Global Finance 2nd Exam - Past Paper

**GLOBAL FINANCE 2^ND^ EXAM** **International Parity Conditions** Refer to a set of economic theories that explain the relationships between exchange rates, inflation, interest rates, and price levels across different countries. These conditions help in understanding how financial markets should...

**GLOBAL FINANCE 2^ND^ EXAM** **International Parity Conditions** Refer to a set of economic theories that explain the relationships between exchange rates, inflation, interest rates, and price levels across different countries. These conditions help in understanding how financial markets should behave under ideal economic circumstances, assuming no market imperfections like capital controls or transaction costs. **Concerns in international trade** - Discrepancies may arise as a consequence when the settlement is executed in one currency as against the other currency. - Economic conditions and changes in economic conditions **Parities** - Generally refer to conditions of equality or equivalence between two economic variables, often in international finance and economics. The term is commonly used in the context of exchange rates, interest rates, and purchasing power to describe relationships that should theoretically hold between different economies. - The value of one currency in terms of another at an established exchange rate. - "the euro\'s parity with the dollar" In international finance, \"parity\" often appears in **international parity conditions**, which describe the expected equilibrium relationships between: - **Exchange rates** (e.g., Purchasing Power Parity) - **Interest rates** (e.g., Interest Rate Parity) - **Inflation and interest rates** (e.g., Fisher Effect) - **Real interest rates across countries** (e.g., Real Interest Rate Parity) **International parities** - Relationships between the values of two or more currencies and the respective economic conditions in these countries - The way in which these relationships respond to the changing economic conditions in these countries **Why international parities important?** - They establish relative currency values - Evolution in terms of economic circumstances - Cross border arbitrage may be possible when they are violated. **Three international parities** 1. purchasing power parity (PPP) 2. covered interest rate parity (CIRP) 3. uncovered interest rate parity (UIRP) or the international Fisher effect (IFE). **Purchasing Power Parity** - concerned with the relative values or the exchange rate of two currencies and the prices in the two countries - based on a plain idea that the two currencies involved in the calculation of the exchange rate have the same purchasing power for the same good sold in the two countries - law of one good, one price **Versions of PPP** 1. **Absolute PPP**- studies the exchange rate for the two currencies in terms of the absolute prices for the same basket of goods in the two countries 2. **Relative PPP**- examines how the exchange rate changes over time in response to changes in the price levels in the two countries **Absolute purchasing power** - best described by the law of one good, one price - Ph = S × Pf - Ph is the price for a good or basket of goods in the domestic or home country - Pf is the price for the same good or basket of goods in the foreign country - S is the exchange rate expressed as the units of the home currency per foreign currency unit - S = Ph/Pf **Foreign Currency Derivatives** - a financial derivative whose payoff depends on the foreign exchange rates of two (or more) currencies. - used for hedging foreign exchange risk or for currency speculation and arbitrage **Examples of foreign exchange derivatives** 1. foreign currency forward contracts 2. foreign currency futures 3. foreign currency swaps 4. currency options 5. foreign exchange binary options **Derivatives** - Their value is derived from an underlying asset, a foreign currency. **Foreign Currency Forward and Futures Contracts** - Forward - non-standardized contract between two parties to buy or sell an asset (foreign currency) at a specified future time at a price agreed upon today. - Spot contract - which is an agreement to buy or sell a foreign currency today. - The price agreed upon is called the **delivery price (exchange rate),** which is equal to the forward exchange rate at the time the contract is entered into. - a private and customizable agreement - traded over the counter. **Currency future, also FX future or foreign exchange future** - A futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. - Standardized contracts that trade on stock exchanges - Come with fixed maturity dates and uniform terms - they guarantee payment on the agreed-upon date. - Regulated by Commodity Futures Trading Commission (CFTC) **Foreign Currency Forward Contracts** - A forward contract is an agreement between an MNC and a bank (foreign currency dealer) that specifies the currencies to be exchanged, the exchange rate (forward rate), and the date at which the transaction will occur **Foreign Exchange rate Determination** - **The exchange rate (ER)**-represents the number of units of one currency that exchanges for a unit of another **Currency Value** - The value of a currency is always given in terms of another currency - Thus the value of a U.S. dollar in terms of British pounds is the £/\$ exchange rate. - The value of the Japanese yen in terms of dollar is the \$/¥ exchange rate. **Currency Appreciation** - This means that a currency appreciates with respect to another when its value rises in terms of the other. - The dollar appreciates with respect to the yen if the ¥/\$ exchange rate rises. **Currency Depreciation** - a currency depreciates with respect to another when its value falls in terms of the other - The dollar depreciates with respect to the yen if the ¥/\$ exchange rate falls - Note that if the ¥/\$ rate rises, then its reciprocal, the \$/¥ rate **Example** - Example 1: U.S. dollar (US\$) to the Canadian dollar (C\$) - On January 6, 2010, EC\$/US\$ = 1.03. - On January 6, 2009, EC\$/US\$ = 1.19. - Use the percentage change formula, (new value − old value)/old value: (1.03 − 1.19) 1.19 = −0.16 1.19 = −0.134. Multiply by 100 to write as a percentage to get −0.134 × 100 = −13.4%. - Therefore, we have calculated the change in the value of the U.S. dollar in terms of Canadian dollar, and since the percentage change is negative, this means that the dollar has depreciated by 13.4 percent with respect to the C\$ during the previous year. **Arbitrage** - **Arbitrage**- generally means buying a product when its price is low and then reselling it after its price rises in order to make a profit. - **Currency arbitrage** means buying a currency in one market (e.g., New York) at a low price and reselling, moments later, in another market (e.g., London) at a higher price **Spot Exchange Rate** - Refers to the exchange rate that prevails on the spot, that is, for trades to take place immediately. **Forward Exchange Rate** - Refers to the rate that appears on a contract to exchange currencies either 30, 60, 90, or 180 days in the future. **Key Takeaways** - An exchange rate denominated x/y gives the value of y in terms of x. · When an exchange rate denominated x/y rises, then y has appreciated in value in terms of x, while x has depreciated in terms of y. · Spot exchange rates represent the exchange rate prevailing for currency trades today. Forward, or future, exchange rates represent the exchange values on trades that will take place in the future to fulfill a predetermined contract. · Currency arbitrage occurs when someone buys a currency at a low price and sells shortly afterward at a higher price to make a profit. · Hedging refers to actions taken to reduce the risk associated with currency trades. **Transaction Exposure** - measures gains or losses that arise from the settlement of existing financial obligations the term of which are stated in a foreign currency - Purchasing or selling on credit - Borrowing or lending funds when repayment is to be made in a foreign currency. - Acquiring assets or incurring liabilities denominated in foreign currencies. **The Foreign-Exchange Market and Parity Conditions** **FOREIGN-EXCHANGE MARKET** - This is a market where one country's currency can be exchanged for that of another country. - It is an informal network of telephone, telex, satellite, facsimile, and computer communications between banks, foreign-exchange dealers, arbitrageurs, and speculators. **THE MARKET OPERATES SIMULTANEOUSLY AT THREE TIERS:** 1. Individuals and corporations buy and sell foreign exchange through their commercial banks. 2. Commercial banks trade in foreign exchange with other commercial banks in the same financial center. 3. Commercial banks trade in foreign exchange with commercial banks in other financial centers. **MAJOR PARTICIPANTS IN THE\ EXCHANGE MARKET** - *Commercial banks* - *Central banks* **Commercial Banks** - Commercial banks participate in the foreign-exchange market as intermediaries for customers such as MNCs and exporters. - These commercial banks also maintain an ***interbank market.*** - In other words, they accept deposits of foreign banks and maintain deposits in banks abroad. Commercial banks play three key roles in international transactions: 1\. They operate the payment mechanism. 2\. They extend credit. 3\. They help to reduce risk. **OPERATING THE PAYMENT MECHANISM** - The commercial banking system provides the mechanism by which international payments can be efficiently made. This mechanism is a collection system through which transfers of money by drafts, notes, and other means are made internationally. - In order to operate an international payments mechanism, banks maintain deposits in banks abroad and accept deposits of foreign banks. - These accounts are debited and credited when payments are made. Banks can make international money transfers very quickly and efficiently by using telegraph, telephones, and computer services. **EXTENDING CREDIT** - Commercial banks also provide credit for international transactions and for business activity within foreign countries. - They make loans to those engaged in international trade and foreign investments on either an unsecured or a secured basis. **REDUCING RISK** - The letter of credit is used as a major means of reducing risk in international transactions. - It is a document issued by a bank at the request of an importer. - In the document, the bank agrees to honor a draft drawn on the importer if the draft accompanies specified documents. - The letter of credit is advantageous to exporters. Exporters sell their goods abroad against the promise of a bank rather than a commercial firm. ***Central Banks*** - Central banks serve as their governments' banker for domestic and international payments. - In other words, central bank operations reflect government transactions, transactions with other central banks and various international organizations, and intervention to influence exchange rate movements. **Spot Exchange Quotation: The Spot Exchange Rate** - The foreign-exchange market employs both *spot and forward exchange rates.* - The spot rate is the rate paid for delivery of a currency within two business days after the day of the trade. **Direct Vs. Indirect Quotation** - **Direct Quotation -** is a foreign exchange rate quoted as the domestic currency per unit of the foreign currency. - **Indirect Quotation -** Expresses the amount of foreign currency required to buy or sell one unit of the domestic currency. ***The bid--ask spread*** - A bank's bid price is the price at which the bank is ready to buy a foreign currency. - A bank's ask price is the price at which the bank is ready to sell a foreign currency. - The bid--ask spread is the spread between bid and ask rates for a currency; this spread is the bank's fee for executing the foreign-exchange transaction: **International Parity Conditions** There are five major theories of exchange rate determination: 1. The theory of purchasing power parity. 2. The Fisher effect. 3. The international Fisher effect. 4. The theory of interest rate parity. 5. The forward rate as an unbiased predictor of the future spot rate. **EFFICIENT EXCHANGE MARKETS** - Efficient exchange markets exist when exchange rates reflect all available information and adjust quickly to new information. - In other words, the concept of efficient exchange markets depends on three hypotheses: 1. Market prices such as product prices, interest rates, spot rates, and forward rates should reflect the market's consensus estimate of the future spot rate. 2. Investors should not earn unusually large profits in forward speculation. Because exchange rate forecasts based on market prices are accurate, publicly available forecasts of the future spot rate do not lead to unusual profits in forward speculation. 3. It is impossible for any market analyst to beat the market consistently. ***THE THEORY OF PURCHASING POWER PARITY*** - The **theory of purchasing power parity (PPP) explains why the parity relationship exists** between inflation rates and exchange rates. The PPP theory has an absolute version and a relative version. - The absolute version of the PPP theory maintains that the equilibrium exchange rate between domestic and foreign currencies equals the ratio between domestic and foreign prices. - The relative version of the PPP doctrine states that in the long run, the exchange rate between the home currency and the foreign currency will adjust to reflect changes in the price levels of the two countries. ***THE FISHER EFFECT*** - The **Fisher effect**, named after economist **Irving Fisher**, assumes that the nominal interest rate in each country is equal to a real interest rate plus an expected rate of inflation: - nominal rate = real rate + inflation - The real interest rate is determined by the productivity in an economy and a risk premium commensurate with the risk of a borrower. The nominal interest rate embodies an inflation premium sufficient to compensate lenders or investors for an expected loss of purchasing power. ***THE THEORY OF INTEREST RATE PARITY*** - The movement of short-term funds between two countries to take advantage of interest differentials is a major determinant of the spread between forward and spot rates. - According to the interest parity theory, the spread between a forward rate and a spot rate should be equal but opposite in sign to the difference in interest rates between two countries. ***A synthesis of international parity conditions*** - In the absence of predictable exchange market intervention by central banks, an expected rate of change in a spot rate, differential rates of national inflation and interest, and forward premiums or discounts are all directly proportional to each other. - Because money, capital, and exchange markets are efficient, these variables adjust very quickly to changes in any one of them. **ARBITRAGES** - Arbitrage is the purchase of something in one market and its sale in another market to take advantage of a price differential. Professional arbitrageurs quickly transfer funds from one currency to another in order to profit from discrepancies between exchange rates in different markets.