BA 543

1. BA 543 The Market for Foreign Exchange Rate Risk Control Instruments By: Gurjot Dhaliwal

2. Foreign Currency Markets • Largest Trading Market in the World • $1.2 Trillion average daily trading volume • Open 24/7

3. Exchange Rates • The amount of US dollars necessary to acquire one unit of foreign currency, and this is the dollar price of one unit of foreign currency; or • The number of units of foreign currency necessary to acquire one US dollar, or the foreign currency price of one dollar.

4. Direct Quotes • The number of units of a local currency exchangeable for one unit of a foreign currency. • $1/.8152 Euro

5. Indirect Quotes • The number of units of a foreign currency that can be exchanged for one unit of a local currency. • 1 Euro / $1.2268

6. Bid – Ask Spread • In the floating market currencies are traded just as in the open market with a bid price and an ask price. The difference between the two is the bid ask spread. The bid is always given first. • An example of a bid ask spread is 1 Euro = $1.33-42. This means that there is a bid price of $1.33 and the sellers are asking $1.42 per Euro.

7. Currency Risk • Is the risk that a currency’s value may change adversely • Also termed foreign exchange risk

8. Exchange Rate Regimes • Fixed Rates – A country establishes a fixed band in which a currency is allowed to trade relative to another countries currency. • Floating Rates – A country allows its currency to move according to market conditions. • Managed Floating Rates – A country allows its currency limited movement according to the market but actively purchases currency to control where its currency moves.

9. Purchasing Power Parity • Consumer Price Index Brief Explanation of the CPI The Consumer Price Index (CPI) is a measure of the average change in prices over time of goods and services purchased by households. The Bureau of Labor Statistics publishes CPIs for two population groups: (1) the CPI for Urban Wage Earners and Clerical Workers (CPI-W), which covers households of wage earners and clerical workers that comprise approximately 32 percent of the total population and (2) the CPI for All Urban Consumers (CPI-U) and the Chained CPI for All Urban Consumers (C-CPI- U), which cover approximately 87 percent of the total population and include in addition to wage earners and clerical worker households, groups such as professional, managerial, and technical workers, the self- employed, short-term workers, the unemployed, and retirees and others not in the labor force. The CPIs are based on prices of food, clothing, shelter, and fuels, transportation fares, charges for doctors' and dentists' services, drugs, and other goods and services that people buy for day-to-day living. Prices are collected in 87 urban areas across the country from about 50,000 housing units and approximately 23,000 retail establishments- department stores, supermarkets, hospitals, filling stations, and other types of stores and service establishments. All taxes directly associated with the purchase and use of items are included in the index. Prices of fuels and a few other items are obtained every month in all 87 locations. Prices of most other commodities and services are collected every month in the three largest geographic areas and every other month in other areas. Prices of most goods and services are obtained by personal visits or telephone calls of the Bureau's trained representatives. In calculating the index, price changes for the various items in each location are averaged together with weights, which represent their importance in the spending of the appropriate population group. Local data are then combined to obtain a U.S. city average. For the CPI-U and CPI-W separate indexes are also published by size of city, by region of the country, for cross-classifications of regions and population-size classes, and for 27 local areas. Area indexes do not measure differences in the level of prices among cities; they only measure the average change in prices for each area since the base period. For the C-CPI-U data are issued only at the national level. It is important to note that the CPI-U and CPI-W are considered final when released, but the C-CPI-U is issued in preliminary form and subject to two annual revisions. The index measures price change from a designed reference date. For the CPI-U and the CPI-W the reference base is 1982-84 equals 100.0. The reference base for the C-CPI-U is December 1999 equals 100. An increase of 16.5 percent from the reference base, for example, is shown as 116.5. This change can also be expressed in dollars as follows: the price of a base period market basket of goods and services in the CPI has risen from $10 in 1982-84 to $11.65.

10. Purchasing Power Parity • Consumer Price Index • Brief Explanation of the CPI - The Consumer Price Index (CPI) is a measure of the average in prices over time of goods and services purchased by households.

11. CPI • It is a price index which tracks the prices of a specified set of consumer goods and services, providing a measure of inflation

12. Purchasing Power Parity • Consumer Price Index • Big Mac Index

13. Purchasing Power Parity Big Mac Index As of publication a Big Mac in the United States cost $2.90. A Big Mac in China cost $1.26. Therefore the implied PPP 3.59. This can be compared against the current differences in currency valuations and showed that the Chinese Yuan was undervalued by 57%. This is an example of why most countries are pressuring China to allow the Yuan to float.

14. Purchasing Power Parity • Consumer Price Index • Big Mac Index • Starbucks Latte Index

15. Cross Rates • Comparison of two foreign currencies via a third currency such as the dollar

16. Triangular Arbitrage • An arbitrage strategy employed to take advantage of cross rate mispricing between the U.S. dollar and the two foreign currencies

17. Triangular Arbitrage Example • Euro dollar Rate: .8 Euro / $ • Yen dollar Rate: 122 Yen / $ • Implied Cross Rate: 122 Yen / .8 Euro = 152.5 Yen/Euro • Yen Euro Rate: 140 • Because there is a difference between the actual rate of 140 and the implied rate of 152.5 there exists an opportunity for arbitrage

18. Triangular Arbitrage Example Cont. • A US investor borrows $100 million. This would be used to buy 12.2 billion Yen. $100 Million US 122 Yen / $ 12.2 billion Yen

19. Triangular Arbitrage Example Cont. • A US investor borrows $100 million. This would be used to buy 12.2 billion Yen. • Trade the 12.2 billion Yen for Euro’s at the market rate of 140 Yen / Euro yielding 87.14 million Euro’s. $100 Million US 122 Yen / $ 87.14 Million Euro 12.2 billion Yen 140 Euro / Yen

20. Triangular Arbitrage Example Cont. • A US investor borrows $100 million. This would be used to buy 12.2 billion Yen. • Trade the 12.2 billion Yen for Euro’s at the market rate of 140 Yen / Euro yielding 87.14 million Euro’s. • The 87.14 million Euros would then be traded back to US dollars at .8 Euro / $ yielding $108.93 Million $108.93 Million $100 Million US 122 Yen / $ .8 Euro / $ 87.14 Million Euro 12.2 billion Yen 140 Euro / Yen

21. Triangular Arbitrage Example Cont. $8.93 Million Profit • A US investor borrows $100 million. This would be used to buy 12.2 billion Yen. • Trade the 12.2 billion Yen for Euro’s at the market rate of 140 Yen / Euro yielding 87.14 million Euro’s. • The 87.14 million Euros would then be traded back to US dollars at .8 Euro / $ yielding $108.93 Million. • The investor would then repay the $100 million. The investor keeps the $8.93 Million profit, or 8.93%. $108.93 Million $100 Million US .8 Euro / $ 122 Yen / $ 87.14 Million Euro 12.2 billion Yen 140 Euro / Yen

22. Triangular Arbitrage Example Cont. • This can be double checked by measuring the difference between the implied and actual cross rates. • (152.5 – 140)/ 140 = 8.93% • $100 Million * 8.93% = $8.93 Million Profit