoặc giảm Spread:
Order Cost (Chi phí đặt lệnh): Tăng.
Inventory Cost (Chi phí lưu kho): Tăng.
Competition (Cạnh tranh): Giảm.
Volume (Khối lượng giao dịch): Giảm.
Currency Risk (Rủi ro tiền tệ): Tăng.
4
4/16/2018
Depreciation and appreciation
• Depreciation/weakening/deterioration of a currency (exchange
rate depreciation) refers to a drop (a fall) in the foreign
exchange value of a floating currency.
• Appreciation/strengthening of a currency (exchange rate
appreciation) refers to a gain (a rise) in the foreign exchange
value of a floating currency.
1.
Depreciation (Mất giá):
•
Là sự suy yếu hoặc giảm giá trị của một đồng tiền so với đồng
tiền khác trong hệ thống tỷ giá thả nổi.
•
Tỷ giá giảm nghĩa là đồng nội tệ trở nên ít giá trị hơn.
2.
Appreciation (Tăng giá):
•
Là sự tăng giá trị hoặc mạnh lên của một đồng tiền so với đồng
tiền khác trong hệ thống tỷ giá thả nổi.
•
Tỷ giá tăng nghĩa là đồng nội tệ trở nên có giá trị hơn.
13
Depreciation and appreciation
1.
Định nghĩa:
•
Đồng tiền mất giá khi giá trị của nó giảm so với đồng tiền khác.
•
Một đồng tiền bị mất giá trở nên kém giá trị hơn, vì vậy có thể
đổi được ít ngoại tệ hơn.
2.
Ví dụ:
•
Tỷ giá USD/EUR tăng từ 1 USD = 1 EUR lên 1 USD = 1.20
EUR:
•
Điều này nghĩa là cần nhiều USD hơn để mua 1 EUR.
•
USD mất giá so với EUR.
•
Ngược lại, EUR tăng giá so với USD.
3.
Bài tập:
•
Nếu tỷ giá JPY/USD thay đổi từ 110 JPY = 1 USD lên 120 JPY
= 1 USD, đồng JPY có mất giá hay tăng giá?
•
Đáp án: JPY mất giá, vì cần nhiều JPY hơn để đổi 1 USD.
• Depreciation is a decrease in the value of a currency relative
to another currency.
 A depreciated currency is less valuable (less expensive)
and therefore can be exchanged for (can buy) a smaller
amount of foreign currency.
 USD1/EUR1 ! USD1.20/EUR1 means that the dollar has
depreciated relative to the euro. It now takes USD1.20 to
buy one euro, so that the dollar is less valuable.
 The euro has appreciated relative to the dollar:
it is now more valuable.
14
Depreciation and appreciation
1.
• Appreciation is an increase in the value of a currency relative
to another currency.
 An appreciated currency is more valuable (more
expensive) and therefore can be exchanged for (can buy) a
larger amount of foreign currency.
 USD1/EUR1 ! USD0.90/EUR1 means that the dollar has
appreciated relative to the euro. It now takes
only USD0.90 to buy one euro, so that the dollar is more
valuable.
 The euro has depreciated relative to the dollar:
it is now less valuable.
Định nghĩa:
•
Đồng tiền tăng giá khi giá trị của nó tăng so với đồng tiền khác.
•
Một đồng tiền được tăng giá trở nên giá trị hơn, vì vậy có thể
đổi được nhiều ngoại tệ hơn.
2.
Ví dụ:
•
Tỷ giá USD/EUR giảm từ 1 USD = 1 EUR xuống 1 USD = 0.90
EUR:
•
Điều này nghĩa là cần ít USD hơn để mua 1 EUR.
•
USD tăng giá so với EUR.
•
Ngược lại, EUR mất giá so với USD.
3.
Bài tập:
•
Nếu tỷ giá GBP/USD thay đổi từ 0.75 GBP = 1 USD lên 0.70
GBP = 1 USD, đồng GBP có tăng giá hay mất giá?
•
Đáp án: GBP tăng giá, vì cần ít GBP hơn để đổi 1 USD.
15
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4/16/2018
Mất giá của một đồng tiền (Depreciation):
1.
Ảnh hưởng:
•
Đồng tiền mất giá trở nên ít giá trị hơn, vì vậy có thể
mua được ít hàng hóa nhập khẩu hơn.
•
Hàng hóa nhập khẩu trở nên đắt đỏ hơn và hàng hóa
xuất khẩu rẻ hơn đối với người mua nước ngoài.
2.
Ví dụ:
•
Một chiếc xe Honda giá ¥3,000,000:
•
Với tỷ giá ¥0.0098/USD, giá xe là:
Depreciation and appreciation
• A depreciated currency is less valuable, and therefore it can
buy fewer foreign produced goods that are denominated in
foreign currency.
 How much does a Honda cost? ¥3,000,000
 ¥3,000,000 x $0.0098/¥1 = $29,400
 ¥3,000,000 x $0.0100/¥1 = $30,000
3,000,000 \times 0.0098 = 29,400 \text{ USD}.
• A depreciated currency means that imports are more
expensive and domestically produced goods and exports are
less expensive.
• A depreciated currency lowers the price of exports relative to
the price of imports.
16
•
Với tỷ giá ¥0.0100/USD, giá xe là:
3,000,000 \times 0.0100 = 30,000 \text{ USD}.
•
Nhận xét: Giá xe tăng khi đồng nội tệ mất giá.
3.
Bài tập:
•
Nếu tỷ giá ¥0.0095/USD, giá của chiếc xe Honda
¥3,000,000 là bao nhiêu USD?
Đáp án:
3,000,000 \times 0.0095 = 28,500 \text{ USD}.
Tăng giá của một đồng tiền (Appreciation):
1.
Ảnh hưởng:
•
Đồng tiền tăng giá trở nên có giá trị hơn, vì vậy có thể
mua được nhiều hàng hóa nhập khẩu hơn.
•
Hàng hóa nhập khẩu trở nên rẻ hơn và hàng hóa xuất
khẩu đắt đỏ hơn đối với người mua nước ngoài.
2.
Ví dụ:
•
Một chiếc xe Honda giá ¥3,000,000:
•
Với tỷ giá ¥0.0098/USD, giá xe là:
Depreciation and appreciation
• An appreciated currency is more valuable, and therefore it
can buy more foreign produced goods that are denominated
in foreign currency.
3,000,000 \times 0.0098 = 29,400 \text{ USD}.
 How much does a Honda cost? ¥3,000,000
 ¥3,000,000 x $0.0098/¥1 = $29,400
 ¥3,000,000 x $0.0090/¥1 = $27,000
•
• An appreciated currency means that imports are less
expensive and domestically produced goods and exports are
more expensive.
• An appreciated currency raises the price of exports relative to
the price of imports.
17
Price in the US
Exchange rate
Price in Germany
$2,000/computer
(home country)
$1.08/€
€1,851.9
$2,000/computer
(home country)
$10.8
$1.20/€
€1,666.7
$1.08/€
€10/wine
(home country)
$12.0
$1.20/€
€10/wine
(home country
Với tỷ giá ¥0.0090/USD, giá xe là:
3,000,000 \times 0.0090 = 27,000 \text{ USD}.
•
Nhận xét: Giá xe giảm khi đồng nội tệ tăng giá.
3.
Bài tập:
•
Nếu tỷ giá ¥0.0105/USD, giá của chiếc xe Honda
¥3,000,000 là bao nhiêu USD?
Đáp án:
3,000,000 \times 0.0105 = 31,500 \text{ USD}.
2.
Nhận xét:
•
Khi đồng USD mất giá (tỷ giá tăng từ $1.08/€ lên
$1.20/€):
•
Hàng hóa tại Mỹ trở nên rẻ hơn ở châu Âu.
•
Hàng hóa nhập khẩu từ châu Âu trở nên đắt hơn ở
Mỹ.
3.
Bài tập:
•
Nếu tỷ giá thay đổi thành $1.15/€, giá của máy tính tại
Đức sẽ là bao nhiêu khi giá tại Mỹ là $2,000?
Đáp án:
\text{Giá tại Đức} = 2,000 \div 1.15 = €1,739.13.
When a currency depreciates, this country’s goods abroad
become cheaper and foreign produced goods in this
country become more expensive.
18
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4/16/2018
1. A U.S firm plans to use 1 million USD to pay salary for 200
labours or 5,000 USD/1 labour per annum in Vietnam
• At the start, the exchange rate is 21,000VND/USD:
21,000 x 5,000 = 105 million VND/1 labour
• Then if the exchange rate is 22,000VND/USD:
22,000 x 5,000/105,000,000 = 209 labours
Ví dụ 1: Ảnh hưởng của tỷ giá đến chi phí lao động tại Việt Nam
1.
Đầu bài:
•
Một công ty Mỹ dự định sử dụng 1 triệu USD để trả lương cho
200 lao động tại Việt Nam với mức lương 5,000 USD/người/năm.
•
Ban đầu, tỷ giá là 21,000 VND/USD:
•
1 triệu USD tương đương:
21,000 \times 5,000 = 105 \text{ triệu VND/người}.
2. A U.S firm plans to invest in Canada
• At the start: the U.S. firm purchased the Canadian dollars at
1 CAD = 0.8615 USD
• At the end of investment period: the U.S. firm sells C$ for U.S.
dollars at 1 CAD = 0.8644 USD
• The return is 0.8644 USD - 0.8615 USD for 1 CAD
An appreciation of home currency will encourage investment
abroad.
•
•
Nếu tỷ giá thay đổi thành 22,000 VND/USD:
1 triệu USD tương đương:
22,000 \times 5,000 = 110 \text{ triệu VND/người}.
•
Số lao động tuyển dụng được là:
\frac{1,000,000}{110,000} = 209 \text{ lao động.}
Bài tập:
19
•
Nếu tỷ giá tăng thành 23,000 VND/USD, công ty Mỹ có thể
tuyển bao nhiêu lao động?
Đáp án:
\frac{1,000,000}{23,000 \times 5,000} = 217 \text{ lao động.}
1.
•
•
Đầu bài:
Công ty Mỹ mua đồng CAD ở mức 1 CAD = 0.8615 USD.
Khi kết thúc, công ty bán đồng CAD ở mức 1 CAD = 0.8644
•
Lợi nhuận:
USD.
\text{Return} = 0.8644 - 0.8615 = 0.0029 \text{ USD/CAD.}
Devaluation and revaluation
Nhận xét:
• Devaluation of a currency implies an official lowering of the
value of a country's currency within a fixed exchange rate
system, by which the monetary authority formally sets a new
fixed rate with respect to a foreign reference currency.
Contrast to "revaluation".
• Revaluation of a currency refers to a deliberate
upward adjustment to a country's official exchange rate
relative to a chosen foreign currency. Only the monetary
authority (i.e. central bank) can alter the official value of the
currency.
20
Overvaluation and undervaluation
• An overvalued currency is one in which the current market
value is stronger than the value predicted by a theory or
model.
• An undervalued currency is one in which the current market
value is weaker than the value predicted by a theory or
model.
•
Appreciation của đồng USD khuyến khích đầu tư ra nước
1.
•
Devaluation (Phá giá):
Là sự giảm giá chính thức của đồng tiền trong hệ thống tỷ giá
•
Quyết định bởi cơ quan quản lý tiền tệ (như ngân hàng trung
ngoài.
cố định.
ương).
•
Ví dụ:
•
Đồng VND bị phá giá từ 1 USD = 20,000 VND thành 1 USD =
22,000 VND.
2.
Revaluation (Định giá lại):
•
Là sự tăng giá chính thức của đồng tiền trong hệ thống tỷ giá cố
định.
•
Quyết định bởi cơ quan quản lý tiền tệ.
•
Ví dụ:
•
Đồng VND được định giá lại từ 1 USD = 22,000 VND thành 1
USD = 20,000 VND.
1.
Overvaluation (Định giá cao):
•
Xảy ra khi giá trị thị trường của một đồng tiền cao hơn giá trị dự
đoán theo mô hình lý thuyết.
2.
Undervaluation (Định giá thấp):
•
Xảy ra khi giá trị thị trường của một đồng tiền thấp hơn giá trị
dự đoán theo mô hình lý thuyết.
Nhận xét:
•
Overvaluation gây ra hàng hóa xuất khẩu trở nên đắt đỏ và
nhập khẩu rẻ hơn.
•
Undervaluation giúp hàng xuất khẩu rẻ hơn và tăng khả năng
cạnh tranh quốc tế.
Bài tập:
•
Nếu tỷ giá lý thuyết là 1 USD = 22,000 VND, nhưng tỷ giá thực
tế là 1 USD = 23,000 VND, đồng VND đang được định giá như thế nào?
Đáp án: VND bị định giá thấp (Undervalued).
21
7
4/16/2018
CNY/ USD
10
1993: CNY5.76/USD
1994: CNY8.62/USD
9
Aug 2005: CNY8.1/USD
8
Jun 2008: CNY6.86/USD
7
6
5
4
3
2
1980: CNY1.53/USD
1
Feb-10
May-10
Feb-09
Aug-09
Nov-09
Nov-08
May-09
Feb-08
Aug-08
May-08
Aug-07
Nov-07
Jul-06
Jan-07
Apr-07
Oct-06
Jul-05
Jan-06
Apr-06
Oct 2005
Jul-04
Jan-05
Apr-05
Oct-04
2002
Apr-04
1999
1996
Jan-04
1993
1990
1987
1984
1981
1978
1975
1972
1969
0
Sources: State Administration of Foreign Exchange of the People's Republic of China; People's Bank of China.
http://www.macrotrends.net/2575/us-dollar-yuan-exchange-rate-historical-chart
CNY/ USD Mar 1981 - Mar 2018
8
4/16/2018
As of Oct 1, 2016
Currency
Weight
USD
41.73%
EUR
30.93%
CNY
10.92%
JPY
8.33%
GBP
8.09%
- CFETS RMB Index mainly refers to CFETS (China Foreign Exchange Trade System) currency basket, including
CNY versus FX currency pair listed on CFETS. The sample currency weight is calculated by international trade
weight with adjustments of re-export trade factors. The sample currency value refers to the daily CNY Central
Parity Rate and CNY reference rate (e.g. THB).
- BIS Currency Basket RMB Index mainly refers to BIS currency basket. The ratio used to calculated the BIS
effective exchange rate using the top 13 currencies (there are a total of 40 currencies) of the BIS currency basket.
The sample currency weight is in accordance with BIS sample currency weight. As to CNY versus FX currency pair
listed on CFETS, the sample currency value refers to the daily CNY Central Parity Rate and CNY reference rate
(e.g. THB). Otherwise, the sample currency value is calculated as the cross currency FX rate based on cross
currency method with the daily USD Central Parity Rate and FX spot rate of this currency against USD.
- SDR Currency Basket RMB Index mainly refers to SDR currency basket. The sample currency weight is
calculated as the relative weights in SDR currency basket. The sample currency value refers to the daily CNY
Central Parity Rate.
The trade-weighted CFETS RMB index
was unveiled in December 11, 2015,
The CFETS RMB
index was introduced
on 11 Dec, 2015. It is
meant to be a
guidance for market
participants to look at
the value of the
Renminbi against a
basket of currencies
instead of focusing on
the USDCNY
exchange rate only.
China foreign exchange reserves
1981-2018
9
4/16/2018
China foreign exchange reserves
2008-2018
China GDP growth rate 1989-2018
10
4/16/2018
China inflation rate 1986-2018
11
4/16/2018
12
4/16/2018
Source: Ministry of Commerce of the People's Republic of China.
Official exchange rate and trading band, VND/USD, 1991-2016
26/2/99: +-0.1%
1/7/02: +-0.25%
31/12/06: +-0.5%
24/12/07: +-0.75%
10/3/08: +-1%
11/6/08: 16139->16461 (2%)
27/6/08: 16451->16516 (bđ+-2%)
7/11/08: +-3%
25/12/08: 16494->16989 (3%)
 2008: 5.4%
11/2/11: 18932->20693 (9.3%, bđ+-1%)
24/3/2009: +-5%
7/9/11: Công bố duy trì tỷ giá biến động
26/11/09: 17034->17961 (bđ+-3%)
trong phạm vi 1% 2011: 10%
2009: 5.7%
2008-2011: 29.3%
11/2/10: 17941->18544 (3.4%)
7/1/15, 7/5/15, 18/8/15: tăng 3% TGLNH, mỗi lần 1%
18/8/10: 18544->18932 (2.1%)
11/8/15 và 18/8/15: biên độ từ ±1% lên ±2% và ± 3%
 2010: 5.5%
Nguồn: Tác giả tổng hợp từ số liệu của NHNN
IMF, 2016
13
4/16/2018
Dong’s bilateral exchange rates against USD, EURO and Japanese Yen, 2005:1-2011:7
300
35000
30000
250
25000
200
20000
150
15000
100
10000
USD
EUR
Yen
50
5000
0
Note: Monthly average selling exchange rates of VCB. An upward trend
means a depreciation of the Vietnamese dong.
Source: SBV
Thg7-11
Thg1-11
Thg7-10
Thg1-10
Thg7-09
Thg1-09
Thg7-08
Thg1-08
Thg7-07
Thg1-07
Thg7-06
Thg1-06
Thg7-05
Thg1-05
0
42
14
Thg7-10
Thg4-10
Thg7-11
Thg4-11
Thg1-11
Thg10-10
5000
Thg1-10
Thg10-09
Thg7-09
Thg4-09
Thg1-09
Thg10-08
Thg7-08
Thg4-08
Thg1-08
Thg10-07
Thg7-07
Thg4-07
Thg1-07
Thg10-06
Thg7-06
Thg4-06
Thg1-06
Thg10-05
Thg7-05
Thg4-05
Thg1-05
4/16/2018
VND/USD movements: 2005-11
25000
20000
15000
10000
Lower margin
Central rate
Upper margin
0
VCB's selling rate
Source: SBV
15
4/16/2018
16
4/16/2018
49
Commercial bank‘s exchange rate
VND/USD
11/6: 16139-16461
27/6: 16451-16516
25/12: 16494-16989
Source: www.tuoitre.com.vn/Tianyon/Index.aspx?ArticleID=286915&ChannelID=11
50
Interest rates and Inflation in 2008-09
Source: SBV
51
17
4/16/2018
52
53
9
8
Prime interest rate
7
Refinancing interest rate (upper band)
6
Interest rate corridor
5
OMO rate
4
3
Discount interest rate (low er band)
2
1
Mar-07
Dec-06
Jun-06
Sep-06
Mar-06
Dec-05
Jun-05
Sep-05
Mar-05
Dec-04
Jun-04
Sep-04
Mar-04
Dec-03
Jun-03
Sep-03
Mar-03
Dec-02
Jun-02
Sep-02
0
54
18
4/16/2018
Interest rates movements in 2008-11
16
15
14
15
15
15
15
14 14
14
14
13
10.8 10.8 10.8
10
11
13
12
10.8 10.8 10.8
14
13
13
12
13
12
12
11
10
8.75
8.25
10
9.5
9
8.5
7.5
7.8
6 6.5
6
8
8
7
7
6
6
7
5
4
12
12
12
9
9
11
11
7.5
8
13
13
13
12
11
9
9
7
7
9
8
7
6
5
4.5
3.6
2
Prime rate
Rediscounting rate
Required deposit rate
Required treasury bills rate
1/5/2011
1/4/2011
8/3/2011
17/02/11
11/05/10
01/12/09
01/10/09
10/04/09
01/03/09
01/02/09
22/12/08
05/12/08
21/11/08
05/11/08
21/10/08
01/10/08
19/08/09
01/07/08
11/06/08
17/03/08
19/05/08
Refinancing rate
01/09/08
1.2
1.2
01/02/08
1/1/2008
0
1.2
Overnight lending rate
Source: SBV
55
Interest rates movements in 2001-15
Cross Rates
• Many currency pairs are only inactively traded, so their exchange
rate is determined through their relationship to a widely traded
third currency (cross rate). The cross rate of currency pairs is
determined through their relationship to a third currency.
• Normally, the crossrate if the exchange rate between two nondollar currencies.
• Or a cross exchange rate reflects the amount of one foreign
currency per unit of another foreign currency.
• Purpose: to identify arbitrage opportunities.
• Exp: JPY98.5/USD
SGD1.48/USD
JPY/SGD 
98.5 JPY/$
 66.5541
SGD1.48/$
57
19
4/16/2018
Thu 30 Oct 2008 | 10:18 EDT
US$
¥en
Euro
UK £
US$
1.0
98.5000
0.7717
0.6097
¥en
0.010146
1.0
0.007835
0.006189
Euro
1.2950
127.6000
1.0
0.7896
UK £
1.6390
161.4600
1.2655
1.0
Source: Reuters
1.
•
Chuyển đổi 500 USD sang JPY.
Đáp án:
500 \times 98.5000 = 49,250 \, \text{JPY}.
2.
•
Chuyển đổi 10,000 JPY sang USD.
Đáp án:
10,000 \times 0.0100146 = 100.146 \, \text{USD}.
All quotes delayed at least 15 minutes
58
Công thức tính tỷ giá chéo:
•
Công thức:
Cross rates (zero transaction cost)
S(E/K) = S(E/$) \times S($/K).
I J
I
I J
,   
K K
J K K
I K
I
I K
,   
K J
J K J
•
•
•
•
•
Ví dụ:
Tỷ giá EUR/USD = 0.7534, USD/VND = 17,500:
Tỷ giá EUR/VND:
S(\text{EUR/VND}) = 0.7534 \times 17,500 = 23,228 \, \text{VND}.
Given S(£/$) và S(€/$)  £/€ = (£/$)/(€/$ )
Given S(£/$) và S($/€)  £/€ = (£/$)*($/€)
Bài tập:
1USD
1USD
,

17,500VND 0.7534EUR
1USD
1USD
17,500VND 23,228VND



0.7534EUR 17,500VND 0.7534EUR
1EUR
1USD
1EUR
,

23,228VND 0.7534EUR
1USD
1EUR
1USD


0.7534EUR 23,228VND 17,500VND
1.
Tính tỷ giá chéo giữa GBP và JPY dựa trên bảng tỷ
•
•
GBP/USD = 1.6390, USD/JPY = 98.5000.
Đáp án:
giá:
S(\text{GBP/JPY}) = 1.6390 \times 98.5000 = 161.329 \, \text{JPY}.
59
Example
Completing the following cross-rate table. Explain how to calculate.
AUD
Australia
Britain
Canada
Switzerland
US
GBP
CAD
CHF
USD
1.53
0.65
1.45
1.37
-
20
4/16/2018
Cross rates (non-zero transaction cost)
Given GBP/USD = (0,6568 - 0,6868), EUR/USD = (0,7534 - 0,7834)
1USD
1USD


0.6568GBP 0.6868GBP
1USD
1USD

0.7534 EUR 0.7834EUR
A customer has EUR and needs GBP:
1. Sell EUR buy USD  1USD = 0.7834EUR
2. Sell USD buy GBP  1USD = 0.6568GBP
 1USD
1USD
,

0.6568GBP 0.7834 EUR
1USD
1USD
0.6568GBP 0.8384GBP



0.7834 EUR 0.6568GBP 0.7834 EUR
1EUR
 Bid cross rate for the euro (£/€ ): £/bid€ = (£/bid$)/(€/ask$) 61
Cross rates (non-zero transaction cost)
1USD
1USD


0.6568GBP 0.6868GBP
1USD
1USD

0.7534EUR 0.7834EUR
A customer has GBP and needs EUR:
1. Sell GBP buy USD  1USD = 0.6868 GBP
2. Sell USD buy EUR  1EUR = 0.7534USD

1USD
1USD
,

0.6868GBP 0.7534 EUR
1USD
1USD
0.6868GBP 0.9116GBP



0.7534 EUR 0.6868GBP 0.7534 EUR
1EUR
 Ask cross rate for the euro: £/ask€ = (£/ask$)/(€/bid$)
62
Cross rates (non-zero transaction cost)
Given GBP/USD = (0,6568 – 0,6868) và USD/EUR = (1,2765 – 1,3273)
1USD
1USD


0.6568GBP 0.6868GBP
1EUR
1EUR

1.2765USD 1.3273USD
A customer has EUR and needs GBP:
1. Sell EUR buy USD  1EUR = 1.2765USD
2. Sell USD buy GBP  1USD = 0.6568GBP

1USD
1EUR
,

0.6568GBP 1.2765USD
1USD
1EUR
1EUR


0.6568GBP 1.2765USD 0.8384GBP
 Bid cross rate for the euro: £/bid€ = (£/bid$)*($/bid€)
63
21
4/16/2018
Cross rates (non-zero transaction cost)
1USD
1USD


0.6568GBP 0.6868GBP
1EUR
1EUR

1.2765USD 1.3273USD
A customer has GBP and needs EUR:
1. Sell GBP buy USD  1USD = 0.6868 GBP
2. Sell USD buy EUR  1EUR = 1.3273 USD

1USD
1EUR
,

0.6868GBP 1. 3273USD
1USD
1EUR
1EUR


0.6868GBP 1.3273USD 0.9116GBP
 Ask cross rate for the euro: £/ask€ = (£/ask$)*($/ask€)
64
Example
• JPY/EUR?
if USD/EUR = 1.42-1.48
JPY/USD = 90.50 – 90.80
• AUD/GBP?
if USD/GBP = 1.65 – 1.67
USD/AUD = 0.95 – 0.98
65
Example
3. A firm has an export receipt of USD500,000 and needs
EUR200,000 for import payments. The spot rates quoted by
Vietcombank are:
VND/USD = 20,870-950
VND/EUR = 27,700-850
What is USD/EUR applied by Vietcombank?
22
4/16/2018
Measuring
Exchange Rate Movements
• The percentage change (% D in the value of a
foreign currency is computed as
St – St-1
St-1
where St denotes the spot rate at time t.
• A positive % D represents appreciation of the
foreign currency, while a negative % D represents
depreciation.
Soft and hard
• Soft or Weak – describes a currency that is expected
to devalue or depreciate relative to major currencies.
– Also refers to currencies being artificially sustained by their
governments
• Hard or Strong – describes a currency that is
expected to revalue or appreciate relative to major
trading currencies.
Soft Currency (Tiền tệ yếu):
•
Là đồng tiền được kỳ vọng sẽ mất giá (depreciate)
hoặc phá giá (devalue) so với các đồng tiền lớn khác.
•
Thường do các yếu tố:
•
Chính sách hỗ trợ nhân tạo của chính phủ.
•
Nền kinh tế yếu, không ổn định.
Hard Currency (Tiền tệ mạnh):
•
Là đồng tiền được kỳ vọng sẽ tăng giá (appreciate)
hoặc định giá lại (revalue) so với các đồng tiền lớn khác.
•
Đặc điểm:
•
Nền kinh tế ổn định, mạnh mẽ.
•
Được sử dụng phổ biến trong giao dịch quốc tế.
68
sign contract today and have immediate hiệu lực
Spot and forward exchange rate
• The spot exchange rate is the quoted price for foreign
exchange to be delivered at once or in two days for interbank
transactions.
• A forward rate is an exchange rate quoted today for
settlement at some future date.
• Measuring a change in spot exchange rate:
(New value – Old value) / Old value
1. Spot Exchange Rate (Tỷ giá giao ngay):
•
Là tỷ giá được báo giá cho việc trao đổi ngoại tệ được
thực hiện ngay lập tức hoặc trong vòng 1-2 ngày làm việc (giao dịch liên
ngân hàng).
•
Ví dụ:
•
Tỷ giá giao ngay USD/VND = 23,500 nghĩa là 1 USD
đổi được 23,500 VND và giao dịch hoàn thành trong vòng 2 ngày.
2. Forward Exchange Rate (Tỷ giá kỳ hạn):
•
Là tỷ giá được báo giá hôm nay cho một giao dịch
được thực hiện tại một thời điểm trong tương lai.
•
Ví dụ:
•
Tỷ giá kỳ hạn USD/VND cho 6 tháng tới là 23,800
nghĩa là sau 6 tháng, bạn có thể mua 1 USD với giá 23,800 VND.
69
23
4/16/2018
Spot and Forward Exchange Rates
70
1. Khái niệm
•
Tỷ giá danh nghĩa là tỷ giá phản ánh khả năng trao đổi giữa hai
đồng tiền, cụ thể là số lượng một đồng tiền này cần để mua một đơn vị đồng tiền
khác.
•
Nó cho biết sức mua của đồng nội tệ so với ngoại tệ, nhưng
không tính đến sự thay đổi về giá cả hàng hóa giữa hai quốc gia.
The nominal exchange rate
• The nominal exchange rate is the rate at which one can
exchange the currency of one country for the currency of
another country.
• The nominal exchangerate reflects the purchasing power of
the domestic currency in exchange for a foreign currency
• Change in the nominal exchange rate (change in foreign
currency) by direct quotation
NERt - NERt 1
NERt 1
71
The real exchange rate
• The real exchange rate adjusts the nominal exchange rate for
changes in nations‘ prices levels and thereby measures the
purchasing power of domestic goods and services in exchange
for foreign goods and services.
• The real exchange rate is the rate at which one can exchange
the goods and services from one country for the goods and
services from another country.
• The real exchange rate indicates changes in international
purchasing power.
NER(VND / USD )  P * (USD)
P (VND )
NER (USD / VND )  P(VND )
RERvolume quotation 
P * (USD)
RER price quotation  
1. Khái niệm
•
Tỷ giá thực điều chỉnh tỷ giá danh nghĩa dựa trên mức giá
hàng hóa của hai quốc gia, đo lường khả năng cạnh tranh về giá cả của hàng hóa/
dịch vụ trong nước so với nước ngoài.
•
Phản ánh khả năng mua hàng hóa thực tế, không chỉ là giá trị
danh nghĩa.
(P*=current price level)
three situtation; RER>1: hàng hóa đắt hơn trong nước
•
RER < 1:
•
Hàng hóa/dịch vụ trong nước rẻ hơn so với quốc tế → Tăng
khả năng cạnh tranh.
72
•
•
RER = 1:
Giá cả hàng hóa/dịch vụ trong và ngoài nước cân bằng.
24
4/16/2018
1. Khi nào tỷ giá thực mất giá (Real Exchange Rate Depreciates)?
Change in the real exchange rate (price
quotation)
• Real exchange rate depreciates (USD appreciates in real terms
against VND) when:
 inflation in the US increases
 inflation in Vietnam decreases
 VND deppreciates against the USD
PUSt - PUSt 1
PUSt1
 US =
t
 VN =
t
PVN t - PVNt 1
PVNt 1
Tỷ giá thực mất giá khi:
1.
Lạm phát ở Mỹ tăng lên:
•
Giá cả hàng hóa ở Mỹ tăng nhanh hơn giá cả hàng
hóa ở Việt Nam, làm giảm giá trị thực của USD.
2.
Lạm phát ở Việt Nam giảm:
•
Giá cả hàng hóa ở Việt Nam thấp hơn tương đối so
với hàng hóa ở Mỹ, khiến VND có lợi thế cạnh tranh hơn.
3.
VND mất giá so với USD:
•
Khi tỷ giá danh nghĩa tăng (NER tăng), tức là cần
nhiều VND hơn để mua 1 USD.
RERt - RERt 1 NERt - NERt 1
=
 πUSt - πVN t
NERt 1
RERt 1
73
RER 2003= 100x1,22/1,2 * 102/105 =98,762
RER Index
NER
RER  100 
actual value
Index, 2002 100
NER

in base year 2002
Price index in foreign country
Price index in domestic country
RER index refer to the change in price index of the foreign country
relative to that of the domestic country.
2000 2001 2002 2003
2004
2005
NER
1.10
1.13
1.20
1.22
1.30
1.40
2006
1.40
CPI in Germany (2002=100)
95
98
100
105
111
113
115
109
105
CPI in the US (2002=100)
97
98
100
102
104
RER Index (2002=100)
93.6
94.2
100
98.8
101.5 112.5 106.5
weighted-average: bình quân,
real: thực, effective: hiệu quả
Nominal effective exchange rate
• An effective exchange rate (EER) is a measure of the weightedaverage value of a currency relative to two or more other
currencies (the weighted-average value of bilateral exchange
rate). EER tracks the movement of a currency against a number
of currencies.
• The nominal effective exchange rate (NEER) is based on
nominal bilateral exchange rates.
1.
NER (Nominal Exchange Rate):
•
Tỷ giá giữa USD và VND: 1 USD =
23,500 VND (chỉ so sánh hai đồng tiền trực tiếp).
2.
NEER (Nominal Effective Exchange
Rate):
•
Giả sử Việt Nam giao thương với 3 đối
tác chính:
•
Mỹ (50% trọng số): NER USD/VND =
23,500.
•
Nhật Bản (30% trọng số): NER JPY/VND
= 180.
•
EU (20% trọng số): NER EUR/VND =
27,000.
•
Tính NEER:
NEER = (23,500 \times 0.5) + (180 \times 0.3) +
(27,000 \times 0.2) = 17,204.
•
Effective Exchange Rate (EER):
•
Là một chỉ số đo lường giá trị bình quân gia quyền
(weighted-average) của một đồng tiền so với hai hoặc nhiều đồng tiền
khác.
•
EER phản ánh sự biến động của một đồng tiền đối với
một nhóm các đồng tiền.
•
Nominal Effective Exchange Rate (NEER):
•
Là tỷ giá hối đoái hiệu quả dựa trên tỷ giá danh nghĩa
song phương (nominal bilateral exchange rates).
•
Phản ánh sự thay đổi giá trị của một đồng tiền mà
không điều chỉnh theo lạm phát.
n
NEER   e j  w j
j 1
• NEER↑→VND falls in value against other currencies.
• NEER↓→VND rise against other currencies.
NEER   INER X j / EUR  j
n
j 1
•
e_j: Tỷ giá danh nghĩa song phương giữa đồng tiền
trong nước và đồng tiền thứ j.
•
w_j: Trọng số (tỷ trọng thương mại) của đồng tiền j
trong nhóm các đồng tiền.
w
•
INER (X_j / EUR): Tỷ giá danh nghĩa hiệu quả của
đồng tiền X_j so với đồng Euro.
•
NEER tăng (↑):
•
Đồng tiền trong nước mất giá (depreciates)
so với nhóm các đồng tiền khác.
•
NEER giảm (↓):
•
Đồng tiền trong nước tăng giá (appreciates)
so với nhóm các đồng tiền khác.
25
4/16/2018
Real effective exchange rate
Real effective exchange rate (REER) is an effective
exchange rate based on real bilateral exchange rates.
REER  NEER 
n
CPIw
, CPIw   CPI j  GDPj
CPIVN
j 1
REER↑→VND depreciates in real terms against other
currencies. The competitiveness of export products is
improved.
n 
P
REER    INER( X j / EUR)  

Pj 
j 1 
wj
P: deflation index (EU)
Constructing an Effective Exchange Rate
• Select a basket of currencies: only the most
important currencies, i.e. major trade,
investment partners
• Select a base year – a reference point in time:
the base year value is equal to 100.
• Select weights: a means of placing
greater/less emphasis on the more/least
important currencies in the currency basket.
tỷ giá (index) * tỷ trọng
Example of a EER
• Use 2004 as the base year, two top trading partners
of the US are Canada and Japan. Calculate NEER,
REER
NER 2004
NER 2006
CPI2004
CPI2006
2004 U.S.
exports
2004 U.S.
imports
Canada
1.4$C/$
1.45$C/$
115.6
117.7
160,900
209,087
Japan
120.48
119.20
114.4
116.6
51,449
121,428
119
118
U.S.
26
4/16/2018
Vietnam: Effective exchange rate indices (2000=100)
Source: IMF Country Report No.07/387
REER has appreciated by 30% since 2010 and the dong is likely to appreciate further
as the exchange rate becomes more flexible. The REER has appreciated steadily from
low levels since 2005, by 4% on average every year.
27
4/18/2018
19/2
International Parity Conditions
Assoc. Prof. Dr. Mai Thu Hien
Faculty of Banking and Finance
Foreign Trade University
1
International Parity Conditions
• Some fundamental questions managers of MNEs,
international portfolio investors, importers, exporters and
government officials must deal with every day are:
 What are the determinants of exchange rates?
 Are changes in exchange rates predictable?
• The economic theories that link exchange rates, price
levels, and interest rates together are called international
parity conditions.
• These international parity conditions form the core of the
financial theory that is unique to international finance.
• For reading: Eiteman 12e chapter 7, Pilbeam 3e chapter
6, Levi 4e chapter 8
2
International Parity Conditions
• These theories do not always work out to be “true” when
compared to what students and practitioners observe in
the real world, but they are central to any understanding
of how multinational business is conducted and funded
in the world today.
• The mistake is often not with the theory itself, but with
the interpretation and application of said theories.
3
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4/18/2018
Theories of exchange rate
determination
1. Purchasing power parity
2. Interest rate parity
3. International Fisher effect
4
Price-based Methodologies for Equilibrium
Exchange Rate Assessment
• Assessing the equilibrium level of the exchange rate is a
critically important policy objective
• Consequences of substantial currency misalignments
extremely costly “Currency Wars” Sept- Nov 2010
• Here we examine certain price-based methodologies for
assessing equilibrium exchange rates
• Collectively known as purchasing power parity, PPP theories
of exchange rate determination
5
1. Purchasing power parity
• Provides the link between price levels and the exchange
rate between two countries:
 The law of one price
 Purchasing power parity by homogeneous goods
(absolute and relative)
 Purchasing power parity by heterogenous goods
 A generalized version of PPP
- a distinction between traded and non-trade goods Productivity Differentials in the Traded Goods Sector:
Balassa-Samuelson Effects
6
2
4/18/2018
The law of one price
• Assumes that:
 Identical products or services can be produced and
sold in two different markets (homogeneity of goods).
 No restrictions exist on the sale (trade barriers) or
transportation costs of moving the product between
markets.
 Competitive markets to establish this condition
• States that: Consider the price of a good j, at time t in the
domestic, Pj, and foreign country, Pj*. The Law of One
Price states:
Pj,t = St . Pj,t*
 The products prices should be the same in both
markets when prices are expressed in terms of the
same (domestic) currency.
7
The law of one price
If NER = $1.5/£, a sweater that sells for $45 in the US must sell for
£30 in the UK, the dollar price of the sweater in the UK is ($1.5/£) *
(£30) = $45
If NER = $1.55/£ then a sweater is sold:
In the UK: £30 or ($1.55/£) * (£30) = $46.5
In the US: $45
 Buy sweaters in the US and ship them to the UK (until prices
are equal in the two locations)
 In the forex market, the demand for $↑ when UK traders
exchange £ for $  the dollar appreciates
 In the US, the demand for sweaters↑  price of sweaters↑
demand for $↑  the dollar appreciates
 In the UK, the supply of sweater increases  price of sweaters
in the UK↓  demand for £↓  the pound depreciates
 Thus, the dollar appreciates relative to the pound until the
exchange rate falls to the original level.
8
The law of one price
If NER = $1.45/£ then a sweater is sold:
In the UK: £30 or ($1.45/£) * (£30) = $43.5
In the US: $45
Buy sweaters in the UK and ship them to the US until
prices are equal in the two locations.
PUS = NER ($/£) * PUK
Law of one price (LOP) implies dollar price of good j is the
same wherever it is sold.
9
3
4/18/2018
Raw Big Mac Index, Nominal Rates Economist 16/10/2010
1. In USA Big Mac
cost $3.71
2. In Brazil – Guido
Mantega casualty of
“Currency War” it
is $5.26: suggest
Real overvalued by
≈ 42%
3. Euro overvalued by
29%
4. In China it is $2.18
Yuan undervalued
by ≈ 40%
10
After adjusting for GDP per person (Income)
Economist 28/07/2011
Regression
Line
China less undervalued, but Euro and Real still overvalued relative to
11
USD (note USD is itself undervalued vs other currencies)
Why LOP may not hold
• Transaction Costs
– Let the price of a book (j) in the US be Pjt = USD 40 and the spot
exchange rate be St = USD/GBP 2.0. If the shipping and
insurance costs for exporting the book are USD 4, the price of the
book in the UK, Pjt* could be as low as GBP 18, or as high as GBP
22, before you consider an arbitrage transaction.
• Non-traded goods
• Quantitative or Tax restrictions (Quotas and Tariffs)
• Imperfect competition
– Exclusive dealerships => segmented markets.
– Manufacturers discourage parallel imports to profit from price
discrimination.
– Entry costs hinder arbitrage.
– Reluctance to change prices (menu costs).
12
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Purchasing Power Parity by
homogenous goods
• Purchasing power parity is the application of the law of one price
across countries for all goods and services, or for representative
groups (“baskets”) of goods and services.
PUS = NER (USD/GBP) . PUK
PUS = level of average prices in the US (Price level of domestic
commodity basket measured in units of domestic currency)
PUK = level of average prices in the UK (Price level of foreign
commodity basket measured in units of foreign currency)
NER (USD/GBP) = USD - GBP nominal exchange rate
• Purchasing power parity states that the exchange rate between
two countries' currencies equals the ratio of the countries’ price
levels.
• Purchasing power parity asserts that all countries’ price levels are
equal when measured in terms of the same currency (assumptions
hold as the LOP).
13
Purchasing Power Parity by
homogenous goods
• Purchasing power parity comes in 2 forms:
 Absolute PPP: Exchange rates equal the level of relative average
prices across countries.
 Relative PPP: changes in exchange rates equal changes in prices
(inflation) between two periods
14
Absolute purchasing power parity
•
•
•
•
APPP states that the spot exchange rate is determined
by the relative prices of similar baskets of goods or
exchange rates equal the level of relative average prices
across countries (application of law of one price to price
levels):
NER (USD/GBP) = PUS / PUK
If Price Levels based on same basket of goods with
identical weights, then APPP follows from LOP
If goods baskets are not identical APPP follows only as
an approximation (RPPP) even if LOP held exactly for all
goods
By comparing the prices of identical products
denominated in different currencies, we could determine
the “real” or PPP exchange rate that should exist if
markets were efficient.
15
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4/18/2018
Problems with absolute PPP
• APPP is unlike to hold because:
 All goods not identical in both countries.
 In fact, restrictions exist on transaction costs and trade barriers.
 Statistical problems: different basket of goods are used in
different countries to compute price indices and difference in
proportion of goods and services consumption in different
countries (because of different tastes and needs)
 RPPP can be expected to hold even in the presence of
such distortions.
16
Relative purchasing power parity
• RPPP is a weaker form of PPP, and relaxes assumptions of
APPP
• RPPP holds that PPP is not particularly helpful in determining
what the spot rate is today, but that the relative change in
prices between two countries over a period of time determines
the change in the exchange rate over that period, or changes
in exchange rates equal changes in prices (inflation) between
two countries over period of times or if domestic price level
increases by x%, domestic currency depreciates by x%.
(NERUSD/GBP,t+1 - NERUSD/GBP,t) / NERUSD/GBP,t = p US - p UK
where p = inflation rate from period t to t+1
∆NER ≈ ∆P - ∆P*
∆NER >0 (∆P > ∆P*): domestic currency depreciates/foreign currency
appreciates
∆NER <0 (∆P < ∆P*): domestic currency appreciates/foreign currency
depreciates
17
Relative purchasing power parity
• In other words, if the spot exchange rate between two
countries starts in equilibrium, any change in the
differential rate of inflation between them tends to be
offset over the long run by an equal but opposite change
in the spot exchange rate.
• If not, these price changes lead to a deficit on the current
account in the BOP unless offset by capital and financial
flows (country experiences higher inflation than those of
its trading partners and its exchange rate doesn’t change
 more imports  deficit).
18
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Exhibit 7.2 Relative Purchasing Power Parity
(PPP)
7-19
Relative purchasing power parity
• The absolute version of PPP: St = PUS,t / PUK,t
where PUS,t and PUK,t are the price index values (cost of the
baskets of goods) in USD and GBP at time t
• Annual percentage change in price levels in the US and the
UK at time t+1 (or inflation rate) p
• The spot exchange rate at time t+1 would be:
St+1 = PUS,t (1+ pUS)/ PUK,t(1+ pUK) = St (1+ pUS)/ (1+ pUK)
• Change in the spot rate between t and t+1:
(St+1 - St) / St = (pUS - pUK) / (1 + pUK)
• Approximated by dropping the denominator (1 + pUK) if it is
consider to be small, then (St+1 - St) / St = pUS - pUK
or ∆S = pUS – pUK
20
Example
So if Pt = 100 and inflation at home is 6% per annum, and Pt *
is 200 and inflation is 3%. If St = 2 initially:
•
This implies: Pt+1 = 106 and P*t+1 = 206
 St+1/2 = 1.06/1.03 = 1.0291
• The RPPP condition predicts that St+1, the exchange rate
at t+1 will be St+1 = 2.0582 (= 2 x 1.0291).
•
This is a depreciation of domestic currency of 2.91%
• In practice, under RPPP the percentage change in the
exchange rate (= 2.91%) is approximated by the inflation
differential (6 - 3)% = 3% ≈ 2.91%
21
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4/18/2018
PPP and the Real Exchange Rate
The real exchange rate, Q, measures the relative price
level of foreign to domestic goods (both expressed in units
of domestic currency), namely (ignoring time subscripts):
(1)
1. Under APPP
Q = S.P*/P
or, in logarithm:
q = s + p* - p
The Real Exchange Rate is constant:
S = P / P* → Q = 1 (q = 0)
Q >1 (Q rises): domestic currency depreciates
Q <1 (Q falls): domestic currency appreciates
2. Under RPPP
Q = k.S.P*/P
where k is a constant
or, in logarithms:
q = c + s + p* - p
Where: c = log (k) = 0 under APPP
(2)
A change in the ratio of price levels implies an equal
proportionate change in the exchange rate
22
PPP and the Real Exchange Rate


1
CA  RER  Y *   Y   RER  CA  Y *   Y  


 is very high ( = ) → RER = 1
where : real exchang rate elasticity of CA ( > 0):
measuring the responsiveness of the trade balance to a
change in real exchange rate.
The effects of RER on CA depend on:
• : RER↑→CA↑
• Value of :
 If domestic and foreign goods are homogenous or perfectly
substitutable:  is high ( = ): RER↑(→1)→ CA↑ (high): PPP
 If domestic and foreign goods are heterogenous or imperfectly
substitutable:  small: RER↑→CA↑ (small)
23
Exchange Rates Pass-through
• The degree to which the prices of imported and exported goods
change as a result of exchange rate changes is termed passthrough.
• Although PPP implies that all exchange rate changes are passed
through by equivalent changes in prices to trading partners,
empirical research in the 1980s questioned this long-held
assumption.
• For example, a car manufacturer may or may not adjust pricing of
its cars sold in a foreign country if exchange rates alter the
manufacturer’s cost structure in comparison to the foreign market.
• Pass-through can also be partial as there are many mechanisms by
which companies can compartmentalize or absorb the impact of
exchange rate changes.
• The degree of Pass-through is measured by the proportion if the
exchange rate change reflected in foreign currency price.
• Price elasticity of demand is an important factor when determining
pass-through levels.
24
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4/18/2018
Exchange Rates Pass-through
BMW automobile is produced in Germany and sold in the
US: S(USD/EUR) = 1, PBMW, EUR = EUR35,000
 PBMW, USD = EUR35,000 * USD1,000/EUR = USD35,000
• Exchange rate pass-through: If EUR appreciates 20%
versus USD, price of BMW should theoretically increase by
20% to:
PBMW, USD=EUR35,000*USD1,200/EUR = USD42,000
• Exchange rate pass-through is partial: USD price of BMW
rises only to
USD40,000 by 40,000/35000 = 1.1429 = 14.29%, not by 20%.
 degree of pass-though is 14.29%/20% = 0.71 = 71%:
Only 71% of the exchange rate change was pass through to
the USD price. The remaining 29% has been absorbed by
25
BMW.
Empirical Evidence on PPP
Theories
University of Manchester
26
Nominal Exchange Rates changes and
Inflation Differentials: 1974-2006
Infln
Diffs
vs
USA
CPIs
45º = PPP line
Changes in average annual exchange rates: 21 countries for 32 years vs USD
1. On the left: 672 1-year changes (32 years x 21 countries)
2. On the right: 84 (non-overlapping) 8-year changes, 1974-82,
1983-90, 1991-1998, 1999-2006.
27
9
4/18/2018
Nominal Exchange Rates changes and
Inflation Differentials: 1974-2006
Infln
Diffs
vs
USA
CPIs
Changes in average annual exchange rates: 21 countries for 32 years vs USD
1. On the left: 42 (non-overlapping) 16-year changes
2. On the right: 21 (non-overlapping) 32-year changes
28
Nominal Exchange Rates changes and
Inflation Differentials: 1974-2006
Infln
Diffs
vs
USA
CPIs
672 1-year changes
29
Changes in average annual exchange rates: 21 countries for 32 years vs USD
Summary of empirical evidence on PPP
• Empirical studies have found that violations of purchasing
power parity over the short to medium term are extremely
common – see the 1-year evidence
• Shocks can push the exchange rate away from its
equilibrium (mean) PPP value for quite long periods
• The rate of re-adjustment back to the PPP value is slow –
half-life of 3 years (plus) in many studies.
• This may be due to a combination of factors, including lack
of integration of the world’s goods markets (because of
protectionism, taxes, transportation and transaction costs,
‘sticky’ goods market prices, etc).
30
10
4/18/2018
Summary of empirical evidence on PPP
• Relative PPP may not hold in the short-run, but there is
strong evidence it is a reasonably good approximation in
the long-run.
• However, it may take 3-5 years to reach long-run
equilibrium (in the sense PPP holds).
• Thus, for several years, Q may be rising or falling,
affecting competitiveness, trade balances (net exports)
and output levels.
31
Purchasing power parity: Empirical
findings conclusions
• Two general conclusions can be made from these tests:
 PPP holds up well over the very long run but poorly for shorter
time periods; and,
 The theory holds better for countries with relatively high rates of
inflation and underdeveloped capital markets.
• Empirical testing of PPP and the law of one price has
been done, but has not proved PPP to be accurate in
predicting future exchange rates.
32
Mean Reversion in Real Exchange Rate
• The fact that over time scatter plot converges to 45° PPP line
in long-run means
• Q, the Real Exchange Rate has a tendency to revert to its
own average or mean value
This property is called MEAN REVERSION
• Moreover, in the long-run this equilibrium value is consistent
with PPP
33
11
4/18/2018
Issues with PPP as a Theory of the
Real Equilibrium Exchange Rate
Two important points to note
•
The scatter plots produced using CPI consumer price
indices: we could equally have used




•
WPI (wholesale Price indices)
Unit labour cost indices
GDP deflators
Export Price indices
Applying PPP with a different choice of price indices can
yield very different measures of the real equilibrium
exchange rate, Q. In other words, our value of the
equilibrium Q is dependent upon which price indices we
choose to undertake our calculation
34
Case Study: Real Exchange Rate:
UK and Germany 1970-2000
Consider following hypothetical question
• What conversion rate for GBP to Euro would have been most
appropriate if UK had chosen to adopt the Euro in Jan 2001?
• Plausible Answer: Its real equilibrium exchange rate with
Germany…over what time period?
– post-Bretton Woods (post 1970)
– Post 1990?
• In other words, the average value to which Q tends to mean
revert in a particular time period
35
Case Study: Real Exchange Rate: UK and
Germany 1970-2000
CPI
GDP Defl
Unit Lab Cost
WPI
1970-2000
Source: IMF Calculations
Export prices
1990-2000
36
12
4/18/2018
Case Study: Real Exchange Rate: UK
and Germany 1970-2000
• Each of the 5 panels shows a different measure of Real
Exchange Rate with 5 different price indices
• Also takes average level since 1970 and since 1990
• So, 10 different measures of how much sterling GBP
misaligned against the DEM (hence the euro) at the end of
2001
• All 10 values suggest GBP overvalued (euro excessively
weak) – useful for Policymakers
• However, estimates range from an overvaluation of 10%
to more than 40%
• Issue…which do you pick?
37
PPP: Graphical findings
1973-2002: the British price level rose 99% relative to the U.S price
level, and as the theory of PPP predicts, the dollar appreciated
against the pound by 73%, smaller than the 99% increase predicted
by PPP.
1985-87: the British price level rose relative to that of the U.S. Instead
of appreciating as PPP theory predicts, the U.S. Dollar actually
38
depreciated by 40% against the pound.
Trick: If a factor increases the demand for
domestic goods relative to foreign goods, the
domestic currency will appreciate and vice versa.
Source: Mishkin (2006), chapter 19
39
13
4/18/2018
The Links Between LOP, APPP and RPPP
•
•
•
•
•
If absolute PPP holds, then so will relative PPP.
Relative PPP may hold even if there are persistent
deviations in the average absolute price levels across
countries, so…..
If prices in London are persistently 80% higher than in
Brussels, relative PPP holds.
The deviation from relative PPP can always be computed even in cases where the consumption bundles differ
across countries.
Even if one cannot compare different consumption bundles
directly, it is still possible to compare changes in the prices
of these baskets of goods.
Even when LOOP holds for every single good, APPP will
not generally hold if the consumption bundles (weights)
differ across countries.
40
Shortcomings of PPP
• Do not consider interest rates, government‘s intervention, statistical
problem, productivity differentials (Balassa-Samuelson Model) among
the factors that affect the exchange rates.
• Do not consider substitution effect: increase in price level of
domestically-produced goods can be substituted by other goods rather
than imported goods.
• Do not consider changes in technology and natural resources.
• Works in the long run, not the short run.
• Many goods and services are not traded: e.g. housing, land, services
such as restaurant meals, haircuts, and golf lessons. Thus change in
the demand of those may cause domestic price to change relative to
foreign price of the same basket.
• Based only on the international exchange of goods and services and
do not consider financial flows and money stocks.
41
The application of PPP
• Defining that a country‘s exchange rate is overvalued or
undervalued with respect to PPP.
• Making cross country comparisons of income, wages, or
GDP.
• Forecasting the exchange rate in the long run.
42
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Overvaluation or undervaluation
• Individual national currencies often need to be evaluated against
other currency values to determine relative purchasing power.
• The objective is to discover whether a nation’s exchange rate is
“overvalued” or “undervalued” in terms of PPP.
• This problem is often dealt with through the calculation of exchange
rate indices such as the nominal effective exchange rate index.
• Nominal effective exchange rate index uses actual exchange rate to
create an index of the value of the subject currency overtime on a
weighted average basis. It does not really indicate anything about
the true value of the currency, or any thing related to PPP. It
calculates how the currency value relates to some arbitrarily chosen
base period.
• Real effective exchange rate index indicates how the weighted
average purchasing power of the currency has changed relative to
some arbitrarily selected base period.
43
Exhibit 7.3 IMF’s Real Effective Exchange
Rate Indexes for the United States, Japan,
and the Euro Area (2000 = 100)
7-44
An index value above 100 would suggest an overvalued currency
from a competitive perspective, or vice versa.
Exhibit 7.1 The McCurrency Menu – the
Hamburger Standard
2 ways to calculate the undervaluation or overvaluation of currencies
versus USD:
• Implied PPP rate/Actual rate -1 = 3.5/6.83 – 1 = -0.4879 ≈ -49%
• Price in China in USD/Price in the US in USD = 1.83/3.57 -1 = -0.4874 ≈
-49%
45
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Example
pUS
pUK
$/£2000 $/£2004
8.80% 9.13% 1.639 1.871
Which currency is overvalued or undervalued?
46
Example
47
Cross-country comparisons
48
16
4/18/2018
Exercise
• P7.1-7.5, 7.6, 7.10, 7.23
49
A version of PPP by heterogenous goods
If domestic goods and foreign goods are heterogenous,
price levels in domestic and foreign countries are
different P ≠ NER . P*
 Apply the LOOP to the consumption prices of the
baskets of commodities provided that domestic and
foreign consumers have identical preference on those
baskets, so that ratios of domestic and foreign
commodities in the domestic basket of commodities are
the same as those in the foreign basket of commodities.
50
A version of PPP by heterogenous goods


 P 
P 
  P 
NER
PC  P α  NER  P*
α
C*

 NER 
1 α
* 1 α

PC
 P C  NER  PC *
PC *
where a, 1- a: weight of domestic and foreign commodities
PC, PC*: domestic and foreign consumption price
measured in domestic and foreign currency
51
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A generalized version of PPP
- a distinction between traded and non-trade goods• Make a distinction between traded and non-trade goods (nontradable goods are those that cannot be traded internationally at a
profit, such as houses and certain services such as a haircut, or
restaurant food): PN, P*N  PC = Pa T . P1-a N
• Tradable goods of the two countries are homogenous PT, P*T
where PT = NER . P*T  PC* = (P*Ta . (P*N1-a
   
α
RER  NER 
1 α
P C* PT PT*  PN*


P C PT*
PTα  PN1α
1 α
 P* P* 
 RER   N T 
 PN PT 
weights (a and 1- a) indicate the (%) importance of tradable (T) and nontradable (N) goods’ prices in the economies price level.
In logarithm: q = (1- a) . (pN*- pT*) - (1- a) . (pN - pT)
RER = 1 if the relationship between traded and non-traded goods in 52
domestic and foreign country is the same.
Productivity Differentials in the Traded Goods
Sector: Balassa-Samuelson Effects
• Balassa and Samuelson argue that labour productivity in
rich countries is higher than that in poor countries.
• This productivity differential occurs predominately in the
tradables rather than non-tradables sector.
• Assumptions:
– Wages are the same in the tradables and non-tradables sector
within each economy and positively related to productivity
– Prices are determined positively by wages and inversely by
productivity.
53
Productivity Differentials in the Traded Goods
Sector: Balassa-Samuelson Effects
Relationships:
• In the poor economy: PN = W N/QN and PT = W T/QT
• In the rich economy: P*N = W*N/Q*N and P*T = W*T/Q*T
• Wages are the same in the tradables and non-tradables
sector: W N = W T and W*N = W*T
• Productivity is higher in rich country’s tradables sector
than that in poor country, but the same in nontradables
sector: Q*T > QT and Q*N = QN
• The price ratios of traded goods to non-traded goods in
each country: PN/PT = s and P*N/P*T = s*
• PPP holds for the tradables sector: S.P*T = PT
18
4/18/2018
Productivity Differentials in the Traded Goods
Sector: Balassa-Samuelson Effects
Results:
• P*N/P*T =! PN/PT
 (W*N/Q*N).(Q*T/W*T) =! (W N/QN).(QT/WT)
 Q*T/Q*N =! QT/QN .
Since Q*T > QT and Q*N = QN
 Q*T/Q*N > QT/QN
 P*N/P*T > PN/PT
 s* > s : Relative price of nontrables to tradables will be
higher in rich country.
• From P*N/P*T > PN/PT
 S.P*N/SP*T > PN/PT .
Since S.P*T = PT
 S.P*N > PN : PPP doesn’t work for non-traded goods.
55
Productivity Differentials in the Traded Goods
Sector: Balassa-Samuelson Effects
• PC*/ PC = [(P*T a .(P*N1-a ] / [PaT . P1-aN]
 PC*/ PC = (P*T /PT )a . (P*N /PN )(1-a)
Since S.P*T = PT and SP*N > PN
 (P*T /PT )a . (P*N /PN )(1-a > (P*T /S.P*T )a . (P*N /S.P*N )(1-a
 (P*T /PT )a . (P*N /PN )(1-a > (1/S)a . (1/S )(1-a
 (P*T /PT )a . (P*N /PN )(1-a > 1
 PC*/ PC > 1
 PC*> PC : Prices are on average higher in rich countries
than in poor countries
56
Balassa-Samuelson Effects and the RER
q = (1- α)(pN*- pT*) - (1- α)(pN - pT)
<<<
B
1. A will be smaller than B, thereby causing the real exchange
rate to appreciate.
2. In other words, the real exchange rate will appreciate if
productivity in the tradables sector is higher in the domestic
country than in the foreign country.
Exp: Since WWII, Japan has had higher productivity in its
tradables sector than the US, which leads to a fall in
Japanese traded goods prices relative to US traded goods
prices. To maintain the PPP for tradables goods the yen
should appreciate against the dollar in real terms (by 9% in
the period of 1973-1983, so-called Japanese Economic
57
Miracle, see Chung et al., 2004).
19
4/18/2018
2. Interest rate parity
• Provides the link between interest rates and exchange
rates between two countries:
 Interest arbitrage (covered and uncovered)
 Interest rate parity (covered and uncovered)
58
An Introduction
• We address the issue of the FOREX market’s efficiency.
• Prices should fully reflect information available to market
participants.
• It follows that in an efficient market (equilibrium)
international investors will have no desire to switch
investments from domestic to foreign currency
denominated assets, or vice-versa.
• Efficient market hypothesis can be reduced to the joint
hypothesis that:
–
–
FOREX market participants are risk neutral
FOREX participants (in an aggregate sense) act as if they are
endowed with rational expectations (adjusted for risk and formed
rationally)
59
An Introduction
• Most often, FOREX market efficiency discussions have
taken place in the context of the link between Spot and
Forward FOREX exchange rates?
• Forward Rate also reflects “market” expectations
(adjusted for risk and formed rationally) of the level of the
future spot exchange rate which will prevail at the time
the forward contract matures:
• What is the basis for these claims of the spot-forward
exchange rate relationship? Arbitrage strategy
60
20
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An Introduction
Arbitrage strategy
• Trading strategies involving no market risk (all prices
are locked-in) at the time the strategy is initiated.
– Buy low, sell high
– Transactions executed simultaneously
• These strategies also involve no initial investment (any
funds required can be borrowed at known rates, so again
no market risk)
• May involve other risks (counterparty credit risk)
• An Efficient Market implies: no profitable arbitrage
opportunities exist
61
Interest Arbitrage
Hypothesis
• Domestic and foreign financial assets are homogenous
(perfect substitution)
• Costless arbitrage (no transaction cost, no capital barriers,
no country risk)
• Perfect competitive market
• Arbitrageurs act in the market and their activities push
market back to parity conditions. Arbitrageurs are riskneutral. If they are risk-averse, the risk premium  should
be added to the formula i  i*  ENER  
62
Interest arbitrage
• Arbitrage can be defined as the act of simulteneously
buying and selling the same or equivalent assets or
commodities for the purpose of making certain,
guaranteed profits.
• Arbitrage is a process through which an investor can buy
an asset or combination of assets at one price and
occurently sell at a higher price, thereby earning a profit
without investing any money or being exposed to any
risk.
• As long as there are profitable arbitrage opportunities,
the market cannot be in equilibrium. The market can be
said in equilibrium when no profitable arbitrage
opportunities exist.
• Interest arbitrage is an operation that aims to benifit from
the short-term employment of liquid funds in the financial
centre where the yield is highest.
63
21
4/18/2018
Interest arbitrage
• Covered investment or borrowing involves two foreign
exchange transaction costs, one on the spot market, the
other on the forward market.
• Covered interest arbitrage invoves the coverage of
economic agents (not speculators) against exchange risk
by having recourse to the forward exchange market.
64
Covered Interest Arbitrage
Eurodollar rate = 8.00 % per annum
Start
End
$1,000,000
$1,040,000
$1,044,638
x 1.04
Dollar money market
S =¥ 106.00/$
180 days
Arbitrage
Potential
F 180 = ¥ 103.50/$
Yen money market
¥ 106,000,000
x 1.02
¥ 108,120,000
Euroyen rate = 4.00 % per annum
65
Uncovered Interest Arbitrage (UIA):
The Yen Carry Trade
Investors borrow yen at 0.40% per annum
Start
¥ 10,000,000
End
x 1.004
Japanese yen money market
S =¥ 120.00/$
360 days
¥ 10,040,000 Repay
¥ 10,500,000 Earn
¥
460,000 Profit
S360 = ¥ 120.00/$
US dollar money market
$ 83,333.33
x 1.05
$ 87,500.00
Invest dollars at 5.00% per annum
In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts the proceeds to another currency
such as the U.S. dollar where the funds are invested at a higher interest rate for a term. At the end of the period, the investor
exchanges the dollars back to yen to repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the
period is roughly the same as at the start, or the yen has fallen in value against the dollar, the investor profits. If, however, the yen
were to appreciate versus the dollar over the period, the investment may result in significant loss.
66
22
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Determining the currency of investment
?
1 + i   F  1 S  1  i 
1 + i   F  1 S   1  i * :
1 i
JPY0
JPYn
F
1S
*
JPY deposit choosing
1 + i   F  1 S  1  i *  :
USD0
USD deposit choosing
USDn
1  i*
67
Determining the currency
in which to borrow
?
1 i
JPY0
JPYn
F
1S
1 + i   F  1 S   1  i 
*
1 + i   F  1 S   1  i*  :
USD borrowing
1 + i   F  1 S  1  i* :
USD0
USDn
1  i*
JPY borrowing
68
Borrowing and investing
for arbitrage profit
?
1 i
JPY0
JPYn
1 + i   F  1 S  1  i 
*
1 + i   F  1 S   1  i  :
*
F
1S
JPY investing, USD borrowing
1 + i   F  1 S   1  i  :
*
USD0
1  i*
USDn
JPY borrowing, USD investing
69
23
4/18/2018
Interest rate parity
• Interest rate parity (IRP) is an arbitrage condition that
must hold when international financial markets are in
equilibrium (provides the linkage between the foreign
exchange markets and the international money markets).
• IRP theory states the difference in the national interest
rates for securities of similar risk and maturity should be
equal to, but opposite in sign to, the forward discount or
premium for the foreign currency, except for transaction
costs.
• IRP derives with the assumptions that there are no
transaction costs, political risks of investing abroad, and
taxes.
70
Interest Rate Parity
i $ = 8.00 % per annum
(2.00 % per 90 days)
Start
End
x 1.02
$1,000,000
$1,020,000
$1,019,993*
Dollar money market
90 days
S = SF 1.4800/$
F 90 = SF 1.4655/$
Swiss franc money market
x 1.01
SF 1,480,000
SF 1,494,800
i SF = 4.00 % per annum
(1.00 % per 90 days)
•Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.
71
Interest rate parity
1 + i  = F  1 S   1  i *  : IRP
F  S i  i*
F S

 i  i* 
 1  i*
S
1  i*
S
i  i *  f  s : reduced form


i  i *  F  S  S : CIP :
interest differenti al equals the forward margin
i  i *  ( ES  S ) S : UIP
72
24
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Interest rate parity
KX  KX ( RR )
KM  KM ( RR)
 i*  ENER 
NK  NK ( RR )  NK  

i



Where  : RR elasticity of NK ( > 0).
The effects of RR on NK depends on:
•  :  ↑→NK↑
• The value of  :
 If domestic and foreign financial assets are homogenous or perfectly
substitutable:  high: RR↑→NK↑ (high): IRP
 If domestic and foreign financial assets are heterogenous or imperfectly
substitutable :  small: RR↑→NK↑ (small)
73
Uncover interest rate parity
    RR  NK 1   1
RR 
i *  ENER
 i  i*  ENER  RR  1
i
74
Covered interest rate parity
it  it*  NERtT,t 1  NERt
hay
i  i*  f  s
75
25
4/18/2018
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to
appreciate from its present level of $0.50 to $0.52 in 30 days.
Borrows at 7.20% for 30
days
4. Holds
$20,912,320
1. Borrows $20
million
Returns $20,120,000
Profit of $792,320
Exchange at
$0.52/NZ$
Exchange at
$0.50/NZ$
2. Holds NZ$40
million
Lends at 6.48% for 30
days
3. Receives
NZ$40,216,000
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to
depreciate from its present level of $0.50 to $0.48 in 30 days.
Borrows at 6.96% for 30
days
1. Borrows NZ$40
million
Exchange at
$0.50/NZ$
2. Holds $20
million
4. Holds
NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
or $800,640
Lends at 6.72% for 30
days
Exchange at
$0.48/NZ$
3. Receives
$20,112,000
Example
Suppose that the annual interest rate is 5 percent in the
United States and 8 percent in the U.K., and that the
spot exchange rate is $1.50/£ and the forward exchange
rate, with one-year maturity, is $1.48/£. In terms of our
notation, i$ = 5%, i£ = 8%, S = $1.50, and F = $1.48.
Assume that the arbitrager can borrow up to $1,000,000
or £666,667, which is equivalent to $1,000,000 at the
current spot exchange rate. Check if IRP is holding
under current market conditions?
78
26
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Interest Rate Parity and Equilibrium
• The following exhibit illustrates the conditions necessary
for equilibrium between interest rates and exchange
rates.
• The disequilibrium situation, denoted by point A, is
located off the interest rate parity line.
• However, the situation represented by point A is
unstable because all investors have an incentive to
execute the same covered interest arbitrage, which is
virtually risk-free.
79
FS
 1  i*
S


IP
A
0.04
0.03
0.02
B
F
0.01
-0.03
-0.04
-0.01
-0.02
0
0.01
C
-0.02
-0.03
•
•
-0.04
D
0.02
0.03
0.04
i  i*
-0.01
•
•
Extra borrowing in JPY will put upward pressure
E
on JPY interest rates.
The spot sale of JPY for USD will help bid up
the spot price of USD, that S(JPY/USD) will
increase.
The USD that were purchased will be used to
invest in USD securities. This will cause the
price of USD securities to increase, and
therefore cause dollar yields to decrease, that
is, i* will fall.
The forward sale of USD will lower F(JPY/USD)
80
Forward rate as an unbiased predictor
of the future spot rate
Hypothesis: Market is efficient.
• The forward exchange rate today (Ft,t+1), time t, for
delivery at future time t +1, is used as a predictor of the
spot rate that will exist at that day in the future.
• The forward rate is termed an unbiased predictor of the
future spot rate (UFR),
• Unbiased prediction simply means that the forward rate
will, on average, overestimate and underestimate the
actual future spot rate in equal frequency and degree
(Et(St+1) = Ft,t+1). The sume of the errors equals zero.
• Intuitively this means that the distribution of possible
actual spot rates in the future is centered on the forward
rate.
81
27
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Exhibit 4.10 Forward Rate as an Unbiased
Predictor for Future Spot Rate
Exchange rate
t1
t2
t3
t4
F2
S2
S1
Error
Error
F1
F3
Error
S3
S4
t1
t2
t3
t4
Time
The forward rate available today (Ft,t+1), time t, for delivery at future time t+1, is used as a “predictor” of the
spot rate that will exist at that day in the future. Therefore, the forecast spot rate for time St2 is F 1; the actual spot
rate turns out to be S 2. The vertical distance between the prediction and the actual spot rate is the forecast error.
When the forward rate is termed an “unbiased predictor of the future spot rate,” it means that the forward rate
over or underestimates the future spot rate with relatively equal frequency and amount. It therefore “misses the
mark” in a regular and orderly manner. The sum of the errors equals zero.
82
Expected
change in
exchange rate
E∆S = E∆NER
-2
Parity line
Forward premium (+)
hay forward discount (-)
f-s
-2
83
3. International Fisher Effect
Fisher equation
• The Fisher Effect states that nominal interest rates in each
country are equal to the required real rate of return plus
compensation for expected inflation. i = (1 + r).(1+p) - 1
This equation reduces to (in approximate form): i  r  p
where i is the nominal interest rate, r is the real interest
rate and p is the inflation rate
• Expectation form: i  r  EP  r  i  EP
• This obtains from
(1  i)  (1  r )(1  EΔP)
• Empirical tests (using ex-post) national inflation rates have
shown the Fisher effect usually exists for short-maturity
government securities (treasury bills and notes).
84
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3. International Fisher Effect
ES  S *
 i  ES  i *  ENER
S
IP with
ES = S.(1+E∆S)
i  i* 
Expected PPP
ENER  EP  EP*
International Fisher
effect (real interest
parity condition)
i  i *  EP  EP *
i  EP  i *  EP *
The percentage differential in the expected inflation rates
equals the differential between comparable interest rates in
different countries. In equilibrium, real interest rates are
equal in different countries.
85
Exercises
• P7.7, 7.8, 7.11-7.15, 7.17, 7.22, 7.24, 7.25
29
10/24/2018
Exchange Rate
Mechanism/Regime/System
Exchange Rate Systems
• Exchange rate systems/mechanisms/regimes can be classified
according to the degree to which the rates are controlled by
the government.
• Exchange rate systems normally fall into one of the following
categories:
 fixed
 freely floating
 managed float
 pegged
Fixed Exchange Rate System
• In a fixed exchange rate system, exchange rates are either
held constant or allowed to fluctuate only within very narrow
bands.
• The Bretton Woods era (1944-1971) fixed each currency’s
value in terms of gold.
• The 1971 Smithsonian Agreement which followed merely
adjusted the exchange rates and expanded the fluctuation
boundaries. The system was still fixed.
1
10/24/2018
Fixed Exchange Rate System
• Pros: Work becomes easier for the MNCs.
• Cons: Governments may revalue their currencies. In fact, the
dollar was devalued more than once after the U.S.
experienced balance of trade deficits.
• Cons: Each country may become more vulnerable to the
economic conditions in other countries.
Freely Floating Exchange Rate System
• In a freely floating exchange rate system, exchange rates are
determined solely by market forces.
• Pros: Each country may become more insulated against the
economic problems in other countries.
• Pros: Central bank interventions that may affect the economy
unfavorably are no longer needed.
Freely Floating Exchange Rate System
• Pros: Governments are not restricted by exchange rate
boundaries when setting new policies.
• Pros: Less capital flow restrictions are needed, thus enhancing
the efficiency of the financial market.
2
10/24/2018
Freely Floating Exchange Rate System
• Cons: MNCs may need to devote substantial resources to
managing their exposure to exchange rate fluctuations.
• Cons: The country that initially experienced economic
problems (such as high inflation, increasing unemployment
rate) may have its problems compounded.
Managed Float Exchange Rate System
• In a managed (or “dirty”) float exchange rate system,
exchange rates are allowed to move freely on a daily basis and
no official boundaries exist. However, governments may
intervene to prevent the rates from moving too much in a
certain direction.
• Cons: A government may manipulate its exchange rates such
that its own country benefits at the expense of others.
Pegged Exchange Rate System
• In a pegged exchange rate system, the home currency’s value
is pegged to a foreign currency or to some unit of account,
and moves in line with that currency or unit against other
currencies.
• The European Economic Community’s snake arrangement
(1972-1979) pegged the currencies of member countries
within established limits of each other.
3
10/24/2018
Pegged Exchange Rate System
• The European Monetary System which followed in 1979 held
the exchange rates of member countries together within
specified limits and also pegged them to a European Currency
Unit (ECU) through the exchange rate mechanism (ERM).
 The ERM experienced severe problems in 1992, as economic
conditions and goals varied among member countries.
Pegged Exchange Rate System
• In 1994, Mexico’s central bank pegged the peso to the U.S.
dollar, but allowed a band within which the peso’s value could
fluctuate against the dollar.
 By the end of the year, there was substantial downward pressure on
the peso, and the central bank allowed the peso to float freely. The
Mexican peso crisis had just began ...
Currency Boards
• A currency board is a system for maintaining the value of the
local currency with respect to some other specified currency.
• For example, Hong Kong has tied the value of the Hong Kong
dollar to the U.S. dollar (HK$7.8 = $1) since 1983, while
Argentina has tied the value of its peso to the U.S. dollar (1
peso = $1) since 1991.
4
10/24/2018
Currency Boards
• For a currency board to be successful, it must have credibility
in its promise to maintain the exchange rate.
• It has to intervene to defend its position against the pressures
exerted by economic conditions, as well as by speculators
who are betting that the board will not be able to support the
specified exchange rate.
Exposure of a Pegged Currency to Interest
Rate Movements
• A country that uses a currency board does not have complete
control over its local interest rates, as the rates must be
aligned with the interest rates of the currency to which the
local currency is tied.
• Note that the two interest rates may not be exactly the same
because of different risks.
Exposure of a Pegged Currency to
Exchange Rate Movements
• A currency that is pegged to another currency will have to
move in tandem with that currency against all other
currencies.
• So, the value of a pegged currency does not necessarily reflect
the demand and supply conditions in the foreign exchange
market, and may result in uneven trade or capital flows.
5
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Dollarization
• Dollarization refers to the replacement of a local currency
with U.S. dollars.
• Dollarization goes beyond a currency board, as the country no
longer has a local currency.
• For example, Ecuador implemented dollarization in 2000.
A Single European Currency
• In 1991, the Maastricht treaty called for a single European
currency. On Jan 1, 1999, the euro was adopted by Austria,
Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg,
Netherlands, Portugal, and Spain. Greece joined the system in
2001.
• By 2002, the national currencies of the 12 participating
countries will be withdrawn and completely replaced with the
euro.
A Single European Currency
• Within the euro-zone, cross-border trade and capital flows
will occur without the need to convert to another currency.
• European monetary policy is also consolidated because of the
single money supply. The Frankfurt-based European Central
Bank (ECB) is responsible for setting the common monetary
policy.
6
10/24/2018
A Single European Currency
• The ECB aims to control inflation in the participating countries
and to stabilize the euro within reasonable boundaries.
• The common monetary policy may eventually lead to more
political harmony.
• Note that each participating country may have to rely on its
own fiscal policy (tax and government expenditure decisions)
to help solve local economic problems.
A Single European Currency
• As currency movements among the European countries will
be eliminated, there should be an increase in all types of
business arrangements, more comparable product pricing,
and more trade flows.
• It will also be easier to compare and conduct valuations of
firms across the participating European countries.
A Single European Currency
• Stock and bond prices will also be more comparable and there
should be more cross-border investing. However, nonEuropean investors may not achieve as much diversification as
in the past.
• Exchange rate risk and foreign exchange transaction costs
within the euro-zone will be eliminated, while interest rates
will have to be similar.
7
10/24/2018
A Single European Currency
• Since its introduction in 1999, the euro has declined against
many currencies.
• This weakness was partially attributed to capital outflows
from Europe, which was in turn partially attributed to a lack of
confidence in the euro.
• Some countries had ignored restraint in favor of resolving
domestic problems, resulting in a lack of solidarity.
A Single European Currency
1.80
 strengthens € weakens 
1.60
€/£
1.40
1.20
1.00
€/$
€/100¥
0.80
0.60
0.40
Jan-99
€/SwF (Swiss Franc)
Jul-99
Jan-00
Jul-00
Jan-01
Jul-01
Alternative Exchange Rate Regimes (policy)
1. No country-specific exchange rate or a Currency Union.
2. Fixed parity or peg (it can be a currency board)
3. Fixed parity in an exchange rate union (example the European Monetary System)
4. Crawling peg
5. Purchasing Power of Parity rules
6. Exchange rate bands or target zones
7. Managed (or dirty) float
8. Free float
9. Multiple Exchange Rates
10. Dual Exchange Rates
24
8
10/24/2018
No country-specific exchange rate or a
Currency Union
•
•
•
There are geographical areas which thought to be Optimal Currency
Areas. Optimal Currency Areas: are groups of regions with economies
closely linked by trade in goods and services and by factor mobility.
Ideally, these regions also share a common legal, and regulatory
framework.
Costs:
 Gives up independent (all) monetary policy
 Loss of economic stability (output)
Benefits:
 Eliminates transactions costs
 Imposes inflationary discipline
 Reduces (but not avoids) speculative attacks
25
Fixed parity or peg
• Parity or peg (it can be a currency board)
1. Fixed to a single currency
2. Fixed to a basket of currencies
• In a currency board a monetary institution issues base money (notes,
coins and may also include some reserves held by commercial banks)
solely in the exchange for foreign assets. Hence, all or a large share of the
monetary base is backed by foreign exchange reserves.
• Costs:
 Gives up independent (all or partial) monetary policy
 Loss of economic stability (output)
 May lead to “overvaluation” of the real exchange rate
 Subject to speculative attacks
• Benefits:
 Imposes inflationary discipline – may be useful in bringing inflation
down quickly.
 Transparency may increase policy credibility
26
Balance Sheet Difference
• Central Bank Balance Sheet
Assets
Liabilities
Foreign Assets
$
Private bank deposits
$
Domestic Assets
$
Currency in circulation
$
• Currency Board
Total Assets ($)
Total Liabilities ($)
Assets
Foreign Assets
Total Assets ($)
Liabilities
$
Private bank deposits
$
Currency in circulation
$
Total Liabilities ($)
27
9
10/24/2018
Some illustrations
Estonia and Lithuania
• The Bank of Estonia and the Bank of Lithuania separate their activities
into The Issue Department (the currency board) and the Banking
Department (responsible for all the other activities of a central bank).
Hong Kong
• The Hong Kong Monetary Authorities perform many of the operations of a
central bank (clearing, discount window). The do not issues notes. There
are some banks which have authority to issue notes of which the
Hongkong and Shanghai Banking Corporation is the largest. The FOREX
reserves that back these notes are deposited at the Office of the
Exchange Fund.
28
Fixed parity in an exchange rate union
•
Example: the European Monetary System
•
The difference with the unilateral peg is that now a group of countries
have simultaneously decided to peg their exchange rates against the
members of the currency union while floating against nonmember
countries.
•
Same costs and benefits as unilaterally fixed rates.
29
Crawling Peg
•
Costs:
 Gives up independent (partial) monetary policy
 Loss of economic stability (output)
 May still lead to “overvaluation” of the real exchange rate, although
less so than a fixed parity
 Subject to speculative attacks
•
Benefits:
 May be useful in bringing inflation down (although not as quickly as a
fixed exchange rate.)
 Transparency may increase policy credibility (if the authorities don’t
fiddle too much with the rate of crawl)
30
10
10/24/2018
Purchasing Power of Parity rules
• Under a PPP rule the aim it to fix the real exchange rate at or near its
current level, so (qt – qt-1)/qt-1 = 0
• To do so the rate of devaluation is adjusted to accommodate inflation
differentials, (Et – Et-1 )/Et-1 = Πt-1 – Π*t-1
• Costs:
 Gives up nominal anchor, monetary policy is subordinated to
maintaining the PPP rule
 May lead to an inflationary spiral
• Benefits:
 Stabilizes exports (although not necessarily output)
 Avoids the “overvaluation” of the real exchange rate
 Less subject to speculative attacks
31
Exchange rate bands or target zones
• Targeted to:
a) Fixed central parity
b) Crawling central parity
• Most of these costs and benefits apply only to the extent that it is a
sufficiently wide floatation band (not less than 5% on each side).
• Costs:
 Gives up independent (partially) monetary policy
 Some loss of economic stability (output)
 Still subject to speculative attacks (especially if band lacks credibility)
• Benefits:
 Central Bank has more independence than in the fixed parity
 Imposes inflationary discipline.
 Transparency may increase policy credibility
32
Managed (or dirty) float
• Costs:
 Lacks transparency, may be less useful in establishing policy credibility
and or bringing down inflation.
 The economy is still not insulated from external shocks
 Greater exchange rate volatility may hurt trade
• Benefits:
 Far less subject to speculative attacks, although exchange rate
volatility may be high (see above)
 Greater monetary policy independence (and, hence, greater ability to
engage in counter-cyclical policies.
33
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10/24/2018
Free Float
• Costs and benefits the same as managed float, with more
monetary policy independence and more exchange rate
volatility.
34
Multiple Exchange Rates
• The central bank purchases and sells foreign exchange at different rates
for different current and capital account transactions.
• Current account transactions
1. Importers need foreign exchange to buy the goods they import.
Usually, they get the official rate (O). This is a subsidy to them because
they give up fewer pesos (intis, bolivares, whatever) to purchase one
dollar, than if they had to buy the dollars at the Free (F) or at the
“black market” rate.
However, if the aim is to discourage imports they could conduct these
transactions at a very depreciated exchange rate. One that makes
importers give up a lot of pesos to purchase one dollar. It is a tax on
importers and would work much like a tariff.
1. Exporters, on the other hand, are sellers of foreign exchange, since
when they sell goods abroad their paid in foreign currencies. Usually
they get the free rate or a preferential rate (P). This is also a subsidy
because they get more pesos for each dollar they sell.
35
Multiple Exchange Rates
• Capital account and other financial transactions
1. Repatriation of flight capital: If you want to encourage people to bring
their money back into the country (they can use this money, purchase
equity, domestic bonds, or whatever other domestic asset they feel
like buying) you want to give them a special rate (S). If your really
desperate you can give them a super special (SS) rate. More pesos for
each dollar they bring back.
2. If I want to prevent people from closing their bank accounts and
sending their money to foreign banks you have to offer a competitive
exchange rate and this may mean a super special rate.
36
12
10/24/2018
Multiple Exchange Rates
• Costs:
 Lacks transparency, may be less useful in establishing policy credibility
and or bringing down inflation.
 Leads to inefficiencies in resource allocation
 Budgetary costs can be substantial
 Exacerbates special interest problems and corruption
 Still vulnerable to speculative attacks
• Benefits:
 Can replace commercial policy without circumventing trade
agreements, such as the General Agreement on Tariffs and Trade
(GATT).
 Used to redistribute income
 Can foster nontraditional exports
37
Dual Exchange Rates
• A system of dual exchange rates has two rates: an “official” rate that
applies to many trade transactions, and a “financial” or “free” rate at
which all other transactions take place. If we measure the exchange rate
as pesos/dollar, F > O. The gap between F and O will widen sharply ahead
of financial crises and devaluations.
• Costs:
 Still lacks transparency
 Leads to inefficiencies in resource allocation
 Some budgetary costs
 Exacerbates special interest problems and corruption
 Still vulnerable to speculative attacks
• Benefits:
 Can in a limited way replace commercial policy without circumventing
trade agreements, such as the General Agreement on Tariffs and Trade
(GATT).
 Can foster nontraditional exports
 Can insulate trade from temporary shocks to capital flows (ie the
official rate will be less volatile than the financial rate).
38
Whither to peg or not
• The Theory of Optimum Currency Areas
• The gains:
 The monetary efficiency gain from joining the fixed exchange rate
system equals the joiner’s saving from avoiding uncertainty, confusion,
and calculation and transactions costs that arises when the exchange
rate is allowed to float.
 Examples of such costs include the costs of hedging against exchange
rate fluctuations, brokerage fees (you have to pay for foreign exchange
transactions), exporters and importers may have inventory costs).
• The role of economic integration in:
 Goods markets
 Asset markets
 Factor markets
 Other features facilitating integration:
 Common legal framework
 Common institutional arrangements
39
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10/24/2018
Theory of Optimum Currency Areas
 A conclusion on the links between the degree of integration between
the “fixing” country and the country (or area) that it “fixes to” is that
the degree of integration and the “efficiency gains” are positively
related. This relationship is captured in the upward-sloped GG
schedule.
• The losses:
 The economic stability loss from joining stems from the pegging
country’s loss of independent monetary and exchange rate policy,
which can’t be used to stabilize output (counter-cyclical policies). It is
also the result of asymmetric shocks.
 The higher the degree of integration between the joining country and
the exchange rate area (or country) the smaller the economic stability
loss. This negative relationship is captured in the downward-sloped LL
schedule.
40
Theory of Optimum Currency Areas
• Balancing the gains and losses: Putting the LL and GG schedules together.
• In any point to the right of the intersection of the LL and GG schedules –
the country has a net gain from the peg.
• Any point to the left the country would have a net loss from pegging.
• Shifting the LL schedule:
 The size and frequency of country specific shocks.
41
Shifting the GG schedule
•
The role of credibility and the efficiency gains/integration link
•
•
Reality checks:
How do we measure economic integration?
1. Trade in goods and services, (IM+EX)/Y is a reasonable proxy. This is a
measure of GROSS trade flows, the CA balance gives NET flows.
2. Trade in assets (domestic assets held abroad+foreign assets held
domestically)/Y. This is a measure of GROSS capital flows, the KA
balance gives NET flows.
3. Labor market integration. Compare internal (to the country) versus
external migration.
42
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10/24/2018
Theory of Optimum Currency Areas
• How do we measure the size and frequency of country-specific
disturbances (or shocks)?
• How do we know whether two or more countries are subject to common
or idiosyncratic shocks?
• How do we measure credibility?
• Other “political economy”considerations – transparency, political
dimension, interest groups
43
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4/16/2018
Buổi 05: 10/02/2025
Simple Model of
Exchange Rate Determination
mô hình đơn giản về tỷ giá hối đoái
Assoc. Prof. Dr. Mai Thu Hien
Faculty of Banking and Finance
Foreign Trade University
Supply-and-Demand view of
exchange rate
quan điểm cung-cầu về tỷ giá hối đoái
tỷ giá hối đoái được xác định bởi mqh giữa cung và cầu
• Simple model of exchange rate determination: Supplyand-Demand view of Exchange rate
• Factors affecting exchange rate
• Foreign exchange intervention
ngoại tệ
sự can thiệp của ngân hàng trung ương
các yếu tố ảnh hưởng
2
Supply-and-Demand view of
exchange rate
•
•
•
•
không giới hạn tỷ giá
Assumptions:
No exchange rate limitation
No exchange rate manipulation
Forex supply = Goods exports + Capital imports
Forex demand = Goods imports + Capital exports
không có sự thao túng tỷ giá
cung ngoại tệ = xuất khẩu hàng hóa + nhập
khẩu vốn
cầu ngoại tệ = nhập khẩu hàng hóa + xuất khẩu vốn
nhập khẩu vốn = ngoại tệ thành nội tệ
3
xuất khẩu vốn = đổi nội tệ thành ngoại tệ
1
4/16/2018
cung và cầu ngoại tệ bằng nhau trên thị
trường
Exchange Rate Equilibrium
1.
•
• An exchange rate represents the price of a currency,
which is determined by the demand for that currency
relative to the supply for that currency.
Cung ngoại tệ lớn hơn cầu (Supply > Demand):
Nội tệ mạnh lên vì có quá nhiều ngoại tệ trên thị
trường.
2.
Value of €
Cầu ngoại tệ lớn hơn cung (Demand > Supply):
•
Nội tệ suy yếu do nhu cầu ngoại tệ cao hơn lượng
ngoại tệ sẵn có.
S: Supply of €
$1.35
equilibrium
exchange rate
$1.30
hối đoái thấp => giá trị nội tệ cao
$1.25
D: Demand for €
hối đoái cao => ngoại tệ cao
Quantity of €
usd/vnd = 22000vnd/usd < 23000 vnd/usd
Goods export-imports and forex exports-imports
$/€
$/€
E1
S€
E2
D€
$/€
E
Q€
S€
D€
E1
Q€
E2
Q€
5
Goods export-imports and forex exports-imports
RER 
Xuất nhập khẩu hàng hóa và xuất nhập khẩu ngoại hối
•
NER: Tỷ giá danh nghĩa (Nominal Exchange Rate)
•
P*: Mức giá ở nước ngoài
•
P: Mức giá trong nước
•
Khi RER tăng (nội tệ mất giá), xuất khẩu sẽ tăng, và
nhập khẩu sẽ giảm vì hàng hóa trong nước trở nên rẻ hơn so với hàng
ngoại.
NER(USD / EUR )  P * (EUR )
NER  P *
or RER 
P (USD)
P
EX = EX (RER,Y*) where EXRER , EXY* > 0
IM = IM (RER,Y) where IMRER < 0 < IMY
Where EX: real exports (quantity)
IM : real imports
Y: home income
Y*: foreign income
RER: real exchang rate
NER: nominal exchange rate (P/P*)
P: domestic currency price of goods
P*: foreign currency price of goods
•
Ngược lại, nếu RER giảm (nội tệ
tăng giá), nhập khẩu sẽ tăng, và xuất khẩu sẽ
giảm.
6
2
4/16/2018
Trade balance and the real exchange rate
• Real trade account CA is the result of the export and import
of goods and services.
CA = CA(RER,Y*,Y) where CARER, CAY* > 0 > CAY
• Nominal current account CAnom where CAnom /P = CA
CAnom  P  EX  NER  P *  IM
CAnom P  EX NER  P*


 IM
P
P
P
 CA  EX  RER  IM  EX RER, Y *   RER  IM RER, Y 
NER  RER  CA 
7
Trade balance and the real exchange rate
CA  CARER, Y * , Y   CA  RER  Y *   Y  

where : real exchang rate elasticity of CA ( > 0): measuring
the responsiveness of the trade balance to a change in real
exchange rate.
The effects of RER on CA depend on:
•
: RER↑→CA↑
• Value of :
 If domestic and foreign goods are homogenous or perfectly
substitutable:  is high ( = ): RER↑(→1)→ CA↑ (high): PPP
 If domestic and foreign goods are heterogenous or
imperfectly substitutable:  small: RER↑→CA↑ (small)
8
Capital export-imports and forex exports-imports
• The rate of return on domestic valuables/investment i
• The rate of return on investment abroad: i* + E∆NER, because
 Invest $1 abroad (EU), receive €1/NER . (1+ i*) where $/€ = NER
 Exchange € received for $ at expected exchange rate ENER, have
$1/NER . (1+ i*) . ENER
 The rate of return on overseas investment is
1/NER . (1+ i*) . ENER - 1
 Then
 ENER  NER  NER 

NER

 i*  ENER
  1  i   1  1  i   1  ENER   1

*
*
where E∆NER = (ENER – NER) / NER
9
3
4/16/2018
Tài khoản vốn (NK) là chênh lệch giữa xuất khẩu vốn và nhập
khẩu vốn.tỷ g
Khi thu nhập trong nước (Y) tăng, nhập khẩu vốn (IMK)
cũng tăng.
RR càng cao (tức là lãi suất trong nước cao hơn quốc
tế), dòng vốn chảy vào (KK) càng lớn.
NK = KK - IMK = K(RR) - IMK(Y): Tài khoản vốn bằng xuất
khẩu vốn trừ nhập khẩu vốn.
IMK = IMK(Y): Nhập khẩu vốn phụ thuộc vào thu nhập quốc gia
(Y).
KK = K(RR): Xuất khẩu vốn (KK) phụ thuộc vào RR (sự khác
biệt giữa lãi suất trong nước và quốc tế).
Tỷ giá hối đoái thả nổi là cơ chế trong đó tỷ giá ngoại tệ
được xác định bởi cung và cầu trên thị trường ngoại
hối, mà không có sự can thiệp trực tiếp của ngân hàng
trung ương.
10
Capital export-imports and forex exports-imports
KX = KX(RR) where KXRR>0
KM = KM(RR) where KMRR<0
NK = KX – RER . KM ≈ NK(RR) where NKRR>0
Where
RR = (i* + E∆NER) / i: relation between foreign and
domestic rate of return
KX: capital exports (real value)
KM: capital imports (real value)
NK: capital account balance (real value)

Capital account and RR
KX  KX ( RR )
KM  KM ( RR )
 i*  ENER 
NK  NK ( RR )  NK  

i


Where  : RR elasticity of NK ( > 0).
The effects of RR on NK depends on:
•  :  ↑→NK↑
• The value of  :
 If domestic and foreign financial assets are homogenous or perfectly
substitutable:  high: RR↑→NK↑ (high): IRP
 If domestic and foreign financial assets are heterogenous or imperfectly
substitutable :  small: RR↑→NK↑ (small)
11
12
Forex supply and demand in the flexible
exchange rate regime
FXs = EX(RER,Y*) + KM(RR)
= FXs(RER,Y*,RR)
where
FXsRER, FXsY* > 0 > FXsRR
FXd = IM(RER,Y) + KX(RR)
= FXd(RER,Y,RR)
FXdy, FXdRR > 0 > FXdRER
where
increase
money supply
4
4/16/2018
tómt
Forex supply and demand in the flexible
exchange rate regime
$/€
$/€
€
P
+
FXs
FXd
€
P* Y Y* i
+
+ +
- +
-
i* E∆NER
+
+
13
Pc (CPI): every month the official go to market and make survey to get
changes in price to get CPI and we chose basket of goods and services
but divide into 2 types: domestic and imported products.
aP + (1-a)P*xRER
RER: real exchange rate
Forex supply and demand in the fixed
exchange rate regime
$/€
$/€
S1
Intervention
∆R
E
country like vietnam the central bank if not have strong enough to control
inflation, what should they do? (3-month policy strategy
S1
Intervention
S2
E1
vietnam dong depreciates -> increase inflation ->
exchange rate - inflation controller
S2
central bank = independent bank
3 kinds of independence: personnel (governor is not body of gov) governor can use measure without dependence on gov
∆R
D2
D1
Q€
D2
D1
Q€
14
Conclusions
• What determines the exchange rate?
– Demand and supply
• What factors might affect demand and supply?
central bank in vietnam is not independent
central bank follows objective of controlling inflation without government’s
guide. vietnam can adopt inflation targeting or money targeting
for banks do not need to use nominal anchor to control inflation
Qs: most central banks intervene to fix exchange rate
Thailand crisis 1998 (3rd gen crisis)
thailand good eco growth (export), attract most of the world and FDI into
them, they encourage export, the fix exchange rate to attract investment
at the same time, they open liberal rights (capital was free to run out of
thailand, they have no control of capital flow, fix exchange rate and liberal
rights capital account violates
in thailand, they fix exchange rate liberights. when everything is in order,
they can export to the rest of the world and foreign currency and
accumulate and also many investors
if export reduce and exchange rat under depreciation, what central bank
do (thailand) -> they raise interest rate to be more attractive, attract more
foreign capital flow and some observe the situation and export reduce
and increase interest rate and pour capital into thailand and they did
speculate: bought currency at lower rates and wait until increase and sell
higher
double mismatch - mất cân đối tiền tệ/mất cân
đối kỳ hạn (asian 1997)
example: borrow short-term and , thailand maintain fixed rate with the
wtiness of bank system double mistmach when bank announces, the
country suffer financial crisis
in vietnam we dont announce what did rightoff, sometimes we read
? consequences of the intervention (buy or sell reserve to intervene or
raise rate/indirect: use other monetary policy instrument (interest rate),
financing using open market operation, reserve requirement
increase money supply when buy exit
money supply
central bank control money supply ?
OMO,
5
4/16/2018
Example
16
Factors affecting exchange rates
Factors that influence a spot exchange rate
e = f (∆INF, ∆INT,∆INC, ∆GC, ∆EXP)
 Relative Inflation Rates: Change in the differential between two
countries’ inflation
 Relative Interest Rates
 Relative Income Levels
 Government control
 Expectations
where e is the percentage change in the spot rate.
17
Factors affecting exchange rates
Relative inflation rates
$/€
S1
S0
r1
U.S. inflation 
  U.S. demand for European
goods, and hence €.
  European desire for U.S.
r0
D1
D0
goods, and hence the supply
of €.
Quantity of €
6
4/16/2018
Factors affecting exchange rates
Relative Interest Rates
$/ €
S0
S1
r0
U.S. interest rates 
  U.S. demand for European
bank deposits, and hence €.
  European desire for U.S.
r1
D0
D1
bank deposits, and hence
the supply of €.
Quantity of €
Factors affecting exchange rates
Relative Interest Rates
• A relatively high interest rate may actually reflect
expectations of relatively high inflation, which
discourages foreign investment (although a relatively
high interest rate may attract foreign inflows to invest
in securities offering high yields).
• It is thus useful to consider real interest rates, which
adjust the nominal interest rates for inflation.
diret nonsterillized intervention
Factors affecting exchange rates
Relative Interest Rates
•
real
interest 
rate
nominal
interest – inflation rate
rate
Other things constant, a high U.S. real interest rate
relative to other countries tend to boost the dollar’s value
7
4/16/2018
Factors affecting exchange rates
Relative Income Levels
$/€
S0 ,S1
r1
r0
U.S. income level 
  U.S. demand for European
goods, and hence €.
 No expected change for the
D1
supply of €.
D0
Quantity of €
Factors affecting exchange rates
Government Controls
• Governments may influence the equilibrium exchange
rate by:
– imposing foreign exchange barriers,
– imposing foreign trade barriers,
– intervening in the foreign exchange market, and
– affecting macro variables such as inflation, interest
rates, and income levels.
Factors affecting exchange rates
Expectations
• Foreign exchange markets react to any news that may
have a future effect.
• Institutional investors often take currency positions
based on anticipated interest rate movements in various
countries.
• Because of speculative transactions, foreign exchange
rates can be very volatile.
8
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Factors affecting exchange rates
Expectations
Signal
Poor U.S. economic indicators
Impact on $
Weakened
Fed chairman suggests Fed is
unlikely to cut U.S. interest rates
A possible decline in German
interest rates
Central banks expected to
intervene to boost the euro
Strengthened
Strengthened
Weakened
Factors affecting exchange rates
Other factors affecting exchange rates
• Factors that influence capital flows of the balance of
payments
• Preference for foreign products
• Change in dosmetic wealth
• Change in riskness of domestic investment relative to
foreign investment
26
Factors affecting exchange rates
Interaction of Factors
• Trade-related factors and financial factors sometimes
interact. Exchange rate movements may be
simultaneously affected by these factors.
• For example, an increase in the level of income
sometimes causes expectations of higher interest rates.
9
4/16/2018
Factors affecting exchange rates
Interaction of Factors
• Over a particular period, different factors may place
opposing pressures on the value of a foreign
currency.
• The sensitivity of the exchange rate to these factors
is dependent on the volume of international
transactions between the two countries.
Factors affecting exchange rates
Trade-Related
Factors
1. Inflation
Differential
2. Income
Differential
3. Gov’t Trade
Restrictions
Financial
Factors
1. Interest Rate
Differential
2. Capital Flow
Restrictions
U.S. demand for foreign goods, i.e.
demand for foreign currency
Foreign demand for U.S. goods,
i.e. supply of foreign currency
Exchange rate
between
foreign
currency and
the dollar
U.S. demand for foreign securities,
i.e. demand for foreign currency
Foreign demand for U.S.
securities, i.e. supply of foreign
currency
Factors affecting exchange rates
How Factors Have Influenced Exchange Rates
• Because the dollar’s value changes by different
magnitudes relative to each foreign currency, analysts
often measure the dollar’s strength with an index.
• The weight assigned to each currency is determined by
its relative importance in international trade and/or
finance.
10
4/16/2018
Value of Foreign Currency Index Over Time
With Respect to the Dollar
250
 strengthens $ weakens 
200
$ due to
relatively high
U.S. inflation &
growth
150
100
50
Higher U.S.
interest
rates
large
balance of Persian Gulf
trade
War
deficit
U.S. interest rates 
high U.S.
interest rates, a
somewhat depressed U.S.
economy, & low
inflation
0
1972
1976
1980
1984
relatively high U.S.
interest rates, & lower
balance of trade deficit
1988
1992
1996
2000
Note: The index reflects equal weights of £, ¥, French franc, German mark, and Swiss franc.
Online Application
• Exchange rate releases and historical data may
be found at the Federal Reserve website
http://www.federalreserve.gov/.
MONETARY
COUNTRY
UNIT
Oct. 1 Oct. 2 Oct. 3 Oct. 4 Oct. 5
*AUSTRALIA
DOLLAR
0.4923 0.4953 0.4971 0.4975 0.5060
BRAZIL
REAL
2.6870 2.7000 2.7290 2.7290 2.7540
CANADA
DOLLAR
1.5794 1.5696 1.5688 1.5680 1.5626
CHINA, P.R. YUAN
8.2768 8.2768 8.2768 8.2768 8.2768
DENMARK
KRONE
8.1151 8.1267 8.0968 8.1339 8.1115
*EMU MEMBERS EURO
0.9159 0.9149 0.9181 0.9141 0.9168
DOLLAR
7.7992 7.7993 7.7995 7.7998 7.7999
RUPEE
48.03
48.03
47.96
48.04
48.05
YEN
120.27 120.78 120.67 120.63 120.37
.8003 3.8003 3.8005
Online Application
• Check out these foreign exchange sites:
– http://pacific.commerce.ubc.ca/xr/
– http://sonnet-financial.com/rates/full.asp
– http://www.oanda.com/
11
4/16/2018
Foreign exchange intervention
•
•
•
•
•
Each country has a government agency (called the central
bank) that may intervene in the foreign exchange market to
control the value of the country’s currency.
Foreign exchange intervention includes:
Purchase or sale of foreign exchange
Through the monetary policy channel to change interest
rates.
Through the portfolio balance channel to change domestic
and foreign currency assets
Through the signaling or expectations channel
Through the order flow channel (Central banks may be able
to alter order flows with their own orders)
34
Foreign exchange intervention
Reasons for foreign exchange intervention
• To maintain an exchange rate target (in the fixed
exchange rate regime) or to signal a desired exchange
rate movements/to dampen exchange rate volatility (in
the flexible exchange rate regime)
• To achieve a variety of overall economic objectives, such
as controlling inflation, maintaining competitiveness or
maintaining financial stability (to counter disorderly
market conditions)
• To influence the amount of foreign exchange reserves
35
Foreign exchange intervention
Two kinds of foreign exchange intervention:
• Direct intervention: usually most effective when there is a
coordinated effort among central banks.
• Indirect intervention
36
12
4/16/2018
Direct intervention
• Refer to the exchange of foreign currency reserves for
other currencies in the foreign exchange market (with the
purpose of establishment of implicit exchange rate
boundaries, revaluation, or devaluation).
• When a central bank intervenes in the foreign exchange
market without adjusting for the change in money supply,
it is said to engaged in nonsterilized intervention.
• In a sterilized intervention, a central bank intervenes in
the foreign exchange market and simultaneously
engages in offsetting transactions in the Treasury
securities market. In a sterilized intervention, Treasury
securities are purchased or sold at the same time to
maintain the money supply.
37
Sterilzed and unsterilized intervention
• Sterilized intervention if it does not change the monatary base.
• Unterilized intervention if it changes the monetary base.
The Federal Reserve routinely "sterilizes" intervention in the FX market, which
prevents the intervention from changing the amount of bank reserves from levels
consistent with established monetary policy goals. For instance, if the New York
Fed sells dollars to buy a foreign currency, the sale adds reserves to the banking
system. In order to sterilize the transaction, the Fed, in its domestic open market
transactions, may remove reserves through the sale of government securities.
38
Nonsterilized Intervention
Federal Reserve
To Strengthen
the €
$
€
Banks participating
in the foreign
exchange market
Federal Reserve
To Weaken the
€
$
€
Banks participating
in the foreign
exchange market
13
4/16/2018
Sterilized Intervention
T- securities
Federal Reserve
To Strengthen
the €
$
€
$
Banks participating
in the foreign
exchange market
$
Federal Reserve
To Weaken the
€
$
Financial
institutions
that invest
in Treasury
securities
€
Banks participating
in the foreign
exchange market
T- securities
Financial
institutions
that invest
in Treasury
securities
Online
Application
http://www.federalreserve.gov
Treasury and Federal Reserve Foreign Exchange Operations
During the third quarter of 2000, the dollar appreciated 8.2 percent against the euro and
2.0 percent against the yen. On a trade-weighted basis, the dollar ended the quarter 4.1
percent stronger against the currencies of the United States' major trading partners. On
September 22, the U.S. monetary authorities intervened in the foreign exchange markets,
purchasing 1.5 billion euros against the dollar. The operation, which was divided evenly
between the U.S. Treasury Department's Exchange Stabilization Fund and the Federal
Reserve System, was coordinated with the European Central Bank and the monetary
authorities of Japan, Canada, and the United Kingdom.
Indirect intervention
• By influencing factors (interest rates, OMO, reserve
requirements) that determine the value of a currency, or
the use of foreign exchange controls
(restrictions/regulations on foreign exchange
management).
• For example, the Fed may attempt to increase interest
rates (and hence boost the dollar’s value) by reducing
the U.S. money supply.
– Note that high interest rates adversely affects local
borrowers.
42
14
4/16/2018
Foreign exchange management
19.2.2025
• Control on current account: exports and imports of banknotes, export
proceeds
• Control on capital account :
 Control on FDI: outward DI and inward DI
 Control on capital market securites:
- Purchase and sale or issue locally by non-residents
- Purchase and sale or issue abroad by residents
 Control on money market instruments
 Control on collective investment securities
 Control on derivatives and other instruments
 Control on credit operations(coomercial credits, financial credits,
guarantees, sureties, and financial backup facilities)
 Control on real estate transactions
 Control on personal capital transactions
 Provisions specific to commercial banks and other credit institutions
(borrowing/lending abroad, maintance of account abroad, lending to nonresidents, lending locally in foreign exchange, differential treatment of
deposits account in foreign exchange, open foreign exchange position
limits)
43
Intervention as a Policy Tool
• Like tax laws and money supply, the exchange rate is a
tool which a government can use to achieve its desired
economic objectives.
• A weak home currency can stimulate foreign demand for
products, and hence local jobs. However, it may also
lead to higher inflation.
• A strong currency may cure high inflation, since the
intensified foreign competition should cause domestic
producers to refrain from increasing prices. However, it
may also lead to higher unemployment.
Impact of Government Actions on Exchange Rates
Government Monetary
and Fiscal Policies
Relative Interest
Rates
Relative Inflation
Rates
Relative National
Income Levels
International
Capital Flows
Exchange Rates
International
Trade
Government
Purchases & Sales
of Currencies
Tax Laws,
etc.
Government Intervention in
Foreign Exchange Market
Quotas,
Tariffs, etc.
15
Chapter 3
The Balance of Payments
Mai Thu Hien
Faculty of Banking and Finance
Foreign Trade University
Email: maithuhien712@yahoo.com
1
Reading
• Eiteman 12e chapter 4
2
What is the BOP?
• The balance of payments (BP/BOP) is a statistical record of
all international economic transactions between residents of
the reporting country and residents of the rest of the world
during a given time period (usually in a year, sometimes are
published on a more regular monthly and quarterly basis).
• Residents comprise individuals, households, firms, and the
public authorities.
• The subsidiaries of a multinational are treated as being a
resident in the country in which they are located even if their
shares are actually owned by domestic residents.
• International organizations such as the IMF, the WB, UN
and the EC are treated as being foreign residents even
though they may actually located in the reporting countries.
• Tourists are regarded as being foreign residents if they stay
in the reporting country for less than 1 year.
3
1
What is the BOP?
• BOP data is important for government policymakers and
MNEs as it is a gauge of a nations competitiveness or
health (domestic and/or foreign)
• For a 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 (dividends, interest, license
fees, royalties and other cash disbursements)
– A forecast of a country’s market potential (especially
in the short run)
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4
Typical BOP Transactions
• Each of the following represents an international
economic transaction that is counted in and captured in
the US BOP:
– A US subsidiary of a foreign MNE acts as a distributor
for the MNEs products in the US market
– A US based firm, manages the construction of a
major water treatment facility in a foreign country
– The US subsidiary of a foreign firm pays profits
(dividends) back to a parent in its home (foreign)
country
– The US government finances the purchase of military
equipment for a foreign military ally
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5
Typical BOP Transactions
• Each of the following represents an international economic
transaction that is counted in and captured in China:
– A Chinese subsidiary of a Japanese automobile manufacturer
acts as a distributor for the Japanese made automobiles in the
Chinese market
– A Chinese-based firm manages the construction of a major
water treatment facility in an overseas country
– The Chinese subsidiary of a foreign firm pays profits (dividends)
back to its parent firm
– Overseas firms purchase raw materials in China
– A Chinese tourist purchases souvenirs in an overseas country
– An overseas investor purchases a Chinese debt security through
an investment broker outside China
4-6
2
Collection, reporting and presentation
of the BOP
• The BOP statistics record purchases or sales of goods
and services or of financial assets between domestic and
foreign residents.
• Reported figures are normally in the domestic currency
of the reporting country.
• The government statistical agencies compile and collect
statistics from customs authorities, surveys of tourist
numbers and expenditures, data on capital inflows and
outflows from credit institutions, information on
government expenditures and receipts with foreign
residents from local authorities and central government
agencies.
• The IMF provides a set of guidelines for the compilation
of the BOP statisitics published in its BOP manual and
the BOP statistics of all its members in a standardized
format: the BOP Statistical Yearbook and the
7
International Financial Statistics.
The BOP as a Flow Statement
• The BOP is often misunderstood as many people infer
from its name that it is a balance sheet, whereas in fact it
is a cash flow statement
• By recording all international transactions over a period
of time such as a year, it tracks the continuing flows of
purchases and payments between a country and all
other countries
• It does not add up the value of all assets and liabilities of
a country on a specific date (as an individual firm’s
balance sheet would do)
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8
The BOP as a Flow Statement
• Two types of business transactions dominate the BOP:
 Exchange of Real Assets (goods and services)
 Exchange of Financial Assets (financial claims)
• Although assets can be identified as belonging to distinct
groups, it is easier to think of all assets simply as goods
that can be bought or sold (a clock versus a bond).
9
3
BOP accounts
• The BOP is composed of two main sections (primary
sub accounts) - the current account (refer to income
flows or change in the right of the ownership) and the
capital/financial account (record changes in assets and
liabilities or change in the right of the usage), which are
further sub-divided.
• In addition, the Official Reserves account tracks
government currency transactions
• A fourth account, the Net Errors and Omissions
account is produced to preserve the balance of the
BOP
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10
CA = TB + SB + IC + Tr
KA = KL+ KS + KTr
BB = CA + KA
OB = CA + KA + OM
OB = -OFB
OFB = ∆R + L + ≠
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11
Kết cấu cán cân thanh toán quốc tế










Hạng mục thường xuyên (CA)
Cán cân thương mại (TB)
- Xuất khẩu hàng hoá
- Nhập khẩu hàng hoá
Cán cân dịch vụ: (du lịch, cước phí vận tải, bảo hiểm, hoa hồng môi giới) (SE)
- Xuất khẩu dịch vụ
- Nhập khẩu dịch vụ
Cán cân thu nhập: (đầu tư) (IC*)
- Thu nhập trả cho người lao động
- Thu nhập từ vốn đầu tư: lợi tức, cổ tức, trái tức.
Cán cân chuyển giao một chiều (cho, biếu, tặng) (Tr) CA = TB + SE + IC + Tr
KA = KL+ KS + KTr
- Chuyển tiền của tư nhân
- Chuyển tiền của chính phủ
BB = CA + KA
Hạng mục vốn (KA)
OB = CA + KA + OM
Cán cân vốn ngắn hạn (KS)
OB = -OFB
- Tín dụng thương mại
OFB = ∆R + L + ≠
- Giao dịch giấy tờ có giá ngắn hạn
Cán cân vốn dài hạn (KL)
- Đầu tư của nước ngoài vào trong nước
- Đầu tư của trong nước ra nước ngoài
Chuyển giao vốn một chiều (viện trợ không hoàn lại nhằm mục đích đầu tư) (KTr)
Sai sót thống kê (OM)
Cán cân bù đắp chính thức (OFB)
Thay đổi dự trữ gồm có vàng, ngoại hối, IMF position (∆R)
Vay IMF và các NHTW khác (L)
Các nguồn tài trợ khác (≠)
12
4
The Current Account
• The Current Account includes all international
economic transactions with income or payment flows
occurring within one year, the current period (cash
flows completed within one year, such as for the
import or export of goods and services). It consists of
the following four subcategories:
– Goods trade and import of goods
– Services trade
– Income
– Current transfers
• The Current Account is typically dominated by the first
component which is known as the Balance of Trade
(BOT) even though it excludes service trade
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13
Exhibit 3.3 U.S. Trade Balance & Balance on Services
& Income, 1985-2003 (billions of US$)
$200
$100
$0
–$100
–$200
–$300
–$400
–$500
–$600
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Copyright © 2007 Pearson AddisonBalance on goods
Balance on services and income
Wesley. All rights reserved.
Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2004.
14
Exhibit 4.3 Chinese Trade Balance and Balance on Services
and Income, 1998-2007 (Millions of US dollars)
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15
5
The Current Account
• The deficits in the BOT of the past decade have
been an area of considerable concern for the
United States, in both the public and private
sectors
• The goods trade deficit saw the decline of heavy
traditional industries in the U.S. (steel,
automobiles, automotive parts, textiles)
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16
The Capital/Financial Account
• The Capital Account of the balance of payments
measures all international economic transactions of
financial assets in which investors acquire ownership of
a foreign asset, such as a company, or a portfolio
investment, such as bonds or shares of common stock. It
is divided into two major components:
– The Capital Account
– The Financial Account
• The Capital Account is minor (in magnitude), while the
Financial Account is significant
17
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All rights reserved.
The Capital/Financial Account
A. Capital Account (Tài khoản vốn)
a. Capital transfers (Chuyển giao vốn)
b. Acquisition/disposal of nonproduced, nonfinancial assets (Mua bán các tài sản phi sản xuất, phi tài chính)
B. Financial account (Tài khoản tài chính)
a. Direct investment (Đầu tư trực tiếp)
- Direct Investment Abroad (Đầu tư trực tiếp ra nước ngoài)
- Direct Investment in Economy (Đầu tư trực tiếp vào nền kinh tế)
b. Portfolio Investment (Danh mục đầu tư)
- Porfolio Investment Assets (Tài sản đầu tư vào chứng từ có giá)
Equity Securities (Cổ phiếu)
Debt Securities (Chứng khoán nợ)
- Portfolio Investment Liabilities (Nghĩa vụ nơ các chứng từ có giá)
Equity Securities (Cổ phiếu)
Debt Securities (Chứng khoán nợ)
c. Other Investment (Các khoản đầu tư khác)
- Other Investment Assets (Các tài sản đầu tư khác)
Moneytary Authority (Các cơ quan tiền tệ)
General Government (Chính phủ)
Banks (Các ngân hàng)
Other Sectors (Các khu vực khác)
- Other Investment Liabilities (Các nghĩa vụ nợ đầu tư khác)
Moneytary Authority (Các cơ quan tiền tệ)
General Government (Chính phủ)
Banks (Các ngân hàng)
Other Sectors (Các khu vực khác
)
18
6
The Financial Account
• Financial assets can be classified in a number of
different ways including the length of the life of the asset
(maturity) and the nature of the ownership (public or
private)
• The Financial Account, however, focuses on the degree
of investor control over the assets or operations
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19
The Financial Account
• The Financial Account consists of three components;
– Direct Investment – in which the investor exerts some
explicit degree of control over the assets
– Portfolio Investment – in which the investor has no
control over the assets
– Other Investment – consists of various short-term and
long-term trade credits, cross-border loans, currency
deposits, bank deposits and other A/R and A/P
related to cross-border trade
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20
Direct Investment
• This is the net balance of capital dispersed from and into the US for
the purpose of exerting control over assets.
• Foreign direct investment arises from 10% ownership of voting
shares in a domestic firm by foreign investors.
• The source of concern over foreign investment in any country
focuses on two topics: control and profit.
• Some countries possess restrictions on foreigners may own in their
country.
• The general rule or premise is that domestic land, assets and
industry should be owned by residents of the country.
• Concerns over profit stem from the same argument.
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21
7
Portfolio Investment
• This is the net balance of capital that flows in and out of
the U.S. but does not reach the 10% threshold of direct
investment.
• The purchase of debt securities across borders is
classified as portfolio investment because debt securities
by definition do not provide the buyer with ownership or
control.
• Portfolio investment is motivated by a search for returns
rather than to control or manage the investment.
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22
Exhibit 3.6 Current and Financial/Capital Account
Balances for the United States, 1992-2003 (billions of US$)
$600
$400
$200
$0
–$200
–$400
–$600
1992
1993
1994
1995
1996
Current Account
1997
1998
1999
2000
2001
2002
2003
Capital/Financial Account
Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2004.
Copyright © 2007 Pearson Addison-Wesley.
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23
Exhibit 4.5 The Chinese Financial Account 1998-2007
(Millions of US dollars)
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24
8
Net Errors & Omissions/
Official Reserves Accounts
• The Net Errors and Omissions account ensures that the BOP
actually balances because the sum of all flows accounted for in the
current account and the capital/financial accounts should, in theory,
equal changes in a country’s monetary reserves. Because data for
the BOP is collected on a single entry basis and some data is
missed, the equalization usually does not occur. The imbalance is
plugged by an entry called “errors and omissions,” which makes the
accounts balance.
• The Official Reserves Account is the total reserves held by official
monetary authorities within the country.
• These reserves are normally composed of the major currencies
used in international trade and financial transactions (hard
currencies).
• The significance of official reserves depends generally on whether
the country is operating under a fixed exchange rate regime or a
floating exchange rate system.
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25
The BOP in Total
• A surplus in the BOP implies that the demand for the
country’s currency exceeded the supply and that the
government should allow the currency value to increase
– in value – or intervene and accumulate additional
foreign currency reserves in the Official Reserves
Account.
• A deficit in the BOP implies an excess supply of the
country’s currency on world markets, and the
government should then either devalue the currency or
expend its official reserves to support its value.
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26
How do the BOP accounts balance?
• Due to the double entry of each transaction, the balance
of payments accounts will balance by the following
equation:
current account + capital account + reserves account = 0
• Because data for the balance of payments is collected
on a single entry basis and some data is missed: errors
and omissions is plugged to make the BOP balance
current account + capital account + reserves account +
OM = 0
• Under pure exchange rate regime:
current account + capital account = 0
27
9
US BOP, 2002
28
Hạng mục thường xuyên (BCA) Hạng mục vốn (BKA) của Mỹ
500
400
300
200
100
U.S. BCA
0
-1001982 1984 1986 1988 1990 1992 1994 1996 1998 2000
U.S. BKA
-200
-300
-400
-500
Source: IMF International Financial Statistics Yearbook, 2000
Hạng mục thường xuyên (BCA) Hạng mục vốn (BKA) của Anh
40
30
20
10
0
-101982
UK BCA
1984
1986
1988
1990
1992
1994
1996
1998
2000
UK BKA
-20
-30
-40
-50
Source: IMF International Financial Statistics Yearbook, 2000
Cán cân thanh toán quốc tế
30
10
Hạng mục thường xuyên (BCA) Hạng mục vốn (BKA) của Nhật
150
100
50
Japan BCA
0
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
-50
Japan BKA
-100
-150
Source: IMF International Financial Statistics Yearbook, 2000
31
Hạng mục thường xuyên (BCA) Hạng mục vốn (BKA) của Đức
80
60
40
20
Germ any BCA
0
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
-20
Germ any BKA
-40
-60
-80
Source: IMF International Financial Statistics Yearbook, 2000
32
Hạng mục thường xuyên (BCA) Hạng mục vốn (BKA) của Trung Quốc
Cán cân thanh toán quốc tế
35
30
25
20
15
China BCA
10
China BKA
5
0
-51982 1984 1986 1988 1990 1992 1994 1996 1998 2000
-10
-15
Source: IMF International Financial Statistics Yearbook, 2000
11
Vietnam’s Balance of Payments
Balance of payments (mn. USD)
Export, fob
Import, fob
Trade balance
Other trade of goods, services and income
+ increase
- decrease
Unilateral transfer
Private
Official
Current account
Capital account
Direct investment
Indirect investment
Other short-term investment
Other long-term investment
Loans and savings
Statistical discrepancy
Overall balance
Change in foreign exchange reserves*
2006
39826
-42602
-2776
-1437
5768
-7205
4049
3800
249
-164
3088
2315
1313
-30
1025
-1535
1398
4322
-4322
2007
48561
-58999
-10438
-3084
7196
-10280
6430
6180
250
-7092
17730
6516
6243
79
2269
2623
-439
10199
-10199
2008
62685
-75468
-12783
-5351
8363
-13714
7311
6804
507
-10823
12341
9279
-578
1971
992
677
-1045
473
-473
2009
57096
-64703
-7607
-5449
6519
-11968
6448
6018
430
-6608
6755
6900
-71
256
4473
-4803
-9022
-8875
8875
2010
72192
-77339
-5147
-7025
7916
-14941
7885
7569
316
-4287
6201
7100
2370
1043
2751
-7063
-3679
-1765
1765
2011
96906
-97356
-450
-8009
9274
-17283
8685
8326
359
226
5921
6480
1412
1615
3226
-6812
-4998
1149
-1149
* – : increase in the foreign exchange reserves
BOP accounting
• There are three main elements of the actual process of
measuring international economic activity:
– Identifying what is and is not an international
economic transaction
– Understanding how the flow of goods, services,
assets, and money create debits and credits to the
overall BOP
– Understanding the bookkeeping procedures for BOP
accounting
• It is a daunting task to measure all international
transactions that take place in and out of a country over
a year
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35
BOP accounting
• BOP accounting is based on the principle of double-entry
bookeeping.
• Each transaction between a domestic and foreign
resident has two sides to it, a receipt and a payment,
and both are recorded in the BOP statistics.
• Each receipt of currency from residents of the rest of the
world is recorded as a credit term (a plus in the
accounts), while each payment to residents of the rest of
the world is recorded as a debit (a minus in the account).
• The BOP must balance. It cannot be in disequilibrium
unless something has not been counted or has been
counted improperly
• A subaccount of the BOP may be imbalanced, but the
entire BOP of a single country is always balanced.
36
12
Double-entry bookkeeping
37
Example of BOP Accounting
• You import a DVD of Japanese anime by using your
debit card.
• The Japanese producer of anime deposits the funds in
its bank account in San Francisco. The bank credits the
account by the amount of the deposit.
DVD purchase
–$30
(current account)
Credit (“sale”) of bank account by bank
+$30
(financial account)
29
Example of BOP Accounting
• You invest in the Japanese stock market by buying $500
in Sony stock.
• Sony deposits your funds in its Los Angeles bank
account. The bank credits the account by the amount of
the deposit.
Purchase of stock
–$500
(financial account)
Credit (“sale”) of bank account by bank
+$500
(financial account)
39
13
Example of BOP Accounting
• US banks forgive a $100 M debt owed by the
government of Argentina through debt restructuring.
• US banks who hold the debt thereby reduce the debt by
crediting Argentina's bank accounts.
Debt forgiveness: non-market transfer
–$100 M
(capital account)
Credit (“sale”) of bank account by bank
+$100 M
(financial account)
31
41
The BOP Interaction with Key
Macroeconomic Variables
• A nation’s balance of payments interacts with nearly all
of its key macroeconomic variables
• Interacts means that the BOP affects and is affected by
such key macroeconomic factors as:
– Gross Domestic Product (GDP)
– The exchange rate
– Interest rates
– Inflation rates
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42
14
The BOP and GDP
• In a static (accounting) sense, a nation’s GDP can be
represented by the following equation:
GDP = C + I + G + X – M
C = consumption spending
I = capital investment spending
G = government spending
X = exports of goods and services
M = imports of goods and services
X – M = the current account balance
43
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All rights reserved.
The BOP and GDP
GDP = C + I + G + X – M
• A positive current account balance contributes directly to
increasing the measure of GDP, a negative current
account balance contributes directly to decreasing the
measure of GDP.
• An increase or decrease in GDP contributes to the
current account deficit or surplus.
44
The BOP and Interest Rates
• Apart from the use of interest rates to intervene in the foreign
exchange market, the overall level of a country’s interest rates
compared to other countries does have and impact on the
financial account of the BOP
• Relatively low real interest rates should normally stimulate an
outflow of capital seeking higher rates elsewhere  BOP
deficit
• However, in the case of the U.S., the opposite has occurred
due to perceived growth opportunities and political stability –
allowing it to finance its large fiscal deficit
• However, it is beginning to appear that the favorable inflow on
the financial account is diminishing while the current account
balance is worsening – making the U.S. a bigger debtor nation
vis-à-vis the rest of the world
• Relatively high real interest rate should stimulate an inflow of
capital seeking higher interest rates in home country
currencies  BOP surplus.
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All rights reserved.
45
15
The BOP and inflation rates
• Lower-priced imports increase the import and then make
the BOP more negative.
• Higher-priced imports lower the import and then make
the BOP more positive.
46
The BOP and Exchange Rates
• A country’s BOP can have a significant impact on the
level of its exchange rate and vice versa
• The relationship between the BOP and exchange rates
can be illustrated by use of a simplified equation that
summarizes BOP Data (see next slide)
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47
The BOP and Exchange Rates
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP
Where:
X = exports of goods and services
Current Account
M = imports of goods and services
Balance
CI = capital inflows
Capital Account
CO = capital outflows
Balance
FI = financial inflows
Financial Account Balance
FO = financial outflows
FXB = official monetary reserves
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48
16
The BOP and Exchange Rates
• Fixed Exchange Rate Countries
– Under a fixed exchange rate system, the government
bears the responsibility to ensure that the BOP is
near zero
• Floating Exchange Rate Countries
– Under a floating exchange rate system, the
government has no responsibility to peg its foreign
exchange rate
• Managed Floats
– Countries operating with a managed float often find it
necessary to take action to maintain their desired
exchange rate values
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49
Trade Balances and Exchange Rates
• A country’s import and export of goods and services is
affected by changes in exchange rates
• The transmission mechanism is in principle quite
simple: changes in exchange rates change relative
process of imports and exports, and changing prices in
turn result in changes in quantities demanded through
the price elasticity of demand
• Theoretically, this is straightforward, in reality global
business is more complex
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50
The BOP and exchange rates
51
17
The BOP and exchange rates
52
The BOP and exchange rates
53
The BOP and exchange rates
54
18
The BOP and exchange rates
Under Pure
floating
exchange rate
CA+KA=0
55
Vietnam: BOP
14000
6
Overall BP
12000
5
10000
4
8000
3
6000
Forex reserves
2
4000
1
2000
0
0
2000
2001
2002
2003
2004
2005
2006
56
57
19
58
59
Capital Mobility
• The degree to which capital moves freely across borders
is critically important to a country’s balance of payments
• The financial account surplus has probably been one of
the major reasons that the U.S. dollar has been able to
maintain its value over the past 20 years
Copyright © 2010 Pearson Addison-Wesley.
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60
20
Capital Mobility
• The authors argue that the post-1860 era can be
subdivided into four distinct periods with regard to capital
mobility.
– 1860-1914 – continuously increasing capital mobility
as the gold standard was adopted and international
trade relations were expanded
– 1914-1945 – global economic destruction, isolationist
economic policies, negative effect on capital
movement between countries
– 1945-1971 – Bretton Woods era say a great
expansion of international trade
– 1971-2002 – floating exchange rates, economic
volatility, rapidly expanding cross-border capital flows
Copyright © 2010 Pearson Addison-Wesley.
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61
Exhibit 4.9 A Stylized View of
Capital Mobility in Modern History
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62
Capital Flight
• Although no single definition of capital flight exists, it has
been characterized as occurring when capital transfers
by residents conflict with political objectives.
• Many heavily indebted countries have suffered capital
flight, compounding their debt service problems.
• Capital can be moved via international transfers, with
physical currency, collectables or precious metals,
money laundering or false invoicing of international trade
transactions.
Copyright © 2010 Pearson Addison-Wesley.
All rights reserved.
63
21
Approaches to the BOP
• Elasticity approach: the impact of exchange rate
changes on the current account position of a country
assuming domestic and foreign prices are fixed.
• Absorption approach: the impact of exchange rate
changes on the current account position of a country in
terms of its impact on domestic income and spending
• Monetary approach
64
Elasticity approach to the BOP
• Provides an analysis of what happens to the current
account balance when a country devalues its currency.
• Emphasizes prices as a determinant of the BOP.
• Focuses on demand conditions and assumes that the
supply elasticities for domestic export good and foreign
import good are perfectly elastic, so that changes in
demand volumes have no effect on prices. Or domestic
and foreign prices are fixed so that changes in relative
prices are caused by changes in the nominal exchange
rate.
• Two direct effects of a devaluation on the current
balance, one of which works to reduce a deficit, whilst
the other actually contributes to making the deficit worse
than before.
65
Elasticity approach to the BOP
• The current account balance when expressed in terms of
the domestic currency is
CA = P . EX – NER . P* . IM  CA = X – NER . M
 X = NER . M
P, P*: domestic, foreign price level
EX, IM: volume of domestic exports and imports
X, M: value of domestic exports and imports
• In difference form: dCA = dX – NER . dM - M . dNER
66
22
Elasticity approach to the BOP
• Dividing by the change in the exchange rate dNER
dCA
dX
NER  dM M  dNER



dNER dNER
dNER
dNER
dCA
dX X
X
dM M
M




 NER  M
dNER dNER NER NER dNER NER NER


 ( X , NER )
 ( M , NER )
dCA
X
 hX 
 hM  M  M
dNER
NER
dCA 1
X
1
1

 hX 
 hM  M   M 
dNER M
NER  M
M
M
dCA
 M  h X  hM  1
dNER
• hX and hM : price elasticity of demand for exports and
imports, defined as the percentage change in
exports/imports over the percentage change in price as 67
represented by the percentage change in the exchange rate
Marshall-Lerner Condition
dCA
 M  h X  h M  1
dNER
Starting from a position of equilibrium in the current account:
• dCA/dNER < 0: a devaluation will lead to a deterioration of the current
account only if hX + hM < 1, because: NER  PEX (in foreign
currency), PIM (in domestic currency)  X (value of export) and M
(value of import) (the price effect)
• dCA/dNER > 0: a devaluation will improve the current account only if
hX + hM > 1, because: NER  PEX (in foreign currency), PIM (in
domestic currency)  volume of EX, volume of IM  X (value of
export)  and M (value of import) (the volume effect)
 The net effect depends on whether the price or volume effect
dominates.
 A devaluation may work better for industrialized countries than for
developing countries because many developing countries are heavily
dependent on imports and their price elasticity of demand for imports
was likely to be very low, while for industrialized countries, the price
68
elasticity of demand for exports may be quite elastic.
Marshall-Lerner Condition
GBP0.5/USD
GBP0.666/USD
dX/X=(105-100)/100
dS/S=(0.666-0.5)/0.5
hx=(dX/X)/(dS/S)= 0.15
69
23
The J-Curve Effect
• The Marshall-Lerner condition may not be fulfilled in the
short run although it generally holds over the long run
leads to the phenomenon of the J-curve effect.
• In the short run, export volumes and import volumes do
not change much so that the country receives less exports
revenue and spend more on imports leading to a
deterioration in the current balance.
• After a time lag export volumes start to increase and
import volumes start to decline and consequently the
current deficit starts to improve and eventually moves into
suplus.
• A time lag in consumer and producer responses and
imperfect competition explain the slow responsiveness of
export and import volumes in the short run and greater
70
responses in the long run.
Exhibit 4.8 Trade Balance Adjustment to
Exchange Rate Changes: The J-Curve
CA = P . EX – NER . P* . IM
Copyright © 2010 Pearson Addison-Wesley.
All rights reserved.
In the short run, a depreciation of domestic currency leads to an initial
deficit of the current account, but after a time lag it improves.
The J-Curve Effect
+
Change in
balance of trade
0
-
Change in
balance of trade
Time
After depreciation
+
Time
0
After appreciation
72
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Chapter 4
International Financial Markets
Mai Thu Hien
Faculty of Banking and Finance
Foreign Trade University
Email: maithuhien712@yahoo.com
FTU
Faculty of Banking and Finance
FBF
International Financial Markets
• Introdution
– Global financial markets
– The reasons for the globalization of financial markets
– Classification of global financial markets
• International Financial Markets
– Foreign exchange market and derivatives market
– International money market (Eurocurrency market)
– International credit market (Eurocredit market)
– International bond market
– International (world) stock markets
Introduction
• Globalization of financial markets means the
integration of financial markets throughout the world in
to an international financial market.
• Because of the globalization of financial markets,
entities in any country seeking to raise funds need not
be limited to their domestic financial market.
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Introduction
• The factors that have led to the integration of financial
markets:
- Global competition has forced the governments to
deregulate or liberalize various aspects of their
financial markets so that their financial enterprises
can compete effectively around the world.
- Technological advances have increased the
integration and efficiency of the global financial
markets.
- Institutionalization of financial markets is the shifting
of financial markets from dominance by retail
investors to institutional investors, who have been
more willing to transfer funds across national borders
to improve the risk/reward opportunity of a portfolio.
Motives for using
International Financial Markets
• The markets for real or financial assets are prevented
from complete integration by barriers such as tax
differentials, tariffs, quotas, labor immobility,
communication costs, cultural differences, and financial
reporting differences.
• Yet, these barriers can also create unique opportunities
for specific geographic markets that will attract foreign
investors.
Motives for using
International Financial Markets
• Investors invest in foreign markets:
– to take advantage of favorable economic conditions;
– when they expect foreign currencies to appreciate
against their own; and
– to reap the benefits of international diversification.
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Motives for using
International Financial Markets
• Creditors provide credit in foreign markets:
– to capitalize on higher foreign interest rates;
– when they expect foreign currencies to appreciate
against their own; and
– to reap the benefits of international diversification.
Motives for using
International Financial Markets
• Borrowers borrow in foreign markets:
– to capitalize on lower foreign interest rates; and
– when they expect foreign currencies to depreciate
against their own.
Classification of Global Financial Markets
Internal market
(national market)
Domestic market
External market
(international market,
offshore market and
Euromarket)
Foreign market
- The foreign market of a country is where the securities of issuers not
domiciled in the country are sold and traded. For example: Securities issued
by non-US firms in the US. The rules governing the issuance of foreign
securities are those imposed by regulatory authorities where the security is
issued.
-The external market includes securities with following features: at issuance
they are offered simultaneously to investor in a number of countries, and they
are issued outside the jurisdiction of any single country.
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Internationalization of Financial Markets
• Foreign exchange markets
• Eurocurrency market: Eurocurrencies - foreign currencies
deposited in banks outside the home country
- Eurodollars: U.S. dollars deposited in foreign banks outside the
U.S. or in foreign branches of U.S. banks
• Eurocredit markets
• International bond markets (Foreign bond and Eurobond):
- Foreign Bonds: sold in a foreign country and denominated in that
country’s currency
- Eurobond: bond denominated in a currency other than that of the
country in which it is sold (a bond denominated in USD sold in
London)
• World Stock Markets
Foreign Exchange Market
• The foreign exchange market allows currencies to be
exchanged in order to facilitate international trade or
financial transactions.
Foreign Exchange Market
History of Foreign Exchange
1. Gold Standard (1876 – 1913)
2. Agreements on Fixed Exchange Rates
a. Bretton Woods Agreement 1944
b. Smithsonian Agreement 1971
3. Floating Exchange Rate System
12
4
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Foreign Exchange Market
• The system for establishing exchange rates has evolved over time.
– From 1876 to 1913, each currency was convertible into gold at a
specified rate, as dictated by the gold standard.
– This was followed by a period of instability, as World War I began
and the Great Depression followed.
– The 1944 Bretton Woods Agreement called for fixed currency
exchange rates.
– By 1971, the U.S. dollar appeared to be overvalued. The
Smithsonian Agreement devalued the U.S. dollar and widened
the boundaries for exchange rate fluctuations from ±1% to ±2%.
– Even then, governments still had difficulties maintaining
exchange rates within the stated boundaries. In 1973, the official
boundaries for the more widely traded currencies were
eliminated and the floating exchange rate system came into
effect.
Foreign Exchange Transactions
• There is no specific building or location where traders
exchange currencies. Trading also occurs around the
clock.
• The market for immediate exchange is known as the
spot market.
• The forward market enables an MNC to lock in the
exchange rate at which it will buy or sell a certain
quantity of currency on a specified future date.
Foreign Exchange Transactions
• Hundreds of banks facilitate foreign exchange
transactions, though the top 20 handle about 50% of the
transactions.
• At any point in time, arbitrage ensures that exchange
rates are similar across banks.
• Trading between banks occurs in the interbank market.
Within this market, foreign exchange brokerage firms
sometimes act as middlemen.
5
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Foreign Exchange Transactions
• The following attributes of banks are important to foreign
exchange customers:
– competitiveness of quote
– special relationship between the bank and its
customer
– speed of execution
– advice about current market conditions
– forecasting advice
Currency Futures and Options Market
• A currency futures contract specifies a standard volume
of a particular currency to be exchanged on a specific
settlement date. Unlike forward contracts however,
futures contracts are sold on exchanges.
• Currency options contracts give the right to buy or sell a
specific currency at a specific price within a specific
period of time. They are sold on exchanges too.
Online Application
• Check out these foreign exchange sites:
– http://pacific.commerce.ubc.ca/xr/
– http://sonnet-financial.com/rates/full.asp
– http://www.oanda.com/
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International Money Market
1. Corporations or governments in a particular
country need for short-term funds denominated
in a currency different from their home currency.
2. Reasons for international money market:
a. Need to borrow funds to pay for imports denominated in
a foreign currency.
b. Borrowing in a currency in which the interest rate is
lower.
19
Eurocurrency Market
• U.S. dollar deposits placed in banks in Europe and other
continents are called Eurodollars.
• In the 1960s and 70s, the Eurodollar market, or what is
now referred to as the Eurocurrency market, grew to
accommodate increasing international business and to
bypass stricter U.S. regulations on banks in the U.S.
Eurocurrency Market
• The Eurocurrency market is made up of several large
banks called Eurobanks that accept deposits and
provide loans in various currencies.
• For example, the Eurocurrency market has historically
recycled the oil revenues (petrodollars) from oil-exporting
(OPEC) countries to other countries.
7
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Eurocurrency Market
• Although the Eurocurrency market focuses on largevolume transactions, there are times when no single
bank is willing to lend the needed amount.
• A syndicate of Eurobanks may then be composed to
underwrite the loans. Front-end management and
commitment fees are usually charged for such
syndicated Eurocurrency loans.
Eurocurrency Market
• The recent standardization of regulations around the
world has promoted the globalization of the banking
industry.
• In particular, the Single European Act has opened up the
European banking industry.
• The 1988 Basel Accord signed by G-10 central banks
outlined common capital standards, such as the
structure of risk weights, for their banking industries.
Online Application
• Learn more about the Single European Act at
http://europa.eu.int/abc/treaties_en.htm.
• Details about the 1988 Basel Accord can be found at
http://www.bis.org/publ/bcbs04a.htm. Check out the new
Basel Capital Accord (2001) at
http://www.bis.org/publ/bcbsca.htm too.
8
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Eurocurrency Market
• The Eurocurrency market in Asia is sometimes referred
to separately as the Asian dollar market.
• The primary function of banks in the Asian dollar market
is to channel funds from depositors to borrowers.
• Another function is interbank lending and borrowing.
Eurocurrencies
• A Eurocurrency is a time deposit of money in an international
bank located in a country different from the country that issued
the currency:
 A Eurodollar is a USD-dominated deposit in a bank outside the US.
 A Eurosterling is British pound sterling-dominated deposit in a bank
outside the United Kingdom.
 A Euroyen is a yen-dominated deposit in a bank outside Japan.
• The Eurocurrency market is the core of international money
market.
• The Eurocurrency market is an external banking system that runs
parallel to the domestic banking system of the country that issued
the currency.
• The Eurocurrency market operates at the interbank and/or
wholesale level  interbank offered rate (LIBOR) and interbank
bid rate (LIBID).
• With the advent of the EURO, it is starting to become a common
practice to refer to international currencries instead of
Eurocurrencies and prime banks instead of Eurobank
• Euribor is the rate at which interbank deposis if the euro are offred
by one prime bank to another in the euro zone.
26
Eurocurrency Securities
•
•
•
•
Eurocredits
Forward Rate Agreements (FRA)
Euronotes
Euro-commercial papers (Euro-CP)
9
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Eurocredit Market
• Loans of one year or longer are extended by Eurobanks
to MNCs or government agencies in the Eurocredit
market. These loans are known as Eurocredit loans.
• Floating rates are commonly used, since the banks’
asset and liability maturities may not match - Eurobanks
accept short-term deposits but sometimes provide longer
term loans.
Eurobond Market
There are two types of international bonds.
• Bonds denominated in the currency of the country where
they are placed but issued by foreign borrowers to the
country are called foreign bonds or parallel bonds: A
German MNC issuing dollar-denominated bond to
U.S.investors in the US market.
– Yankee bonds are dollar-denominated foreign bonds originally
sold to U.S. investors.
– Samurai bonds are yen-denominated foreign bonds originally
sold in Japan.
– Bulldogs bonds are pound sterling-denominated foreign bonds
originally sold in the UK.
• Bonds that are sold in countries other than the country
represented by the currency denominating them are
called Eurobonds (international bonds): A Dutch
borrower issuing dollar-denominated bonds to investors
in the UK, Switzerland, and the Netherland
Eurobonds
(80%)
International bond market
10
5/16/2018
Global bond
• Global bond is very large international bond offering by a
single borrower that is simulteneously sold in North
America, Europe and Asia (là trái phiếu quốc tế được phát
hành bởi 1 nhà phát hành và bán cùng 1 lúc ở Mỹ, Châu
Âu và Châu Á).
• Global bond denominated in the USD and issued by U.S.
Corporations trade as Eurobonds overseas and domestic
bonds in the U.S. domestic market.
• Deutsche Telekom phát hành trái phiếu toàn cầu trị giá
$14,6 tỉ, trong đó có 3 tranches trái phiếu ghi bằng USD
với thời hạn 5,10, 30 năm trị giá $9,5 tỉ, 2 tranches trái
phiếu ghi bằng € với thời hạn 5,10 năm trị giá €3 tỉ, 2
tranches trái phiếu ghi bằng £ với thời hạn 5,30 năm trị giá
£950 triệu và 1 tranche trái phiếu ghi bằng ¥ với thời hạn 5
năm trị giá ¥90 tỉ.
Eurobond Market
• The emergence of the Eurobond market is partially
due to the 1963 Interest Equalization Tax imposed in
the U.S.
• The tax discouraged U.S. investors from investing in
foreign securities, so non-U.S. borrowers looked
elsewhere for funds.
• Then in 1984, U.S. corporations were allowed to
issue bearer bonds directly to non-U.S. investors,
and the withholding tax on bond purchases was
abolished.
Eurobond Market
• Eurobonds are underwritten by a multi-national syndicate
of investment banks and simultaneously placed in many
countries through second-stage, and in many cases,
third-stage, underwriters.
• Eurobonds are usually issued in bearer form, pay annual
coupons, may be convertible, may have variable rates,
and typically have few protective covenants.
11
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Eurobond Market
• Interest rates for each currency and credit conditions in
the Eurobond market change constantly, causing the
popularity of the market to vary among currencies.
• About 70% of the Eurobonds are denominated in the
U.S. dollar.
• In the secondary market, the market makers are often
the same underwriters who sell the primary issues.
International Stock Markets
• In addition to issuing stock locally, MNCs can also obtain
funds by issuing stock in international markets.
• This will enhance the firm’s image and name recognition,
and diversify the shareholder base. The stocks may also
be more easily digested.
• Note that market competition should increase the
efficiency of new issues.
International Stock Markets
• Stock issued in the U.S. by non-U.S. firms or
governments are called Yankee stock offerings. Many of
such recent stock offerings resulted from privatization
programs in Latin America and Europe.
• Non-U.S. firms may also issue American depository
receipts (ADRs), which are certificates representing
bundles of stock. ADRs are less strictly regulated.
12
5/16/2018
Online Application
• Check out the performance of ADRs at
http://www.adr.com.
International Stock Markets
• The locations of the MNC’s operations can influence the
decision about where to place stock, in view of the cash
flows needed to cover dividend payments.
• Market characteristics are important too. Stock markets
may differ in size, trading activity level, regulatory
requirements, taxation rate, and proportion of individual
versus institutional share ownership.
Online Application
• For a summary of the performance of various stock
markets, refer to
http://www.worldbank.org/data/wdi2001/pdfs/tab5_3.pdf
• Visit the stock exchanges at:
– http://dir.yahoo.com/Business_and_Economy/Busines
s_to_Business/Financial_Services/Exchanges/Stock_
Exchanges/
– http://www.aex.nl/finance/beurzen.html
13
5/16/2018
International Stock Markets
• Electronic communications networks (ECNs) have been
created to match orders between buyers and sellers in
recent years.
• As ECNs become more popular over time, they may
ultimately be merged with one another or with other
exchanges to create a single global stock exchange.
Exhibit 3.5 Comparison of Stock Exchanges (as of 2008)
41
41
Madura, 10e
Comparison of
International Financial Markets
• The foreign cash flow movements of a typical MNC can
be classified into four corporate functions, all of which
generally require the use of the foreign exchange
markets.
 Foreign trade. Exports generate foreign cash inflows
while imports require cash outflows.
14
5/16/2018
Comparison of
International Financial Markets
 Direct foreign investment (DFI). Cash outflows to acquire
foreign assets generate future inflows.
 Short-term investment or financing in foreign securities,
usually in the Eurocurrency market.
 Longer-term financing in the Eurocredit, Eurobond, or
international stock markets.
Exhibit 3.7 Foreign Cash Flow Chart of an MNC
44
44
Foreign Cash Flow Chart of an MNC
Foreign
Exchange
Transactions
MNC Parent
Export/Import
Foreign Business
Clients
Export/Import
Dividend
Remittance
& Financing
Short-Term
Investment
& Financing
Eurocurrency
Market
Foreign
Subsidiaries
Medium- &
Long-Term
Financing
Eurocredit &
Eurobond Markets
Short-Term
Investment & Financing
Foreign
Exchange
Markets
Long-Term
Financing
International
Stock Markets
Medium- & Long-Term Financing
Long-Term Financing
15
5/16/2018
Online Application
• For the latest information from financial markets around
the world, visit:
– http://www.bloomberg.com/
– http://finance.yahoo.com/
– http://money.cnn.com/
– http://www.reuters.com/
Online Application
• Find out how these offices regulate the U.S. financial
markets.
• The Department of the Treasury
http://www.ustreas.gov/
• The Federal Reserve System
http://www.federalreserve.gov/
• The Securities and Exchange
Commission
http://www.sec.gov/
16
The Foreign Exchange Market
Mai Thu Hien
Faculty of Banking and Finance
Foreign Trade University
1
The foreign exchange market
• The foreign exchange market provides:
 the physical and institutional structure through which
the money of one currency is exchanged for that of
another country,
 The determination rate of exchange between
currencies
 where foreign exchange transactions are physically
completed.
• Foreign exchange means the money of a foreign country;
that is, foreign currency bank balances, banknotes,
checks and drafts.
• A foreign exchange transaction is an agreement between
a buyer and a seller that a fixed amount of one currency
will be delivered for some other currencies at a specified
2
date.
Geography
• The foreign exchange market spans the globe, with
prices moving and currencies trading somewhere every
hour of every business day.
• As the next exhibit will illustrate, the volume of currency
transactions ebbs and flows across the globe as the
major currency trading centers open and close
throughout the day.
3
1
4
Measuring Foreign Exchange Market: Average Electronic
Conversations Per Hour
25,000
20,000
15,000
10,000
5,000
Greenwich Mean
Time
0
1
2
3
4
5
6
10 AM
Lunch Europe
In Tokyo In Tokyo opening
7
8
9
Asia
closing
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Americas London
open
closing
Afternoon
in America
6 pm Tokyo
In NY opens
Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
Functions of the Foreign
Exchange Market
• The foreign exchange market is the mechanism by which
participants:
 Transfer purchasing power between countries
 Obtain or provide credit for international trade
transactions
 Minimize exposure to the risks of exchange rate
changes
6
2
Market Participants
• The foreign exchange market consists of two tiers:
 The interbank or wholesale market (multiples of
$1MM US or equivalent in transaction size)
 The client or retail market (specific, smaller amounts)
FOREIGN EXCHANGE MARKET (100%)
INTERBANK (85%)
(wholesale market)
NONINTERBANK (15%)
(client/retail market)
BANK-CLIENT (14%)
CLIENT-CLIENT (1%)
7
Market Participants
• Five broad categories of participants operate within
these two tiers:
 bank and nonbank foreign exchange dealers,
 foreign exchange brokers,
 individuals and firms,
 central banks and treasuries, and
 speculators and arbitragers.
8
Bank and Nonbank Foreign
Exchange Dealers
• Banks and a few nonbank foreign exchange dealers
operate in both the interbank and client markets.
• The profit from buying foreign exchange at a “bid” price
and reselling it at a slightly higher “offer” or “ask” price.
• Dealers in the foreign exchange department of large
international banks often function as “market makers.”
• These dealers stand willing at all times to buy and sell
those currencies in which they specialize and thus
maintain an “inventory” position in those currencies.
9
3
Foreign Exchange Brokers
• Foreign exchange brokers are agents who facilitate
trading between dealers without themselves becoming
principals in the transaction.
• For this service, they charge a commission.
• It is a brokers business to know at any moment exactly
which dealers want to buy or sell any currency.
• Dealers use brokers for their speed, and because they
want to remain anonymous since the identity of the
participants may influence short term quotes.
10
Brokers and Dealers
• BROKERS: A broker is a commissioned agent of a buyer (or seller) who
facilitates trade by locating a seller (or buyer) to complete the desired
transaction. A broker does not take a position in the assets he or she trades
- that is, the broker does not maintain inventories in these assets. The profits
of brokers are determined by the commissions they charge to the users of
their services (either the buyers, the sellers, or both).
• Examples of Brokers: Real estate brokers, stock brokers.
• DEALERS: Like brokers, dealers facilitate trade by matching buyers with
sellers of assets; they do not engage in asset transformation. Unlike brokers,
however, a dealer can and does "take positions" (i.e., maintain inventories)
in the assets he or she trades that permit the dealer to sell out of inventory
rather than always having to locate sellers to match every offer to buy.
• Also, unlike brokers, dealers do not receive sales commissions. Rather,
dealers make profits by buying assets at relatively low prices and reselling
them at relatively high prices (buy low - sell high). The price at which a
dealer offers to sell an asset (the asked price) minus the price at which a
dealer offers to buy an asset (the bid price) is called the bid-ask spread
and represents the dealer's gross profit margin on the asset exchange.
• Examples of Dealers: Used-car dealers, dealers in U.S. government bonds,
and Nasdaq stock dealers.
11
Source: www.econ.iastate.edu/classes/econ353/tesfatsion/mish2a.htm
Individuals and Firms
• Individuals (such as tourists) and firms (such as
importers, exporters and MNEs) conduct commercial
and investment transactions in the foreign exchange
market.
• Their use of the foreign exchange market is necessary
but nevertheless incidental to their underlying
commercial or investment purpose.
• Some of the participants use the market to “hedge”
foreign exchange risk.
12
4
Individuals and Firms
• Firms and individuals involved in international
commercial and financial transactions
 Exporters receive foreign currency for the sale of their
goods and services
 Exporters use the forex market to sell foreign
currency and buy AUD
 Importers use the forex market to buy foreign
currency (sell AUD) to be used for purchasing imports
13
Central Banks and Treasuries
• Central banks and treasuries use the market to acquire
or spend their country’s foreign exchange reserves as
well as to influence the price at which their own currency
is traded.
• They may act to support the value of their own currency
because of policies adopted at the national level or
because of commitments entered into through
membership in joint agreements such as the European
Monetary System
• The motive is not to earn a profit as such, but rather to
influence the foreign exchange value of their currency in
a manner that will benefit the interests of their citizens.
• As willing loss takers, central banks and treasuries differ
in motive from all other market participants.
14
Speculators and Arbitragers
• Speculators and arbitragers seek to profit from trading in
the market itself.
• They operate in their own interest, without a need or
obligation to serve clients or ensure a continuous
market.
• While dealers seek the bid/ask spread, speculators seek
all the profit from exchange rate changes and arbitragers
try to profit from simultaneous exchange rate differences
in different markets.
15
5
Speculators, Arbitragers and Hedgers
• Hedgers – trade to cover an open position to avoid risk
(i.e. they are risk averse)
• Arbitragers – trade to make a riskless profit by exploiting
forex anomalies (i.e. they are risk neutral)
• Speculators – risk bearers who take decisions involving
open positions to make profits if expectations are correct
16
Transactions
in the Interbank Market
• A Spot transaction in the interbank market is the
purchase of foreign exchange, with delivery and
payment between banks to take place normally, on the
second following business day.
• The date of settlement is referred to as the value date.
• 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.
• Bid-Ask spreads in the spot FX market:
– increase with FX exchange rate volatility and
– decrease with dealer competition.
17
Transactions
in the Interbank Market
• An outright forward transaction (usually called just
“forward”) requires delivery at a future value date of a
specified amount of one currency for a specified amount
of another currency.
• The exchange rate is established at the time of the
agreement, but payment and delivery are not required
until maturity.
• Forward exchange rates are usually quoted for value
dates of one, two, three, six and twelve months.
• Buying Forward and Selling Forward describe the same
transaction (the only difference is the order in which
currencies are referenced.)
18
6
Transactions
in the Interbank Market
• A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
• Both purchase and sale are conducted with the same
counterparty.
• Some different types of swaps are:
 Spot against forward
 Forward-Forward
 Nondeliverable Forwards (NDF)
19
Market Size
• In April 2001, a survey conducted by the Bank for
International Settlements (BIS) estimated the daily global
net turnover in traditional foreign exchange market
activity to be $1,210 billion.
• This was the first decline observed by the BIS since it
began surveying banks on foreign currency trading in the
1980s.
20
1000
900
800
700
Spot
Forwards
Swaps
600
500
400
300
200
100
0
1989
1992
1995
1998
2001
2004
Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 9.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
7
800
700
United States
United Kingdom
Japan
Singapore
Germany
600
500
400
300
200
100
0
1995
1992
1989
1998
2001
2004
Source: Bank for International Settlements, “Triennial Central Bank Survoreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 13.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
Because all exchange transactions involve two currencies, percentage
shares total 200%
90
US Dollar
Euro
Deutschemark
French Franc
EMS Currencies
JapaneseYen
Pound Sterling
Swiss Franc
80
70
60
50
40
30
20
10
0
1989
1992
1995
1998
2001
2004
Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 11.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
Foreign Exchange Market
Classification
• The exchange and OTC
• Spot market, forward market, swap market, futures
market and option market
24
8
Growth of Derivatives Markets
(Figure 5.1)
700
600
Size of
Market
($ trillion)
OTC
Exchange
500
400
300
200
100
0
Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08
Risk Management and Financial
Institutions, 2e, Chapter 5,
Copyright © John C. Hull 2009
25
Foreign Currency Derivatives
26
Foreign Currency Derivatives
• Financial management of the MNE in the 21st century
involves financial derivatives.
• Derivatives are financial instruments that offer a return
based on the return of some underlying asset.
• These derivatives, so named because their values are
derived from underlying assets, are a powerful tool used
in business today.
• These instruments can be used for two very distinct
management objectives:
 Speculation – use of derivative instruments to take a
position in the expectation of a profit
 Hedging – use of derivative instruments to reduce the
risks associated with the everyday management of
corporate cash flow
27
9
Derivatives contracts
• A derivative contract is a financial instrument with a return
that is obtained from or derived from the return of another
underlying financial instrument
• Derivatives contracts are created on and traded in two
distinct but related types of markets: exchange traded and
over the counter
 Exchange-traded contracts have standard terms and
features and are traded on an organized derivatives
trading facility.
 Over-the-counter contracts are any transactions created
by two parties anywhere else.
28
Derivatives contracts
Exchange-traded
derivatives contracts
• Traded in the exchange
• Have standardized terms
(have public standardized
transactions)
• Default-risk free
• Daily settlement or
marking to market (refers
to the procedure that the
gains and losses on each
party‘s position are
credited and charged on
a daily basis)
Over-the-counter
derivatives contracts
• Traded off the exchange
through dealers
• Do not have standard
terms (have a private and
customized transaction)
• Default risk exists (subject
to the possibility that the
other party will default)
• Settlement at expiration of
the contract
29
Derivatives contracts
• Derivatives contracts can be classified into two general
categories: forward commitments and contingent claims.
 A forward commitment is a contract in which the two
parties enter into an agreement to engage in a
transaction at a later date at a price established at the
start. Three types of forward commitments are
forward contracts, futures contracts and swaps.
 A contingent claim is a derivative contract with a
payoff dependent on the occurence of a future event.
We generally refer to this type of derivatives as
option.
30
10
Derivatives
Contingent claims
Exchangetraded
Over-thecounter
Options
Forward commitments
Exchangetraded
Over-thecounter
Futures
Forward
Swaps
31
The purpose of derivatives markets
•
•
•
•
price discovery (provide price information)
risk management
market efficiency improvement
trading efficiency (have low transaction cost )
32
Foreign exchange net turnover by market
segment: daily averages, April 2001
Market
Turnover in Percentage
billions of $ share
segment
Spot market
387
33.0
Forwards
787
66.6
Outright
131
11.0
Swaps
656
55.6
Options (OTC) 60
0.4
Total
1234
Source: Levi (2005),p.53
33
11
Spot transaction
• 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.
• Bid-Ask spreads in the spot FX market:
– increase with FX exchange rate volatility and
– decrease with dealer competition.
McGraw-Hill/Irwin
Inc. All rights reserved.
4-34
Copyright © 2001 by The McGraw-Hill Companies,
Foreign currency forward contract
• A foreign currency forward contract is an agreement
between two parties in which one party, the buyer, agrees
to buy from the other party, the seller, a currency at a
future date at a price established at the start of contract.
• The parties to the transaction specify the forward
contract‘s terms and conditions. In this sense, the contract
is said to be customized. Each party is subject to the
possibility that the other party will default.
• The holder of a long forward contract (the long) is
obligated to take delivery of the underlying asset and pay
the forward price at expiration. The holder of a short
forward contract is obligated to deliver the underlying asset
and accept payment of the forward price at expiration.
35
Foreign currency forward contract
• The forward contract hedge locks in a price
• Neither party pays any money at the start
36
12
Delivery and settlement of
a forward contract
• When a forward contract expires, two possible
arrangements that can be used to settle the obligations
of the parties:
 Delivery: the long will pay the agreed-upon price to the
short, who in turn will deliver the underlying asset to the
long (a deliverable forward contract).
 Cash settlement: permits the long and the short to pay
the net cash value of the position (F-St) on the delivery
date (a cash-settled forward contract or nondeliverable
forwards NDFs).
F
Buyer (the long)
Seller (the short)
37
Underlying
Termination of a forward contract
• Until the contract expires
• Prior to expiration: Assume that the contract calls for delivery rather
than cash settlement at expiration
‒ Enter another forward contract at opposite position expiring at the same time as
the original forward contract (because of price changes in the market during the
period since the original contract was created, this new contract would likely have
a different price). The company may have credit risk if the counterparty on the
long or the short contract fails to pay.
‒ To avoid credit risk, the company contacts the same counterparty with whom
they engaged the original contract. They could agree to cancel both contracts,
the company receives $2. This termination is desirable for both parties because it
eliminates the credit risk. If the initial counterparty is a bank, the company
requests, at the start, that its initial contract be offset and the bank will charge a
fee (= F0 - F1). Note that it is possible that the company might receive a better
price from another counterparty. If that price is sufficiently attractive and the
companty does not perceive the credit risk to be too high, it may choose to deal
with the other counter party.
Long 3 months (40$)
F0
38
F1 Short 2 months (42$)
Forward rate
F 1 i
1 i

F S
S 1  i*
1  i*
i, i* interest rate per annum
If F is n-year forward rate
 1 i 

F  S  
*
1 i 
If F is one-year forward rate
F S
If F is 12/m-month forward rate,
simple interest rate
F S
n
1 i
1  i*
1 i m
1  i* m
13
Forward margin
fi
Forward (j/i) - Spot(j/i) 360

100%
Spot(j/i)
n
n: the number of days between contract date and delivery
date
• f > 0: forward premium, f < 0: forward discount
• fi is forward margin of the currency i with regard to j
(annual percentage)
 fi > 0: the forward premium on the currency i
 fi < 0: the forward discount on the currency i
• fi is annualized percentage difference between the
forward rate and the spot rate (CIP)
• fi is expected change in the spot rate (UIP)
40
Example
Assuming the spot rate SF1.4800/$, a 90-day euro
SF deposit rate of 4.00% per annum, and a 90-day
eurodollar deposit rate of 8.00% per annum,
calculate 90-day forward rate F(SF/$).
41
Profit from forward contracts
P↑→ the buyer benefits
P↑→ the seller benefits
Profit
Profit (Payoff)
Price of
underlying
at maturity ST
Long Position
Payoff = ST - X
Price of
underlying
at maturity ST
Short Position
Payoff = X - ST
42
14
Forward quotation on a points basis
• The forward rates are quoted in terms of points, also
referred to as cash rate (for maturity up to 1 year) and
swap rate (for two years or longer).
Bid
Ask
Outright spot
¥118,27 ¥118,37
plus points (three months)
-2,88
-2,87
Outright forward
¥115,39 ¥115,50
288 points (For JPY 1 pip = 0.01 --> 288 points
= 0.01 * 288= 2.88JPY)
Forward point quotation for the Euro and
Japanese Yen
Euro: Spot & Forward ($/€)
Yen: Spot & Forward (¥/$)
Term
Mid rates
Bid
Ask
Mid rates
Spot
1.0899
1.0897
1.0901 118.32
1w
1.0903
3
4 118.23
-10
-9
1 mo
1.0917
17
19 117.82
-51
-50
6 mo
1.1012
112
113 115.45
-288
-287
1 yr
1.1143
242
245 112.50
-584
-581
Swap 2 yr
rates 5 yr
1.1401
481
522 106.93
-1150
-1129
1.2102
1129
1276 92.91
-2592
-2490
Cash
rates
Mid rates are the numerical average of bid and ask
Bid
Ask
118.27 118.37
Source: Eiteman (2010),p.150
Outright Foward Quotations on the
U.S.Dollar/British Pound in the Financial Press
The Wall Street Journal
US$ Equivalent
Thu
Wed
Currency per US$
Thu
Wed
U.K. (pound)
1.8410
1.8343 .5432
.5452
One-month forward
1.8360
1.8289 .5447
.5468
Six-months forward
1.8120
1.8048 .5519
.5541
Source: Eiteman (2007), p.193
15
Figure 23.1 Spot and Forward Prices in
Foreign Exchange
Foreign currency futures
• A foreign currency futures contract is an alternative to a
forward contract that calls for future delivery of a
standard amount of foreign exchange at a fixed time,
place and price.
• It is similar to futures contracts that exist for commodities
such as cattle, lumber, interestbearing deposits, gold,
etc.
• In the US, the most important market for foreign currency
futures is the International Monetary Market (IMM), a
division of the Chicago Mercantile Exchange.
47
Foreign currency futures
• Contract specifications are established by the exchange
on which futures are traded.
• Major features that are standardized are:
 Contract size
 Method of stating exchange rates
 Maturity date
 Last trading day
 Collateral and maintenance margins
 Settlement
 Commissions
 Use of a clearinghouse as a counterparty
48
16
Foreign Currency Futures
• Foreign currency futures contracts differ from forward
contracts in a number of important ways:
 Futures are standardized in terms of size while forwards
can be customized
 Futures have fixed maturities while forwards can have
any maturity (both typically have maturities of one year
or less)
 Trading on futures occurs on organized exchanges
while forwards are traded between individuals and
banks
 Futures have an initial margin that is marked to market
on a daily basis while only a bank relationship is needed
for a forward
 Futures are rarely delivered upon (settled) while
49
forwards are normally delivered upon (settled)
Exchanges Trading Futures
•
•
•
•
•
•
•
•
Eurex (Germany and Switzerland)
Chicago Mercantile Exchange
Chicago Board of Trade
LIFFE (London)
BM&F (Brazil)
New York Mercantile Exchange
Tokyo Commodity Exchange
and many more
50
Widely Traded Financial Futures Contracts
Source: Mishkin (2006)
51
17
Widely Traded Financial Futures Contracts
Source: Mishkin (2006)
52
Marking to Market
Your balance
Initial
margin
Maint.
margin
margin call
time
Example of a Futures Trade
(page 27-29)
• An investor takes a long position in 2 December
gold futures contracts on June 5
– contract size is 100 oz.
– futures price is US$1250
– initial margin requirement is
US$6,000/contract
– maintenance margin is US$4,500/contract
Options, Futures, and Other
Derivatives, 8th Edition,
Copyright © John C. Hull 2012
54
18
Marking to market
Day
Trade
Settle
Daily
Price ($) Price ($) Gain ($)
1
1,250.00
Cumul.
Margin
Margin
Gain ($) Balance ($) Call ($)
12,000
1
1,241.00
−1,800
− 1,800
10,200
2
1,238.30
−540
−2,340
9,660
…..
…..
…..
……
6
1,236.20
−780
−2,760
9,240
7
1,229.90
−1,260
−4,020
7,980
8
1,230.80
180
−3,840
12,180
…..
…..
16
…..
1,226.90
…..
…..
……
780
−4,620
15,180
4,020
Options, Futures, and Other
Derivatives, 8th Edition,
Copyright © John C. Hull 2012
55
Example
A GBP futures contract at the CME on 18 Dec 2003
• Opening price $1.6002/£
• Contract value £62,500
• Standard margin: $2,000
• Maintenance level/margin: $1,500
Source: Levi (2007), p.71
56
Example
Consider a hypothetical futures contract in which the
current price is $212. The initial margin requirement is
$10, and the maintenance margin requirement is $8. You
go long 20 contracts and meet all margin calls but do not
withdraw any excess margin.
A. When could there be a magin call?
B. Complete the table
C. How much your total gains or losses by the end of
day 6?
19
Day
Beginning
Balance
Funds
Futures
Deposited Price
0
212
1
211
2
214
3
209
4
210
5
204
6
202
Price
Change
Gain/
Loss
Ending
Balance
Example
• 5-Jun: Purchase 2 gold futures contracts at COMEX
– Delivery in Dec
– Futures price: $400
– Quantity: 100 ounces
– Initial deposit: $2000/contract
– MM: $1500/contract
– No withdrawal on the deposit
• Estimate the margin call with respect to change in gold
price
• Calculate the profit/loss from this operation
Futures Price
400
397
396.1
398.2
397.1
396.7
395.4
393.3
393.6
391.8
392.7
387
387
388.1
388.7
391
392.4
Gain/loss
Acc.Results Margin
Margin call
20
Foreign currency options
• A foreign currency option is a contract giving the option
purchaser (the buyer) the right, but not the obligation, to
buy or sell a given amount of foreign exchange at a fixed
price per unit for a specified time period (until the maturity
date)
• There are two basic types of options, puts and calls.
 A call is an option to buy foreign currency
 A put is an option to sell foreign currency
• The buyer of an option is termed the holder, while the
seller of the option is referred to as the writer or grantor.
• An American option gives the buyer the right to exercise
the option at any time between the date of writing and the
expiration or maturity date.
• An European option can be exercised only on its
61
expiration date.
62
Foreign currency options
• Every option has three different price elements:
 The exercise or strike price – the exchange rate at
which the foreign currency can be purchased (call) or
sold (put).
 The premium – the cost, price, or value of the option
itself- usually paid in advance by the buyer to the
seller. An option‘s value at expiration is called its
payoff.
 The underlying or actual spot exchange rate in the
market.
63
21
The concept of moneyness of an option
• For Put Options
 In-the-Money = Spot Price is below Option Strike
(Exercise) Price
 Out-of-the Money = Spot Price is above Option Strike
(Exercise) Price
 At-the-Money = Spot Price and Strike (Exercise) Price
are the same
• For Call Options
 In-the-Money = Spot Price is above Option Strike
(Exercise) Price
 Out-Of-the-Money = Spot Price is below Option Strike
(Exercise) Price
 At-The Money = Spot Price and Option Strike
(Exercise) Price are the same
64
Example
A contract is traded at the spot price of $1,170
Strike price
Spot price Calls
Puts
1,175
> 1,170
OTM
ITM
1,170
= 1,170
ATM
ATM
1,165
< 1,170
ITM
OTM
65
Profit/loss for a call option
• Spot price > Strike price: the buyer would excercise the
option and possesses an unlimited profit potential.
• Spot price < Strike price: the buyer would choose not to
excercise the option and his total loss would be limited to
only what he paid for the option (limited loss potential).
• Strike price < Spot price < break-even price: the gross
profit earned on excercising the option and selling the
underlying currency covers part (but not all) of the
premium cost.
66
22
+C
0
-C
S
X X+C
67
Profit/loss for a put option
• Spot price < Strike price: the buyer would excercise the
option and has unlimited profit potential (up to a
maximum of strike price minus primium, when spot price
would be zero)
• Spot price > Strike price: the buyer would choose not to
excercise the option and so would lose only the premium
paid for the option (limited loss potential).
• Break-even price < Spot price < Strike price: the buyer
will recoup part (but not all) of the premium cost, the
writer will lose part, but not all, of the premium received
68
X-P
P
0
-P
-(X-P)
X-P X
S
69
23
Profit and Loss for the Buyer of a
Call Option
• Buyer of a call:
– Assume purchase of August call option on Swiss
francs with strike price of 58½ ($0.5850/SF), and a
premium of $0.005/SF
– At all spot rates below the strike price of 58.5, the
purchase of the option would choose not to exercise
because it would be cheaper to purchase SF on the
open market
– At all spot rates above the strike price, the option
purchaser would exercise the option, purchase SF at
the strike price and sell them into the market netting a
profit (less the option premium)
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.
Profit and Loss for the Buyer of a Call
Option on Swiss francs
“At the money”
Strike price
Profit
(US cents/SF)
“Out of the money”
“In the money”
+ 1.00
+ 0.50
0
- 0.50
Unlimited profit
57.5
58.0
Limited loss
58.5
59.0
59.5
Spot price
(US cents/SF)
Break-even price
- 1.00
Loss
The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates less
than 58.5 (“out of the money”), and an unlimited profit potential at spot rates above 58.5 cents/SF (“in the money”).
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
Exhibit 8.4 Buying a Call Option on
Swiss Francs (long call)
72
Profit = (Spot Rate – Strike Price) - Premium
24
Profit and Loss for the Writer of
a Call Option
• Writer of a call:
– What the holder, or buyer of an option loses, the writer
gains
– The maximum profit that the writer of the call option can
make is limited to the premium
– If the writer wrote the option naked, that is without owning
the currency, the writer would now have to buy the
currency at the spot and take the loss delivering at the
strike price
– The amount of such a loss is unlimited and increases as
the underlying currency rises
– Even if the writer already owns the currency, the writer will
experience an opportunity loss
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.
Profit and Loss for the Writer of a Call
Option on Swiss francs
“At the money”
Strike price
Profit
(US cents/SF)
+ 1.00
+ 0.50
0
Break-even price
Limited profit
57.5
58.0
58.5
59.0
- 0.50
59.5
Spot price
(US cents/SF)
Unlimited loss
- 1.00
Loss
The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot
rates less than 58.5, and an unlimited loss potential at spot rates above (to the right of) 59.0 cents/SF.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
Exhibit 8.5 Selling a Call Option on
Swiss Francs (short call)
75
Profit (loss) = Premium – (Spot Rate – Strike Price)
25
Profit and Loss for the Buyer of a
Put Option
• Buyer of a Put:
– The basic terms of this example are similar to those just
illustrated with the call
– The buyer of a put option, however, wants to be able to sell the
underlying currency at the exercise price when the market price
of that currency drops (not rises as in the case of the call option)
– If the spot price drops to $0.575/SF, the buyer of the put will
deliver francs to the writer and receive $0.585/SF
– At any exchange rate above the strike price of 58.5, the buyer of
the put would not exercise the option, and would lose only the
$0.05/SF premium
– The buyer of a put (like the buyer of the call) can never lose
more than the premium paid up front
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.
Profit and Loss for the Buyer of a Put Option
on Swiss francs
“At the money”
Strike price
Profit
(US cents/SF)
“In the money”
“Out of the money”
+ 1.00
+ 0.50
0
Profit up
to 58.0
57.5
- 0.50
- 1.00
58.0
58.5
59.0
59.5
Limited loss
Spot price
(US cents/SF)
Break-even
price
Loss
The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates
greater than 58.5 (“out of the money”), and an unlimited profit potential at spot rates less than 58.5 cents/SF (“in the
money”) up to 58.0 cents.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
Exhibit 8.6 Buying a Put Option on
Swiss Francs (long put)
78
Profit = (Strike Price – Spot Rate) - Premium
26
Profit and Loss for the Writer of
a Put Option
• Seller (writer) of a put:
– In this case, if the spot price of francs drops below
58.5 cents per franc, the option will be exercised
– Below a price of 58.5 cents per franc, the writer will
lose more than the premium received fro writing the
option (falling below break-even)
– If the spot price is above $0.585/SF, the option will
not be exercised and the option writer will pocket the
entire premium
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
Profit and Loss for the Writer of a Put Option
on Swiss francs
“At the money”
Profit
(US cents/SF)
Strike price
+ 1.00
+ 0.50
Break-even
price
Limited profit
0
- 0.50
57.5
Unlimited loss
up to 58.0
58.0
58.5
59.0
59.5
Spot price
(US cents/SF)
- 1.00
Loss
The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates
greater than 58.5, and an unlimited loss potential at spot rates less than 58.5 cents/SF up to 58.0 cents.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
Exhibit 8.7 Selling a Put Option on
Swiss Francs (short put)
81
Profit (loss) = Premium – (Strike Price – Spot Price)
27
Call or Put
If price
Short Put
Long Call
X
X
Short Call
Long Put
X
82
X
Call Option position
ST ≤ X
ST > X
Option value at expiration (payoffs) CT
Long Call
CT = max (0, ST – X)
ST – X (ITM)
0 *(OTM)
-CT = -max (0, ST – X)
Short Call
0
X - ST
Profit P
CT – C0 = max (0, ST – X) – C0
Long Call
-C0
Short Call
ST - X– C0
-CT + C0
C0
X - ST + C0
Breakeven point
Maximum profit
Minimum loss
Long Call
ST* = X + C0
∞
C0
Short Call
ST* = X + C0
C0
∞
C0 : call option premium
*/: C T cannot sell for less than zero because that would mean that the option seller would have to pay the
option buyer. A buyer would not pay more than zero because the option will expire an instant later with no
value). Special case: ST = X  option is treated as OTM because the option is 0 at expiration.
Example
•
•
•
•
Call option: exercise price: USD2000, premium C =
USD81.75.
Determine the value at expiration and profit for a buyer
under two outcomes: the price of underlying at expiration
is USD1900 and 2100
Determine the maximum profit and loss to the buyer
Determine the breakeven price of the underlying at
expiration
Graph the value at expiration and the profit
28
Put Option position
ST < X
ST ≥ X
Option value at expiration (payoffs) PT
Long Put
PT = max (0, X – ST)
X – ST (ITM)
0 *(OTM)
-PT = -max (0, X – ST)
Short Put
0
ST - X
Profit P
PT – P0 = max (0, X – ST) – P0
Long Put
X – ST – P0
Short Put
-P0
-PT + P0
Breakeven point
Maximum profit
Long Put
ST* = X - P0
X - P0
Minimum loss
P0
Short Put
ST* = X - P0
P0
X - P0
P0 : put option premium
*/: P T cannot be worth less than zero because the option seller would have to pay the option buyer. It
cannot be worth more than zero because the buyer would not pay for a position that, an instant later, will
be worth nothing. Special case: ST = X  option is treated as OTM because the option is 0 at expiration.
Example
•
•
•
•
Put option: Exercise price USD2000, premium P =
USD79.25.
Determine the value at expiration and profit for a buyer under
two outcomes: the price of underlying at expiration is
USD1900 and 2100
Determine the maximum profit and loss to the buyer
Determine the breakeven price of the underlying at expiration
Graph the value at expiration and the profit
Swiss Franc Option Quotation
(U.S. Cents/SF)
Calls - Last
Puts - Last
Option &
Strike Aug Sep Dec Aug Sep Dec
Underlying price
58.51
58
0.71 1.05 1.28 0.27 0.89 1.81
58.51
58.51
58½
59
0.50 0.50 0.99 0.30 0.66 1.21 0.90 1.36 -
Spot rate 58½ means
$0.5850/SF
Each option =SF62,500. The August,
September, and December listings are
the option maturities or expiration dates.
Source: Eiteman (2007), p.214
87
29
Option Pricing and Valuation
• Premium = Intrinsic value + Time value
• Intrinsic value is the financial gain if the option is exercised
immediately.
• The time value of an option exists because the price of the
underlying currency, the spot rate, can potentially move
further and further into the money between the present time
and the option’s expiration date.
• On the date of maturity, an option will have a value equal to its
intrinsic value (zero time remaining means zero time value,
time value = 0
88
Exhibit 8.8
Analysis of Call
Option on
British Pounds
with a Strike
Price = $1.70/£
89
Intrinsic Value, Time Value & Total Value for a Call Option on British
Pounds with a Strike Price of $1.70/£
Option Premium
(US cents/£)
6.0
-- Valuation on first day of 90-day maturity -5.67
Total value
5.0
4.00
4.0
3.30
3.0
2.0
1.67
Time value
Intrinsic
value
1.0
0.0
1.66
1.67
1.68
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.
1.69
1.70
1.71
1.72
1.73
1.74
Spot rate ($/£)
30
Intrinsic value
• For a call option:
Intrinsic value = Spot price – Strike price
 Intrinsic value = 0: if the strike price > the spot price
 Intrinsic value > 0: if the spot price > the strike price
• For a put option:
Intrinsic value = Strike price – Spot price
 Intrinsic value = 0: if the strike price < the spot price
 Intrinsic value > 0: if the spot price < the strike price
91
Exhibit 8.9 The Intrinsic, Time, and Total Value Components
of the 90-Day Call Option
on British Pounds at Varying Spot Exchange Rates
92
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Exhibit 8.10 Decomposing Call Option
Premiums: Intrinsic Value and Time
Value
93
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
31
Exhibit 8.12 Foreign Exchange Implied Volatility for Foreign Currency
Options, January 30, 2008
94
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
The option-pricing formula
C  F  Nd1   E  Nd2  erd T
2
 F   
ln       T
E  2 
d1 
 T
d 2  d1    T
P  F  N d1   1  E  N d 2   1 e  rd T
95
Currency option pricing sensitivity
• The pricing of any currency option combines six elements
(factors influencing currency option prices):
 Present spot rates
 Time to maturity
 Forward rates
 Interest differential (US dollar interest rates and foreign
currency interest rates)
 Volatility (standard deviation of daily spot price
movements)
96
32
Currency option pricing sensitivity
Call
Put
Strike price
-
+
Time to maturity
+
+
Interest differential
-
+
Volatility
+
+
Forward rates
+
-
Spot rates
+
97
Currency option pricing sensitivity
• Forward rate sensitivity:
 Standard foreign currency options are priced
around the forward rate because the current spot
rate and both the domestic and foreign interest
rates are included in the option premium
calculation
 The option-pricing formula calculates a subjective
probability distribution centered on the forward rate
 This approach does not mean that the market
expects the forward rate to be equal to the future
spot rate, it is simply a result of the arbitragepricing structure of options
 The larger the difference between the forward rate
and the spot rate, the higher the call option
premium and the lower the put option premium.
98
Currency option pricing sensitivity
• Spot rate sensitivity (delta):
 The sensitivity of the option premium to a small change
in the spot exchange rate is called the delta
 delta = Δ premium / ∆Spot rate
delta = ($0,038/£-$0,033/£)/($1,71/£-$1,70/£)=0,5
 The higher the delta, the greater the probability of the
option expiring in-the-money
 For a call option, option values increase with the
increase of the spot rate.
 For a put option, option values increase with the
decrease of the spot rate.
99
33
Currency option pricing sensitivity
• Time to maturity – value and deterioration (theta):
 Time to maturity is the amount of time left in an
option before it expires
 The expected change in the option premium from a
small change in the time to expiration is termed theta
 theta = Δ premium / ∆time
 Option values increase with the length of time to
maturity
 A trader will normally find longer-maturity option
better values, giving the trader the ability to alter an
option position without suffering significant time
value deterioration
100
Theta: Option Premium Time Value
Deterioration
Option Premium
(US cents/£)
A Call Option on British Pounds: Spot Rate = $1.70/£
7.0
In-the-money (ITM)
call ($1.65 strike price)
6.0
5.0
4.0
At-the-money (ATM)
call ($1.70 strike price)
3.0
2.0
Out-of-the-money (OTM)
call ($1.75 strike price)
1.0
0.0
90
80
70
60
50
40
30
20
10
0
Copyright © 2007 Pearson Addison-Wesley.
Days remaining to maturity
All rights reserved.
theta= (ct3,3/£-ct3,28)/(90-89)=0,02
Currency option pricing sensitivity
• Sensitivity to volatility (lambda):
 Option volatility is defined as the standard deviation
of daily percentage changes in the underlying
exchange rate
 Volatility is important to option value because of an
exchange rate’s perceived likelihood to move either
into or out of the range in which the option will be
exercised
 lambda = Δ premium / Δ volatility
102
34
Currency option pricing sensitivity
• Volatility is viewed in three ways:
 Historic
 Forward-looking
 Implied
• Because volatilities are the only judgmental component
that the option writer contributes, they play a critical role
in the pricing of options.
• All currency pairs have historical series that contribute to
the formation of the expectations of option writers.
• In the end, the truly talented option writers are those with
the intuition and insight to price the future effectively.
• Traders who believe that volatilities will fall significantly
in the nearterm will sell (write) options now, hoping to
buy them back for a profit immediately volatilities fall,
causing option premiums to fall.
103
Currency option pricing sensitivity
• Sensitivity to changing interest rate differentials (rho and
phi):
 Currency option prices and values are focused on the
forward rate
 The forward rate is in turn based on the theory of
Interest Rate Parity
 Interest rate changes in either currency will alter the
forward rate, which in turn will alter the option’s
premium or value
• A trader who is purchasing a call option on foreign
currency should do so before the domestic interest rate
rises. This timing will allow the trader to purchase the
option before its price increases.
104
Currency option pricing sensitivity
• The expected change in the option premium from a small
change in the domestic interest rate (home currency) is
the term rho.
rho = Δ premium / Δ US $ interest rate
• The expected change in the option premium from a small
change in the foreign interest rate (foreign currency) is
termed phi.
phi = Δ premium / Δ foreign interest rate
105
35
Interest Differentials and Call Option
Premiums
Option Premium (US cents/£)
8.0
A Call Option on British Pounds: Spot Rate = $1.70/£
7.0
ITM call ($1.65 strike price)
6.0
5.0
4.0
ATM call ($1.70 strike price)
3.0
2.0
OTM call ($1.75 strike price)
1.0
0.0
-4.0
-3.0
-2.0 -1.0
0
1.0
2.0
3.0
Interest differential: iUS$ - i £ (percentage)
4.0
5.0
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.
Currency Option Pricing Sensitivity
• The sixth and final element that is important to option
valuation is the selection of the actual strike price.
• A firm must make a choice as per the strike price it
wishes to use in constructing an option (OTC market).
• Consideration must be given to the tradeoff between
strike prices and premiums.
Copyright © 2007 Pearson AddisonWesley. All rights reserved.
1-107
Option Premiums for Alternative
Strike Rates
Option Premium
(US cents/£)
Current spot rate = $1.70/£
7.0
6.0
5.0
OTM Strike rates
4.0
ITM Strike rates
3.0
2.0
1.0
0.0
1.66
1.67
1.68
1.69
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.
1.70
1.71
1.72
1.73
1.74
1.75
Call strike price (U.S. dollars/£)
36
Summary of Option Premium
Components
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.
1-109
Foreign currency swaps
• A swap is an agreement between two parties to exchange a
series of future cash flows. It is an over-the-counter
transaction consisting of a series of forward contracts
(usually a spot transaction plus a forward transaction in the
reverse direction).
• A foreign currency swap is an agreement to buy and sell
foreign exchange at pre-specified exchange rates, where
the buying and selling are seperated in time.
 A swap-in Canadian consists of an agreement to buy Canadian
dollars spot, and also an agreement to sell Canadian dollars
forward.
 A swap-out Canadian consists of an agreement to sell Canadian
dollars spot and to buy Canadian dollars forward.
 A forward-forward swap involves two forward transactions to buy
Canadian dollars for 1-month forward and sell Canadian dollars for
2-months forward.
 A rollover swap is the one that the purchase and sale are seperated
by only one day.
110
A
1. Sell $ spot for £
2. Buy $ forward
1. Sell £ spot for $
2. Buy £ forward
At present, A has $ and needs £
After 3 months, A needs $
B
At present, B needs $
After 3 months, B has $ and needs £
111
37
Example
Sport rate S(VND/USD) = 17,750-17,800
i$ = 4%/year
iVND = 8%/year
Today A has export receipts in USD and needs
VND for domestic payments. After 3 months, A
needs USD for import payments.
In contrast, B needs USD for import payments
at present and in 3 months, B receives USD
from the export contract and will sell this export
receipt for VND.
112
The payment on a currency swap
• In a currency swap, each party makes payments to the
other in different currencies.
• A currency swap can have:
 One party pay a fixed rate in one currency and the
other pay a fixed rate in the other currency (a fixed-forfixed currency swap)
 Both pay a floating rate in their respective currencies (a
floating-for-floating-rate currency swap)
 The first party pay a fixed rate in one currency and the
second party pay a floating rate in the other currency (a
fixed-for-floating-rate currency swap)
 The first party pay a floating rate in one currency and
the second party pay a fixed rate in the other currency
(a floating-for-fixed currency swap)
• The notional principal is usually exchanged at the
beginning and at the end of the life of the swap, although113
this exchange is not mandatory.
A fixed-for-fixed curency swap
114
38
Firm
AA
BB
USD
10%
9%
AUD
7%
8%
115
116
Swap point and outright forward
Spot (Can$/$) 6-month Outright forward
swap
1.3965-70
23-27
1.3988-97
(1.3965+23)-(1.3970+27)
1.3965-70
27-23
(1.3938-47)
(1.3965-27)-(1.3970-23)
Swap points/rate
Source: Levi (2005), chapter 3
117
39
Hedging using forward
• Suppose that it is September and an importer considers
that the GBP is likely to increase in value over the next 3
months. Assuming that the importer will have to pay
GBP100,000 for its import contract. The importer can
hedge by purchasing forward GBP 100,000 at the
forward price of USD2.0. Suppose that the importer’s
expectation is correct and the price of GBP rises/falls to
USD 2.2/1.8 by December.
John Hull
Hedging using options
• Consider an investor who in May of a particular year
owns 1000 Microsoft shares. The share price is USD28
per share. The investor is concerned about a possible
share price decline in the next two months and wants
protection. The investor could buy ten July put option
contracts on Microsoft at CBOT with a strike price of
USD27.50, which is selling at USD1.
John Hull
Hedging using forward and options
• Suppose that it is September and an importer considers
that the GBP is likely to increase in value over the next 3
months. The GBP price is currently USD 1.9 and a 3month call option with a strike price of USD 2.05 is
currently selling for USD0.05. Assuming that the
importer will have to pay GBP100,000 for its import
contract. There are two possible alternatives. One
alternative is to purchase forward GBP 100,000 at the
forward price of USD2.0, the other involves the purchase
of 4,000,000 call options. Suppose that the importer’s
expectation is correct and the price of GBP rises/falls to
USD 2.2/1.8 by December.
John Hull
40
Foreign currency speculation
• Speculation is an attempt to profit by trading on
expectations about prices in the future.
• Speculators can attempt to profit in the:
 Spot market – when the speculator believes the
foreign currency will appreciate in value
 Forward market – when the speculator believes the
spot price at some future date will differ from today’s
forward price for the same date
 Futures market – if a speculator buys a futures
contract, they are locking in the price at which they
must buy that currency on the specified future date or
vice versa.
 Options markets – extensive differences in risk
patterns produced depending on purchase or sale of
121
put and/or call.
Speculation using spot and forward
contracts
Spot rate S($/SF)=0.5851
Six-month forward F($/SF)=0.5760
A speculator has $100,000 with which to speculate and
believes that in six months the spot rate will be
$0.6000/SF.
122
Speculation using forward
Hans Schmidt uses $10 million to speculate on the euro
Assumptions
Initial investment (funds available)
Current spot rate (US$/€)
30-day forward rate (US$/€)
Expected spot rate in 30 days (US$/€)
a)
Values
$10,000,000
$0.8850
$0.9000
$0.8440
b)
Values
$10,000,000
$0.8850
$0.9000
$0.9440
123
41
Speculation using futures
The Mexican peso futures contract traded on the
Chicago Mercantile Exchange is for 500,000 new
Mexican Peso (MXN).
Define the speculator transactions if he believes the
Mexican peso will fall/rise in value versus the
U.S.dollar by March, using the March settle price on
the Mexican peso futures of $0.10958/Ps.
Suppose the spot exchange rates at maturity (by
March) are $0.09500/Ps and $0.11000/Ps.
124
Speculation using spot and futures
A speculator in February thinks that the GBP will
strengthen relative to the USD over the next two
months and prepare to speculate GBP 250,000. He
can purchase GBP250,000 in the spot market at the
price of USD2.0470 in the hope that the GBP can be
sold later at a higher price or can take a long position
in four CME April contracts in GBP at the price of
USD2.0410 . The initial margin requirement is
assumed to be USD 5,000 per contract. Suppose that
the exchange rate rises/falls to USD2.1/2.0 in April.
John Hull
125
Speculation using spot and options
Suppose that it is October and a speculator considers
that the GBP is likely to increase in value over the next 2
months. The GBP price is currently USD 2 and a 2-month
call option with a strike price of USD 2.05 is currently
selling for USD0.05. Assuming that the speculator is
willing to invest USD 2,000. There are two possible
alternatives. One alternative is to purchase GBP 1,000,
the other involves the purchase of 40,000 call options.
Suppose that the speculator’s hunch is correct and the
price of GBP rises/falls to USD 2.2/1.8 by December.
John Hull
126
42
Arbitrage
• Spatial/Two-point arbitrage
• Triangular/Three-point arbitrage
127
Spatial/Two-point arbitrage
h and f are any two currencies.
sh/f : the exchange rate of currency f with currency h in H
financial centre (price of currency f in terms of currency h).
sf/h : the exchange rate of currency h with currency f in F
financial centre
The consistency/neutrality condition: sh/f . Sf/h = 1
sh/f .sf/h ≠ 1: arbitrage opportunity
• Foreign exchange arbitrage is the act of profiting from
differences between the exchange rates of foreign exchange.
• Spatial arbitrage refers to an arbitrage transaction that is
conducted in two different markets, or seperated by space.
128
Example
The exchange rate in Tokyo is ¥98.5000/$.
The exchange rate in New York is ¥98.3000/$.
Calculate arbitrage profit when the arbitrageur has $,
which is equivalent to ¥100 million.
129
43
Example
• Example:
Bank C Bid Ask
NZ$ $.635 $.640
Bank D Bid Ask
NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to
Bank D @ $.645. Profit = $.005/NZ$.
Example
London
£0.6064-80/€
Frankfurt €1.6244-59/£
Define arbitrage opportunity?
131
Three-point/triangular arbitrage
h, f and m are any three currencies.
sf/m : price of currency m in terms of currency f.
sh/f : price of currency f in terms of currency h.
sh/m: price of currency m in terms of currency h.
The cross rate: sf/m= sh/m/sh/f
With sh/f = 1/sf/n, we have sf/m= sh/m/sh/f = sf/h.sh/m
With sf/m= 1/sm/f, we have sf/m= sf/h.sh/m or 1/sm/f = sf/h .sh/m
Then sf/h . sh/m .sm/f= 1 or sh/m . sm/f . sf/h=1
The consistency/neutrality condition: sf/m= sf/h.sh/m
sf/m /sf/h ≠ sh/m: arbitrage opportunity
Triangular arbitrage involves more than two currencies
and/or markets
132
44
Example
Barclays Bank quotes $1.6410/£
Deutsche Bank quotes €1.3510/£
Citibank quotes
$1.3223/€
Calculate arbitrage profit of a market trader with
$1,000,000.
133
Example
• Example:
Bid
Ask
British pound (£)
$1.60/£
$1.61/£
Malaysian ringgit (MYR) $.200/MYR $.202/MYR
£
MYR8.1/£ MYR8.2/£
Buy £ @ $1.61, convert @ MYR8.1/£, then sell MYR @
$.200. Profit = $.01/£. (MYR8.1/£$0.2/MYR=$1.62/£)
Example
Bid
$1.60/£
$.200/MYR
MYR8.1/£
£
MYR
£
Value of MYR in $
Exchange MYR for $ at
$0.2/MYR
(MYR50310=$10062)
MYR
Ask
$1.61/£
$.202/MYR
MYR8.2/£
$
Value of £ in $
Buy £ for $ at $1.61/£
($10000=£6221)
£
Value of £ in MYR
Exchange £ for MYR at MYR8.1/£
(£6221=MYR50310)
•
When the exchange rates of the currencies are not in equilibrium,
triangular arbitrage will force them back into equilibrium.
45
Risk management applications of
swap strategies
Mai Thu Hien
Faculty of Banking and Finance
Foreign Trade University
Email: maithuhien712@yahoo.com
Web: http://web.ftu.edu.vn/maithuhien/
Outline
• Introduction to swaps (interest rate swaps, currency
swaps, equity swaps)
• Swap pricing and valuing
• Risk management using swap strategies
INTRODUCTION TO SWAP
MTH10
Swap
• A swap is an agreement between two parties to exchange
a series of future cash flows.
• For most types of swaps, one party makes payments that
are determined by a random outcome, such as an interest
rate, a currency rate, an equity return, or a commodity
price. These payments are commonly referred to as
variable or floating. The other party either makes variable
or floating payments determined by some other random
factor or makes fixed payments. At least one type of swap
involves both parties making fixed payments, but the
values of those payments vary due to random factors.
• Other definition: Swap is an over-the-counter transaction
consisting of a series of forward contracts.
4
Slide 4
MTH10
xem Madura (2007), Levi (2005), p.59
CFA Level 1
Mai Thu Hien, 4/10/2013
MTH15
Natures of swap
• Although technically a swap can have a single payment, most
swaps involve multiple payments. Thus, we refer to a swap as a
series of payments.
• In fact, we have already covered a swap with one payment, which
is just a forward contract. Hence, a swap is basically a series of
forward contracts.
• With this idea in mind, we can see that a swap is like an
agreement to buy some thing over a period of time. We might be
paying a variable price or a price that has already been fixed; we
might be paying an uncertain price, or we might already know the
price we shall pay.
• When a swap is initiated, neither party pays any amount to the
other. Therefore, a swap has zero value at the start of the
contract.
• However, each party pays the notional principal to the other, but
the amounts exchanged are equivalent, though denominated in
two different currencies.
5
Slide 5
MTH15
xem Madura (2007), Levi (2005), p.59
CFA Level 2, p.253
Mai Thu Hien, 5/21/2012
MTH17
Natures of swap
• Each date on which the parties make payments is called a
settlement date, some times called a payment date.
• The time between settlement dates is called the settlement period.
• On a given settlement date when payments are due, one party
makes a payment to the other, which in turn makes a payment to
the first party. With the exception of currency swaps and a few
variations associated with other types of swaps, both sets of
payments are made in the same currency. Consequently, the
parties typically agree to exchange only the net amount owed from
one party to the other, a practice called netting.
• Note the implication that swaps are generally settled in cash. It is
quite rare for swaps to call for actual physical delivery of an
underlying asset.
• A swap always has a termination date, the date of the final
payment. We can think of this date as its expiration date, as we do
with other derivatives.
• The original time to maturity is sometimes called the tenor of a
6
swap.
Slide 6
MTH17
xem Madura (2007), Levi (2005), p.59
CFA Level 2, p.253
Mai Thu Hien, 5/21/2012
MTH18
Natures of swap
• The swap market is almost exclusively an over-thecounter market, so swaps contracts are customized to the
parties' specific needs.
• Several of the leading futures exchanges have created
futures contracts on swaps. These contracts allow
participants to hedge and speculate on the rates that will
prevail in the swap market at future dates. Of course,
these contracts are not swaps themselves but, as
derivatives of swaps, they can in some ways serve as
substitutes for swaps. These futures contracts have been
moderately successful, but their volume is insignificant
compared with the-over-the-counter market for swaps.
7
Slide 7
MTH18
xem Madura (2007), Levi (2005), p.59
CFA Level 2, p.253
Mai Thu Hien, 5/21/2012
MTH20
Natures of swap
• Default is possible whenever a payment is due. When a
series of payments is made, there is default risk potential
throughout the life of the contract, depending on the financial
condition of the two parties. But default can be somewhat
complicated in swaps.
– Exp, on a settlement date, Party A owes Party B a payment of
$50,000 and Party B owes Party A a payment of $12,000. Agreeing to
net, Party A owes Party B S38,000 for that particular payment, Party
A may be illiquid, or perhaps even bankrupt, and unable to make the
payment. But it may be the case that the market value of the swap,
which reflects the present value of the remaining payments, could be
positive from the perspective of Party A and negative from the
perspective of Party B. In that case, Party B owes Party A more for
the remaining payments.
• The handling of default in swaps can be complicated,
depending on the contract specifications and the applicable
laws under which the contract was written. In most cases,
the above situation would be resolved by having A be in
default but possessing an asset, the swap, that can be used
8
to help settle its other liabilities.
Slide 8
MTH20
xem Madura (2007), Levi (2005), p.59
CFA Level 2, p.253
Mai Thu Hien, 5/21/2012
Termination of a swap
• A swap has a market value that can be calculated during
its life.
– If a party holds a swap with a market value of $125,000, it can
settle the swap with the counterparty by having the counterparty
pay it $125,000 in cash. This payment terminates the transaction
for both parties.
• From the opposite perspective, a party holding a swap
with a negative market value can terminate the swap by
paying the market value to the counterparty.
• Terminating a swap in this manner is possible only if the
counterparties specify in advance that such a transaction
can be made, or if they reach an agreement to do so
without having specified in advance. In other words, this
feature is not automatically available and must be agreed
to by both parties.
Termination of a swap
• Many swaps are terminated early by entering into a
separate and offsetting swap.
– For example, suppose a corporation is engaged in a swap to make
fixed payments of 5% and receive floating payments based on
LIBOR, with the payments made each 15 January and 15 July.
Three years remain on the swap.
– That corporation can offset the swap by entering into an entirely
new swap in which it makes payments based on LIBOR and
receives a fixed rate with the payments made each 15 January and
15 July for three years.
• The swap fixed rate is determined by market conditions at
the time the swap is initiated. Thus, the fixed rate on the
new swap is not likely to match the fixed rate on the old
swap, but the effect of this transaction is simply to have the
floating payments offset; the fixed payments will net out to
a known amount. Hence, the risk associated with the
floating rate is eliminated. The default risk, however, is not
eliminated because both swaps remain in effect.
Termination of a swap
• Another way to terminate a swap early is sell the swap to
another counterparty.
– Suppose a corporation holds a swap worth $75,000. If it can
obtain the counterparty's permission, it can find another party to
take over its payments. In effect, it sells the swap for $75,000 to
that party. This procedure, however, is not commonly used.
• A final way to terminate a swap early is by using a
swaption. This instrument is an option to enter into a
swap at terms that are established in advance. Thus, a
party could use a swaption to enter into an offsetting
swap, as described above.
MTH16
Types of swaps
• The underlying assets in a swap can be a currency, interest
rate, stock, or commodity:
– Currency swap: each party makes interest payments to the other in
different currencies. In a currency swap the principal is usually
exchanged at the beginning and the end of the swap’s life.
– Interest rate swap: it is a currency swap in which both currencies are
the same. Because we are paying in the same currency, there is no
need to exchange notional principal at the beginning and at the end
of an interest rate swap.
– A plain vanilla swap: it is simply an interest rate swap in which one
party pays a fixed rate and the other pays a floating rate, with both
sets of payments in the same currency.
– Commodity swaps are very commonly used. Exp, airlines enter into
swaps to hedge their future purchases of jet fuel. They agree to make
fixed payments to a swap dealer on regularly scheduled dates and
receive payments determined by the price of jet fuel. Gold mining
companies use swaps to hedge future deliveries of gold. Other
parties dealing in such commodities as natural gas and precious
metals often use swaps to lock in prices for future purchases and 12
sales.
Slide 12
MTH16
xem Madura (2007), Levi (2005), p.59
CFA Level 2, p.253
Mai Thu Hien, 5/21/2012
Types of swaps
• In addition, swaps can be based on non-storable
commodities, like electricity and the weather. In the case of
the weather, payments are made based on a measure of a
particular weather factor, such as amounts of rain,
snowfall, or weather related damage.
• Other types of swaps: Floating-for-floating interest rate
swaps, amortizing swaps, step up swaps, forward swaps,
constant maturity swaps, compounding swaps, LIBOR-inarrears swaps, accrual swaps, diff swaps, cross currency
interest rate swaps, equity swaps, extendable swaps,
puttable swaps, swaptions, commodity swaps, volatility
swaps…(Hull)
13
Currency swaps
MTH12
Currency swaps
• In a currency swap, each party makes interest payments to the
other in different currencies.
• A foreign currency swap is an agreement to buy and sell foreign
exchange at pre-specified exchange rates, where the buying and
selling are seperated in time.
 A swap-in Canadian consists of an agreement to buy Canadian
dollars spot, and also an agreement to sell Canadian dollars forward.
 A swap-out Canadian consists of an agreement to sell Canadian
dollars spot and to buy Canadian dollars forward.
 A forward-forward swap involves two forward transactions to buy
Canadian dollars for 1-month forward and sell Canadian dollars for 2months forward.
 A rollover swap is the one that the purchase and sale are seperated
by only one day.
• lt is important to clear up some terminology confusion. Foreign
exchange swap or foreign currency swap sounds as if it might he
referring to a currency swap. In fact, an FX swap is just a long
position in a forward contract on a foreign currency and a short
position in a forward contract on the same currency with a
different expiration. Why this transaction is called a swap is not
clear, but this transaction existed before currency swap were 15
created.
Slide 15
MTH12
xem Madura (2007), Levi (2005), p.59
Mai Thu Hien, 11/10/2008
Currency swap: Example
• Let’s consider a 6-month currency agreement between
Microsoft and Renaud entered on February 1, 2011.
• Microsoft pays a fixed interest rate of 5% in Euros and
receives a 3% interest rate in dollars from Renault.
• The principal amounts are 20 millions
Currency swap: Example
Currency Swap: Example
A swap agreement that IBM to pay 5% on a sterling
principal of £10,000,000 & receive 6% on a US$
principal of $18,000,000 every year for 5 years
USD18 million
IBM
BP
GBP10 million
USD 6%
IBM
BP
GBP 5%
Options, Futures, and Other
Derivatives 7th Edition, Copyright
© John C. Hull 2008
18
The Cash Flows
Cash flows to IBM in currency swap
Date
Dollar Cash Flows
(millions)
Sterling cash flow
(millions)
Feb 1, 2011
-18.0
+10.0
Feb 1, 2012
+1.08
−0.50
Feb 1, 2012
+1.08
−0.50
Feb 1, 2014
+1.08
−0.50
Feb 1, 2015
+1.08
−0.50
Feb 1, 2016
+19.08
−10.50
Options, Futures, and Other
Derivatives, 8th Edition, Copyright
© John C. Hull 2012
19
Typical Uses of a Currency Swap
• Conversion from a liability in one currency to a liability in
another currency:
– IBM can issue USD18 million of USD-denominated bond at 6%. The
swap transforms this transaction into one where IBM has borrowed
GBP10 million at 5%
– The initial exchange of principle converts the proceeds of the bond
issue from USD to GBP
– The subsequent exchanges in the swap have the effect of swapping
the interest and principal payments from USD to GBP
• Conversion from an investment in one currency to an
investment in another currency:
– IBM can invest GBP10 million in the UK to yield 5%/year but feels
that USD will strengthen against GBP and prefers USD-denominated
investment
– The swap transforms the UK investment into a USD18 million
investment in the US yielding 6%
Options, Futures, and Other
Derivatives 7th Edition, Copyright
© John C. Hull 2008
20
Comparative Advantage Arguments
for Currency Swaps
(Table 7.8, page 165)
General Electric wants to borrow 20 million AUD
Qantas wants to borrow 15 million USD, 1 AUD = 0.75 USD
USD
AUD
General Electric
5.0%
7.6%
Qantas
7.0%
8.0%
Swap: General Electric borrows USD at 5%
Qantas Airways borrows AUD at 8%
They then use a currency swap to transform GE’s loan to
AUD loan and Qantas Airways’ loan into a USD loan.
Options, Futures, and Other Derivatives 7th Edition,
Copyright © John C. Hull 2008
21
Comparative Advantage Arguments for Currency Swaps
FI makes net gain of 0.2%, transforms the USD interest rate of 5% to an AUD interest
rate of 6.9% for GE (GE is 0.7% better off than it would be if it went directly to AUD
markets). Similarly for Qantas.
USD 6.3%
USD 5%
USD 5%
General
Electric
Financial
Institutions
AUD 6.9%
Qantas
Airways
AUD 8.0%
AUD 8.0%
Qantas bears exchange rate risk because it pays 1.1% in AUD and 5.2% in USD
USD 5.2%
USD 5%
USD 5%
General
Electric
Financial
Institutions
AUD 6.9%
Qantas
Airways
AUD 8.0%
AUD 6.9%
GE bears exchange rate risk because it receives 1.1% in USD and pays 8% in AUD
USD 6.3%
USD 6.1%
USD 5%
General
Electric
Financial
Institutions
AUD 8.0%
Qantas
Airways
AUD 8.0%
AUD 8.0%
Example
• Let’s consider the case of a European Treasurer who
anticipates a depreciation of the dollar against the euro.
He decides to use a swap dollar against Euro.
• Spot price USD/EUR: EUR0.7879 (sale) and EUR0.7880
(purchase)
• 6-month price USD/EUR: EUR0.7875 (sale) and
EUR0.7877 (purchase)
Example
• Exchange loss : 500€ due to the anticipated depreciation
of the dollar
• Without the swap contract, the loss would have been
higher than the anticipated loss by the market
• Comment: The Swap pricing is 4 / 3
• The swap points are the difference between the
exchange rate of the forward transaction and the
exchange rate of the spot transaction.
Example
Two firms Edem and Surcouf face the following interest rates:
Assume that the firm Edem wants to borrow US dollars at a floating
rate of interest and the firm Surcouf wants to borrow Canadian
dollars at a fixed interest rate.
A financial institution is planning to arrange a swap and requires a
50-basis point spread.
If the swap is to appear equally attractive to Edem and Surcouf
companies, what rates of interest will Edem and Surcouf end up
paying?
USD (Floating)
GBP (Fixed)
Edem
Libor + 0.5%
5%
Surcouf
Libor + 1%
6.5%
The payments on a currency swap
• In a currency swap, each party makes payments to the
other in different currencies.
• A currency swap can have:
 One party pay a fixed rate in one currency and the
other pay a fixed rate in the other currency (a fixed-forfixed currency swap)
 Both pay a floating rate in their respective currencies (a
floating-for-floating-rate currency swap)
 The first party pay a fixed rate in one currency and the
second party pay a floating rate in the other currency (a
fixed-for-floating-rate currency swap)
 The first party pay a floating rate in one currency and
the second party pay a fixed rate in the other currency
(a floating-for-fixed currency swap)
• The notional principal is usually exchanged at the
beginning and at the end of the life of the swap, although
this exchange is not mandatory.
26
A fixed-for-fixed curency swap
27
Firm
AA
BB
USD
10%
9%
AUD
7%
8%
28
29
The Cash Flows
Date
AUD Cash Flows
(millions)
USD cash flow
(millions)
Feb 1, 2011
-2.0
+1.0
Feb 1, 2012
+0.2
−0.1
Feb 1, 2013
+0.2
−0.1
Feb 1, 2014
+0.2
−0.1
Feb 1, 2015
+0.2
−0.1
Feb 1, 2016
+2.2
−1.1
Options, Futures, and Other
Derivatives, 8th Edition, Copyright
© John C. Hull 2012
30
Issuing a Dollar-Denominated bond and using
a currency swap to convert to
a Euro-denominated bond
TGT wants to open a few stores in Germany and needs EUR9 million to fund.
TGT would like to issue a fixed-rate euro-denominated bond with face value of
EUR9 million, but it is not very well known in Europe.
TGT issues a five-year USD10 million bond at 6%. It then enters into a swap with
DB.
€9m at 4.9%
TGT
$10m at 5.5%
DB
This transaction looks just like TGT issuing a bond with face value of EUR9 million
(4.9%) and that bond is purchased by DB. TGT converts EUR9 million to
USD10 million and buys a dollar-denominated bond issued by DB (5.5%). Thus, TGT
issues a bond in EUR and accordingly makes payments to DB in EUR.
DB, appropriately makes interest payments in USD to TGT. At the end, they each
pay off the face values of the bond they have issued. In fact, neither TGT of DB
actually issues or purchases a bond. They exchange only a series of cash flow that
replicated the issuance and purchases of these bonds.
220,500 = 0.049(180/360)9
275,000 = 0.055(180/360)10
TGT issues a bond in dollars. It
takes the dollars and passes them
through to DB, which gives TGT
the €9 million it needs. On the
interest payment dates, the swap
generates $275,000 of the
$300,000 in interest TGT needs to
pay its bondholders. In turn, TGT
makes interest payments in euros.
Still, small dollar interest
payments are necessary because
TGT cannot issue a dollar bond at
the swap rate. At the end of the
transaction, TGT receives $10
million back from DB and passes
it through to its bondholders. TGT
pays DB €9 million, thus
effectively paying off a eurodenominated bond.
33
• TGT has effectively issued a dollar-denominated bond and
converted it to a euro-denominated bond. In all likelihood, it
can save on interest expense by funding its need for euros
in this way, because TGT is better known in the US than in
Europe. Its swap dealer, DB, knows TGT well and also
obviously has a strong presence in Europe. Thus, DB can
pass on its advantage in euro bond markets to TGT.
• In addition, had TGT issued a euro-denominated bond, it
would have assumed no credit risk. By entering into the
swap, TGT assumes a remote possibility of DB defaulting.
Thus, TGT saves a little money by assuming some credit
risk.
• Recall that Target effectively converted a fixed rate loan in
dollars to a fixed-rate loan in euros. Suppose instead that
TGT preferred to borrow in euros at a floating rate. It then
would have specified that the swap required it to make
payments to DB at a floating rate. Had TGT preferred to
issue the dollar-denominated bond at a floating rate, it
would have specified that DB pay it dollars at a floating rate.
Example
Consider a currency swap in which the domestic party pays
a fixed rate in the foreign currency, GBP, and the
counterparty pays a fixed rate in USD. The notional
principal are $50 million and €30 million. The fixed rate are
5.6% in dollars and 6.25% in pounds. Both sets of
payments are made on the basis of 30 days per month and
365 days per year, and the payments are made
semiannually.
A. Determine the initial exchange of cash that occurs at the
start of the swap.
B. Determine the semiannual payments.
C. Determine the final exchange of cash that occurs at the
end of the swap.
D. Give an example of a situation in which this swap might be
appropriate.
Example
A U.S. company enters into a currency swap in which it
pays a fixed rate of 5.5% in euros and the counterparty
pays a fixed rate of 6.75% in dollars. The notional
principals are $100 million and €116.5 million. Payments
are made semiannually and on the basis of 30 days per
month and 360 days per year.
A. Calculate the initial exchange of payments that takes
place at the beginning of the swap.
B. Calculate the semiannual payments.
C. Calculate the final exchange of payments that takes
place at the end of the swap.
Example
A British company enters into a currency swap in which it
pays a fixed rate of 6% in dollars and the counterparty
pays a fixed rate of 5% in pounds. The notional
principals are £75 million and $105 million. Payments
are made semiannually and on the basis of 30 days per
month and 360 days per year.
A. Calculate the initial exchange of payments that takes
place at the beginning of the swap.
B. Calculate the semiannual payments.
C. Calculate the final exchange of payment that takes place
at the end of the swap.
Interest rate swaps
Interest swap
• An interest rate swap is a currency swap in which both
currencies are the same.
• Because we are paying in the same currency, there is no
need to exchange notional principal at the beginning and
at the end of an interest rate swap.
• The interest payments can be, and nearly always are,
netted. If one party owes $X and the other owes $Y, the
party owing the greater amount pays the net difference.
which greatly reduces the credit risk.
• There is no reason to have both sides pay a fixed rate.
The two streams of payments would be identical in that
case. So in an interest rate swap, either one side always
pays fixed and the other side pays floating, or both sides
pay floating (called a basis swap), but never do both sides
pay fixed.
Plain vanilla swap
• Consider a swap to pay Currency A fixed and Currency B
floating. Currency A could be dollars, and B could be
euros. The first case is a dollar-denominated plain vanilla
swap; the second is a euro-denominated plain vanilla
swap.
• A plain vanilla swap is simply an interest rate swap in
which one party pays a fixed rate and the other pays a
floating rate, with both sets of payments in the same
currency.
• Both sets of payments are on the same notional principal
and occur on regularly scheduled dates.
• In fact, the plain vanilla swap is probably the most
common derivative transaction in the global financial
system.
Example
• Let us now illustrate an interest rate swap. Suppose that on 15 Dec,
General Electric Company (NYSE: GE) borrows money for one year
from Bank of America (NYSE: BAC). The loan is for $25 million and
specifies that GE will make interest payments on a quarterly basis on
15 Mar, Jun, Sep, and Dec for one year at the rate of LlBOR plus 25
basis points. At the end of the year, it will pay back the principal. On
15 Dec, Mar, Jun, and Sep, LIBOR is observed and sets the rate for
that quarter. The interest is then paid at the end of the quarter.
• GE believes that it is getting a good rate, but fearing a rise in interest
rates, it would prefer a fixed-rate loan. It can easily convert the
floating-rare loan to a fixed-rate loan by engaging in a swap. Suppose
it approaches JP Morgan Chase (NYSE:JPM), a large dealer bank,
and requests a quote on a swap to pay a fixed rate and receive
LlBOR, with payments on the dates of its loan payments. The bank
prices the swap and quotes a fixed rate of 6.2% (Typically the rate is
quoted as a spread over the rate on a U.S. Treasury security with a
comparable maturity. Suppose the yield on a two-year Treasury note
is 6%. Then the swap would be quoted as 20 basis points over the
two-year Treasury rate. By quoting the rate in this manner, GE knows
what it is paying over the Treasury rate, a differential called the swap
spread). The fixed payments will be made based on a day count of
90/365, and the floating payments will be made based on 90/360.
Current LIBOR is 5.9%.
The first fixed payment, which GE makes to JPM, is $25,000,000(0.062)(90/
365) = $382,192. This is also the amount of each remaining fixed payment.
The first floating payment, which JPM makes to GE, is $25,000,000(0.059)
(90/360) = $368,750. Of course, the remaining floating payment will not be
known until later.
• Note in Exhibit 4 that we did not show the notional
principal, because it was not exchanged. We could
implicitly show that GE received $25 million from JPM
and paid $25 million to JPM at the start of the swap. We
could also show that the same thing happens at the end.
If we look at it that way, it appears as if GE has issued a
$25 million fixed-rate bond, which was purchased by
JPM, which in turn issued a $25 million floating-rate
bond, which was in turn purchased by GE.
• In fact, neither party actually issued a bond, but they
have generated the cash flows that would occur if GE
had issued such a fixed-rate bond, JPM had issued such
a floating-rate bond, and each purchased the bond of the
other. In other words, we could include the principals on
both sides to make each set of cash flows look like a
bond, yet the overall cash flows would be the same as
on the swap.
Exhibit 5 shows the net effect of the swap and the loan. GE pays LIBOR plus 25 basis
points to Bank of America on its loan, pays 6.2% JPM, and receives LIBOR from
JPM. The net effect is that GE pays 6.2 + 0.25 = 6.45% fixed.
• JPM is engaged in a swap to pay LIBOR and receive 6.2%. It is
exposed to the risk of LIBOR increasing. It would, therefore, probably
engage in some other type of transaction to offset this risk. One
transaction commonly used in this situation is to sell Eurodollar
futures. Eurodollar futures prices move $25 in value for each basis
point move in LIBOR. JPM will determine how sensitive its position is
to a move in LIBOR and sell an appropriate number of futures to
offset the risk.
• Bank of America is exposed to LIBOR as well, but in the banking
industry, floating-rate loans are often made because the funding that
the bank obtained to make the loan was probably already at LIBOR
or a comparable floating rate.
• It is possible but unlikely that GE could get a fixed-rate loan at a
better rate. The swap involves some credit risk: the possibility,
however small, that JPM will default. In return for assuming that risk,
GE in all likelihood would get a better rate than it would if it borrowed
at a fixed rate.JPM is effectively a wholesaler of risk, using its
powerful position as one of the world's leading banks to facilitate the
buying and selling of risk for companies such as GE. Dealers profit
from the spread between the rates they quote to pay and the rates
they quote to receive. The swaps market is, however, extremely
competitive and the spreads have been squeezed very tight, which
makes it very challenging for dealers to make a profit. Of course, this
competition is good for end users, because it gives them more
attractive rates.
Example
Determine the upcoming payments in a plain vanilla
interest rate swap in which the notional principal is €70
million. The end user makes a semiannual fixed payments
at the rate of 7%, and the dealer makes semiannual
floating payments at Euribor, which was 6.25% on the last
settlement period. The floating payments are made on the
basis of 180 days in the settlement period and 360 days in
a year. The fixed payments are made on the basis of 180
days in the settlement period and 365 days in a year.
Payments are netted, so determine which party pays which
and what amount.
Example
A U.S. company has entered into an interest rate swap
with a dealer in which the notional principal is $50 million.
The company will pay a floating rate of LIBOR and
receive a fixed rate of 5.75%. Interest is paid
semiannually, and the current LIBOR is 5.15%. Calculate
the first payment and indicate which party pays which.
Assume that floating-rate payment will be made on the
basis of 180/360 and fixed-rate payments will be made
on the basis of 180/365.
Example
A German company that has issued floating-rate notes
now believes that interest rates will rise. It decides to
protect itself against this possibility by entering into an
interest rare swap with a dealer. In this swap, the
notional principal is €25 million and the company will
pay a fixed rate of 5.5% and receive Euribor. The
current Euribor is 5%. Calculate the first payment and
indicate which party pays which. Assume that floatingrate payments will be made on the basis of 90/360 and
fixed-rate payments will be made on the basis of 90/
365.
An Example of a “Plain Vanilla”
Interest Rate Swap
• An agreement by Microsoft to receive 6-month
LIBOR & pay a fixed rate of 5% per annum every 6
months for 3 years on a notional principal of $100
million
• Next slide illustrates cash flows that could occur
(Day count conventions are not considered)
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One Possible Outcome for Cash Flows to Microsoft
(Table 7.1, page 150)
Date
LIBOR
Floating Cash
Flow
Fixed Cash
Flow
Net Cash
Flow
Mar 5, 2012
4.20%
Sep 5, 2012
4.80%
+2.10
−2.50
−0.40
Mar 5, 2013
5.30%
+2.40
−2.50
−0.10
Sep 5, 2013
5.50%
+2.65
−2.50
+ 0.15
Mar 5, 2014
5.60%
+2.75
−2.50
+0.25
Sep 5, 2014
5.90%
+2.80
−2.50
+0.30
+2.95
−2.50
+0.45
Mar 5, 2015
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Typical Uses of an Interest Rate Swap
• Converting a liability from
– fixed rate to floating rate
– floating rate to fixed rate
• Converting an investment from
– fixed rate to floating rate
– floating rate to fixed rate
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Intel and Microsoft (MS) Transform a Liability
(Figure 7.2, page 151)
Swap:
5%
Intel
MS
LIBOR
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Intel and Microsoft (MS) Transform a Liability
(Figure 7.2, page 151)
• For MS, the swap could be used to transform a floating-rate loan
into a fixed-rate loan. Suppose that MS borrows USD100 million at
LIBOR + 0.1%. After entering into the swap, MS has 3 cash flows:
– Pays LIBOR + 0.1% to its outside lenders
– Receives LIBOR under the swap
– Pays 5% under the swap
• Three cash flows net out to an interest payment of 5.1%  The
swap transformed borrowing at a floating LIBOR+0.1% into
borrowing at a fixed rate of 5.1%
5%
5.2%
Intel
MS
LIBOR+0.1%
LIBOR
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Intel and Microsoft (MS) Transform a Liability
(Figure 7.2, page 151)
• For Intel, the swap could transform a fixed-rate loan into a floating-rate
loan. Suppose that Intel borrows USD100 million at 5.2%. After
entering into the swap, Intel has 3 cash flows:
– Pays 5.2% to its outside lenders
– Pays LIBOR under the swap
– Receives 5% under the swap
• Three cash flows net out to an interest payment of LIBOR + 0.2% 
The swap transformed borrowing at a fixed rate of 5.2% to borrowing
at a floating LIBOR+0.2%
5%
5.2%
Intel
MS
LIBOR+0.1%
LIBOR
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Financial Institution is Involved
(Figure 7.4, page 152)
• Financial Institution earns 3 basis point (0.03%) on two offsetting
transactions with Intel and MS.
• MS ends up borrowing at 5.1% + 0.015% = 5.115% :
– Pays LIBOR+0.1%
– Pays x%
– Receives LIBOR
We have -LIBOR - 0.1% - x% + LIBOR = -5.115%  x = 5.015%
• Intel ends up borrowing at LIBOR+0.2% + 0.015% = LIBOR + 0.215%
– Pays 5.2%
– Pays LIBOR
– Receives y%
We have -5.2% - LIBOR + y% = -LIBOR – 0.215%  y = 4.985%
y=4.985%
5.2%
Intel
x=5.015%
F.I.
LIBOR
MS
LIBOR
LIBOR+0.1%
55
Intel and Microsoft (MS) Transform an Asset
(Figure 7.3, page 152)
• Suppose that MS owns USD100 million in bonds that will provide
interest at 4.7%. After entering into the swap, MS has 3 cash flows:
– Receives 4.7% on the bonds
– Receive LIBOR under the swap
– Pays 5% under the swap
• Three cash flows net out to an interest inflow of LIBOR-0.3%  The
swap transformed an asset earning 4.7% into an asset earning
LIBOR - 0.3%.
5%
4.7%
Intel
MS
LIBOR-0.2%
LIBOR
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Intel and Microsoft (MS) Transform an Asset
(Figure 7.3, page 152)
• For Intel, the swap could transform an asset earning a floating interest
rate into an asset earning a fixed interest rate. Suppose that Intel has
an investment of USD100 that yields LIBOR - 0.2%. After entering into
the swap, Intel has 3 cash flows:
– Receives LIBOR - 0.2% on its investment
– Pays LIBOR under the swap
– Receives 5% under the swap
• Three cash flows net out to an interest inflow of 4.8%  The swap
transformed an asset earning LIBOR - 0.2% into an asset earning
4.8%.
5%
4.7%
Intel
MS
LIBOR-0.2%
LIBOR
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Financial Institution is Involved
(See Figure 7.5, page 153)
• Financial Institution earns 3 basis point (0.03%) on two offsetting
transactions with Intel and MS.
• MS ends up earning at LIBOR – 0.3% - 0.015% = LIBOR – 0.315%:
– Receives LIBOR
– Pays x%
– Receives 4.7%
We have LIBOR - x% + 4.7% = LIBOR – 0.315%  x = 5.015%
• Intel ends up earning at 4.8% - 0.015% = 4.785%
– Receives LIBOR – 0.2%
– Pays LIBOR
– Receives y%
We have LIBOR - 0.2% – LIBOR + y% = 4.785%  y = 4.985%
y=4.985%
x=5.015%
4.7%
Intel
F.I
MS
LIBOR-0.2%
LIBOR
LIBOR
58
Quotes By a Swap Market Maker
(Table 7.3, page 154)
Maturity
Bid (%)
Offer (%)
Swap Rate (%)
2 years
6.03
6.06
6.045
3 years
6.21
6.24
6.225
4 years
6.35
6.39
6.370
5 years
6.47
6.51
6.490
7 years
6.65
6.68
6.665
10 years
6.83
6.87
6.850
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Market Makers
• Many large financial institutions act as market makers for swaps,
since unlikely that two companies have completely compatible
needs.
• Bid/Offer rates differ by 3 to 4 basis points. Average of bid and offer
rates is the swap rate.
• Bfix = Value of fixed-rate bond underlying the swap
• Bfl = Value of floating-rate bond underlying the swap
• Swaps have zero value, so Bfix = Bfl.
Day Count
• A day count convention is specified for fixed and floating
payment
• For example, LIBOR is likely to be actual/360 in the US
because LIBOR is a money market rate
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Confirmations
• Confirmations specify the terms of a transaction
• The International Swaps and Derivatives has developed
Master Agreements that can be used to cover all
agreements between two counterparties
• Governments now require central clearing to be used for
most standardized derivatives
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The Comparative Advantage Argument
(Table 7.4, page 156)
• AAACorp wants to borrow floating
• BBBCorp wants to borrow fixed
Fixed
Floating
AAACorp
4.0%
6 month LIBOR − 0.1%
BBBCorp
5.2%
6 month LIBOR + 0.6%
• At initial:
‒ AAACorp borrows fixed-rate funds at 4%
‒ BBBCorp borrows floating-rate funds at LIBOR+0.6%
• After swap:
– AAACorp ends up with floating rate
– BBBCorp ends up with fixed rate
63
The Swap (Figure 7.6, page 157)
•
Swap:
– AAACorp agrees to pay BBBCorp at LIBOR
– BBBCorp agrees to pay AAACorp at 4.3%
• AAACorp has three cash flows:
– Pays 4% to outside lender
– Receives 4.35% from BBB Corp
– Pays LIBOR to BBBCorp
The net effect of cash flows is that AAACorp pays LIBOR - 0.35% (0.25%
less than it would pay if it went directly to floating-rate market) or Libor0.1% - 0.25%
• BBBCorp has three cash flows:
– Pays LIBOR +0.6% to outside lender
– Receives LIBOR from AAACorp
– Pays 4.35% to AAACorp
The net effect of cash flows is that BBBCorp pays 4.95% (0.25% less than
it would pay if it went directly to fixed-rate market) or 5.2% - 0.25%
4.35%
4%
AAACorp
BBBCorp
LIBOR+0.6%
LIBOR
64
The Swap when a Financial Institution is Involved
(Figure 7.7, page 157)
• Financial Institution earns 4 basis point (0.04%) on two offsetting
transactions with AAACorp and BBBCorp.
• AAACorp ends up borrowing at LIBOR – 0.35% + 0.02% = LIBOR – 0.33%:
– Receives y%
– Pays 4%
– Pays LIBOR
We have -LIBOR -4% + y% = - LIBOR + 0.33%  y = 4.33%
• BBBCorp ends up borrowing at 4.95% + 0.02% = 4.97%
– Receives LIBOR – 0.2%
– Pays LIBOR+0.6%
– Receives x%
We have -LIBOR - 0.6% + LIBOR - x% = -4.97%  x = 4.37%
4.33%
4.37%
4%
AAACorp
F.I
BBBCorp
LIBOR+0.6%
LIBOR
LIBOR
65
Criticism of the Comparative
Advantage Argument
• The 4.0% and 5.2% rates available to AAACorp and
BBBCorp in fixed rate markets are 5-year rates
• The LIBOR − 0.1% and LIBOR + 0.6% rates available in
the floating rate market are six-month rates
• BBBCorp’s fixed rate depends on the spread above
LIBOR it borrows at in the future
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Example
• Let’s consider 2 companies that borrow money in the
Eurocurrency market.
Fixed
Floating
Firm A
T%
Libor
Firm B
T% + 2%
Libor + 1%
Example
(with FI)
• Let’s consider 2 companies, Microsoft and Intel that
borrow money in the Eurocurrency market. The
remuneration of the financial institution in change of the
transaction is 0.03%
Fixed
Floating
Microsoft
5.1%
Libor + 0.1%
Intel
5.2%
Libor + 0.3%
Example
We consider the firm Arco and the firm Cooper have
been offered the following rates on a $ 20 million 5-year
loan: The firm Arco requires a floating rate loan.
Design a swap that will net a bank, acting as
intermediary, 0.1% and that will appear equally attractive
to both companies.
Fixed
Floating
Arco
6%
Libor + 0.1%
Cooper
6.7%
Libor + 0.4%
Example
We consider the firm Arco and the firm Cooper have
been offered the following rates on a $ 20 million 5-year
loan: The firm Arco requires a floating rate loan.
Design a swap that will net a bank, acting as
intermediary, 0.1% and that will appear equally attractive
to both companies.
Fixed
Floating
Arco
6%
Libor + 0.1%
Cooper
6.7%
Libor + 0.4%
The Nature of Swap Rates
• Six-month LIBOR is a short-term AA borrowing rate
• The 5-year swap rate has a risk corresponding to the
situation where 10 six-month loans are made to AA
borrowers at LIBOR
• This is because the lender can enter into a swap where
income from the LIBOR loans is exchanged for the 5-year
swap rate
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The Nature of Swap Rates
• Swap rate is the average of:
– the fixed rate that a swap market maker is prepared to pay in exchange
for receiving LIBOR (bid)
– the fixed rate that it is prepared to receive in return for paying LIBOR
(offer)
• Swap rates are nearly risk free.
• A financial institute can earn the 5-year swap rate by
– Lending the principal for the first 6 months to a AA-borrower and then
relend it for successive 6-month periods to other AA-borrowers
– Enter into a swap to exchange the LIBOR income for the 5-year swap
rate.
• In other words 8-year swap rate is an interest rate with credit risk
corresponding to 16 consecutive 6-month LIBOR loans to AA
companies.
• Swap rates are less than AA borrowing rates since more attractive
to lend money for short periods of time (6-month) than for long
periods of time to retain liquidity.
Using Swap Rates to Bootstrap the
LIBOR/Swap Zero Curve
• Consider a new swap where the fixed rate is the swap
rate
• When principals are added to both sides on the final
payment date the swap is the exchange of a fixed rate
bond for a floating rate bond
• The floating-rate rate bond is worth par. The swap is
worth zero. The fixed-rate bond must therefore also be
worth par
• This shows that swap rates define par yield bonds that
can be used to bootstrap the LIBOR (or LIBOR/swap)
zero curve
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Example of Bootstrapping the
LIBOR/Swap Curve
(Example 7.1, page 160)
• 6-month, 12-month, and 18-month LIBOR/swap
rates are 4%, 4.5%, and 4.8% with continuous
compounding.
• Two-year swap rate is 5% (semiannual)
2.5e 0.040.5  2.5e 0.0451.0  2.5e 0.0481.5  102.5e 2 R  100
• The 2-year LIBOR/swap rate, R, is 4.953%
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Determining Swap/Zero Rates
• Use of LIBOR rates as risk-free rates used to price futures contracts.
• Only know LIBOR rates up to 12-month period.
• Extend LIBOR rates past 12 months via Eurodollar futures (up to 5
years, usually)
• Traders use swap rates to extend LIBOR zero curve further. Called
the LIBOR/Swap zero curve.
• How to determine the curve:
– New floating-rate bond is always equal to its principal value (par value)
when using LIBOR/Swap zero curve for discounting. (Since rate of
interest is LIBOR and LIBOR is discount rate)
– Next Bfl = Bfix for a new swap where fixed rate equals swap rate (again
at start). This implies both Bfl and Bfix equal the notional principal.
– Together imply that swap rates define a par yield bond.
– Use bootstrap argument.
Example of determining
Swap/Zero Rates
The 1-year LIBOR rate is 10%. A bank trades swaps where a fixed
rate of interest is exchanged for 12-month LIBOR with payments
being exchanged annually. The 2-and 3-year swap rates (expressed
with annual compounding) are 11% and 12% per annum. Estimate
the 2- and 3-year LIBOR zero rates.
Example of determining
Swap/Zero Rates
The two-year swap rate implies that a two-year LIBOR bond with a
coupon of 11% sells for par. If R2 is the two-year zero rate:
11e−0.10×1.0 + 111e−R2×2.0 = 100
so that R2 = 0.1046. The three-year swap rate implies that a threeyear LIBOR bond with coupon of 12% sells for par. If R3 is the threeyear zero rate
12e−0.10×1.0 + 12e−0.1046×2.0 + 112e−R2×3.0 = 100
so that R3 = 0.1146. The 2- and 3-year rates are 10.46% and
11.46% with continuous compounding.
Overnight Indexed Swaps
• Fixed rate for a period is exchanged for the geometric
average of the overnight rates
• Should OIS rate equal the LIBOR rate? A bank can
– Borrow $100 million in the overnight market,
rolling forward for 3 months
– Enter into an OIS swap to convert this to the 3month OIS rate
– Lend the funds to another bank at LIBOR for 3
months
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Overnight Indexed Swaps
continued
• ...but it bears the credit risk of another bank in this
arrangement
• The OIS rate is now regarded as a better proxy for the
short-term risk-free rate than LIBOR
• The excess of LIBOR over the OIS rate is the LIBOROIS spread. It is usually about 10 basis points but spiked
at an all time high of 364 basis points in October 2008
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Swaps & Forwards
• A swap can be regarded as a convenient way of
packaging forward contracts
• Although the swap contract is usually worth zero
at the outset, each of the underlying forward
contracts are not worth zero
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Credit Risk
• A swap is worth zero to a company initially
• At a future time its value is liable to be either positive or
negative
• The company has credit risk exposure only when its
value is positive
• Some swaps are more likely to lead to credit risk
exposure than others
• What is the situation if early forward rates have a
positive value?
• What is the situation when the early forward rates have
a negative value?
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10/28/2021
Chapter 2
The International Monetary System
Mai Thu Hien
Faculty of Banking and Finance
Foreign Trade University
History of the IMS
1876-1913
The Gold Standard
1914-1944
The interwar years and World War II
1944
Bretton Woods and the IMF
1945-1973
Fixed exchange rates
1973-present
Eclectic currency arragement
2
History of the International
Monetary System
• The Gold Standard (1876 – 1913)
– Gold has been a medium of exchange since
3000 BC
– “Rules of the game” were simple, each country
set the rate at which its currency unit could be
converted to a weight of gold
– Currency exchange rates were in effect “fixed”
– Expansionary monetary policy was limited to a
government’s supply of gold
– Was in effect until the outbreak of WWI as the
free movement of gold was interrupted
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1
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History of the International
Monetary System
• The Inter-War Years & WWII (1914-1944)
– During this period, currencies were allowed to
fluctuate over a fairly wide range in terms of
gold and each other
– Increasing fluctuations in currency values
became realized as speculators sold short
weak currencies
– The US adopted a modified gold standard in
1934 (devalued from $35 to $20.67/ounce)
– During WWII and its chaotic aftermath the US
dollar was the only major trading currency that
continued to be convertible
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1-4
History of the International
Monetary System
• Bretton Woods and the International
Monetary Fund (IMF) (1944)
– As WWII drew to a close, the Allied Powers
met at Bretton Woods, New Hampshire to
create a post-war international monetary
system
– The Bretton Woods Agreement established a
US dollar based international monetary system
and created two new institutions the
International Monetary Fund (IMF) and the
World Bank
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1-5
History of the International
Monetary System
– The International Monetary Fund is a key
institution in the new international monetary
system and was created to:
• Help countries defend their currencies against
cyclical, seasonal, or random occurrences
• Assist countries having structural trade problems if
they promise to take adequate steps to correct these
problems
– The International Bank for Reconstruction and
Development (World Bank) helped fund postwar reconstruction and has since then
supported general economic development
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2
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History of the International
Monetary System
• Eurocurrencies
– These are domestic currencies of one country
on deposit in a second country
– The Eurocurrency markets serve two valuable
purposes:
• Eurocurrency deposits are an efficient and
convenient money market device for holding excess
corporate liquidity
• The Eurocurrency market is a major source of shortterm bank loans to finance corporate working capital
needs (including export and import financing)
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History of the International
Monetary System
• Eurocurrency Interest Rates: Libor
– In the Eurocurrency market, the
reference rate of interest is the London
Interbank Offered Rate (LIBOR)
– This rate is the most widely accepted
rate of interest used in standardized
quotations, loan agreements, and
financial derivatives transactions
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1-8
History of the International
Monetary System
• Fixed Exchange Rates (1945-1973)
– The currency arrangement negotiated at Bretton Woods
and monitored by the IMF worked fairly well during the
post-WWII era of reconstruction and growth in world
trade
– However, widely diverging monetary and fiscal policies,
differential rates of inflation and various currency shocks
resulted in the system’s demise
– The US dollar became the main reserve currency held
by central banks, resulting in a consistent and growing
balance of payments deficit which required a heavy
capital outflow of dollars to finance these deficits and
meet the growing demand for dollars from investors and
businesses
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History of the International
Monetary System
– Eventually, the heavy overhang of dollars held by
foreigners resulted in a lack of confidence in the ability of
the US to met its commitment to convert dollars to gold
– The lack of confidence forced President Richard Nixon
to suspend official purchases or sales of gold by the US
Treasury on August 15, 1971
– This resulted in subsequent devaluations of the dollar
– Most currencies were allowed to float to levels
determined by market forces as of March, 1973
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1-10
History of the International
Monetary System
• An Eclectic Currency Arrangement
(1973 – Present)
– Since March 1973, exchange rates have
become much more volatile and less
predictable than they were during the
“fixed” period
– There have been numerous, significant
world currency events over the past 30
years
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1-11
The IMF’s Exchange Rate
Regime Classifications
• The International Monetary Fund classifies
all exchange rate regimes into eight
specific categories
– Exchange arrangements with no separate legal
tender
– Currency board arrangements
– Other conventional fixed peg arrangements
– Pegged exchange rates within horizontal
bands
– Crawling pegs
– Exchange rates within crawling pegs
– Managed floating with no pre-announced path
– Independent floating
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Fixed Versus Flexible
Exchange Rates
• A nation’s choice as to which currency
regime to follow reflects national priorities
about all facets of the economy, including:
– inflation,
– unemployment,
– interest rate levels,
– trade balances, and
– economic growth.
• The choice between fixed and flexible
rates may change over time as priorities
change.
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1-13
Fixed Versus Flexible
Exchange Rates
• Countries would prefer a fixed rate regime
for the following reasons:
– stability in international prices
– inherent anti-inflationary nature of fixed prices
• However, a fixed rate regime has the
following problems:
– Need for central banks to maintain large
quantities of hard currencies and gold to
defend the fixed rate
– Fixed rates can be maintained at rates that are
inconsistent with economic fundamentals
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1-14
Attributes of the “Ideal” Currency
• Possesses three attributes, often
referred to as the Impossible Trinity:
– Exchange rate stability
– Full financial integration
– Monetary independence
• The forces of economics to not allow
the simultaneous achievement of all
three
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1-16
Emerging Markets
and Regime Choices
• A currency board exists when a country’s central
bank commits to back its monetary base – its
money supply – entirely with foreign reserves at
all times.
• This means that a unit of domestic currency
cannot be introduced into the economy without an
additional unit of foreign exchange reserves being
obtained first.
– Argentina moved from a managed exchange
rate to a currency board in 1991
– In 2002, the country ended the currency board
as a result of substantial economic and political
turmoil
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1-17
Emerging Markets
and Regime Choices
• Dollarization is the use of the US dollar as
the official currency of the country.
• One attraction of dollarization is that sound
monetary and exchange-rate policies no
longer depend on the intelligence and
discipline of domestic policymakers.
– Panama has used the dollar as its official
currency since 1907
– Ecuador replaced its domestic currency with
the US dollar in September, 2000
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The Euro:
Birth of a European Currency
• In December 1991, the members of
the European Union met at
Maastricht, the Netherlands to finalize
a treaty that changed Europe’s
currency future.
• This treaty set out a timetable and a
plan to replace all individual ECU
currencies with a single currency
called the euro.
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1-19
The Euro:
Birth of a European Currency
• To prepare for the EMU, a convergence
criteria was laid out whereby each member
country was responsible for managing the
following to a specific level:
– Nominal inflation rates
– Long-term interest rates
– Fiscal deficits
– Government debt
• In addition, a strong central bank, called
the European Central Bank (ECB), was
established in Frankfurt, Germany.
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1-20
Effects of the Euro
• The euro affects markets in three
ways:
– Cheaper transactions costs in the Euro
Zone
– Currency risks and costs related to
uncertainty are reduced
– All consumers and businesses both
inside and outside the Euro Zone enjoy
price transparency and increased pricebased competition
1-21
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Achieving Monetary Unification
• If the euro is to be successful, it must have
a solid economic foundation.
• The primary driver of a currency’s value is
its ability to maintain its purchasing power.
• The single largest threat to maintaining
purchasing power is inflation, so the job of
the EU has been to prevent inflationary
forces from undermining the euro.
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1-22
Exchange Rate Regimes:
The Future
• All exchange rate regimes must deal with the tradeoff
between rules and discretion (vertical), as well as
between cooperation and independence (horizontal)
(see exhibit 2.8)
• The pre WWI Gold Standard required adherence to
rules and allowed independence
• The Bretton Woods agreement (and to a certain extent
the EMS) also required adherence to rules in addition
to cooperation
• The present system is characterized by no rules, with
varying degrees of cooperation
• Many believe that a new international monetary
system could succeed only if it combined cooperation
among nations with individual discretion to pursue
domestic social, economic, and financial goals
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1-23
Mini-Case Questions: The Revaluation
of the Chinese Yuan
• Many Chinese critics had urged
China to revalue the yuan by 20% or
more. What would the Chinese
yuan’s value be in US dollars if it had
indeed been devalued by 20%?
• Do you believe that the revaluation of
the Chinese yean was politically or
economically motivated?
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Mini-Case Questions: The Revaluation
of the Chinese Yuan (cont’d)
• If the Chinese yuan were to change by the
maximum allowed per day, 0.3% against the
US dollar, consistently over a 30 or 60 day
period, what extreme values might it reach?
• Chinese multinationals would now be facing
the same exchange rate-related risks borne
by US, Japanese, and European
multinationals. What impact do you believe
this rising risk will have on the strategy and
operations of Chinese companies in the nearfuture?
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