International Finance 4th Grade/GE PDF

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 FINANCE (4th GADE/GE) THEMATIC BLOCK 1: THE FOREIGN EXCHANGE MARKET AND EXCHANGE RATES LESSON 2. HEDGE AND RISK MANAGEMENT INDEX OF CONTENTS  Hedging using Swaps  Hedging using futures and options International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 2  HEDGING USING SWAPS INTEREST RATE SWAPS (IRS) Fixed-Variable IRS (Coupon Swap or Plain Vanilla ) Variable-Variable IRS (Basis Swap ) CURRENCY SWAPS Fixed-Variable Currency Swap ( Cross-currency coupon Swap ) Variable-Variable Currency Swap (Floating rate currency Swap ) Fixed-Fixed Currency Swap (Standard currency Swap ) International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 3 HEDGING USING SWAPS INTEREST RATE SWAP (IRS) Definition An interest rate swap is a private financial contract between two parties, who undertake to exchange interest payment obligations corresponding to financial loans, for a certain period of time and in the same currency, without transfer of principal. Swap contracts carry counterparty risk Counterparty risk: that the party with whom we have negotiated the operation fails to comply with its obligations on the established settlement dates. Swaps are usually carried out through a financial institution, which acts as an intermediary to guarantee the successful completion of the operation. The counterparty risk is mitigated when the transaction is arranged through a financial intermediary. The relationship between the buyer and seller of a swap contract is anonymous International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 4  HEDGING USING SWAPS INTEREST RATE SWAP (IRS) Requirements for an IRS to be carried out : Two parties that decide to manage their interest risk, and have contrary expectations about its evolution. Each one can access a certain market under different conditions than the other party. The global position of the two parties represents savings with respect to the individual position of each of them Characteristics of an IRS An exchange of future cash flows. Cash flows are calculated on a different basis (fixed and variable or both variables) Interests are settled by differences (net interests payments) The cash flows are denominated in the same currency. There is no exchange of principal. International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 5 HEDGING USING SWAPS INTEREST RATE SWAP (IRS) FIXED-VARIABLE IRS (COUPON SWAP OR PLAIN VANILLA ) Swap leg Each of the sets of payments associated with each interest rate Fixed leg (normally annually) Variable leg (normally semiannual) Swap Coupon Fixed rate to pay Notional Base on which interest is calculated (also called notional principal)  Swap Broker Intermediary who buys and sells the interest rate at a certain price International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 6  HEDGING USING SWAPS INTEREST RATE SWAP (IRS) FIXED-VARIABLE IRS (COUPON SWAP OR PLAIN VANILLA ) Example Company (A): has debt at a fixed interest rate, but thinks that interest rates may have a downward trend and would like to be in debt at a variable rate: Debt nominal: 1 million EUR Term: 4 years Fixed interest rate: 3.75% (annual payments) Company (B): has debt at a variable rate, but is concerned about a possible rise of interest rates and would prefer to be in debt at a fixed rate. Debt nominal: 1 million EUR Term: 4 years Variable interest rate: EURIBOR + 25 bp (semi-annual payments) International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 7 HEDGING USING SWAPS INTEREST RATE SWAP (IRS) FIXED-VARIABLE IRS (COUPON SWAP OR PLAIN VANILLA ) Example The two companies could arrange a Swap, which basically consists of each company paying the interest denominated in the base of the other company. For the swap to fulfill its objective, it must be designed properly; it is not just a direct exchange of interests between the parties. To do this, the most common thing is that the Swap is done through a financial intermediary (Swap Broker), who is the one who designs the contract. For example, the intermediary buys and sells the EURIBOR with the following structure:  EURIBOR: 3.25-75 (buys EURIBOR at 3.25% and sells it at 3.75%) To calculate the effective cost of the operation, the days will have to be adjusted depending on the market from which the payments for each leg come: In the money market, commercial years (360 days) are usually used (REAL/360 convention) In the debt market, calendar years (365 days) are usually used (REAL/365 convention) International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 8  HEDGING USING SWAPS INTEREST RATE SWAP (IRS) FIXED-VARIABLE IRS (COUPON SWAP OR PLAIN VANILLA) 3.25% 3.75% Swap Broker Company A Company B EURIBOR: 3.25-75 EURIBOR EURIBOR 3.75% EURIBOR +25bps Company A wants to be in debt at a variable rate: it will sell the EURIBOR to the Swap Broker Company B wants to be in debt at a fixed rate: it will buy the EURIBOR from the Swap Broker Payments: 360 Company A: 3.75% + EURIBOR - 3.25% = EURIBOR + 50bp EURIBOR+50 =EURIBOR+49bp 365 365 Company B: EURIBOR +25bps + 3.75% - EURIBOR = 4% +3.75%=4.003% 25 360 The Swap Broker earns the difference between the buying and selling price (50 bp). If a company makes a mistake in predicting interest, it has two alternatives: Enter into a reverse swap Exit the Swap by paying the Swap Broker the difference between the two legs (Swap Value) International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 9 HEDGING USING SWAPS INTEREST RATE SWAP (IRS) HEDGE THROUGH AN IRS Company B's debt has a term of 4 years and variable semiannual payment. To hedge against increases in the EURIBOR, enters the Swap with a Swap coupon of 3.75% per year. 3.75% Cost with swap: Swap Broker EURIBOR +25bp + 3.75% - EURIBOR Company B 365 EURIBOR: 3.25-75 25 3.75%=4.003% EURIBOR 360 EURIBOR +25bp 0 0.5 1 1.5 ……. 4 Loan 𝐸𝑈𝑅𝐼𝐵𝑂𝑅. 25𝑝𝑏 365 𝐸𝑈𝑅𝐼𝐵𝑂𝑅 25𝑝𝑏 365 𝐸𝑈𝑅𝐼𝐵𝑂𝑅. 25𝑝𝑏 365 𝐸𝑈𝑅𝐼𝐵𝑂𝑅 25𝑝𝑏 365 Nominal: 1M EUR ∗ ∗ ∗ ∗ 2 360 2 360 2 360 2 360 Swap Notional: 1M EUR Fixed leg 3.75% 3.75% 𝐸𝑈𝑅𝐼𝐵𝑂𝑅 365 𝐸𝑈𝑅𝐼𝐵𝑂𝑅 365 𝐸𝑈𝑅𝐼𝐵𝑂𝑅 365 𝐸𝑈𝑅𝐼𝐵𝑂𝑅. 365 Variable leg ∗. ∗ ∗ ∗ 2 360 2 360 2 360 2 360 Hedge 25𝑝𝑏 365 25𝑝𝑏 365 25𝑝𝑏 365 25𝑝𝑏 365 ∗ 3.75% ∗ ∗ 3.75% ∗ 2 360 2 360 2 360 2 360 International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 10  HEDGING USING SWAPS 3.75% INTEREST RATE SWAP (IRS) Swap Broker Company B HEDGE THROUGH AN IRS EURIBOR: 3.25-75 EURIBOR EURIBOR +25bp EURIBOR Direct debt Payment Calendar Fixed leg Variable leg (forecast) payments hedged 01/01/2025 2.75% -1 000 000 -1 000 000 01/07/2025 3.00% 15 208 13 941 1 267 01/01/2026 3.25% 16 476 37 500 15 208 38 767 01/07/2026 3.75% 17 743 16 476 1 267 01/01/2027 4.25% 20 278 37 500 19 010 38 767 01/07/2027 4.75% 22 813 21 545 1 267 01/01/2028 5.00% 25 347 37 500 24 080 38 767 01/07/2028 5.50% 26 615 25 347 1 267 01/01/2029 6.00% 1 029 149 37 500 27 882 1 038 767 IRR 4.34% 4.01% Whatever happens with interest rates (EURIBOR), the company will pay an IRR of 4.01%. By adjusting the notional of the swap we can carry out partial hedging: Unhedged: 500 000 EUR (4.34%) Notional Nominal Total Cost 500 000 EUR 1 000 000 EUR 4.17% Hedged: 500 000 EUR (4.01%) International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 11 HEDGING USING SWAPS INTEREST RATE SWAP (IRS) VALUATION OF AN IRS The value of a Swap is equal to the difference between the fixed and variable legs. Swap Value = Current Value (Fixed leg) - Current Value (Variable leg) At the time of contracting the value of the swap must be zero. Throughout the life of the swap, the evolution of interest rates will affect the payments of the variable leg, which will cause the value of the swap to vary in one direction or another. Zero coupon curve (Term structure of interest rates) To calculate current values, the appropriate discount rate must be used, which is the zero coupon rate that exists in the market at the time of valuation for each maturity. Zero coupon rates indicate the return that the market would be demanding for each term, for a risk-free asset that does not pay periodic coupons. Zero coupon rates are not directly observable in the financial markets (especially for maturities greater than one year). They are calculated from different interest rates observable in the market through methodologies such as "Bootstrapping". International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 12  HEDGING USING SWAPS INTEREST RATE SWAP (IRS) VALUATION OF AN IRS Value of the fixed leg: it is calculated as if it were a fixed rate bond, with the following structure: Interest: equal to the swap coupon Nominal: equal to the notional of the swap Discount rate: the zero coupon rate that exists in the market for each maturity. Coupon Coupon Coupon Notional 0 1 2 n 0𝑟 0𝑟 0𝑟 Coupon 𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝐹𝑖𝑥𝑒𝑑 𝑙𝑒𝑔 1 r 1 r International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 13 HEDGING USING SWAPS INTEREST RATE SWAP (IRS) VALUATION OF AN IRS  Value of the variable leg: the future reference interest rates are not known. The variable leg calculates the coupons for the expired period (that is, the coupon for period n is calculated with the interest rate of the previous period). Therefore, the first coupon is known. 𝑬𝒖𝒓𝒊𝒃𝒐𝒓𝟎 𝐸𝑢𝑟𝑖𝑏𝑜𝑟 𝐸𝑢𝑟𝑖𝑏𝑜𝑟 Notional 0 1 2 n 0𝑟 0𝑟 0𝑟 The current value of the variable leg is equal to the current value of the first coupon plus the notional at the zero coupon interest rate for the first coupon period: Coupon 𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑙𝑒𝑔 1 r Financially, it is indifferent to pay flows indexed to EURIBOR or to pay the corresponding principal and let the recipient invest it in at EURIBOR rate. International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 14  HEDGING USING SWAPS INTEREST RATE SWAP (IRS) VALUATION OF AN IRS Example One year after carrying out the operation, Company B wants to know the value of the swap. There are three years left until expiration Swap coupon (3.75% annually) Semi-annual variable coupons (EURIBOR) Reference interest rates: EURIBOR at the time of valuation=3% Term structure of interest rates Term TSIR Expiration (Zero Coupon) 0.5 3.150% 1 3.250% 2 3.759% 3 4.279% International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 15 HEDGING USING SWAPS INTEREST RATE SWAP (IRS) VALUATION OF AN IRS To calculate the first coupon of the variable leg, two adjustments must be made: As it is semi-annual, the EURIBOR term will have to be adjusted We have to adjust the days TSIR Discount Current Current Calendar Term Fixed rate Variable rate (Zero Coupon) Factor Fixed rate Variable rate 01/01/2026 01/07/2026 0.50 3.15% 1 015 208.33 0.984738 0.00 999 714.32 01/01/2027 1.00 3.25% 37 500 0.968523 36 319.61 0.00 01/01/2028 2.00 3.76% 37 500 0.928849 34 831.82 0.00 01/01/2029 3.00 4.28% 1 037 500 0.881781 914 847.28 0.00 Swap Coupon 3.75% 985 998.71 999 714.32 EURIBOR (t-1) 3% Notional 1 000 000 Difference -13 715.60 Swap with positive value for the one who pays fixed and receives variable, in the money (ITM) Swap with negative value for the one who pays variable and receives fixed, out of the money (OTM) International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 16  HEDGING USING SWAPS INTEREST RATE SWAP (IRS) VALUATION OF AN IRS The valuation of the Swaps allows the theoretical Swap coupon to be calculated for each moment (fixed coupon (c%) that makes the value of the two legs of the Swap equal) TSIR Discount Current Variable Calendar Term Fixed rate Variable rate Current Fixed rate (Zero Coupon) Factor rate 01/01/2025 07/01/2025 0.50 3.15% 1 015 208.33 0.984738 999 714.32 01/01/2026 1.00 3.25% c 0.968523 C*0.968523 0.00 01/01/2027 2.00 3.76% c 0.928849 C*0.928849 0.00 01/01/2028 3.00 4.28% C+1 000 000 0.881781 (C+1 000 000)*0.881781 0.00 Theoretical swap c% coupon Coupon in um. C=c%*1 000 000 C* 0.968523 + C *0.928849 + (C+1 000 000)* 0.881781 = 999 714.32 EURIBOR (t-1) 3% c%= 4.24% Notional 1 000 000 Theoretical Swap coupon: 4.24% (has a direct relationship with the evolution of interest rates) If at that moment we wanted to enter into that swap, the swap coupon would be 4.24% instead of the 3.75% it had a year before. International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 17 HEDGING USING SWAPS CURRENCY SWAPS A currency swap is used to hedge the risk of exchange rate volatility. It is a financial contract between two parties, who wish to exchange their respective principals, of equal amounts, but in different currencies. During the period of time determined in the swap, interest payment streams are exchanged in different currencies At the end of the period the principal amounts are exchanged at the exchange rate agreed upon at the beginning of the agreement. The principals have typically been obtained by borrowing in the respective markets. International Finance - 4º GADE/GE (2024-25) – Professor Dr. Carlos López Gutiérrez - Universidad de Cantabria 18  HEDGING USING SWAPS CURRENCY SWAPS COMPARISON BETWEEN CURRENCY SWAPS AND IRS: In Currency Swaps, interest payments are made in different currencies, while in IRSs they are made in the same currency. In Currency Swaps there is an exchange of the principal and in IRS there is not. The agreed exchange rate is usually the spot rate at the beginning of the swap. Alternative execution: There may be no exchange of principals, but a compensatory payment is established for the currency that has appreciated. Currency Swaps, like IRS, are usually carried out with the intervention of a specialist intermediary (swap broker,