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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.
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.
the FX 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
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.
Cross Rates
Suppose that S($/) = 1.50
i.e. $1.50 = 1.00
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
$1.00
S($/)=1.50
Credit Agricole
S(/)=122
Triangular Arbitrage
As easy as 1 2 3:
$
1. Sell our $ for , Barclays S(/$)=80 3 1
Credit Lyonnais
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(/$)=80 3 1 Credit Lyonnais
S ($/)= 1.50
If we went counter clockwise we would be the source of arbitrage profits, not the recipient!
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
The exchange rate between two countrys currencies would be determined by their relative gold contents.
$5 = 1
British pound
French franc
Par Value
U.S. dollar
Gold
Pegged at $35/oz.
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.
Forward margin
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 -$1.90).
If the identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, the products price should be the same in both markets. This is called the law of one price. If the two markets are in two different countries, the products price may be stated in different currency terms, but the price of the product should still be the same.
Relative PPP: This more general idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period.
F($/) = S($/)
1 + $ 1 +
$ =Inflation in US, = Inflation in euro. F($/)=forward exchange rate b/w $ and S($/)= spot rate b/w $ and
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 = $2/ P
F($/) = S($/)
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?
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%.
/$
/$
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%
Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist) (1 + i)
F S
$/ $/
$/
= (1 + i$)
$/
$1,000 S$/
IRP
Step 2: Invest those pounds at i Future Value =
$1,000 S$/ (1+ i)
$1,000
$1,000
= IRP
S$/
Since both of these investments have the same risk, they must have the same future valueotherwise an arbitrage would exist
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($/)
or
/$
1+i 1+i
F = S
$/
$/
i$ = 7.10%
i = 11.56%
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 = $1,071
Why?
If F360($/) $1.20/, an astute trader could make money with one of the following strategies:
Arbitrage Strategy I
If F360($/) > $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.
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.
800
Arbitrage II
Step 1: borrow 800 More than 892.48
Step 5: Repay your pound loan with 892.48 . Step 4: repatriate to the U.K. F(360) 1
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 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/) = $120M in one year. b) Form a forward market hedge as shown below.
How many dollars will it take to acquire 89.64 million at the start of the year if S($/) = $1.25/?
$1.00 $112.05 = 89.64 1.25
1+i 1+i
F = S
$/
$/