Lecture 1 FOREX – Part 1 PDF

Advanced Finance Lecture 1 FOREX – Part 1 Dr. Hadeer Mounir [email protected] Course Outline Course Instructor: Dr. Hadeer Mounir Email: [email protected] Office: B3.112 Office Hours: Appointments by Email Course Assessment Final Exam 40% Midterm...

Advanced Finance Lecture 1 FOREX – Part 1 Dr. Hadeer Mounir [email protected] Course Outline Course Instructor: Dr. Hadeer Mounir Email: [email protected] Office: B3.112 Office Hours: Appointments by Email Course Assessment Final Exam 40% Midterm 20% Course Work: 40% Quizzes 20% (Best 2 of 3) Assignments 20% (Best 2 of 3)  Course Content 1. Foreign Exchange Market (FOREX): Lec. 1 - 5 2. Hedging Exchange Rate Risk: Lec. 6 3. Stock Market Indices: Lec. 7 4. Efficient Market Hypothesis (EMH): Lec. 8 5. Mergers & Acquisitions (M&A): Lec. 9 - 10 6. Leasing: Lec. 11  Lecture 1 Learning Goals Overview on Foreign Exchange Markets & Characteristics Exchange Rates Quotations Bid-Ask Spread  Introduction to Foreign Exchange Markets (FEM/ FOREX) Foreign Exchange (FE): the money of a foreign country Foreign Exchange Market (FEM) (Forex): is the market for buying and selling “trading” foreign currencies or foreign exchange. So, it is the market in which one country’s currency is traded for another’s. Common Currency Codes: US Dollar = USD $, British Pound = GBP £, Euro = EUR €, Swiss Francs = CHF, Japanese Yen = JPY ¥, Egyptian Pound = EGP….  Characteristics of Foreign Exchange Markets (FEM/ FOREX) Characteristics of FOREX: 1. An over-the-counter “OTC” market: there is no single central location where traders get together; have no physical marketplace; Instead, traders communicate using computer terminals, phones, and other telecommunications devices 2. 24/7 : Trades spread over most time zones, sleepless market. 3. High Liquidity: The currency is considered to be the most widely traded financial instrument across the globe, making the forex market highly liquid. 4. FX market is the largest market in the world Global Currency Trading: The Trading Day Foreign Exchange Market Participants -Central Banks -Commercial Banks -Firms: Importers and exporters -Individuals -Portfolio managers -FOREX Brokers -Speculators -Investors (Traders) Exchange Rate Quotation An exchange rate is the price of one country’s currency in terms of another country’s currency. Simply, how many units of one currency in return for another currency. 2 Methods of Quotations “2 ways of expressing Exchange Rate”: 1) Direct Quote “American way” 2) Indirect Quote “European way” Exchange Rate Quotation 2 Methods of Quotations “expressing”: Assume EGP is home currency 1. Direct Quotation or “American”: the price of 1 foreign currency in terms of home currency or simply the domestic price of foreign currency. The amount of home currency needed to purchase one unit of a foreign currency. USD 1.00=EGP48, expressed as EGP 48/$. How many EGP it takes to buy 1$. Base Currency Price Currency 2. Indirect Quotation or “European”: the price of 1 home currency in terms of foreign currency or the foreign price of a domestic currency. The amount of foreign currency required to purchase one unit of Home currency. EGP 1.00 = USD 0.02, expressed as $0.02/EGP. Base Currency Price Currency Notice that the two numbers are reciprocals of each other (1/48 = 0.02).  Exchange Rates EGP is Home (Domestic, Local) Currency Direct Quote: USD 1 = EGP 47.7 NOTE: DO NOT FORGET TO WRITE THE CURRENCY Indirect Quote EGP 1 = USD 0.021 Notice that the two quotes are reciprocals of each other. Since 1 USD = 47.5 EGP we can immediately get the indirect by reciprocal 1 EGP = 1 / 47.5 = 0.021 USD We can also use the concept of Cross multiplication 1 USD = 47.5 EGP ?? USD = 1 EGP ?? USD = (1 X 1) / 47.5 = 1 / 47.5 = 0.021 USD (Same result as reciprocal) Example: Assume EGP is the home currency Direct 1.00 EUR = 52 EGP or EGP 52/€. Indirect: 1.00 EGP = 0.019 EUR or € 0.019/EGP.  Exchange Rates Note: Every Exchange Rate can be Direct and Indirect at the same time based on the nationality of the persons: Example: $0.008715/ JPY “0.008715 USD per 1 JPY” Direct quote in the US (American), and an indirect quote in Japan (Japanese) JPY 114.75/$ “114.75 JPY per 1 USD” Direct quote in Japan (Japanese), and an indirect quote in the US (American).  Exchange Rates Ex: Suppose a traveler has $10,000, and the exchange rate is C$1.5 per $, how many Canadian Dollars can he buy? Exchange rate: $ 1 = C$ 1.5 Using Cross Multiplication: $1 = C$ 1.5 $ 10,000 = C$ ??? “different currencies – multiply” 10,000 $ X 1.5 C$ = C$ 15,000 Ex: Suppose an American tourist is visiting India and he wants to buy a souvenir that costs 2000 Indian Rupees and the current exchange rate is INR 45/ USD, How much does it cost in US dollars? Exchange rate: USD 1 = INR 45 How to solve? If different currencies we Again using cross multiplication: Multiply USD 1 = INR 45 If Same currencies we Divide USD ?? = INR 2000 “Same currencies – divide” 2000 INR ÷ 45 INR = USD 44.44 Exchange Rates Ex: a) How many yen will it cost a Japanese importer to purchase $1,000 worth of oranges from a Californian farmer? b) How many dollars will it take for that farmer to buy a Japanese machine priced in Japan at 30,000 yen (¥)? The exchange rate is ¥107.52 per USD Answer : The exchange rate is $ 1 = ¥107.52 a) The $1000 of oranges will require the Japanese importer to come up with $ 1000 × ¥107.52 = ¥107,520. b) The machine will require the American importer to come up with ¥30,000/ ¥ 107.52 = $279. Currency Appreciation/Depreciation Appreciation (or strengthening) of a currency: When the currency’s "spot" rate has increased in value in terms of some other currency “based on supply and demand”. Depreciation (or weakening) of a currency: When the currency’s spot rate has decreased in value in terms of some other currency “based on supply and demand”. Example, suppose that the current exchange rate is $1.06/€ but after 3-month it becomes $1.28/ € This means the euro has appreciated against the U.S. dollar, and the US dollar has depreciated against the euro.  Bid-Ask Spread Because a dealer does not know whether the prospective customer is to buy or sell, quotes are given in pairs. First rate: ‘buy’ or ‘bid’ price Second rate: ‘sell’, ‘ask’ or ‘offer’ price The bid price is what the dealer (Bank) is willing to pay for a currency to buy it, The ask price is the rate at which a dealer (Bank) will sell the same currency. Bid-Ask Spread Example: If USD/GBP is 2.0816 – 2.0820 (1 GBP = 2.0816 USD – 2.0820 USD) This is a direct quote in the US and an indirect quote in the UK. A US bank will buy £1 for $ 2.0816 (Bid) and sell £1 for $2.0820 (Ask). If GBP/USD is 0.4803 – 0.4804 (1 USD = 0.4803 GBP – 0.4804 GBP) This is a direct quote in the UK and an indirect quote in the US. Quotes can be expressed in only the differing decimal points (or pips), such as USD/GBP is 2.0816 –20. 13 Bid-Ask Spread Banks provide foreign exchange services for a fee: a bank’s bid (direct) quote for a foreign currency will be less than its (direct) ask quote. The bid-ask spread is defined as the difference between the ask rate and bid rate However, the bid-ask spread is the usually given as a percentage and it is calculated as: Bid-Ask Spread % = (ask rate – bid rate)/ask rate Example, suppose that If USD/GBP is currently 2.0816 – 20, the bid- ask spread is equal to (2.0820-2.0816)/2.0820 =.0001921 or 0.019%. Bid-Ask Spread When direct quotations are converted to indirect quotations, bid and ask quotes are reversed. That is: The direct ask price is the reciprocal of the indirect bid price. The direct bid price is the reciprocal of the indirect ask price. No matter how the quote is made, dealers will always buy low and sell high to make profits. Bid-Ask Spread Examples – Exchange Rates Ex: If an Egyptian client wants to sell 10,000 USD, how much will he receive from the Egyptian bank? Rate: EGP/USD 47 - 48 Answer: USD 1 = 47 EGP – 48 EGP “Direct for the Egyptian” Client sells $ 10,000, Meaning Bank buys $10,000 , so we use the lower Price “Bid rate” (47 EGP/ 1$) 1$ = 47 EGP 10000$ = ?? EGP Thus, USD 10000 X 47 EGP = 470,000 EGP  Examples – Exchange Rates Ex: Ellen is an American traveling to Europe, and wants to buy EUR 5,000. At the airport, the following is stated: EUR 1 = 1.30 - 1.40 USD. How much would she pay? Answer: We have to use the ask “higher price” as the bank sells euros Ask Rate: USD 1.40/EUR. Thus, 5,000 euros cost EUR 5,000 x USD 1.40 = 7,000 USD. Examples – Exchange Rates Ex: If an Egyptian client wants to sell 150,000 Euros, how much will he receive from the Egyptian bank? Rate: EUR / EGP 0.01850- 0.01852 Answer: 1 EGP = 0.01850- 0.01852 EUR “Indirect to Egyptian” Note that this is an indirect quote to Egyptian and that the transaction amount 150,000 Euro does not have the same currency as the Base currency (1 EGP) Client sells Euro (buys EGP), Bank buys Euro (Sells EGP at Ask price) In this case, we need to reverse so instead of the bank buying at Bid, in this case, Bank buys at Ask (0.01852 EUR) since Indirect Quote 150,000 Euro ÷ 0.01852 Euro = 8,099,352 EGP “Another solution” Examples – Exchange Rates Ex: If an Egyptian client wants to sell 150,000 Euros, how much will he receive from the Egyptian bank? Rate: EUR / EGP 0.01850- 0.01852 Another Solution: 1 EGP = 0.01850- 0.01852 EUR “Indirect to Egyptian” We can get the reciprocal “Direct Quote” so that the transaction amount currency would be same as the Base Currency. Get the Reciprocal and reverse the Bid and Ask positions: Old Bid: EUR 1 = 1/0.01850 = 54.0540 EGP (New Ask) Old Ask: EUR 1 = 1 /0.01852 = 53.9956 EGP (New Bid) 1 EUR = 53.9956 EGP – 54.0540 EGP Client sells 150,000 EUR, Bank buys 150,000 EUR at Bid (53.996 EGP/ 1 EUR) 150,000 EUR X 53.9956 EGP = 8,099,340 EGP Examples – Exchange Rates Ex.: Consider a traveler who wants to visit Japan and need 50,000 JPY. The American bank quotes the following: USD 1 = 149 JPY - 150 JPY. How much dollars would the traveler pay? Answer: The American traveler buys yen (Sells “pays in” USD), Bank sells Yen (Bank Buys USD at the Bid price of USD): USD 1 = 149 JPY JPY 50,000 / JPY 149 = USD 335.57. FOREX to be Continued Next Lecture