“International Finance and Payments” Lecture VI “International FX Markets” Lect. Cristian PĂUN URL: Academy of Economic Studies Faculty of International Business and Economics

Lecture 6: International FX Markets2 Risks in international financing - review risks mean potential losses caused by different factors in case of a specific transaction in international financing we have: environmental risks, company risks and project risks; country risk: describe the economic and political environment of a country interest risk: is determined by an unfavorable evolution of interest rates on international financial markets currency exposure: affects financing denominated in different currencies; default risk: expresses the capacity of a company to pay-back its debt in terms of liquidity, solvability and profitability;

Lecture 6: International FX Markets3 FX Markets – basic concepts Foreign currency: money from abroad circulated within an economy, including coins and paper notes. Exchange rate: the exchange rate is the price of one country’s currency in terms of another country’s currency FX Market: the place where brokerage firms and banks are connected over an electronic network that allows them to convert the currencies of most countries. Exchange rate regime: the legal environment about FX transactions and FX market.

Lecture 6: International FX Markets4 FX Markets – main characteristics The FX market is a highly active, highly decentralized market for currency conversions that operates almost 24 hours per day around the world (see the next slide). The vast majority of foreign exchange (FX) trading is done over-the-counter (OTC) Most transactions have the USD on one side (USD is a vehicle currency) FX Market is a Wholesale Market- Interbank Market and Retail--Client Market too; About 700 banks worldwide stand ready to make a market in Foreign exchange. Non-bank dealers account for about 20% of the market. The FX market is the most active market in the world ($1,210 trillion turnover per day, worldwide, in April 2001)

Lecture 6: International FX Markets5 Around-the-clock FX trading Average Electronic Conversions Per Hour Greenwich Mean Time Tokyo opens Asia closing 10 AM In Tokyo Afternoon in America London closing 6 pm In NY Americas open Europe opening Lunch In Tokyo

Lecture 6: International FX Markets6 Size of the FOREX Market Geographic Distribution of Foreign Exchange Turnover (daily averages in April, billions of US dollars) Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001,” October 2001,

Lecture 6: International FX Markets7 World inter-bank FX transactions By currency pairs

Lecture 6: International FX Markets8 World FX transactions $1.2 trillion/day (2001)

Lecture 6: International FX Markets9 FX Markets – Direct quote vs. Indirect quote Quoted exchange rates can be either direct or indirect, one method is usually the convention Direct: home currency per unit of foreign currency Examples from US perspective: US Dollars (USD) per British Pound (GBP) US Dollars (USD) per Euro (EUR) Indirect: foreign currency per unit of home currency Examples from ROL perspective: Japanese Yen (JPY) per US Dollar (USD) Swiss Francs (CHF) per US Dollar (USD) Pound, CAD, AUD, NED - Indirect Quote USD, Euro, ROL – Direct Quote

Lecture 6: International FX Markets10 FX Markets – The Bid / Ask Spread bid price--the price a dealer (NOT you) is willing to pay you for a currency. ask price--the amount the dealer wants you to pay for a currency. The bid-ask spread is the difference between the bid and ask prices 1 USD = – 550 ROL 1 USD = – ROL The spread = ROL / 1 USD

Lecture 6: International FX Markets11 Exchange rates - Nominal Exchange Rate: the price between the local currency and a foreign currency - Real Exchange Rate: the nominal exchange rate adjusted with prices differential: RFX=NFX x (P ROM -P US )/(1+P US ) - Effective Exchange Rate: the nominal exchange rate between a currency basket (simple or weighted): EFX=1/n (NFX USD +NFX yen +NFX pound ) Effective Exchange Rate: the effective exchange rate between a currency basket (simple or weighted): EFX=1/n (RFX USD +RFX yen +NFX pound ) Calculated by IMF, Morgan Guaranty Trust Company, Federal Reserve Bank

Lecture 6: International FX Markets12 Cross exchange Rates Suppose that S($/€) =.50  i.e. $1 = 2 € and that S(¥/€) = 50  i.e. €1 = ¥50 What must the $/¥ cross rate be? What must the ¥/$ cross rate be? The use of cross exchange rate: - To determine exchange rate between two different foreign currencies; - in arbitrage transaction (buy and sell on different FX markets)

Lecture 6: International FX Markets13 Depreciation and Appreciation of a currency A depreciation of the local currency means that it takes more local currency to buy a unit of foreign currency  An appreciation of the local currency is the opposite Example:  If the $/€ exchange rate goes up from 1.20 to 1.30 the dollar has depreciated against the euro  but, the euro has appreciated against the dollar. Valuation / Devaluation of a currency -When a government interviews on FX market to manage (to fix) the exchange rate at a specific level (value) - Specific in the case of fixed exchange regimes The relationship between depreciation of local currency and export development !!!

Lecture 6: International FX Markets14 Currency regimes Define the regulations related to the FX Rate mechanism (Central Bank intervention on FX Market, official exchange rate, exchange rate control) Fixed Exchange Regime Hybrid Exchange Regimes Dirty Float or Managed Float Fixed Band Crawling Band Fixed Peg Crawling Peg Currency Board. Free Floating Exchange Regimes

Lecture 6: International FX Markets15 “Dirty” or managed float Central Bank Intervention A B Exchange Rate Central Bank Intervention

Lecture 6: International FX Markets16 Fixed Band Central Bank Intervention Anchor

Lecture 6: International FX Markets17 Crawling Band T1T2T3 Fixed Anchor Adjustable Margins Fixed Margins Adjustable Anchor

Lecture 6: International FX Markets18 Fixed and Crawling Peg Fixed Peg Crawling Peg

Lecture 6: International FX Markets19 Currency Regimes and FX Rate Control Currency RegimesLowMediumHigh Fixed Exchange Rate Currency Board Fixed Peg Crawling Peg Narrow Band Oblique Band Wide Band Crawling Band Mixed Currency Regime Managed Float Free Floating FX Rate Control

Lecture 6: International FX Markets20 Convertibility of a currency Full convertible currency: no restrictions in terms of transactions volume, capital transfers and FX Market access for residents and non- residents; Partial convertible currency:  Current Account Convertibility  Capital Account Convertibility No Convertibility: FX Market is very restrictive

Lecture 6: International FX Markets21 Spot transactions In the inter-bank market, the standard size trade for a spot transaction is about U.S. $10 million; Private information is an important determinant of spot exchange rates. Bid-Ask spreads in the spot FX market:  increase with FX exchange rate volatility and  decrease with dealer competition. The settlement or value date for a spot transaction (the date on which the parties actually exchange assets) occurs two business days after the deal is made ;

Lecture 6: International FX Markets22 Forward Transactions A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. Main characteristics: Usual maturity: 30, 90 and 180 days; It is not a stock exchange contract; Implies a direct negotiations with the bank It is not standardized; It has a fixed value established in the initial moment; It has not a secondary market; Can be finished only at the maturity; It is considered a money market instrument

Lecture 6: International FX Markets23 Forward transactions Long ForwardShort Forward Profit Loss Exchange Rate at the Maturity Initial Spot Exchange Rate

Lecture 6: International FX Markets24 Forward Contracts and Risk Management Position in a credit Currency Exposure Forward Strategy DebtorLocal currency will increase Long Forward CreditorLocal currency will decrease Short Forward

Lecture 6: International FX Markets25 Forward and Spot Quotations Spot1, ($)2,30 - 2,30 3 / 4 (€)263, ¥ Forward 1 m0,75 - 0,73 cents5/8 - 1/2 cents0.15 ¥ premium 0.10 ¥ discount Forward 2 m1,35 - 1,32 cents1 1/8 - 1 cents0.17 ¥ premium 0.8 ¥ discount Forward 3 m2,03 - 2,00 cents1 5/ /2 cents0.19 ¥ premium 0.6 ¥ discount Pound against USD, Euro and Yen Rule for pips: - If the pip for bid is higher than pip for ask then – - If the pip for bid is lower than pip for ask then +

Lecture 6: International FX Markets26 FX Rate Determinants Traditional Approach (Keynes) Purchasing Power Parity (PPP) Monetary Approach (Friedman) Interest Power Parity General Equilibrium Theory Mundell – Fleming Model Rudiger Dornbush Model

Lecture 6: International FX Markets27 Traditional Approach The foreign trade is the most important factor for FX Rate The current account deficit or surplus should be taken into consideration  If M > X than the local currency will depreciate against foreign currency  If M < X than the local currency will appreciate against foreign currency The Model Equation: CSV = F (p-p*, Y-Y*, R-R*) Prices GDP Growth Interest rates

Lecture 6: International FX Markets28 Purchasing Power Parity Low of one price: we can write an equation for the law of one price as: P i LC = P i FC * E where P i LC is the local currency price of good i P i FC is the foreign currency price of good i E is the dollar to euro exchange rate Or we can rearrange the equation to get E = P i LC / P i FC

Lecture 6: International FX Markets29 Monetary Approach M x V = P x T M = k x P x Y ROL USD FX Rate = (M - M*) + (Y - Y*) + (k - k*)

Lecture 6: International FX Markets30 Interest Power Parity General Equilibrium Theory (p - p*) / (1+p*) = (d - d*)/ (1+ d*) = (f - s) / (1 + s) = (s 1 – s 0 ) / (1 + s 0 ) Real MarketMoney MarketSpot and Forward FX Market (i - i*)/ (1+ i*) = (s 1 – s 0 ) / (1 + s 0 ) i – interest rate (i * - interest rate from abroad) s 0 – initial spot exchange rate s 1 – predicted spot

Lecture 6: International FX Markets31 FX Determinants - conclusion Changing of FX Rate for a particular currency can be determined by the action of the following variables: current account deficits real economic growth inflation differential interest rate differential economic structure monetary aggregates (M1 and M2)