FM 477: International Finance

London School of Economics

Liliana Varela

Lecture 1

l.v.varela@lse.ac.uk

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 Admin

• Classes: Mondays 11:00-14:00, MAR 1.04.

• My office: Marshal Building, MAR 7.38.

• Office hours: Mondays 14:30-15:30 (please confirm by email).

• Email: l.v.varela@lse.ac.uk.

• Assessment:
− Take-home assignment (30%).
− ICA (60%).
− Participation grade (10%):
∗ Homework assignments (5%).
∗ Active participation in class (5%).

• Supporting textbook:
− Eun and Resnick, International Financial Management, McGraw-Hill (8
Ed).

− Additional references would be indicated in each lecture slide.

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 Structured Project

• Written piece of work (≈ 6000 words) on a question that interests you.

• This question needs to be related to the material of this course.

• Illustrate how concepts learned in the course can shed light on specific real
world questions.

• It is an empirical project with some data work and conceptual discussion.

• It replaces the ICA (60% of final grade).

• A FM477 guideline is posted in Moodle.

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 Themes

1. The foreign exchange market

2. International financial management

2.1 Forward, future and options

2.2 Management of currency exposure

3. Exchange rate determination

4. International portfolio investment

5. Balance of payment and crises in open economies

6. Current trends in the global economy

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 Today

1. The foreign exchange rate market

1. What is special about international finance?

2. The foreign exchange rate market

2. International financial management

1. FX forwards

2. Interest Rate Parity

Reading: Chapters 5 and 6, Eun and Resnick, International Financial Management,

Mc Graw Hill, 8th Edition.

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1.1 What is special about International Finance?

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 Motivation

→ We live in a globalised economy: consumption, production, investing and

financing are global.

• MNC’s production and financing is global.

− Production chain is global.
− Major MNCs (BP, IBM, Toyota, etc.) have their shares listed on foreign
stock exchanges.
→ Example: Earthquake in Japan 2011.

• Trade and pricing are global.

→ Example: dollar pricing

• Domestic firms can borrow from abroad in foreign currency.

• Banks finance and invest globally.

→ What is special about International Finance?

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 What is special about International Finance?

1. Foreign exchange risk:

• Production: if £ depreciates, imports from EU, USA, China become more
expensive in the UK.

• Financing: Hungarian firms borrowing in e. During Global Financial crisis

10% depreciation of HUF Forint, many firms in financial distress.

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 What is special about International Finance?

2. Political risk:
• Changes in the "rules of the game": from taxes to expropriation.
− In 2012, the Argentinean government nationalised a majority stake
in YPF (largest oil company), worth approx. $10 billion, held by the
Spanish government.

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 What is special about International Finance?

3. Market imperfections:
• Legal restrictions, transaction and transportation costs, information
asymmetry, discriminatory taxation, etc.
− Can induce to locate production overseas. Example: Honda to
establish production in Ohio (US) to circumvent trade barriers.

4. Expanded set of opportunities:

• Firms: i) can locate production in other countries to gain access to other
markets, lower production costs, etc; ii) raise funds in capital markets
where the cost of capital is lowest; iii) obtain economies of scale from
exporting to more markets.
• Investors can diversify their portfolio internationally to lower risk or/and
obtain higher return.

→ Understanding and managing exchange rate and political risk and coping with
market imperfections are important parts of international finance.

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1.2 The Foreign Exchange Rate Market

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1.2 The Foreign Exchange Rate Market

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 The Foreign Exchange Rate Market

• FX market is the largest financial market in the world.

• Trading of spot and FX derivatives is $6.6 trillion per day.

• Includes spot, forward, swaps, options, futures, etc.

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 Who is trading?

• Two-tier market: i) interbank market, ii) retail market.

• Five groups of participants:

− International banks: core of the FX market.

− Non-bank dealers: investment banks, mutual funds, pension funds, hedge

funds.

− Corporations and retail clients: MNCs, and private individuals.

− FX Brokers: match dealer orders to buy and sell currencies for a fee, but
do not take a position themselves.

− Central banks: interventions to stabilize the currency.

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 Who is trading?

• Reporting dealers (38%): large commercial and investment banks.

• Other financial institutions (55%): smaller commercial banks, mutual funds,

pension funds, etc.

• Non-financial customers (7%): corporations and private individuals.

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 When do market participants trade?

• Electronic conversations per hour

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 Where do they trade?

• London, NY and Hong Kong are the dominant trading centres.

Country % of Turnover
UK 43.1
US 16.5
Hong Kong 7.6
Singapore 7.6
Japan 4.6

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 What are they trading?

• Spot 30% of the FX market.

• FX derivatives 70% of the FX market (mainly FX swaps and Forwards).

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 What currencies are they trading?
• Most transactions involve a USD counterpart:
− Advanced economies: USD/EUR (24%), USD/JPY (13.2%), USD/GBP (9.6%).

− Emerging markets: USD/CNY(4.1%), USD/HKD(3.3%).

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 The Spot Market

• The exchange rate can be very volatile with sudden jumps.

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 Interbank Market

• Network of correspondent banking relationships: commercial banks holding

demand deposit accounts with one another.

• Example:
− U.S. importer purchasing goods from a Dutch Exporter for e750,000.

− Importer contacts his U.S. Bank, which offers a price of $1.3092/e1.00.

− U.S. Bank debits importer’s account $981,900 (e750,000 x $1.3092).

− U.S. Bank instructs its correspondent bank in the Euro zone to debit
e750,000 and to credit that amount to Dutch Exporter’s bank account.

• How banks communicate with each other?

− SWIFT (Society for Worldwide Interbank Financial Telecommunication) is
a message transfer system allowing international banks to communicate
instructions to one another.
− CHIPS (Clearing House Interbank Payments System) provides a
clearinghouse for the interbank settlement.

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 The Spot Market

• Two ways to quote the exchange rate:

− US dollars per unit of foreign currency.
→ May 16 2016: $1.4402 per £1 or $1.1321 per e1.

− Foreign currency per unit of US dollar.

→ May 16 2016: £.6944 per $1 or e.8833 per $1.

• Notation: S(j/k) price of one unit of currency k in terms of currency j.

− American terms: S($/£)=$1.4402 or S($/e)=$1.1321.

− European terms: S(£/$)=£.6944 or S(e/$)=e.8833.

1 1
S($/£) = and S(£/$) =
S(£/$) S($/£)

1 1
1.4402 = and .6944 =
.6944 1.4402

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GBP vs US Dollar: European vs American Terms

Source: Bloomberg, FX data.

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Argentinean Peso vs US Dollar: European vs American Terms

Source: Bloomberg, FX data.

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 Cross-Exchange Rate Quotations

• Exchange rate between a currency pair where neither currency is the US dollar.
− American terms:

S($/£) 1.4402
S(e/£) = → S(e/£) = = 1.2721
S($/e) 1.1321

− European terms:

S(e/$) 0.8833
S(e/£) = → S(e/£) = = 1.2720
S(£/$) 0.6944

• Alternative expression for cross-exchange rate

h i
S(j/k) = S(j/$) × S($/k) S(j/k) = (EU term in j) x (US term for k)

− Example:

S(e/£) = S($/£) x S(e/$) = 1.4402 x 0.8833 = 1.2721

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 The Bid-Ask Prices
• Traders buy currency at the bid price and sell at the ask price.

Bid Ask

S(£/$) buy $1 (pay £x) (A) sell $1 (get £x) (A)

S($/£) buy £1 (pay $x) sell £1 (get $x)

1. Example bank dealer

− Bank bid (buy): S b (£/$) = £.6944 (buy $1, pay £x). (A)

− Bank ask (sell) : S a ($/£) = $1.4402 (sell £1, get $x). (B)

2. Corresponding relationships
− Bank bid (buy) : S b ($/£) = $1.4402 (buy £1, pay $x). (B)

− Bank ask (sell) : S a (£/$) = £.6944 (sell $1, get £x). (A)

Reciprocal relationship between American and European bid-ask:

1 1
S a ($/£) = and S a (£/$) =
S b (£/$) S b ($/£)

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 The Bid-Ask Prices
• Traders buy currency at the bid price and sell at the ask price.

Bid Ask

S(£/$) buy $1 (pay £x) sell $1 (get £x)

S($/£) buy £1 (pay $x) (B) sell £1 (get $x) (B)

1. Example bank dealer

− Bank bid (buy): S b (£/$) = £.6944 (buy $1, pay £x). (A)

− Bank ask (sell) : S a ($/£) = $1.4402 (sell £1, get $x). (B)

2. Corresponding relationships
− Bank bid (buy) : S b ($/£) = $1.4402 (buy £1, pay $x). (B)

− Bank ask (sell) : S a (£/$) = £.6944 (get £x, sell $1). (A)

Reciprocal relationship between American and European bid-ask:

1 1
S a ($/£) = and S a (£/$) =
S b (£/$) S b ($/£)

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 The Bid-Ask Prices
• Example bank dealer
− Bank bid (buy): S b (£/$) = £.6944 (buy $1, pay £x). (A)

− Bank ask (sell) : S a ($/£) = $1.4402 (sell £1, get $x). (B)

• Corresponding relationships
− Bank bid (buy) : S b ($/£) = $1.4402 (buy £1, pay $x). (B)

− Bank ask (sell) : S a (£/$) = £.6944 (sell $1, get £x). (A)

• Reciprocal relationship between American and European bid-ask:

1 1
S a ($/£) = and S a (£/$) =
S b (£/$) S b ($/£)

Bid Ask

S(£/$) buy $1 (A) sell $1

S($/£) buy £1 sell £1 (B)

Notes: blues and reds are reciprocal equals.

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 The Bid-Ask Prices
• Example bank dealer
− Bank bid (buy): S b (£/$) = £.6944 (buy $1, pay £x). (A)

− Bank ask (sell) : S a ($/£) = $1.4402 (sell £1, get $x). (B)

• Corresponding relationships
− Bank bid (buy) : S b ($/£) = $1.4402 (buy £1, pay $x). (B)

− Bank ask (sell) : S a (£/$) = £.6944 (sell $1, get £x). (A)

• Reciprocal relationship between American and European bid-ask:

1 1
S a ($/£) = and S a (£/$) =
S b (£/$) S b ($/£)

Bid Ask

S(£/$) buy $1 sell $1 (A)

S($/£) buy £1 (B) sell £1

Notes: blues and reds are reciprocal equals.

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 The Bid-Ask Spread

• So far, we ignored bid-ask spread.

• Assume bid price is $0.0005 less than the ask price.

→ S a ($/£) = $1.4402, then S b ($/£) = $1.4397.
1 1
→ S a (£/$) = S b ($/£)
= $1.4397
= £.6946.

→ Ask price £.6946 is higher than bid price £.6944.

• Reciprocal relationship between American and European bid-ask quotations:

Bid Ask

S($/£) 1.4397 1.4402

S(£/$) 0.6944 0.6946

Notes: blues and reds are reciprocal equals.

• Bid quotation: big figure "1.43", small figure "97".

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 Cross-Rate Trading Desk

• A firm wants to exchange £ into Swiss Francs (SF).

• The bank can either quote S b (SF /£) or S a (£/SF ).

• Currency against currency: quote bid $ per £ and then quote bid SF per $.

S b (SF /£) = S b (SF /$) x S b ($/£)

S b (SF /£) = (EU term bid price in SF) x (US term bid price for £)

• The reciprocal is
S a (£/SF ) = S a (£/$) x S a ($/SF )

S a (£/SF ) = (EU term ask price in £) x (US term ask price for SF)

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 Cross-Rate Trading Desk: Exercise

Bid Ask
$/£ $1.4397 $1.4402

£/$ £0.6944 £0.6946

$/e $1.1316 $1.1321

e/$ e0.8833 e0.8837

1. Compute S b (e/£) and its reciprocal

S b (e/£) = S b (e/$) x S b ($/£) = 0.8833 x 1.4397 = 1.2717.
Reciprocal: S a (£/e) = 1/1.2717 = 0.7863.

2. Compute S a (e/£) and its reciprocal

S a (e/£) = S a (e/$) x S a ($/£) = 0.8837 x 1.4402 = 1.2727.
Reciprocal: S b (£/e) = 1/1.2727 = 0.7857.

e/£ bid-ask prices are e1.2717-e1.2727; and £/e: £0.7857-0.7863.

Cross-rate bid-ask rates are larger : e/£ bid-ask spread is e0.001 vs e/$
of e0.0004.

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 Triangular Arbitrage

• Some banks specialise in making a direct market between nondollar currencies.

• If quotes are not consistent with cross-exchange rates → triangular arbitrage.

• Triangular arbitrage: trade out $ into a second currency, then trading it for a
third currency, which is in turn traded for $.

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 Triangular Arbitrage
Example 1: an arbitrageur has $5,000,000.
a. Credit Lyonnais buys $ at S b (e/$) = 0.8833.

b. Barclays buys £ at S b ($/£) = 1.4397.

→ a. and b. imply a cross-rate: S b (e/£) = 1.4397 x 0.8833 = e1.2717.

c. Credit Agricole direct market between £ and e: S a (e/£) = e1.2712.

→ CA selling cross-price is lower than buying price! Gains from arbitrage.

Convert $ into e: sell $5M to Credit Lyonnais:

$5, 000, 000 x e.8833 = e4, 416, 500.

Convert e into £: sell e4,416,500 to Credit Agricole

e4, 416, 500/e1.2712 = £3, 474, 276.

Convert £ into $: sell £3,474,276 to Barclays

£3, 474, 276 x $1.4397 = $5, 001, 915.

Arbitrage profit of $1,915.

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2.1. FX Forwards

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 Forward Market
• Forward: contract today for a future sales or purchase of the foreign exchange.

• Maturity: 1, 3, 6, 9 and 12 months; but non-standard maturities also available.

• Forward rate quotation: FN (j/k), price of unit of currency k in terms of

F ($/k)
currency j for delivering in N months. Cross-exchange rates: FN (j/k) = FN ($/j)
N
FN (j/$)
or FN (j/k) = FN (k/$)
.

• Long and short: buy (a long position) or sell (a short position) FX forward.

• Example:
American terms European terms

− S($/SF ) = 1.0229 − S(SF /$) = .9776

− F1 ($/SF ) = 1.0242 − F1 (SF /$) = .9764

− F3 ($/SF ) = 1.0270 − F3 (SF /$) = .9737

− F6 ($/SF ) = 1.0318 − F6 (SF /$) = .9692

→ SF at a premium to the dollar. → Dollar at a discount to the SF.

→ Expect the dollar to depreciate. → Expect the SF to appreciate.

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 Forward Premium

• Forward premium: premium or discount rate as an annualized percentage

deviation from the spot rate.

American terms European terms

FN ($/j) − S($/j) FN (j/$) − S(j/$)

fN,j = x 360/days; fN,$ = x 360/days
S($/j) S(j/$)

• Example:
S($/U) = .009172 and F3,U = .009198; S(U/$) = 109.03 and F3,$ = 108.72

.009198 − .009172 360 108.72 − 109.03 360

f3,U = x = 0.0111 f3,$ = x = −0.0111
.009172 92 109.03 92

U trades vs $ at a 1.11% premium for de- $ trades vs U at a -1.11% discount for de-
livery in 3-months. livery in 3-months.

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2.2 Interest Rate Parity

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 Interest Rate Parity (IRP)
• Assume the US investor has $1.

• Two investment options:

(i) invest locally at the US interest rate → value at maturity: $1(1 + i$ ).

(ii) invest in UK and hedge the currency risk with a forward. 3 transactions:
1. exchange $1 for pounds: £(1/S), at the spot rate (S) (in US terms).

2. invest the pound at i£ , with maturity value of £(1/S)(1 + i£ ).

3. sell the maturity value using a forward $[(1/S)(1 + i£ )]F .

• The non-arbitrage condition implies the IRP

F
(1 + i$ ) = (1 + i£ )
S

→ UK investment coupled with forward hedging is a perfect substitute for the

domestic U.S. investment: no default or currency risk.

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 Interest Rate Parity (IRP)

Alternatively, we can construct an arbitrage portfolio:

1. Borrow $S in the US to buy £1 at Transactions CF0 CF1

1. Borrow in the US $S −S(1 + i$ )
the spot S($/£).
2. Lend in the UK -$S S1 (1 + i£ )
2. Lend £1 in the UK at (1 + i£ ). 3. Sell the £ receivable forward 0 (1 + i£ )(F − S1 )

Net cash flow 0 (1 + i£ )F − (1 + i$ )S

3. Selling the maturity value of the UK
investment forward.

→ Again, this implies that

(1 + i£ )F = (1 + i$ )S

   
F −S F −S
or i$ − i£ = (1 + i£ ) ∼
=
S S

• Note that (i) the arbitrage portfolio is fully self-financed, (ii) net cash flow at
maturity is know with certainty.

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 Interest Rate Parity (IRP), Implication

(1 + i£ )F = (1 + i$ )S

Implication of IRP:

• If the $ is at a forward discount (F > S), then i$ > i£ .

→ if $ is at a forward discount, the $ is expected to depreciate (F ($/£)).

→ i$ should be higher than i£ to compensate for the expected depreciation $.

• If the $ is at a forward premium (F < S), then i$ < i£ .

→ if $ is at a forward premium, the $ is expected to appreciate (F ($/£)).

→ i£ should be higher than i$ to compensate for the expected depreciation £.

• F 6= S as long as i$ 6= i£ .

→ if IRP holds, no arbitrage opportunity and investor is indifferent between investing

in $ or in £ using a forward. If IRP doesn’t hold, there is covered interest arbitrage.

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 Covered Interest Arbitrage

(1 + i£ )F = (1 + i$ )S

Example
• Assume 1-year interest rate: i$ = 5%, i£ = 8%, S = $1.80/£ and F = $1.78/£.

• Does IRP hold?

F 1.78
What is the implied i$ ? S
(1 + i£ ) = 1.80
(1.08) = 1.068 > 1 + i$ = 1.05.

Profitable arbitrage opportunity: borrow in the US and lend in the UK.

• Arbitrage:
Borrow in the US $1M, & pay back $1,050,000=$1,000,000 x 1.05.

Buy £555,556 in spot using $1M and invest it in the UK.

Obtain at maturity £600,000= £555,556 x 1.08.

Sell £600,000 forward in exchange for $1, 068, 000 = £600, 000x $1.78/£.

At maturity, the arbitrageur makes: $18,000 (=$1,068,000-$1,050,000).

→ without any risk!

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 Interest Rate Parity
(1 + ie )F = (1 + i$ )S

Example 2
• Assume: i$ = 8% and ie = 5% (per annum), S=e.8000/$, F 3 months =e.7994/$.

• Convert annual interest rate to quarterly, and S and F to American terms.

− i$ = 8/4 = 2% and ie = 5/4 = 1.25%.

− S = 1/.8000 = $1.250/e and F = 1/.7994 = $1.251/e.

F 1.251
• What is the implied i$ ? S
(1 + ie ) = 1.250
(1.0125) = 1.0133 < 1 + i$ = 1.02.

• Arbitrage: (hint start with e800,000)

− Borrow e800,000, & pay back in 3-month e810,000 (e800,000 x 1.0125).

− Buy $1,000,000 using the e800,000 and invest in US.

− Obtain at maturity $1,020,000=$1,000,000 x (1.02).

− Buy e810,000 forward in exchange for $1, 013, 310 = e810, 000($1.251).

− At maturity, the arbitrageur makes: $6,690 (=$1,020,000-$1,013,310).

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 Covered Interest Rate Parity Violations after the Financial Crisis
• Du, Tepper and Verdelhan (2018) report systematic deviation from the IRP
after the financial crisis.
924 The Journal of Finance⃝
R

50
0
−250 −200 −150 −100 −50
Basis Points

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

AUD CAD CHF DKK EUR

GBP JPY NOK NZD SEK

Figure 2. Short-term Libor-based deviations from covered interest rate parity. This fig-
ure plots the 10-day moving averages of the three-month Libor cross-currency basis, measured in
bps for G10 currencies. Covered interest rate parity implies that the basis should be zero. The
$,Libor Libor $,Libor Libor
Libor basis is equal to yt,t+n −(yt,t+n −ρt,t+n), where n = three months, yt,t+n and yt,t+n denote
the U.S. and foreign three-month Libor rates, and ρt,t+n ≡ 1n ( ft,t+n −st ) denotes the forward pre-
mium obtained from the forward ft,t+n and spot st exchange rates. (Color figure can be viewed at
wileyonlinelibrary.com)

C.2. Long-Term
Source: Libor
Du, Tepper Cross-Currency
and Basis
Verdelhan (2018).
At long maturities, the long-term CIP deviation based on Libor is given
by the spread on the cross-currency basis swap. A cross-currency basis swap
involves an exchange of cash flows linked to floating interest rates referenced 45 / 45