International Finance 2024-2025 Course Presentation PDF

International Finance 2024-2025  Course objectives Help you to prepare to work in increasingly globalized financial and product markets. Topics: 1. FX Markets, 2. Direct vs Indirect Quotations, Spot vs Forward Quotations 3. Bid-ask Spreads, 4. Demand and Supply Model 5....

International Finance 2024-2025  Course objectives Help you to prepare to work in increasingly globalized financial and product markets. Topics: 1. FX Markets, 2. Direct vs Indirect Quotations, Spot vs Forward Quotations 3. Bid-ask Spreads, 4. Demand and Supply Model 5. International Monetary Arrangements, 6. Balance of Payments 7. FX Forward Contracts 8. Currency Options. 9. Interest Rate Parity 10. Purchasing Power Parity  Reference textbook International Financial Management 8th edition Authors: Eun C., Resnick B. & Tuugi Chuluun, Publisher: McGraw-Hill Available at IESEG’s library  Course organization Syllabus available from IESEG-online Course Progression: Day 1-3: basic exchange rate markets. Day 4-6: on exchange rate risk hedging. Day 7-8: on long-term exchange rate determinants. Day 9: Presentations.  Assessment and Group presentation Final unseen exam (35%) Three in-class quizzes (45%) 45 minutes each quiz Tentatively scheduled on class 3, class 6, and class 9 Group presentation (20%) Work in groups of 3 (or 4 max) Presentation Format: 20-30 min. in-class presentation on topics provided on MyCourses; Presentation dates: Starting from session 2. Topics must be selected by the end of the second session (see MyCourses).  Lecturers Hamid Babaei/ CENGIZ, Umur/ VUONG, Hung-Cuong  DAY ONE/TWO/THREE Topics: FX markets; Quotations; BoP Foreign exchange in the news  Why do firms expand internationally? A multinational corporation (MNC) is a company engaged in producing and selling goods or services in more than one country. There are about 75,000 MNCs in the world. MNCs invest in foreign countries for several reasons: The size and growth potential of the market. The fear of future protectionism (Japanese firms investing in the U.S. is a good example). The desire to compete with and learn from rivals on their home ground. Lower relative production costs in some countries. Foreign firms may also seek access to new technology to improve their global competitiveness. As a way to hedge currency risk.  Why Engage in International Transactions? The opportunity to internationally move people, money and material can add value to firms that operate internationally (MNCs) and investors of financial securities because: - Can access multiple capital sources, thus lowering cost of capital for MNCs - Can choose among different countries, thus reducing taxable income - Can diversify portfolios of securities internationally - Can diversify internationally sourcing, production and selling of products As a result, MNCs and international investors could reap higher returns and less risky earnings than their domestic counterparts https://en.wikipedia.org/wiki/List_of_circulating_currencies MNCs  What Types of Risks are Involved? The decision to go international brings following risks: - Exposure to foreign exchange fluctuations (very difficult to predict) - Exposure to political and macroeconomic risks of different countries To protect against such risks, MNCs and investors may participate in option, forward and/or futures markets  Valuation of domestic firms The value of a firm is equal to net present value of stream of expected future cash flows There are three basic elements for measuring value of a firm: - The future streams of cash flows - The required rate of return by the investors - The time period at which each cash flow is expected Valuation of domestic firms 𝒏 𝑬(𝑪𝑭$,𝒕 ) 𝑽𝒂𝒍𝒖𝒆 = ෍ (𝟏 + 𝒌)𝒕 𝒕=𝟏 𝑬(𝑪𝑭$,𝒕 ) = expected future cash flows to be received at the end of period 𝑡 𝑛 = number of periods into the future in which cash flows are received 𝑘= required rate of return by investors (or cost of equity capital)  Valuation of MNCs A MNC’s financial decisions include: - how much financing to obtain in each currency - how much investment to direct in each currency - how much business to conduct in each country Such decisions determine MNC exposure to international environment, since its cash flows determined by exchange rate parities Eg Nissan’s financial decisions include - raise funds (by taking loans or issuing new shares/bonds) in ¥, $, € and £ - use proceeds denominated in different currencies to build plants in UK/EU/US/JP - target specific markets (say EU) so that large share of revenues denominated in € (yet shareholders expect dividends paid in ¥)  Valuation of MNCs 𝒏 σ𝒎 𝒋=𝟏[𝑬(𝑪𝑭𝒋,𝒕 ) × 𝑬(𝑬𝑹𝒋,𝒕 )] 𝑽𝒂𝒍𝒖𝒆 = ෍ (𝟏 + 𝒌)𝒕 𝒕=𝟏 𝑬(𝑪𝑭𝒋,𝒕 ) = expected cash flows denominated in currency 𝑗 to be received by parent firm at the end of period 𝑡 𝑬(𝑬𝑹𝒋,𝒕 ) = expected exchange rate at which currency 𝑗 can be converted into domestic currency at the end of period 𝑡 𝑘 = the weighted average cost of capital of parent company  Valuation of MNCs Exposure to Exchange Rate Risk foreign economies 𝒏 σ𝒎 𝒋=𝟏[𝑬(𝑪𝑭𝒋,𝒕 ) × 𝑬(𝑬𝑹𝒋,𝒕 )] 𝑽𝒂𝒍𝒖𝒆 = ෍ (𝟏 + 𝒌)𝒕 𝒕=𝟏 MNCs face exchange rate risk - ie the risk that foreign currency profits may evaporate in domestic currency terms (eg ¥ for Nissan) due to unfavorable exchange rate fluctuations. International Environmental Laws, Regulations, and Standards Affecting Multinational Firms Kyoto Protocol: Aimed at reducing greenhouse gas emissions. Impacts firms by mandating emission reductions and promoting carbon trading. Paris Agreement: Focuses on limiting global temperature rise. Requires firms to set and report on emissions targets. Basel Convention: Controls the transboundary movements of hazardous wastes and their disposal. Affects firms involved in waste production and disposal.  Paris agreement Paris Agreement Goals: Limit global temperature rise to 1.5°C. Encourage countries to implement policies that reduce greenhouse gas emissions. Binding Nature: Unlike the Kyoto Protocol, which imposed binding emission reduction targets only on developed countries, the Paris Agreement is non-binding in terms of enforcement but requires all signatories (developed and developing) to submit Nationally Determined Contributions (NDCs). While the commitments under NDCs are not legally binding, the reporting and transparency framework is. Countries must regularly report progress and enhance their targets every 5 years. Differences with Kyoto Protocol: Kyoto Protocol: Focused exclusively on developed countries with binding targets, based on the principle of "common but differentiated responsibilities." Paris Agreement: Includes all countries, recognizing that climate action requires global participation.  Paris agreement and multinational firms Carbon Pricing Mechanisms: Countries may implement carbon pricing systems, such as carbon taxes or cap-and-trade programs, to meet their commitments. Multinational firms must factor these costs into their operations, potentially leading to higher operational expenses and the need for investments in emissions reduction technologies. Energy Efficiency and Renewable Energy: To align with the Paris Agreement, firms are incentivized or required to increase energy efficiency and transition to renewable energy sources. This could involve significant capital expenditure on upgrading facilities, altering manufacturing processes, or investing in renewable energy projects. Sustainable Supply Chains: Firms are pressured to ensure that their supply chains are sustainable and comply with the environmental standards set by various countries. This might mean re-evaluating suppliers, adopting greener logistics practices, and reducing the overall carbon footprint of their operations.  Paris agreement Transferring Emission Reductions: The Paris Agreement allows countries to trade carbon credits through Internationally Transferred Mitigation Outcomes. If Country A reduces emissions beyond its NDC target, it can sell the excess reductions to Country B, enabling both to meet their commitments. This creates a global carbon market, encouraging investments in emission reduction projects worldwide. Influence on Tax Policies: Introduction of carbon pricing mechanisms, including taxes and cap-and-trade systems. Development of carbon credit markets to encourage investments in renewable energy. France introduced a carbon tax on fossil fuels (€44.60/ton CO₂ in 2023). Similar policies are being adopted globally.  Impact on Multinational Firms Compliance Costs: Firms must invest in technology and processes to comply with varying international laws. Operational Changes: Companies may need to alter their supply chains and production processes. Risk Management: Ensuring compliance minimizes legal risks and enhances corporate reputation. Market Opportunities: Sustainable practices can lead to new market opportunities and customer loyalty. Aperam's Approach to Sustainability Across Different Regions Europe Project Example: Green Steel Production Initiative: Develop steel production processes that significantly reduce CO2 emissions. Impact: Achieve carbon neutrality goals and meet stringent EU environmental regulations. South America Project Example: Biodiversity Conservation in Brazil Initiative: Implement projects to protect local biodiversity near production sites. Impact: Preserve ecosystems and enhance environmental sustainability in the region.  Aperam's Approach to Sustainability Across Different Regions Outcomes and Impact Environmental Performance: Significant reductions in energy consumption, emissions, and water usage. Circular Economy: Increased use of recycled materials, promoting a circular economy in the steel industry. Community Benefits: Improved quality of life in local communities through social responsibility initiatives. Innovative Products: Development of sustainable steel products that meet global market demands.  For financial investors Also investors face exchange rate risk – i.e. the risk that foreign currency profits may evaporate once expressed in domestic currency due to unfavorable exchange rate movements Example: Suppose $1 = ¥100 and you buy 10 shares of Toyota for ¥100,000 (i.e. $100 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = ¥10,000 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒). One year later the investment in shares has appreciated by 10% at ¥110,000 - as long as exchange rate $ / ¥ remains constant, your investment in 𝑈𝑆$ is now valued $1,100 (= 110,000/100). - but, if the ¥ has depreciated to $1 = ¥120 then your initial investment of $1,000 is now~valued $916.67 (= 110,000/120).  Forecasting exchange rates To mitigate the effect of exchange rate risk MNCs and investors must be able to predict future fluctuation in exchange rates - but exchange rate forecasting notoriously difficult - more on this to follow when we cover BoP and PPP International Monetary System  International Monetary System Bimetallism: Before 1875 Classical Gold Standard: 1875–1914 Interwar Period: 1915–1944 Bretton Woods System: 1945–1972 The Flexible Exchange Rate Regime: 1973–Present  International Monetary System Bretton Woods System: 1945–1972 Monthly USD/JPY Exchange Rate  European Monetary System To establish a “zone of monetary stability” in Europe. To coordinate exchange rate policies vis-à-vis the non-EMS currencies. To pave the way for the eventual European monetary union. Daily USD/EUR Exchange Rate Daily CHF/EUR Exchange Rate Foreign Exchange (FOREX) Markets  Learning Objectives Understanding of function and structure of the FOREX Market Understand how to read market quotations Derive cross-rate quotations Analyze FOREX forward market Define concept of forward premium - Material for this lecture: Eun and Resnick, chapter 5  Function and Structure of FOREX Market Foreign exchange (FOREX) markets make it possible conversion of purchasing 26 power from one currency into another, trading of foreign exchange options, forward and futures contracts and currency swaps FOREX markets are over-the-counter (OTC) markets - trading does not take place in a centralised marketplace (ie an exchange) -rather the FOREX market is a worldwide network of bank currency traders, non- bank dealers and FX brokers connected one to another via electronic dealing systems Trading activities consist of speculative/arbitrage/hedging transactions - attempts to correctly judge future price movements in one currency versus another - attempts to profit from temporary price discrepancies among currencies - attempts to isolate from exchange rate risk  FOREX Market FOREX market largest financial market in the world - open 365 days a year, 24/7 - exchange rates constantly change, take a look! Main hubs of FOREX transactions are UK and US  Structure of FOREX Market Shares of Reported Global Foreign Exchange Turnover by Country, 2023  Structure of FOREX Market FOREX made of commercial banks and foreign exchange brokers - they trade in most of currencies - they are connected continuously via e-platforms Participants in FOREX are -individual and institutional investors, firms and MNCs: place buy/sell orders of foreign currencies with commercial banks and/or brokers Structure of FOREX Market Individuals MNCs Speculators Institutional Investors Central Banks Individuals MNCs Speculators Institutional Investors 29  Structure of FOREX Market 30 FOREX made of commercial banks and foreign exchange brokers - they trade in most of currencies - they are connected continuously via e-platforms Participants in FOREX are - individual and institutional investors, firms and MNCs: place buy/sell orders with commercial banks and/or brokers -commercial banks: carry out buy/sell orders on behalf of their clients by dealing either directly with other banks (about 200 banks) or with brokers -brokers: can often provide better quotation as they collect buy/sell orders from many banks and for multiple currencies Structure of FOREX Market Individuals MNCs Speculators Institutional Investors Broker Local Bank Central Banks Broker Local Bank Individuals MNCs Speculators Institutional Investors 31 Structure of FOREX Market Individuals MNCs Speculators Institutional Investors Broker Local Bank Central Banks Derivative Major Banks Markets International Interbank Market Broker Local Bank Individuals MNCs Speculators Institutional Investors 32  Structure of FOREX Market FOREX made of commercial banks and foreign exchange brokers - they trade in most of currencies - they are connected continuously via e-platforms Participants in FOREX are -individual and institutional investors, firms, MNCs and international investors: place buy/sell orders with commercial banks - commercial banks: carry out buy/sell orders from their clients by dealing either directly with other banks (about 200 banks) or with brokers -brokers: can often provide better quotation as they collect buy/sell orders from many bank and for multiple currencies -central banks: might intervene in FOREX by buying/selling national currency in order to influence demand and supply and eventually market quotations Structure of FOREX Market Individuals MNCs Speculators Institutional Investors Broker Local Bank Central Banks Derivative Major Banks Markets International Interbank Market Broker Local Bank Individuals MNCs Speculators Institutional Investors 34 Structure of FOREX Market OTC foreign exchange turnover Net-net basis,1 daily a ve r a g e s in April, in billions of U S dollars Ta b l e 1 Instrument 2001 2004 2007 2010 2013 2016 Foreign exchange instruments 1,239 1,934 3,324 3,973 5,357 5,067 Spot transactions 386 631 1,005 1,489 2,047 1,652 Outright forwards 130 209 362 475 679 700 Foreign exchange swaps 656 954 1,714 1,759 2,240 2,378 Currency swaps 7 21 31 43 54 82 Options and other products² 60 119 212 207 337 254 Memo: 3 Turnover at April 2 0 1 6 exchange rates 1,381 1,884 3,123 3,667 4,917 5,067 4 Exchange-traded derivatives 12 25 77 145 145 115 1 A d j u s t e d for local a n d c ros s - bo rd e r inter-dealer d o u b l e - c o u n t i n g (ie “ net-net” basis). 2 T h e category “ other F X p ro d u c t s ” covers h i g h l y l e v e r a g e d t r a n s a c t i o n s a n d /o r t r a d e s w h o s e n o t i o n a l a m o u n t i s v a r i a b l e a n d w h e r e a d e c o m p o s i t i o n i n t o i n d i v i d u a l p l a i n v a n i l l a c o m p o n e n t s w a s i m p r a c t i c a l or i m p o s s i b l e. 3 N o n - U S d ol l a r l e g s of f o r e i g n c u r r e n c y t r a n s a c t i o n s w e r e c o n v e r t e d i n t o o r i g i n a l c u r r e n c y a m o u n t s at a v e r a g e e x c h a n g e rates f o r A p r i l of e a c h s u r v e y y e a r a n d t h e n r e c o n v e r t e d i n t o U S d o l l a r a m o u n t s at a v e r a g e A p r i l 2016 e x c h a n g e rates. 4 So u rc e s : E u r o m o n e y T radedata; F u t u r e s In d us t ry Association ; T h e O p t i o n s Clearin g Co rp oration; B I S derivatives statistics. F o re ig n e x c h a n g e f u t u r e s a n d o p t i o n s traded wo rl d wi d e. Source: http://www.bis.org/publ/rpfx13.htm 35 FX markets across the globe FX markets across the globe and Trade Activity FX markets by currency  FOREX Market Spot market: The decentralized market for buying and selling currencies for immediate delivery. Spot transactions involve the current exchange rate, typically settled within two business days. Outright Forward: A binding contract to exchange a specific amount of currency at a predetermined rate on a future date. This is used to hedge against future exchange rate fluctuations. Currency Swaps: Agreements to exchange principal and interest payments in different currencies. They help manage long-term exposure to currency and interest rate risks. FX Swaps: A simultaneous purchase and sale of identical amounts of one currency for another, with different settlement dates. FX swaps are used for short-term hedging and liquidity management. Currency options: Contracts that provide the right, but not the obligation, to buy or sell a currency at a specified rate before a certain date. These are used to hedge against potential adverse movements in exchange rates. FX markets by instrument The Spot Market Spot rate quotations can be direct or indirect Direct: how many dollars do I need to buy one unit of foreign currency? e.g., “British Pounds is worth about 2 US dollars” Indirect: how many unit of foreign currency do I need to buy one dollar? e.g., “one US dollar is worth about 0.5 British Pound” Notation: - 𝑆(𝑗/𝑘) is the price of one unit of currency k in terms of j - For instance 𝑆(£/$) = 0.5 (indirect) and 𝑆($/£) = 2 (direct) Spot Rate Quotations The direct quote for British pound is £1 = $1.5627 Direct: how many dollars do I need to buy one unit of foreign currency? Spot Rate Quotations The indirect quote for British pound is: £.6399 = $1 Indirect: how many units of GBP do I need to buy one dollar? Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote as 1 1.5627 = 0.6399  How market makers buy/sell FX? Role of Market Makers: Market makers, such as banks or brokers, actively buy and sell foreign exchange (FX) to provide liquidity in the market. By doing so, they generate profits from the spread between buying and selling prices. Buying and Selling Process: Market makers buy FX at a price lower than the price they sell it for. For example, a broker may be willing to buy British pounds (£) at $1.9072, but sell them at $1.9077 or higher. Profit from the Spread: The profit comes from the difference between the buying price ($1.9072) and the selling price ($1.9077). This difference is known as the spread, which represents the earnings of the market maker.  Parallel with market makers of cars Role of Car Dealers Car dealers act as market makers for second-hand cars. They buy and sell vehicles, generating profit from the difference between buying and selling prices. Buying and Selling Process Dealers purchase cars at a lower price and sell at a higher price. For example, a car dealer may buy a second-hand Renault Clio for €9,000 and sell it for €10,000. Profit from the Spread The profit is made from the difference between the buying price (€9,000) and the selling price (€10,000). This difference is the spread. Impact of Market Power on the Spread The spread is influenced by the number of dealers in the market: More car dealers lead to a smaller spread due to increased competition. Fewer car dealers result in a larger spread due to less competition. DAY TWO/THREE Bid-ask spread  The FX Bid-Ask Spread Bid price refers to the highest price a market maker (e.g., a bank/broker) pays at any given time to purchase something Ask price refers to the lowest price at which a market maker sells something - the ask price (also known as the "offer/selling" price) will almost always be higher than the bid price (“purchasing price”) -for instance, a broker who wants to buy £ is willing to buy at $1.9072 (bid price) or less while she wants to sell £ at $1.9077 or more (ask price) S B ($ / £) = 1.9072 S A ($ / £) =1.9077 Market makers (banks/brokers) make profits out of difference between ask and bid prices - such difference is called bid-ask spread - bid-ask (percentage) spread defined as [𝑆𝐴($/£) - 𝑆𝐵($/£)]/𝑆𝐴($/£) The FX Bid-Ask Spread Bid Price: The price at which a dealer is willing to buy £ for $. Example: The dealer buys £ for $ at the Bid, client sell £ for $. Ask Price: The price at which a dealer is willing to sell £ for $. Example: The dealer sells £ for $ at the Ask, client buys £ for $. Calculating the Bid-Ask Spread The bid-ask spread represents the difference between the ask and bid prices, expressed as a percentage of the ask price: 𝐴𝑠𝑘 − 𝐵𝑖𝑑 1.4484 − 1.4482 %𝑠𝑝𝑟𝑒𝑎𝑑 $ /£ = = = 0.01381% 𝐴𝑠𝑘 1.4484 Bid Ask $/£ 1.4482 1.4484 ¥/$ 111.490 111.530  The FX Bid-Ask Spread Example Suppose a spot exchange rate quote of Bid: £0.865/ € (that is 1 € = £ 0.865 or £1 = € 1/0.865 = € 1.156 ) Broker/Bank always buys at this “low” rate Ask: £0.889/ € (that is 1 € = £ 0.889 or £1 = € 1/0.889 = € 1.125 ) Broker/Bank always sells at this “high” rate If you wish to purchase 1,000 £, how many € would you require? You must pay the broker/bank “Ask” rate. Thus, you need to have: 1000 x 1.125 = € 1 125 If you decide to sell 1,000 £, how many € would you receive? You must pay the broker/bank “Bid” rate. Thus, you will receive: 1000 x 1.156 = € 1 156  The FX Bid-Ask Spread https://fr.investing.com/currencies/live-currency-cross-rates From now on we ignore the bid-ask spread and assume that FX quotation are an average between the two - e.g., if bid price is $1.9072 and ask price is $1.9077 we make simplifying assumption that FX quotation is (1.9077+1.9072)/2 = 1.90745  Exercise Assume that a bank's bid rate on Swiss francs is £0.25 and its ask rate is £0.26. Its bid-ask percentage spread is: a. 4.00%. b. 4.26%. c. about 3.85%. d. Both a. and c. are correct  Exercise Consider the USD/GBP whose bid price is 1,2110 and ask price is 1,2112. Which of the following answers is correct: a. The spread is 0.0002 b. The percentage spread is 0.0165% c. The relative spread is 0.000165 d. All of the above are correct  Exercise FOREX made of a. A small network of commercial banks and foreign exchange brokers that trade in most of currencies and they are connected continuously via e-platforms. b. A large network of retail investors in foreign currencies that buy and sell depending on the market’s quotation. c. Uniquely by central banks that buy and sell foreign currencies at a fixed price determined by the national government. d. None of the above is correct.  Exercise Which one of the following statement is correct: a. MNCs face exchange rate risk - ie the risk that foreign currency profits may evaporate in domestic currency terms due to unfavorable exchange rate fluctuations. b. MNCs are isolated from exchange rate risk as they do not undertake any international transaction. c. An EU-based car manufacturer that buys aluminum from Canada and sells cars in Europe is not exposed to exchange rate risk d. None of the above is correct  Exercise The European markets for foreign currencies are: a. London and Frankfurt b. Paris and Madrid c. Amsterdam and Milan d. Geneva and Berlin  Exercise Spot rate quotations can be direct or indirect a. Direct specifies how many dollars are needed to buy one unit of foreign currency b. Indirect specifies how many unit of foreign currency are needed to buy one dollar c. S($/£)=2 is an example of direct quotation d. All the above are correct Cross Exchange Rates Cross Exchange Rates Quotations Cross-rate is an exchange rate between a currency pair where neither currency is the US $ - computed by making use of respective exchange rate against US $ Suppose that 𝑆($/€) = 2 and 𝑆(¥/$) = 50 - i.e. €1 = 2 $ and $1 = ¥50 - then I would need ¥100 to buy €1 More formally the ¥ / € cross-rate can be computed as ¥ $ ¥ = × € € $ 2$ 50¥ 100¥ × = ⇒ €1 = ¥100 ⇒ 𝑆 ¥/€ = 100 1€ 1$ 1€  Exercise Suppose you observe the following exchange rates: €1 = $1.25; £1 = $2.00. What must the euro-pound exchange rate be? a. €1 = £1.60 b. €1 = £0.625 c. €2.50 = £1 d. €1 = £2.50  Exercise Assume the Canadian dollar is equal to £0.50 and the Euro is equal to £1.2. The value of the Euro in Canadian dollars is: a. about 1.3231 Canadian dollars. b. about 2.4 Canadian dollars. c. about 2.136 Canadian dollars. d. about 1.7951 Canadian dollars. Exercises: Triangular Arbitrage Assume you have $1 000 000 to trade. The exchange rates between Swiss Franc, the US dollars and Japanese Yen are summarized below: Credit Suisse: $1.0018/SFr JPMorgan: ¥111.49/$ Mizunho: ¥112.20/SFr Is there an opportunity to earn arbitrage profit? How? 69 Spot Exchange Rates (The Demand/Supply Model)  Demand/Supply Model Since adoption of floating exchange rate regime in 1973 the topic of modelling exchange rate fluctuations has become very important - prior 1973 countries adopted fixed exchange rates under Bretton Woods Agreement  Demand/Supply Model Demand/Supply model posits that exchange rate (ie the price) of currencies can be analyzed like any other good by using demand and supply  Demand/Supply Model S(€ /$) Consider US as home country and exchange rate expressed as S(€/$). €1.4/$1 If US $ appreciates against € (e.g. from 1.2 €/$ to 1.4 €/$) price of US goods for EU importers increases leading to reduced demand for US $ by EU importers (and lower volume of US exports) €1.2/$1 Thus demand for US $ depends upon demand for US goods by EU importers €1/$1 Hence demand of US dollar is downward sloping D1 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model S1 Consider US as home country and exchange S(€ /$) rate S(€/$) €1.4/$1 US citizens/firms need to make payments in € for EU goods imported into US €1.2/$1 US citizens/firms offer US $ in exchange of € so that supply of US $ is equivalent to US €1/$1 demand for € 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model S1 Spot rate S(€/$) determined by interaction of S(€ /$) demand and supply of US $ Demand and supply of US $ changes over time and so does spot rate S(€/$) €1.2/$1 D1 0 10,000 Quantity of $  Demand/Supply Model S1 S(€ /$) €1.5/$1 Question: What happen if exchange rate in the market is €1.5/$1 ? €1.2/$1 Exchange rates change continuously! Have a look: http://www.fxstreet.com/rates-charts/forex-rates/ D1 0 10,000 Quantity of $  Demand/Supply Model Consider US as home country and exchange S(€ /$) rate expressed as S(€/$) €1.4/$1 Any factor that increases/decreases demand for US exports (eg rise/fall EU income, fall/rise in price of US goods) results in shift €1.2/$1 rightward/leftward of demand €1/$1 D1 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model Consider US as home country and exchange S(€ /$) rate expressed as S(€/$) €1.4/$1 Any factor that increases/decreases demand for US exports (eg rise/fall EU income, fall/rise in price of US goods) results in shift €1.2/$1 rightward/leftward of demand. Eg rise in EU income increases export of US goods to EU €1/$1 countries and it shifts demand for US $ rightward from D1 to D2 D1 D2 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model S1 Consider US as home country and exchange S(€ /$) rate S(€/$). €1.4/$1 As US $ appreciates against € (ie s(€/$)↑) the cost of EU goods becomes cheaper for US €1.2/$1 residents and US demand for EU goods increases. €1/$1 Stronger US demand for EU goods leads to increased demand for € in exchange of $ This yields upward supply curve for supply of US $ 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model S1 Consider US as home country and exchange S(€ /$) rate S(€/$) €1.4/$1 Any factor that increases/decreases demand for EU exports (eg rise/fall US income, €1.2/$1 rise/fall in price of US goods) results in shift rightward/leftward of supply curve S €1/$1 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model S1 S2 Consider US as home country and exchange S(€ /$) rate S(€/$) €1.4/$1 Any factor that increases/decreases demand for EU exports (eg rise/fall US income, €1.2/$1 rise/fall in price of US goods) results in shift rightward/leftward of supply curve S €1/$1 Eg rise in US income increases demand for EU goods and demand for € shifting supply of $ rightward from S1 to S2 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model S1 S(€ /$) €1.2/$1 D1 D2 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model S1 S2 S(€ /$) €1.2/$1 D1 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model S1 S2 S(€ /$) €1.2/$1 D1 D2 0 8,000 10,000 14,000 Quantity of $  Demand/Supply Model S1 S2 S(€ /$) €1.4/$1 €1.2/$1 €1/$1 D1 D2 0 8,000 10,000 14,000 Quantity of $  Exercises The equilibrium exchange rate of pounds is $1.70. At an exchange rate of $1.72 per pound: a) U.S. demand for pounds would be less than the supply of pounds for sale and there would be a shortage of pounds in the foreign exchange market. b) U.S. demand for pounds would exceed the supply of pounds for sale and there would be a surplus of pounds in the foreign exchange market. c) U.S. demand for pounds would be less than the supply of pounds for sale and there would be a surplus of pounds in the foreign exchange market d) U.S. demand for pounds would be equal to the supply of pounds for sale and there would be a shortage of pounds in the foreign exchange market  Exercises Any event that reduces the euro area demand for Japanese yen should result in an in the value of the Japanese yen with respect to , other things being equal. a. increase; euro b. increase; noneuro currencies c. decrease; noneuro currencies d. decrease; euro FX determination in the short-run: The Balance of Payments  Learning Objectives: - Structure of Balance of Payments (BoP) - The Current Account - The Capital Account - Statistical Discrepancy - Official Reserves Account - The BoP Identity - BoP trends in major countries - Material can be found in Eun and Resnick, chapter 3  US BoP data Consider following BoP for US which have adopted a flexible exchange rate Credits Debits Current Account 1 Exports $1,418.64 2 Imports ($1,809.18) 3 Unilateral Transfers $10.24 ($64.39) Balance Current Account ($444.69) Capital Account 4 Direct Investment $287.68 ($152.44) 5 Portfolio Investment $474.39 ($124.94) 6 Other Investments $262.64 ($303.27) Balance Capital Account $444.26 7 Statistical Discrepancies 0.13 Overall Balance ($0.30)  Balance of Payments The Balance of Payments (BoP) is the statistical record of a country’s international transactions over a certain period - it is presented in the form of double-entry bookkeeping Example: If a business takes out a bank loan for $10,000, recording the transaction would require: a debit of $10,000 to an asset account called "Cash” a credit of $10,000 to a liability account called "Loan Payable". The basic entry to record this transaction in a general ledger will be: Credit Debit Notes Payable $10,000 Cash $10,000  Balance of Payments When we say “a country’s BoP” we refer to transactions of its citizens, firms and government From now on assume US is home country BoP important because provides detailed information concerning demand and supply of a country’s currency - if US import more than what they export then supply of US dollars (by US residents) likely to exceed demand of dollars (by non-US residents) - if US import less than what they export then demand of US dollars likely to exceed supply of dollars  Balance of Payments Credit entries are US exports of goods, services and financial claims - foreigners require dollars to pay US providers of goods, services and financial claims - they originate demand for US $ Debit entries arise from US imports of goods, services and financial claims -US citizens/firms need foreign currencies (eg € in exchange of US $) to pay providers of EU goods, services and financial claims - they originate supply of US $ Notice that not only international trade of goods/services but also cross-border investments are recorded in BoP - portfolio investments: mainly stocks and bonds (speculative purposes) - foreign direct investments (FDI): when investors acquire control of foreign businesses  BoP Entries: Example Suppose that Maplewood Bicycles in US imports $100,000 worth of bicycle frames from Mercian Bicycles in UK This is a debit entry for US BoP (and credit entry for UK BoP) This will lead to a rise in supply of US $ and demand for British pounds - Maplewood has to pay Mercian in GBP - so they will sell US $ on FX market in exchange of GBP  Balance of Payments Accounts The BoP accounts record all transactions between the residents of a country and residents of all foreign nations They are composed of the following: - Current Account (BCA): exports, imports of goods/services - Capital Account (BKA): purchasing/sales of financial & real assets - Statistical Discrepancy: residual term due to omitted and/or mis-recorded transactions - Official Reserves Account: purchases/sales of international reserve assets (US dollars, foreign currencies, gold) by government.  Current Account (BCA) Record of import/export of goods/services BCA = Exports – imports ± unilateral transfers Unilateral transfers are foreign aids, reparations, grants and gifts - it is residual term If imports > exports a country is running a trade deficit If exports > imports a country is running a trade surplus If BCA 𝐸 is referred to as trading in-the-money. b. If 𝑆𝑡 = 𝐸 the call option is trading at-the-money. c. If 𝑆𝑡 < 𝐸 the call option is trading out-of-the-money. d. All of the above statements are correct.  Exercises A call option has a premium of $0.1 and the exercise price is $1.2, and the spot exchange rate is $1.35, the value at expiration and the profit to the option holder are closest to: a. Value = -$0.05; Profit = $0.15 b. Value = $0.15; Profit = $0.05 c. Value = $0; Profit = $0.15 d. Value = $0.15; Profit = $0.15  Exercises If a put option has a premium of $3 and the exercise price is $100, and the price of the underlying is $105, the value at expiration and the profit to the option seller are closest to: a. Value = -$3; Profit = $0 b. Value = $0; Profit = $8 c. Value = $0; Profit = $3 d. Value = $3; Profit = $8  DAY SEVEN/EIGHT FX determination in the long-run IRP, PPP  Motivation This part examines several key international parity relationships including interest rate parity and purchasing power parity. This allows us to understand the forces driving exchange rate fluctuations as these changes would impact investment and financing opportunities. Two key definitions: Arbitrage is the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits. Law of one price prevails when the same or equivalent things are trading at the same price across different locations or markets, precluding profitable arbitrage opportunities. Interest rate parity Investment and exchange rate risk: Example Suppose you have $1 to invest over a one-year period Option 1: Invest domestically. How much will you receive after one year? If US interest rate is 𝒊$, you will get $𝟏 𝟏 + 𝒊$ Option 2: You can invest $1 in the UK. How much will you receive? First, you need to convert $1 into £ at the exchange rate S (spot rate, $ per £) 1 You get an amount of £( ) 𝑆 Second, suppose interest rate is 𝑖£ in the UK, you will get the full maturity of 𝟏 £( )(𝟏 + 𝒊 ) 𝑺 £ Third, after one year, you will convert the £ into $ → Exchange risk How to hedge this risk? Answer: use a forward contract. Suppose the forward exchange rate is F ($ per £), you will receive 𝟏 £ 𝑺 𝟏 + 𝒊£ 𝑭  Investment and exchange rate risk: Example We derive a equilibrium Arbitrage formal statement ofthat implies Interet Rate returns Parity: from domestic and foreign investments should be the same. This means that: 𝟏 $𝟏 𝟏 + 𝒊$ = $ 𝟏 + 𝒊£ 𝑭 𝑺 Or, we have: 𝑭 𝟏 + 𝒊$ = 𝟏 + 𝒊£ 𝑺 𝟏 + 𝒊$ 𝑭=𝑺 𝟏 + 𝒊£  Interest Rate Parity (IRP) According to the IRP theory, the currency of the country with a lower interest should be at a forward premium in terms of the currency of the country with the higher rate. In particular, IRP is an arbitrage condition that must hold when international financial markets are in equilibrium. Furthermore, IRP provides the linkage between interest rates in two different countries IRP : Example Suppose that the annual interest rate in the U.S is 5%. The Spot exchange rate $/£ = 1.50 The 180-day forward rate is $/£ = 1.45 The U.S. periodic interest rate (180) is: 0.05 × 180 / 360 = 0.025 If IRP holds: 1 + 𝒊£ = 1.5 (1 + 0.025)/1.45 => 𝒊£ = 6% Thus, the annual UK interest rate is approximately 12%. Similarly, you can calculate forward rate based on the two interest rates and spot rate.  Covered interest arbitrage (CIA) CIA opportunities emerge if IRP does not hold. 𝑭 If 𝟏 + 𝒊$ > 𝟏 + 𝒊£ , you are better off by investing in the US 𝑺 𝑭 If 𝟏 + 𝒊$ < 𝟏 + 𝒊£ , you are better off by investing in the UK 𝑺 Covered interest arbitrage (CIA) Numerical example: Assume 𝒊$ = 𝟓% and 𝒊£ = 𝟖% The spot rate 𝟏. 𝟖 $/£ and the exchange forward is 𝟏. 𝟕𝟖 $/£ Assume you can borrow $1,000,000. What is the arbitrage profit?  Covered interest arbitrage (CIA) 𝒊$ = 𝟓% and 𝒊£ = 𝟖% The spot rate $1.8/£ and the exchange forward is $1.78/£ First, we check that the IRP condition is not holding: 𝟏.𝟕𝟖 𝟏 + 𝟓% = 𝟏. 𝟎𝟓 < ( )(𝟏 + 𝟖%) ≈ 𝟏. 𝟎𝟔𝟖 𝟏.𝟖  Covered interest arbitrage (CIA) Second, profit could be earned by buying what was cheap (borrowing from the US) and selling what was dear (investing in the UK): Borrow 1 million USD from the US bank. At the maturity, repay $1,000,000.(1+0.05)=$1,050,000 Exchange to Pound at spot rate $1.8/£ and get £555,556 Invest in the UK and get £555,556.(1+0.08)=£600,000 at the maturity Sell £600,000 forward at rate $1.78/£, and get $1,068,000 The arbitrage profit is $18,000 (see the cash-flow analysis in the next slide) Covered interest arbitrage (CIA) Transactions 𝑪𝑭𝟎 𝑪𝑭𝟏 1. Borrow $1,000,000 $1,000,000 -$1,050,000 2. Buy £ spot -$1,000,000 £555,556 3. Lend £555,556 -£555,556 £600,000 4. Sell £600,000 forward -£600,000 $1,068,000 Net cash flow 0 $18,000 Covered interest arbitrage (CIA) The arbitrage opportunity only lasts for a short while, because: - Arbitrageurs will borrow $ as much as possible → the interest rate will rise in the US (𝒊$ ↑) - Arbitrageurs will lend £ in the UK → the interest will fall in the UK (𝒊£ ↓) - Arbitrageurs will increase buying £ in the spot market → the £ will appreciate (relatively to $) in the spot market (𝑆 ↑) - Arbitrageurs will increase selling the pound forward → the £ will depreciate (relatively to $) in the forward market (𝐹 ↓)  Exercises Suppose the yield on one-year Swiss Franc government bonds is 4%, and the yield on one-year US Treasury notes is 8%. Furthermore, the Swiss France /USD spot rate was 1.8. a) What should be the value of a one-year forward rate? b) If the Swiss Franc were trading in the one-year forward market at 1.75, what is the arbitrageur’s profit if he can borrow CHF10 million?  Answer Suppose the yield on one-year Swiss Franc government bonds is 4%, and the yield on one-year US Treasury notes is 8%. Furthermore, the Swiss France /USD spot rate was 1.8. a) What should be the value of a one-year forward rate? Applying the IRP: 𝟏 + 𝒊𝑪𝑯𝑭 𝟏 + 𝟎. 𝟎𝟒 𝑭=𝑺 = 𝟏. 𝟖 ≈ 𝟏. 𝟕𝟑𝟑 𝟏 + 𝒊$ 𝟏 + 𝟎. 𝟎𝟖  Answer b) If the Swiss Franc were trading in the one-year forward market at 1.75, what is the arbitrageur’s profit if he can borrow CHF10 million? The arbitrage would work as follows: 1. Borrow CHF10 million today for one year at 4% 2. Convert the borrowed CHF to dollars in the spot market at an exchange rate of CHF1.8/$ 3. Invest the dollars for one year at 8% 4. Buy the CHF forward one year at CHF1.75/$ Answer b) If the Swiss Franc were trading in the one-year forward market at 1.75, what is the arbitrageur’s profit if he can borrow CHF10 million? The arbitrage would work as follows: 1. Borrow CHF10 million today for one year at 4%, or repay CHF 10,400,000 2. Convert the borrowed CHF to dollars in the spot market at an exchange rate of CHF1.8/$. We derive: CHF10 million = $5,555,556 3. Invest the dollars for one year at 8%. After one year, arbitrageur receives $5,555,556×1.08=$6,000,000 which is convertible to CHF10,500,000 through the forward. 4. Buy the CHF forward one year at CHF1.75/$. Thus, the amount of $ needed to repay CHF10,400,000 is 10,400,000/1.75=$5,942,857. 5. The profit is ($6,000,000 - $5,942,857) = $57,143 or CHF10,500,000- CHF10,400,000=CHF100,000 IRP and exchange rate determination Recall the IRP formula 𝟏 + 𝒊$ 𝑭=𝑺 𝟏 + 𝒊£ Or 𝟏 + 𝒊£ 𝑺= 𝑭 𝟏 + 𝒊$ If F and 𝒊£ are fixed, then S is decreasing in 𝒊$ Higher interest rate in the US will lead to lower exchange rate This means we need less $ to buy £ Thus, higher interest rate in the US leads to stronger dollar Uncovered interest rate parity The interest rate differential between a pair of countries is approximately equal to the expected rate of change in the exchange rate Where 𝑬 𝒆 = 𝒊$ − 𝒊£ 𝑬 𝑺𝒕+𝟏 − 𝑺𝒕 𝑬 𝒆 = 𝑺𝒕 𝑬(𝒆) is the expected change in the exchange rate over the (𝑡, 𝑡 + 1) period Example 1 Suppose the annual interest rate in the US is 5% and in the UK is 8%. The uncovered IRP suggests that the £ will depreciate against the $ by 3% 𝑬 𝒆 = 𝒊$ − 𝒊£ = 𝟓% − 𝟖% = 𝟑%  Example 2 Suppose the one year interest rate for Japanese yen is 3% and 5% for U.S. dollars, and the exchange rate is $0.00945 per yen. What is the expected future exchange rate in one year? E(e) = 0.05 - 0.03 = 0.02 This means that the spot rate is expected to increase by 2% ⟹ E(S) = 0.00945 x 1.02 = $0.009639  Exercises Interest-rate parity refers to the concept that, where market imperfections are few, a) the same goods must sell for the same price across countries b) interest rates across countries will eventually be the same c) there is an offsetting relationship between interest rate differentials and differentials in the forward spot exchange market d) there is an offsetting relationship provided by costs and revenues in similar market environments.  Exercises There can be an opportunity for covered interest arbitrage if: a) the interest rate is low and the exchange rate is high b) the forward/spot rate difference is either larger or smaller in percentage terms than the difference in the interest rates on the two currencies c) there is a time lag on the settlement of the transactions d) the interest rate is high and the exchange rate is low  Exercises If the US interest rate is 4% per year and the UK interest rate is 9% per year, which of the following is true: a) The dollar will depreciate 5% in one year b) The pound will appreciate 9% in one year c) The pound will depreciate 5% in one year d) The dollar will appreciate 9% in one year.  Exercises True or False? There are 2 countries in the world, Home and Foreign; Foreign’s interest rate is fixed, and the expected future exchange rate is exogenously fixed. Given these conditions, a rise in the Home interest rate today will lead to a stronger Home currency today (i.e. an appreciation of the Home currency.) The Absolute and Relative PPP  Absolute Purchasing Power Parity Law of one price (LOOP) posits that the price of a certain good (for instance a Ferrari car) must be the same across countries once measured in a common currency. When LOOP is applied internationally to a standard commodity basket we have PPP. Let P$ represent the price in USD of a standard commodity basket in US, P£ the pound price of the same basket in the UK and S($/£) is spot exchange rate (how many USD needed to buy 1£) PPP postulates that price of commodity baskets must be the same in US and UK P$ = S($/£)·P£  PPP and Exchange Rate Determination Assume you know both 𝑃$ and 𝑃£ then can compute the theoretical (PPP- based) exchange rate 𝑃$ 𝑆 $Τ£ = 𝑃£ PPP asserts that the exchange rate between two currencies should equal the ratio of the countries’ price levels For example, if a given basket of goods costs $300 in the US and £150 in the UK then the price of that basket in terms of dollars should be: 𝑃$ $300 𝑆 $Τ£ = = = $2/£ 𝑃£ £150  Exercises The PPP posits that a. The cost of a haircut in the US should be exactly the same as the cost in Hong Kong b. Rates of inflation must be the same everywhere c. Spot exchange rates are the best predictor of expected inflation rates. d. None of the above  Relative PPP When we consider rate of changes of P$, P£ and S($/£) we have the relative version of PPP - where 𝑒 is rate of change of spot exchange rate S($/£), while $ and £ are inflation rates in US and UK 𝝅$ − 𝝅£ 𝒆= ≅ 𝝅$ − 𝝅£ 𝟏 + 𝝅£ Relative PPP states that rate of change in exchange rate must be equal to the differences in inflation rates Example: If the US inflation is 5% and UK inflation is 8% then the pound should depreciate by 3% (more precisely by 2.78%)  PPP attributed to Cassell’s writings in 1920s, but origins date back to GustavRicardo David Cassell 1772-1823 1866-1945 David Ricardo  Exercises Assume that the expected inflation for the next year is 20% for Turkey and 2% for the Euro area. According to the Relative PPP the exchange rate Turkish Lira/Euro is expected to a. Appreciate (i.e. less Turkish Lira will be needed to buy one Euro) b. Appreciate by 18% (i.e. 18% less Turkish Lira will be needed to buy one Euro) c. Depreciate by 18% (i.e. 18% additional Turkish Lira will be needed to buy one Euro) d. None of the above  Exercises Assume the Relative PPP holds. If a country experiences high inflation relative to the UK, its exports to the UK will eventually , its imports will , and there is pressure on its currency's equilibrium value. a. decrease; increase; upward (appreciating) b. decrease; decrease; upward (appreciating) c. increase; decrease; downward (depreciating) d. decrease; increase; downward (depreciating) e. increase; decrease; upward (appreciating) Interpret the table Empirical Tests of PPP Theory (Does the PPP hold?) Actual USD/JPY and (calculated) PPP Exchange Rates Actual USD/GBP and (calculated) PPP Exchange Rates Actual EUR/USD and (calculated) PPP Exchange Rates  %changes in $ / £ rate and inflation differential (US-UK) Diagram below depicts %changes in S($/£) rate (dotted line) and the inflation differential between the US and UK (solid line).  Evidence on PPP General evidence is that Absolute and Relative PPP do not hold at least in short term (i.e. over short time horizons of 3-5 years) so that - price ratio and level of exchange rates not aligned (Absolute PPP) - inflation differentials and changes in exchange rates not aligned (Relative PPP) PPP holds up well over the very long term but is poor for short-term horizons PPP holds better for countries with relatively high rates of inflation and underdeveloped capital markets - e.g. evidence in favour of PPP for Turkish lira – US$ exchange rate - strong departures from PPP for Euro-US$ exchange rate  Evidence on PPP The PPP may not hold because - Exchange rates also affected by differentials in interest rates, income levels, political risk, etc. - Baskets of commodities not identical across countries -Many services are not tradable (eg hair cuts, driving school tuitions, etc) and therefore not exposed to arbitrage forces (remember here the LOOP) - Trade barriers (tariff etc.) and transportation costs However, PPP-based exchange rates still provide valuable benchmark to determine whether an exchange rate is overvalued or undervalued  Exercises Purchasing power parity implies that national price levels should be equal after: a) they are converted to a common currency b) sufficient time has passed c) trade deficits are remedied d) local economic factors are considered  Exercises The “Big Mac Index” is a version of purchasing power parity hypothesis. a) price index b) single good c) bundled d) cumulative  Exercises Consider diagram below which depicts % changes in S($/£) rate (dotted line) and the inflation differential between the US and UK (solid line). a. Relative PPP holds because volatility of S($/£) and inflation differential is similar b. Relative PPP holds because volatility of S($/£) is greater than that of inflation differential c. Relative PPP doesn’t hold as volatility of S($/£) is greater than that of inflation differential d. None of the above  Exercises Consider diagram below which depicts % changes in S($/£) rate (dotted line) and the inflation differential between the US and UK (solid line). a. Relative PPP holds because volatility of S($/£) and inflation differential is similar b. Relative PPP holds because volatility of S($/£) is greater than that of inflation differential c. Relative PPP doesn’t hold as volatility of S($/£) is greater than that of inflation differential d. None of the above  Exercises Which of the following is NOT an obstacle to calculating purchasing power parity across countries? a) tariffs b) transportation costs c) non-tariff barriers d) fixed exchange rates  Exercises Assume that a Big Mac hamburger is selling for £1.99 in the United Kingdom, the same hamburger is selling for $2.71 in the United States, and the actual exchange rate (to buy $1.00 with British pounds) is 0.63. According to , the British pound is the US dollar. a) purchasing-power parity; undervalued b) interest-rate parity; undervalued c) purchasing-power parity; overvalued d) interest-rate parity; overvalued Pls can I ask you to fill the module evaluation form available from iesegonline? Thanks for your time and collaboration! Thanks for attending the module and hope you enjoyed it! I wish you the best of luck for the exam and the rest of your studies at IESEG