International Finance FINA 5331 Lecture 5: Balance of Payments concluded. The market for foreign exchange Read: Chapters 5 Aaron Smallwood Ph.D.

Official reserves The official settlements balance, sometimes referred to as the overall balance, is the total balance on the current account plus the balance on all NON-OFFICIAL reserve transactions. It must be exactly offset by the balance on official reserves transactions

Official reserves When a country buys foreign reserves (for example, if the People’s Bank of China acquires dollars): –China’s assets increase: Debit entries in official reserves (a deficit) –Offset by an official settlements surplus If a country must sell official reserves (Thailand in 1997 because of speculative attacks): –The country’s reserve assets decrease: Credit entries in official reserves (a surplus) –Offset by an official settlements deficit.

Foreign Exchange Market Products and Activities A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies). A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months).

Foreign Exchange Market Products and Activities Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk. A foreign exchange swap is the simultaneous sale of a currency for spot delivery and purchase of that currency for forward delivery. Foreign exchange swaps can be used by dealers to manage the maturity structure of their currency positions.

Foreign Exchange Market Products and Activities Speculation entails more than the assumption of a risky position. It implies financial transactions undertaken when an individual’s expectations differ from the market’s expectation. Arbitrage is the simultaneous, or nearly simultaneous, purchase of asset in one market for sale in another market with (for our purposes) the expectation of a risk-free profit.

FOREX Players Broadly speaking the FX market consists of 5 groups –International banks –Bank customers –Non-bank dealers Include investment banks, mutual funds, and hedge funds. –FX brokers –Central banks

FX Market Participants The FX market is a two-tiered market: –Interbank market (wholesale) About banks worldwide stand ready to make a market in foreign exchange. Other financial institutions account for about 53% of the market. There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. –Client market (retail) Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

Size of the FOREX market (billions of US $) Daily Average ALL 1,5271,2391,9343,3243,9715,345 SPOT ,0051,4882,046 OUTRIGHT FORWARD FOREX SWAPS ,7141,7592,228 CURRENCY SWAPS OPTIONS SOURCE: Bank for International Settlements

Currency shares CURRENCY USD EURN/A JPY GBP AUD CHF CAD MXN CNY

Trends in CNY

Recent changes In 2010, PBOC establishes a target value against the dollar. The actual value of the exchange rate was maintained within bands of +/-0.50%. –Daily parity value is changed everyday, creating a “crawling peg” system In April 2012, the band was widened to +/- 1% creating more flexibility.

Example According to an article published in The Wall Street Journal on March 10, 2014: “As sluggish economic news sent jitters through the market, the People's Bank of China set the daily reference rate Monday at to the dollar.” This implies that the actual value can move as –High as: *6.1312=RMB –As low: *6.1312=RMB

According to the article After the PBOC set the reference rate, the RMB price of the dollar increased relative to the reference rate. ``On Monday (March 10), the yuan touched against the dollar.”

Spot Rate Quotations A direct quotation for the US is: –The U.S. dollar equivalent. –E.g., “a Japanese Yen is worth about a penny.” For China: direct quote for the dollar is about RMB An indirect quotation is: –The price of a U.S. dollar in the foreign currency. –E.g., “you get 100 yen to the dollar.

Spot rate quotations Currencies U.S.-dollar foreign-exchange rates in late New York trading as of March 5, Friday Country/currencyin US$per US$Country/currencyin US$per US$ Swiss franc Euro area euro mos forward most forward China, RMB mos forward Japanese yen British pound mos forward mos forward most forward most forward mos forward mos forward

The Bid-Ask Spread The bid price is the price a dealer is willing to pay you for something. The ask price is the amount a dealer wants you to pay for something. It doesn’t matter if we’re talking used cars or used currencies: the bid-ask spread is the difference between the bid and ask prices.

The Bid-Ask Spread A dealer could offer: –A bid price of $ per €. –An ask price of $ per €. While there are a variety of ways to quote the above, the bid-ask spread represents the dealer’s expected profit. Percent spread =

The Bid-Ask Spread A dealer pricing pounds in terms of dollars would likely quote these prices as 02–08. Anyone trading $10m knows the “big figure.”… 1.59 USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds

The Bid-Ask Spread Notice that the reciprocal of the direct bid quote gives the ask price: USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds

Sample Problem A businesswoman has just completed transactions in Italy and England. She is now holding €250,000 and £500,000 and wants to convert to RMB. Her bank provides this quotation: GBP/RMB – RMB/EUR – Pounds: ? Euros: ? Total: ?  What are her proceeds from conversion?

Proceeds Pounds: We buy RMB in the market for RMB: £500,000/ =RMB 4,944, Euros: We sell euros in the market for euros: €250,000* = RMB 2,063,500 Total: RMB 7,008,120.25

Spot FX 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 with bid-ask spreads USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds RMB

So? What are the RMB/pound bid and ask prices? Suppose a trader sells £ 10,000. How much do they receive? The trader effectively sells pounds for RMB

What about selling yuan? Suppose we sell RMB10,000. We could figure the cross-currency rate, by asking: - How much do we receive when we first buy dollars with RMB? RMB10,000* = $1,622 - How much do we receive from selling dollar for pounds? $1,622/ = £1, Effectively RMB ask price for the pound: 10,000/1,019.16= RMB BID/ASK price: –

Concept of arbitrage Suppose you are lucky enough to see two currency windows next to each other. At the first window you see the following quote for the euro: –RMB – At the second window you observe the following: –RMB –

What? Can easily profit: –Buy euros at the first bank for RMB –Sell them at the second bank for RMB –Maybe not too realistic. Let’s consider triangular arbitrage: –Involves three markets. Let’s start with a simple example.

Triangular Arbitrage $ £ ¥ Credit Lyonnais S($/£)=1.50 Credit Agricole S(¥/£)=125 Barclays S(¥/$)=100 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

Triangular Arbitrage Barclays S(¥/$)=100 The implied S(¥/£) cross rate is S(¥/£) = 150 Credit Agricole has posted a quote of S(¥/£)=125 so there is an arbitrage opportunity. So, how can we make money? Buy the ¥125; ¥150. $ Credit Lyonnais S($/£)=1.50 Credit Agricole S(¥/£)=125 ¥ £

Triangular Arbitrage Sell $100,000 for ¥ at S(¥/$) = 100 receive ¥10,000,000 Sell ¥10,000,000 for £ at S(¥/£) = 125 receive £80,000 Sell £ 80,000 for $ at S($/£) = 1.50 receive $120,000 profit per round trip = $ 120,000- $100,000 = $20,000

Review: Triangular Arbitrage ¥ € $ Budapest: S(¥/€) = Madrid S($/€)= Tokyo S($/¥)= Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

Review: Triangular Arbitrage Sell $10,000,000 for ¥ at S($/ ¥ ) ask = $ receive ¥992,063, Sell our ¥992,063, for € at S(¥/ €) = ¥ receive €7,798, Sell € 7,798, for $ at S($/€) = receive $10,112, profit per round trip = $ 10, $10,000,000 = $112,918.41

Triangular Arbitrage: One more We want to consider another example with bid-ask spreads. See example in the textbook, with the following quotes: –Market for pounds: $ –Market for euros: $ –Market for pounds: € Implied price in the third market is POUND UNDERVALED!

Exploit the arbitrage opportunity Suppose we start with $1,000,000 First, we need to get euros so we can buy pounds in the 3 rd market. –Start by selling dollars for euros: We receive: $1,000,000/ = €678, –Sell euros for pounds: We receive: €678,242.00/ = £509, –Finally, sell pounds for dollars We receive: £509,573.25* = $1,004, PROFIT: $4,