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ECN 160B Lectures 3 and 4 International Macroeconomics

ECN 160B Lectures 3 and 4 International Macroeconomics. Galina A. Schwartz Department of Economics University of CA, Davis. FOREX market . How does it work? (What rules govern it?) By and large As any other market – ForEx market

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ECN 160B Lectures 3 and 4 International Macroeconomics

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  1. ECN 160B Lectures 3 and 4International Macroeconomics Galina A. Schwartz Department of Economics University of CA, Davis Lecture 3 ECN160B

  2. FOREX market • How does it work? (What rules govern it?) By and large • As any other market – ForEx market • DefinitionVehicle currency is one widely used to denominate international contracts of parties not residing in the country issuing the vehicle currency. KO, p. 331 • Means of exchange rate formation • Supply-demand (as for any other market price) • Arbitrage as a tool to reach equilibrium • Presence of vehicle currency Lecture 3 ECN160B

  3. FOREX market (same as Lecture 2, slide 7) • Major Actors (Players or Participants) • Commercial Banks • Interbank Trading • Corporations • Non-Bank Financial Institutions • Central Banks • ? Individuals ? • Why KO mentions individuals only briefly? • they transact via intermediaries • volume is an insignificant fraction of total volume Lecture 3 ECN160B

  4. FOREX Market Characteristics • Arbitrage – buy low, sell high KO, p. 330 • Today: Global Markets • Communications (fast and cheap) • Laws: have to be compatible why? • Arbitrage argument (if laws differ, market participants will choose a location with most favorable laws) • Why prices differ? [for example with location] • Imperfect market competition (supply side) • Price discrimination (demand side) • Differences in market conditions (ex. Risk Characteristics) • Prices (exchange rates) are close or not, and why? • Arbitrage, arbitrage, arbitrage Lecture 3 ECN160B

  5. Exchange Rates as Prices • Why there are so many different exchange rates? • Wholesale (interbank trading), KO, p. 329 • Retail, KO, p. 329 • Spot, KO, p. 331 • Forward, KO, p. 332 • Off-shore versus On-shore (regulated versus unregulated), later -- KO, Ch. 21 • It is no mystery: exchange rate is just a price • As any market, FOREX market has price dispersion • What limits price dispersion? -- Arbitrage (i.e. competition) Lecture 3 ECN160B

  6. FOREX market • How does it work? (What rules govern it?) By and large • As any other market exchange market • Factors and means of price formation • Supply-demand • Arbitrage • Presence of vehicle currency Lecture 3 ECN160B

  7. ForEX transactions • Exchange rates: • Spot (but really 2 days) (clearing) • Forward (30, 90, 180 days) rate quoted in forex deals with value date of > 2 days • Types of ForEx contracts ● Spot ● Forward ● Swap [spot sale +forward repurchase] ● Futures ● Options Lecture 3 ECN160B

  8. ForEX Market Characteristics • Rate of Return (+ we will relate this to arguments about Interest Rate Parity) • Expected • real (savers care of exp. Real rate) • All else equal, returns should be equal, but • Risk (variability of returns) • Liquidity (cost (ease) & speed to sell the asset) • What affects liquidity? Ex. Market volume Lecture 3 ECN160B

  9. Hedging • Hedge:engage in a financial transaction that reduces or eliminates risk • Basic hedging principle: • Hedging risk involves engaging in a financial transaction that offsets a long position by taking a short position, or offsets a short position by taking a additional long position • Question: What is short/long position? Lecture 3 ECN160B

  10. Forward Markets (exchange rates & interest rates) • Long position = agree to buy securities at future date Hedges by locking in future interest rate if funds coming in future • Short position = agree to sell securities at future date Hedges by reducing price risk from change in interest rates if holding bonds • Pros • 1. Flexible • Cons • 1. Lack of liquidity: hard to find counterparty • 2. Subject to default risk: requires information to screen good from bad risk Lecture 3 ECN160B

  11. LTCM events & GCM regulation • LTCM Marks a New Era of • Technical Trading • LTCM manifests GCM regulatory problems • Should Hedge Funds be regulated? How? • Could Hedge Funds be regulated? • Fed rescue: would it be more rescues? • Who really paid for the rescue: Banks, Taxpayers or … ? Lecture 3 ECN160B

  12. Next Lecture • More about Exchange Rates • Expectations • Expected rate of return • Equilibrium • Connection with interest rates • Interest Rates Parity • Covered (uses forward rate) • Uncovered (uses expectations) • Your preparation: Read KO Ch. 13 Lecture 3 ECN160B

  13. Summary of Today • ForEx Markets Characteristics (Parameters) ●Liquidity ●Risk ●Rate of Return • Concepts: • Vehicle currency • Arbitrage • ForEx Contracts ●Spot ●Forward ●Future ●Option ●Swap • Have a Nice Day Lecture 3 ECN160B

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