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International Finance

International Finance. Wendy Jeffus Boston College. How to Short Currency. It is not costless to take a short position. Imagine the spot rate between the Indonesian rupiah and the U.S. dollar is: S 0 = 2,000IDR/USD

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International Finance

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  1. International Finance Wendy Jeffus Boston College

  2. How to Short Currency • It is not costless to take a short position. • Imagine the spot rate between the Indonesian rupiah and the U.S. dollar is: • S0 = 2,000IDR/USD • If the rupiah was 2,000IDR/USD and you thought that the currency would devalue, you could short the rupiah.

  3. How to Short Currency • Borrow IDR (perhaps interest rates are 50% in Indonesia) • Let’s borrow Rp1,000,000,000. • Convert IDR to USD @ 2,000IDR/USD = $500,000 • Lend the USD at the going rate (i.e. 5%) you will earn $25,000 over a year for a total of $525,000 • If no devaluation: you lose 45% (the difference between the two exchange rates) • $525,000 x Rp2,000 = 1,050,000,000 • Loan Amount due = 1,000,000,000 x (1 + 50%) = 1,500,000,000 • Short fall = 450,000,000 @ 2,000IND/USD = $225,000 • Of course if the rupiah strengthens versus the dollar you could lose a lot more!

  4. How to Short Currency • But, if there is a devaluation (for example to 10,000IND/USD) your gain can be calculated as follows: • $525,000 x Rp10,000 = 5,250,000,000 • Loan Amount due = 1,000,000,000 x (1 + 50%) = 1,500,000,000 • Gain = 3,750,000,000 @ 10,000IND/USD = $375,000

  5. Speculators… • Might see domestic interest rates skyrocket, which weakens the fabric of the economy. • Why? Because construction gets depressed, interest rates make working capital more expensive for businesses, and as companies come under stress, consumers spend less… • In addition if analysis reveals that banks and corporations have borrowed foreign currency, then there will be hedging activities that will also put pressure on the currency to devalue. • And sometimes, start rumors of devaluation… Source Interview with Rob Johnson from Panic, pp. 96 - 105

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