FX Technical Analysis. Is the study and interpretation of price movements in order to determine future trends A technician assumes that all fundamental.

FX Technical Analysis

Is the study and interpretation of price movements in order to determine future trends A technician assumes that all fundamental factors are reflected in the price and that history tends to repeat itself. The tools of a technician are bar charts, point and figure charts, and line charts. Technicians will use mathematical models and will also study behavioral models. Technical Analysis

All technical analysis is based upon the following three assumptions. 1. All publicly available information about a tradable currency is already in its price. 2. Prices move in trends or patterns. 3. History repeats itself. Technicians believe there is little profit to be gained by researching economic fundamentals. ASSUMPTIONS

For example, if the head of the American Federal Reserve (central bank) said that the American Federal Reserve would cut interest rate in the near future, fundamental analysts would immediately buy Swiss francs, euros and yen in exchange for dollars. The selling of dollars by traders who follow fundamentals would trigger a downward movement in the dollar against other currencies. Technicians follow trends

The technicians who were watching charts while the head of the Fed spoke would notice a plunge in the dollar on the charts. As different exchange rates began new trends, technicians would change their foreign exchange positions in the market. In this scenario, the technicians follow the lead of the fundamental analysts. Technicians follow trends

Elliot theory - Prices progress into wave patterns Dow theory - oldest theory in technical analysis, the market follows trends. THE BASIC THEORIES

Classify price movements in patterned waves. 5 Impulse waves, 3 Corrective waves, 8 movements comprise a complete wave cycle Technicians should determine the role of a wave in relation to the greater wave structure. http://www.investopedia.com/video/play/underst anding-Elliott-wave-theory Elliot Wave

Elliot wave

Find the trend - Weekly and monthly charts are most ideally suited for identifying that longer term trend. Once the overall trend has been identified, buy on the dips during rising trends, and sell the rallies during downward trends. WHAT TO LOOK FOR

Support and resistance - A support level is usually the low point in any chart pattern, whereas a resistance level is the high or the peak of the pattern. Buy near support levels and sell near resistance levels that are unlikely to be broken What to look for

Measures a currency's price relative to itself It is past performance and is also front weighted The RSI absolute levels are 1 and 100. Traditionally, buy signals are triggered at 30 and sell signals are triggered at 70. Relative Strength Index

Margin Margin is borrowing money from a broker to buy a stock or currency pair and using the investment as collateral. Investors generally use margin to increase their purchasing power to enable them to own more stock or take larger positions in the market, without fully paying for it. Margin exposes investors to the potential for higher losses

Example Buy stock with cash for $50 or buy stock with $25 cash and $25 loan. If the stock price rises to $75 then 50% return on cash invested for the first case and 100% for the second case. If the price goes down to $25 then 50% loss on cash invested for the first case and 100% for the second. If you take a loan from the broker to buy stock, the broker has the right to sell your stock as collateral for the loan.

Forex Example If a client opens an account with $100,000, with an agreed margin level of 5%, the client will be allowed to trade with 20 times leverage which means that the client needs to maintain 5% of any open position. Value of $2 000 000 ($100 000 divided by 5%).

Risks You can lose more money than you have invested You may have to deposit additional cash your account on short notice to cover market losses You may be forced to sell some or all of your securities when market prices reduce the value of your securities Your brokerage firm may sell some or all of your securities without consulting you to recoup the loan it made to you.

Securities A Financial Instrument Debt – Banknotes, Bonds – Principal and Interest. Equity – Stocks and Shares, derivative contracts – No interest. Right to control and profits from company.

Stop-Loss In order to limit the risks, a trader should continuously monitor the status of the positions against current market prices and should run stop-loss orders for each position open. A stop-loss order specifies that an open position (trade) should be closed automatically when the exchange rate for the currency pair in question reaches the specified threshold.

Week 2:The International Monetary System A Discussion of Foreign Exchange Regimes (i.e., The Arrangement by which a Country’s Exchange Rate is Determined)

What is the International Monetary System? It is the overall financial environment in which global businesses and global investors operate. It is represented by the following 3 sub-sectors: –International Money and Capital Markets Banking markets (loans and deposits) Bond markets (offshore, or euro-bond markets) Equity markets (cross listing of stock) –Foreign Exchange Markets Currency markets (and foreign exchange regimes) –Derivatives Markets Forwards, futures, options… This lecture will focus on the foreign exchange market

Concept of an Exchange Rate Regime The exchange rate regime refers to the arrangement by which the price of country’s currency is determined within foreign exchange markets. This arrangement is determined by individual governments (essentially how much control if any they wish to exert on the actual exchange rate). Foreign currency price is: –The foreign exchange rate (referred to as the “spot rate”). –Expresses the value of a county’s currency as a ratio of some other country. Since the 1940’s that other currency has been the U.S. dollar.

Foreign Exchange Rate Quotations There are two generally accepted ways of quoting a currency’s foreign exchange rate (i.e., the ratio of one currency to the U.S. dollar). –American terms and European Terms quotes American terms quotes: Expresses the exchange rate as the amount of U.S. dollars per 1 unit of a foreign currency. –For Example: $1.65 per 1 British pound –Or $1.45 per 1 European euro –Or $1.06 per 1 Australian dollar

Foreign Exchange Rate Quotations European terms quote: Expresses the exchange rate as the amount of foreign currency per 1 U.S. dollar –For Example: 76.67 yen per 1 U.S. dollar –Or 7.80 Hong Kong dollars per 1 U.S. dollar –Or 6.38 Chinese yuan per 1 U.S. dollar For reporting and trading purposes, most of the world’s major currencies are quoted on the basis of American terms (Pound and Euro); however, the majority of the world’s currencies are quoted on the basis of European terms. –http://www.bloomberg.com/markets/currencies/http://www.bloomberg.com/markets/currencies/

A Model for Illustrating Exchange Rate Regimes We can think of current exchange rate regimes as falling along a spectrum as represented by a national government’s involvement in affecting (managing) their country’s exchange rate. No Involvement by Government Very Active Involvement by Government Market forces are Determining Exchange rate Government is Determining or Managing the Exchange rate

Exchange Rate Regimes Today Minimal (if any) Involvement by Government Active Involvement by Government Market forces are Determining Exchange rate Government is Determining or Managing the Exchange rate Floating Rate Regime Managed Rate (“Dirty Float”) Regime Pegged Rate Regime

Classification of Exchange Rate Regimes: Floating Rate Regimes F loating Currency Regime: –No (or at best occasional) government involvement (i.e., intervention) in foreign exchange markets. –Market forces, i.e., demand and supply, are the primary determinate of foreign exchange rates (prices). Financial institutions (global banks, investment firms), multinational firms, speculators (hedge funds), exporters, importers, etc. Central banks may intervene occasionally to offset what they regard as “inappropriate” or “disorderly” exchange rate levels.

Classification of Exchange Rate Regimes: Managed Rate Regimes Managed Currency (“Dirty Float”) Regime: –High degree of intervention of government in foreign exchange market (perhaps on a daily basis). Purpose: to offset moderate market forces and produce an “desirable” exchange rate level or path. –Usually done because exchange rate is seen as important to the national economy (e.g., export sector or the price of critical imports or as a means to control inflation). –Currency’s exchange rate will be managed in relation to another currency (or a basket ) Preferred currencies are the US dollar and Euro.

Classification of Exchange Rate Regimes: Pegged (Fixed) Rate Regimes P egged Currency Regime –Governments directly link (i.e., peg) their currency’s rate to another currency. Government sets the exchange rate with a certain band (e.g., + or – 1%) of a fixed rate or within a narrow margin, or sometimes use a crawling peg (e.g., + or – 2%) of a trend. –Occurs when governments are reluctant to let market forces determine rate. –Exchange rate seen as essential to country’s economic development and or trade relationships. –Governments are also concerned about the potential negative impacts of a open capital market (i.e., disruptive flows of short term funds – “hot money.”)

Examples of Currencies by Regime Floating Rate Currencies: –Canadian dollar (1970), U.S. dollar (1973), Japanese yen (1973), British pound (1973), Australian dollar (1985), New Zealand dollar (1985), South Korean Won (1997), Thailand baht (1997), Euro (1999), Brazilian real (1999), Chile peso (1999), Argentina Peso (2002). Managed (Floating) Rate Currencies: –Singapore dollar, 1981, Costa Rica colon (U.S. dollar), Malaysia ringgit (2005, Market Basket), Vietnam dong (11/08 U.S. dollar). Pegged Rate Currencies – to a fixed rate (against the U.S. dollar or market basket): –Hong Kong dollar, since 1983 (7.8KGD = 1USD), Saudi Arabia riyal (3.75SAR = 1USD), Oman rial (0.385OMR = 1USD) Pegged Rate Currencies (Crawling Peg) – to a trend (against the U.S. dollar or market basket): –China yuan (7/05 Market Basket), Bolivia boliviano (U.S. dollar) Note: The IMF notes that 66 out of 192 countries they classify use the U.S. dollar as a “anchor.” Data above as of 2009.

Changing Exchange Rate Regimes: 1970 -2010 (IMF Classifications) % by Number of Countries% by GDP of Countries

Simplified Model of Floating Exchange Rates (Market Determined Rates) The market “equilibrium” exchange rate at any point in time can be represented by the point at which the demand for and supply of a particular foreign currency produces a market clearing price, or: Supply (of a certain FX) Price Demand (for a certain FX) Quantity of FX

Simplified Model: Strengthening FX Any situation that increases the demand (d to d’) for a given currency will exert upward pressure on that currency’s exchange rate (price). Any situation that decreases the supply (s to s’) of a given currency will exert upward pressure on that currency’s exchange rate (price). s s’ s p d d’ d q q

Simplified Model: Weakening FX Any situation that decreases the demand (d to d’) for a given currency will exert downward pressure on that currency’s exchange rate (price). Any situation that increases the supply (s to s’) of a given currency will exert downward pressure on that currency’s exchange rate (price). s s s’ p d’ d d q q

Factors That Affect the Equilibrium Exchange Rate: Changes in Demand Relative (short-term) interest rates. –Affects the demand for financial assets (increase demand for high interest rate currencies). Relative rates of inflation. –Affects the demand for real (goods) and financial assets; hence the demand for currencies Low inflation results in increase global demand for a country’s goods. Low inflation results in high real returns on financial assets. Relative economic growth rates. –Affects longer term investment flows in real capital assets (FDI) and financial assets (stocks and bonds). Changes in global and regional risk. –Safe Haven Effects: Foreign exchange markets seek out safe haven countries during periods of uncertainty.

Safe Haven Effect: September 11, 2001

Factors That Affect the Equilibrium Exchange Rate: Government Intervention Foreign exchange intervention policy if a government feels its currency is “too weak” –Government will buy their currency in foreign exchange markets Create demand and push price up. Foreign exchange intervention policy if government feels its currency is “too strong” –Government will sell their currency in foreign exchange markets Increase supply to bring price down.

Market Intervention by Central Banks Use the model below to explain how intervention by a central bank can respond to (1) a “weak” currency and (2) a “strong” currency (assume it wants to offset either condition): Supply (of a certain FX) Price Demand (for a certain FX) Quantity of FX

Factors That Affect the Equilibrium Exchange Rate: Government Interest Rate Adjustments Some governments may also use interest rate adjustments to influence their currencies. When a currency become “too weak:” –Governments might raise short term interest rates to encourage short term foreign capital inflows. Higher interest rates make investments more attractive and increase demand for the currency. When a currency becomes “too strong:” –Governments might lower short term interest rates to discourage short term foreign capital inflows. Lower interest rates will make investments less attractive and reduce the demand for the currency.

Factors That Affect the Equilibrium Exchange Rate: Carry Trade Strategies Carry trade strategy: A foreign exchange trading strategy in which a trader sells a currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. This strategy offers profit not only from the interest rate difference (overnight interest rate) but additionally from the currency pair’s fluctuation. An example of a "yen carry trade": A trader borrows Japanese yen from a Japanese bank, converts the funds into Australian dollars and buys an Australian bond for the equivalent amount. If we assume that the bond pays 4.5% and the Japanese borrowing rate is 1.0%, the trader stands to make a profit of 3.5% as long as the exchange rate between the countries does not change. –In this example, the trader is short on yen and long on Australian dollars.

Impact of Carry Trades on Exchange Rates Carry trades can result in a huge amount of capital flows in and out of currencies. –High interest rate currency will experience increase demand. –Low interest rate currency will experience increase in supply. Combined this will result in a strengthening of the high interest rate currency against the low interest rate currency. However, when traders reverse their positions, the opposite exchange rate effects will occur. –When do they reverse: During periods of increasing global uncertainty about interest rates and exchange rates.

The Foreign Exchange Market An Empirical Analysis of the Impact of Foreign Exchange Regimes on Exchange Rates

Relationship of Exchange Rate Volatility to Exchange Rate Regime Question: Given the spectrum of exchange rate regimes which can confront both global firms and global investors, an important question is whether there is a difference in exchange rate volatility from one regime to another. –An additional question: what happens to volatility when regimes change?

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using monthly data from January 1990 – August 2011 Floating Currencies: –British Pound:2.31% –Japanese Yen:2.30% –Australian Dollar:3.22% –Euro:2.59% Managed Currencies: –Singapore Dollar:1.20% Pegged Currencies (“Crawling Peg): –Chinese Yuan:0.42% (since July 2005) Pegged Currencies (Fixed Rate): –Hong Kong Dollar:0.12% (peg at 7.8 since Oct 1983)

Volatility of 3 Exchange Rate Regimes (Monthly Data, Jan 1990 – Aug 2011)

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using weekly data from August 2008 – August 2011 Floating Currencies: –British Pound:1.55% –Japanese Yen:1.26% –Australian Dollar:2.17% –Euro:1.55% Managed Currencies: –Singapore Dollar:0.73% Pegged Currencies (“Crawling Peg): –Chinese Yuan:0.16% Pegged Currencies (Fixed Rate): –Hong Kong Dollar:0.07%

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using daily data from August 2008 – August 2011 Floating Currencies: –British Pound:0.77% –Japanese Yen:0.80% –Australian Dollar:1.30% –Euro:0.82% Managed Currencies: –Singapore Dollar:0.41% Pegged Currencies (“Crawling Peg): –Chinese Yuan:0.11% Pegged Currencies (Fixed Rate): –Hong Kong Dollar:0.04%

Intermediate and Long Term Trend Changes by Regime GBP: Floating Rate CurrencySGD: Managed Currency

Intermediate and Long Term Trend Changes CNY Crawling Peg Currency (since July 2005) HKD: Pegged Currency (since Oct 1983 at 7.8)

Issues of Floating Currencies Floating currencies present the greatest ongoing risk for global firms and global investors. –Data showed that these currencies are very volatile over the short term (e.g., Monthly, weekly and daily basis). –Complicates doing business or investing on an ongoing basis for: Exporters, importers, global asset managers, global commercial banks, overseas sales and manufacturing subsidiaries. What will be the costs and returns associated with different markets and different investments? Thus, global firms and global investors need to pay close attention to their floating currency exposures and utilize appropriate risk management tools. –Issue: How easy is it to forecast a floating rate currency’s price?

Managed Currencies (Dirty Float) Under this regime, governments manage their currency to offset (i.e., counteract) market forces. –They do this when market demand factors or supply factors are seen as creating undesirable exchange rate moves. –They do this as a monetary policy target to achieve inflation target (e.g., Singapore). –As a result, over the short term, these currencies are not as volatile as floating currencies. Exchange rate management may occur on –A regular basis or when governments feel conditions warrant. Management involves either –intervention action (buying or selling currencies) or –interest rate adjustments (to affect demand/capital flows).

Pegged Currency Regimes Under a pegged currency regime, g overnments link their national currency to a key international currency (usually the U.S. dollar or the euro or some “market basket” of currencies). Why do governments peg their currencies? –A peg is seen as a necessary condition to promote confidence in the currency and in the country and promoting economic growth. May encourage foreign direct investment or long term capital inflows. Or by pegging the currency at an undervalued currency this may support the country’s export sector. –Pegs can either be at a fixed rate (e.g., Hong Kong dollar) or in relation to a trend (i.e., a crawling peg). –As long as the peg is maintained, the exchange rate risk is negligible (recall there is some potential daily variation). –Peg is maintained through market intervention (buying and selling)

Hong Kong Dollar: Pegged to a Fixed Rate (7.8HKD = 1 USD)

Daily Volatility of the Hong Kong Dollar Over the Last 6 Months

Saudi Arabia Riyal

Issues with Pegged Currencies As long as the peg is maintained, this regime presents the smallest risk to global firms; however there is the potential for enormous risk, when: –Governments either (1) abandon the peg for another foreign currency regime or (2) adjust to a new peg. –These changes occur either by An orderly change adopted by the government (China from a fixed peg to a crawling peg on July 21, 2005 with more changes which followed and to be discussed in a later slide). Peg coming under successful market attack (e.g., British pound in 1992; Argentina, February 11, 2002; Mexico from a crawling peg to a float on December 22, 1994; Some Asian currencies in 1997). These changes can have substantial impacts on global firms and global investors. Thus, global firms and global investors must be on the alert for exchange rate regime changes.

China Policy Decision: From a Fixed Peg to a Crawling Peg to a Fixed Peg to a Crawling Peg

Currency Regime Changes Due to “Currency Attacks” Another situation that changes currency regimes occurs when a peg comes under attack by the market. –Attacks occur because the market is convinced that the peg is unrealistic and unsustainable (ie., the government doesn’t have the political will or resources in the form of hard currency to defend the peg.

In 1990, the U.K. joined Europe’s exchange rate mechanism (ERM). –Under this arrangement the U.K. agreed to peg the pound to the German mark at a rate of 1:2.95 (+- 3%). During the next two years, the German economy surged and the U.K. economy fell into recession. By 1992, Germany had raised interest rates and the U.K. was forced to follow. In September 1992, George Soros decided to bet against the pound (he felt it was overvalued) and his hedge fund started selling pounds short. The U.K. responded by buying pounds and selling U.S. dollars and by raising interest rates twice in one day (to 12 and then 15%) On September 17, the U.K. government announced they were leaving the ERM British Pound: Driven Out of the Exchange Rate Mechanism in 1992

Mexican Peso Crawling Peg (with a Floor of 3.0512): Abandoned Dec 1994

Philippine Peso During the Asian Currency Crisis, 1997

Implications of the 1997 Asian Currency Crisis for Regional Economic Growth: Average GDP Growth

Impact of Asian Currency Crisis for Global Investors

Argentina: Abandoning a Fixed Peg: Moving to a Floating Regime, Jan 2002

Percent Change in ARS-USD Daily Data, Jan 1, 2000 – Dec 31, 2001

Percent Change in ARS-USD Daily Data, Jan 1, 2003– Jan 1, 2005

Response of Currencies to Dropping a Peg Regime

Abandoning a Pegged Rate and the Currency Weakens: RISKS for Global Firms and Investors As noted, changes in exchange rate regimes pose potential risks for global firms. Using the Argentina example, discuss the following: –What do you think happened to foreign multinationals located in and selling in Argentina after the peso weakened? For Example: McDonalds’ U.S. dollar profits in Argentina? –What do you think happened to foreign multinationals exporting to Argentina after the peso weakened? For example: Boeing ability to export airplanes to Argentina? –What do you think happened to the portfolios of investors holding Argentina stocks and bonds?

Abandoning a Pegged Rate and the Currency Weakens: OPPORTUNITIES for Global Firms However, changes in exchange rate regimes also offer potential opportunities for global firms. Again, using the Argentina example: –What do you think happened to foreign multinationals importing from Argentina after the peso weakened? For Example: Wal-Mart’s U.S. dollar cost associated with importing goods from Argentina? –What do you think happened to foreign multinationals considering expanding FDI into Argentina after the peso weakened? For Example: The new U.S. dollar cost to Ford Motor Company considering setting up a production facility in Argentina?

Potential Costs to Holding a Peg If market forces push a pegged currency above its peg (i.e., the currency becomes “too strong” or “overvalued”) this happens because: –The market is buying the currency, then Government management involves either selling the pegged currency on foreign exchange markets (thus, buying hard currency) or reducing domestic interest rates. Issues: If the government sells its currency this created to potential for expansion of its domestic money supply and hence inflationary pressures. On the other hand, lowering domestic interest rates can also stimulate domestic investment and economic activity which may lead to inflationary pressures.

Potential Costs to Holding a Peg If market forces push a pegged currency below its peg (i.e., the currency becomes “too weak” or “undervalued”) this happens because: –The market is selling the currency, then –Government management involves either buying the pegged currency on foreign exchange markets (thus, selling hard currency or raising domestic interest rates. Issues: Does the government want to give up its hard currency (does it have potentially better uses for this (e.g., buying oil or paying off international debts) On the other hand, raising domestic interest rates can dampen economic activity and lead to rising unemployment. –Note: These last two slides summarize one reason (i.e., the costs) why major central banks have probably gotten out of the currency management business.

Appendix 1: Monitoring FX Intervention

Most major central banks provide timely information regarding their intervention activities in foreign exchange markets. As on example see: –http://www.ny.frb.org/markets/foreignex.ht mlhttp://www.ny.frb.org/markets/foreignex.ht ml This site provides a quarterly report on both the U.S. dollar and intervention activities on behalf of the dollar. Go to archives, July 30, 1998 to view intervention activity.

Week 3: The Foreign Exchange Market The Structure of the Foreign Exchange Market

The Foreign Exchange Market Sometimes referred to as the forex or FX market. It is the market where one currency is traded for another currency. –For example, buying yen through selling dollars. –Buying dollars through selling euros. The foreign exchange market is the mechanism by which one transfers purchasing power form one country to another, obtains or provides credit for international trade transactions, moves funds cross border, and minimizes exposure (e.g., through forward contracts) to foreign exchange risk. Commercial transactions do not involve moving physical currency, but rather represent changes in bank deposits. –For example, buying a yen deposit at a bank through selling a dollar deposit at that bank.

Participants in the FX Market Participants in the FX market include: –Financial institutions (Commercial banks), –Organizations conducting commercial transactions (e.g., the treasury departments of manufacturing firms, retail firms). –Organizations conducting investment transactions (mutual funds), –Speculators (e.g., hedge funds) –Central banks –Foreign exchange brokers (who match buy and sell orders but do not carry inventory).

Participants in the FX Market The foreign exchange market consists of two tiers: the interbank or wholesale market, and the client or retail market. –Interbank market: The inter-bank market is composed of participants such as global commercial banks (as market makers), large non- financial corporations and central banks. This segment represents over 80% of total market. In the interbank market, about 100-200 banks worldwide stand ready to make a market in foreign exchange (i.e., to quote prices at which they will buy and sell currencies). –However, most of the total forex volume is transacted through about 10 banks.

Top Banks in the F.X. Market: Average Market Share, 7 year period 2004 - 2010 BankCountry of Headquarters % Share of Market Years in the Top 10 Deutsche BankGermany36%7 UBSSwitzerland22%7 BarclaysUnited Kingdom12%7 CitiUnited States 6%7 JPMorganUnited States 3%3 Goldman SachsUnited States 3%5 RBSUnited Kingdom 3%6 HSBCUnited Kingdom 2%7 Credit SuisseSwitzerland 2%3 Morgan StanleyUnited States 2%2

The FX Market: An Overview World’s largest financial market with an estimated volume of $4.0 trillion dollars per day in trades ($3.3 in 2007). –NYSE-Euronext stock exchange currently about $40 billion per day. Market is a 24/5(7) over-the-counter market. –Major markets open Monday through Friday; Middle East markets also open on weekends (Saudi Arabia and Bahrain) –There is no central trading location (i.e., no central trading floor). –Trades take place through a network of computers (e.g., Reuters screens) and telephone connections all over the world. –Estimates of Daily Volume –1973: $ 10 to 20 billion –1989: $ 590 billion –1992: $ 820 billion (+39%) –1995: $1.190 trillion (+45%) –1998: $1.490 trillion (+25%) –2001: $1.200 trillion (-19%) –2004: $1.880 trillion (+57%) –2007: $3.210 trillion (+71%) –2010: $4.000 trillion (+25%) Note: BIS April Surveys from1989 on.

Largest 3 Foreign Exchange Centers, 1995 – 2010 (% of Total)

Other Trading Centers, 1995 and 2010, Percent of Total Market Country19952010 Singapore6.65.3 Switzerland5.45.2 Hong Kong5.64.7 Australia2.53.8 France3.83.0 Denmark1.92.4 Germany4.82.1 Canada1.91.2 Sweden1.20.9 Korea0.2 (1998)0.9 Russia0.3 (1998)0.8

Currency Distribution in FX Market, Percent of Average Daily Turnover CurrencyISO19982001200420072010 U.S. DollarUSD86.689.988.085.684.9 EuroEUR….37.937.437.039.1 Deutsche MarkDEM30.5…. Japanese YenJPY21.723.520.817.219.0 British PoundGBP11.013.016.514.912.9 Australian DollarAUD 3.0 4.3 6.0 6.6 7.6 Swiss FrancCHF 7.1 6.0 6.8 6.4 Canadian DollarCAD 3.5 4.5 4.2 5.3 Hong Kong DollarHKD 1.0 2.2 1.8 2.7 2.4 Swedish KronaSEK 0.3 2.5 2.2 2.7 2.2 New Zealand DollarNZD 0.2 0.6 1.1 1.9 1.6 Note: Because 2 currencies are involved in each transaction, the sum of the percentage shares of individual currencies equals 200%

Other Currencies, Percent of Average Daily Turnover CurrencyISO19982001200420072010 Korean WonKRW0.20.81.11.21.5 Singapore DollarSGD1.1 0.91.21.4 Norwegian KroneNOK0.21.51.42.11.3 Mexican PesoMXN0.50.81.11.3 Indian RupeeINR0.10.20.30.70.9 Russian RoubleRUB0.3 0.60.70.9 Polish ZlotyPLN0.10.50.40.8 South African RandZAR0.40.90.70.90.7 Brazilian RealBRL0.20.50.30.40.7 Chinese YuanCNY0.0 0.10.50.3 Thai BahtTHB0.10.2

Global Foreign Exchange Market by Currency Pair; Percent of Total Currency Pair 19982001200420072010 USD/EUR….30282728 USD/DEM20…. USD/JPY1920171314 USD/GBP 8 101312 9 USD/AUD 3 4 6 6 6 USD/CAD 3 4 4 4 5 USD/CHF 5 5 4 5 4 EUR/JPYNa 3 3 3 3 EUR/CHFNa 1 2 2 2 JPY/AUDNa<1 1

Currency Pair Trades by Market Center; Percent of Total for Center Currency Pair U.K. 2001 U.K. 2010 U.S. 2001 U.S. 2010 Japan 2004 Japan 2010 USD/EUR333233321210 USD/JPY161424136162 EUR/JPY 3 3Na 7 9 Others: USD/GBP221310 USD/CAD 3 4 9 USD/AUD 3 6 6 USD/CHF 4 4 5 EUR/GBP 4 4 EUR/CHF 2 2

Types of FX Transactions Most transactions in the foreign exchange market are executed on a spot, forward, or swap basis: Spot: A spot transaction requires almost immediate delivery of foreign exchange. Forward: A forward transaction requires delivery at a future date of a specified amount of one currency for a specified amount of another currency. The exchange rate to prevail at the settlement date is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are normally quoted for value dates of one, two, three, six, and twelve months. Actual contracts can be arranged for other lengths. Swap: A swap transaction involves the simultaneous purchase and sale of a given amount of foreign exchange for two different dates. The most common type of swap is a spot against forward, where one buys (or sells) a currency in the spot market and simultaneously sells (or buys) the same amount back in the forward market.

Swaps Explained Corporations use FX swaps for cross border funding purposes. Assume a corporation has euros in a bank in Europe and has a USD funding requirement of over the next 3 months in the United States. The firm would like to use its euros to fund this USD financing need, but incur no foreign exchange risk. Solution: –(1) Sell the euros at the spot rate for USD. –(2) Simultaneously, buy a 3 month forward contract to buy back the euros and deliver U.S. dollars.

F.X. Turnover by Type of Transaction; Amount and % of Total Foreign Exchange Instrument 19982001200420072010 Spot Transactions Outright Forwards F.X. Swaps Currency Swaps Options and others Total Foreign Exchange Instrument 19982001200420072010 Spot Transactions Outright Forwards F.X. Swaps Currency Swaps Options and others Total Foreign Exchange Instrument 19982001200420072010 Amount (Billions USD)1,5271,2391,9343,3243,981 Spot Transactions 568 386 6311,0051,490 Outright Forwards 128 130 209 362 475 F.X. Swaps 734 656 954 1,7141,765 Currency Swaps 10 7 21 31 43 Options and others 87 60 119 212 207 Percent of Total Spot Transactions37.2%31.2%32.6%30.2%37.4% Outright Forwards 8.4%10.5%10.8%10.9%11.9% F.X. Swaps48.1%53.0%49.3%51.6%44.3% Currency Swaps 0.7% 0.6% 1.1% 0.9% 1.1% Options and others 5.7% 4.8% 6.2% 6.4% 5.2%

Trading Times for the Market Foreign exchange trades on a 24 hour basis, with major financial centers open Monday through Friday. Weekday trading begins in Sydney, Australia, Monday morning (6:00am local time). –Which is Sunday 4pm EST in New York; Sunday 8pm in London, and Monday 5:00am in Japan. Weekday trading ends in New York, Friday afternoon (5pm EST). –Which is Friday 10pm in London, and Saturday 6:00am in Japan. Weekend trades take place in the Middle East (e.g., in Bahrain with 360 offshore banks; 65 US banks). Weekday Summary: Foreign exchange trading begins Australia, moves to Asia (Tokyo, Hong Kong, and Singapore), then to the Middle East, then to Europe (Paris and London), and finally to North America (New York and the west coast).

24-Hour Global Market: Times Represent Local Trading Hours Europe: LONDON 8am – 5pm Middle East: Bahrain NEW YORK 8am – 5pm Other Asia: TOKYO 8am – 5pm (7am – 7pm) Opens Monday 6am Sydney Closes: Friday 5pm New York

Normal Trading Sessions and Session Overlaps SessionKey Ma rket Local TimeN. Y. EDTGMTOverlaps AsianTokyo(7:00am) 8:00am – 5: 00pm (7:00 pm) (6:00pm) 7:00pm – 4:00am (6:00am) (10:00pm) 11:00pm – 8:00am (10 :00pm) Tokyo: 4:00pm – 5:00pm (7:00pm ) with London: 7: 00am – 8:00am (10:00am) EuropeanLondon7:00am – 5: 00pm 3:00am – 12:00pm 7:00am – 4 :00pm London: 1:00pm – 5:00pm with N ew York: 8:00am – 12:00pm North Am erica New Yor k 8:00am – 5: 00pm 12:00pm – 9:00pm No overlap with Tokyo and New York

London’s Unique Position Due to the geographic positioning of London in relation to New York and Tokyo, London enjoys a trading day which overlaps with the other two. –Thus, London trading in the afternoon corresponds with New York trading in the morning (8 to noon). –And, London trading in the morning corresponds with Tokyo trading in the late afternoon (4 to 5pm/7pm). –However, as noted, New York (regular trading times) and Tokyo trading times do NOT overlap. It isn’t surprising that the currency market is most active when the major sessions overlap.

Importance of London Measuring FOREX Market Activity: Average Electronic Conversations 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

Foreign Exchange Rates by Time of Transaction Completion Spot Exchange Rates: –Quotes to buy or sell a certain amount of foreign currency at the current market rate, for settlement in two business days (1 day in the case of CAD/USD). The difference between the deal and settlement date reflects time needed confirm the agreement and to arrange the transfer of funds across various international centers. Forward Exchange Rates: –Quotes for future buy or sell transactions (3 business days and out). Forward markets are used by businesses and investors to protect against unexpected future changes in exchange rates. Forward rate allows businesses and investors to “lock” in an exchange rate for some future period of time. The price (i.e., the forward exchange rate) of a forward contract is based on the spot rate at the time the deal is booked, with an adjustment which represents the interest rate differential between the two currencies concerned.

Wall Street Journal Spot Foreign Exchange Rates, Sept. 26 2012 Country/currencyIn USD Per USD Wed Sept 26Tues Sept 25Wed Sept 26Tues Sept 25 Australian dollar1.03711.03900.96420.9624 UK pound1.61651.61880.61860.6177 Japan yen0.012860.0128577.7577.80 Euro-area euro1.28711.29000.77690.7752 Swiss Franc1.06431.06660.93960.9375 Source: http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnkhttp://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnk Note: In USD = American Terms and per USD = European Terms Look at the above rates and determine if a particular currency appreciated (strengthened) or depreciated (weakened) against the U.S. dollar from Thursday to Friday

Answers to Previous Slide Foreign Currency Change Country/currencyIn USD Per USD Wed Sept 26 Tues Sept 25 Wed Sept 26 Tues Sept 25 Australian dollar1.03711.03900.96420.9624AUD weakened UK pound1.61651.61880.61860.6177GBP weakened Japan yen0.012860.0128577.7577.80JPY strengthened Euro-area euro1.28711.29000.77690.7752EUR weakened Swiss Franc1.06431.06660.93960.9375CHF weakened Source: http://online.wsj.com/mdc/public/page/2_3021- forex.html?mod=mdc_curr_pglnkhttp://online.wsj.com/mdc/public/page/2_3021- forex.html?mod=mdc_curr_pglnk Note: In USD = American Terms and per USD = European Terms Look at the above rates and determine if a particular currency appreciated (strengthened) or depreciated (weakened) against the U.S. dollar from Thursday to Friday

Cross Rates The term cross rate generally refers to the exchange rate between two non- USD currencies. These rates are calculated off of each currency’s exchange rate in relations to the USD. –Example: EUR-USD = 1.2871 and GBP- USD = 1.6165 –Thus the GBP-EUR cross rate is = 1.6165/1.2871 = 1.2559 (i.e., GBP = 1.2559 Euros)

Cross Rates Assume the following rates: –GBP-USD = 1.6189 –USD-JPY = 77.6800 Calculate the GBP-JPY cross rate. –Convert the GBP-USD rate to European terms; 1/1.6189 =.6177 –Then the GBP-JPY cross rate is 77.6800/.6177 = 125.7588 (i.e., 1 GBP – 125.7588 yen) Go to Bloomberg.com

Spot Trade Date and Spot Value Date The spot trade date is the date that the agreement was entered into and the spot value date is the date that the settlement will occur. –Spot Trade Date: will establish the exchange rate. –Spot Value Date will determine when funds are transferred. Two business days from spot trade date (except for USD/CAD trades). –Weekends are not business days and if there is a holiday in one of the clearing centers, then the spot value day is extended.

Identifying Spot Trade Dates and Spot Value Dates Currency PairSpot Friday, Sept 16, 2011 Spot Trade DateSpot Value Date GBP/USD1.5788 CAD/USD1.0223 Currency PairSpot Wednesday, Dec 24, 2008 GBP/USD1.4765 CAD/USD0.8238

Identifying Spot Trade Dates and Spot Value Dates: Answers Currency PairSpot Friday, Sept 16, 2011 Spot Trade DateSpot Value Date GBP/USD1.5788Sept 16, 2011Tuesday, Sept 20 (2 bus days) CAD/USD1.0223Sept 16, 2011Monday, Sept 19 (1 bus day) Currency PairSpot Wednesday, Dec 24, 2008 GBP/USD1.4765Dec 24, 2008Monday, Dec 29 (2 bus days) CAD/USD0.8238Dec 24, 2008Friday, Dec 26 (1 bus day)

American and European Terms Quotes If you have one type of quote, it is easy to determine the second, as the second is simply the reciprocal of the first quote. For example: –American terms quote for AUD = 1.0371 –Thus the European terms equivalent is simply 1/1.0371 = 0.9642 Confirm this answer with the slide: Wall Street Journal Spot Foreign Exchange Rates, Sept. 26 2012

Calculating American and European Terms Quotes Country/CurrencyAmerican Terms European Terms Answer Brazilian Real0.5841 New Zealand Dollar1.2062 Solution: Calculate the reciprocal Brazilian Real1/0.5841 = New Zealand Dollar1/1.2062 =

Calculating American and European Terms Quotes: Answers Country/CurrencyAmerican Terms European Terms Answer Brazilian Real0.5841 New Zealand Dollar1.2062 Solution: Calculate the reciprocal Brazilian Real1/0.5841 =1.7120 New Zealand Dollar1/1.2062 =0.8291

Forward Rate Quotes Forward exchange rates are set (by market makers) at either a premium or discount of their spot rates. –If a currency’s forward rate is higher in value than its spot rate, the currency is being quoted at a forward premium. –If a currency’s forward rate is lower in value than its spot rate, the currency is being quoted at a forward discount. Look at the next slide to identify a currency selling at a forward premium and at a forward discount.

Wall Street Journal Forward Foreign Exchange Rates, April 24, 2009 Country/currencyIn USD Per USD Friday Sept 16Thursday Sept 15Friday Sept 16Thursday Sept 15 British pound (spot)1.57881.5800 1-mos forward1.57831.5795 3-mos forward1.57731.5785 6-mos forward1.57601.5772 Japanese Yen (spot)76.7976.70 1-mos forward76.7676.67 3-mos forward76.7176.60 6-mos forward76.6076.47 Source: http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnkhttp://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnk Note: In USD = American Terms and per USD = European Terms

Foreign Exchange Rates, April 24, 2009: Answer Country/currencyIn USD Per USD Answer Friday Sept 16 Thursday Sept 15Friday Sept 16 Thursday Sept 15 British pound (spot)1.57881.5800 1-mos forward1.57831.5795Discount 3-mos forward1.57731.5785Discount 6-mos forward1.57601.5772Discount Japanese Yen (spot)76.7976.70 1-mos forward76.7676.67Premium 3-mos forward76.7176.60Premium 6-mos forward76.6076.47 Source: http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnkhttp://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnk Note: In USD = American Terms and per USD = European Terms

Forward Rate Dates Forward rate settlement dates are calculated off of the spot value date (i.e., the spot transaction settlement date). The forward settlement date is the “calendar date” (adjusting for holidays and weekends). Thus a 1 month forward with a spot value date of Wednesday September 21 st would have a settlement date on Friday October 21 st (a 31 day run). While a 1 month forward with a spot value date of Friday, September 23 rd would have a settlement date on Monday, October 24 th (a 32 day run) – because the 23 rd is a Sunday. Additionally a 1 month forward has to occur in the following month. So a Monday January 31 st would have a settlement date of Monday February 28 th (a 29 day run). –This is a similar requirement for longer forwards. –Assume: Spot Value date: Thursday 31st March (last business day in March) –2 months: Tuesday 31st May (a 2 month run of 61 days) –3 months: Thursday 30th June (a 3 month run of 91 days)

What is the Spot Trade Date and Spot Value (Settlement) Date? For a spot deal GBP/USD done on Monday September 26. –What is the spot trade date? –What is the spot value date? For a spot deal USD/CAD done on Friday September 30? –What is the spot trade date? –What is the spot value date?

Answers: What is the Spot Trade Date and Spot Value (Settlement) Date? For a spot deal GBP/USD done on Monday September 26. –What is the spot trade date? Sept 26 –What is the spot value date? Sept 28 For a spot deal USD/CAD done on Friday September 30? –What is the spot trade date? Sept 30 –What is the spot value date? Oct 3

What is the Trade Date, SpotValue Date and Settlement Date for Forwards For a 2 month forward deal GBP/USD done on Friday September 23. –What is the trade date? –What is the spot value date? –What date will the forward be settled? –What is the 2 month run? For a 2 month forward deal USD/CAD done on Friday September 30? –What is the trade date? –What is the spot value date? –What date will the forward be settled? –What is the 2 month run?

Answers: What is the Trade Date, Spot Value Date and Settlement Date for Forwards For a 2 month forward deal GBP/USD done on Friday September 23. –What is the trade date? Sept 23 –What is the spot value date? Sept 27 –What date will the forward be settled? Nov 28 –What is the 2 month run? 63 For a 2 month forward deal USD/CAD done on Friday September 30? –What is the trade date? Sept 30 –What is the spot value date? Oct 3 –What date will the forward be settled? Dec 5 –What is the 2 month run? 64

The Foreign Exchange Market Understanding Foreign Exchange Quotes

The Role of Global Banks in the FX Market Large global banks (e.g., Deutsche Bank) are involved in the interbank (i.e., wholesale) FX markets through: –(1) Their “external” clients” (Other large banks, exporters, importers, multinational firms, central banks, large non-bank financial institutions) Acting in a broker capacity at the request of these clients. –(2) Their own banks (trading to generate profits). Acting in a “dealer” (i.e., trading) capacity (Taking positions (long and short) in currencies to make a profit). –In dealing with external clients, these large banks are performing a “market maker” function: Quoting prices upon demand to other parties in the interbank market, and Buying and selling currencies at their quoted prices.

“Making the Market” in FX The market maker function involves two primary foreign exchange activities: (1) A willingness of the market maker to provide the market with “on-going” (i.e., continuous) two way quotes upon request: –(1) Provide a price at which they will buy a currency –(2) Provide a price at which they will sell a currency This function provides the market with transparency (2) A willingness of the market maker to actually buy and/or sell at the prices they quote: –Thus the market maker offers “firm” prices into the market! This function provides the market with liquidity.

Base and Quote Currency Recall that a foreign exchange quote is simply the ratio of one currency to another. Thus, a “complete” market maker quote consist of two ISO designations (e.g., EUR/USD or USD/JPY): –The first ISO currency quoted in the sequence is referred to as the base currency. –The second ISO currency quoted is referred to as the quote currency. –For examples above: EUR/USD: EUR is the base currency and USD is the quote currency. USD/JPY: USD is the base currency and JPY is the quote currency.

Bid and Ask Quotes A market maker always provides the market with two prices, specifically a price at which they will buy a currency and a price at which they will sell a currency. Example: EUR/USD: 1.2102/1.2106 –The first number quoted by the market maker is the market maker’s buy price for 1 unit of the base currency ($1.2102). This is the market maker’s bid quote (or buy price) –The second quoted number is the market marker’s sell price for 1 unit of the base currency ($1.2106). This the market maker’s ask quote (or sell price)

Bid Ask Quote Example Example : GBP/USD: 1.5535/1.5537. Assume you’re dealing with the market maker; Questions: –(1) How much will you pay for 1 pound; –(2) how much will get when you sell 1 pound; –(3) how much will you pay for 1 U.S dollar; –(4) how much will you get when you sell 1 U.S. dollar? Answers:

Bid Ask Quote Example Answers Example : GBP/USD: 1.5535/1.5537. Assume you’re dealing with the market maker;Questions: –(1) How much will you pay for 1 pound; $1.5537 –(2) how much will get when you sell 1 pound; $1.5535 –(3) how much will you pay for 1 U.S dollar; 1/1.5535 =.6437 (64.37 British cents) –(4) how much will you get when you sell 1 U.S. dollar? 1/1.5537 =.6430 (64.36 British cents)

Bid Ask European Terms Example Assume the following USD/JPY: 76.35/76.45 (Note: now the base currency is the dollar and the quote currency is the yen) Assume you’re dealing with the market maker; –Question: (1) How much will you pay for 1 dollar; –(2) how much will get when you sell 1 dollar; –(3) how much will you pay for 1 yen; –(4) how much will you get when you sell 1 yen? Answers:

Bid Ask European Terms Answers Assume the following USD/JPY: 76.35/76.45 (Note: now the base currency is the dollar and the quote currency is the yen) Assume you’re dealing with the market maker; –Question: (1) How much will you pay for 1 dollar; 76.45 yen –(2) how much will get when you sell 1 dollar; 76.35 yen –(3) how much will you pay for 1 yen; 1/76.35 = 0.0130975 (U.S. cents) –(4) how much will you get when you sell 1 yen? 1/76.45 = 0.0130804 (U.S. cents)

Bid Ask Spreads The Bid Ask spread is the “profit” that a market maker bank will make on a “round” transaction (i.e., buying and selling an equal amount at the stated price). Regardless of the type of quote (American terms or European terms), the ask price is always higher than the bid. –That is, what they will sell the base currency for is always higher than what they will buy the base currency at.

Assume the following GBP/USD quote: 1.7921/1.7929 –What is the dollar spread to the market maker on a “round” transaction (assume 10 million pound transactions)? Ask $1.7929 x £10,000,000 = $17,929,000 (price to sell pounds) Bid $1.7921 x £10,000,000 = $17,921,000 (price to buy pounds) Spread (Commission) = $ 8,000 (on round transaction) Bid Ask Spreads

Bid Ask Spread: European Terms Assume the following USD/CAD quote: –1.0200/1.0210 Note the ask price is higher What is the spread on a round transaction assuming a $1,000,000 USD transaction. –Ask price 1.0210 x $1,000,000 = 1,021,000 CAD –Bid price = 1.020 x $1,000,000 = 1,020,000 CAD –Spread = 1,000 CAD

Foreign Exchange Pips (or Points) Pips (sometimes called points) refer to the smallest unit by which the prices for the currency pair may vary. –Pip stands for percentage in point. In the example: GBP/USD: 1.5535/1.5537, the difference in the bid quote and ask quote lies in the fourth decimal place, or 2 pips. –A Pip for a 4 decimal place quoted currency is actually 0.0001 of an exchange rate Most currencies are quoted out to 4 decimal places.

Observations About Bid/Ask Spreads Bid and ask spreads widen or narrow in response to a number of factors. For example: –Spreads increase with exchange rate volatility and uncertainty. –Spreads decrease with increases in market maker competition. –Spreads are smaller in wholesale (interbank) market than in retail market (and tourist market). Example: GPB/USD for September 26, 2011 Wholesale: 1.5514 5 /1.5515 8 ; pip spread = 1.3 Retail: 1.5512/1.5516; pip spread = 4 Tourist retail (Wells Fargo quote): 1.4489/1.6152; spread = 0.1663 cents –Spreads can differ slightly among market markets. As market makers attempt to adjust their positions and thus make dealing with them more or less attractive.

Which Way is the Currency Moving? Remember when viewing a foreign exchange quote, assign a value of 1 to the base currency (the base currency is the first in the ISO pair). The quotes you see refer to one unit of this base currency. Thus, whenever the bid and ask prices are moving up, that means that the base currency is getting stronger (relative to the quote currency) and the quote currency is getting weaker (relative to the base currency). Conversely, whenever the bid and ask prices are moving down, that means that the base currency is getting weaker (relative to the quote currency) and the quote currency is getting stronger.

Example: Which way is the Currency Moving? Weakening or Strengthening? CurrencyOctober 4, 2012 October 5, 2012 Move of Foreign Currency Move of USD EUR/USD1.30181.3036 GBP/USD1.61931.6133 USD/JPY78.5078.67 USD/CHF0.93060.9298

Example: Which way is the Currency Moving? Weakening or Strengthening ? CurrencyOctober 4, 20 12 October 5, 20 12 Move of Fore ign Currency Move of USD EUR/USD1.30181.3036EUR strength ening USD weakeni ng GBP/USD1.61931.6133GBP weakeni ng USD strength ening USD/JPY78.5078.67JPY weakenin g USD strength ening USD/CHF0.93060.9298CHF strength ening USD weakeni ng

Let’s Look at Real Time Currency Quotes Go to the following web-site: http://www.fxstreet.com/http://www.fxstreet.com/ At this site, link to: Rates and Charts –Go to Retail Rates Live Select currency as USD Observe ISO quotes Observe bid and ask quotes. Understand what currency and at what price the market maker is buying or selling (base currency). Understand what price you (a non-market maker) would buy or sell the base currency to the market maker. Observe changes in bid and ask quotes. –If these are going up, the base currency is strengthening and the quote currency is weakening. Reverse is true if these are going down. –Next, link to: Interbank FX Rates Live and observe majors and G7 (note quotes to 5 decimal places)

Let’s Look at Real Time Currency Charts Again, go to the following web-site: http://www.fxstreet.com/ http://www.fxstreet.com/ At this site, link to: Rates and Charts –Go to Streaming Forex Charts Observe different currency pairs: Make sure you know which currency in the pair is strengthening and which is weakening. Observe different time scales from ticks out to monthly.

Candle Stick Charting of FX Patterns Examples Go to FXStreet.com At this site, link to: Rates and Charts Go to Streaming Forex Charts Under chart type go to Candle Stick

Week 4: The Forward Exchange Market Understanding Forward Exchange Quotes and the Use of the Forward Market

Foreign Exchange Rate Quotes and the Use of the Market Recall that exchange rates can be quoted for two possible settlement dates: –Immediate settlement (actually 1 or 2 business days): Called the Spot Rate. –Settlement at some date in the future: Called the Forward Rate. Use of the forward market: To protect foreign currency cash flows against foreign currency exposure (specifically against unanticipated changes in exchange rates).

Examples of Spot and Forward Quotes Monday, October 4, 2010 GBP/USDRate Pip Difference (From Spot) –Spot:1.5833 –1 month Forward1.5829- 4 –3 month Forward1.5822- 11 –6 month Forward1.5812- 21 USD/JPY –Spot83.42 –1 month Forward83.39- 3 –3 month Forward83.33- 9 –6 month Forward83.22-20 Source: Wall Street Journal: http://online.wsj.com/mdc/public/page/2_3021-forex.html http://online.wsj.com/mdc/public/page/2_3021-forex.html

Forward Discounts and Premiums GBP/USD (i.e., American Terms): GBP Selling at a Forward Discount Against the USD USD/GBP (i.e., European Terms): USD Selling at a Forward Premium Against the GBP

Forward Discounts and Premiums USD/JPY (i.e., European Terms): USD Selling at a Forward Discount Against the JPY JPY/USD (i.e., American Terms): JPY Selling at a Forward Premium Against the USD

Forward Premium or Discount? CurrencyExchange Rate: Sept 27, 2011 Foreign Currency Forward Discount or Premium in Pips USD: Forward Discount or Premium in Pips USD/CHF Spot0.8959 1-month0.8955 3-month0.8941 6-month0.8921 AUD/USD Spot0.9911 1-month0.9871 3-month0.9803 6-month0.9713

Forward Premium or Discount? CurrencyExchange Rate: Sept 27, 2011 Foreign Currency Forward Discount or Premium in Pips USD: Forward Discount or Premium in Pips USD/CHF Spot0.8959 1-month0.8955Premium (+4 pips)Discount (-4 pips) 3-month0.8941Premium (+18 pips)Discount (-18 pips) 6-month0.8921Premium (+38 pips)Discount (-38 pips) AUD/USD Spot0.9911 1-month0.9871Discount (-40 pips)Premium (+40 pips) 3-month0.9803Discount (-108 pips)Premium (+108 pips) 6-month0.9713Discount (-198 pips)Premium (+198 pips)

Forward Exchange Contracts Forward exchange contracts are over the counter instruments written by market maker banks Market maker banks quote bid and ask prices for various currencies for forward periods upon request. Bids are prices at which they will buy “base” currency and ask are prices at which they will sell the “base” currency. –Popular journals publish forward quotes for standard time periods. For example the Wall Street Journal publishes 1, 3 and 6 months forward. –However, forward contracts are not limited to these standard periods. Quotes can be obtained for specific time periods as requested by bank customers (thus tailored to client needs). Large banks will quote forward rates up to one year in the majority of currency pairs and further out in the major currencies (out to 5 and 10 years).

Outright Forwards An outright forward exchange contract is a transaction to buy or sell one currency against another for a fixed forward value date. –The fixed forward value date is the contract’s settlement date (note: this is similar to the spot value date on a spot contract). The forward exchange rate is fixed on the date of dealing (called the forward trade date) and is set against the current spot rate (i.e., on the spot trade date). An outright forward contract is a contractual obligation on both parties, i.e., the bank and the client.

Forward Quote Example 4/4/2011Complete Quote (bid/ask) –Spot (GBP/USD):1.5833/1.5836 –6 month Forward (GBP/USD):1.5812/1.5816 Thus the market maker will: –Buy GBP spot at $1.5833 and sell GBP spot at $1.5836; spot trade date 4/4/2011 and spot value date (settlement date) 4/6/2011. –Or: Buy GBP in 6 months at $1.5812 and sell GBP in 6 months at $1.5816.

Assume: A U.S. firm has a British pound liability due in 6 months. The liability totals 1million GBP –Firm has an open short position in GBP. Problem with an “uncovered” (open) short position. –If the GBP spot rate strengthens in 6 months, it will cost more in USD to pay the liability. Solution: U.S. company can “lock” in the USD cost of the GBP liability by buying GBP 6 months forward at the forward rate quoted. In doing so, the U.S. firm has “covered” (i.e., hedged) its GBP liability due in 6 months. Using the Forward Market to Hedge (Cover) an Open Short Position

Use the information on the previous slide (a U.S. firm has a 1million GBP 6 month open short position) and assume the following market maker quotes for GBP/USD: –Spot1.5634/1.5637 –1 month1.5629/1.5632 –3 month1.5620/1.5624 –6 month1.5608/1.5610 Question: What is the known USD liability in 6 months if the U.S. firm uses a forward contact to hedge its foreign exchange exposure? ____________________________ Example: Using the Forward Market to Hedge (Cover) an Open Short Position

Use the information on the previous slide (a U.S. firm has a 1million GBP 6 month open short position) and assume the following market maker quotes for GBP/USD: –Spot1.5634/1.5637 –1 month1.5629/1.5632 –3 month1.5620/1.5624 –6 month1.5608/1.5610 Question: What is the known USD liability in 6 months if the U.S. firm uses a forward contact to hedge its foreign exchange exposure? ₤1,000,000 x 1.5610 = $1,561,000 Example: Using the Forward Market to Hedge (Cover) an Open Short Position

Assume: A U.S. firm has a British pound account receivable due in 3 months. The receivable totals 1 million GBP –Firm has an open long position in GBP. Problem with an “uncovered” (open) long position. –If the GBP spot rate weakens in 3 months, the U.S. firm will receive fewer U.S. dollars. Solution: U.S. company can “lock” in the USD return of the GBP account receivable by selling GBP 3 months forward at the forward rate quoted. In doing so, the U.S. firm has “covered” (i.e., hedged) its GBP receivable due in 3 months. Using the Forward Market to Hedge (Cover) an Open Long Position

Use the information on the previous slide (a U.S. firm has a 1million GBP 3 month open long position) and assume the following market maker quotes for GBP/USD: –Spot1.5634/1.5637 –1 month1.5629/1.5632 –3 month1.5620/1.5624 –6 month1.5608/1.5610 Question: What is the known USD equivalent expected in 3 months if the U.S. firm uses a forward contact to hedge its foreign exchange exposure? _______________________ Example: Using the Forward Market to Hedge (Cover) an Open Long Position

Use the information on the previous slide (a U.S. firm has a 1million GBP 3 month open long position) and assume the following market maker quotes for GBP/USD: –Spot1.5634/1.5637 –1 month1.5629/1.5632 –3 month1.5620/1.5624 –6 month1.5608/1.5610 Question: What is the known USD equivalent expected in 3 months if the U.S. firm uses a forward contact to hedge its foreign exchange exposure? ₤1,000,000 x 1.5620 = $1,562,000 Example: Using the Forward Market to Hedge (Cover) an Open Long Position

Assume: A British firm has a 1 million USD liability due in 1 month. Assume the following market maker quotes for GBP/USD: –Spot1.5634/1.5637 –1 month1.5629/1.5632 –3 month1.5620/1.5624 –6 month1.5608/1.5610 Question: What is the known GBP liability in 1 month if the British firm uses a forward contact to hedge its foreign exchange exposure? _______________________ Using the Forward Market to Hedge (Cover) an Open Short Position

Assume: A British firm has a 1 million USD liability due in 1 month. Assume the following market maker quotes for GBP/USD: –Spot1.5634/1.5637 –1 month1.5629/1.5632 –3 month1.5620/1.5624 –6 month1.5608/1.5610 Question: What is the known GBP liability in 1 month if the British firm uses a forward contact to hedge its foreign exchange exposure? 1/1.5629 = 0.6398362 x $1,000,000 = ₤639,836.20 Using the Forward Market to Hedge (Cover) an Open Short Position

Assume: A British firm has a 1 million USD account receivable which it expects to receive in 3 months. Assume the following market maker quotes for GBP/USD: –Spot1.5634/1.5637 –1 month1.5629/1.5632 –3 month1.5620/1.5624 –6 month1.5608/1.5610 Question: What is the known GBP equivalent expected in 3 months if the British firm uses a forward contact to hedge its foreign exchange exposure? ________________________ Using the Forward Market to Hedge (Cover) an Open Long Position

Assume: A British firm has a 1 million USD account receivable which it expects to receive in 3 months. Assume the following market maker quotes for GBP/USD: –Spot1.5634/1.5637 –1 month1.5629/1.5632 –3 month1.5620/1.5624 –6 month1.5608/1.5610 Question: What is the known GBP equivalent expected in 3 months if the British firm uses a forward contact to hedge its foreign exchange exposure? 1/1.5624 = 0.6400409 x $1,000,000 = ₤640,040.90 Using the Forward Market to Hedge (Cover) an Open Long Position

Forward Exchange Contract Risks Credit Risk (counterparty risk): The risk that the currency contracted to be purchased or sold on some future date will not be delivered. (1) Bank Risk (“Herstatt Risk”*): Risk that the bank which sold the client a forward contract will default prior to payment. –*Named after German bank I.D. Herstatt which unexpectedly closed in 1974 and thus defaulted on its FX commitments (both spot and forwards). (2) Client Risk: Risk that client who purchased a forward contract fails to deliver currency. –Client might go bankrupt, or –Foreign currency account receivable is not paid (to client).

Protecting Against Counterparty Risk Bank Risk: Deal with only the top (and most credit worthy) banks. –Stay away from banks with overexposures in high risk areas. Client Risk: –Ensure payment on foreign currency account receivables through bankers’ acceptances. –Bankers’ acceptances: Payment is guaranteed by commercial bank (not dependent upon the foreign company).

Forward Quotes Day’s close (in actual rates) –http://online.wsj.com/mdc/public/page/2_3021 -forex.htmlhttp://online.wsj.com/mdc/public/page/2_3021 -forex.html Rates (in pips from spot) –http://www.forexpros.com/rates- bonds/forward-rateshttp://www.forexpros.com/rates- bonds/forward-rates We will examine this site in more detail in the next lecture (The Forward Market and the Forward Exchange Rate)

Bankers’ Acceptances A bankers acceptance is a time draft drawn on a bank, and is typically used to finance an international transaction where an exporter is unwilling to offer their goods or services on credit to an importer. A banker's acceptance is issued by the importer and is an order for its bank to pay an exporter certain amount of money at a predetermined date. Once the bank accepts this order, they are liable for payment to the exporter. Once the Bankers acceptance has been signed by the bank on behalf of the importer, the exporter may either hold the acceptance until maturity date or sell it on the secondary market at a discount of its par. Bankers acceptances are a major part of the U.S. money markets, providing liquidity to exporters and low risk interest income to secondary market buyer. They are typically traded at a spread above the U.S. T-bills and the rate is referred to as the Banker's Acceptance rate. For current bankers’ acceptances rates view: http://online.wsj.com/mdc/public/page/2_3020- moneyrate.html http://online.wsj.com/mdc/public/page/2_3020- moneyrate.html

Life Cycle of a Bankers’ Acceptance

The Forward Exchange Market Determining the Appropriate Forward Exchange Quote: The Interest Rate Parity Model

China’s Foreign Exchange Trade System China’s Foreign Exchange Trade System (CFETS) was founded in April 1994 as part of China’s FX reforms. Today CFETS plays a significant role in managing the Yuan exchange rate. CFETS is a sub-institution of the People's Bank of China (PBC). Its main foreign exchange functions include: providing a system for foreign exchange trading; organizing interbank FX trading, providing information on the FX, market; and engaging in other businesses authorized by the PBC. CFETS is headquartered in Shanghai.

How do Market Makers Determine the Forward Exchange Rate? The quoted forward rate is not a reflection of where market makers think the spot exchange rate will be on that forward date. Lloyds Bank, UK (Corporate Banking and Treasury Training Publication) : “Forward rates.. are not the dealer's [i.e., market maker bank’s] opinion of where the spot rate will be at the end of the period quoted.” So what determines the forward rate? –Quick answer: Interest rate differentials between currencies being quoted, or the Interest Rate Parity Model. –To develop this concept, and the Interest Rate Parity Model, we will work through the following example.

Consider Cross Border Investing Assume a U.S. investor has $1 million to invest for 1 year and can select from either of the following 1 year investments: –(1) Invest in a U.S. government bond and earn 2.0% p.a. –(2) Invest in an Australian government bond and earn 5.5% p.a. If the U.S. investor invests in Australian government bonds, he/she will receive a known amount of Australian dollars in 1 year when the bond matures. –Principal repayment and interest payment both in AUD.

Risk of Investing Cross Border Question: Using the previous example, what is the risk for the U.S. investor if he/she buys the 1 year Australian government bond? Answer: The risk associated with foreign exchange exposure in AUD (open position). –The U.S. investor will be paid a specified amount of Australian dollars 1 year from now: –The risk is the uncertainty about the Australian dollar spot rate 1year from now. If the Australian dollar (spot) weakens, the U.S. investor will receive fewer U.S. dollars at maturity: –Example: If the Australian dollar weakened by 2% by the end of the year, this reduces the return on the Australian investment (from 5.5 % to 3.5%).

Solution to The Currency Risk for the U.S. Investor Question: Using the previous example, how could the U.S. investor manage the risk associated with this Australian dollar exposure? Solution: The US investor can cover the Australian dollar investment by selling Australian dollars 1 year forward (a short position). –Australian dollar amount which the investor will sell forward would be equal to the principal repayment plus earned interest (Note: this was the known amount of AUD to be received in 1 year).

Calculating the U.S. Dollar Equivalent of the Maturing AUD Government Bond when Covered Assume: –A 1 year Australian Government Bond with a par value of 1,000AUD (assume you purchased 100 of these at par) –Assume an annual coupon of 5.5% (payable at the end of the year) –Assume the following market maker bank quoted exchange rates: AUD/USD spot1.0005/1.0009 AUD/USD 1 year forward0.9650/0.9657 Calculate the USD covered amount when the bond matures: ______________________

Answer: U.S. Dollar Equivalent of the Maturing AUD Government Bond Amount of AUD to be received in 1 year from maturing bonds: –Par value = AUD1,000 x 100 = AUD100,000 –Interest (5.5% coupon) = 100,000 x 0.055 = AUD5,500 –Total received = AUD105,500 (to be sold forward) Exchange rates: AUD/USD spot1.0005/1.0009 AUD/USD 1 year forward0.9650/0.9657 USD covered amount (to be received in 1 year) = AUD105,500 x 0.9650 = USD101,807.50

Concept of Covered Return The covered return (i.e., hedged return) on a cross border investment is the return after the investment’s foreign exchange risk has been covered with the appropriate forward contract. The forward exchange rate will determine the “covered” investment return for the U.S. investor. In the previous example, how would you determine the covered return (as a %) to the U.S. investor?

Calculating the Covered Return Answer: Calculate the yield to maturity on the investment when covered. Note: Yield to Maturity is the internal rate of return (IRR), or the discount rate that sets the present value of the future cash inflow to the price of the investment, –So given: –AUD/USD spot1.0005/1.0009 –AUD/USD 1 year forward0.9650/0.9657 USD Purchase Price = AUD100,000 x 1.0009 = USD100,090 USD Hedged Equivalent Cash Inflow in 1 year = AUD105,500 x 0.9650 = USD101,807.50 Solve for the IRR (k): -100,090 = 101,807.50/(1+k) –http://www.datadynamica.com/IRR.asphttp://www.datadynamica.com/IRR.asp k = 1.72% (Why is this different from the 5.5%) –Answer: Because AUD is selling at a 1 year forward discount.

Another Example of a Covered Return Assume the following: –A 1 year Japanese Government Bond with a coupon of 1%. –Par value of 100,000 yen and selling at par. –Exchange Rates: USD/JPY spot:76.61/76.65 1 year forward:73.50/73.55 Calculate the covered return for a U.S. investor on the above JGB

Answer to JGB Covered Return Step 1: Calculate the USD purchasing price of the JGB: –100,000/76.61 (note this is spot bid) = 1305.31 Step 2: Calculate the yen inflow expected in 1 year: –100,000 x 1.01 = 101,000 (note: coupon rate is 1%) Step 3: Calculate the USD equivalent of the 1 year yen inflow using a forward contract. –101,000/73.55 = 1373.22 (note this is 1 year ask) Ask is the price at which the bank will sell you dollars. Step 4: Calculate the IRR (using the web site) –-1305.31= 1373.22/(1+k); k = 5.21% (Why is this different from the 1%)

Covered Interest Arbitrage  Covered interest “arbitrage” is a situation that occurs when a covered return offers a higher return than that in the investor’s home market.  As an example assume:  1 year interest rate in U.S. is 4%  1 year interest rate in Australia is 7%  AUD 1 year forward rate is quoted at a discount of 2%.  In this case, a U.S. investor could invest in Australia and  Cover (sell Australian dollars forward) and earn a covered return of 5% (7% - 2%) which is 100 basis points greater than the U.S. return  This is covered interest arbitrage: earning more (when covering) than the rate at home.

Explanation for Covered Interest Arbitrage Opportunities  Covered interest arbitrage will exist whenever the quoted forward exchange rate is not priced correctly.  If the forward rate is priced correctly, covered interest arbitrage should not exist.  Going back to our original example:  (1) Invest in a U.S. government bond and earn 2.0%.  (2) Invest in an Australian government bond and earn 5.5%  If the AUD 1 year forward were quoted at a discount of 3.5%, then the covered return (2%) and the home return (2%) would be equal.

The Appropriate Forward Exchange Rate and the Interest Rate Parity Model The Interest Rate Parity Model (IRP) offers an explanation of the market’s correctly priced (i.e., “equilibrium”) forward exchange rate. –This equilibrium rate is the forward rate that precludes covered interest arbitrage The Interest Rate Parity Model states: –“That in equilibrium the forward rate on a currency will be equal to, but opposite in sign to, the difference in the interest rates associated with the two currencies in the forward transaction.” Thus, the equilibrium forward rate is whatever forward exchange rate will insure that the two cross border investments will yield similar returns when covered.

Test of the Interest Rate Parity Model: 1974-1992

Interest Rate Parity Model, 2004

IRP: October 16, 2012 Currency Pair FX Rate: Spot and 3 Month Forward Is the Foreign Currency Forward at a Discount or Premium ? What is the IRP Interest Rate Explanation for the Forward Rate? AUD/USDFX Rate Spot1.0275 3 months1.0200 GBP/USD Spot1.6111 3 months1.6109 USD/JPY Spot78.89 3 months78.82 USD/CHF Spot0.9260 3 months0.9247

IRP: October 16, 2012 CurrencyFX RateWhat is the IRP Interest Rate Explanation for the Forward Rate? Actual 3 Month Interest Rates (%): Source: The Economist AUD/USDFX Rate Spot1.0275AUD selling at a forward discount 3 months1.0200Australian interest rates must be higher than U.S interest rates Australia = 3.63% U.S. = 0.34% GBP/USD Spot1.6111GBP selling at a forward discount 3 months1.6109U.K. interest rates must be higher than U.S. interest rates U.K. = 0.54% U.S. = 0.34%

IRP: October 16, 2012 CurrencyFX RateWhat is the IRP Interest Rate Explanation for the Forward Rate? Actual 3 Month Interest Rates (%): Source: The Economist and Bloomberg USD/JPYFX Rate Spot78.89JPY selling at a forward premium 3 months78.82Japanese interest rates must be lower than U.S. interest rates Japan = 0.19% U.S. = 0.34% USD/CHF Spot0.9260CHF selling at a forward premium 3 months0.9247Swiss interest rates must be lower than U.S. interest rates Switzerland = 0.04% U.S. = 0.34%

How is the Forward Rate Calculated? Market maker banks calculate their quoted forward rate is calculated from three observable numbers: –The (current) spot rate. –A foreign currency interest rate. –A home currency interest rate (assume to be the U.S.). Note: The maturities of the interest rates used should be approximately equal to the calculated forward rate period (i.e., maturity of the forward contract). What interest rates are used? –Interbank market (wholesale) interest rates for currencies (sometimes called euro-deposit rates). Large global banks quote each other and clients market interest rates in a range of currencies.

Example: October 11, 2012 http://www.forexpros.com/rates- bonds/forward-rateshttp://www.forexpros.com/rates- bonds/forward-rates

Forward Rate Pips off of Spot EUR Selling at a Forward Premium CAD Selling at a Forward Discount

Forward Rate Formula for European Terms Quote Currencies The formula for the calculation of the equilibrium European terms forward foreign exchange rate is as follows: FTet = Set x [(1 + INTf) / (1 + INTus)] Where: –FTet = forward foreign exchange rate at time period T, expressed as units of foreign currency per 1 U.S. dollar; thus European terms, i.e., “et” –Set = today's European terms spot foreign exchange rate, –INTf = foreign interest rate for a maturity of time period T (expressed as a percent, e.g., 1% = 0.01) –INTus = U.S. interest rate for a maturity of time period T

Example: Solving for the Forward European Terms Exchange Rate Assume the following data: –USD/JPY spot = ¥120.00 –Japanese yen 1 year interest rate = 1% –US dollar 1 year interest rate = 4% Calculate the 1 year yen forward exchange rate: Set up the formula and insert data. –FTet = Set x [(1 + INTf) / (1 + INTus)]

Example: Solving for the Forward European Terms Exchange Rate Assume the following data: –USD/JPY spot = ¥120.00 –Japanese yen 1 year interest rate = 1% –US dollar 1 year interest rate = 4% Calculate the 1 year yen forward exchange rate: –FTet = Set x [(1 + INTf) / (1 + INTus)] –FTet = ¥120 x [(1 +.01) / (1 +.04)] –FTet = ¥120 x.971153846 –FTet = ¥116.5384615

Forward Rate Formula for American Terms Quote Currencies The formula for the calculation of the equilibrium American terms forward foreign exchange rate is as follows: FTat = Sat x [(1 + INTus) / (1 + INTf)] Where: –FTat = forward foreign exchange rate at time period T, expressed as the amount of 1 U.S. dollars per 1 unit of the foreign currency; thus American terms, or at) –Sat = today's American terms spot foreign exchange rate. –INTus = U.S. interest rate for a maturity of time period T (expressed as a percent, e.g., 4% = 0.04) –INTf = Foreign interest rate for a maturity of time period T

Example: Solving for the American Terms Forward Exchange Rate Assume the following data: –GPB/USD spot = $1.9800 –UK 1 year interest rate = 6% –US dollar 1 year interest rate = 4% Calculate the 1 year pound forward exchange rate: Set up the formula and insert data: –FTat = Sat x [(1 + INTus) / (1 + INTf)]

Example: Solving for the American Terms Forward Exchange Rate Assume the following data: –GPB/USD spot = $1.9800 –UK 1 year interest rate = 6% –US dollar 1 year interest rate = 4% Calculate the 1 year pound forward exchange rate: –FTat = Sat x [(1 + INTus) / (1 + INTf)] –FTat = $1.9800 x [(1 +.04) / (1 +.06)] –FTat= $1.9800 x.9811 –FTat = $1.9426

Appendix A Calculating the forward rate for periods less than and greater than one year

Formulas and Interest Rates The formulas used in the previous slides show you how to calculate the forward exchange rate 1 year forward. The following slides illustrate how to adjust the forward rate formula for periods other than 1 year. Important: –All interest rates quoted in financial markets are on an annual basis, thus and adjustment must be made to allow for other than annual interest periods.

Forwards Less Than 1 Year: European Terms FTet = Set x [(1 + ((INTf) x n/360)) / (1 + ((INTus) x n/360))] Where: –FT = forward foreign exchange rate at time period T, expressed as units of foreign currency per 1 U.S. dollar; –Set = today's European terms spot foreign exchange rate. –INTf = foreign interest rate for a maturity of time period T –INTus = U.S. interest rate for a maturity of time period T –n = number of days in the forward contract (note: we use a 360 day year in this formula). Note: What we have added to the original formula is an adjustment for the time period (n/360)

European Terms Example: Less than 1 year Assume: USD/JPY spot = 82.00 6 month Japanese interest rate = 0.12%* 6 month U.S. interest interest rate= 0.17%* *These are interest rates expressed on an annual basis. Calculate the 6 month forward yen FTet = Set x [(1 + ((INTf) x n/360))/ (1 + ((INTus) x n/360))] Ftet = 82.00 x [(1 + ((0.0012 x 180/360))/((1 + ((0.0017 x 180/360))] FTet = 82.00 x (1.0006/1.00085) FTet = 82.00 x.9997 FTet = 81.9795

Forwards More Than 1 Year: American Terms FTat = Sat x [(1 + (INTus) n / (1 + (INTf) n ] Where: –FT = forward foreign exchange rate at time period T, expressed as the amount of 1 U.S. dollars per 1 unit of the foreign currency. –Sat = today's American terms spot foreign exchange rate. –INTus = U.S. interest rate for a maturity of time period T –INTf = Foreign interest rate for a maturity of time period T –n = number of years in the forward contract.

American Terms Example: More than 1 Year Assume: GBP/USD spot = 1.5800 5 year United Kingdom interest rate = 1.05%* 5 year United States interest rate = 1.07%* *These are interest rates expressed on an annual basis. Calculate the 5 year forward pound: FTat = Sat x ((1 + INTus) n /(1 + INTf) n ) FTat = 1.5800 x ((1 + 0.0107) 5 /(1 + 0.0105) 5 ) FTat = 1.5800 x (1.05466/1.05361) FTat = 1.5800 x 1.001 FTat = 1.5816 (Note: This is the forward 5 year rate)

Week 5: Parity Models and Foreign Exchange Rates Evaluating Current Spot Rates and Forecasting Rates with Parity Models: The Purchasing Power Parity Model

What are Parity Models? Parity is defined as a state of equilibrium. Foreign exchange parity models “estimate” what the equilibrium spot exchange rate should be (under the model’s assumptions): –(1) Is today’s spot rate appropriate? –(2) What might the spot rate be in the future (forecasting future spot rates). Generally involving a long term forecasting horizon. Parity models have an economic basis (i.e., theory) for their spot rate determination.

Why are Parity Models Important? Testing the “correctness” of a spot rate. –Could be important for a trading strategy. –Is the currency overvalued or undervalued? Overvalued: perhaps a sell short strategy. Undervalued: perhaps a buy long strategy. Establishing a future spot rate –Could be important for: International capital budgeting decisions –Converting estimated foreign currency cash flows into MNC’s home currency as part of the capital budgeting process (location decision). Investment and Financing decisions –Converting estimated investment inflows from investments into home currency equivalents and converting estimated financing outflows into home currency equivalents.

Two Major Spot FX Parity Models (1) Purchasing Power Parity (PPP) –Model assumes relative rates of inflation (or relative prices) between two countries as the major determinant of future spot exchange rates. The subject of this lecture (2) International Fisher Effect (IFE) –Model assumes relative rates of long term interest between two countries as the major determinant of future spot exchange rates. The subject of the next lecture

Purchasing Power Parity Theory The Purchasing Power Parity (PPP) explains and quantifies the relationship between inflation and spot exchange rates. The theory of Purchasing Power Parity says that in the long run, differences in inflation rates between countries are transmitted through changes in relative exchange rates. I The theory states that the spot exchange rate between two currencies should be equal to the ratio of the two countries’ price levels. –Idea was first proposed by the classical economist, David Ricardo, in the 19 th century. –The concept was expanded by the Swedish economist, Gustav Cassel, during the years after WW1 (1918 -) when countries in Europe were experiencing hyperinflation.

Anecdotal Evidence in Support of PPP Model Historically low inflation rate countries have been associated with strong currencies: –Switzerland, Japan, Germany Historically high inflation rate countries have been associated with weak currencies: –Countries in South America and Africa Argentina, Brazil, Peru and Chile Zimbabwe

Two Forms of PPP Absolute PPP: –At a point in time, the equilibrium spot exchange rate is that rate which results in the prices of similar goods in two different countries being equal. This form of the PPP can be used to test how “appropriate” a current spot exchange rate is and to indicate a future move in the exchange rate. Relative PPP: –Over time, the change in the exchange rate between two currencies should be equal to the rate of change in the prices of similar goods between the two countries. This form of the PPP is used to forecast the equilibrium spot exchange rate in the future and generally over a long time horizon.

Rationale Behind the PPP: The Law of One Price The Purchasing Power Parity model is based on the Law of One Price: –The Law of One Price states that all else equal (i.e., no transaction costs or other frictions, like tariffs or cultural differences) a product’s price (adjusted by the exchange rate) should be the same in all markets. –Why will the product’s price be the same? The principle of competitive markets assumes that prices will equalize as consumers shift their purchases to those markets (or countries) where prices are the lowest. Also arbitrage activities will (might) result in similar prices.

Law of One Price Formulas The Law of One Price assumes that prices for similar products between two countries should be the same after adjusting for exchange rates, or –The price of product A in the United States in U.S. dollars (P USD ), adjusted by the spot exchange rate, should equal the foreign currency price (P FC ) of product A in a foreign country. Law of One Price formulas: –P USD  Spot FX rate ET = P FC Where ET = European Terms quote –P USD /Spot FX rate AT = P FC Where AT = American Terms quote

Example 1: Law of One Price Assume: –A Big Mac hamburger costs $4.00 in the United States and –The current yen spot exchange rate (USD/JPY) is ¥76.75 According to the Law of One Price, the “equilibrium” Big Mac hamburger price in Japan should be: P USD  Spot FX Rate ET = P ¥ $4.00 x ¥76.75 = ¥307 –At these two local currency prices ($4.00 and ¥307) and given the spot exchange rate (76.75) there is no difference in exchange rate adjusted prices for a Big Mac in the United States and Japan.

Example 2: Law of One Price Assume: –A Big Mac hamburger costs $4.00 in the United States and –The current British pound spot exchange rate (GBP/USD) is $1.5380 According to the Law of One Price, the “equilibrium” Big Mac hamburger price in the UK should be: P USD /Spot FX Rate AT = P £ $4.00/$1.5380 = £2.60 –At these two local currency prices ($4.00 and £2.60) and given the spot exchange rate (1.5380) there is no difference in exchange rate adjusted prices for a Big Mac in the United States and the United Kingdom.

The Absolute PPP Exchange Rate The absolute PPP spot exchange rate is the exchange rate which results in the prices of similar goods between two countries being the same. For European Terms quoted currencies the absolute PPP formula is: –Absolute PPP FX Rate ET = P FC /P USD –Where P FC is the price in the foreign market –And P USD is the price in the U.S. market

Example: The Absolute PPP Exchange Rate For European Terms Quotes –Example: Assume the price of a Starbuck’s grande vanilla latte in the United States is $3.75 and 7.40CHF in Switzerland. Given this information, calculate the absolute PPP USD-CHF spot exchange rate. –Absolute PPP FX Rate ET = P FC /P USD –USD-CHF ______________

Answer –Example: Assume the price of a Starbuck’s grande vanilla latte in the United States is $3.75 and 7.40CHF in Switzerland. Given this information, calculate the absolute PPP spot exchange rate. –Absolute PPP FX Rate ET = P FC /P USD –Spot USD-CHF FX Rate ET = 7.40/3.75 = 1.9733 –At 1.9733 the price of this Starbucks is the same in the U.S. and Switzerland: 7.40/1.9733 = $3.75

The Absolute PPP Exchange Rate: American Terms Quotes For American Terms quoted currencies the absolute PPP formula is: –Absolute PPP FX Rate AT = P USD /P FC –Where P FC is the price in the foreign market –And P USD is the price in the U.S. market Example: Assume the price of an official NBA basketball in the U.S. is $180 and in the U.K the price is 105 pounds. Calculate the Absolute PPP Exchange Rate.

Answer Example: Assume the price of an official NBA basketball in the U.S. is $180 and in the U.K the price is 105 pounds. Given this information, calculate the Absolute PPP Exchange Rate Absolute PPP FX Rate AT = P USD /P FC Spot GBP-USD = 180/105 = 1.7143 At 1.7143 the price of this basketball is the same in the U.S. and the U.K.: 105 x 1.7143 = $180.00

Evaluating Spot Rates Once we have calculated the absolute PPP exchange rate, we can compare that rate to the actual spot rate as one test of the “correctness” of the actual spot rate as well as the future move in the exchange rate. Using the Absolute PPPs on the previous slides and actual spot rates (Oct 26, 2012), comment on the data (is the foreign currency overvalued or undervalued? What about the U.S. dollar?): –(1) USD-CHF PPP ET = 1.9733 (actual spot = 0.9346) –(2) GBP/USD PPP AT = 1.7143 (actual spot = 1.6106)

Answers Using the Absolute PPPs on the previous slides and actual spot rates (Oct 26, 2012), comment on the data. Is the foreign currency overvalued or undervalued? What about the U.S. dollar?: –(1) USD-CHF PPP ET = 1.9733 (actual spot = 0.9346) CHF is overvalued (USD is undervalued) –(2) GBP/USD PPP AT = 1.7143 (actual spot = 1.6106) GBP is undervalued (USD is overvalued)

Rules for the Absolute PPP The Absolute PPP can be used to “estimate” whether a foreign currency’s spot rate is overvalued or undervalued and possible future move by using the following rules: Absolute PPP European Terms: –If PPP Spot < Current Spot, then the currency is undervalued (thus currency may appreciate). E.g.: PPP = 100; Current Spot = 110 –If PPP Spot > Current Spot, then the currency is overvalued (thus currency may depreciate). E.g.: PPP = 100; Current Spot = 90 Absolute PPP American Terms: –If PPP Spot > Current Spot, then the currency is undervalued (thus currency may appreciate). E.g.: PPP = $1.20; Current Spot = $1.00 –If PPP Spot < Current Spot, then the currency is overvalued (thus currency may depreciate). E.g.: PPP = $1.20 Current Spot = $1.40

Using the Absolute PPP In theory, the “absolute” PPP Spot exchange rate can be used to assess the “correctness” of a current spot rate on the basis of similar goods in different countries. –It suggests the possibility that a currency is overvalued or undervalued, and by how much? –Perhaps we can use this model for forecast the future move of a currency. Where can we get data for the Absolute PPP model? –One source is the Economist "Big Mac” index. –http://www.economist.com/markets/Bigmac/Index. cfmhttp://www.economist.com/markets/Bigmac/Index. cfm

October 14, 2010 Interpreting the Data In the United States, a Big Mac costs $3.71. While in China, a Big Mac costs 14.5 yuan. –Given the Oct 2010 exchange rate (USD/CNY) of 6.6514 a Big Mac in China worked out to $2.18 (14.5/6.6514). Note this is the Big Mac price on the chart. The Absolute PPP for the yuan is the ratio of the yuan cost to the dollar cost, or: 14.5/3.71 = 3.9084. Comparing spot (6.6514) to PPP (3.9084) suggested that the yuan was undervalued by 41% –(6.6514-3.9084/6.6514 =.41%)

Big Mac Index, January 2012

Changes in Currencies, 2007 - 2012

A Test of the Big-Mac: 1999, The Introduction of the Euro The Euro was introduced on January 1, 1999. The first day ending trading price was $1.1874. –According to the Big-Mac data, at the time of the euro’s introduction the Absolute PPP Spot rate could be calculated as follows: Average price of a Big-Mac in the euro zone = €2.53 Average price of a Big-Mac in the U.S. = $2.63 Absolute PPP Spot Rate AT = $2.63/€2.53 = $1.04 –What does the Absolute PPP spot rate suggest about the euro on the day it was introduced? –Comparing the actual spot ($1.1874) to the Absolute PPP Spot ($1.04) suggested the euro was overvalued by about 12.5% on the day it began trading.

What Happened to the Euro? January 1, 1999 – December 31, 1999

Absolute PPP in Practice In practice, use of the absolute PPP to test the “correctness” of a spot exchange rate depends on a number of factors: –Goods that are tradable; necessary for the assumption of competitive markets. –Goods that are comparable. Are the goods really similar in quality and quantity? –Are there government policies (tariffs and quotas) which render such goods not useful for absolute PPP calculations? –Are there cultural differences which render such goods not useful for absolute PPP calculations?

Examining Discrepancies Between Absolute PPP and Actual FX Rates When the actual FX rate differs from the Absolute PPP rate, one needs to examine reasons for the discrepancy to determine if the spot rate will, or will not, move towards the Absolute PPP. (1) Examine the exchange rate regime and the commitment of the government for that regime. –Does this account for the discrepancy between the Absolute PPP and the spot rate? –Chinese yuan and Hong Kong dollar. (2) Are there economic or financial conditions which could account for the observed discrepancy and how long might they dominate the spot rate? –Relative economic performance, interest rates, trade balances, capital flows, safe haven effects, etc. –Swiss franc

Other Sources of Absolute PPP To this point, we have focused on single goods when explaining and using the absolute PPP model. However, a better use of the Absolute PPP model would probably involve a market basket of goods, not just one. –Market basket PPP exchange rates are published by both the OECD and the World Bank. http://stats.oecd.org/Index.aspx?datasetcode= SNA_TABLE4http://stats.oecd.org/Index.aspx?datasetcode= SNA_TABLE4

OECD PPP Exchange Rates and Actual Rates FX200520062007200820092010 USD/JPY 110.22116.30117.75103.3693.5787.78 PPP: 129.55124.61120.16116.84115.35111.38 USD/CHF 1.24521.25381.20041.08311.08811.0429 PPP: 1.74271.65931.59971.55051.53131.5104 USD/CNY 8.1943 7.9734 7.6075 6.9487 6.8314 6.7703 PPP: 3.448 3.465 3.622 3.821 3.764 3.946 EUR/USD1.24361.25451.36871.46481.38921.3244 PPP: 1.1670 1.2035 1.2157 1.2383 1.2505 1.2357 GBP/USD1.81821.84002.00011.83841.55781.5452 PPP: 1.5719 1.5949 1.5506 1.5638 1.5570 1.5349 AUD/USD0.76370.75300.83680.83880.77990.9173 PPP: 0.7203 0.7095 0.7008 0.6761 0.6887 0.6611

Comparing Actual to PPP

Relative Purchasing Power Parity The second PPP model, the Relative Purchasing Power Parity model, is concerned with the “change” in the exchange rate over time. –The Relative Purchasing Power is not assessing the “correctness” of the current spot rate. The relative PPP model suggests that spot exchange rates move in a manner opposite to the inflation differential between the two countries. –Specifically, the Relative PPP model suggests that the percent change in a spot exchange rate should be equal to, but opposite in direction to, the difference in the rates of inflation between countries. –This is a model which may be used to forecast an actual future spot rate.

Hyperinflation and Exchange Rates: Zimbabwe in 2008 (July 2008, Annual Inflation 231,150,888%)

Zimbabwe With Stable Prices Since 2009 (July 2012: 3.24% Annual Rate of Inflation)

PPP Over the Long Term, 1980 - 2000 Lower Rates of Inflation High Inflation Countries

Relative PPP Formula: American Terms For an American Term quoted currency: –PPP Spot Rate AT = Current Spot Rate AT x ((1 + INF US ) n /(1 + INF FC ) n ) Where: –PPP Spot Rate AT is the expected American Terms quoted spot rate some date in the future. –Current spot rate expressed in American terms. –INF US is the expected annual rate of inflation in the United States (in decimal form). –INF FC is the expected annual rate of inflation in the foreign country (in decimal form). –N is the number of years in the future (which corresponds to the forecasted time period).

Relative PPP Formula: American Terms Assume: –Current spot rate for British pounds (GBP/USD = $1.80 –Expected annual rate of inflation in the U.S. = 2.0% –Expected annual rate of inflation in the U.K. = 3.0% Given this data, calculate the Relative PPP spot pound FX rate 2 years from now using: PPP Spot Rate AT = Current Spot Rate AT x ((1 + INF US ) n /(1 + INF FC ) n )

Answer Given: –Current spot rate for British pounds = $1.80 –Expected annual rate of inflation in the U.S. = 2.0% –Expected annual rate of inflation in the U.K. = 3.0% Then, the spot pound 2 years from now is equal to: PPP Spot Rate AT = Current Spot Rate AT x ((1 + INF US ) n /(1 + INF FC ) n ) –Spot rate in 2 years = 1.80 (1+.02) 2 /(1+.03) 2 –Spot rate in 2 years = 1.80 (1.0404/1.0609) –Spot rate in 2 years = 1.80 (.9807) –Spot rate in 2 years = $1.7653

Relative PPP Formula: European Terms For European Term quoted currency: –PPP Spot Rate ET = Current Spot Rate ET x ((1 + INF FC ) n /(1 + INF US ) n ) Where: –PPP ET spot rate is the expected European Terms quote spot rate at some date in the future. –Current spot rate expressed in European terms. –INF FC is the expected annual rate of inflation in the foreign country (in decimal form). –INF US is the expected annual rate of inflation in the United States (in decimal form). –N is the number of years in the future (which corresponds to the forecasted time period).

Relative PPP Formula: European Terms Assume: –Current spot rate for Japanese yen = 111.00 –Expected annual rate of inflation in the U.S. = 2.0% –Expected annual rate of inflation in Japan = 1.0% Given this data, calculate the Relative PPP spot yen FX rate 2 years from now using: PPP Spot Rate ET = Current Spot Rate ET x ((1 + INF FC ) n /(1 + INF US ) n )

Answer Given: –Current spot rate for Japanese yen = 111.00 –Expected annual rate of inflation in the U.S. = 2.0% –Expected annual rate of inflation in Japan = 1.0% Given this data, calculate the Relative PPP spot yen FX rate 2 years from now: PPP Spot Rate ET = Current Spot Rate ET x ((1 + INF FC ) n /(1 + INF US ) n ) –Spot rate in 2 years = 111 (1+.01) 2 /(1+.02) 2 –Spot rate in 2 years = 111 (1.0201/1.0404) –Spot rate in 2 years = 111 (.9805) –Spot rate in 2 years = 108.84

Testing the PPP Model The PPP model has been the subject of many empirical tests. The tests involving the absolute PPP have generally concluded that commodity price arbitrage does not exist. –Thus, prices of similar goods do not seem to equalize between countries. –Perhaps this is explained on the basis of barriers to commodity price arbitrage across borders (e.g., transportation, tariffs,,culture). Tests of the relative PPP, over long periods of time, are more encouraging (recall the slide of the Relative PPP from 1980 – 2000)

PPP Over the Long Term, 1980 - 2000 Lower Rates of Inflation High Inflation Countries

Is the Relative PPP Useful for Short Time Periods? While some studies have validated the reliability of the relative PPP model for “explaining” the long term relationship between inflation and exchange rate, studies which have examined the short term relationship have shown that actual FX rates can often move against the PPP rate. –See 2 slides which follow. Perhaps this can be explained on the basis of short term potential factors which can move the exchange rate away from PPP. –Safe haven effects, government intervention, carry trade transactions, dirty floats, etc.

Tests of the PPP over the Short Run: The Euro and CAD The EuroThe Canadian Dollar

PPP Over the Short Term: G-9 Countries Quarterly Data; 1974 - 1998 Quarterly inflation differentials to the U.S. against the exchange rate change. Source: Catherine Ho, “Time to Equilibrium in Exchange Rates, Global Financial Journal, 2012

The Relative PPP in Practice While some historical data tends to validate the relative PPP over long periods of time, the practical issue for users is estimating future rates of inflation. How can we do this? –Use recent historical data to estimate the future, or for a benchmark starting point. –Combine historical data with likely outcomes which might affect inflation (e.g., government deficits, economic growth, monetary policy) –Use independent forecasts of inflation date

Historical Inflation Data Historical and Current Data: –Visit Central Bank Web sites at: http://www.bis.org/cbanks.htm –Or visit the Economist http://www.economist.com/index.html –Link to Economic and Financial Indicators (go to output, prices and jobs data).

Parity Models and Foreign Exchange Rates Evaluating Current Spot Rates and Forecasting Rates with Parity Models: International Fisher Effect

Islamic Law (Sharia) Sharia, or Islamic law, influences the legal code in most Muslim countries. –Sharia (an Arabic word meaning "the right path“) originated as an important part of the Islamic religion. –It is estimated that 1.3 billion people in the world practice the Islamic religion, second only to Christianity (with 2.5 billion people). –Saudi Arabia and Iran apply Islamic law most extensively, and other countries uses it to varying degrees (including Egypt).

Islamic Capital Markets Islamic financial markets and institutions are based on Sharia Law. As such, Islamic financial institutions and financial instruments (banking, bonds and equities) must comply (i.e., be sharia compliant) with the following: –Prohibition of Riba (Interest). –Avoidance of Gharar (Ambiguity) in agreements. –Prohibition of Maisir (Gambling/Speculation). –No involvement in production and/or distribution of prohibited commodities (e.g., alcoholic beverages). The total Islamic capital market has been estimated a 1.2 trillion USD and includes banking (31% of the market), and the bond and equity markets (69%).

Islamic Financial Institutions/Markets These include: –Islamic Banking Institutions: Estimated at 15% of the world’s banking sector. –Islamic Bonds: Called a sukuk (“sue-coat”). Sukuk bonds are based on a pool of reference assets (land, fixed assets). Holders receive “rental” returns based on the future profits generated by these assets (asset- backed certificates). Malaysia accounts for about 2/3 rd of the outstanding sukuk market. There are currently USD226b worth of sukuk outstanding with 64% denominated in Malaysian ringgits and 15% in USD. Secondary market: Sukuk bonds trade on the Paris platform of NYSE-Euronext. –Islamic Equities. Major market is Malaysia. Almost 90% of the stocks trading on the Malaysian stock (Bursa Malaysia)

Islamic Bonds (Sukuk) Issued by sovereigns (e.g., Malaysia, Saudi Arabia, Kuwait) and corporates (e.g., Dana Gas based in the UAE). Like conventional bonds subject to: –Interest rate risk Need to adjust to changes in the “opportunity” cost of investing (thus inverse relationship). –Default risk Investors need to assess the value of the reference assets. –Exchange rate risk: Results from a mismatch of the currency of the reference assets and the currency of denomination of the Sukuk. And can be insured through the CDS market.

Recall: Two Major Spot FX Parity Forecasting Models Purchasing Power Parity (PPP) –Model assumes relative rates of inflation between two countries as the major determinant of the future spot exchange rate. International Fisher Effect (IFE) –Model assumes relative rates of long term interest between two countries as the major determinant of the future spot exchange rate. This is the subject of this lecture.

International Fisher Effect The International Fisher Effect (IFE) model uses market interest rates rather than inflation rates to explain why exchange rates change over time. The model consists of two parts: –(1) Fisher Effect which is an explanation of the market (i.e., nominal) interest rate, and –(2) The International Fisher Effect which is an explanation of the relationship of market interest rates to exchange rates. The model is attributed to the American economist, Irving Fisher. Born in upstate New York in 1867. Ph.D. in economics from Yale. - Quantity Theory of Money (MV=PT) - Phillips Curve

Explanation of Market Interest Rate Fisher market interest rate model developed in his book the Theory of Interest (1930) Fisher’s interest rate model states that the market rate of interest on a default free bond is the sum of: (1) a real rate requirement. –The real rate requirement reflects the reward that should accrue to a lender for “lending to a productive economy.” (2) the market’s expected rate of inflation (i.e., an inflation premium which represents the markets’ expectation of future rates of inflation). –This inflation premium protects investors against a loss of purchasing power. Market (nominal) interest rate on a default free bond = real rate requirement + inflation expectations.

Fisher Real Rate Requirement Defined by Fisher as “The reward for lending into a productive economy.” Problem: This real rate requirement is much easier to conceptualize than it is to actually measure. –Conceptually, however, it is probably related to economic growth theory, with an economy’s growth dependent upon the productivity of its workforce, capital stock, and population. While the real rate requirement cannot be observed, different estimation methods relying on theoretical “growth” models have suggested: –A range of 2-3% for both the United States and the euro area. –A rate of 3% for the United Kingdom Sources: Manrique and Manuel Marques (2004), Laubach and Williams (2003), Giammarioli and Valla (2003), Larsen and McKeown (2004)

Estimating the Real Rate Requirement for the United States

Relative Stability of Market Interest Rate Components Given that the market interest rate on a default free bond consists of two components: (1) real rate requirement and (2) inflationary expectations, the question arises as to the relative stability of these two components. Real rate requirement is assumed to be relatively (more) stable. –Changes in real rate only occur slowly in response to technology changes, population growth, population skills, changes in the capital stock, etc. Inflationary expectations, however, are subject to potentially wide variations over short periods of time.

The Relation of Inflation to Long Term U.S. T-Bond Interest Rates: 1965 – 2011

The Relation of Inflation to Short Term U.S. T-Bill Interest Rates: 1965 – 2011

The Relation of Inflation to Interest Rates in the U.K. : 1989 – 2011

The Relation of Inflation to Interest Rates in Canada : 1961– 2005

International Assumptions of the Fisher Model On an international level, the Fisher Model assumes that the real rate requirement is similar across major industrial countries. Thus any observed market interest rate differences between counties according to this model is accounted for on the basis of differences in inflation expectations. Example: –If the United States 1 year market interest rate is 5% and the United Kingdom 1 year market interest rate is 7%, then: –The expected rate of inflation over the next 12 months must be 2% higher in the U.K. compared to the U.S.

The International Fisher Effect The second part of the Fisher model, the International Fisher (IFE) effect assumes that: –Changes in spot exchange rates are related to differences in market interest rates between countries. –Reason: Because differences in interest rates capture differences in expected inflation, and inflation is assumed to be the major determinant of future exchange rates.

IFE relationship to Exchange Rates –Currencies of high interest rate countries will weaken. Why: These countries have high inflationary expectations The annual depreciation of the currency will be equal to the observed interest rate differential. –Currencies of low interest rate countries will strengthen. Why: These countries have low inflationary expectations. The annual appreciation of the currency will be equal to the observed interest rate differential. The International Fisher Effect

IFE Examples Assume the following: –I year Government bond rate in U.S. = 5.00% –1 year Government bond rate Japan = 2.00% –Current spot rate (USD/JPY) = 70.00 According to the IFE, What should happen to the yen and why. And by how much (percent) should the yen exchange rate change per year? Now assume the following: –I year Government bond rate in U.S. = 1.00% –1 year Government bond rate Japan = 3.00% –Current spot rate (USD/JPY) = 70.00 According to the IFE, What should happen to the yen and why? And by how much (percent) should the yen exchange rate change per year?

Answers Given: –1 year Government bond rate in U.S. = 5.00% –1 year Government bond rate Japan = 2.00% –Spot rate (USD/JPY) = 70.00 According to the IFE, the yen should appreciate 3.0% per year against the U.S. dollar. Why: Lower rate of inflation in Japan. 1 year from now the spot rate will equal: –70 - (70 x.03) = 70 – 2.1 = 67.90 –This represents a appreciation of 3% over the current spot rate, and is a n amount which is equal to the interest rate differential. Second example (2% higher interest rate in Japan) According to the IFR, the yen should depreciate 2% per year against the U.S. dollar. Why: Higher rate of inflation in Japan. –70 + (70 x.02) = 70 + 1.4 = 71.40 –This represents a depreciation of 2% over the current spot rate, and is an amount which is equal to the interest rate differential.

IFE Formula: American Terms For American Term quoted currency: –IFE Spot Rate AT = Current Spot Rate AT x (1 + INT US ) n /(1 + INT FC ) n Where: –IFE Spot Rate AT forecasted spot rate quoted in American Terms. –Current Spot Rate AT is the American Terms spot rate. –INT US is the current annual market interest rate in the United States (in decimal form). –INT FC is the current annual market interest rate in the foreign country (in decimal form). –N is the number of years in the future (i.e., the forecast horizon).

Example: IFE American Terms Forecast Assume: –Current spot rate for British pounds: GBP/USD 1.5560 –Annual rate of interest on 5 year Government bonds: United States = 1.07% United Kingdom = 1.37% –Use the IFE formula below to calculate the spot pound 5 years from now: IFE Spot Rate AT = Current Spot Rate AT x (1 + INT US ) n /(1 + INT FC ) n Insert data and solve.

Answer Given: –Current spot rate for British pounds: GBP/USD 1.5560 –Annual rate of interest on 5 year Government bonds: United States = 1.07% United Kingdom = 1.37% Use the IFE formula to calculate the spot pound 5 years from now: IFE Spot Rate AT = Current Spot Rate AT x (1 + INT US ) n /(1 + INT FC ) n IFE Spot Rate AT = 1.5560 x (1 + 0.0107) 5 /(1 + 0.0137) 5 IFE Spot Rate AT = 1.5560 x (1.0107) 5 /(1.0137) 5 IFE Spot Rate AT = 1.5560 x (1.05466/1.0704) IFE Spot Rate AT = 1.5560 x.9853 IFE Spot Rate AT = 1.5331 (This is the forecasted spot rate 5 years from now; is the pound expected to appreciate or depreciate and why?)

IFE Formula: European Terms For European Term quoted currency: –IFE Spot Rate ET = Current Spot Rate ET x (1 + INT FC ) n /(1 + INT US ) n Where: –IFE Spot Rate ET is the forecasted spot rate quoted in European Terms. –Current spot rate ET is the European terms spot rate. –INT FC is the current annual market interest rate in the foreign country (in decimal form). –INT US is the current annual market interest rate in the United State (in decimal form). –N is the number of years in the future (i.e., the forecast horizon).

Example: IFE European Terms Forecast Assume: –Current spot rate for Japanese yen: USD/JPY 76.84 –Annual rate of interest on 2 year Government bonds: United States = 0.29% Japan = 0.14% –Use the IFE formula below to calculate the spot yen rate 2 years from now: IFE Spot Rate ET = Current Spot Rate ET x (1 + INT FC ) n /(1 + INT US ) n Insert data and solve.

Answer Given: –Current spot rate for Japanese yen: USD/JPY 76.84 –Annual rate of interest on 2 year Government bonds: United States = 0.29% Japan = 0.14% –Use the IFE formula to calculate the spot yen rate 2 years from now: IFE Spot Rate ET = Current Spot Rate ET x (1 + INT FC ) n /(1 + INT US ) n IFE Spot Rate ET = 76.84 x (1 + 0.0014) 2 /(1 + 0.0029) 2 IFE Spot Rate ET = 76.84 x (1.0014) 2 /(1.0029) 2 IFE Spot Rate ET = 76.84 x (1.0028)/(1.00581) IFE Spot Rate ET = 76.84 x.9970 IFE Spot Rate ET = 76.61(This is the forecasted spot rate 2 years from now; is the yen expected to appreciate or depreciate and why?)

Empirical Tests of IFE Empirical tests of the long term relationship lend some support to the relationship postulated by the international Fisher effect. –See slides which follow Over the short term substantial deviations can occur: –Emil Sundqvist, 2002 study of 1993 – 2000 data, correlating quarterly interest rate differentials to quarterly exchange rate changes found the following R-squares: Swedish krona: 11.5%, Japanese yen: 8.9%, British pound: 3.6%, Canadian dollar: 1.4%, German mark: 1.4%

Evidence in Support of the IFE: Japan

Evidence in Support of the IFE: The Euro-Zone

Evidence in Support of the IFE: New Zealand (NZD-USD)

Evidence in Support of the IFE: New Zealand (NZD-AUD)

Evidence in Support of the IFE: Norway (Exchange Rate Index)

Problematic Issues Regarding the PPP and IFE PPP model issues: –User needs to “forecast” the future rates of inflation. –How does one do this for very long periods of time? –Perhaps it is easier for shorter time periods (e.g., 1 year). IFE model issues: –User relies on market interest rate data to “proxy” for future inflation. –However, are real rates similar across countries? See slide next page. –Do real rates change over time? –Inflationary expectations during the forecasted horizon are subject to change.

Are Real Rates Similar? CountryAverage Annual Growth Rate in Real GDP 1990 – 2006 United States3.3% (3.25%: 1947 – 2012) Australia3.6% (3.51%: 1960 – 2012) New Zealand3.3% (2.24%: 1988 – 2012) Canada3.2% (3.34%: 1962 – 2012) United Kingdom2.7% (2.57%: 1956 – 2012) Total OECD2.7% Euro Area1.9% (1.77%: 1995 – 2012) Japan1.3% (2.12%: 1981 – 2012)

Practical Use of PPP and IFE Neither model appears appropriate for short term forecasting (less than 1 year). Both models work better for the long term and in this regard appear to be good indicators of the long term trend in the exchange rate: –Relatively high (low) inflation currencies will exhibit long term depreciation (appreciation). –Relatively high (low) interest rate currencies will exhibit long term depreciation (appreciation).

Lecture 10: Understanding Foreign Exchange Exposure The Risk Associated with Foreign Exchange Exposure. The Specific Types of Foreign Exchange Exposure Facing Global Firms and Global Investors.

What is Foreign Exchange Exposure and Exposure Risk? Foreign exchange exposure comes about when a firm or investor has an open position in a foreign currency. –Open position: Unhedged; subject to exchange rate risk –Open long position: Expect to receive foreign currency in the future –Open short position: Need to pay foreign currency in the future Foreign exchange exposure risk refers to the possibility that a foreign currency may move in a direction which is financially detrimental to the global firm or global investor. Important: Global firms and investors cannot have foreign exchange exposure in their home currencies. –This suggests a strategy for managing exposure.

Risk with an Open Foreign Currency Position Open long position (when you expect to receive foreign currency in the future). –Specific risk is that the foreign currency may weaken against your home currency, thus reducing the home currency equivalent of the long position. Open short position (when you expect to pay foreign currency in the future). –Specific risk is that the foreign currency may strengthen against your home currency (thus requiring more home currency to acquire the foreign currency). This increases the home currency equivalent of the short position.

Examples of FX Open Long Position Risk Assume a U.S. based multinational firm has an account receivable denominated in yen with an expected payment date 30 days in the future. The invoice totals ¥75,500,000. The current spot rate (USD-JPY) is 90.2500 Now assume the following 2 FX outcomes: –In 30 days the spot rate is 95.4500 –In 30 days the spot rate is 82.2200 Calculate the gain or loss in USD under both assumptions above.

Answers: First calculate the USD value with an exchange rate of 90.2500: –75,500,000/90.2500 = $836,565.09 Assume the FX rate goes to 95.4500 –Note: The yen weakened –75,500,000/95.4500 = $790,990.04 –Loss of 790,990.04 – 836,565.09 = $45,575 Assume the FX rate goes to 82.2200 –Note: The yen strengthened –75,500,000/82.2200 = $918,268.06 –Gain of 918,268.06 – 836,565.09 = $81,702.97

Examples of FX Open Short Position Risk Assume a U.S. based multinational firm has an account payable denominated in pounds with an expected payment date 30 days in the future. The invoice totals £6,750,000. The current spot rate (GBP-USD) is 1.5250 Now assume the following 2 FX outcomes: –In 30 days the spot rate is 1.5875 –In 30 days the spot rate is 1.4225 Calculate the gain or loss in USD under both assumptions above.

Answers: First calculate the USD value with an exchange rate of 1.5250: –6,750,000 x 1.5250 = $10,293,750 Assume the FX rate goes to 1.5875 –Note: The pound has strengthened –6,750,000 x 1.5875 = $10,715,625 –Loss of 10,293,750 – 10,715,625 = $421,875 Assume the FX rate goes to 1.4225 –Note: The pound has weakened –6,750,000 x 1.4225 = $9,601,875 –Gain of 10,293,750 – 9,601,875 = $691,875

Risks Associated with FX Exposure There are three specific risks to global firms and/or global investors from their foreign exchange exposures: –(1) Settlement Value Risk: Occurs because foreign currency denominated contracts and investments, in the home currency equivalent of the firm or investor, can be adversely affected by changes in exchange rates. Fixed income investments (e.g., bonds). Fixed income liabilities (e.g., bonds and bank loans) Accounts receivable held by multinationals. Accounts payable owed by multinationals.

Risks Associated with FX Exposure –(2) Future Cash Flow Risk: Occurs because the home currency equivalents of anticipated (expected) foreign currency cash flows can be adversely affected by changes in FX rates. Foreign currency cash inflows and outflows: –Future revenues from ongoing multinational operations. –Future costs associated with ongoing multinational operations. Note: the net impact of this cash flow exposure depends upon the net cash flow position of the firm. –For example, if foreign currency revenues exceed foreign currency costs, a strong foreign currency with have a net positive effect on the net home currency equivalent. –And if foreign currency costs exceed foreign currency revenues, a strong foreign currency will have a net negative effect on the net home currency equivalent.

Risks Associated with FX Exposure –(3) Global Competitive Risk: Occurs because the competitive position of a firm can be affected by adverse changes in exchange rates. Exporting firms are adversely affected if the currencies of their overseas markets weaken. –More difficult to compete with domestic firms. Importing firms are adversely affected if the currencies of their overseas markets strengthen. –May need to increase their home market selling prices. Overseas production is adversely affected if the currencies of these “outsourcing” countries strengthens. –Home currency equivalent of producing offshore will increase.

Types of Foreign Exchange Exposure Facing Global Firms There are three types of foreign exchange exposures that global firms may face as a result of their international activities. These foreign exchange exposures are: –Transaction exposure Results from a global firm engaged in current transactions involving contractual arrangements in foreign currencies (e.g., invoices coming due, loans coming due, interest payments coming due, etc). –Economic exposure Results from future and unknown transactions in foreign currencies resulting from a global firm’s long term involvement in a particular market (i.e., because of a long term physical presence in that foreign market). –Translation exposure (sometimes called “accounting” exposure). Important for global firms with a physical presence in a foreign country needing to consolidate their individual country financial statements for reporting purposes.

Transaction Exposure Transaction Exposure: Results when a firm agrees to “fixed” cash flow foreign currency denominated contractual agreements. –Examples of transaction exposure: An Account Receivable denominate in a foreign currency. A maturing financial asset (e.g., a bond) denominated in a foreign currency. An Account Payable denominate in a foreign currency. A maturing financial liability (e.g., a loan) denominated in a foreign currency.

Incident of Exporting and Importing Transaction Exposure By Global Firm’s Home Country CountryExports in Home Currency (% of invoices) Imports in Home Currency (% of invoices) United States96.0%85.0% Germany81.5%52.6% France58.5%48.9% United Kingdom57.0%40.0% Italy38.0%27.0% Japan34.3%13.3% Note: 1988 Data

Economic Exposure Economic Exposure: Results from the “physical” entry of a global firm into a foreign country. –This is a long term foreign exchange exposure resulting from a previous FDI location decision. Economic exposure impacts the firm through contracts and transactions which have yet to occur, but will, in the future. These are really “future” transaction exposures which are unknown today. Economic exposure also impacts the firm through its operating income (revenue) and costs which are denominated in the currency of the foreign country.

Translation Exposure Translation Exposure: Results from the need of a global firm to consolidated its financial statements to include results from foreign operations. –Consolidation involves “translating” subsidiary financial statements in local currencies (i.e., in the foreign markets where the firm is located) to the home currency of the firm (i.e., the parent). –Consolidation can result in either translation gains or translation losses. These are essentially the accounting system’s attempt to measure foreign exchange “ex post” exposure.

Foreign Exchange Exposure for a Global Investor Foreign exchange exposure for a global investor results from the acquisition of financial assets denominated in a currency other than the home currency of the investor. FX exposure can affect: (1) The home currency equivalent market price of those assets and (2) The home currency equivalent cash flows (dividends and interest) associated with particular financial assets.

Risk Elements for Global Investors in Equities The specific risk components associated with common stock (equities): –Company risk (micro risk): Decisions of management; changes in management; success or failure of (new) products. –Environment risk (macro risk): Risk produced by the industry (competition), governments (regulation), country (business cycles) and global environment in which the company operates. –Market risk (systematic risk): Associated with movements in the overall equity market of a country. Under CAPM, measured by the stock’s beta. –Exchange rate risk: Associated with investing in equities who’s market price and dividends are denominated in other than the home country of the investor.

Risk Elements for Global Investors in Bonds The specific risk components associated with bonds (i.e., fixed income securities): –Default risk (credit risk): Risk that issuer will not be able to repay debt as contracted. Corporates: Cash flow issues. Sovereigns: Governmental debt servicing issues. –Market risk (price risk): Associated with changes in the market’s overall assessment of risk and willingness to take risk (or avert risk). –Contagion risk: Associated with spillover effects from other countries. –Exchange rate risk: Associated with investing in bonds who’s market price and interest payments are denominated in other than the home country of the investor.

Exchange Rates and Bond Yields The gap between the U.S. dollar un-hedged and hedged Global Treasuries shows the effect currency has played in these annual returns. In most years (with the exception of 2005 and the first quarter of 2009), currency moves (represented by unhedged returns) benefited the U.S. investor (this is shown by the difference between the unhedged and hedge indexes).

Managing Foreign Exchange Exposure with Operational Hedges A discussion of the various operational arrangements which global firms and global investors can use when managing open foreign exchange positions

Hedging Known Future Cash Flows In the next lecture, the hedging techniques will discuss (forwards and options) are most appropriate for covering transaction exposure. –Transaction exposures have known foreign currency cash flows and thus they are easy to hedge with financial contracts. The majority of transaction exposure risk results from receivables (payables) from exports (imports) contracts and repatriation of dividends. –Usually, the time frame for these committed transactions (the time between contracting and payment) is relatively short. However, it can in some cases reach several years, where deliveries are committed a long time in advance (forward sales of airplanes or building contracts).

Quick Preview: Identifying Sources of Transaction Exposure Transaction exposure arises from: (1) Purchasing or selling, on credit, goods or services denominated in foreign currencies. (2) Borrowing or lending denominated in foreign currencies. (3) Acquiring financial assets or incurring liabilities denominated in foreign currencies.

Dealing with Transaction Exposure Through Operational Hedges While global companies can manage their transaction exposures with financial hedges, they can also utilize operational hedges. –Operational hedges refers to “internal” organizational strategies that firms use to deal with their currency exposures. –With respect to transaction exposure, potential operational techniques include: Risk Shifting: Invoicing overseas purchases and sales in home currency. Netting: Hedged net amounts of transaction exposures. Leading (speeding up) and Lagging (slowing down) payments in response to changes in exchange rates.

Operational Hedging of Transaction Exposures: Risk Shifting, Home Currency Invoicing, 2003-2007 Data

Operational Hedging: Netting Given that large and globally diverse multinational firms may need to manage exchange rate risk associated with several different currencies these generally consider their net exposure to currency risk instead of just looking at each currency separately. Global firms will achieve netting through a centralized approach because a non- centralized, whereby each subsidiary assesses and manages its individual exposure to exchange rate risk will result in redundancy and added costs in hedging.

Transaction Exposure Using "Net" Cash Flows Centralized exposure management requires headquarters to consolidate the net amount of currency inflows and outflows for all subsidiaries categorized by currency. Consider two subsidiaries X & Y of a U.S. MNC: Subsidiary X has net inflow (long position) of £500,000 Subsidiary Y has net outflows (short position) of £600,000 Then, the consolidated "net" outflow for this multinational corporation is £100,000 which is the amount to be hedged. Additionally, if the pound weakens it will be unfavorable to X but favorable to Y. If hedging is limited to net exposure, transaction cost savings are realized.

Operational Hedging: Leading and Lagging Payments Refers to the timing of when a firm with an FX exposed position will initiate foreign currency payments (or specifically when the firm has an open short position). Leading (“speeding-up) Payments. –Lead payments when home currency is weakening (i.e., foreign currency is strengthening). Lagging (“slowing down/delaying”) Payments –Lag payments when home currency is strengthening (i.e., foreign currency is weakening).

Hedging Unknown Cash Flows In the previous examples we were dealing with known foreign currency cash flows (resulting from current “transactions”). However, economic exposures do not provide the firm with this “known” cash flow information. Economic exposure refers to the impact of exchange rate movements on the home currency value of uncertain future cash flows. Global firm: Uncertain future cash flows relate to the firm’s costs (e.g., raw materials, labor costs, etc.) and output prices and sales (e.g., product prices). Global investor: Uncertain future cash flows relate to the future dividends and changes in market prices.

Channels of Economic Exposure for Firms (1) Direct effects of FX changes result from a company’s actual involvement in foreign markets. Impact on the home currency equivalents of cost and revenue streams in overseas markets. (2) Indirect effects refer to FX induced changes in foreign company competition in a company’s domestic market. Foreign competitors exporting into company’s home country (FX induced change in competitive position of foreign exporters). Foreign companies setting up FDI activities in company’s home country. Both (1) and (2) driven by globalization.

The Globalization of Business Firms: 2010 Data for S&P 500 Firms

Data for Selected S&P 500 Companies, Sorted by Percentage Point Increase

The Global Reach of Selected U.S. Companies, 2010 Data Wal-Mart. Total revenue: $420 billion, 26% from overseas; nearly 5,000 stores in 14 foreign countries, including China, India, the U.K., and Latin America. Bank of America. Total revenue: $134 billion, 20% from overseas. Europe is biggest market. Ford. Total revenue: $129 billion, 51% from overseas; Canada and Europe. Boeing. Total revenue: $64 billion in revenue, 41% from overseas; Europe, Asia, and the Middle East. Intel. Total revenue: $44 billion, 85% from overseas. Taiwan, followed by China. Amazon. Total revenue: $34 billion, 45% from overseas; Canada, several European countries, Japan, and China. McDonald's. Total revenue: $24 billion, 66% from overseas; Europe and Asia. Nike. Total revenue: $21 billion, 50% from overseas; North America, Europe and China.

McDonald’s, 2010 Annual Report

Impact of FX Changes on Sales Note: Excluding F/X estimates sales based on the previous year’s exchange rate

Dealing with Economic Exposure Recall that economic exposure is long term and involves unknown future cash flows. What can the firm do to manage this economic exposure? –Firm can employ an “operational hedge.” –One such strategy involves global diversification of production and/or sales markets to produce natural hedges for the firm’s unknown foreign exchange exposures. –As long as currencies associated with these different markets do not move in the same direction, the firm can “stabilize” its overall home currency equivalent cash flow.

Global Diversification of Sales Subway: –35,561 restaurants in 98 countries –Visit: http://www.subway.com/subwayroot/explor eourworld.aspx http://www.subway.com/subwayroot/explor eourworld.aspx McDonald’s (2010): –32,737 restaurants in 117 countries.

Balancing Costs and Revenues: Restructuring to Reduce Economic Exposure Restructuring involves shifting the sources of costs or revenues to other locations in order to match cash inflows and outflows in foreign currencies. Restructuring Decisions: –Should the firm attempt to increase or decrease sales in specific countries (i.e., revenues)? –Should the firm attempt to increase or decrease dependency on foreign suppliers (i.e., cost)? –Should the firm establish or eliminate production facilities in foreign markets (i.e., costs)? –Should the firm increase or decrease its level of foreign currency denominated debt (i.e., costs)?

Nike’s Global Diversification of Manufacturing for Footwear, By Country, 2005 Country Percent China36 Vietnam26 Indonesia22 Thailand15 Big Four99 Others: Argentina, Brazil, India, Mexico, and South Africa Source: Nike, 2005 Annual report

MarketRevenue Percent United States $5,129.337.3% EMEA 4,281.631.2% Asia Pacific 1,897.313.8% Americas 695.8 5.1% Other 1,735.7 12.6% Total $13,739.7 Note: EMEA is Europe, Middle East and Africa Nike’s Global Diversification of Sales by International Region (U.S. Dollars in Millions), 2005

Is Nike a Balanced Firm? Foreign Currency Costs concentrated in: –Yuan, Dong, Rupiah, Baht Foreign Currency Revenues concentrated in: –Euros, Pounds, Yen What if the cost currencies strengthen (against the USD) and the revenue currencies weaken (against the USD)? –Negative impact on USD profits –Possible solution: Adjust prices in revenue countries. What if the cost currencies weaken and the revenue currencies strengthen? –Positive impact on USD profits How could Nike balance its overseas activities?

A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure Step 1: Determining Specific Foreign Exchange Exposures –What type of exposure are you dealing with? –By currency and net amounts (i.e., long minus short positions) –Are the net amounts worth hedging? If they are go to Step 2; if not, no need to hedge. Step 2: Forecasting Exchange Rates –Determining the potential for and possible range of currency movements. Important to select the appropriate forecasting model. A “range” of forecasts is probably appropriate here (i.e., forecasts under various assumptions) How comfortable are you with your forecast? If comfortable, go to Step 3. If not, hedge.

A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure Step 3: Assessing the Impact of Forecasted Exchange Rates on Company’s Home Currency Equivalents (What is the Measured Risk?). –Impact on earnings, cash flow, liabilities (positive or negative?) –Go to Step 4 Step 4: Deciding Whether to Hedge or Not –Determine whether the anticipated impact of the forecasted exchange rate change merits the need to hedge. –Perhaps the estimated negative impact on home currency equivalent is so small as not to be of a concern. –But, if impact is unacceptable, go to Step 5 –Or, perhaps the firm feels it can benefit from its exposure. –If this is the case, go to Step 6

A Comprehensive Approach or Assessing and Managing Foreign Exchange Exposure Step 5: Selecting the Appropriate Hedging Instruments if Risk is Unacceptable. –Consider: Which hedge is appropriate for the type of exposure? –Financial and/or operational Firm’s familiarity and comfort level with types of hedging strategies. Review the cost involved with different financial contracts. Step 6: Selecting the Appropriate Strategy to Position the Firm to Take Advantage of a Favorable Exchange Rate Change. –Consider: Partial “open” position versus complete “open” position. Which financial contract will achieve your objective?

Appendix 1 The following slides illustrate how companies deal with and report translation exposures

Translation Exposure Translation exposure is commonly referred to as “accounting exposure” because it refers to the impact of exchange rate changes on the consolidated financial reports of a global firm. –These include impacts on assets and liabilities and profits which have been acquired or occurred in the past. Why do global firms need to consolidate statements? To report financial results to their shareholders. To report income to taxing authorities. –The accounting approach for consolidating financial statements depends upon the accounting requirements of the firm’s headquartered country. The U.S. is governed by FASB 52. –Balance sheet and income statement gains or losses associated with the consolidation process show up in the shareholders’ equity account

Nike’s 2005 Financial Statement Summary Consolidated Balance Sheet, Fiscal 2005 (millions of U.S. dollars) Assets$8,793.6 Liabilities$3,149.4 Shareholders’ Equity $5,644.2 –Of which foreign currency translation adjustments were: 70.1* *This is a cumulative amount (e.g., in 2004 it was $27.5

Lecture 11: Managing Foreign Exchange Exposure with Financial Contracts A discussion of the various financial arrangements which global firms and global investors can use when managing open foreign exchange positions

The BRICs An acronym for the economies of Brazil, Russia, India and China combined. The general consensus is that the term was first prominently used in a Goldman Sachs report from 2003. –The BRIC thesis suggested that China and India would become the world's dominant suppliers of manufactured goods and services, respectively, while Brazil and Russia would become dominant as suppliers of raw materials. More recently South Africa (“S”) was added to the list; thus BRICS

Initial Interest in the BRIC Countries The conventional wisdom at that time was that these four emerging countries would become the driving force behind global economic growth. –See: Posted reading: The Braking of the BRICS Mutual funds introduced BCIC focused funds: –For Example: Templeton BRIC Fund; HSBC BRIC Fund; NIKK (Japan) BRICs Equity Fund From November 2001 to November 2007, BRIC equity markets soared: –Brazil 369%, India 499%, Russia 630%, and China 817%

BRICS Projections and Performance GDP Projections Equity Market Performance

BRIC Growth Rates 2000 - 2010

BRICS Indicators

BRICS Currencies

BRICS Equity Markets 2011 and 2012 (The Economist) Country2011 Local C urrency Retu rn 2011 USD Re turn 2012 Local C urrency Retu rn (to Nov 11) 2012 USD Re turn (to Nov 11) China-22.7%-19.1%-4.3%-3.5% Brazil-14.3%-22.1%+3.1%-5.4% India-22.6%-34.6%+22.3%+20.1% Russia-15.4%-19.0%+1.3%+3.3% South Africa+2.4%-17.0%+17.2%+9.3% United States+7.3% +5.9%

Assessing Foreign Exchange Exposure All global firms and global investors are faced with the need to analyze their foreign exchange exposures. –In some cases, the analysis of foreign exchange exposure is fairly straight forward and known. –For example: Transaction exposure. There is a fixed (and thus known) contractual obligation (in some foreign currency). –While in other cases, the analysis of the foreign exchange exposure is complex and less certain. –For example: Economic exposure There is uncertainty as to what the firm’s exposures will look like over the long term. –Specifically when they will take place and what the amounts will be.

The Concept of Hedging In using a financial hedge, a firm negotiates a financial contract which establishes a situation opposite to the foreign exchange exposure it wishes to hedge. –A firm or investor with an open long position in a foreign currency will: Offset the original long position with a short position in the same currency. –A firm with an open short position in a foreign currency will: Offset the original short position with a long position in the same currency. –In essence, the firm is “covering” (“offsetting”) the original foreign exchange position. Since the firm or investor has “two” opposite foreign exchange positions, they can cancel each other out.

To Hedge or Not to Hedge? What are some of the factors that would influence a global firm or global investor’s decision to hedge its open foreign exchange exposures? –(1) The assessment of the future strength or weakness of the foreign currency the firm or investor is exposed in. For example: If a firm or investor has a long position (short position) in what they forecast will be a strong (weak) currency they may decide not to hedge, or, perhaps, do a partial hedge. –(2) How comfortable one is with the results of the above forecast. The less comfortable, the more likely to hedge. –On the other hand, firms and investors may decide not have any currency exposures and simply focus on their core business. Does Starbuck’s want to sell coffee overseas or “speculate” on currency moves? Obviously, this is different from a firm managing a hedge fund, or a currency trading floor?

Hedging Strategies for Firms Assumption: Given the downside risk associated with an open FX position, we can assume that most global firms and investors would probably prefer to hedge (fully or partially) their foreign exchange exposures. Question: how can firms hedge? –(1) Financial Contracts (the subject of this lecture) Forward contracts (also futures contracts) Options contracts (puts and calls) Money market hedges, specifically borrowing or investing in local financial markets (covered in appendix 1). –(2) Operational Hedges Geographic diversification (spreading the risk). Contract manufacturing (e.g., Nike).

Commercial Bank Forward Contracts Contracts which allow the firm or investor to (1) either buy or sell a specified amount of foreign currency on (2) a future date (i.e., forward date) at (3) an exchange rate specified today (i.e., at a forward exchange rate). –A forward contract is a firm commitment on the part of both parties (i.e., cannot be canceled). –For an open long FX position: Hedge with a forward sale of the foreign currency. –For an open short FX position: Hedge with a forward purchase of the foreign currency. Forward contracts allow the global firm or investor to lock in the home currency equivalent of an anticipated foreign currency cash flow.

Example of a Long Position Assume: U.S. firm has sold a product to a German company and the U.S. firm agrees to accept payment of €100,000 in 30 days. –What type of exposure does the U.S. firm have? Answer: Open long transaction exposure; resulting from an agreement to receive a fixed amount of foreign currency in the future. –What is the potential problem for the U.S. firm if it does not hedge the position long open? The risk that the euro will weaken over this period, and in 30 days the euro will be worth less (in terms of U.S. dollars) than it is at today’s spot rate. This would result in a foreign exchange loss for the firm.

Hedging an Open Long Position with a Forward Contract Assume the U.S. firm decides it wants to hedge (i.e., cover) its open long foreign exchange transaction exposure of €100,000 (refer to the previous slide) –The U.S. firm asks a market maker bank for a 30 day forward quote and receives the following: –EUR/USD 1.2300/1.2400. Assume the U.S. firm hedges its exposure at the quote above. Which quote should it use for its hedge? Calculate the amount of U.S. dollars to be received in 30 days.

Answer Assume the U.S. firm decided to hedge (cover) its open long foreign exchange transaction exposure of €100,000. –The U.S. firm has the following market maker bank 30 day forward euro quote: –EUR/USD 1.2300/1.2400. –What does this 30 day forward quote mean? Bid: Market maker will buy euros in 30 days for $1.2300 Ask: Market maker will sell euros in 30 days for $1.2400 –With a forward contract to sell euros, the U.S. firm can lock in the U.S. dollar equivalent of the long position at the bid price, or $123,000.

Example of a Short Position Assume: a U.S. firm has purchased a product from a British company and the U.S. firm agrees to pay £100,000 in 30 days. –What type of exposure does the U.S. firm have? Answer: Open short transaction exposure; resulting from an agreement to pay a fixed amount of foreign currency in the future. –What is the potential problem if the U.S. dos not hedge this position short open? The risk that the pound will strengthen over this period, and in 30 days it will take more U.S. dollars (than at today’s spot rate) to purchase the required pounds. This would result in a foreign exchange loss for the firm.

Hedging an Open Short with a Forward Contract Assume the U.S. firm decides it wants to hedge (i.e., cover) this open short foreign exchange transaction exposure of £100,000 (see previous slide). –The U.S. firm asks a market maker bank for a 30 day forward quote and receives the following: –GBP/USD 1.7500/1.7600. Assume the U.S. firm hedges its exposure at the quote above. Which quote should it use for its hedge? Calculate the amount of U.S. dollars it will need in 30 days to meet its pound liability.

Answer Assume the U.S. firm decided to hedge (cover) its open short foreign exchange transaction exposure of £100,000. –The U.S. firm has the following market maker bank 30 day forward pound quote: –GBP/USD 1.7500/1.7600. –What does this 30 day forward quote mean? Bid: Market maker will buy pounds in 30 days for $1.7500 Ask: Market maker will sell pounds in 30 days for $1.7600 –With a forward contract to sell pounds, the U.S. firm can lock in the U.S. dollar equivalent of the short position at the ask price, or $176,000.

Advantages of a Forward Contract These contracts are written by market maker banks to the “specifications” of the global firm or global investor (i.e., they can be tailored to the specific needs of the bank’s clients): –For some exact amount of a foreign currency. –For some specific date in the future (forward date). –With no upfront fees, deposits, or commissions. Contracts offered at Bid and Ask prices on forward date. –And they are easy to understand. Global firm or investor knows exactly what the home currency equivalent of a fixed amount of foreign currency will be in the future.

Upside Potential of an Open Position Assume an open long position: €100,000 to be received in 30 days. –Upside potential: if the euro strengthens, the euro is worth more in U.S. dollars. Assume an open short position: £100,000 payable in 30 days. –Upside potential: if the pound weakens, it takes fewer U.S. dollars to buy pounds. Disadvantage of a Forward Contract: Since a forward contract locks in a specific forward spot rate, the upside potential from an open position is eliminated.

Foreign Exchange Options Contracts The second type of financial contract used to hedge foreign exchange exposure is an options contract. An options contract offers the hedging firm the right, but not the obligation, to either (1) buy (referred to as a “call” option) or to (2) sell (referred to as a “put” option) a given quantity of some foreign exchange, and to do so: –at a specified “strike” price (i.e., at an exchange rate), and –at a specified date in the future. Recall a forward contract is an obligation.

Foreign Exchange Options Contracts Options contracts allow the hedging firm to take advantage of a favorable change in the exchange rate (i.e., the upside potential), while providing “insurance” against unfavorable changes in the exchange rate. However, the hedging firm pays for this right in the form of an option’s premium (which is a non-refundable upfront fee). –Options contracts are either written by global banks (market maker banks) or purchased on organized exchanges (e.g., the Chicago Mercantile Exchange). –Market maker banks offer individually tailored options contracts, while organized exchanges only offer standardized contracts.

FX Put Option Put options allow a hedging firm to sell a (1) specified amount of foreign currency on (2) a specified future date and at (3) a specified “strike” price (i.e., exchange rate) all three of which are set today. –A put option is a potential “short” position so it can be used to offset a foreign currency open long position. –Put options provides the firm with an lower limit price (“floor”) for the foreign currency it expects to receive in the future (i.e., insurance against a weakening foreign currency). –If the future spot rate proves to be advantageous (i.e., the foreign currency strengthens), the option holder will not exercise the put option, but instead sell the foreign currency in the spot market. Flexibility to take advantage of a favorable change in the exchange rate (i.e., a strong foreign currency).

Put Option Example Assume a U.S. firm with a 30 day account receivable (i.e., long position) in euros: –Firm anticipates receiving €100,000 in 30 days. Assume the current spot rate (EUR/USD) is $1.2500/$1.2600 Thus, at the current spot bid rate the receivable is worth $125,000. –Assume the firm negotiates a put contract with a market maker bank at a “strike price” of $1.2000. –Note, the U.S. firm has established a lower limit (“floor”) exchange rate for these euros at $1.20 (or $120,000 for the receivable). –Assume the market maker bank charges a non- refundable up-front fee of $2,000 for this contract to lock in this lower limit at $1.20 (This is the option’s premium on this put contract).

Put Option Example -- Continued Assume in 30 days the EUR-USD spot rate quote is: 1.1500/1.1700 –Question: What has the euro done from the spot rate 30 days ago (1.2500/1.2700)? –Question: What is the account receivable worth at this current spot rate and how does this compare to the rate 30 days ago? –Question: What should the U.S. firm do with its options contract? –Question: Given the current spot rate, what will be the optimal USD amount with this strategy?

Answer: Put Option Example Assume in 30 days the EUR-USD spot rate quote is 1.1500/1.1700 –Question: What has the euro done from the spot rate 30 days ago (1.2500/1.2700)? Euro has weakened by $0.1000 per euro. –Account receivable is now worth $115,000 at this bid spot rate (or $10,000 less than on origination date). –Question: What should the U.S. firm do and what will be the outcome? U.S. firm should exercise its put option and sell the euros to the bank at the strike price of $1.2000. Firm will receive $120,000 less the $2,000 up front fee, or $118,000.

Put Option Example -- Continued Now assume in 30 days the EUR-USD spot rate is 1.3500/1.3700 –Question: What has the euro done from the rate 30 days ago (1.2500/1.2700)? –What is the account receivable worth at this current spot rate and how does this compare to the rate 30 days ago? –Question: What should the U.S. firm do with its options contract? –Question: Given the current spot rate, what will be the optimal USD amount with this strategy?

Answer: Put Option Example Now assume in 30 days the EUR-USD spot rate is 1.3500/1.3700 –Question: What has the euro done from the rate 30 days ago (1.2500/1.2700)? Euro has strengthened by $0.1000 per euro. –Account receivable is now worth $135,000 at this bid spot rate (or $10,000 more than on the original date). –What should the U.S. firm do? Firm should not exercise its put option and instead sell the euros in the spot market at $1.3500 Firm will end up receiving $135,000 (less the $2,000 up front fee), or $133,000 for the euros.

Review of Put Option Example We can see from the previous example, that with the use of a put option, the hedging firm was able to establish (“lock in”) a lower limit for its open long FX position. The hedging firm can also walk away from the put contract if the exchange rate moves in its favor (i.e., take advantage of the upside potential if the foreign currency strengthens). Recall that this was not possible with a forward contract.

FX Call Option Call options allow a hedging firm to buy a (1) specified amount of foreign currency at (2) a specified future date and at a (3) specified a price (i.e., at an exchange rate) all three of which are set today. –A call option is a potential “long” position so it can be used to offset a foreign currency short position. –Call options provides the holder with an upper limit price (“ceiling”) for the foreign currency the firm needs in the future. –If the future spot rate proves to be advantageous (i.e., the foreign currency weakens), the option holder will not exercise the call option, but instead buy the foreign currency in the spot market. Flexibility to take advantage of a favorable change in the exchange rate (i.e., a weak foreign currency).

Call Option Example Assume a U.S. firm which with a 30 day account payable (i.e., a short position) in pounds: –Firm knows that it must pay £100,000 in 30 days. Assume the current spot rate (GBP/USD) is 1.7200/1.7400 Thus the payable will cost $174,000 at the current spot ask rate. –Assume the firm negotiates a call contract with a “strike price” of 1.8000 –Note: the U.S. firm has established an upper limit exchange rate for these pounds at $1.8000 (or $180,000 for the payable). –Assume the market maker bank charges a non- refundable fee of $3,000 for this contract to lock in this upper limit (this is the option’s premium).

Call Option Example -- Continued Assume in 30 days the GBP-USD spot rate is: 1.8400/1.8600 –Question: What has the pound done from the spot rate 30 days ago (1.7200/1.7400)? –Question: What is the amount of account payable at this current spot rate and how does this compare to the rate 30 days ago? –Question: What should the U.S. firm do with its options contract? –Question: Given the current spot rate, what will be the optimal USD amount with this strategy?

Answer: Call Option Example Assume in 30 days the GBP-USD spot rate is: 1.8400/1.8600 –What has the pound done from the spot rate 30 days ago (1.7200/1.7400)? Pound has strengthened, by $0.1200 per pound –Account payable will now require $186,000 at this spot ask rate (or $6,000 more than on origination date). –What should the U.S. firm do? U.S. firm should exercise its call option and buy pounds at the strike price of $1.8000. Firm will pay $180,000 plus the $3,000 up front fee, or $183,000, for the pounds

Call Option Example -- Continued Assume in 30 days the GBP-USD spot rate is: 1.6500/1.6600 –Question: What has the pound done from the spot rate 30 days ago (1.7200/1.7400)? –Question: What is the amount of account payable at this current spot rate and how does this compare to the rate 30 days ago? –Question: What should the U.S. firm do with its options contract? –Question: Given the current spot rate, what will be the optimal USD amount with this strategy?

Answer: Call Option Example Assume in 30 days the GBP-USD spot rate is: 1.6500/1.6600 –What has the pound done from the spot rate 30 days ago (1.7200/1.7400)? Pound (ask) has weakened, by $.0800 per pound –Account payable will now require $166,000 at this spot rate (or $8,000 less than on origination date). –What should the U.S. firm do? U.S. firm should not exercise its call option and instead buy pounds at the current spot rate of $1.6600. Firm will pay $166,000 plus the $3,000 up front fee, or $169,000, for the pounds.

Review of Call Option Example We can see from the previous example, that with the use of a call option, the hedging firm was able to establish (“lock in”) a upper limit for its open short FX position. The firm can also walk away from the call contract if the exchange rate moves in its favor (i.e., take advantage of the upside potential if the foreign currency weakens). Recall that this was not possible with a forward contract.

Overview of Options Contracts Important advantage: –Options provide the global firm with the potential to take advantage of a favorable change in the spot exchange rate. Important disadvantages: –Options can be costly: Firm must pay an upfront non-refundable option premium which it loses if it does not exercise the option. –Recall there are no upfront fees with a forward contract. This fee must be considered in calculating the home currency equivalent of the foreign currency. This cost can be especially relevant for smaller firms and/or those firms with liquidity (i.e., cash flow) issues. –More difficult to understand (relative to forward contracts)

Factors Affecting Options’ Premiums ParameterCall PremiumPut Premium Strike PriceAs strike price increases (relative to the spot) the call premium decreases As strike price decreases (relative to the spot) the put premium decreases Time to maturityAs time to maturity increases, the likelihood of the option being exercised increases, thus the premium increases. VolatilityAs volatility increases there is high degree of potential movement about the spot rate of the currency. Thus the greater the volatility, thus the premium increases. Volatility is without a doubt the most important factor of the options’ pricing factors.

What Hedges are Used? 1995 study by Kwok and Folks of Fortune 500 companies revealed: Type of ProductHeard of Used –Forwards100.0%93.1% –Bank (O-T-C) Options 93.5%48.4% –FX Futures 98.8%20.1% –Exchange Traded Options 96.4%17.3% Why do you think the forwards were preferred over the others? Why do you think bank options were preferred over exchange traded options? Do you think you would see these same results today?

Explaining The Findings (1) Why was there a use preference for forward contracts over others? –Perhaps because they are simple to understand and simple to use. –Forward contract can be tailored to specific needs of hedging firms. –There is no upfront cost. (2) Why was there a use preference for bank options over exchange options? –Again, tailored to specific needs of hedging firms. –Exchange traded options are “standardized” with regard to currency, the amount, and the maturity dates of the contract.

Appendix 1 Money Market Hedges

Hedging Through Borrowing or Investing in Foreign Markets The third strategy used by global firms to hedge open foreign exchange exposure is through the use of borrowing or investing in foreign financial markets (i.e., in foreign currencies). –This strategy is commonly referred to as a money market hedge since it involves short term financial assets and liabilities. Offsetting an open long position: Borrowing (i.e., taking on a liability) in a foreign currency. –The borrowing produces an offsetting short position. Offsetting an open short position: Investing (i.e., acquiring an asset) in a foreign currency. –The investing produces an offsetting long position.

Hedging a Long Position Assume a U.S. firm expects to receive £1,000,000 in 1 year as a result of a sale to a British company. The U.S. firm could: –Sell the pounds (in 1 year) at the 1 year forward bid rate, or –Purchase a put option on the pounds to sell pounds at a strike price in 1 year, or, Or, use a Money Market Hedge: –(1) Borrow pounds now. –(2) Swap out of pounds into dollars at the current spot rate. –(3) In 1 year, when the firm receives payment from the British company, use those pounds to pay off the bank loan. Note: The loan (from the borrowing) produces a short FX position which offsets the original long FX position.

Money Market Hedge Example Assume: –(1) a U.S. firm has a 1 year open long position of £1,000,000 (resulting from an account receivable) –(2) The current pound spot rate (GBP/USD) is: $1.85/$1.87 –(3) The U.K. 1 year loan rate is 5.26% per annum. With a money market hedge: –( 1) Borrow £950,000 (Note: at 5.26%, £49,970 is the interest on a £950,000 loan). Thus total loan payback in I year = £999,970. –(2) Swap out of £950,000 into U.S. dollars (sell £s at spot) Receive $1,757,500 (at bid quote of $1.85; £950,000 x $1.85) –(3) In 1 year, use the £1,000,000 account receivable to pay off the loan. Loan payoff = £950,000 + £49,970 = £999,970

What has the firm accomplished with this money market strategy? –The firm has effectively offset its initial foreign currency long position with the foreign currency denominated loan (which is a short position). –The firm as also converted its initial foreign currency long position into its home currency and has received its home currency now (before receiving payment). –The firm has hedged against a weakening of the foreign currency. –However, the firm cannot benefit from a favorable change in the exchange rate (i.e., if the pound strengthens). Outcome of Money Market Strategy for a Long Position

Hedging a Short Position Assume a U.S. firm needs to pay £1,000,000 in 1 year as a result of a purchase from a British company. The U.S. firm could: –Buy the pounds (in 1 year) at the 1 year forward ask rate, or –Purchase a call option on the pounds to buy pounds at a strike price in 1 year, or, Use a Money Market Hedge: –(1) Borrow U.S. dollars now –(2) Swap out of dollars into pounds at the current spot rate. –(3) Invest in a 1 year pound denominated financial asset. –(4) In 1 year, when the pound denominated financial asset matures, use the proceeds to pay off the £1,000,000 account payable. Note: The financial asset (i.e., from the investment) produced a long FX position which offsets the original short FX position.

Money Market Hedge Example Assume: –(1) A 1 year short position of £1,000,000 –(2) The current spot rate (GBP/USD) is: $1.85/$1.87 –(3) The U.K. 1 year investing rate is 8%. With a money market hedge: –The U.S. firm needs £926,000 today, which if invested at 8% (U.K. interest rate) for a year will approximate the £1,000,000 it needs in 1 year for its short position. £926,000 x 1.08 = £1,000,080.00 –(1) Borrow $1,731,620. At the ask spot rate, this is the amount of dollars the firm needs to acquire £926,000 (£926,000 x $1.87 = $1,731,620). –(2) Swap out of dollars into pounds: Receive £926,000 (at ask quote of $1.87; $1,731,620/$1.87 = £926,000) –(3) Invest £926,000 in a 1 year U.K. financial asset at 8%. –(4) Use the maturing U.K. asset (actually equal to £1,000,080) to meet the account payable in 1 year.

Outcome of Money Market Strategy for a Short Position What has the firm accomplished with this strategy? –The firm has effectively offset its foreign currency short exposure with the foreign currency denominate asset which is a long position –The firm has converted its foreign currency liability into a home currency liability. –The firm has hedged against a strengthening of the foreign currency. –However, the firm will cannot benefit from a favorable change in the exchange rate (i.e., if the pound weakens).

Fifth Edition Objective: Discussion of international capital markets with a discussion of both the primary and secondary equity markets throughout the world. International Equity Markets

A Statistical Perspective Market Structure, Trading Practices, and Costs International Equity Market Benchmarks i Shares MSCI Trading in International Equities Factors Affecting International Equity Returns Chapter Outline A Statistical Perspective Market Capitalization of Developed Countries Market Capitalization of Developing Countries Measures of Liquidity Measures of Market Concentration Market Structure, Trading Practices, and Costs Trading in International Equities International Equity Market Benchmarks i Shares MSCI Factors Affecting International Equity Returns A Statistical Perspective Market Structure, Trading Practices, and Costs Trading in International Equities International Equity Market Benchmarks i Shares MSCI Factors Affecting International Equity Returns A Statistical Perspective Market Structure, Trading Practices, and Costs Trading in International Equities International Equity Market Benchmarks i Shares MSCI Factors Affecting International Equity Returns A Statistical Perspective Market Structure, Trading Practices, and Costs Trading in International Equities International Equity Market Benchmarks i Shares MSCI Factors Affecting International Equity Returns A Statistical Perspective Market Structure, Trading Practices, and Costs Trading in International Equities Magnitude of International Equity Trading Cross-Listing of Shares Yankee Stock Offerings The European Stock Market American Depository Receipts International Equity Market Benchmarks i Shares MSCI A Statistical Perspective Market Structure, Trading Practices, and Costs Trading in International Equities International Equity Market Benchmarks i Shares MSCI Factors Affecting International Equity Returns A Statistical Perspective Market Structure, Trading Practices, and Costs Trading in International Equities International Equity Market Benchmarks i Shares MSCI Factors Affecting International Equity Returns Macroeconomic Factors Exchange Rates Industrial Structure A Statistical Perspective Market Structure, Trading Practices, and Costs Trading in International Equities International Equity Market Benchmarks i Shares MSCI Factors Affecting International Equity Returns 13-372

Market Capitalization of Developed Countries Market Capitalization of Developing Countries Measures of Liquidity Measures of Market Concentration A Statistical Perspective 13-373

At year-end 2006, total market capitalization of the world’s equity markets stood at $54,195 billion. Of this amount, 81 percent is accounted for by the market capitalization of the major equity markets from 29 developed countries. Market Capitalization of Developed Countries 13-374

The other 19% is accounted for by the market capitalization of developing countries in “emerging markets”. –Latin America –Asia –Eastern Europe –Mideast/Africa http://www.rba.gov.au/publications/bulletin/2010 /dec/pdf/bu-1210-7.pdf Market Capitalization of Developing Countries 13-375

–Standard & Poor’s Emerging Markets Data Base classifies a stock market as “emerging” if it meets at least one of two general criteria: (1) it is located in a low- or middle-income economy as defined by the World Bank, and/or (2) its investable market capitalization is low relative to its most recent GNI figures. Emerging Markets 13-376

The equity markets of the developed world tend to be much more liquid than emerging markets. –Liquidity refers to how quickly an asset can be sold without a major price concession. So, while investments in emerging markets may be profitable, the investor’s focus should be on the long term. Measures of Liquidity 13-377

Primary Markets –Shares offered for sale directly from the issuing company. Secondary Markets –Provide market participants with marketability and share valuation. Market Structure, Trading Practices, and Costs 13-378

Market Order –An order to your broker to buy or sell share immediately at the market price. Limit Order –An order to your broker to buy or sell at the at a price you want, when and if he can. If immediate execution is more important than the price, use a market order. Market Structure, Trading Practices, and Costs 13-379

Dealer Market –The stock is sold by dealers, who stand ready to buy and sell the security for their own account. –In the U.S., the OTC market is a dealer market. Auction Market –Organized exchanges have specialists who match buy and sell orders. Buy and sell orders may get matched without the specialist buying and selling as a dealer. New York Stock Exchange (NYSE) Electronic Exchanges – Computers match buy and sell orders. Most Exchanges e.g. London –http://www.investopedia.com/articles/stocks/11/explaining- eight-biggest-stock-exchanges.asp#axzz1eJD6AUNE Market Structure, Trading Practices, and Costs 13-380

There are approximately 80 major national stock markets. –Western and Eastern Europe once had more than 20 national stock exchanges where at least 15 different languages were spoken. –It appears that over time a European stock exchange will eventually develop. However, a lack of common securities regulations, even among the countries of the European Union, is hindering this development. Today, stock markets around the world are under pressure from clients to combine or buy stakes in one other to trade shares of companies anywhere, at a faster pace. Market Consolidations And Mergers 13-381

Magnitude of International Equity Trading Cross-Listing of Shares Yankee Stock Offerings The European Stock Market American Depository Receipts Trading in International Equities 13-382

During the 1980s world capital markets began a trend toward greater global integration. Diversification, reduced regulation, improvements in computer and communications technology, increased demand from MNCs for global issuance. Magnitude of International Equity Trading 13-383

Cross-Listing refers to a firm having its equity shares listed on one or more foreign exchanges. The number of firms doing this has exploded in recent years. Cross-Listing of Shares 13-384

It expands the investor base for a firm. –Very important reason for firms from emerging market countries with limited capital markets. Establishes name recognition for the firm in new capital markets, paving the way for new issues. May offer marketing advantages. May mitigate possibility of hostile takeovers. Advantages of Cross-Listing 13-385

The direct sale of new equity capital to U.S. public investors by foreign firms. –Privatization in South America and Eastern Europe –Equity sales by Mexican firms trying to “cash in” following implementation of NAFTA Yankee Stock Offerings 13-386

Foreign stocks often trade on U.S. exchanges as ADRs. It is a receipt that represents the number of foreign shares that are deposited at a U.S. bank. The bank serves as a transfer agent for the ADRs American Depository Receipts 13-387

There are many advantages to trading ADRs as opposed to direct investment in the company’s shares: –ADRs are denominated in U.S. dollars, trade on U.S. exchanges and can be bought through any broker. –Dividends are paid in U.S. dollars. –Most underlying stocks are bearer securities, the ADRs are registered. American Depository Receipts 13-388

A good example of a familiar firm that trades in a U.S. as an ADR is Volvo AB, the Swedish car maker. Volvo trades in the U.S. on the NASDAQ under the ticker VOLVY. –The depository institution is JPMorgan ADR Group. –The custodian is a Swedish firm, S E Banken Custody. Of course, Volvo also trades on the Stockholm Stock Exchange under the ticker VOLVB. Volvo ADR 13-389

The merger of Daimler Benz AG and Chrysler Corporation in November 1998, created DaimlerChrysler AG, a German firm. The merger simultaneously created a new type of equity share called Global Registered Shares (GRS). GRS are one share traded globally, unlike ADRs, which are receipts for bank deposits of home-market shares and traded on foreign markets. The company was renamed Daimler AG in October 2007 when it spun off Chrysler. The primary exchanges for Daimler GRS are the Frankfurt Stock Exchange and the NYSE; however, they are traded on a total of 20 exchanges worldwide. The shares are fully fungible—a GRS purchased on one exchange can be sold on another. They trade in both U.S. dollars and euros. Global Registered Shares 13-390

The main advantages of GRS over ADRs appear to be that all shareholders have equal status and direct voting rights. The main disadvantage of GRS appears to be the greater expense in establishing the global registrar and clearing facility. GRS have met with limited success; many companies that considered them opted instead for ADRs. Deutsche Bank, UBS, and NYSE Euronext also trade as GRS. Global Registered Shares 13-391

North America Europe Asia/Pacific Rim International Equity Market Benchmarks 13-392

North American Equity Market Benchmarks

European Equity Market Benchmarks

Asia/ Pacific Rim Equity Market Benchmarks

Country-specific baskets of stocks designed to replicate the country indexes of 22 countries. i Shares are exchange traded funds that trade on the American Stock Exchange and are subject to U.S. SEC and IRS diversification requirements. –Low cost, convenient way for investors to hold diversified investments in several different countries. i Shares MSCI 13-396

Macroeconomic Factors Exchange Rates Industrial Structure Factors Affecting International Equity Returns 13-397

The data do not support the notion that equity returns are strongly influenced by macro factors. That is correspondent with findings for U.S. equity markets. Macroeconomic Factors Affecting International Equity Returns 13-398

Exchange rate movements in a given country appear to reinforce the stock market movements within that country. One should be careful not to confuse correlation with causality. Exchange Rates 13-399

Studies examining the influence of industrial structure on foreign equity returns are inconclusive. http://www.bloomberg.com/video/80432558/ http://video.app.msn.com/watch/video/profits -global-currency/3xl03wti?cpkey=f8618917- ab3a-4882-965f- 18880c0c42b7%7C%7C%7C%7C Industrial Structure 13-400

International bond market

The total market value of the world’s bond markets are about 50% larger than the world’s equity markets. The U.S. dollar, the euro, the pound sterling, and the yen are the four currencies in which the majority of domestic and international bonds are denominated. Proportionately more domestic bonds than international bonds are denominated in the dollar (44.2 percent versus 36.1 percent) and the yen (15.4 percent versus 2.6 percent) while more international bonds than domestic bonds are denominated in the euro (47.5 percent versus 21.5 percent) and the pound sterling (8.3 percent versus 2.5 percent). The World’s Bond Markets: A Statistical Perspective: 12-402

Amounts of Domestic and International Bonds Outstanding CurrencyDomesticPercent Internationa lPercentTotal Percen t U.S. $ 18,596.1 044.2%7,129.2036.1% 25,725.3 041.6% Euro €9,032.5021.5%9,395.8047.5% 18,428.3 029.8% Pound £1,033.702.5%1,635.208.3%2,668.904.3% Yen ¥6,478.2015.4%504.82.6%6,983.0011.3% Other6,968.2016.5%1,099.005.6%8,067.2013% Total 42,108.7 0100%19,764.00100% 61,872.7 0100% (As of Mid-Year 2007 in Billions of U.S. Dollars)

Amounts of Domestic and International Bonds Outstanding (As of Mid-Year 2007 in U.S. $Billions) 12-404

Domestic and International Bonds Outstanding (As of Mid-Year 2007 in U.S. $Billions) Percentage

Bearer Bonds and Registered Bonds National Security Registrations Withholding Taxes Recent Regulatory Changes Global Bonds Foreign Bonds and Eurobonds 12-406

Bearer Bonds are bonds with no registered owner. As such they offer anonymity but they also offer the same risk of loss as currency. Registered Bonds: the owners name is registered with the issuer. U.S. security laws require Yankee bonds sold to U.S. citizens to be registered. A bond denominated in U.S. dollars that is publicly issued in the U.S. by foreign banks and corporations Bearer Bonds and Registered Bonds

Yankee bonds must meet the requirements of the SEC, just like U.S. domestic bonds. Many borrowers find this level of regulation burdensome and prefer to raise U.S. dollars in the Eurobond market. Eurobonds sold in the primary market in the United States may not be sold to U.S. citizens. A Eurobond is an international bond that is denominated in a currency not native to the country where it is issued. Of course, a U.S. citizen could buy a Eurobond on the secondary market. National Security Registrations

A global bond is a very large international bond offering by a single borrower that is simultaneously sold in North America, Europe and Asia. –Global bond issues were first offered in 1989. Global bonds denominated in U.S. dollars and issued by U.S. corporations trade as Eurobonds overseas and domestic bonds in the U.S. Global Bonds 12-409

The largest corporate global bond issue to date is the $14.6 billion Deutsche Telekom multicurrency offering. The issue includes –three U.S. dollar tranches with 5-, 10-, and 30-year maturities totaling $9.5 billion, –two euro tranches with 5- and 10-year maturities totaling €3 billion, –two British pound sterling tranches with 5- and 30- year maturities totaling £950 million, –and one 5-year Japanese yen tranche of ¥90 billion. Deutsche Telekom Global Bond 12-410

Straight Fixed Rate Debt Floating-Rate Notes Equity-Related Bonds Zero Coupon Bonds Dual-Currency Bonds Composite Currency Bonds Types of Instruments 12-411

These are “plain vanilla” bonds with a specified coupon rate and maturity and no options attached. Since most Eurobonds are bearer bonds, coupon dates tend to be annual rather than semi-annual. The vast majority of new international bond offerings are straight fixed-rate issues. Straight Fixed Rate Debt 12-412

Just like an adjustable rate mortgage. Common reference rates are 3-month and 6-month U.S. dollar LIBOR the London Interbank Offered Rate. the interest rate one bank charges another for a loan. it is used as the key point of reference for financial instruments. Floating-Rate Notes 12-413

There are two types of equity-related bonds: convertible bonds and bonds with equity warrants. Equity-Related Bonds 12-414

A convertible bond issue allows the investor to exchange the bond for a predetermined number of equity shares of the issuer. –The floor-value of a convertible bond is its straight fixed-rate bond value. –Convertibles usually sell at a premium above the larger of their straight debt value and their conversion value. Investors are usually willing to accept a lower coupon rate of interest than the comparable straight fixed coupon bond rate because they find the conversion feature attractive. Convertible Bonds 12-415

These bonds allow the holder to keep his bond but still buy a specified number of shares in the firm of the issuer at a specified price. –They can be viewed as straight fixed-rate bonds with the addition of a call option (or warrant) feature. –The warrant entitles the bondholder to purchase a certain number of equity shares in the issuer at a prestated cash price over a predetermined period of time. With a convertible bond, you surrender the bond to get the shares. Here you pay cash and keep the bond. Bonds with Equity Warrants 12-416

Zeros are sold at a large discount from face value because there is no cash flow until maturity. In the U.S., investors in zeros owe taxes on the “imputed income” represented by the increase in present value each year, while in Japan, the gain is a tax-free capital gain. Pricing is very straightforward: Zero Coupon Bonds PV = PAR (1 + r) T 12-417

A straight fixed-rate bond, with interest paid in one currency, and principal in another currency. Japanese firms have been big issuers with coupons in yen and principal in dollars. Good option for a MNC financing a foreign subsidiary. Dual-Currency Bonds 0134NN – 1 ¥¥¥$¥

Denominated in a currency basket, like the SDRs or ECUs instead of a single currency. Often called currency cocktail bonds. Typically straight fixed rate debt. Composite Currency Bonds 12-419

Instrument Straight Fixed-Rate Floating Rate Note Convertible BondAnnualFixedCurrency of issue or conversion to equity shares. Straight fixed rate with equity warrants AnnualFixedCurrency of issue plus conversion to equity shares. ZerononezeroCurrency of issue Dual Currency Bond AnnualFixedDual currency Frequency of Payment Annual Size of Coupon Payoff at Maturity Characteristics of International Bond Market Instruments Currency of issueFixed Every 3 or 6 monthsVariableCurrency of issue

Currency Distribution of International Bond Amounts Outstanding Currency20032004200520062007 Euro4,834.506,216.006,317.808,310.109,395.80 U.S. $4,492.504,906.305,380.506,400.607,129.20 Pound778.7981.81,063.701,450.001,635.20 Yen488.6530.5472.2487.3504.8 Swiss franc195.6227.9208.8253.8273.5 Canadian dollar79.3112.6146.7178232.6 Other233.3306.7394.3649.3592.9 Total11,102.5013,281.8013,984.0017,569.1019,764.00

Distribution of International Bond Offerings 20032004200520062007 Australia162225.5259.3352405 Canada267.2294.8311346.7401.1 France700.8888.5937.81,197.201,309.20 Germany1,810.302,110.202,071.802,463.802,612.80 Italy510.5716.4705.1903.4996.6 Japan255.2280.7261.2304.1316.3 Netherlands532.8652.8680.7870.4961.4 U.S.1,032.101,267.901,426.301,881.302,117.00 U.K.3,011.803,262.703,446.304,297.304,947.10 Other Developed Countries1,559.002,090.702,320.903,191.703,774.20 Off-shore Centers128.9151.4173.3195.7213 Developing Countries630.8790.9855.6989.81,109.50 International Institutions501549.3534.7575.7600.8 Total (in U.S. $Billions)11,102.5013,281.8013,984.0017,569.1019,764.00 12-422

Distribution of International Bond Offerings by Type of Issuer 20032004200520062007 Financial institutions8,032.509,756.7010,509.0013,537.5015,404.50 Governments1,122.301,413.801,431.901,621.901,739.90 International501.1549.3534.7575.8600.8 Corporate issuers1,446.601,562.101,508.501,834.002,019.00 Total (in U.S. Billions)11,102.5013,281.8013,984.0017,569.1019,764.00 12-423

Fitch IBCA, Moody’s and Standard & Poor’s sell credit rating analysis. Focus on default risk, not exchange rate risk. Assessing sovereign debt focuses on political risk and economic risk. International Bond Market Credit Ratings

Primary Market –Very similar to U.S. underwriting. Secondary Market –OTC market centered in London. Comprised of market makers as well as brokers. Market makers and brokers are members of the International Capital Market Association (ICMA), a self-regulatory body based in Zurich. Clearing Procedures –Euroclear and Cedel handle most Eurobond trades. Eurobond Market Structure 12-425

A borrower desiring to raise funds by issuing Eurobonds to the investing public will contact an investment banker and ask it to serve as the lead manager of an underwriting syndicate that will bring the bonds to market. The underwriting syndicate is a group of investment banks, merchant banks, and the merchant banking arms of commercial banks that specialize in some phase of a public issuance. The lead manager will sometimes invite co- managers to form a managing group to help negotiate terms with the borrower, ascertain market conditions, and manage the issuance. Eurobond Practices: Primary Market 12-426

The managing group, along with other banks, will serve as underwriters for the issue, that is, they will commit their own capital to buy the issue from the borrower at a discount from the issue price. –The discount, or underwriting spread, is typically in the 2 to 2.5 percent range. By comparison, the spread averages about 1 percent for domestic issues. –Most of the underwriters, along with other banks, will be part of a selling group that sells the bonds to the investing public. Eurobond Practices: Primary Market 12-427

Eurobonds initially purchased in the primary market from a member of the selling group may be resold prior to their maturities to other investors in the secondary market. The secondary market for Eurobonds is an over-the-counter market with principal trading in London. However, important trading is also done in other major European money centers, such as Zurich, Luxembourg, Frankfurt, and Amsterdam. Eurobond Practices: Secondary Market

The secondary market comprises market makers and brokers connected by an array of telecommunications equipment. Market makers stand ready to buy or sell for their own account by quoting two- way bid and ask prices. Market makers trade directly with one another, through a broker, or with retail customers. –The bid-ask spread represent market makers’ only profit; no other commission is charged. Eurobond Practices: Secondary Market

Eurobond transactions in the secondary market require a system for transferring ownership and payment from one party to another. Two major clearing systems, Euroclear and Clearstream International, handle most Eurobond trades. Euroclear is based in Brussels and is operated by Euroclear Bank. Clearstream is located in Luxembourg. Clearing Procedures 12-430

Both clearing systems operate in a similar manner. –Each clearing system has a group of depository banks that physically store bond certificates. –Members of either system hold cash and bond accounts. When a transaction is conducted, electronic book entries are made that transfer book ownership of the bond certificates from the seller to the buyer and transfer funds from the purchaser’s cash account to the seller’s. Physical transfer of the bonds seldom takes place. Clearing Procedures

Euroclear and Clearstream perform other functions associated with the efficient operation of the Eurobond market. –(1) The clearing systems will finance up to 90 percent of the inventory that a Eurobond market maker has deposited within the system. –(2) The clearing systems will assist in the distribution of a new bond issue. The clearing systems will take physical possession of the newly printed bond certificates in the depository, collect subscription payments from the purchasers, and record ownership of the bonds. –(3) The clearing systems will also distribute coupon payments. The borrower pays to the clearing system the coupon interest due on the portion of the issue held in the depository, which in turn credits the appropriate amounts to the bond owners’ cash accounts. Other Functions of the Clearing System

There are several international bond market indices. J.P. Morgan and Company –Domestic Bond Indices –International Government bond index for 18 countries. –Widely referenced and often used as a benchmark. –Appears daily in The Wall Street Journal International Bond Market Indices 12-433

Foreigners holding Nestlé bearer shares were exposed to political risk in a country that is widely viewed as a haven from such risk. The Nestlé episode illustrates –The importance of considering market imperfections. –The peril of political risk. –The benefits to the firm of internationalizing its ownership structure. An Example of Foreign Ownership Restrictions: Nestlé

Week 10: Valuation Models for MNCs and Global Investors

Defining A Financial Center A Financial Center is a location: –That has a heavy concentration of financial institutions providing a wide range of financial services (including banking, insurance, cash management, asset management). London, New York, and Tokyo are regarded as the world's three premier financial centers. An Offshore Financial Center is a location: –That provides financial services to nonresidents on a scale that is disproportionately larger in comparison to the size and the financing of its domestic economy (IMF definition). Examples include: The Cayman Islands, Gibraltar, Bahrain, and Hong Kong –The Cayman Islands, with a domestic population of 52,000, has 250 banks, with approximately $415 billion in deposits (making it one of the largest financial centers in the world). Is London an offshore financial center?

Objective of Lecture In order to understand and appreciate the international forces which multinational firms and global investors face, we need to develop valuation models for global companies and investors. The models which we will develop are patterned after the Anglo-Saxon model of corporate behavior and investment valuations.

Valuation Concepts Anglo-Saxon Approach: –Firm Evaluation: Consider the value of the firm and corporate behavior in terms of (maximizing) the market value of the firm for shareholders. Capital budgeting techniques evaluate projects and corporate investments on the basis of the present value of their cash flows. –Financial Asset Evaluation: Consider the present value of the anticipated future income stream from a particular financial asset.

Anglo-Saxon Valuation Model for Corporation: Present Value of Future Cash Flow $,tWhere E(CF $,t ) represents expected cash flows to be received at the end of period t, N represents the number of periods into the future in which cash flows are received, and K represents the required rate of return by investors. 439

Measuring the International Cash Flows for a U.S. Based MNC Where CF j,t represents the amount of cash flow denominated in a particular foreign currency j at the end of period t, Where S j,t represents the exchange rate at which the foreign currency can be converted into U.S. dollars at the end of period t. 440

Changes in the Value of a MNC MNC Valuation Model V changes result from: (1) Changes in foreign market conditions: Will impact on foreign currency earnings and thus on foreign currency cash flows (CF). (2) Changes in political environment and political risk (policy of foreign government towards MNC): Will impact on foreign currency earnings and thus on foreign currency cash flows (CF). (3) Changes in the MNC’s cost of capital, i.e., the required return (k). (4) Changes in the exchange rate resulting from exposure to exchange rate risk (S); noting that: –Stronger foreign currency will increase U.S. dollar equivalent of cash flows. –Weaker foreign currency will decrease U.S. dollar equivalent of cash flows.

S&P 500 Companies Percent of Total Sales from Overseas Markets 2005:43.3% 2006:43.6% 2007:45.8% 2008:47.0% 2009:46.6% 2010:46.3% 2011:46.1% MNCs Concentration on Foreign Markets (CF in Valuation Model)

U.S. MNCs Involvement in Foreign Markets (CF in Valuation Model) Company% Sales from O verseas Market s Other Comments (Major markets, etc) Intel85%Chips and Processors to Taiwan and China McDonalds66%Europe and Asia (400 stores in China) GE54%Europe and China Ford51%Canada, Europe, and China Nike50%1/3 of shoe manufacturing in China Amazon45%Canada and Japan Wal-Mart26%5,000 stores in 14 foreign countries Starbucks25%Canada, UK and China account for 66%

Foreign MNCs Involvement in Foreign Markets (CF in Valuation Model) Company% Sales from Overseas Markets Other Comments (Major markets, etc) Japanese: Komatsu81%China accounts for 23% Canon80.5%Europe accounts for 31.3% Bridgestone74%North America accounts for 42% Honda66%North America accounts for 37% U.K.: Rolls Royce88%United States accounts for 32% Germany: BMW81%United States and China each account for 17% Chinese: Haier30%

Foreign Exchange Exposures for Selected MNCs CompanySelected F.X. Exposure McDonalds (USA)Revenues exposed to pounds, euros, yen and yuan (re nminbi) Ford (USA)Revenues exposed to Canadian dollars, pounds, euros and yuan (renminbi) Nike (USA)Costs exposed to yuan (renminbi) Komatsu (Japan)Revenues exposed to yuan (renminbi) Canon (Japan)Revenues exposed to euros and pounds Bridgestone (Japan)Revenues exposed to U.S. dollars Honda (Japan)Revenues exposed to U.S. dollars; costs exposed to U. S. dollars Rolls Royce (U.K.)Revenues exposed to U.S. dollars BMW (Germany)Revenues exposed to U.S. dollars and yuan (renminbi) ; costs exposed to U.S. dollars

Exchange Rates Volatility (S in the Valuation Formula)

Euro Exchange Rate; Daily Data: 1999 - Present

Yen Exchange Rate; Daily Data: 1971 - Present

Example: Exchange Rate Impacts on Operating Profits Japanese Multinationals Sony, which generates more than 70 percent of revenue outside of Japan, says it loses about 2 billion yen of annual operating profit for each yen gain against the U.S. currency. Toyota notes that every one-yen gain in the Japanese currency against the dollar reduces Toyota’s annual operating profit by 30 billion yen. Yen in 2011

Valuation Models for Financial Assets Bonds: Present value of: –Coupon payments + Par Value (face or maturity value) In U.S., par value = $1,000 Discount rate (k) is adjusted for opportunity cost and risk adjustments. Stocks: Present value of: –Future cash flow (Dividends, earnings) Foreign currency denominated financial assets: Valuation model adjustment needs to be made for changes in exchange rates.

Do Bond Yields Vary Globally? FT Data (August 24, 2012)

Do Equity Returns Vary Globally? Country and Sto ck Market % Change in Lo cal Currency Te rms; Dec 31, 20 11 to Aug 22, 20 12 USA: DJIA+7.8% Japan: TOPIX+4.7% U.K. FTSE100+3.6% Canada: TSX+1.4% France; CAC40+9.6% Germany: DAX+19.0% Singapore: STI+15.2% S. Africa: JSE+11.4 Country and Sto ck Market % Change in Loc al Currency Term s; Dec 31, 2011 to Aug 22, 2012 Greece: Athex-6.0% Spain: Madrid SE-13.5% Argentina: MERV-1.1% China: SSEA-4.2% Israel: TA-100-0.1 MSCI Data: Developed Mkts+8.9% Emerging Mkts+5.8%

Do Exchange Rates Affect Equity Returns? Data for 2010 CountryLocal Currency ReturnU.S. Dollar Return Japan- 1.6%+10.0% Australia- 1.3%+10.0% Switzerland- 0.4%+ 6.6% Canada- 0.4%+20.1% Italy-11.6%-19.0% Germany+16.5%+ 6.7% United Kingdom+11.7%+ 6.9% South Africa+15.7%+26.6% Hong Kong+ 8.6%+ 8.4% Memo: United States (DJIA)+12.4% Euro-Zone (17)- 0.9%- 9.2%

Exchange Rates in 2010 JPY (Equity Market: -LC1.6%; +USD10.0%) GBP (Equity Market: +LC11.7%; +USD6.9%)

Exchange Rates in 2010 EUR (Equity Market: -LC0.9%; -USD9.2%) HKD (Equity Market: +LC8.6%; +USD8.4%)

Equity Returns, Dec 31, 2011 – Aug 22, 2012 CountryLocal Currency ReturnU.S. Dollar Return Japan+ 8.0%+ 5.4% Australia+ 7.1%+10.1% Switzerland+ 9.1%+ 4.3% Canada+ 1.4%+ 4.3% Greece- 6.0%- 11.1% Germany+19.0%+12.6% United Kingdom+ 3.6%+ 4.7% Hong Kong+ 7.9%+ 8.0% Saudi Arabia+ 9.7% Memo: United States (DJIA)+ 7.8% Euro-Zone (17)+ 7.3%+ 1.5%

And What About the BRICS? 2011 CountryLocal Curr ency Retu rn USD Retur n Brazil-14.3%-22.1% Russia-15.4%-19.0% India-22.6%-34.6% China-22.7%-19.1% S. Africa+ 2.4%-17.0% U.S.+ 7.3% 2012 to August 22 CountryLocal Curr ency Retu rn USD Retur n Brazil+ 4.6%- 3.5% Russia+ 2.9%+ 3.5% India+15.5%+10.0% China- 4.2%- 5.2% S. Africa+11.4%+ 9.3% U.S.+ 7.8%

Do Exchange Rates Affect Bond Returns?

Exchange Rate Adjusted Bond Returns Return on German Bonds, 1994 - 1999 Exchange Rate Adjusted Returns on Government Bonds, 2005 YearLocal Market% ChangeUSD Return Return*in Local Currency** 1994-1.8%11.8%10.0% 199516.3%9.6%25.9% 19967.3%-7.7%-0.4% 19976.2%-15.2%-9.0% 199810.9%8.9%19.8% 1999-2.1%-14.3%-16.4% * = Interest (coupon payment) +/- Change in market price **1994 - 1998: % change in Deutschmark; 1999 % change in Euro

Hong Kong as a Financial Center After being ceded by China to the British (as a result of the Opium Wars) under the Treaty of Nanking in 1842, the colony of Hong Kong rapidly became a regional center for financial and commercial services with China and South Asia. During the Korean War, the U.N. imposed an embargo on mainland China (for its support of North Korea) and as a result many “industrialist moved from the mainland to Hong Kong and set up light industry export companies. During this period, Hong Kong grew as a shipping and textile export center. However, China's open-door policy in 1978 was the year that marked the new era of Hong Kong and its re-birth as a major economic and financial center. As manufacturing moved out of Hong Kong to mainland China, it was replaced by services, and Hong Kong GDP boomed as trade and investment links with China exploded. Global financial services also flourished because of Hong Kong’s British-style legal system and the fact that English is spoken fluently both of which supported Hong Kong’s financial networks with London, New York and other leading global cities. In additional, Hong Kong has had long existing stock market (since 1891). Today it is an important market for IPO (second only to New York last year) and funds management. Today Hong Kong is the world’s sixth largest foreign exchange trading center, with 4.7% of the world’s total trades (or $238 billion per day). 71 of the largest 100 banks in the world have an operation in Hong Kong. Hong Kong is the world's 9th largest international banking center in terms of the volume of external transactions, and the second largest in Asia after Japan. The banking sector plays a vital role in establishing Hong Kong as a major loan syndication center in the region. The Hong Kong Stock Exchange is Asia's third largest stock exchange in terms of market capitalization behind the Tokyo Stock Exchange and the Shanghai Stock Exchange and fifth largest in the world. As of 31 Dec 2010, the Hong Kong Stock Exchange had 1,413 listed companies with a combined market capitalization of $2.7 trillion. Hong Kong was hit hard by the Asian Financial Crisis that struck the region in mid-1997, just at the time of the handover of the colony back to Chinese administrative control. The crisis prompted a collapse in share prices and the property market. However, unlike most Asian countries, Hong Kong (as well as mainland China) maintained their currencies’ exchange rates with the U.S. dollar rather than devaluing.

Defining International Financial Centers A Framework for Considering What Determines an International Financial Center

What is an International Financial Center? There are many possible dimensions to an International Financial Center, however, one important starting characteristic is to offer the necessary with infrastructure to support the financial needs of international businesses. Other characteristics of an International Financial Center include: 1.A center from which international financial business can be conducted profitably, easily and efficiently. 2.A center with skilled management and intellectual talent covering business, finance and interdependent services such as legal, insurance and accounting, to provide multi-disciplined teams that facilitate large cross borders transactions in the most efficient manner possible (e.g., in the shortest possible time frame; at a competitive cost).

Characteristics of an International Financial Center 3.A center with deep liquid and sophisticated money and capital markets and competitive tax and regulatory regimes. 4.A center with significant offshore business skills. 5.A center that can add significant value to financial services provided from it, through a workforce that can respond promptly and in an innovative manner. 6.A center with the world-class telecommunications, financial information providers, and IT capacity combined with a large, well educated, multilingual workforce. 7.A center where all facets of financial services: CEOs; senior traders, regional headquarters, treasury operations, data processing, and other support functions and can be located efficiently. 8.A center with an attractive environment (living and working) for business.

Categories of Financial Centers Global Financial Centers: These are centers that serve clients from all over the world in the provision of the widest possible array of international financial services. There are two true international financial centers: London and New York. Regional Financial Centers: they serve their regional rather than their national economies. Examples include Dubai, Hong Kong, Singapore. Non-Global and non-Regional Financial Centers: These are centers that provide a wide range of international financial services but cater mainly to the needs of their national economies rather than their regions or the world. Perhaps they are best referred to as national Financial Centers. They include Tokyo, Paris, Frankfurt, and Sydney Offshore Financial Centers: These are centers that many view as primarily tax havens for wealth management and global tax management rather than providing the full array of international financial services. They are jurisdictions that have financial institutions engaged primarily in business with non-residents and with external assets and liabilities out of proportion to the needs of their domestic economies. They include the Cayman Islands, Gibraltar, Isle of Man, Liechtenstein, Monaco, and Mauritius (IMF 2000 classifications).

Comparison of Financial Centers, 2006 Data from the Economist

FX Technical Analysis. Is the study and interpretation of price movements in order to determine future trends A technician assumes that all fundamental.

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FX Technical Analysis. Is the study and interpretation of price movements in order to determine future trends A technician assumes that all fundamental.

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Presentation on theme: "FX Technical Analysis. Is the study and interpretation of price movements in order to determine future trends A technician assumes that all fundamental."— Presentation transcript:

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