Fin 603 Week 3

1. Fin 603 Week 3 Currencies, Gold Futures, andCommercial Paper

2. Some Online Sources for the Meanings of Finance Words Available for Free • Investopedia: Very comprehensive and designed for individual investors • The Campbell Harvey glossary: A more academic collection of words • The Yahoo Finance glossary: A useful third source Professor Ross Miller • Fall 2005

3. About Class PowerPoint Slides • Some slides will change from the time they are first posted • Significant changes can come during the day of the first class in which they are presented and immediately after that class • Minor changes can continue for the next week or two • Slides with answers • Posted after the material has been covered in all sections of both Fin 525 and 603 Professor Ross Miller • Fall 2005

4. Euro Professor Ross Miller • Fall 2005

5. European Central Bank (ECB) • The European Union’s (EU) version of the Fed • The euro can be viewed as an experiment in which several European nations share a common currency and have a common central bank • Many EU countries have not adopted the Euro • United Kingdom (British pound) • Scandinavian Countries (Norway, Sweden, and Denmark each have their own currencies) • Switzerland (Swiss franc) is not part of the EU Professor Ross Miller • Fall 2005

6. “Spot” EUR/USD Exchange Rate • “Spot” means the rate for an exchange of currencies right not, as opposed to “forward” which is an exchange in the future • The euro is generally quoted as a direct exchange rate(how many $US it is worth) • Most other currencies are quoted in terms of how many of them a dollar can purchase because then when the exchange rate goes up, the value of the dollar also goes up • Conversely, when the EUR/USD exchange rate goes up, the value of the dollar (relative to the euro) goes down Professor Ross Miller • Fall 2005

7. Foreign Exchange • The financial function of converting between currencies on either a spot or forward/futures basis is known as foreign exchange • Foreign exchange is often referred to as forex or f/x Professor Ross Miller • Fall 2005

8. The Spot Rate of the Euro From Near Its Inception (1/1/1999)Through 8/25/2005 Currency charts available here Professor Ross Miller • Fall 2005

9. Reasonably Current Spot Exchange Rates Are Easy to Find On the Internet (Bloomberg) Professor Ross Miller • Fall 2005

10. More Current Rates from MSN via Excel • In Excel, Type /DD followed by a carriage return (The Data Menu followed by “Import External Data”) • You can then open: “MSN MoneyCentral Investor Currency Rates.iqy” • This will import MSN’s currency quotes, which are delayed 20 minutes (or more) Professor Ross Miller • Fall 2005

11. Not-So-Current Rates from Google • To find the a somewhat stale EUR/USD rate, enter “1 euro in $” into Google • Enter other amounts to do quick (but not necessarily accurate) current translations • For example, “$800 in euros” Professor Ross Miller • Fall 2005

12. Let’s Focus On the Bloomberg Euro Quote from the early afternoon of 9/8/2005 IndirectEUR/USD rate Direct EUR/USD rate Professor Ross Miller • Fall 2005

13. What This Means • €1 (1 Euro) = $1.2399 (Direct rate) • $1 = €0.8065 (Indirect rate) • Is this correct? • For $1.2399 = 1.2399 x 0.8065 Euros = €0.99997935 • That’s pretty close, considering the rounding Professor Ross Miller • Fall 2005

14. Does This Mean You Can Really Get These Rates? • No. Like any other market, there is a bid price and an ask price • The difference between ask and bid (the spread) is smaller for large institutional customers than for retail customers Professor Ross Miller • Fall 2005

15. The Bid and Ask Sides of Spot Currencies(From Australia’s Ozforex, also 9/8/2005) Professor Ross Miller • Fall 2005

16. What Does This Quote Mean? • You can buy a euro for $1.2408 • You can buy a Dollar for 1/1.2403 = €0.80626 • Suppose you took $10,000, bought euros, and then converted back to dollars • $10,000 would get you 10,000/1.2408 euros or €8,059.32 • Your € would then buy you 8,059.32/0.80626 dollars or $9,995.93 • Hence, the spread comes to about 4 b.p. Professor Ross Miller • Fall 2005

17. What Would Happen If You Kept Converting Back and Forth Between Euros and Dollars Long Enough? Professor Ross Miller • Fall 2005

18. What Would Happen if the Bid Price for Euros (in terms of Dollars) Were Higher Than the Ask Price? Professor Ross Miller • Fall 2005

19. (Pure) Arbitrage • An opportunity for pure arbitrage exists when you can find a way to sell something for more than it costs you without taking on any risk • Cost should ideally include all appropriate costs • Commissions, spreads and market impact • Taxes • Labor and capital requirements • Banks would appear to be exploiting arbitrage opportunities by making a spread, but there are risks to being a market maker Professor Ross Miller • Fall 2005

20. Markets and Arbitrage • Market forces will quickly eliminate most opportunities for arbitrage • Simple opportunities (such as those in currency conversion) will be eliminated more quickly than complicated ones • Finance often uses no-arbitrage arguments to determine the relative values of financial instruments, especially derivative securities (forward/futures contracts, options, etc.) Professor Ross Miller • Fall 2005

21. Remember This From Last Week • Can a bank make big money borrowing in euros (at low interest rates), converting the euros to dollars, investing in dollars, and then converting back to pay off the loan? Professor Ross Miller • Fall 2005

22. The Problem With This Attempt at Arbitrage • It is not pure arbitrage because the value of the dollar can decline over the term of the loan and if it decline enough, the trade loses money • What if we can “lock in” a future exchange rate? • This is easy to do using forward and futures contracts in currency (we will concentrate of forward contracts, because they are easier to understand and quotes are more widely available) Professor Ross Miller • Fall 2005

23. EUR/USD Forward Contract • An agreement to exchange euros for dollars on a specified future date at a specified exchange rate • The counterparty (the financial institution on other side of the trade) is almost always a major bank (JP Morgan Chase, Citigroup, etc.) • Unlike currency futures contracts, currency forward contracts cannot be traded Professor Ross Miller • Fall 2005

24. Forward Currency Transactions Are Not Just for Banks • Any company that uses foreign components or sells good abroad is exposed to the risk of currency fluctuations • A deal that is profitable at current forward rates, could become unprofitable if rates change • Forward contracts can “lock in” a profit • The use of forward (and futures) contracts to insure against changes in currency rates is one form of hedging Professor Ross Miller • Fall 2005

25. The Financial Times Publishes This Comprehensive Table of Forward Dollar Rates Professor Ross Miller • Fall 2005

26. Let’s Focus on the Euro Spot Rate: 1.2412 1-Month Forward Rate 1.2428 3-Month Forward Rate 1.2465 1-Year Forward Rate 1.2651 • The table shows that on an annual basis, the dollar drops by 1.5% vs. the euro over 1 month, by 1.7% over 3 months, and by 1.9% over 1 year Professor Ross Miller • Fall 2005

27. Interest-Rate Parity • The “financial law” that any extra interest that you can expect to make by switching into a currency with a higher interest rate will be exactly offset by a decline in the value of that currency is known as interest rate parity • Exceptions to interest-rate parity are small and fleeting Professor Ross Miller • Fall 2005

28. The General Form of The Interest-Rate Parity Formula F0 = direct exchange rate T years from now E0 = spot direct exchange rate (the rate now) rdomestic = interest rate in the “home currency” (usually U.S. dollars in this course) rforeign= interest rate in the other currency, (usually euros in this course) Professor Ross Miller • Fall 2005

29. How Well Does It Work? • The first question gives you an example to work through and we will go over it next week Professor Ross Miller • Fall 2005

30. What Does Interest-Rate Parity Mean for Financial Markets Currently? • The value of the dollar has declined relative to other major currencies over the past year and markets expect it to continue to decline • In order for the return on dollar-denominated assets to be competitive in the international marketplace, interest rates for dollars must be higher than interest rates for holdings in other competitive currencies, most notably the euro and the Japanese yen. Professor Ross Miller • Fall 2005

31. The Other Parity:Purchasing-Power Parity • Purchasing-power parity states that goods should cost the same in all currencies • Unlike interest rate parity, it is not an ironclad financial law • Consider the Big Mac Professor Ross Miller • Fall 2005

32. The Economist’s Big Mac Index Professor Ross Miller • Fall 2005

33. What Doesn’t Purchasing-Power Parity Work as Well as Interest-Rate Parity? Professor Ross Miller • Fall 2005

34. How Good are Forward Currency Rates At Predicting the Future? • On average, not bad • They appear to conform to the unbiased expectations hypothesis • This means that when you look at forward currency rates, the market is giving you its best estimate of what a euro, yen, etc. will be worth in the future dollars • As a precise estimate, pretty bad • While forward rates are right on average, the dispersion around that average is enormous Professor Ross Miller • Fall 2005

35. The Problem With Currencies • There are no accepted models for the future movements of currencies, because they depend on: • Politics • Trade policy • Global macroeconomics, etc. • Also, exchange rates are not “going anywhere” for “stable” economies • Stocks go up over long enough periods of time • U.S. risk-free interest rates tend toward 6%-8% over even longer periods of time Professor Ross Miller • Fall 2005

36. Gold (spot)Price = $448.60/ounce at 12:12PM 9/14/2005 • Note technically a financial instrument, but a physical commodity Professor Ross Miller • Fall 2005

37. New York Mercantile Exchange (NYMEX) • The main exchange for petroleum products and precious metals in the U.S. • Includes COMEX (acquired in 1994) • Trades futures contracts and options on those futures Professor Ross Miller • Fall 2005

38. COMEX Gold Futures (Symbol: GC) • Each contract is the delivery at a specified future date of 100 troy ounces of gold • Minimum price movement for futures (one tick) is $0.10, which is $10 per contract • Unlike fed funds futures, if a gold contract is held until the delivery date, the actual physical delivery of the gold takes place according the contract specifications • Unlike a forward contract, margin is posted and adjusted daily Professor Ross Miller • Fall 2005

39. A Brief History of Gold • Known in antiquity • Mentioned in various religious texts • Archimedes, the bathtub, Eureka and the gold crown • Recent events • Dollar has been backed by gold (the gold standard) on several occasions during U.S. history • Ownership of gold bullion has been illegal at times • The U.S. last went off the gold standard in 1971 Professor Ross Miller • Fall 2005

40. Why Does the Price of Gold Matter? • It is considered an indicator of faith in the financial system • In particular, because it is “hard currency,” when concerns about inflation arise, the price of gold tends to go up • When investors get nervous, depending on the specific circumstances, gold and U.S. Treasury securities are where money goes in its “flight to safety” Professor Ross Miller • Fall 2005

41. Gold Futures at 12:15PM 9/14/2005 • Note that the price of gold is always higher in future months (additional quotes are available on the NYMEX site) Professor Ross Miller • Fall 2005

42. Do Futures Prices Represent the Market’s Prediction of What Gold Will Be Worth Later? • This was the case for the fed funds futures and we referred to this as the unbiased expectations hypothesis • However, the fed funds futures were not “real,” and gold is very real • It is easy to move gold into the future • Borrow money at the interest rate r • Purchase gold with the money • Lock in a future price with the futures contract Professor Ross Miller • Fall 2005

43. Let’s Compare the Spot and October Futures Priced of Gold Just After Noon on 9/14/2005 • Spot price = $448.60 • October futures price = $449.50 (delivery anytime during the month) • The return on buying gold now and selling in the futures market is: $449.50/$448.60 – 1 = 0.0020 or 20 b.p. Professor Ross Miller • Fall 2005

44. Is Receiving 20 b.p. for Holding Onto Gold for 17 days a Good Deal? Professor Ross Miller • Fall 2005

45. Spot-Futures Parity Theorem • In words, the futures price can exceed the spot price by at most an amount equal cost of “carrying” the item until the earliest time that delivery can be made • Cost of storing the item includes: • The cost of the money tied up in the item • Warehousing, insurance, etc. • Net out any benefits of holding the item (dividends for stocks) • A market where the futures price exceed the spot price by exactly the “cost of carry” is known as a full-carry market Professor Ross Miller • Fall 2005

46. Another Way To Think of the Spot-Futures Parity Theorem When Applied to Gold • Gold is like a currency that pays either no interest or very slightly negative interest (the cost of storage, insurance, etc.) • Applying interest-rate parity with gold as the foreign currency and taking rforeign=0, we have (using S0 instead of E0): Professor Ross Miller • Fall 2005

47. One Loose End: What To Use For rdomestic • This was not a problem for currencies, because everything was Eurodeposits, which have the same risk (that associated with offshore banks) • Standard practice is to use a “risk-free rate” (an idea from the Capital Asset Pricing Model) • The prime candidate for the risk-free rate is the rate on the U.S. Treasury security that matures the same time as the futures contract is delivered Professor Ross Miller • Fall 2005

48. Example • Spot gold: $448.60 • Risk-free rate for 6 months (0.5 years): 3.74% • Then, the 6-month futures price should be: F0= S0(1+r)0.5 = $448.60(1.0374)0.5 = $448.60(1.01852835) = $456.91 Professor Ross Miller • Fall 2005

49. Most Futures Markets are not Full-Carry Markets: Consider NYMEX Unleaded Gasoline Futures Professor Ross Miller • Fall 2005

50. Two Big Words to Impress People With • Contango • A market is in contango when prices are higher in the futures market the further into the future one goes • Some current examples: EUR/USD and gold • Backwardation • A market is in backwardation when prices are lower in the futures market the further into the future one goes • A current example: Unleaded gasoline Professor Ross Miller • Fall 2005