1. International Finance
FIN456 Michael Dimond

2. Foreign Exchange Markets
Provide the physical and institutional structure to
Exchange the money of one country for that of another
Determine the rate of exchange between currencies
Physically complete foreign exchange transactions
A foreign exchange transaction is an agreement between a buyer & seller that a set amount of one currency will be delivered for some other currency at a specified rate
Six main characteristics of the FOREX markets:
The geographic extent
The three main functions
The market’s participants
Its daily transaction volume
Types of transactions including spot, forward and swaps
Methods of stating exchange rates, quotations, & changes in rates

3. Geographic Extent of the Market
Geographically, the FOREX market spans the globe with prices moving and currencies trading every hour of every business day
Major world trading starts each morning in Sydney and Tokyo, then moves west to Hong Kong and Singapore & finishes on the West Coast of the U.S.

4. Functions of the FOREX Market (FX Market)
The FOREX market is the mechanism by which participants
Transfer purchasing power between countries
This is necessary as international trade and capital transactions normally involve parties living in countries with different national currencies
Obtain or provides credit for international trade transactions
Inventories in transit must be financed
Minimize exposure to exchange rate risk
FOREX markets provide instruments utilized in “hedging” or transferring risk to more willing parties
The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retail market
Five broad categories of participants operate within these two tiers
Bank and non bank foreign exchange dealers
Central banks and treasuries
Foreign exchange brokers
Individuals and firms conducting commercial or investment transactions
Speculators and Arbitrageurs

5. Size of the FOREX Market
The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be USD 3.7 trillion in April 2010
Spot transactions at $1,495 bn/day
Outright forwards at $475 bn/day
Swaps at $1,765 bn/day
The London trade alone makes up 36.7% of daily transactions in the foreign exchange market, followed by the US (17.9%), Japan (6.2%), Singapore (5.3%), Switzerland (5.2%) and Hong Kong (4.2%)
Asian markets growing more rapidly than European markets

6. Continuous Linked Settlement
Continuous Linked Settlement (CLS) system (since 2002) eliminates losses if either party unable to settle
CLS links with Real-Time Gross Settlement (RTGS) systems in seven major currencies
Eventually we expect same-day settlement instead of the current lag of two days
The U.S. Commodity Futures Trading Commission (CFTC) regulates foreign exchange trading

7. Transactions in the Interbank Market
Transactions within this market can be executed on a spot, forward, or swap basis
A spot transaction requires almost immediate delivery of foreign exchange
A forward transaction requires delivery of foreign exchange at some future date
A swap transaction is the simultaneous exchange of one foreign currency for another

8. Spot Transactions
A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day
The settlement date is often referred to as the value date
This is the date when most dollar transactions are settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York

9. Outright Forward Transactions
This transaction requires delivery at a future value date of a specified amount of one currency for another
The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed
Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months
Terminology typically used is buying or selling forward
A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros

10. Foreign Exchange Rates & Quotations
A foreign exchange quote is a statement of willingness to buy or sell at an announced rate
In the retail market (newspapers and exchange booths), quotes are often given as the home currency price of the foreign currency
Currency Traditional Symbol ISO 4217 Code
U.S. dollar $ USD
European euro € EUR
Great Britain pound £ GBP
Japanese yen ¥ JPY
Mexican peso Ps MXN

11. Foreign Exchange Rates & Quotations
Interbank quotes – professional dealers or brokers may state quotes in one of two ways
The foreign currency price of one dollar
Sfr1.6000/$, read as Swiss francs per dollar
The dollar price of a unit of foreign currency
$0.6250/Sfr, read as dollars per Swiss franc
The former quote is considered to be in “European terms” and the latter is considered to be “American terms”
Almost all European currencies, except two, are quoted the European way
The Pound Sterling and the Euro are the exceptions
Additionally, Australian and New Zealand dollars are also quoted in American terms

12. Foreign Exchange Rates & Quotations
Direct and Indirect Quotes
A direct quote is a home currency price of a unit of a foreign currency
Sfr1.6000/$ is a direct quote in Switzerland
An indirect quote is a foreign currency price in a unit of the home currency
Sfr1.600/$ is an indirect quote in the US,
$0.625/Sfr is a direct quote in the US and an indirect quote in Switzerland

13. Foreign Exchange Rates & Quotations
Interbank quotes are given as a bid and ask
The bid is the price at which a dealer will buy another currency
The ask or offer is the price at which a dealer will sell another currency
For example the bid and ask for spot euros would probably be shown “1.2170/78” on a video screen.
In some cases between professional traders, they may only quote the last two digits of both the bid and ask, “70-78” because they know what the other figures are.

14. Bid, Ask, and Mid-Point Quotations

15. Foreign Exchange Rates & Quotations
Expressing Forward Quotations on a Points Basis
The previously mentioned rates for yen were considered outright quotes
Forward quotes are different and typically quoted in terms of points
A point is the last digit of a quotation, with convention dictating the number of digits to the right of the decimal
Hence a point is equal to of most currencies

16. Foreign Exchange Rates & Quotations
Expressing Forward Quotations on a Points Basis
The yen is quoted only to two decimal points
A forward quotation is not a foreign exchange rate, rather the difference between the spot and forward rates
Example:
Bid Ask
Outright spot: ¥ ¥118.37
Outright forward: ¥ ¥116.97
Plus points (3 months)

17. Exchange Rates: New York Closing Snapshot

18. Exchange Rates: New York Closing Snapshot (cont.)

19. Cross Rates
Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency
Key Currency Cross Rates, Tuesday, January 4, 2011

20. Foreign Exchange Rate Determining/Forecasting
Three basic approaches
Parity conditions
Balance of Payments
Asset market
These are not competing theories but are in fact complementary theories
Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost

21. Determinants of Foreign Exchange Rates

22. Foreign Exchange Rate Determining/Forecasting
Along with an understanding of the theories, an understanding of the complexities of international political economy, societal and economic infrastructures, and random political and social events is needed when viewing the foreign exchange markets
Infrastructure weaknesses were among the major causes of the exchange rate collapses in emerging markets in the late 1990s
Speculation contributed greatly to the emerging market crises. Uncovered interest rate arbitrage caused by extremely low interest rates in Japan coupled with high real interest rates in the US was a problem in the 1990s
Cross-border foreign direct investment and international portfolio investment into emerging markets dried up during the recent crises
Foreign political risks have been much reduced in recent years as capital markets became less segmented from each other and more liquid
Finally, note that most determinants of spot exchange rates are also in turn affected by changes in the spot rate – in other words, they are not only linked but mutually determined

23. Purchasing Power Parity Approach
PPP is the oldest and most widely followed of the exchange rate theories
PPP is embedded within most theories of exchange rate determination
PPP calculations and forecasts have structural differences across countries and significant data challenges in estimation
Many versions of PPP (see chapter 7) but perhaps the relevant for explaining exchange rate values is Relative Purchasing Power Parity which explains that changes in relative prices between countries drive the change in exchange rates over time

24. Balance of Payments (Flows) Approach
Essentially BOP approach says equilibrium exchange rate is achieved when current account inflows match current account outflows
BOP transactions are widely appealing, captured, and reported
Criticism of the BOP approach is that it focuses on flows rather than stocks of money or financial assets
Relative stocks of money or financial assets do not play a role in the theory
Practitioners use BOP but academics largely dismiss it

25. Monetary Approaches
Changes in supply and demand for money largely determine inflation which in turn alter exchange rates
Prices are flexible in both the short and long-run thus, the transmission impact is immediate
Real economic activity influences exchange rates through any alterations in demand for money
Omits a number of important factors for exchange rate determination including:
The failure of PPP to hold in the short to medium term
Money demand appears to be relatively unstable over time
The level of economic activity and the money supply do not appear to be independent

26. Asset Market Approach (Relative Prices of Bonds)
AKA relative price of bonds or portfolio balance approach
argues that exchange rates are determined by supply and demand for a wide variety of assets
Shifts in supply and demand alter exchange rates
Changes in monetary and fiscal policy alter expectations and thus exchange rates
Theories of currency substitution follow the same basis premises of portfolio rebalance framework
The Asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers
In highly developed countries, foreign investors are willing to hold securities and undertake foreign direct investment based primarily on relative real interest rates and the economic outlook of growth & profitability
Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment

27. Asset Market Approach (Relative Prices of Bonds)
Capital market liquidity is particularly important to foreign institutional investors. Cross-border investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired
A country’s economic and social infrastructure is an important indicator of its ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment
Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a country’s securities and for purposes of evaluating foreign direct investment in that country
The credibility of corporate governance practices is important to cross-border portfolio investors. A firm’s poor corporate governance practices can reduce foreign investors 'influence and cause subsequent loss of the firm’s focus on shareholder wealth objectives
Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries with similar characteristics—at least in the eyes of cross-border investors. Contagion can cause an “innocent” country to experience capital flight with a resulting depreciation of its currency
Speculation can both cause a foreign exchange crisis or make an existing crisis worse

28. Currency Market Intervention
Foreign currency intervention, the active management, manipulation, or intervention in the market’s valuation of a country’s currency, is a component of currency valuation and forecast that cannot be overlooked.
“beggar-thy-neighbor,” policy to keep currency values low to aid in exports, may prove inflationary if some goods MUST be imported … e.g. oil
Direct Intervention - This is the active buying and selling of the domestic currency against foreign currencies. This traditionally required a central bank to act like any other trader in the currency market
Coordinated Intervention - in which several major countries, or a collective such as the G8 of industrialized countries, agree that a specific currency’s value is out of alignment with their collective interests
Indirect Intervention - This is the alteration of economic or financial fundamentals which are thought to be drivers of capital to flow in and out of specific currencies
Capital Controls - This is the restriction of access to foreign currency by government. This involves limiting the ability to exchange domestic currency for foreign currency

29. Forecasting in Practice
In addition to the three approaches to forecasting discussed earlier (Parity Conditions, Balance of Payments, Asset Approach) forecasting practitioners also utilize technical analysis
These analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future
The longer time horizon of the forecast, the more inaccurate the forecast is likely to be
The following summarizes the various forecasting periods, regimes and preferred forecasting methods for each

30. Exchange Rate Forecasting Methods

31. Forecasting in Practice
Decades of theoretical and empirical studies show that exchange rates do adhere to the fundamental principles and theories outlined in the previous sections – fundamentals do apply in the long term
Therefore, there is something of a fundamental equilibrium path for a currency’s value
In the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long term fundamental path – this is sometimes referred to as noise

32. Short-Term Noise Versus Long-Term Trends
Although the various theories surrounding exchange rate determination are clear and sound, it may appear on a day-to-day basis that the currency markets do not pay much attention to the theories

33. Forecasting in Practice
The difficulty is understanding which fundamentals are driving markets at which points in time
One example of this relative confusion over exchange rate dynamics is the phenomenon known as overshooting

34. International Parity Conditions
The economic theories which link exchange rates, price levels, and interest rates together are called international parity conditions
These theories may not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted

35. Prices and Exchange Rates
The Law of one price states that all else being equal (no transaction costs) a product’s price should be the same in all markets
Even if prices for a particular product are in different currencies, the law of one price states that
P$  S = P¥
Where the price of the product in US dollars (P$), multiplied by the spot exchange rate (S, yen per dollar), equals the price of the product in Japanese yen (P¥)

36. Prices and Exchange Rates
Conversely, if the prices were stated in local currencies, and markets were efficient, the exchange rate could be deduced from the relative local product prices $

37. Purchasing Power Parity & The Law of One Price
If the Law of One Price were true for all goods, the purchasing power parity (PPP) exchange rate could be found from any set of prices
Through price comparison, prices of individual products can be determined through the PPP exchange rate
This is the absolute theory of purchasing power parity
Absolute PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods

38. Relative Purchasing Power Parity
If the assumptions of absolute PPP theory are relaxed, we observe relative purchasing power parity
This idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between countries over a period of time determines the change in exchange rates
Moreover, if the spot rate rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot rate

39. Relative Purchasing Power Parity (PPP)

40. Relative Purchasing Power Parity
Empirical tests of both relative and absolute purchasing power parity show that for the most part, PPP tends to not be accurate in predicting future exchange rates
Two general conclusions can be drawn from the tests:
PPP holds up well over the very long term but is poor for short term estimates
The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets

41. Exchange Rate Indices: Real and Nominal
In order to evaluate a single currency’s value against all other currencies in terms of whether or not the currency is “over” or “undervalued,” exchange rate indices were created
These indices are formed by trade-weighting the bilateral exchange rates between the home country and its trading partners
The nominal exchange rate index uses actual exchange rates to create an index on a weighted average basis of the value of the subject currency over a period of time

42. Exchange Rate Indices: Real and Nominal
The real effective exchange rate index indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period
Example: The real effective rate for the US dollar (E$ ) is found by multiplying the nominal rate index (E$ ) by the ratio of US dollar costs (C$) over foreign currency costs (CFC)
If changes in exchange rates just offset differential inflation rates – if purchasing power parity holds – all the real effective exchange rate indices would stay at 100
If a rate strengthened (overvalued) or weakened (undervalue) then the index value would be ± 100 R N

43. Exchange Rate Pass-Through
Incomplete exchange rate pass-through is one reason that country’s real effective exchange rate index can deviate from it’s PPP equilibrium point
The degree to which the prices of imported & exported goods change as a result of exchange rate changes is termed pass-through
Example: assume BMW produces a car in Germany and all costs are incurred in euros. When the car is exported to the US, the price of the BMW should be the euro value converted to dollars at the spot rate
Where P$ is the BMW price in dollars, P€ is the BMW price in euros and S is the spot rate €
€/$

44. Exchange Rate Pass-Through
Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium level
If the euro appreciated 20% against the dollar, but the price of the BMW in the US market rose to only $40,000, and not $42,000 as is the case under complete pass-through, the pass-through is partial
The degree of pass-through is measured by the proportion of the exchange rate change reflected in dollar prices
The degree of pass-through in this case is partial, 14.29% ÷ 20.00% or approximately Only 71.0% of the change has been passed through to the US dollar price

45. Exchange Rate Pass-Through

46. Interest Rates and Exchange Rates
Prices between countries are related by exchange rates and now we discuss how exchange rates are linked to interest rates
The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. As a formula, The Fisher Effect is
i = r +  + r 
Where i is the nominal rate, r is the real rate of interest, and  is the expected rate of inflation over the period of time
The cross-product term, r , is usually dropped due to its relatively minor value

47. Interest Rates and Exchange Rates
Applied to two different countries, like the US and Japan, the Fisher Effect would be stated as
i = r +  ; i = r +  $
It should be noted that this requires a forecast of the future rate of inflation, not what inflation has been, and predicting the future can be difficult!

48. Interest Rates and Exchange Rates
The international Fisher effect, or Fisher-open, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries
if we were to use the US dollar and the Japanese yen, the expected change in the spot exchange rate between the dollar and yen should be (in approximate form)
Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates
The international Fisher effect predicts that with unrestricted capital flows, an investor should be indifferent between investing in dollar or yen bonds, since investors worldwide would see the same opportunity and compete it away

49. Interest Rates and Exchange Rates
The Forward Rate
A forward rate is an exchange rate quoted today for settlement at some future date
The forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought or sold forward at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days)
The forward rate is calculated by adjusting the current spot rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies

50. Interest Rates and Exchange Rates
The Forward Rate example with spot rate of Sfr1.4800/$, a 90-day euro Swiss franc deposit rate of 4.00% p.a. and a 90-day euro-dollar deposit rate of 8.00% p.a.
Is Sfr1.4800/$ a direct quote or an indirect quote?
What is the forward premium or discount (in percent) on the swiss franc?

51. Interest Rates and Exchange Rates
The forward premium or discount is the percentage difference between the spot and forward rates stated in annual percentage terms
When stated in indirect terms (foreign currency per home currency units, FC/$) then formula is
The positive sign indicates that the Swiss franc is selling forward at a premium of 3.96% per annum (it takes 3.96% more dollars to get a franc at the 90-day forward rate)
NOTE: For direct quotes ($/FC), then (F-S)/S should be applied

52. Currency Yield Curves and the Forward Premium

53. Interest Rate Parity: Linkage between FX markets
Interest rate parity theory states the difference in the national interest rates for securities of similar risk and maturity should be equal, with opposite sign, to the forward discount or premium for the foreign currency (except for transaction costs)
A US dollar-based investor can “cover” risk with a forward contract to become indifferent between dollar-denominated securities and Swiss franc-denominated securities of similar risk and maturity but different nominal rates

54. Covered Interest Arbitrage (CIA)
Because the spot and forward markets are not always in a state of equilibrium as described by IRP, the opportunity for arbitrage exists
The arbitrageur who recognizes this imbalance can invest in the currency that offers the higher return on a covered basis
This is known as covered interest arbitrage (CIA)
CIA can be described in much the same way as IRP was transacted:

55. Covered Interest Arbitrage (CIA)
Rule of Thumb:
If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher yielding currency.
If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

56. What if the trader doesn’t cover his position?
A deviation from CIA is to leave the position uncovered (ie, to not use a forward contract). Investors borrow in currencies with relatively low interest rates and convert the proceeds into currencies with higher rates
The transaction is “uncovered” because the investor does not sell the currency forward, thus remaining uncovered to any risk of the currency deviating. Consider this example of Yen Carry Trade:

57. Forward Rates as an Unbiased Predictor
If the foreign exchange markets are thought to be “efficient” then the forward rate should be an unbiased predictor of the future spot rate
This is roughly equivalent to saying that the forward rate can act as a prediction of the future spot exchange rate, and it will often “miss” the actual future spot rate, but it will miss with equal probabilities (directions) and magnitudes (distances)

58. International Parity Conditions in Equilibrium

59. Prices, Interest and Exchange Rates in Equilibrium
(A) Purchasing power parity
forecasts the change in the spot rate on the basis of differences in expected rates of inflation
(B) Fisher effect
nominal interest rates in each country are equal to the required real rate of return (r) plus compensation for expected inflation ()
(C) International Fisher effect
the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries
(D) Interest rate parity
the difference in the national interest rates should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs
(E) Forward rate as an unbiased predictor
the forward rate is an efficient predictor of the future spot rate, assuming that the foreign exchange market is reasonably efficient

60. Foreign Exchange Rates & Quotations
Intermarket Arbitrage
Cross rates can be used to check on opportunities for intermarket arbitrage
Example: Assume the following exchange rates are quoted
Citibank $1.2223/€
Barclays Bank $1.8410/£
Dresdner Bank €1.5100/£

61. Foreign Exchange Rates & Quotations
Intermarket Arbitrage
The cross rate between Citibank and Barclays is
This cross rate is not the same as Dresdner’s rate quote of €1.5100/£
Therefore, an opportunity exists for risk-less profit or arbitrage
$1.8410/ = €
1.5062/
$1.2223/ €

62. Intermarket (Triangular) Currency Arbitrage