Week2:InternationalFinancialMarkets&ExchangeRateDeterminants
Ch3:InternationalFinancialMarkets
ForeignExchangeMarket• Allowsfortheexchangeofonecurrencyforanother• Exchangeratespecifiestherateatwhichonecurrencycanbeexchangedforanother
HistoryofForeignExchange
• GoldStandard(1876–1913)o Eachcurrencywasconvertibleintogoldataspecifiedrateo SuspendedwhenWW1beganin1914
• AgreementsonFixedExchangeRateso BrettonWoodsAgreement1944-1971o SmithsonianAgreement1971-1973
• FloatingExchangeRateSystemo Widelytradedcurrencieswereallowedtofluctuateinaccordancewith
marketforcesForeignExchangeTransactions
• Theoverthecountermarketisthetelecommunicationsnetworkwherecompaniesnormallyexchangeonecurrencyforanother
• FOREIGNEXCHANGEDEALERSo Intermediariesintheforeignexchangemarket
• SPOTMARKETo Aforeignexchangetransactionsforimmediateexchangeissaidtotradein
SPOTMARKETatSPOTRATE• SpotMarketStructure:
o Tradingbetweenbanksoccurintheinterbankmarket• UseoftheUSDinspotmarkets
o USDiscommonlyacceptedmediumofexchangeinthespotmarket• SPOTMARKETTIMEZONES
o Conductedonlyduringnormalbusinesshoursinagivenlocationo Atanygiventimeonaweekday,somewhereintheworldabankisopenand
readytoaccommodateforeignexchangerequests• SPOTMARKETLIQUIDITY
o MorebuyersandsellersmeansmoreliquidtyForeignExchangeQutations
• Atanygivenpointintime,abank’sbid(buy)quoteforaforeigncurrencywillbelessthanitsask(sell)quote
• Bid/Askspreadofbanks;thebid/askspreadcoversthebank’scostofconductingforeignexchangetransactions
• ComparisonofBid/AskSpreadamongcurrencies;
•
• FactorsthataffecttheSpread
• Ordercostso Costsofprocessingorders,includingclearingcostsandthecostsofrecording
transactions• Remuneration
o Forprovisionofservice• Inventorycosts
o Costsofmaintaininganinventoryofaparticularcurrency• Competition
o Themoreintensethecompetition,thesmallerthespreadquotedbyintermediaries
• Volumeo Currenciesthathavealargetradingvolumearemoreliquidbecausethere
arenumerousbuyersandsellersatanygiventime• CurrencyRisk
o Economicorpoliticalconditionsthatcausethedemandforandsupplyofthecurrencytochangeabruptly
InterpretingForeignExchangeQuotationsDirectvsIndirectquotationsatonepointintime
• DirectQuotationo Representsthevalueoftheforeigncurrencyindollars(numberofdollarsper
currency)o Example:$1.40perEuro
• IndirectQuotationo Representsthenumberofunitsofaforeigncurrencyperdollaro Example:Euro0.7143/Dollaro IndirectQuotation=1/DirectQuotation
Directvsindirectexchangerateovertime
• WhentheEUROisappreciatingagainstthedollar(basedonupwardmovementofthedirectexchangerateoftheeuro),theindirectexchangerateoftheeuroisdeclining
• WhentheEUROISDEPRECIATING(basedonadownwardmovementofthedirectexchangerate)againstthedollar,theindirectexchangerateisrising
Sourceofexchangeratequotations
• YahooFinance• Onlinesources(oanda.com)
CrossExchangeRates
• Crossexchangerateo Theamountofoneforeigncurrencyperunitofanotherforeigncurrency
• Example:o ValueofPeso=$0.07o ValueofCanadianDollar=$0.70
o ValueofpesoinC$=(ValueofPesoin$/ValueofC$in$)o =$0.07/$0.70=C$0.10
HowFinancialMarketsServeMNCsCorporatefunctionsthatrequireforeignexchangemarkets
• foreigntradewithbusinessclients• directforeigninvestment,ortheacquisitionofforeignrealassets• short-terminvestmentorfinancinginforeignsecurities• longer-termfinancingintheinternationalbondorstockmarkets
TheForeignExchangeMarket• “Traditional”turnover5.3trillionUSDperday(April2013)• 5primaryFXtradingcentres:
o UK(41%)o US(19%)o Singapore(6%)o Japan(6%)o HongKongSAR(4%)
• Dealerso FinancialinstitutionsthatactivelyparticipateinFXmarkets(tradingFXfor
themselvesortheircustomers)• OtherFinancialInstitutions
o Non-dealerinstitutions• Non-financialcustomers
o EveryoneelseReportedFXTurnover
• Dealer->Dealer(InterbankMarket)39%• Dealer->OtherFinancialInstitution53%
o Small/RegionalBanks24%o InstitutionalInvestors11%o HedgeFunds11%o OtherInstitutions6%o Centralbanks1%
• Dealer->Non-financialcustomers9%FXExecution
• Voice-directo Phone/notintermediated
• Voice-indirecto Phone,intermediatedbya3rdparty
• Electronic-Directo Executedoveranelectronicmedium,notintermediated
§ Singlebankelectronictradingsystem
§ Otherdirectelectronicmeans• ElectronicIndirect
o Executedoveranelectronicmedium,intermediated§ Interdealermarket;ReutersEikon/EBS§ Multibankdealingsystems
ForeignExchangeMarketTurnover
• MajorCurrencies(173%/200%)o USD87%o EUR33%o JPY23%o GBP11%o AUD9%o CHF5%o CAD5%
• OtherCurrencieso 2%;MXN,CNY,NZD,SEK,RUBo 1%:HKD,NOK,SGD,TRY,KRW,ZAR,BRL,INR,DKK,PLN
• Remainingcurrencies<0.5%
ExchangeRateQuotations• Noorganisationdecidesforeignexchangetradingstandards.• However,particularmarketconventionsarefollowed:
o ISO4217(Currencycode)o ASpotQuotation
§ UNIT*/CURRENCY§ AUD/USD§ 1AUD=??USD
o (*itismarketconventionforthecurrencybeforetheslashtorepresenttheunit(basecurrency))
• Currencybeforetheslashistheunit• CannotreadUNITDIVIDEDBYCURRENCY• AUD/USDtellsyouthatAUDistheunit• UNITWRITTENFIRST
ExchangeratequotationsineconomictextbooksandCFA
• AlleconomictextbookspresentquotationsinaformwhereA/B(representsAdividedbyB)
• CFALevel1,Book2,Reading21:o A/BreferstothenumberofunitsofcurrencyAthatoneunitofcurrencyB
willbuy• FINA3326=USEMARKETCONVETIONofUnit/Currency• PotentialStrategytoeliminateconfusion1) Thinkwhatisthesourceofthequotation(A/BtypicallymeansBdivA,butitcan
meanAdivB)
2) Converttoamathematicalformof
• What1Aussieisworth• 1AUDisworth=0.7534
• Buypricefirst,sellpricesecond• Buyquoteshouldbelowerthansellquote
o 0.7874isactuallylower(INDIRECTFORM)o Actualquote(buy)=1/0.7874=1.27o Actualquote(sell)=1/0.7142=1.40
• YoucantellitsINDIRECTifBUY>SELL• (remember;buyLOW,sellHIGH)• Pricethedealerispreparedtobuy
GOLDisquoteddirectly(Buy<Sell)
BidandAskQuotes
• TheBID–pricetheMARKETMAKERofferstoBUYcurrencyfromtheCUSTOMER• TheASK–pricetheMARKETMAKERofferstoSELLcurrencytothecustomer
o IfyouarebuyingthenyouhavetousetheASKpriceo Pricetheyarewillingtoselltoyou
• Point
o ThelastsignificantdigitBid/AskSpread
• 0.7874/0.7142• Thebid/askspreadis732points(pips)
o Representsdealersprofit• Acommissionisnotnormallycharged(largetrades)• Smalltransactions
o Chargearetailfee• Dealersprofitfromthebid/askspread
o Thebid/askspreadrepresentstheCOSTOFIMMEDIACYo Quotesareadjustedveryquicklyinresponsetonews,expectationsand
tradingstrategies• Determinantsofthebid/askspread
o Liquidityo Breadthanddepth(howmuchtradingisgoingonforthatcurrency)
DirectvsIndirect• DirectQuote
o AmountofHOMECURRENCYNEEDEDtoBUYaUNITOFFOREIGNCURRENCYo Foreigncurrency=thecurrencythedealerisofferingtobuyandsell
• Indirecto AmountofFOREIGNCURRENCYBOUGHTWITHaunitofHOMECURRENCY
• AustraliaisquotedinINDIRECTTERMS• Note:$1.0876/78iscommonlyused
o Thisnotationhasasimplicityadvantagewhenthespreadissmallo Eg1.0216/26or0.7827/30
IndirectQuotation Indirect(UnitnotFC)AUD/USD 0.7874/0.7142
USD=FC• ThemarketmakerofferstobuyUSDatarateof
o 0.7874USD=1AUDo 1USD=1.2700AUD
• ThemarketmakerofferstosellUSDatarateof
o 0.7142USD=1AUDo 1USD=1.4002AUD
DirectQuotation Direct(Unit=FC)USD/AUD 1.2700/1.4002
USD=FC• ThemarketmakerofferstobuyUSDatarateof
o 1.2700AUD=1USDo 1AUD=0.7874
• ThemarketmakerofferstosellUSDatarateofo 1.4002AUD=1USDo 1AUD=0.7142USD
DirectvsIndirect Direct IndirectAUD/USD 0.7142/0.7874
AUD=FC0.7874/0.7142USD=FC
USD/AUD 1.2700/1.4002USD=FC
1.4002/1.2700AUD=FC
• Equivalentquotations• Locationofthequotation–unimportant
AmericanvsEuropeanterms• Americanterms
o NumberofUSdollarsperunitofforeigncurrency• EuropeanTerms
o NumberofforeigncurrencyunitsperUSDUsingtheQuotation
• 1.YouhaveAUD1millionandwantUSdollarso 0.7874/0.7142
• 2.Doyouusethebidorask?o Whatdoyouendupwith?o Whattypeofquotationdowehave?
• ThemarketmakerofferstobuyUSDatarateofexchangeofo 1AUD=0.7874USD
• ThemarketmakerofferstosellUSDatarateofexchangeofo 1AUD=0.7142USD
• 3.AUD1mx0.7142=USD714,200Aroundtrip
• 1.YouhaveUSD714,200andwanttocovertitbacktoAussiedollars o 0.7874/0.7142
• 2.Doyouwantthebidortheask?o WhatdoIwanttodowiththequotedcurrency?o ThemarketmakerofferstobuyUSDatarateofexchangeof
§ 1AUD=0.7874o ThemarketmakerofferstosellUSDatarateofexchangeof
§ 1AUD=0.7142USD• 3.USD714,200/0.7874=AUD907,036
-You’vejustcompleteda‘roundtrip’andlost>9%onthisretailtransaction-Reality:With1mUSDyoucouldachievemorecompetitiverates
CrossRates
• Crossexchangerates:o Expresstherelationbetweentwocurrenciesthateachdifferfromone’s
basecurrency• IntheUS,thetermcrossexchangeratereferstotherelationshipbetweentwonon-
dollarcurrencies• TheUSDistradedin87%ofallFXtransactions(volumemeasure)
o Thiswas90%in2001• INTERBANKMARKET
o Notallpairsaretraded(increasedliquidity)o IwanttoconvertAUDtoSGD,viaUSD
§ 1AUD->USD->SGDo (ifnotdirectlyofferedintheinterbankmarket)o usethisbecauseofliquidity
CrossRateExample
• AUD/USD0.7293/0.7297• USD/SGD1.3700/1.3701• (DIRECTQUOTEONTHEAUDandSDG)
1AUD->0.7293USD-> (0.7293)(1.3700)SGD 0.9991SGD
• AUD/SGD• BidorAsk?Dependsonhowwewanttowritethisquotation
o DirectQuotation->Bid(thedealerisbuyingtheunitinourseriesoftransactions)
o Ifwewantedtowritethisasanindirectquotation,wecouldcallthisanaskquote(thedealerissellingyouthecounter).DealerSell=Ask
• Or,ConvertingSGDtoAUDviaUSD1SGD->(1/1.3701)USD-> (1/1.3701)(1/0.7297)AUD 1.0002AUD
• SGD/AUD(Direct=BID)DirectCrossRate
Chapter4:ExchangeRateDetermination
MeasuringExchangeRatemovements• Depreciation:declineinacurrency’svalue• Appreciation:increaseinacurrency’svalue• Comparingforeigncurrencyspotratesovertwopointsintime,SandSt-1
o o ApositivepercentchangeindicatesthatthecurrencyhasAPPRECIATEDo Anegativepercentchangeindicatesthatithasdepreciation
ExchangeRateEquilibrium• Theexchangeraterepresentsthepriceofacurrency,ortherateatwhichone
currencycanbeexchangedforanother• DEMANDFORACURRENCYincreaseswhenthevalueofthecurrencydecreases,
leadingtoadownwardslopingdemandschedule(SeeExhibit4.2)• SUPPLYOFACURRENCYFORSALEincreaseswhenthevalueofthecurrency
increases,leadingtoanupwardslopingsupplyschedule(EXHIBIT4.3)• EQUILIBIRUMequatesthequantityofpoundsdemandedwiththesupplyofpounds
forsale(EXHIBIT4.4)
FactorsthatInfluenceexchangerates• Theequilibriumexchangeratewillchangeovertimeassupplyanddemandschedule
changes
• RELATIVEINFLATIONRATESo IncreasesinUSinflationleadstoincreaseinUSdemandforforeigngoods,an
increaseindemandforforeigncurrency,andanincreaseintheexchangeratefortheforeigncurrency
o Morepurchasingofimports->requiremoreforeigncurrency->increasedemandofforeigncurrency->increaseintheexchangerate
o Supplywillmovetotheleft
o Valueofthepoundhasincreased(notasmanyUSDbeingbought)o ImpactofRisingUSInflationontheEquilibriumvalueoftheBritishPound:
• Relative Interest Rates
o Increase in US rates leads to increase in demand for US deposits and a decrease in demand for foreign deposits, leading to an increase in demand for dollars and an increased exchange rate for the dollar
o Invest those funds domestically o Not much demand to buy pounds (shift in demand to the left) – more attractive
to invest domestically o If you’re in the UK (UK interest rates the same), more attractive to buy USD
and invest at higher rate o Sell pound and buy USD o More supply of pound o Price of pound has fallen o Impact of rising US interest rates on the equilibrium value of the British
Pound
• Real Interest Rates o Fisher Effect o Real Interest Rate = Nominal Interest Rate – Inflation Rate
Argument that high interest rates pushes up the value of the currency today, but adds pressure in the future market when repayments/returns are being paid out.
• RELATIVEINCOMELEVELSo IncreaseinUSincomeleadstoincreasedinUSdemandforforeigngoodsand
increaseddemandforforeigncurrencyrelativetothedollarandanincreaseintheexchangeratefortheforeigncurrency
o ImpactofrisingUSincomelevelsonequilibriumvalueoftheBritishPound
• • GOVERNMENT CONTROLS via:
o Imposing foreign exchange barriers o Imposing foreign trade barriers o Intervening in foreign exchange markets o Affecting macro variables such as inflation, interest rates and income levels
Expectations
• IMPACTOFFAVOURABLEEXPECTATIONSo Ifinvestorsexpectinterestratesinonecountrytorise,theymayinvestin
thatcountryleadingtoariseinthedemandforforeigncurrencyandanincreaseintheexchangerateforforeigncurrency
• IMPACTOFUNFAVOURABLEEXPECTATIONSo Speculatorscanplacedownwardpressureonacurrencywhentheyexpectit
todepreciate• IMPACTOFSIGNALSONCURRENCYSPECULATION
o Speculatorsmayoverreacttosignalscausingcurrencytobetemporarilyovervaluedorundervalued
• InteractionofFactors:o Somefactorsplaceupwardpressurewhileotherfactorsplacedownward
pressure
• INFLUENCEOFFACTORSACROSSMULTIPLECURRENCYMARKETS
o CommonforEuropeancurrenciestomoveinthesamedirectionagainstthedollar
• INFLUENCEOFLIQUIDITYONEXCHANGERATEADJUSTMENTo Ifacurrency’sspotmarketisliquidthenitsexchangeratewillnotbehighly
sensitivetoasinglelargepurchaseorsale
MovementsinCrossExchangeRates• IfcurrenciesAandBmoveinthesamedirection,thereisnochangeinthecross
exchangerate• WhencurrencyAappreciatesagainstthedollarbyagreater(smaller)degreethan
currencyB,thencurrencyAappreciates(depreciates)againstB• WhencurrencyAappreciates(depreciates)againstthedollar,whilecurrencyBis
unchangedagainstthedollar,currencyAappreciates(depreciates)againstcurrencyBbythesamedegreeasitappreciates(depreciates)againstthedollar
Howforcesaffectthecrossexchangerate
CapitalisingonExpectedExchangeRateMovements• INSTITUTIONALSPECULATIONBASEDONEXPECTEDAPPRECIATION
o Whenfinancialinstitutionsbelievethatacurrencyisvaluedlowerthanitshouldbeintheforeignexchangemarket,theymayinvestinthatcurrencybeforeitappreciates
• INSTITUTIONALSPECULATIONBASEDONEXPECTEDDEPRECIATIONo Iffinancialinstitutionsbelievethatacurrencyisvaluedhigherthanitshould
beintheforeignexchangemarket,theymayborrowfundsinthatcurrencyandconvertittotheirlocalcurrencynowbeforethecurrency’svaluedeclinestoitsproperlevel
• SPECULATIONBYINDIVIDUALSo Individualscanspeculateinforeigncurrencies
Summary• Exchangeratemovementsarecommonlymeasuredbythepercentagechangein
theirvaluesoveraspecifiedperiod,suchasamonthorayear.MNCscloselymonitor
exchangeratemovementsovertheperiodinwhichtheyhavecashflowsdenominatedintheforeigncurrenciesofconcern.
• Theequilibriumexchangeratebetweentwocurrenciesatanytimeisbasedonthedemandandsupplyconditions.Changesinthedemandforacurrencyorthesupplyofacurrencyforsalewillaffecttheequilibriumexchangerate.
• Thekeyeconomicfactorsthatcaninfluenceexchangeratemovementsthroughtheireffectsondemandandsupplyconditionsarerelativeinflationrates,interestrates,andincomelevels,andgovernmentcontrols.Whenthesefactorsleadtoachangeininternationaltradeorfinancialflows,theyaffectthedemandforacurrencyorthesupplyofcurrencyforsaleandthustheequilibriumexchangerate.
• Therearedistinctinternationaltradeandfinancialflowsbetweeneverypairofcountries.Theseflowsdictatetheuniquesupplyanddemandconditionsforthecurrenciesofthetwocountries,whichaffecttheequilibriumcrossexchangeratebetweentheircurrencies.Movementintheexchangeratebetweentwonon-dollarcurrenciescanbeinferredfromthemovementineachcurrencyagainstthedollar.
• Financialinstitutionscanattempttobenefitfromtheexpectedappreciationofacurrencybypurchasingthatcurrency.Analogously,theycanbenefitfromexpecteddepreciationofacurrencybyborrowingthatcurrencyandexchangingitfortheirhomecurrency.