BA 543BA 543

The Market for Foreign The Market for Foreign Exchange Rate Risk Control Exchange Rate Risk Control

InstrumentsInstruments

By: Gurjot DhaliwalBy: Gurjot Dhaliwal

Foreign Currency MarketsForeign Currency Markets

►Largest Trading Market in the WorldLargest Trading Market in the World►$1.2 Trillion average daily trading $1.2 Trillion average daily trading

volumevolume►Open 24/7Open 24/7

Exchange RatesExchange Rates

►The amount of US dollars necessary to The amount of US dollars necessary to acquire one unit of foreign currency, acquire one unit of foreign currency, and this is the dollar price of one unit and this is the dollar price of one unit of foreign currency; orof foreign currency; or

►The number of units of foreign The number of units of foreign currency necessary to acquire one US currency necessary to acquire one US dollar, or the foreign currency price of dollar, or the foreign currency price of one dollar.one dollar.

Direct QuotesDirect Quotes

►The number of units of a local The number of units of a local currency exchangeable for one unit of currency exchangeable for one unit of a foreign currency.a foreign currency.

►$1/.8152 Euro$1/.8152 Euro

Indirect QuotesIndirect Quotes

►The number of units of a foreign The number of units of a foreign currency that can be exchanged for currency that can be exchanged for one unit of a local currency. one unit of a local currency.

►1 Euro / $1.22681 Euro / $1.2268

Bid – Ask SpreadBid – Ask Spread

► In the floating market currencies are In the floating market currencies are traded just as in the open market with traded just as in the open market with a bid price and an ask price. The a bid price and an ask price. The difference between the two is the bid difference between the two is the bid ask spread. The bid is always given ask spread. The bid is always given first. first.

►An example of a bid ask spread is 1 An example of a bid ask spread is 1 Euro = $1.33-42. This means that Euro = $1.33-42. This means that there is a bid price of $1.33 and the there is a bid price of $1.33 and the sellers are asking $1.42 per Euro.sellers are asking $1.42 per Euro.

Currency RiskCurrency Risk

► Is the risk that a currency’s value may Is the risk that a currency’s value may change adverselychange adversely

►Also termed foreign exchange riskAlso termed foreign exchange risk

Exchange Rate RegimesExchange Rate Regimes

► Fixed Rates – A country establishes a fixed Fixed Rates – A country establishes a fixed band in which a currency is allowed to trade band in which a currency is allowed to trade relative to another countries currency.relative to another countries currency.

► Floating Rates – A country allows its Floating Rates – A country allows its currency to move according to market currency to move according to market conditions.conditions.

►Managed Floating Rates – A country allows Managed Floating Rates – A country allows its currency limited movement according to its currency limited movement according to the market but actively purchases currency the market but actively purchases currency to control where its currency moves.to control where its currency moves.

Purchasing Power ParityPurchasing Power Parity► Consumer Price IndexConsumer Price IndexBrief Explanation of the CPI The Consumer Price Index (CPI) is a measure of the average change in prices Brief Explanation of the CPI The Consumer Price Index (CPI) is a measure of the average change in prices

over time of goods and services purchased by households. The Bureau of Labor Statistics publishes CPIs over time of goods and services purchased by households. The Bureau of Labor Statistics publishes CPIs for two population groups: (1) the CPI for Urban Wage Earners and Clerical Workers (CPI-W), which for two population groups: (1) the CPI for Urban Wage Earners and Clerical Workers (CPI-W), which covers households of wage earners and clerical workers that comprise approximately 32 percent of the covers households of wage earners and clerical workers that comprise approximately 32 percent of the total population and (2) the CPI for All Urban Consumers (CPI-U) and the Chained CPI for All Urban total population and (2) the CPI for All Urban Consumers (CPI-U) and the Chained CPI for All Urban Consumers (C-CPI- U), which cover approximately 87 percent of the total population and include in Consumers (C-CPI- U), which cover approximately 87 percent of the total population and include in addition to wage earners and clerical worker households, groups such as professional, managerial, and addition to wage earners and clerical worker households, groups such as professional, managerial, and technical workers, the self- employed, short-term workers, the unemployed, and retirees and others not technical workers, the self- employed, short-term workers, the unemployed, and retirees and others not in the labor force. The CPIs are based on prices of food, clothing, shelter, and fuels, transportation fares, in the labor force. The CPIs are based on prices of food, clothing, shelter, and fuels, transportation fares, charges for doctors' and dentists' services, drugs, and other goods and services that people buy for day-charges for doctors' and dentists' services, drugs, and other goods and services that people buy for day-to-day living. Prices are collected in 87 urban areas across the country from about 50,000 housing units to-day living. Prices are collected in 87 urban areas across the country from about 50,000 housing units and approximately 23,000 retail establishments- department stores, supermarkets, hospitals, filling and approximately 23,000 retail establishments- department stores, supermarkets, hospitals, filling stations, and other types of stores and service establishments. All taxes directly associated with the stations, and other types of stores and service establishments. All taxes directly associated with the purchase and use of items are included in the index. Prices of fuels and a few other items are obtained purchase and use of items are included in the index. Prices of fuels and a few other items are obtained every month in all 87 locations. Prices of most other commodities and services are collected every every month in all 87 locations. Prices of most other commodities and services are collected every month in the three largest geographic areas and every other month in other areas. Prices of most goods month in the three largest geographic areas and every other month in other areas. Prices of most goods and services are obtained by personal visits or telephone calls of the Bureau's trained representatives. and services are obtained by personal visits or telephone calls of the Bureau's trained representatives. In calculating the index, price changes for the various items in each location are averaged together with In calculating the index, price changes for the various items in each location are averaged together with weights, which represent their importance in the spending of the appropriate population group. Local weights, which represent their importance in the spending of the appropriate population group. Local data are then combined to obtain a U.S. city average. For the CPI-U and CPI-W separate indexes are also data are then combined to obtain a U.S. city average. For the CPI-U and CPI-W separate indexes are also published by size of city, by region of the country, for cross-classifications of regions and population-size published by size of city, by region of the country, for cross-classifications of regions and population-size classes, and for 27 local areas. Area indexes do not measure differences in the level of prices among classes, and for 27 local areas. Area indexes do not measure differences in the level of prices among cities; they only measure the average change in prices for each area since the base period. For the C-cities; they only measure the average change in prices for each area since the base period. For the C-CPI-U data are issued only at the national level. It is important to note that the CPI-U and CPI-W are CPI-U data are issued only at the national level. It is important to note that the CPI-U and CPI-W are considered final when released, but the C-CPI-U is issued in preliminary form and subject to two annual considered final when released, but the C-CPI-U is issued in preliminary form and subject to two annual revisions. The index measures price change from a designed reference date. For the CPI-U and the CPI-revisions. The index measures price change from a designed reference date. For the CPI-U and the CPI-W the reference base is 1982-84 equals 100.0. The reference base for the C-CPI-U is December 1999 W the reference base is 1982-84 equals 100.0. The reference base for the C-CPI-U is December 1999 equals 100. An increase of 16.5 percent from the reference base, for example, is shown as 116.5. This equals 100. An increase of 16.5 percent from the reference base, for example, is shown as 116.5. This change can also be expressed in dollars as follows: the price of a base period market basket of goods change can also be expressed in dollars as follows: the price of a base period market basket of goods and services in the CPI has risen from $10 in 1982-84 to $11.65. and services in the CPI has risen from $10 in 1982-84 to $11.65.

Purchasing Power ParityPurchasing Power Parity►Consumer Price IndexConsumer Price Index►Brief Explanation of the CPI - The Brief Explanation of the CPI - The

Consumer Price Index (CPI) is a Consumer Price Index (CPI) is a measure of the average in prices over measure of the average in prices over time of goods and services purchased time of goods and services purchased by households. by households.

CPICPI► It is a price index which tracks the prices It is a price index which tracks the prices

of a specified set of consumer goods and of a specified set of consumer goods and services, providing a measure of inflationservices, providing a measure of inflation

Purchasing Power ParityPurchasing Power Parity

►Consumer Price Consumer Price IndexIndex

►Big Mac Index Big Mac Index

Purchasing Power ParityPurchasing Power Parity

Big Mac IndexBig Mac Index

As of publication a Big Mac in the United States cost $2.90. A Big Mac in China cost $1.26. Therefore the implied PPP 3.59. This can be compared against the current differences in currency valuations and showed that the Chinese Yuan was undervalued by 57%. This is an example of why most countries are pressuring China to allow the Yuan to float.

Purchasing Power ParityPurchasing Power Parity

►Consumer Price IndexConsumer Price Index►Big Mac IndexBig Mac Index►Starbucks Latte IndexStarbucks Latte Index

Cross RatesCross Rates

►Comparison of two foreign currencies Comparison of two foreign currencies via a third currency such as the dollarvia a third currency such as the dollar

Triangular ArbitrageTriangular Arbitrage

►An arbitrage strategy employed to An arbitrage strategy employed to take advantage of cross rate take advantage of cross rate mispricing between the U.S. dollar and mispricing between the U.S. dollar and the two foreign currencies the two foreign currencies

Triangular Arbitrage ExampleTriangular Arbitrage Example

►Euro dollar Rate: .8 Euro / $Euro dollar Rate: .8 Euro / $►Yen dollar Rate: 122 Yen / $Yen dollar Rate: 122 Yen / $► Implied Cross Rate: 122 Yen / .8 Euro Implied Cross Rate: 122 Yen / .8 Euro

= 152.5 Yen/Euro= 152.5 Yen/Euro►Yen Euro Rate: 140Yen Euro Rate: 140►Because there is a difference between Because there is a difference between

the actual rate of 140 and the implied the actual rate of 140 and the implied rate of 152.5 there exists an rate of 152.5 there exists an opportunity for arbitrageopportunity for arbitrage

Triangular Arbitrage Example Triangular Arbitrage Example Cont.Cont.

► A US investor A US investor borrows $100 borrows $100 million. This would million. This would be used to buy 12.2 be used to buy 12.2 billion Yen.billion Yen.

$100 Million US

12.2 billion Yen

122 Yen / $

Triangular Arbitrage Example Triangular Arbitrage Example Cont.Cont.

► A US investor borrows A US investor borrows $100 million. This $100 million. This would be used to buy would be used to buy 12.2 billion Yen.12.2 billion Yen.

► Trade the 12.2 billion Trade the 12.2 billion Yen for Euro’s at the Yen for Euro’s at the market rate of 140 market rate of 140 Yen / Euro yielding Yen / Euro yielding 87.14 million Euro’s.87.14 million Euro’s.

$100 Million US

12.2 billion Yen

122 Yen / $

140 Euro / Yen

87.14 Million Euro

Triangular Arbitrage Example Triangular Arbitrage Example Cont.Cont.

► A US investor borrows A US investor borrows $100 million. This $100 million. This would be used to buy would be used to buy 12.2 billion Yen.12.2 billion Yen.

► Trade the 12.2 billion Trade the 12.2 billion Yen for Euro’s at the Yen for Euro’s at the market rate of 140 market rate of 140 Yen / Euro yielding Yen / Euro yielding 87.14 million Euro’s.87.14 million Euro’s.

► The 87.14 million The 87.14 million Euros would then be Euros would then be traded back to US traded back to US dollars at .8 Euro / $ dollars at .8 Euro / $ yielding $108.93 yielding $108.93 Million Million

$100 Million US

12.2 billion Yen

122 Yen / $

140 Euro / Yen

87.14 Million Euro

.8 Euro / $

$108.93 Million

Triangular Arbitrage Example Triangular Arbitrage Example Cont.Cont.

► A US investor borrows A US investor borrows $100 million. This would $100 million. This would be used to buy 12.2 billion be used to buy 12.2 billion Yen.Yen.

► Trade the 12.2 billion Yen Trade the 12.2 billion Yen for Euro’s at the market for Euro’s at the market rate of 140 Yen / Euro rate of 140 Yen / Euro yielding 87.14 million yielding 87.14 million Euro’s.Euro’s.

► The 87.14 million Euros The 87.14 million Euros would then be traded back would then be traded back to US dollars at .8 Euro / $ to US dollars at .8 Euro / $ yielding $108.93 Million.yielding $108.93 Million.

► The investor would then The investor would then repay the $100 million. repay the $100 million. The investor keeps the The investor keeps the $8.93 Million profit, or $8.93 Million profit, or 8.93%.8.93%.

$100 Million US

12.2 billion Yen

122 Yen / $

140 Euro / Yen

87.14 Million Euro

.8 Euro / $

$108.93 Million

$8.93 Million Profit

►This can be double checked by This can be double checked by measuring the difference between the measuring the difference between the implied and actual cross rates. implied and actual cross rates.

►(152.5 – 140)/ 140 = 8.93%(152.5 – 140)/ 140 = 8.93%►$100 Million * 8.93% = $8.93 Million $100 Million * 8.93% = $8.93 Million

Profit Profit

Triangular Arbitrage Example Triangular Arbitrage Example Cont.Cont.