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What is International Financial Management?

International finance is the branch of financial economics broadly concerned with monetary and macroeconomic interrelations between two or more countries. International finance examines the dynamics of the global financial system, international monetary systems, balance of payments, exchange rates, foreign direct investment, and how these topics relate to international trade.

Whats Special about International Finance?


Foreign Exchange Risk Political Risk Market Imperfections Expanded Opportunity Set

Whats Special about International Finance?


Foreign Exchange Risk
The risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. Suppose $1 = 100 and you buy 10 shares of Toyota at 10,000 per share. One year later the investment is worth ten percent more in yen: 110,000 But, if the yen has depreciated to $1 = 120, your investment has actually lost money in dollar terms.

Whats Special about International Finance?


Political Risk
Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways.

Whats Special about International Finance?


Market Imperfections Legal restrictions on movement of goods, people, and money Transactions costs Shipping costs

Whats Special about International Finance?


Expanded Opportunity Set It doesnt make sense to play in only one corner of the sandbox. True for corporations as well as individual investors.

Foreign Exchange Markets


A Foreign exchange market is a market in which currencies are bought and sold. It is to be distinguished from a financial market where currencies are borrowed and lent. Foreign exchange market is described as an OTC (Over the counter) market . The term foreign exchange market is used to refer to the wholesale a segment of the market, where the dealings take place among the banks .

Foreign Exchange Markets


The leading foreign exchange market in India is Mumbai, Calcutta, Chennai and Delhi is other centres accounting for bulk of the exchange dealings in India.

Foreign exchange market is the largest financial market with a daily turnover of over USD 2 trillion. The largest foreign exchange market is London followed by New York, Tokyo, Zurich and Frankfurt. In most markets, US dollar is the vehicle currency, Viz., the currency used to denominate international transactions. This is despite the fact that with currencies like Euro and Yen gaining larger share, the share of US dollar in the total turn over is shrinking.

Function and Structure of Structure of the FX Market

the FX Market

The Spot Market The Forward Market Spot Market


The Forward Market

The Forward Market

FX Market Participants Correspondent Banking Relationships Spot Rate Quotations The Bid-Ask Spread ForwardTrading Spot FX Rate Quotations Long and Short Forward Positions Cross Exchange Rate Quotations Forward Cross-Exchange Rates Triangular Arbitrage SwapForeign Exchange Market Microstructure Spot Transactions Forward Premium

Participants of Foreign Exchange Market


(i) Corporates (ii) Commercial banks (iii) Exchange brokers (iv) Central banks

Settlement of Transactions
SWIFT: The Society for Worldwide Interbank Financial Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions.

Spot Rate quotation


Direct quotation: The exchange quotation which gives the
price for the foreign currency in terms of the domestic currency is known as direct quotation If Quoting bank is in India than the Direct quotation will be:1 US dollar = 55.1625 INR/ 55.1685 INR

Indirect Quotation: This type of quotation which gives the


quantity of foreign currency per unit of domestic currency is known as indirect quotation. I INR= 0.01813 US DOLLAR

The Bid-Ask Spread


The bid price is the price a dealer is willing to pay you for something. The ask price is the amount the dealer wants you to pay for the thing. The bid-ask spread is the difference between the bid and ask prices.

Cross Rates
Suppose that S($/) = 1.50
i.e. $1.50 = 1.00

and that S(/) = 50


i.e. 1.00 = 50

What must the $/ cross rate be? $1.50 1.00 $1.50 = 1.00 50 50 $1.00 = 33.33 $0.0300 = 1

Triangular Arbitrage
Suppose we observe these banks posting these exchange rates.

$
Barclays S(/$)=80 Credit Lyonnais

S($/)=1.50
First calculate any implied cross rate to see if an arbitrage exists.

Credit Agricole
S(/)=122

1.00
$1.50

$1.00
80 =

1.00
120

Triangular Arbitrage
The implied S(/) cross rate is
122 $1.00 81.33

$
Barclays S(/$)=80 Credit Lyonnais

1.00

1.50

$1.00

Barclays has posted a quote of S(/$)=80 so there is an arbitrage opportunity.

S($/)=1.50

Credit Agricole
S(/)=122

So, how can we make money?

Triangular Arbitrage
As easy as 1 2 3:

$
1. Sell our $ for , Barclays S(/$)=80 3 1

2. Sell our for ,


3. Sell those for $.

Credit Lyonnais

S($/)=1.50 2 Credit Agricole

S(/)=122

Triangular Arbitrage
Sell $150,000 for at S($/) = 1.50

receive 100,000
Sell our 100,000 for at S(/) = 122 receive 12200,000 Sell 12200,000 for $ at S(/$) = 80 receive $152500 profit per round trip = $ 152500 $ 150,000 = $2500

Triangular Arbitrage
Here we have to go clockwise to make moneybut it doesnt matter where we start.

$
Barclays S(/$)=80 3 1 Credit Lyonnais

2 Credit Agricole S(/)=120

S ($/)= 1.50

If we went counter clockwise we would be the source of arbitrage profits, not the recipient!

The Forward Market


A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

Forward Rate Quotations


The forward market for FX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

Forward Rate Quotations


Consider the example from above: for British pounds, the spot rate is $1.9077 = 1.00 While the 180-day forward rate is $1.8904 = 1.00 Whats up with that?

Forward Rate Quotations


Consider the (dollar) holding period return of a dollar-based investor who buys 1 million at the spot and sells them forward:
gain $1,890,400 $1,907,700 $17,300 $HPR= = = pain $1,907,700 $1,907,700 $HPR = 0.0091 Annualized dollar HPR = 1.81% = 0.91% 2

Long and Short Forward Positions


If you have agreed to sell anything (spot or forward), you are short. If you have agreed to buy anything (forward or spot), you are long. If you have agreed to sell FX forward, you are short. If you have agreed to buy FX forward, you are long.

INTERNATIONAL MONETORY SYSTEM

International monetary system can be defined as the institutional framework within which: International payments are made. The movement of capital is accommodated. Exchange rates are determined. It also includes all the instruments, institutions, and agreements that link together the worlds currency, money markets, securities, real estate and commodity markets.

Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973Present

Classical Gold Standard: 1875-1914


During this period in most major countries:
Gold alone was assured of unrestricted coinage There was two-way convertibility between gold and national currencies at a stable ratio. Gold could be freely exported or imported.

The exchange rate between two countrys currencies would be determined by their relative gold contents.

Classical Gold Standard: 1875-1914


For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at 6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: $30 = 6

$5 = 1

Classical Gold Standard: 1875-1914


There are shortcomings:
The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. Even if the world returned to a gold standard, any national government could abandon the standard.

Interwar Period: 1915-1944


Exchange rates fluctuated as countries widely used predatory depreciations of their currencies as a means of gaining advantage in the world export market. Attempts were made to restore the gold standard, but participants lacked the political will to follow the rules of the game. The result for international trade and investment was profoundly detrimental.

Bretton Woods System: 1945-1972


Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank.

Bretton Woods System: 1945-1972


Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within 1% of the adopted par value by buying or selling foreign reserves as necessary. The Bretton Woods system was a dollar-based gold exchange standard.

Bretton Woods System: 1945-1972


German mark

British pound

French franc

Par Value
U.S. dollar

Gold

Pegged at $35/oz.

The Flexible Exchange Rate Regime: 1973-Present.


In the wake of the collapse of the Bretton Woods exchange rate system, the IMF appointed the Committee of Twenty which suggested various options for the exchange rate arrangement. The options were broadly: 1. Free Float and 2. Managed Float 3. Pegging of currency 4. Crawling Peg 5. Dollarization

European Monetary System


Eleven European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives:
To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis--vis nonEuropean currencies. To pave the way for the European Monetary Union.

What Is the Euro?


The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

Euro Area
22 Countries participating in the euro:

Austria Belgium Cyprus Czech Republic Estonia Finland France Germany Greece Hungary Ireland

Italy Latvia Lithuania Luxembourg Malta Poland Portugal Slovak Republic Slovenia Spain The Netherlands

Eurocurrency
Currency deposited by national governments or corporations in banks outside their home market. This applies to any currency and to banks in any country. For example, South Korean won deposited at a bank in South Africa, is considered eurocurrency. Having "euro" doesn't mean that the transaction has to involve European countries. However, in practice, European countries are often involved

Eurocredit
A loan whose denominated currency is not the lending bank's national currency. Eurocredit helps the flow of capital between countries and the financing of investments at home and abroad. These trades add liquidity to both currencies as the U.S. bank accounts for the incoming payments from the loans in U.S. dollar terms, and are often large and function in a long-term basis. A U.S. bank lending a corporation 10 million Russian rubles is an example of Eurocredit.

Euro commercial Paper


An unsecured, short-term loan issued by a bank or corporation in the international money market, denominated in a currency that differs from the corporation's domestic currency.

The Forward Market


A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

Forward Rate Quotations


The forward market for FX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

Forward Rate Quotations


FN(j/k) will refer to the price of one unit of currency k
in terms of currency j for delivery in N months. N equaling 1 denotes One month maturity based on 360-day bankers year. N equaling 3 denotes three month maturity based on 360-day bankers year. S($/)= 0.8470 F1($/)=0.8485 F2($/)=0.8517 F6($/)=0.8573

Forward margin

Forward Rate Quotations


Consider the (dollar) holding period return of a dollar-based investor who buys 1 million at the spot and sells them forward:
gain $1,890,400 $1,907,700 $17,300 $HPR= = = pain $1,907,700 $1,907,700 $HPR = 0.0091 Annualized dollar HPR = 1.81% = 0.91% 2

Forward Cross Exchange Rates


Its just an delayed example of the spot cross rate discussed above. In generic terms
FN ($ / k ) FN ( j / k ) FN ($ / j ) and FN ($ / j ) FN (k / j ) FN ($ / k )

Notice that the $s cancel.

The current spot exchange rate is $1.95/ and the three-month forward rate is $1.90/. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/ in three months. Assume that you would like to buy or sell 1,000,000. a. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation? b. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.86/.

a. If you believe the spot exchange rate will be $1.92/ in three months, you should buy 1,000,000 forward for $1.90/. Your expected profit will be: $20,000 = 1,000,000 x ($1.92 -$1.90). b. If the spot exchange rate actually turns out to be $1.86/ in three months, your loss from the long position will be: -$40,000 = 1,000,000 x ($1.86 -$1.90).

Long and Short Forward Positions


If you have agreed to sell anything (spot or forward), you are short. If you have agreed to buy anything (forward or spot), you are long. If you have agreed to sell FX forward, you are short. If you have agreed to buy FX forward, you are long.

NRI : Repatriable and Non-Repatriable Bank accounts


Repatriable Accounts : Legally Indian rupees can be transferred back to foreign currency, that is money can be converted to any foreign currency. Non-Repatriable Accounts : Money cannot be converted to any foreign currency.

American depositary receipt


An American depositary receipt (ADR) is a negotiable security that represents securities of a non-US company that trade in the US financial markets. Securities of a foreign company that are represented by an ADR are called American depositary shares (ADSs). Each ADR is issued by a domestic depositary bank when the underlying shares are deposited in a foreign custodian bank, usually by a broker who has purchased the shares in the open market local to the foreign company.

Global depository receipt


A global depositary receipt (GDR) is a certificate issued by a depository bank, which purchases shares of foreign companies and deposits it on the account. GDRs represent ownership of an underlying number of shares. Global depository receipts facilitate trade of shares, and are commonly used to invest in companies from developing or emerging markets. Prices of global depositary receipt are often close to values of related shares, but they are traded and settled independently of the underlying share.

FCCB foreign currency convertible bonds


Foreign Currency Convertible Bonds commonly referred to as FCCB's are a special category of bonds. FCCB's are issued in currencies different from the issuing company's domestic currency. Corporates issue FCCB's to raise money in foreign currencies. These bonds retain all features of a convertible bond making them very attractive to both the investors and the issuers.

External commercial borrowing


An external commercial borrowing (ECB) is an instrument used in India to facilitate the access to foreign money by Indian corporations and PSUs. ECBs include commercial bank loans, buyers' credit, suppliers' credit, securitised instruments such as floating rate notes and fixed rate bonds etc. For infrastructure and greenfield projects, funding up to 50% (through ECB) is allowed. In telecom sector too, up to 50% funding through ECBs is allowed. Borrowers can use 25 per cent of the ECB to repay rupee debt and the remaining 75 per cent should be used for new projects

Law of one price

If the identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, the products price should be the same in both markets. This is called the law of one price. If the two markets are in two different countries, the products price may be stated in different currency terms, but the price of the product should still be the same.

Purchasing Power Parity and the Law of One Price:


If the law of one price were true for all goods and services, the purchasing power parity exchange rate could be found from any individual set of prices. Absolute PPP state that the spot exchange rate is determined by the relative prices of similar baskets of goods. S=P1/P2

Relative PPP: This more general idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period.

F($/) = S($/)

1 + $ 1 +

$ =Inflation in US, = Inflation in euro. F($/)=forward exchange rate b/w $ and S($/)= spot rate b/w $ and

PPP might not hold because:


The price indices used to measure PPP may use different weights or different goods and services. Arbitrage may be too costly, because of tariffs and other trade barriers and high transportation costs, or too risky, because prices could change during the time that an item is in transit between countries. Since some goods and services used in the indices are not traded, there could be price discrepancies between countries. Relative price changes could lead to exchange rate changes even in the absence of an inflation differential. Government intervention could lead to a disequilibrium exchange rate.

Purchasing Power Parity and Exchange Rate Determination


The exchange rate between two currencies should equal the ratio of the countries price levels:

P$ S($/) = P

For example, if an ounce of gold costs $300 in the U.S. and 150 in the U.K., then the price of one pound in terms of dollars should be: P$ $300 S($/) = = 150 = $2/ P

Purchasing Power Parity and Exchange Rate Determination


Suppose the spot exchange rate is $1.25 = 1.00 If the inflation rate in the U.S. is expected to be 3% in the next year and 5% in the euro zone, Then the expected exchange rate in one year should be $1.25(1.03) = 1.00(1.05) F($/) = $1.25(1.03) = $1.23 1.00(1.05) 1.00

Purchasing Power Parity and Exchange Rate Determination


The euro will trade at a 1.90% discount in the forward market:

F($/) = S($/)

$1.25(1.03) 1.00(1.05) $1.25 1.00

1.03 1 + $ = = 1.05 1 +

Relative PPP states that the rate of change in the exchange rate is equal to differences in the rates of inflationroughly 2%

As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is R$1.95/$. The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6% and 20.0%, respectively. How would you forecast the exchange rate to be at around November 1, 2000?

The Exact Fisher Effects


An increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country. For the U.S., the Fisher effect is written as: 1 + i$ = (1 + $ ) E(1 + $) Where $ is the equilibrium expected real U.S. interest rate E($) is the expected rate of U.S. inflation i$ is the equilibrium expected nominal U.S. interest rate

If expected inflation is 100 percent and the real required return is 5 percent, what will the nominal interest rate be according to the Fisher effect?

According to the Fisher effect, the relationship between the nominal interest rate, r, the real interest rate a, and the expected inflation rate, i, is 1 + r = (1 + a)(1 + i). Substituting in the numbers in the problem yields 1 + r = 1.05 x 2 = 2.1, or r = 110%.

International Fisher Effect


If the Fisher effect holds in the U.S. 1 + i$ = (1 + $ ) E(1 + $) and the Fisher effect holds in Japan, 1 + i = (1 + ) E(1 + ) and if the real rates are the same in each country $ = then we get the E(1 + ) 1 + i = International Fisher Effect: 1 + i$ E(1 + $)

International Fisher Effect


If the International Fisher Effect holds,
E(1 + ) 1 + i = 1 + i$ E(1 + $) F S E(1 + ) = E(1 + $)

then forward rate PPP holds:

/$

/$

In july, the One year Interest rate is 4% on swiss francs and 13% on U.S. dollars. a. If the current exchange rate is SFr 1= $0.63 what is the expected future exchange rate in one year? b. If a change in expectations regarding future U.S. inflation causes the expected future spot rate to rise to $0.70. what should happen to the US interest rate?

a. 0.6853 b. 15.56%

Interest Rate Parity Defined


IRP is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity.

Interest Rate Parity

Interest Rate Parity Carefully Defined


Consider alternative one year investments for $100,000: 1. Invest in the U.S. at i$. Future value = $100,000 (1 + i$)
2. Trade your $ for at the spot rate, invest $100,000/S$/ in Britain at i while eliminating any exchange rate risk by selling the future value of the British investment forward.
Future value = $100,000(1 + i)

Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist) (1 + i)

F S

$/ $/

$/

= (1 + i$)
$/

Alternative 2: Send your $ on a round trip to Britain

$1,000 S$/

IRP
Step 2: Invest those pounds at i Future Value =
$1,000 S$/ (1+ i)

$1,000

Alternative 1: invest $1,000 at i$


$1,000(1 + i$)

$1,000

Step 3: repatriate future value to the U.S.A.


(1+ i) F$/

= IRP

S$/

Since both of these investments have the same risk, they must have the same future valueotherwise an arbitrage would exist

Interest Rate Parity Defined


The scale of the project is unimportant $1,000 (1+ i) F$/ $1,000(1 + i$) = S$/ F$/ (1+ i) (1 + i$) = S$/

Interest Rate Parity Defined


Formally, 1+i 1+i
$

F = S

$/

$/

Forward Premium
Its just the interest rate differential implied by forward premium or discount. For example, suppose the is appreciating from S($/) = 1.25 to F180($/) = 1.30 The forward premium is given by:
F180($/) S($/)

f180,v$ =

S($/)

360 $1.30 $1.25 = 2 = 0.08 180 $1.25

Interest Rate Parity Carefully Defined


Depending upon how you quote the exchange rate ($ per or per $) we have: 1 + i F = 1 + i$ S
/$

or

/$

1+i 1+i

F = S

$/

$/

so be a bit careful about that

IRP and Covered Interest Arbitrage


If IRP failed to hold, an arbitrage would exist. Its easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.
Spot exchange rate 360-day forward rate S($/) = $1.25/ F360($/) = $1.20/

U.S. discount rate


British discount rate

i$ = 7.10%
i = 11.56%

IRP and Covered Interest Arbitrage


A trader with $1,000 could invest in the U.S. at 7.1%, in one year his investment will be worth $1,071 = $1,000 (1+ i$) = $1,000 (1,071) Alternatively, this trader could 1. Exchange $1,000 for 800 at the prevailing spot rate, 2. Invest 800 for one year at i = 11.56%; earn 892.48 3. Translate 892.48 back into dollars at the forward rate F360($/) = $1.20/, the 892.48 will be exactly $1,071.

Alternative 2:

buy pounds
800 = $1,000 1

Arbitrage I
800

Step 2: $1.25 Invest 800 at i = 11.56% $1,000 892.48 In one year 800 will be worth Step 3: repatriate 892.48 = to the U.S.A. at 800 (1+ i) F360($/) = $1.20/ Alternative 1: invest $1,000 $1,071 F(360) $1,071 = 892.48 at 7.1% 1 FV = $1,071

Interest Rate Parity & Exchange Rate Determination


According to IRP only one 360-day forward rate, F360($/), can exist. It must be the case that F360($/) = $1.20/

Why?
If F360($/) $1.20/, an astute trader could make money with one of the following strategies:

Arbitrage Strategy I
If F360($/) > $1.20/ i. Borrow $1,000 at t = 0 at i$ = 7.1%. ii. Exchange $1,000 for 800 at the prevailing spot rate, (note that 800 = $1,000$1.25/) invest 800 at 11.56% (i) for one year to achieve 892.48 iii. Translate 892.48 back into dollars, if F360($/) > $1.20/, then 892.48 will be more than enough to repay your debt of $1,071.

Step 2: buy pounds 800 = $1,000 $1,000 1 $1.25

Arbitrage I
800 Step 3: Invest 800 at i = 11.56% 892.48 In one year 800 will be worth 892.48 = 800 (1+ i) Step 4: repatriate to the U.S.A. $1,071 < 892.48 F(360)

Step 1: borrow $1,000 More than $1,071 Step 5: Repay your dollar loan with $1,071.

If F(360) > $1.20/ , 892.48 will be more than enough to repay your dollar obligation of $1,071. The excess is your profit.

Arbitrage Strategy II
If F360($/) < $1.20/

i. Borrow 800 at t = 0 at i= 11.56% . ii. Exchange 800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071. iii. Translate $1,071 back into pounds, if F360($/) < $1.20/, then $1,071 will be more than enough to repay your debt of 892.48.

Step 2: buy dollars $1,000 = 800 $1.25 1

800

Arbitrage II
Step 1: borrow 800 More than 892.48

$1,000 Step 3: Invest $1,000 at i$

Step 5: Repay your pound loan with 892.48 . Step 4: repatriate to the U.K. F(360) 1

In one year $1,000 will be worth $1,071

$1,071 > 892.48

If F(360) < $1.20/ , $1,071 will be more than enough to repay your dollar obligation of 892.48. Keep the rest as profit.

IRP and Hedging Currency Risk


You are a U.S. importer of British woolens and have just ordered next years inventory. Payment of 100M is due in one year.
Spot exchange rate 360-day forward rate U.S. discount rate British discount rate S($/) = $1.25/ F360($/) = $1.20/ i$ = 7.10% i = 11.56%

IRP implies that there are two ways that you fix the cash outflow to a certain U.S. dollar amount: a) Put yourself in a position that delivers 100M in one yeara long forward contract on the pound. You will pay (100M)(1.2/) = $120M in one year. b) Form a forward market hedge as shown below.

IRP and a Forward Market Hedge


To form a forward market hedge: Borrow $112.05 million in the U.S. (in one year you will owe $120 million). Translate $112.05 million into pounds at the spot rate S($/) = $1.25/ to receive 89.64 million. Invest 89.64 million in the UK at i = 11.56% for one year. In one year your investment will be worth 100 millionexactly enough to pay your supplier.

Forward Market Hedge


Where do the numbers come from? We owe our supplier 100 million in one yearso we know that we need to have an investment with a future value of 100 million. Since i = 11.56% we need to invest 89.64 million at the start of the year.
100 89.64 = 1.1156

How many dollars will it take to acquire 89.64 million at the start of the year if S($/) = $1.25/?
$1.00 $112.05 = 89.64 1.25

Reasons for Deviations from IRP


Transactions Costs
The interest rate available to an arbitrageur for borrowing, ib,may exceed the rate he can lend at, il. There may be bid-ask spreads to overcome
Capital Controls Governments sometimes restrict import and export of money through taxes or outright bans.

Transactions Costs Example


Will an arbitrageur facing the following prices be able to make money?
Borrowing $ 5% 6% Lending 4.50% 5.50%

1+i 1+i

F = S

$/

$/

Bid Ask Spot $1.00=1.0 $1,01=1,00 0 Forward $0.99=1.0 $1.00=1.00 0

Transactions Costs Example


Try borrowing $1.000 at 5%: Trade for at the ask spot rate $1.01 = 1.00 Invest 990.10 at 5.5% Hedge this with a forward contract on 1,044.55 at $0.99 = 1.00 Receive $1.034.11 Owe $1,050 on your dollar-based borrowing Suffer loss of $15.89

Now try this backwards

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