Finance 2
Spread Percent
((Ask -Bid)/Ask ) x 100
FX market participants
-International Banks -Bank Customers -Nonbank dealers -FX brokers -Central banks
Arbitrage Portfolio
-no net investment -no risk
Two tiers of the FX market
1. wholesale or interbank market: majority of FX trading takes place in the interbank market among international banks that are adjusting inventory positions or conducting speculative arbitrage 2. Retail or client market: international banks service their customers who need foreign exchange to conduct international commerce or trade in international financial assets
Benefits and Costs of Forwards
Benefits - fixed future price of currency Costs - transaction costs, opportunity costs
Real exchange Rate
measures the degree of deviation from PPP over a period of time, assuming PPP held at the beginning of the period q = 1: competitiveness of domestic country unaltered q < 1: competitiveness of the domestic country improves q > 1: competitiveness of the domestic country deteriorates
When converting the base currency to the term currency
multiply the amount by the exchange rate
Efficient Market Hypothesis
hypothesis stating that financial markets are information-ally efficient in that the current prices reflect all the relevant and available information
Bid Price
interbank FX traders buy currency for inventory at this price
Ask Price
interbank FX traders sell from inventory at this price
Hedging Business Cash flows
involves a sing future FX transaction hedge with outright forward
Spot Market
involves almost the immediate purchase or sale of foreign exchange
Forward Market
involves contracting today for the future purchase or sale of foreign exchange Can can buy (long position) or sell (short position)
Hedge Financial Cash Flows
involves two FX transactions separated by time, hedge using a spot-forward swap
Consumer Price Index
measures average change in prices over time in a market basket of goods and services purchased either by urban wage earners and clerical workers or all urban consumers
Producer Price Index
measures average changes in prices received by producers of all commodities at all stages of processing produced in the US
Give a full definition of arbitrage.
Arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.
Discuss the implications of the interest rate parity for the exchange rate determination.
Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be written as: S = [(1 + i£)/(1 + i$)]E[St+1|It] The exchange rate is thus determined by the relative interest rates, and the expected future spot rate, conditional on all the available information, It, as of the present time. One thus can say that expectation is self-fulfilling. Since the information set will be continuously updated as news hit the market, the exchange rate will exhibit a highly dynamic, random behavior.
Give a full definition of the market for foreign exchange.
Broadly defined, the foreign exchange (FX) market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts.
Over the past five years, the exchange rate between British pound and U.S. dollar, $/£, has changed from about 1.90 to about 1.45. Would you agree that over this five-year period that British goods have become cheaper for buyers in the United States?
CFA Guideline Answer: The value of the British pound in U.S. dollars has gone up from about 1.90 to about 1.45. Therefore, the dollar has appreciated relative to the British pound, and the dollars needed by Americans to purchase British goods have decreased. Thus, the statement is correct.
Major Objectives of the forex market participants
Convert purchasing power: exchange one currency for another as part of a business transaction Hedge foreign exchange risk: reduce the impact of changing exchange rates on the firm's cash flow Speculate: use superior information and the ability of derivative securities to fix exchange rates to profit from difference between contracted price and your estimation of the future spot rate Arbitrage: profit from a market imperfection by simultaneously buying currency in one market and selling it in another market for a higher price
Forward rate quotation
F_N(j/k) the price of one unit of currency k in terms of currency j for delivery in N months
Discuss the implications of the deviations from the purchasing power parity for countries' competitive positions in the world market.
If exchange rate changes satisfy PPP, competitive positions of countries will remain unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative competitiveness of countries. If a country's currency appreciates (depreciates) by more than is warranted by PPP, that will hurt (strengthen) the country's competitive position in the world market.
Money provides
Medium of exchange - without money we would have to barter with each other A unit of account - we complain about prices but would find it very difficult to function without them A store of value - imagine your wealth was stored as bananas
Notation for spot rate quotations
S(j/k) refers to the price of one unit of currency k in terms of currency j
Explain the purchasing power parity, both the absolute and relative versions. What causes the deviations from the purchasing power parity?
The absolute version of purchasing power parity (PPP): S = P$/P£. The relative version is: e = π$-π£. PPP can be violated if there are barriers to international trade or if people in different countries have different consumption taste. PPP is the law of one price applied to a standard consumption basket.
How are foreign exchange transactions between international banks settled?
The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another, called correspondent bank accounts. The correspondent bank account network allows for the efficient functioning of the foreign exchange market. As an example of how the network of correspondent bank accounts facilities international foreign exchange transactions, consider a U.S. importer desiring to purchase merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his bank and inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the bank will debit the U.S. importer's account for the purchase of the Dutch guilders. The bank will instruct its correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount of guilders and to credit the Dutch exporter's bank account. The importer's bank will then debit its books to offset the debit of U.S. importer's account, reflecting the decrease in its correspondent bank account balance
Explain and derive the international Fisher effect.
The international Fisher effect can be obtained by combining the Fisher effect and the relative version of PPP in its expectation form. Specifically, the Fisher effect holds that E(π$) = i$-ρ$, E(π£) = i£-ρ£. Assuming that the real interest rate is the same between the two countries, i.e., ρ$ = ρ£, and substituting the above results into the PPP, i.e., E(e) = E(π$)-E(π£), we obtain the international Fisher effect: E(e) = i$-i£. The international Fisher effect holds that the expected rate of exchange rate change is equal to the interest rate differential between a pair of countries.
What is the difference between the retail or client market and the wholesale or interbank market for foreign exchange?
The market for foreign exchange can be viewed as a two-tier market. One tier is the wholesale or interbank market and the other tier is the retail or client market. International banks provide the core of the FX market. They stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, corporations or individuals, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Retail transactions account for only about 14 percent of FX trades. The other 86 percent is interbank trades between international banks, or non-bank dealers large enough to transact in the interbank market
Who are the market participants in the foreign exchange market?
The market participants that comprise the FX market can be categorized into five groups: international banks, bank customers, non-bank dealers, FX brokers, and central banks. International banks provide the core of the FX market. Approximately 100 to 200 banks worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Non-bank dealers are large non-bank financial institutions, such as investment banks, mutual funds, pension funds, and hedge funds, whose size and frequency of trades make it cost-effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs.Most interbank trades are speculative or arbitrage transactions where market participants attempt to correctly judge the future direction of price movements in one currency versus another or attempt to profit from temporary price discrepancies in currencies between competing dealers. FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers.Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price of its currency against that of a major trading partner, or a country that it "fixes" or "pegs" its currency against. Intervention is the process of using foreign currency reserves to buy one's own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively, selling one's own currency for foreign currency in order to increase its supply and lower its price.
A CAD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the market is trading at CAD1.3436-CAD1.3441. What is implied about the trader's beliefs by his prices?
The trader must think the Canadian dollar is going to appreciate against the U.S. dollar and therefore he is trying to increase his inventory of Canadian dollars by discouraging purchases of U.S. dollars by standing willing to buy $ at only CAD1.3435/$1.00 and offering to sell from inventory at the slightly lower than market price of CAD1.3440/$1.00.
Why does most interbank currency trading worldwide involve the U.S. dollar?
Trading in currencies worldwide is against a common currency that has international appeal. That currency has been the U.S. dollar since the end of World War II. However, the euro and Japanese yen have started to be used much more as international currencies in recent years. More importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a market against all other currencies.
What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?
Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate.Most, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit is possible.
European Terms
US dollar is priced in terms of the foreign currency (indirect quote) Example: pounds per dollar
Inflation
a decrease in the purchasing power of a currency over a given time period
Random Walk Hypothesis
a hypothesis stating that in an efficient market asset prices change randomly or follow a random walk, thus the expected future exchange rate is equivalent to the current exchange rate
Money
a means of facilitating economic activity two types: specie - intrinsic value fiat - no intrinsic value by created by government decree
Technical Analysis
a method of predicting the future behavior of asset prices based on their historical patterns
Covered Interest Arbitrage
a situation that occurs when IRP does not hold, thereby allowing certain arbitrage profits to be made without the arbitrageur investing any money out of pocket or bearing any risk
Purchasing Power Parity
a theory stating that the exchange rate between currencies of 2 countries should be equal to the ratio of the countries' price levels of a commodity basket
International Fisher Effect
a theory stating that the expected change in the spot exchange rate between two countries is the difference in the interest rates between the 2 countries
Correspondent Banking Relationships
allows for efficient functioning of the FX market, large commercial banks maintain demand deposit accounts with one another
Forward Swap
an agreement to both buy and sell foreign exchange at specified contracted exchange rates where the buying and selling are separated in time
Interest Rate Parity
an arbitrage condition that must hold when international financial markets are in equilibrium
Settlement
an arrangement by which banks handle transactions among themselves
Cross-Exchange Rate
an exchange rate between a currency pair where neither currency is the US dollar
Fisher Effect
an increase (decrease) in expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country
Deflation
an increase in the purchasing power of a currency over a given time period; can discourage economic activity
Outright forward transaction
an uncovered speculative position in a currency even though it might be part of a currency hedge to the bank customer on the other side of the transaction
Depreciate
become less valuable
Appreciate
become more valuable
Forward short position
believe that spot rate will decrease in x months
Forward Long Position
believe that spot rate will increase in x months
Short Position
buy something but don't pay for x months
Currency Carry Trade
buying a high-yielding currency and funding it with a low-yielding currency without any hedging
Nontradables
commodities that never enter into international trade (haircuts, housing, etc.)
When converting the terms currency to the base currency
divide the amount by the exchange rate
Broker
doesn't own the asset traded but rather assists the owner in the asset's sale
Systematic Factors
economic, political and cultural events that affect all companies in an economy Examples: commodity prices interest rates exchange rates
What are some major sources of cash flow volatility for a firm
economic, political and cultural events that affect individual companies Examples: regulatory changes changes in tastes technological innovation competition
Foreign Exchange Market
encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currencies and trading in foreign currency, spot, forward, futures, swap and options contracts
Asset Inflation
financial assets housing gold other risky assets
Clearing System
for a clearing process to be effective it must be: efficient - handle a large number of transactions with lowest possible costs safe - minimize the risks to individual institutions and the overall system
Dealer
owns the asset traded and is a principal in the transaction
Default risk
payment is defaulted
Liquidity Risk
payment is delayed
Spot Rate
price at which foreign exchange can be sold or purchased for immediate delivery
American Terms
price currencies in terms of the US dollar (direct quote) Example: dollars per pound
Systemic risk
problems with one bank's default places the entire settlement system at risk
Swap Transaction
provides a means for the bank to mitigate the currency exposure in a forward trade -the simultaneous sale (purchase) of spot foreign exchange against a forward purchase (sale) of approximately equal amount of the foreign currency
Long Position
sold something but will not receive the money for x months
Forward Premium/Discount
the amount over (under) the spot exchange rate for a forward rate that is often expressed as an annualized percent deviation from the spot rate
Absolute PPP
the exchange rate is a ratio of the amount of currencies necessary to purchase a defined basket of goods and services
Exchange-Traded Fund
the portfolios of securities that are traded on the stock exchanges like individual securities
Terms currency
the price of the asset being traded
Triangular Arbitrage
the process of trading out of the US dollar into a secondary currency then trading it for a third currency which is in turn trade for US dollars
Law of One Price
the requirement that similar commodities or securities should b trading at the same or similar prices
Wealth
the value of assets owned by a person or a community
Forward Expectation Theory
theory stating that the forward premium or discount is equal to the expected change in the exchange rate between 2 currencies
Uncovered Interest Rate Parity
this parity condition holds that the difference in interest rates between 2 countries is equal to the exchange rate between the countries' currencies
Risk
time trans-curs between the moment when a decision is made and the results of that decision are recognized
Over the Counter (OTC) Market
trading market in which there is no central marketplace; instead buyers and sellers are linked via a network of telephones, telex machines, computers and automated dealing systems
Fundamental Approach
uses various formal models of exchange rate determination for forecasting purposes