1. International Finance FIN456 ♦ Fall 2012 Michael Dimond

2. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Geographic Extent of the Market

4. Michael Dimond School of Business Administration Geographic Extent of the Market

5. Michael Dimond School of Business Administration Functions of the FOREX 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

6. Michael Dimond School of Business Administration Market Participants 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 –Individuals and firms conducting commercial or investment transactions –Speculators and Arbitrageurs –Central banks and treasuries –Foreign exchange brokers

7. Michael Dimond School of Business Administration Bank and Non-bank Dealers These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price Competition among dealers narrows the spread between the bid and offer rate contributing to the market’s efficiency Dealers on behalf of large int’l banks often act as market makers, buy or sell these currencies without necessarily having a counterpart with which to unload the “inventory” They trade amongst other banks and dealers in order to keep their inventory levels at manageable levels Currency trading is profitable and often contributes between 10% - 20% of a banks’ average net income Small- to medium-sized banks participate in the interbank market but rarely act as market makers

8. Michael Dimond School of Business Administration Individuals and Firms Individuals and firms conduct transactions for commercial and investment purposes. For example: –Importers –Exporters –Portfolio investors –MNCs –Tourists Some of these participants use the market to hedge foreign exchange rate risk

9. Michael Dimond School of Business Administration Speculators and Arbitrageurs Speculators and arbitrageurs seek to profit from trading in the market itself They operate for their own interest, without need or obligation to serve clients or ensure a continuous market Speculators seek all their profit from exchange rate changes Arbitrageurs try to profit from simultaneous differences in exchange rates in different markets A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks

10. Michael Dimond School of Business Administration Central Banks and Treasuries Central banks and treasuries use the market to acquire or spend their country’s currency reserves as well as to influence the price at which their own currency trades They may act to support the value of their currency because of their government’s policies or obligations or because of commitments entered through joint float agreements such as the European Monetary System (EMS) Consequently their motive is not to profit but rather influence the foreign exchange value of their currency in a manner that will benefit their interests

11. Michael Dimond School of Business Administration 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

12. Michael Dimond School of Business Administration Foreign Exchange Settlement in Europe

13. Michael Dimond School of Business Administration 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

14. Michael Dimond School of Business Administration 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

15. Michael Dimond School of Business Administration 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

16. Michael Dimond School of Business Administration Swap Transactions A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Both purchase and sale are conducted with the same counterpart A common type of swap is a spot against forward –The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market –Since this transaction occurs at the same time and with the same counterpart, the dealer incurs no exchange rate exposure

17. Michael Dimond School of Business Administration Swap Transactions Forward-forward swaps – A dealer sells £20,000 forward for dollars for delivery in two months at $1.8420/£ and simultaneously buys £20,000 forward for delivery in three months at $1.8400/£ –The difference between the buying and selling price is equivalent to the interest rate differential –Thus a swap can be viewed as a technique for borrowing another currency on a fully collateralized basis

18. Michael Dimond School of Business Administration Swap Transactions Non-deliverable forwards (NDFs) – NDFs possess the same characteristics as traditional forward contracts except that they are settled only in US dollars and the foreign currency being sold or bought forward is not delivered –The dollar-settlement feature reflects the fact that NDFs are contracted offshore and are beyond the reach and regulatory frameworks of the home country governments –Pricing of NDFs reflects basic interest rate differentials

19. Michael Dimond School of Business Administration 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 forward transactions at $475 bn/day –Swaps at $1,765 bn/day

20. Michael Dimond School of Business Administration Size of the FOREX Market The United Kingdom (London) and the United States (New York) make up roughly 55% of the foreign exchange market 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 Currency exchanges paired with the U.S. Dollar

21. Michael Dimond School of Business Administration 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

22. Michael Dimond School of Business Administration 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 1.600 Swiss francs per dollar –The dollar price of a unit of foreign currency $0.6250/Sfr, read as 0.625 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

23. Michael Dimond School of Business Administration 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

24. Michael Dimond School of Business Administration 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.

25. Michael Dimond School of Business Administration Bid, Ask, and Mid-Point Quotations

26. Michael Dimond School of Business Administration 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 0.0001 of most currencies

27. Michael Dimond School of Business Administration BidAsk Outright spot: ¥118.27 ¥118.37 Outright forward: ¥116.84 ¥116.97 Plus points (3 months) -1.43 -1.40 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:

28. Michael Dimond School of Business Administration Foreign Exchange Rates & Quotations Forward Quotations in Percentage Terms –Forward quotations may also be expressed as the percent-per- annum deviation from the spot rate This is similar to the forward discount or premium calculated earlier –The important thing to remember is which currency is being used as the home or base currency For indirect quotes (i.e. quote expressed in foreign currency terms), the formula is

29. Michael Dimond School of Business Administration Foreign Exchange Rates & Quotations Forward Quotations in Percentage Terms –For direct quotes (i.e. quote expressed in home currency terms), the formula is

30. Michael Dimond School of Business Administration ¥ Foreign Exchange Rates & Quotations Forward Quotations in Percentage Terms –Example: Indirect quote –Example: Direct quote

31. Michael Dimond School of Business Administration Exchange Rates: New York Closing Snapshot

32. Michael Dimond School of Business Administration Exchange Rates: New York Closing Snapshot (cont.)

33. Michael Dimond School of Business Administration Cross Rates –Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency –Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (MXP) and Japanese yen (¥) are quoted in US dollars Assume the following quotes: –What is the cross rate of yen to pesos? Japanese yen ¥110.73/$ Mexican pesoMXP 11.4456/$ Foreign Exchange Rates & Quotations

34. Michael Dimond School of Business Administration Key Currency Cross Rates, Tuesday, January 4, 2011

35. Michael Dimond School of Business Administration Citibank $1.2223/€ Barclays Bank$1.8410/£ Dresdner Bank€1.5100/£ 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

36. Michael Dimond School of Business Administration £ £ € € 1.5062/ $1.2223/ $1.8410/  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

37. Michael Dimond School of Business Administration Triangular Arbitrage by a Market Trader

38. Michael Dimond School of Business Administration 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

39. Michael Dimond School of Business Administration Determinants of Foreign Exchange Rates

40. Michael Dimond School of Business Administration 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

41. Michael Dimond School of Business Administration 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

42. Michael Dimond School of Business Administration 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

43. Michael Dimond School of Business Administration 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

44. Michael Dimond School of Business Administration 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

45. Michael Dimond School of Business Administration Asset Market Approach (Relative Prices of Bonds) 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 (as per the previous exhibit) 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 outlook for economic growth and profitability Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment

46. Michael Dimond School of Business Administration 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

47. Michael Dimond School of Business Administration Asset Market Approach (Relative Prices of Bonds) 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

48. Michael Dimond School of Business Administration 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. Central bank’s driving consideration – inflation or unemployment? “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

49. Michael Dimond School of Business Administration Currency Market Intervention 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 –The Chinese regulation of access and trading of the Chinese yuan is a prime example over the use of capital controls over currency value.

50. Michael Dimond School of Business Administration 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

51. Michael Dimond School of Business Administration Exchange Rate Forecasting Methods

52. Michael Dimond School of Business Administration 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

53. Michael Dimond School of Business Administration 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 Short-Term Noise Versus Long-Term Trends

54. Michael Dimond School of Business Administration 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