Page 1 International Finance Lecture 2

Page 2 Foundations of International Financial Management Globalization and the Multinational Firm International Monetary System Balance of Payments The Market for Foreign Exchange International Parity Relationships

Page 3 Balance of Payments The Balance of Payments is the statistical ________ of a country’s (her citizens and her government’s international transactions over a certain period of time. Every country prepares and publishes ________ balance of payment statements. They are composed of the following: –The Current Account –The Capital/Financial Account –Statistical Discrepancy View actual Canadian, US, French, Russian, Ukrainian Balance of Payments statementsCanadianUSFrenchRussianUkrainian

Page 4 The Current and Capital Accounts Current Account –Includes all ________ and ________ of goods and services. –Includes unilateral transfers of foreign aid. –If the debits > credits, then trade deficit. –If the credits > debits, then trade surplus. Capital Account –The capital account measures the difference between home country sales of ________ to foreigners and home country purchases of foreign ________. –Composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

Page 5 Statistical Discrepancy and Official Reserve Account There’s going to be some ________ and misrecorded transactions –we use a “plug” figure to get things to balance. Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF.

Page 6 The Balance of Payments Identity BCA + BKA + BRA = 0 where –BCA = balance on ________ account –BKA = balance on ________ account –BRA = balance on the ________ account Under a pure flexible exchange rate regime, BCA + BKA = 0

Page 7 Canada’s Balance of Payments Source: CANSIM

Page 8 Balance of Payments and the Exchange Rate Current account + Capital account + Reserves –Balance > 0 inflow of capital, quantity ________ of home currency > quantity supplied, ________ pressure on home currency value –Balance < 0 Outflow of capital, quantity demanded of home currency < quantity supplied, ________ pressure on home currency value –Equilibrium can continue __________, disequilibrium cannot. –If the balance is not zero for long time, it is a disequilibrium and will be corrected by the market in the long run several scenarios possible, material for international economics course –Price of home currency is the exchange rate # Units of local currency / 1 unit of foreign currency (direct) # Units of foreign currency / 1 unit of local currency (indirect)

Page 9 Foundations of International Financial Management Globalization and the Multinational Firm International Monetary System Balance of Payments The Market for Foreign Exchange International Parity Relationships

Page 10 The FOREX Market

Page 11 The FOREX Market Structure –Place of trading ________ –Volume Wholesale (________) and retail –Timing ________ : deal now, deliver now (up to 2 business days) ________ (deal now, deliver in the future)

Page 12 Spot Rate Quotations Direct quotation –the Canadian ________ equivalent –e.g. “a Japanese Yen is worth about a penny” Indirect Quotation –the price of a Canadian dollar in the foreign currency –e.g. “you get 100 ________ to the dollar” View daily foreign exchange rate updates from the US Federal Reserve System or the Bank of CanadaFederal Reserve Systemthe Bank of Canada

Page 13 Exchange rates and trade The following table provides domestic prices for three items in Australia and Hong Kong. If AUD 1 = 6 HKD, then what is the likely flow of goods? Ignore transaction costs. ItemAustralia (AUD)HK (HKD) Shoes2080 Watches40180 Surfboards80550

Page 14 Exchange rates and trade Over the past 5 years the CHF/USD exchange rate has changed from 1.20 to Did the Swiss goods become more or less expensive for the US customers?

Page 15 Spot FX trading Bid-ask spread –The bid price is the price a dealer is ________ to pay to buy the currency. –The ask price is the amount the ________ wants to sell you the currency. –The bid-ask spread is the difference between the bid and ask prices. Trading –In the interbank market, the standard size trade is about U.S. $10 million. –A bank trading room is a noisy, active place. –The stakes are high. –The “long term” is about 10 minutes. Cross- rates: view major BloombergBloomberg

Page 16 Bid-ask spread Direct ask (DC/FC) = 1 / Indirect bid (FC/DC) Direct bid (DC/FC) = 1 / Indirect ask (FC/DC) –Notation: DC=domestic currency, FC=foreign currency

Page 17 Example If the direct quotation for the exchange rate is USD/EUR= , then what is the indirect EUR/USD quote?

Page 18 Bilateral arbitrage Assume no transaction costs for now. (=ignore bid- ask spread) Domestic currency is DC, foreign currency is FC, exchange rate is DC/FC You observe two rates at ________ banks: DC/FC bank1 and DC/FC bank2 No-arbitrage: DC/FC bank1 * FC/DC bank2 must ________ Reason: Law of One Price –the price of the same item should be the same regardless of where it is sold, otherwise there will be arbitrage opportunities –Mathematically, DC/FC * FC/DC = 1

Page 19 Bilateral arbitrage You observe the following spot rates in two banks: In Frankfurt: EUR/GBP = and in London: GBP/EUR= Is there an arbitrage opportunity and if yes, what is it? Ignore transaction costs.

Page 20 Bilateral arbitrage You observe the following spot rates in two banks: In Canada: JPY/CAD = and in Japan: JPY/CAD= Is there an arbitrage opportunity and if yes, what is it?

Page 21 Exchange rates and investment A Canadian portfolio manager is planning to buy $15 million worth of German bonds. The manager calls several banks to find out spot rates. The quotes that she gets is below. How many Euros will the manager invest in German bonds? BankABC EUR/CAD

Page 22 Exchange rates and investment A foreign exchange trader at a US bank took a short position of GBP 5,000,000 when the USD/GBP rate was After that the exchange rate changed to (a) Is this movement beneficial for the FX trader in question? (b) How did the US bank’s liability change as a result of this FX rate move?

Page 23 Cross Rates Suppose that S($/SFr) =.50 – i.e. $1 = 2 SFr and that S(¥/SFr) = 50 – i.e. SFr1 = ¥50 What must the $/¥ cross rate be?

Page 24 Cross Rates You find the following rates in the newspaper. USD/EUR=0.9119, CHF/USD=1.5971, JPY/USD= Compute all cross-rates.

Page 25 Cross Rates and Bid-Ask Spread Notation: DC=domestic currency, FC1=foreign currency #1, FC2=foreign currency #2 Cross-rates FC1/FC2 –(FC1/FC2)ask=(FC1/DC)ask * (DC/FC2)ask –(FC1/FC2)bid=(FC1/DC)bid * (DC/FC2)bid Cross-rates FC2/FC1 –(FC2/FC1)ask=(DC/FC1)ask * (FC2/DC)ask –(FC2/FC1)bid=(DC/FC1)bid * (FC2/DC)bid

Page 26 Cross Rates and Bid-ask Spread A bank is quoting the following exchange rates: USD/EUR= , CHF/USD= What is the CHF/EUR cross-rate?

Page 27 Cross Rates and Bid-ask Spread A bank is quoting the following exchange rates: CHF/CAD= , AUD/CAD= An Australian firm asks for CHF/AUD rate. What cross-rate will the bank quote?

Page 28 Triangular Arbitrage Idea: look for the quoted cross-rates FC1/FC2 (between two foreign currencies FC1 and FC2) –And see if they differ from the implied rates suggested by the DC/FC1 and DC/FC2 (domestic currency rates against the two foreign currencies) –If any of the three currencies is over/underpriced, all cross-rates will present arbitrage opportunities. If transaction costs are ignored –Check whether (DC/FC1)*(FC1/FC2)*(FC2/DC)= ________ Transaction costs –Check whether quoted and cross-rate bid-ask spreads overlap for any currency out of our three currencies. –If you have rate 1 [bid1, ask1] and rate 2 [bid2, ask2] such that ask2<bid1, buy at ask2 and sell at bid1.

Page 29 Triangular Arbitrage Example You observe these rates: –Tokyo ¥/$ , NYC SF/$ , Zurich ¥/SF80.00

Page 30 Triangular Arbitrage Example You observe these quotes below. Is any currency arbitrage possible? Calculate cross-rates and compare with the quoted rates

Page 31 Spot Foreign Exchange Microstructure Market Microstructure refers to the ________ of how a marketplace operates. Bid-Ask spreads in the spot FX market: –increase with FX exchange rate volatility and –decrease with dealer competition. Private information is an important determinant of spot exchange rates.

Page 32 The Forward Market A forward contract is an ________ to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract. The forward market for FOREX involves agreements to buy and sell foreign currencies in the ________ at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term contracts are available.

Page 33 The Forward Market Transactions – ________ forward transaction: do a regular forward contract – ________ : simultaneous sale (or purchase) of spot foreign exchange and corresponding purchase (or sale) of approximately equal amount of foreign currency View rates at BMO Economics or Federal Reserve of New YorkBMO EconomicsFederal Reserve of New York

Page 34 The Forward Market You observe the spot rate EUR/USD= and the 1-month forward EUR/USD= , what does it mean? is the dollar trading at premium or discount? Is the dollar weak or strong?

Page 35 The Forward Market Annualized forward premium/discount

Page 36 The Forward Market You observe the following. Spot USD/GBP= , and 6-months forward USD/GBP= Is GBP trading at a premium or discount relative to the USD? Compute the annualized forward discount/premium.

Page 37 Long and Short Forward Positions If you have agreed to sell anything (spot or forward) you are “ ________ ”. If you have agreed to buy anything (forward or spot) you are “ ________ ”. If you have agreed to ________ forex forward, you are short. If you have agreed to ________ forex forward, you are long.

Page 38 Payoff Profiles 0 S 180 ($/¥) F 180 ($/¥) = Short position loss profit

Page 39 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 Long position -F 180 (¥/$) F 180 (¥/$) short position profit

Page 40 Forward Speculation Today the 3-month forward rate is USD/CHF= A currency trader decides to bet on depreciation of the Swiss franks by selling CHF short. He contracts now to sell Swiss franks in 3 months anticipating that at that time the spot rate will change to USD/CHF= Suppose 3 months later the actual spot rate is USD/CHF= Is this a short sale and why? What is the expected payoff for the trader and his counterparty? What is the actual payoff?

Page 41 Forward Speculation The counterparty – –On the actual spot market the same amount ________ –Savings –If the rate dropped to $ instead of rising to $0.7500, would overpay – _______________ What if a trader decides to ignore the contract and not deliver when not profitable? –