Exchange Rates and Arbitrage

1. Joel Graham Joe Griner Exchange Rates and Arbitrage

2. Outline • What are Exchange Rates? • Purchasing Power Parity • History – Exchange Rate Systems • Big Mac Index • Cross Rates • Triangular Arbitrage

3. What are Exchange Rates? • The amount of currency that can be exchanged for a unit of another currency • $1 us = ¥95

4. Example – Exchange Rate Shoe Japan USA ¥7,000 S&H$70.00 S&H Exchange Rate? $1 = ¥100 • This establishes the concept of purchasing power parity, a single product should be the same priceboth countries

5. Example - Continued • Is this assumption always true? • Whatcouldcause prices to be different? • Economic Climate • Government Policy • Inflation

6. Example – Forward Rates Shoe Japan USA ¥7,000 S&H$70.00 S&H 6% -- Inflation -- 3% What is the new price? ¥7,420 S&H $72.10 S&H Exchange Rate? $1 = ¥102.91 Forward Rate = Spot Rate x ( (1 + πfc) ÷ (1 + πdc) )

7. Purchasing Power Parity • Represents the real value of the currency within the country • PPP suggests that two different currencies should adjust so that items cost the same in both countries

8. PPP - Continued • Such adjustments occur through inflationary forces, causing the price of goods in one country to be higher than in the other • When this occurs, exchange rates must change in order to reflect the change in purchasing power between the two currencies

9. History of Exchange Rates • The gold standard • Bretton Woods • Fixed Exchange Rates • End of Fixed Exchange Rates

10. The Gold Standard • For centuries the world’s currency was backed by gold. • In the 1930s, the US dollar was set to a fixed rate of 1 ounce of gold being worth 35 dollars. • The gold standard finally broke down in 1971 do to unstable governmental policies as well as high inflation.

11. Bretton Woods • Held in Bretton Woods, New Hampshire in July 1944. • The 44 allied nations met to discuss international monetary policies. • Created a pegged exchange rate that made the dollar as the reserve currency.

12. Fixed Exchange Rate • Countries pegged their currency against the US dollar which made the US dollar the reserve currency. • The US dollar was convertible into gold. • Countries were required to keep their exchange rate within +/- 1% of parity.

13. End of Fixed Rates • US was spending too much on the Vietnam War and social programs and the dollar was becoming way undervalued. • Too much gold was being exchanged for dollars which decreased the amount of gold in the US • In 1971, Nixon declared that dollars were no longer convertible to gold, which led to the establishment of the floating exchange rate system.

14. Big Mac Index • Since the purchasing power parity concept can be complex and difficult to measure, The Economist established a way to measure real-world PPP using MacDonald’s Big Mac hamburger • The Big Mac was chosen because of it’s availability in many countries around the world and the ability of franchisees in establishing input prices

15. BMI - Continued • The Big Mac PPP exchange rate is calculated between two countries by dividing the price of a Big Mac in country A by the price of a Big Mac in country B. • The Big Mac exchange rate is then compared with the actual market exchange rate • If the calculated rate is lower, then the currency is undervalued, if higher, than it is overvalued

16. BMI – Continued • It is effective in measuring PPP because it is a consistent good, with very few differences across countries • A simple basket of goods can vary greatly by culture, as basic goods defined here in the U.S are significantly different than those in other parts of the world such as in rural India • Big Mac Index: Feb 4th, 2009

17. Direct Quote • A direct quote is expressed as x amount of home currency units = one foreign currency unit • For example: $0.85 = €1

18. Indirect Quote • An indirect quote is simply the reciprocal of a direct quote, expressed as x amount of foreign currency units = one home currency unit • For example: ¥120 = $1

19. Quoting Terms • Quoting in terms of home currency (U.S. Dollars) per unit of foreign currency is called American Terms • Quoting in terms of # of foreign currency units per unit of home currency (U.S. Dollar) is called European Terms • $.20 = ¥1 American Terms • ¥5 = $1 European Terms

20. Cross Rates • The exchange rate between two countries other than the home country can be inferred from their exchange rates with the home currency • Rates calculated in this way are referred to as theoretical cross rates • c$ / $ x € / c$ = € / $

21. Cross Rates - Example 1.08150 CAD per 1 USD X 0.646138 Euro per 1 CAD = 0.698798 Euro to 1 USD • If 0.698798 ≠ the reported Euro to USD exchange rate, an arbitrage opportunity exists

22. Triangular Arbitrage • Barring any government restrictions, riskless arbitrage will assure that the exchange rate between two countries will be the same in both countries • In reality, theoretical cross rates computed from exchange quotes, rarely differ from the actual cross rates quoted by dealers • In the event that an imbalance occurs, a riskless arbitrage opportunity arises

23. Triangular Arbitrage - Workout $ € c$ Beginning with 20,000 USD 20,000 USD 20,000 USD x 1.08150 CAD 13975.96494 Euro ÷ 0.698798 USD per Euro 21630 CAD 13975.96494 Euro 21630 CAD x 0.646138 Euro

24. Triangular Arbitrage - Workout $ € c$ Beginning with 20,000 USD 20,225.02165 USD 20,000 USD x 1.08150 CAD 13975.96494 Euro ÷ 0.690000 USD per Euro Risk Free Profit of $225.022 21630 CAD 13975.96494 Euro 21630 CAD x 0.646138 Euro

25. Triangular Arbitrage • As you can see, even with a difference of .008798 between the theoretical cross rate and the actual exchange rate for euro per dollar, risk free profit can be realized • As large and frequent transactions are carried out to exploit this opportunity, the difference between theoretical rates and reported rates will diminish

26. Questions? • Thank you!