International Finance (4th GADE/GE) PDF - 2024-25

INTERNATIONAL FINANCE (4th GADE/GE) THEMATIC BLOCK 1: THE FOREIGN EXCHANGE MARKET AND EXCHANGE RATES LESSON 1. THE FOREX ORGANIZATION INDEX OF CONTENTS  Forex main characteristics  International Mone...

INTERNATIONAL FINANCE (4th GADE/GE) THEMATIC BLOCK 1: THE FOREIGN EXCHANGE MARKET AND EXCHANGE RATES LESSON 1. THE FOREX ORGANIZATION INDEX OF CONTENTS  Forex main characteristics  International Monetary System  Exchange rates  International parity conditions International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 2  FOREX MAIN CHARACTERISTICS FUNDAMENTAL CONCEPTS Money Concept In economics, money is understood as the legal mean of payment, which is represented by coins or bills and is used as a unit of measurement in economic transactions. It must fulfill the following functions: Mean of payment , universally accepted by all individuals:  Homogeneity.  Small size and weight in relation to its value.  Divisibility into units small enough to be able to exchange any good. Store of value. It must allow savings (transfer present consumption to future consumption).  Durability.  Difficulty of falsification. Unit of account. It must be the unit of measurement in which the prices of all goods and services in the economy are expressed. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 3 FOREX MAIN CHARACTERISTICS FUNDAMENTAL CONCEPTS Definition of foreign currency Is the currency acceptable to both parties in an international transaction. A foreign currency is a deposit in a financial institution in a currency other than one's own ( banknotes, paper money, is not considered foreign currency in the strict sense). Foreign exchange market, FOREX ( Foreign Exchange ) Where suppliers and demanders of foreign currency come together and its price is established. Its main function is to transfer the purchasing power established in one currency to another, thus facilitating international trade and investment. FOREX is the largest and oldest financial market in the world (more than 7.5 billions of USD a day) It is not a physical market but interconnected markets It is an OTC market ( Over The Counter ), mostly interbank It has a global character, it works 24 hours a day International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 4  FOREX MAIN CHARACTERISTICS UNITED KINGDOM CONTINENTAL EUROPE USA (East Coast) JAPAN USA (West Coast) HONG KONG/SINGAPORE 38.1% 40.0% They account for 86.1% 35.0% of trading in FOREX 30.0% 25.0% 19.4% 20.0% 15.0% 9.4% 10.0% 7.1% 4.4% 3.6% 5.0% 2.2% 1.9% 1.7% 1.6% 1.5% 0.0% International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 5 FOREX MAIN CHARACTERISTICS MAIN CHARACTERISTICS OF THE FOREX MARKET Main currencies traded: US dollar (USD), Euro (EUR), Japanese yen (JPY), British pound (GBP). 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 88.4% 90.0% USD/EUR 22.7% USD/JPY 13.5% 80.0% USD/GBP 9.5% USD/CNY 6.6% 70.0% USD/CAD 5.5% USD/AUD 5.1% 60.0% USD/CHF 3.9% 50.0% USD/HKD 2.4% USD/OTH 19.3% 40.0% 30.5% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 26.6% EUR/USD 22.7% 20.0% 16.7% 12.9% EUR/GBP 2.0% 10.0% 7.0% 6.4% 6.2% 1.4% 5.2% EUR/JPY EUR/CHF 0.9% 0.0% USD EUR JPY GBP CNY AUD CAD CHF OTH EUR/OTH 3.5% BIS Triennial Central Bank Survey. Foreign exchange turnover in April 2022 International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 6  FOREX MAIN CHARACTERISTICS MAIN CHARACTERISTICS OF THE FOREX MARKET Transactions in the foreign exchange market can be of different sizes, although it must be considered that operations are done with leverage: Standard Lots: These are trades with a size of 100.000 units of the base currency. Mini Lots: These are trades with a size of 10.000 units of the base currency. Micro Lots: These are trades with a size of 1.000 units of the base currency. Variable lot: they are operations of variable size. The exchange asset is homogeneous and trades at the same price, regardless of the place where the transaction takes place. As there are different financial markets with different hours, could it happen that a certain currency traded at an unequal price in two different markets? This could give rise to arbitrage operations:  Short sale of a currency in a financial market  Immediate purchase in another where its price is lower.  This would make it possible to get benefits without risking anything and without contributing capital, which is why the massive use of arbitrage makes prices tend to converge. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 7 FOREX MAIN CHARACTERISTICS MAIN AGENTS OF THE FOREIGN EXCHANGE MARKET THE CENTRAL BANKS They intervene to manage their reserves or to try to maintain the exchange rates of their currencies at a desired interval (depending on the exchange regime of their currency). INTERMEDIARIES OR BROKERS Mediation between buyers and sellers for a commission. Its function is limited to intermediation, without owning the currency object of the transaction. MARKET MAKERS They buy and sell currencies in the market, providing liquidity to it Although it’s an OTC market, they usually use fixed terms and amounts to facilitate the operative INDUSTRIAL AND COMMERCIAL COMPANIES: Foreign trade operations, financing operations and international investment. INDIVIDUALS Tourism, purchases of goods in another currency, financial operations, etc. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 8  FOREX MAIN CHARACTERISTICS MAIN AGENTS OF THE FOREIGN EXCHANGE MARKET COMMERCIAL BANKS: They can operate in two different ways:  As retailers, attending to the needs of their clients (companies, exporters, tourists, etc. )  As wholesalers, participating in the interbank market. They can obtain a benefit for different concepts:  The differential between the bid and ask exchange rates (spread).  Commissions.  Disposal of funds during the time between receipt of the order and its settlement.  Capital gains obtained as a result of adopting own purchase and sale positions. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 9 INTERNATIONAL MONETARY SYSTEM DEFINITION The International Monetary System (IMS) is the normative and regulatory framework that governs monetary transactions between residents of countries, belonging to the system, that have different currencies. FUNCTIONS The IMS must answer three essential questions: Adjustment: the IMS must provide instruments so that a country can regain balance when it has incurred imbalances in its foreign operations Liquidity: the IMS must allow the necessary liquidity to be available and generated so that countries can meet international payments Trust: the IMS must be able to generate trust among countries, which must perceive it as something stable, safe from speculative attacks. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 10  INTERNATIONAL MONETARY SYSTEM ESSENTIAL ASPECTS Exchange rate fixing mechanisms Fixed exchange rates Floating exchange rates System reserve assets. Commodity standard. Reserves are made up of assets that have intrinsic value, such as precious metals (Gold and Silver have been the main metals that have played this role throughout history). Mixed standard. Reserves are made up of precious metals and other assets that have no intrinsic value (currency or other international references). Fiat standard. All reserves are made up of assets with no intrinsic value Existence of exchange controls and capital movements. Conceptually, it is not an aspect that configures the IMS It really influences the stability of the IMS and acts as a stimulating or restrictive factor in the movement of capital that flows between the different countries. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 11 INTERNATIONAL MONETARY SYSTEM FIXED EXCHANGE RATES They are determined by the monetary authorities, which interfere with the play of supply and demand for currencies to maintain exchange rates at a predetermined level. Countries agree to keep the exchange rate of their currency unchanged against a widely accepted international standard (gold, a strong currency or a basket of currencies). To maintain parity, the Central Bank undertakes to exchange its currency with the private agents that intervene in the market. Imbalances fixed exchange rates (central bank intervention) TCNY/USD TCNY/USD S’’ (CNY) S (CNY) S (CNY) x S’ (CNY) a b b a TS TS D’ (CNY) x D (CNY) D (CNY) D’’ (CNY) Amount of currency (CNY) Amount of currency (CNY) CNY demand rises (D to D') Low demand for CNY (D to D'') The Central Bank will have to increase the supply of The Central Bank will have to lower the supply of CNY by b-a value to maintain the exchange rate at TS CNY by a-b value to maintain the exchange rate at TS International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 12  INTERNATIONAL MONETARY SYSTEM FIXED EXCHANGE RATES Semi-fixed or adjustable exchange rates They allow certain tolerance margins with respect to the fixed rate system. The authorities must prevent fluctuations from exceeding a predetermined upper and lower band (for example, ± 1% over the established parity). If the imbalances are very strong, the monetary authority can change the parity, moving to another exchange rate that can be maintained with less difficulty than the previous one. Devaluation: the monetary authority varies the parity, reducing the value of its currency. Revaluation: the monetary authority varies the parity, increasing the value of its currency. Imbalance semi-fixed exchange rates Imbalance semi-fixed exchange rates TCNY/USD (central bank intervention) TCNY/USD (revaluation) S (CNY) S (CNY) x TS’+m S’ (CNY) a’ b’ TS’ TS+m TS’-m TS TS TS-m D’ (CNY) D’ (CNY) D (CNY) D (CNY) Amount of currency (CNY) Amount of currency (CNY) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 13 INTERNATIONAL MONETARY SYSTEM FLOATING EXCHANGE RATES The monetary authorities renounce establishing fixed parities between currencies Market mechanisms set the level of the exchange rates. The characteristic of the system is the continuous fluctuation of currency prices (supply and demand constantly alter the quotes). Variations in the exchange rate in the floating system are called: Depreciations (not devaluations): decreases in the value of a currency in the market. Appreciations (not revaluations): increases in the value of a currency in the market. Floating exchange rate imbalances TEUR/USD TEUR/USD S (EUR) S (EUR) TS’ TS TS D’ (EUR) TS’’ D (EUR) D (EUR) D’’ (EUR) Amount of currency (EUR) Amount of currency (EUR) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 14  INTERNATIONAL MONETARY SYSTEM FLOATING EXCHANGE RATES Advantages Increases the independence of national economic policy (monetary and fiscal). Smoother adjustments to balance of payments imbalances. Improvement in the liquidity of the IMS, as the Central Banks are not forced to maintain as many reserves as in the case of fixed exchange rates. It favors free trade, as there are no restrictions on the movement of goods and services. Disadvantages Increases risk and uncertainty, which can reduce the volume of trade and investments. Inflationary effects, because the respective governments are not as forced, as in the case of fixed rates, to keep the money supply and inflation under control. Favors speculative movements. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 15 INTERNATIONAL MONETARY SYSTEM FLOATING EXCHANGE RATES vs. FIXED (THE TRILEMMA) An ideal currency should have 3 attributes: Exchange rate stability Autonomy of monetary policy Free international capital mobility This is what is known as the “impossible trinity” (or the trilemma of international finance) Exchange rate stability Autonomy of monetary Free international capital policy mobility Flexible exchange rate International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 16  INTERNATIONAL MONETARY SYSTEM The IMS has evolved over time, and will continue to do so in the future, as the basic political and trade conditions on which the world economy rests continue to change. HISTORICAL EVOLUTION OF EXCHANGE RATE FIXING MODALITIES The System based on two metals, Gold and Silver (before 1875) The Classical Gold Standard System (1875-1914) Interwar period (1915-1944) Bretton -Woods system (1945-1972) Since 1973-Present Exchange regimes within the framework of the current IMS The European Monetary System (1979-1998) The Euro (1999-Present) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 17 INTERNATIONAL MONETARY SYSTEM THE SYSTEM BASED ON TWO METALS, GOLD AND SILVER (BEFORE 1875) SYSTEM BASED ON CERTIFICATES OF DEPOSIT FOR TANGIBLE GOODS System based on the issuance of coins and bills backed by two metals: gold and silver. The backing of each coin could be made with one of the two metals or with both at the same time. The exchange rate was determined by the amount of metal that the coins carried:  The exchange rate between the Pound Sterling (backed exclusively by gold), and the French Franc (backed by silver and gold), was calculated by the ratio of gold that the Pound had with respect to the Franc.  The exchange rate between the French Franc and the German Mark (backed by silver) was determined by the ratio of silver between the two currencies.  The exchange rate between the Pound and the Mark was based on the exchange rate of the two currencies with respect to the Franc. Gresham's Law: When the exchange rate between two metals is officially set, only the most abundant metal will be used as currency, driving the scarce metal out of the system International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 18  INTERNATIONAL MONETARY SYSTEM THE SYSTEM BASED ON TWO METALS, GOLD AND SILVER (BEFORE 1875) EXAMPLE OF FIXING EXCHANGE RATES Pound Sterling (backed by gold): 1 Pound = 1.5 ounces of Gold (1 ounce = 31.10 grams) French Franc (backed by gold and silver): 1 Franc = 0.6 ounces of Gold and 0.4 ounces of Silver German Mark (silver backed): 1 Mark = 0.8 ounces of Silver The exchange rates are set based on the weight of the metals in each of them:. Pound-Franc exchange rate : 0.4 Pounds for each Franc.. Mark-Franc exchange rate : 0.5 Marks for each Franc.. Pound-Mark Exchange Rate : 0.8 Pounds for each Mark. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 19 INTERNATIONAL MONETARY SYSTEM THE CLASSICAL GOLD STANDARD SYSTEM (1875-1914) SYSTEM BASED ON CERTIFICATES OF DEPOSIT OF A GOOD System of fixed exchange rates, where the value of the currency was linked to gold. The unit of account is gold, which is the support for the value of the currencies. Exports and imports of gold were allowed without restrictions. The value of the currrency could be exchanged for gold (full convertibility) Advantages System that provides security and stability, due to the constancy in the value of the currrencies Automatic system. It does not need government measures for its operation Simple system Disadvantages Central banks cannot increase their reserves as the economy grows Lack of liquidity in the system, as the monetary base is limited by the amount of gold International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 20  INTERNATIONAL MONETARY SYSTEM THE CLASSICAL GOLD STANDARD SYSTEM (1875-1914) EXAMPLE OF FIXING EXCHANGE RATES Pound Sterling : 1 ounce of gold = 4 Pounds American Dollar : 1 ounce of gold = 20 Dollars German Mark : 1 ounce of gold = 7 Marks Exchange rates are set based on parity with gold, which is the unit of account: Dollar-Pound exchange rate : 5 Dollars for every Pound Mark-Pound exchange rate : 1.75 Marks for each Pound Mark-Dollar exchange rate : 0.35 Marks for each Dollar International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 21 INTERNATIONAL MONETARY SYSTEM INTERWAR PERIOD (1915-1944) This is a period of great ups and downs and political and economic instability, in many cases as a consequence of the treaties ending World War I. Hyperinflation in the Weimar Republic in Germany “The roaring 20s” in the USA In this period, floating exchange rate systems coexist with attempts to reinstate the gold standard, with some variant to provide more liquidity to the system. In 1922 (Genoa Conference) it was established that smaller countries could keep the currencies of large countries as reserves, in addition to gold. It is a system based on a standard currency or “gold exchange standard”. Each central bank sets its exchange rate, and links it to one of the currencies whose gold price is fixed (standard currency). The absence of international organizations that applied corrective mechanisms, together with the outbreak of the crack of 1929, meant that this system did not fully function. During the great depression, most of the countries that used this system gave up fixed rates and allowed their currencies to fluctuate (high instability until World War II). International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 22  INTERNATIONAL MONETARY SYSTEM THE BRETTON-WOODS SYSTEM (1945-1972) SYSTEM BASED ON A RESERVE CURRENCY Fixed exchange rates in relation to a reserve currency, convertible into gold at a price per ounce. Countries have their reserves in the form of gold and reserve currency. All currencies convertible with each other. They have value in gold through the reserve currency. Advantages Fixed exchange rates impose monetary discipline on the system Provides stability to international prices in trade Calculations for making economic decisions are simplified Disadvantages: The stability of the system depends on a single country, issuer of the reserve currency Lack of liquidity in the system Large reserve needs to maintain the exchange rate A loss of confidence in the system makes it fail International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 23 INTERNATIONAL MONETARY SYSTEM THE BRETTON-WOODS SYSTEM (1945-1972) SYSTEM BASED ON A RESERVE CURRENCY Gold Reserve Currency American dollar German mark Spanish Peseta Pound sterling Japanese yen International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 24  INTERNATIONAL MONETARY SYSTEM THE BRETTON-WOODS SYSTEM (1945-1972) EXAMPLE OF FIXING EXCHANGE RATES US dollar : 1 ounce of gold = 35 US dollars Franc-Dollar exchange rate : 3.5 Francs for every US dollar Mark-Dollar exchange rate : 4.2 Marks for every US dollar Exchange rates are set based on parity with the US dollar, which is the reserve currency that acts as the unit of account:. Mark-Franc exchange rate : 1.2 Marks for each Franc. French Franc : 1 ounce of gold = 122.5 Francs (3.5 Francs per Dollar *35 Dollars per ounce ) German Mark : 1 ounce of gold = 147 Marks (4.2 Marks per Dollar *35 Dollars per ounce ) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 25 INTERNATIONAL MONETARY SYSTEM THE BRETTON-WOODS SYSTEM (1945-1972) In 1944, at the Bretton Woods Conference (USA), the new International Monetary System (IMS) was designed after the end of the War. The dollar is established as the reserve currency (directly convertible into gold at $35/ounce) Fixed exchange standard, with oscillations of +/- 1% with respect to the pre-set parities. Changes in parity cannot exceed +/- 10% with respect to the initial parity (prior authorization is required for larger variations) Only countries' central banks can exchange dollars for gold. It is agreed to create two international organizations to control imbalances in the system The IMF, which performs tasks of supervision and regulation of the new monetary rules, as well as providing financial assistance in case of monetary imbalances. The World Bank, for financing development projects. In 1968, the IMF agreed to the creation of Special Drawing Rights (SDG), units of account based on a basket of currencies, as a new means of international payment. In 1971, at the Smithsonian Agreement , it is agreed to raise the price of gold to $38/ounce, and allow fluctuations of +/-2.25% on the fixed parities. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 26  INTERNATIONAL MONETARY SYSTEM THE BRETTON-WOODS SYSTEM (1945-1972) In 1971 the convertibility of the dollar into gold was suspended. During 1973, the main world currencies floated and the dollar devalued again to $42.22/ounce (the peseta floated in 1974). International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 27 INTERNATIONAL MONETARY SYSTEM SINCE 1973-CURRENT FREE FLOAT SYSTEM (FIAT MODEL) Based on the free operation of market forces. The balance between supply and demand for currencies determines exchange rates. Ratified by IMF members in January 1976 in the Jamaica Agreement: Flexible exchange rates were declared acceptable to IMF members, and central banks would avoid intervening in markets Gold was officially abandoned as an international reserve asset In the general framework of the IMS from March 1973 to the present, each country, unilaterally or multilaterally in a restricted scope, can choose between different alternatives (" de jure" exchange rate regime ). Since 1999, the IMF began to classify the “de facto” exchange rate regimes, based on the behavior of the monetary authorities in the foreign exchange market, which does not always correspond to the “de jure” exchange rate regime that they claim to follow. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 28  INTERNATIONAL MONETARY SYSTEM FROM 1973-PRESENT FREE FLOAT SYSTEM (PURE FIDUCIARY MODEL) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 29 INTERNATIONAL MONETARY SYSTEM EXCHANGE REGIMES IN THE FRAMEWORK OF THE CURRENT IMS Floating agreements. Free Floating  The monetary authorities let their currency float freely and intervene in the currency markets only occasionally.  The IMF considers this system if three interventions are not exceeded in the last six months (the duration of each one cannot exceed 3 days). Floating  The monetary authorities let their currency float freely, but carry out more interventions in the currency markets to redirect the exchange rate  There must not be an explicit objective regarding the exchange rate. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 30  INTERNATIONAL MONETARY SYSTEM EXCHANGE REGIMES IN THE FRAMEWORK OF THE CURRENT IMS Soft regimes for pegging the exchange rate of one country's currency to another currency Conventional Peg : Fixed rate with a reference currency and limited margin.  The currency is linked to a reference currency, establishing a fluctuation band that does not exceed ± 1% for at least 6 months. Stabilized Arrangements : Fixed rate with a reference currency and higher margin.  Similar to the previous one, but with greater fluctuation margins (±2%). Crawling Peg : Sliding fixed types.  A parity is established, but small adjustments are made (weekly or monthly) to adjust the fixed rate to the market situation. Crawl- like arrangements : Fixed sliding rates with a limited margin.  ±2% margins around a statistically identified trend for at least 6 months.  Pegged Exchange rate within horizontal bands : Fixed types with sliding horizontal bands.  Fixed types with sliding bands of different amounts. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 31 INTERNATIONAL MONETARY SYSTEM EXCHANGE REGIMES IN THE FRAMEWORK OF THE CURRENT IMS Strict regimes of pegging the currency of one country to another currency. No separate legal tender  Regimes in which the national currency is replaced with and a reference currency.  Given that this currency can only be created in its country of origin, the country that adopts this system will have liquidity to the extent that foreign currency comes in from exports of goods and services or capital inflows. Currency Board  A fixed exchange rate or parity of the country's currency with a reference currency is established through a regulation with the status of law.  In order to maintain parity, the country's monetary base must be fully backed by the reference currency (some flexibility may be allowed depending on the robustness of the country's financial system). International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 32  INTERNATIONAL MONETARY SYSTEM FLOTATION AGREEMENTS ( Market determined rates ) Free Floating (31) Australia, Canada , Chile, Japan , Mexico , Norway , Poland , Russia , Sweden , United United Kingdom _ States , EMU Floating (35) Albania, Brazil , Colombia, Hungary , Iceland , India, Indonesia, Israel, Korea , New Zealand , Peru , South Africa , Thailand , Turkey , Uruguay SOFT REGIMES FOR LINKING THE EXCHANGE RATE OF THE CURRENCY OF ONE COUNTRY TO ANOTHER CURRENCY ( Soft pegs ) Conventional Peg (40) Pegged to USD ( The Bahamas, Bahrain , Barbados, Iraq, Jordan , Qatar, Saudi Arabia) Pegged to the EUR (Cape Verde, Denmark , WAEMU, CEMAC) Pegged to a basket of currencies ( Fiji , Libya ) Stabilized Arrangements Pegged to USD (Guyana, Iran , Lebanon, Maldives ) (23) Pegged the EUR ( Croatia , North Macedonia) Pegged to a basket of currencies ( Singapore ) Crawling Peg (3) Pegged to USD (Honduras, Nicaragua) Pegged to a basket of currencies (Botswana ) Crawl- like arrangements Pegged to USD ( Afghanistan , Argentina, Vietnam) (24) Pegged the EUR (Romania, Switzerland) Pegged to a basket of currencies (China, Solomon Islands ) Pegged Exchange rate Pegged to a basket of currencies ( Morocco ) within horizontal bands (1) STRICT REGIMES OF LINKAGE OF THE CURRENCY OF ONE COUNTRY TO ANOTHER CURRENCY ( Hard Pegs ) No separate legal tender Pegged to USD (Ecuador, El Salvador, Marshall Islands , Micronesia, Panama ) (14) Pegged to EUR (Andorra, Kosovo, Montenegro, San Marino) Currency Board (12) Pegged to USD (ECCU , Djibouti , Hong Kong ) Pegged to EUR ( Bosnia and Herzegovina, Bulgaria ) RESIDUAL Other managed Pegged to a basket of currencies (Kuwait, Syria ) arrangements (11) Others ( Myanmar, Haiti , Zambia ) Annual Report on exchange arrangements and exchange restrictions 2022. International Monetary Fund International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 33 INTERNATIONAL MONETARY SYSTEM EXCHANGE RATE REGIMES Fixed exchange rates Intermediate regimes Floating exchange rates (Hard Pegs) (Soft pegs) (Market determined rates) No separate Floating Free Floating Currency board legal tender Conventional Stabilized Crawling Crawl- like Pegged Exchange rate peg Arrangements peg arrangements within horizontal bands International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 34  INTERNATIONAL MONETARY SYSTEM MONETARY UNIONS For monetary purposes, the member countries of a monetary union are considered as a unit MONETARY UNION MEMBER COUNTRIES EMU Austria, Belgium , Cyprus , Estonia , Finland , France , European Economic and Germany , Greece , Ireland , Italy , Latvia , Lithuania , Monetary Union Luxembourg , Malta, Netherlands , Portugal, Slovak Republic , Slovenia , Spain WAEMU West African Economic and Benin , Burkina Faso, Côte d'Ivoire , Guinea-Bissau, Mali, Monetary Union Niger , Senegal, Togo CEMAC Central African Economic and Cameroon, Central African Rep., Chad, Rep. of Congo, Monetary Community Equatorial Guinea, Gabon ECCU Eastern Caribbean Currency Antigua and Barbuda, Dominica, Grenada, St. Kitts and Union Nevis, St. Lucia, St. Vincent and the Grenadines International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 35 INTERNATIONAL MONETARY SYSTEM THE EUROPEAN MONETARY SYSTEM (1979-1998) SYSTEM BASED ON AN ARTIFICIAL STANDARD CURRENCY, and value based on a basket of currencies. In 1972 the CEE countries decided to implement the “snake in the tunnel”:  It limited variations with respect to the USD within a “tunnel” of 4.5% width.  It limited exchange differences between European currencies to +/-2.25% The existence of the “tunnel” with respect to the dollar lasted only until early 1973. The “snake” remained until 1978 when the decision was made, by the European Council, to create the European Monetary System (EMS) , which would come into force in March 1979.  The ECU is created (European Currency Unit ) or European unit of account.  It imposed bilateral limits between European currencies of +/-2.25% (narrow band of oscillation) or +/- 6% (broad band of oscillation) Advantages: The problems of lack of liquidity are solved as it is an artificial currency It prevents a single country from controlling the entire system International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 36  INTERNATIONAL MONETARY SYSTEM THE EUROPEAN MONETARY SYSTEM (1979-1998) Weighting of national currencies with respect to the value of the ECU The ECU was made up of all the currencies of the EEC countries, whether or not they were attached to the SME. The relative weight of each currency in the ECU was established based on the economic importance of each country (considering the GDP and the volume of foreign trade). Currency 1979–1984 1984–1989 1989–1998 German Mark (DEM) 33.0% 32.1% 32.0% French Franc (FRF) 19.8% 19.1% 20.3% British Pound (GBP) 13.3% 15.0% 12.5% Netherlands Guilder (NLG) 10.5% 10.1% 10.0% Belgian Franc (BEF) 9.6% 8.6% 8.2% Italian Lira (ITL) 9.5% 10.0% 7.8% Spanish Peseta (ESP) - - 4.1% Danish Krone (DKK) 3.1% 2.7% 2.7% Irish Pound (IEP) 1.2% 1.2% 1.1% Portuguese Escudo (PTE) - - 0.7% Greek Drachma (GRD) - 1.3% 0.4% Luxembourgish Franc (LUF) - - 0.3% TOTAL 100% 100% 100% International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 37 INTERNATIONAL MONETARY SYSTEM THE EURO (1999-PRESENT) SINGLE CURRENCY SYSTEM We are facing a Monetary Union in the strict sense, not an Economic Union (for example, there is a lack of fiscal harmonization between the different countries involved). The Euro countries have made important cessions of sovereignty, such as renouncing their own monetary or exchange rate policy. For EU countries that are not yet members of the euro, there is a revised exchange rate mechanism (ERM2) that defines broad exchange rate bands against the euro (±15%) and specifies reciprocal intervention agreements to support these rates. Irrevocable exchange rates of Euro currencies Exchange Exchange Currency Currency rate rate Austrian Shilling (ATS) 13,760 Luxembourgish Franc (LUF) 40,340 Greek Drachma (GRD) 340,750 Irish Pound (IEP) 0.788 Portuguese Escudo (PTE) 200,482 Italian Lira (ITL) 1936.270 Netherlands Guilder (NLG) 2,204 German Mark (DEM) 1956 Belgian Franc (BEF) 40,340 Finnish Mark (FIM) 5,946 French Franc (FRF) 6,560 Spanish Peseta (ESP) 166,386 International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 38  INTERNATIONAL MONETARY SYSTEM THE EURO (1999-PRESENT) 1st phase: July 1990 to December 1993: First measures to liberalize the movement of capital and preparation of the Convergence Plans. 2nd phase: January 1994 to December 1998: Creation of the European Monetary Institute (EMI) and verification of the countries that met the convergence criteria to move on to the third phase. Inflation: 1.5% above the average of the 3 countries with the lowest inflation Interest rates: 2% above the average of the 3 countries with the lowest inflation Public deficit: 3% GDP Public debt: 60% of GDP (or clearly decreasing trend towards that amount) Exchange rate: at least two years within the EMS bands  3rd phase: January 1999: Full operation of the ECB, irrevocable fixation of the exchange rates of the different currencies and introduction of the euro. The implementation of the euro went through the following periods: Transitional period: January 1999 to December 2001: The euro becomes the single currency in the Eurozone countries, although without physical representation in the form of banknotes and coins.  Period of duality: January 2002 to February 2002: The new euro banknotes and coins were put into circulation, with the old European currencies disappearing from legal tender. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 39 INTERNATIONAL MONETARY SYSTEM THE EURO (1999-PRESENT) ADVANTAGES The elimination of uncertainty regarding the exchange rate. The reduction of transaction costs in the countries of the euro zone. Greater transparency and competition in the European market Expansion of markets and greater ease of access Greater access to financing sources Financial markets The euro as an international currency Charles R. Bean (1992): A complete trip through the EU (12) in 1992, changing currency in each one, resulted in the loss of half the money in commissions International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 40  INTERNATIONAL MONETARY SYSTEM THE EURO (1999-PRESENT) DISADVANTAGES Impossibility of carrying out monetary policies at the national level Each State, individually, cannot alter exchange rates to respond to temporary economic crises or unilaterally modify national interest rates. Limiting the use of fiscal policies at the national level Probability of the existence of unemployment problems in some areas that would be difficult to combat due to the loss of sovereignty in monetary policy Need to introduce some type of transfers between the richest and most disadvantaged areas of the Eurozone, to try to achieve real convergence of the Member States  Cohesion Fund: intended for Member States whose gross national income per capita is less than 90% of the EU average income. Its objective is to reduce socioeconomic disparities and promote sustainable development.  European Regional Development Fund (ERDF): its objective is to strengthen socioeconomic cohesion within the EU by correcting imbalances between its regions  Instrument for Pre-Accession Assistance (IPA) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 41 INTERNATIONAL MONETARY SYSTEM THE EURO (1999-PRESENT) THEORY OF OPTIMAL MONETARY AREAS. Optimal monetary areas are groups of regions with economies closely linked by trade in goods and services and by factor mobility. In these areas a fixed exchange rate will better serve the economic interests of members if the degree of trade in products and factors between the economies is high. The theory of optimal monetary areas emerged in the early 1960s in order to analyze under what conditions it may be of interest to different countries to form a monetary union, or in other words, share the same currency. An optimal monetary area should meet the following conditions (Robert Mundell): High mobility of human capital between countries. Flexibility for the entry and exit of financial capital between nations. The economic cycles of countries should be synchronized, or at least related. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 42  INTERNATIONAL MONETARY SYSTEM THE EURO (1999-PRESENT) GG Curve (Monetary Efficiency Gain) THEORY OF OPTIMAL MONETARY AREAS  Gains derived from the advantages of having a fixed exchange rate (exchange rate Gains/losses for the stability, less uncertainty) joining country It will grow with greater integration:  Intense trade with countries in the area (↑) GG  Free mobility of productive factors (capital and labor) (↑) Losses > Gains LL curve (Loss of economic stability) Profits > Losses  Losses derived from the disadvantages of having a fixed exchange rate (lack of autonomy of monetary policy and exchange rate). It will decrease with greater integration: LL  Intense trade with countries in the area (↓)  Free mobility of productive factors (capital Θ and labor) (↓) Degree of economic integration Θ = Minimum level of integration so that between joining country and profits begin to exceed losses exchange rate area International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 43 EXCHANGE RATES DEFINITION The exchange rate is defined as the price of one currency with respect to another, that is, how many units of a certain currency must be paid to buy one unit of another currency. The different currencies have a standardized nomenclature according to ISO 4217. It is made up of three letters, the first two are the two letters of the country code of the currency according to the ISO 3166-1 standard and the third is the initial of the currency itself. USA Japanese Swiss Pound Swedish Danish Canadian Australian EURO Dollar Yen Frank sterling Krone Krone Dollar Dollar USD EUR JPY CHF GBP SEK DKK CAD AUD The standardization of nomenclature eliminates confusion caused by some currency names such as dollar, franc, peso or pound, which are used in numerous countries, but which refer to different currencies. Some currencies have a specific symbol, such as USD ($), EUR (€), or GBP (£). These symbols are not used for all currencies, and in some cases the same symbol is used for two different currencies, such as the Japanese Yen (JPY) and the Chinese Yuan (CNY), which share the same symbol (¥). It is essential to use a standard that allows each currency to be unequivocally identified. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 44  EXCHANGE RATES In the foreign exchange market the exchange occurs between two currencies, so the exchange rate can be given from the point of view of each of the parties.  Direct exchange rate: number of units of national currency necessary to acquire one unit of foreign currency. Eg : Acquire a US dollar for 0.80 Euros.  Indirect exchange rate: number of units of foreign currency needed to purchase one unit of domestic currency. Eg : Acquire a Euro for 1.25 US dollars The two measures express the same (each one is the inverse of the other): 0.80. In FOREX, there is a standard established to express the exchange relationship between two currencies through their symbols, for example, 1.25 EUR/USD or 1.25 EURUSD. The currency on the left is called the base currency (EUR). The currency on the right is called the price or counter currency (USD). The ratio indicates how many units of counter currency must be paid to buy one unit of the base currency. In this example it means that we must pay 1.25 USD (counter currency) for each EUR (base currency). International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 45 EXCHANGE RATES Exchange rates allow you to know the equivalent amount in different currencies at a given moment in time. Example : We know that the exchange rate is 1.2050 EUR/USD. To calculate the equivalent value in EUR and USD of any monetary amount: 100 000 EUR ⇒ 100 000 𝐸𝑈𝑅 ∗ 1.2050 𝐸𝑈𝑅/𝑈𝑆𝐷 120 500 𝑈𝑆𝐷 100 000 USD ⇒ 82 987.55 𝐸𝑈𝑅. / The FOREX pairwise representation can be confusing, since the slash that divides the two symbols can be mistakenly interpreted as a fraction, when in reality its interpretation is just the opposite. Sometimes you can see the use of alternative forms to facilitate the calculations, which adds even more confusion to the terminology:  Exchange Rate: 1.2050 $/€  100 000 € ⇒ 100 000 € ∗ 1.2050 $/€ 120 500 $ International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 46  EXCHANGE RATES CROSS RATES It is the exchange rate calculated indirectly based on the exchange rates of two currencies with a third reference Cross exchange table (the column is the counter currency and the row is the base currency) Counter Currency Base currency Source: investing.com Knowing the exchange rate of the USD against different currencies, through the cross exchange rate we can calculate the exchange rate of the other currencies among themselves. GBP to EUR exchange rate 1.1391 EUR/USD * 0.7873 USD/GBP = 0.8968 EUR/GBP 0.8780 USD/EUR*1.2702 GBP/USD= 1.1151 GBP/EUR International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 47 EXCHANGE RATES Changes in exchange rates are called depreciations or appreciations. It is essential to use exchange rates appropriately, because it affects the calculations made. Paradox: the percentage of appreciation of one currency with respect to another does not coincide with the depreciation of the second with respect to the first. EXAMPLE Moment 0 Moment 1 1.2050 EUR/USD 1.2550 EUR/USD 1.2550 𝐸𝑈𝑅⁄𝑈𝑆𝐷 1.2050 𝐸𝑈𝑅⁄𝑈𝑆𝐷 Variation 4.15% 1.2050 𝐸𝑈𝑅⁄𝑈𝑆𝐷 1 1 1.2550 𝐸𝑈𝑅/𝑈𝑆𝐷 1.2050 𝐸𝑈𝑅/𝑈𝑆𝐷 Variation 3.98% 1 1.2050 𝐸𝑈𝑅/𝑈𝑆𝐷 0.7968 𝑈𝑆𝐷/𝐸𝑈𝑅 0.8298𝑈𝑆𝐷/𝐸𝑈𝑅 Variation 3.98% 0.8298𝑈𝑆𝐷/𝐸𝑈𝑅 International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 48  EXCHANGE RATES TRIANGULAR ARBITRAGE Currency exchanges cannot generate returns by the mere fact of the transaction, because arbitrage opportunities would occur. Opportunities for triangular arbitrage occur when the following equilibrium condition between the price of three currencies in the foreign exchange market is not respected: EUR/USD ∗ USD/JPY ∗ JPY/EUR ≅ 1 If this equilibrium situation did not occur, it would be possible to obtain returns by taking advantage of the imbalances between currencies in the market. In that case, the actions of the arbitrageurs would cause the market itself to adjust prices until equilibrium was reached again. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 49 EXCHANGE RATES TRIANGULAR ARBITRAGE EXAMPLE: If we have the exchange rates between these three currencies: Exchange rate 1.2068 EUR/USD 107.43 USD/JPY 129.64 EUR/JPY 1 EUR/USD ∗ USD/JPY ∗JPY/EUR 1.2068 ∗ 107.43 ∗ 1.00005 ≅ 1 129.64 Arbitrage operation with a volume of 1000 EUR:  Convert EUR to USD=1 000 𝐸𝑈𝑅 ∗ 1.2068 EUR/USD 1 206.8 𝑈𝑆𝐷  Convert USD to JPY =1 206.8 𝑈𝑆𝐷 ∗ 107.43 USD/JPY 129 646.52 𝐽𝑃𝑌.  Convert JPY to EUR = 1 000.05 𝐸𝑈𝑅. /.  Result = 0.005% International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 50  EXCHANGE RATES TRIANGULAR ARBITRAGE EXAMPLE: Suppose the balance is broken: Initial ER Final ER The EUR appreciates 3.70% against the USD ->1.2515 EUR/USD EUR/USD 1.2068 1.2515 The USD depreciates 1.25% against the JPY -> 106.09 USD/JPY USD/JPY 107.43 106.09 JPY remains the same with EUR -> 129.64 EUR/JPY EUR/JPY 129.64 129.64 1 ↑ 𝐸𝑈𝑅/𝑈𝑆𝐷 ∗↓ 𝑈𝑆𝐷/𝐽𝑃𝑌 ∗↔ JPY/EUR 1.2515 ∗ 106.09 ∗ 1.02416 129.64 The result of the arbitrage operation would be: Convert EUR to USD=1 000 𝐸𝑈𝑅 ∗ 1.2515EUR/USD 1 251.5 𝑈𝑆𝐷 Convert USD to JPY =1 251.5 𝑈𝑆𝐷 ∗ 106.09 USD/JPY 132 771.64 𝐽𝑃𝑌. Convert JPY to EUR = 1 024.16 𝐸𝑈𝑅. /. Result = 2.416% International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 51 EXCHANGE RATES TRIANGULAR ARBITRAGE EXAMPLE: The possibility of arbitrage would bring the market back to equilibrium: The EUR appreciates 3.70% with the USD ->1.2515 EUR/USD Initial ER Final ER The USD depreciates 1.25% against the JPY -> 106.09 USD/JPY EUR/USD 1.2068 1.2515 USD/JPY 107.43 106.09 The JPY has to depreciate against the EUR by 2.36%->132.77 EUR/JPY EUR/JPY 129.64 132.77 1 ↑ 𝐸𝑈𝑅/𝑈𝑆𝐷 ∗↓ 𝑈𝑆𝐷/𝐽𝑃𝑌 ∗↓ JPY/EUR 1.2515 ∗ 106.09 ∗ ≅1 132.77 The result of the arbitrage operation would be: Convert EUR to USD=1 000 𝐸𝑈𝑅 ∗ 1.2515EUR/USD 1 251.5 𝑈𝑆𝐷 Convert USD to JPY =1 251.5 𝑈𝑆𝐷 ∗ 106.09 USD/JPY 132 771.64 𝐽𝑃𝑌. Convert JPY to EUR = 1 000.01 𝐸𝑈𝑅. /. Result = 0.001% International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 52  EXCHANGE RATES TYPES OF TRANSACTIONS IN FOREX SPOT OPERATIONS A currency purchase and sale is carried out in the spot market, when the exchange is carried out immediately. By standard convention, settlement will occur up to two business days after the transaction date. The spot exchange rate is expressed in pips (Price interest point). A pip is a standardized unit, which is the last digit of the exchange rate (usually the fourth digit). The pip is used to measure an alteration in the exchange rate of a certain currency pair. For most pairs a pip is one ten thousandth of the exchange rate (1/10,000). Example: If the exchange rate goes from 1.2249 EUR/USD to 1.2250 EUR/USD , this movement is equal to one pip (1 pip = 0.0001) If the exchange rate goes from 107.15 USD/JPY to 107.16 USD/JPY , this movement is equal to 1 pip (1 pip = 0.01) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 53 EXCHANGE RATES TYPES OF TRANSACTIONS IN FOREX FORWARD OPERATIONS Forward operations, or forward, are transactions for maturities greater than two days (one month, two months, three months, six months, one year, etc.). The characteristics of the operation are set today, where the exchange rate that will be applied is determined. Delivery is made at a future date, at the predetermined exchange rate. When we analyze the forward price and compare it with the spot exchange rate we have: Forward discounted quote: the forward rate is lower than the spot rate. Forward premium quote: the forward rate is higher than the spot rate. Forward quotes can be expressed in two alternative ways: Outright price : expressed the same as the spot price, it is the number of units of price currency per unit of base currency. Swap quote: expresses the points of difference between the forward rate and the spot rate, so in this case the premium, or discount, of the forward rate is reflected. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 54  EXCHANGE RATES FORWARD OPERATIONS (FORWARD) Swap quote: The expression in swap points (or forward points) is the most common, since it allows, at a glance, to know the premium or discount at the different terms. To calculate forward points, the difference in pips with respect to the spot exchange rate is taken into account. The way to calculate them is as follows: 1 Forward points swap 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑆𝑝𝑜𝑡 ∗ 𝑝𝑖𝑝 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑜𝑢𝑡𝑟𝑖𝑔ℎ𝑡 𝑆𝑝𝑜𝑡 Forward points ∗ 𝑝𝑖𝑝 Example: If we have the following exchange rates, expressed in outright quotes: Spot exchange rate: S = 1.1550 EUR/USD One-year forward exchange rate (1Y Forward): f = 1.1350 EUR/USD The forward points with which the EUR is trading at that moment for a period of one year will be: 1 Forward Points(swap) 1.1350 1.1550 ∗ 200 Forward or swap points 0.0001 Knowing the spot price and the forward points, the forward exchange rate can be obtained: 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑜𝑢𝑡𝑟𝑖𝑔ℎ𝑡 1.1550 200 ∗ 0.0001 1.1350 EUR/USD International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 55 EXCHANGE RATES BID AND ASK EXCHANGE RATES (DUAL) The exchange rate in the foreign exchange market is twofold: Buyer exchange rate (Bid price): is the price at which the market buys the base currency. Seller exchange rate (Ask price): is the price at which the market sells the base currency. The bid is cheaper than the ask, and the differential (Spread) is the profit that the intermediary obtains for performing the foreign exchange market maker service. The spread represents a measure of the liquidity of the currency: The more liquid it is, the lower the spread (differential) For currencies that are not liquid, the ask rate will be higher, the bid rate will be smaller, and the spread will be higher. Buyer Seller Differential In % (S/ Bid ) (bid) (Ask) ( Spread) USD/EUR 0.8247 0.8267 0.0020 0.24% USD/GBP 0.5515 0.5531 0.0016 0.29% USD/JPY 108.61 108.76 0.1500 0.14% International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 56  EXCHANGE RATES BID AND ASK EXCHANGE RATES (DUAL) It must be taken into account that this buy-sell position refers to the position of the market operator, and not to that of the client (who will have the opposite position). Example For EUR/USD the market is buying the EUR (base currency) at 1.1259 USD and selling them at 1.1262 USD This way of quoting can also be reflected in a compact way: 1.1259/62 EUR/USD The Spread is 3 pips (1.1262-1.1259=0.0003) How many JPY At what do I have to exchange rate pay if I want to can I buy USD buy USD? with EUR? International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 57 INTERNATIONAL PARITY CONDITIONS Purchasing Power Parity Theory (PPPT) Interest Rate Parity Theory (IRPT) Fisher effect International Fisher effect Expectations Theory (5) Expectations (1) Purchasing power parity Theory Spot exchange Theory (PPPT) rate (4) International Forward Fisher effect Prices exchange rate Interest rates (2) Interest rate parity (3) Fisher effect Theory (IRPT) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 58  INTERNATIONAL PARITY CONDITIONS Purchasing Power Parity Theory (PPPT) Interest Rate Parity Theory (IRPT) Fisher effect International Fisher effect Expectations Theory (5) Expectations (1) Purchasing power parity Theory Spot exchange Theory (PPPT) rate (4) International Forward Fisher effect Prices exchange rate Interest rates (2) Interest rate parity (3) Fisher effect Theory (IRPT) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 58 INTERNATIONAL PARITY CONDITIONS PURCHASING POWER PARITY THEORY (PPP) (5) Expectations (1) Purchasing power parity Theory Spot exchange Theory (PPPT) rate (4) International Forward Fisher effect Prices exchange rate Interest rates (2) Interest rate parity (3) Fisher effect Theory (IRPT) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 59  INTERNATIONAL PARITY CONDITIONS PURCHASING POWER PARITY THEORY (PPPT) PPPT absolute version Establishes that the country’s price level, adjusted by the exchange rate, must be identical in all countries (Law of one price) That is, goods sold in different countries must be sold at the same price when expressed in terms of the same currency. According to the PPPT in absolute version, the exchange rate will be the one that meets the relationship: 𝑃 SB/C : Spot exchange rate of currency B (base) and C (counter) 𝑃 ∗𝑆 / 𝑃 ⇒𝑆 / PB : Price index in the country of currency B (base) 𝑃 PC : Price index in country of currency C (counter) Limitations : It assumes that we are facing competitive markets, without transaction costs. It does not consider that there are non-tradable goods and barriers to trade. It does not consider that there are international differences in the measurement of the price level. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 60 INTERNATIONAL PARITY CONDITIONS PURCHASING POWER PARITY THEORY (PPPT) PPPT absolute version- EXAMPLE Suppose that a mobile phone with certain characteristics costs 940.50 EUR in Spain and 1091.92 USD in the USA. The expected exchange rate would be: 𝑃 1091.92 𝑈𝑆𝐷 𝑆 / 1.1610 𝐸𝑈𝑅/𝑈𝑆𝐷 𝑃 940.50 𝐸𝑈𝑅 If at that moment the exchange rate in the market is the following: 1.1525 EUR/USD The EUR would be undervalued with respect to the USD (1.1525 < 1.1610), so according to this theory the EUR should appreciate. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 61  INTERNATIONAL PARITY CONDITIONS PURCHASING POWER PARITY THEORY (PPPT) PPPT absolute version BIG MAC INDEX ( The Economist ) The Big Mac PPP is the exchange rate that would make a Big Mac burger cost the same anywhere in the world. Under (-)/over(+) Big Mac Current Exchange Big Mac Implied PPP Currency valuation against Local Price (USD/Currency) Dollar Price of the Dollar the dollar (%) (1) (2) (3)=(1)/(2) (4)=(1)/ BMprice (USD) (5)=[(4)-(2)]/(2) Dollar (USD) 5.69 Yuan (CNY) 7.2276 3.53 4.4815 25.5 -37.99% Euro (EUR) 0.9241 6.06 0.9842 5.6 6.50% Pound (GBP) 0.7785 5.90 0.8067 4.59 3.61% Yen (JPY) 150.46 3.19 84.36 480 -43.93% The Big Mac index. July 2024 (The Economist) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 62 INTERNATIONAL PARITY CONDITIONS PURCHASING POWER PARITY THEORY (PPPT) PPPT relative version The PPPT in absolute terms is very restrictive because it indicates that a monetary unit of any currency must have the same purchasing power in any country. The PPPT in relative version proposes that the foreseeable variation in the exchange rate of two currencies will depend on the expected inflation rates in the respective countries. The currency of the country with the highest inflation rate will depreciate. According to the PPPT in relative version, the exchange rate will be the one that meets the relationship: 𝑆 / 1 𝜌 𝑆 / 𝑆 / 𝜌 𝜌 𝑠𝑣 / 𝑆 / 1 𝜌 𝑆 / 1 𝜌 SB/Ct : Spot exchange rate of currency B (base) and C (counter) at time t pj : Expected inflation rate in country “j” svB/C : Spot variation rate International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 63  INTERNATIONAL PARITY CONDITIONS PURCHASING POWER PARITY THEORY (PPPT) PPPT relative version- EXAMPLE Consider the following data, with the spot exchange rate being 1.1525 EUR/USD: ZONE Inflation rate (ρ) Eurozone 2% USA 2.75% The expected change in the exchange rate would be: 𝜌 𝜌 0.0275 0.02 𝑠𝑣 / 0.74% 1 𝜌 1 0.02 The expected exchange rate would be: 𝑆 / 1.1525 ∗ 1 0.0074 1.1610 𝐸𝑈𝑅/𝑈𝑆𝐷 The EUR is expected to appreciate against the USD because inflation rate is lower in the Euro Zone International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 64 INTERNATIONAL PARITY CONDITIONS INTEREST RATE PARITY THEORY (IRPT) (5) Expectations (1) Purchasing power parity Theory Spot exchange Theory (PPP) rate (4) International Forward Fisher effect Prices exchange rate Interest rates (2) Interest rate parity (3) Fisher effect Theory (IRP) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 65  INTERNATIONAL PARITY CONDITIONS INTEREST RATE PARITY THEORY (IRPT) The interest rate parity theory establishes that the forward discount or premium of one currency with respect to another is equivalent to the interest rate differential between them. The variables related are the spot and forward exchange rates with the money market interest rates. The forward price of a currency depends on the interest rates of the countries involved, the term and the spot price: 𝑓 / 1 𝑟 𝑓 / 𝑆 / 𝑟 𝑟 𝑖 𝑆 / 1 𝑟 𝑆 / 1 𝑟 SB/C : Spot exchange rate of currency B (base) and currency C (counter). fB/C : Forward exchange rate of currency B (base) and C (counter). rj : interest rate of country “j” iF : Forward currency premium or discount. According to the IRPT the forward rate of the currency with the highest interest rate will quote at a discount. The IRPT is generally observed more faithfully in the markets than the PPPT. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 66 INTERNATIONAL PARITY CONDITIONS INTEREST RATE PARITY THEORY (IRPT) EXAMPLE : Let's consider the following data, with the spot exchange rate (SEUR/USD ) being 1.1525 EUR/USD and the forward rate (fEUR /USD) of 1.1610 EUR/USD: ZONE Interest rates (r) Eurozone 2.492% USA 3.25% 𝑓 / 𝑆 / 1.1610 1.1525 𝐼 0.74% 𝑆 / 1.1525 𝑟 𝑟 0.0325 0.02492 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑙 0.74% 1 𝑟 1 0.02492 The EUR is selling at a forward premium to the USD in the market. IRPT is fulfilled: The Euro forward is appreciated and its interest rates are lower The forward premium is equal to the interest differential between the two currencies International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 67  INTERNATIONAL PARITY CONDITIONS INTEREST RATE PARITY THEORY (IRPT) EXAMPLE : If the IRPT is not met, arbitration opportunities appear: 𝑓 / 𝑆 / 1.1610 1.1525 Spot (SEUR/USD ) 1.1525 𝐼 0.74% Forward (fEUR /USD ) 1.1610 𝑆 / 1.1525 EUR interest rates 2.492% 𝑟 𝑟 0.0325 0.0249 USA interest rates 3.250% 𝐼 0.74% 1 𝑟 1 0.0249 Initial moment EUR borrowing 1000 EUR EUR Spot Sale 1152.5 USD Deposit in USD 1152.5 USD USD forward sale (principal+interest) 1189.96 USD Final moment Cancellation of USD deposit (principal+interest) 1189.96 USD Exchange USD for EUR 1024.92 EUR Loan repayment in EUR (principal+interest) 1024.92 EUR Revenue 0.00 EUR International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 68 INTERNATIONAL PARITY CONDITIONS INTEREST RATE PARITY THEORY (IRPT) EXAMPLE : If the IRPT is not met, arbitration opportunities appear: 𝑓 / 𝑆 / 1.1590 1.1525 Spot (SEUR/USD ) 1.1525 𝐼 0.56% Forward (fEUR /USD ) 1.1590 𝑆 / 1.1525 EUR interest rates 2.492% 𝑟 𝑟 0.0325 0.0249 USA interest rates 3,250% 𝐼 0.74% 1 𝑟 1 0.0249 𝑓 / 1.1525 0.74% → 𝑓 / 1.1610 1.1525 Initial moment EUR borrowing 1000 EUR EUR Spot Sale 1152.5 USD Deposit in USD 1152.5 USD USD forward sale (principal+interest) 1189.96 USD final moment Cancellation of USD deposit (principal+interest) 1189.96 USD Exchange USD for EUR 1026.71 EUR Loan repayment in EUR (principal+interest) 1024.92 EUR Revenue 1.79 EUR International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 69  INTERNATIONAL PARITY CONDITIONS FISHER EFFECT (5) Expectations (1) Purchasing power parity Theory Spot exchange Theory (PPP) rate (4) International Forward Fisher effect Prices exchange rate Interest rates (2) Interest rate parity (3) Fisher effect Theory (IRP) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 70 INTERNATIONAL PARITY CONDITIONS FISHER EFFECT The Fisher effect relates nominal interest rates in a country to its real interest rates and the inflation rate. Nominal interest rate: interest rate offered in the market Real interest rate: interest rate adjusted for expected inflation The Fisher effect establishes that a country's nominal interest rates reflect, in advance, the real required yields adjusted by inflation expectations. 1 𝑟nominal 1 𝑟real ∗ 1 𝜌 In different countries, real yields must tend towards equality, so differences in nominal rates are due to different inflation expectations. 1 𝑟n𝐵 1 𝑟r𝐵 ∗ 1 𝜌 ⇔ 1 𝑟n𝐶 1 𝑟r𝐶 ∗ 1 𝜌 𝑟r𝐵 𝑟r𝐶 𝑟 𝑟 𝜌 𝜌 1 𝑟 1 𝜌 International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 71  INTERNATIONAL PARITY CONDITIONS FISHER EFFECT EXAMPLE : Let's consider the following data regarding nominal interest rates and inflation: ZONE Interest Inflation rates rates Eurozone 2.492% 2% USA 3.25% 2.75% Differences in nominal rates must be adjusted to different inflation expectations 𝑟 𝑟 0.0325 0.02492 0.74% 1 𝑟 1 0.02492 𝜌 𝜌 0.0275 0.02 0.74% 1 𝜌 1 0.02 International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 72 INTERNATIONAL PARITY CONDITIONS INTERNATIONAL FISHER EFFECT (5) Expectations (1) Purchasing power parity Theory Spot exchange Theory (PPP) rate (4) International Forward Fisher effect Prices exchange rate Interest rates (2) Interest rate parity (3) Fisher effect Theory (IRP) International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 73  INTERNATIONAL PARITY CONDITIONS INTERNATIONAL FISHER EFFECT This theory postulates that the total return of the international investor, in different countries, should be equal in the long term. It combines the Purchasing Power Parity Theory (PPPT) and the Fisher effect, relating exchange rates to interest differentials. 𝜌 𝜌 𝑟 𝑟 𝜌 𝜌 𝑃𝑃𝑃𝑇 ⇒ 𝑠𝑣 / Fisher Effect ⇒ 1 𝜌 1 𝑟 1 𝜌 𝑟 𝑟 International Fisher Effect ⇒ 𝑠𝑣 / 1 𝑟 The currencies of countries with high nominal interest rates will have to depreciate in the long term, during the period of these interest rates. However, in the short term, the evidence seems to be the opposite and increases in interest rates in the money market lead to appreciations of the corresponding currency due to the flow of investments attracted by higher profitability. International Finance- 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 74 INTERNATIONAL PARITY CONDITIONS INTERNATIONAL FISHER EFFECT EXAMPLE : Let's consider the following data, with the spot exchange rate being 1.1525 EUR/USD: ZONE Interest rates