Foreign Exchange Market Conducted BY: Mohammad Ramzan, CFA On Behalf of

1. Foreign Exchange Market Conducted BY: Mohammad Ramzan, CFA On Behalf of

2. Course Objectives • Understanding theoretical background of exchange rates • History of Foreign Exchange Market • Market Place • Exchange Rate Regimes • Fundamental Factors • Structure and mechanism of the Foreign Exchange Market • Forward and Swap Rates • Theory of Determination of Exchange Rate: PPP

3. Foreign Exchange • International Trade • Do we need International Trade?

4. Gains from Specialization and International Trade

5. Gains from Specialization and Trade • International trade leads to mutual gain because it allows each country to specialize more fully in the production of those things that it does best according to the law of comparative advantage. • Trade permits each country to use more of its resources to produce those goods that it can produce at a relatively low cost. • With trade, it will be possible for the trading partners to consume a bigger bundle of goods that would be impossible for them to produce and consume domestically.

6. Gains from Specialization, Trade POPFOODSHIRTS USA O,9 100 x 2 = O,9 100 x 1 = 100 JAPAN 50 25 x 3 = 75 25 x 9 = 225 ----------------- -------------- Total World Prod. 275 325 PRICES USA 1 Food = 0.5 Shirt 1 Shirt = 2.0 Foods JAPAN 1 Food = 3 Shirts 1 Shirt = 0.33 Food

7. Gains from Specialization, Trade POPFOODSHIRTS USA O,9O,9 x 2 = 400 0 x 1 = 0 JAPAN 50 0 x 3 = 0 50 x 9 = 450 World Production 400 450 Possibility of trade? US should export food to Japan Japan should export shirts to USA

8. Production possibilities, Japan R Production possibilities, U.S. J1 M US1 S N Before Specialization and Trade United States Japan Clothing(million units) Clothing(million units) 450 450 400 375 350 300 300 250 225 O,9 150 150 100 75 50 Food(million units) Food(million units) 100 O,9 300 400 75 150

9. O Consumption possibilitiesof Japan with trade Consumption possibilitiesof U.S. with trade T Consumption Possibilities with Trade United States Japan Clothing(million units) Clothing(million units) R 450 450 400 375 350 300 300 250 M 225 J1 O,9 150 150 US1 100 75 50 S N 50 Food(million units) Food(million units) 400 100 O,9 300 400 75 150

10. 250 J2 US2 O,9 Consumption Possibilities with Trade United States Japan Clothing(million units) Clothing(million units) R 450 450 O 400 375 350 300 300 250 M 225 J1 O,9 150 150 US1 100 75 50 T S N 50 Food(million units) Food(million units) 400 100 O,9 300 400 75 150

11. Foreign Exchange • International Trade necessitates exchange of currencies • Movement of Capital creates another source of supply and demand • Definition: The price at which one currency is traded in exchange for another in FX market is the exchange rate between the two currencies.

12. Foreign Exchange: History • Bretton Woods: 1944 - 1971 • Delegates from 45 Countries • Pegging of currencies with US Dollar • Margin of movement: 1% +/- • Dollar as a reserve currency • Dollar was convertible to gold (1/35 ounce) • Frequent adjustments took place • US ran a continuous Current A/c Deficit • Vietnam War worsened the US situation • Pressure for convertibility • 1971: US Unilaterally abandoned the convertibility

13. Foreign Exchange: History • Post Bretton Woods: Free float • Some regional treaties • EMU • European Monetary Unit • Currency pegs with 2.5% +/- • Some weak currencies were allowed 6% +/- • Frequent Adjustments • 1992: George Soros humbles BOE out of EMU • 1999: Euro created – Maastricht Treaty

14. Foreign Exchange Markets

15. Foreign Exchange Market • US$ is the cornerstone of the foreign exchange market • Exchange Rates are quoted against US$ • US Worlds biggest economy • Reserve currency status • Safe Haven status • Large amount of world trade in US$ • Almost all commodities traded in US$

16. Factors that affect currency’s Value • National inflation rates – Imports/Exports • Inflation also affects the purchasing power of the currency • Changes in real interest rates – Debt securities Investment. • Differences in economic performance (GDP) – Equity and real asset Investment. • Current Changes in investment climate. Prospects of higher return but also low risk. (Political stability, Legal system, Fair taxation, Capital movement, stable prices policies, Law and Order, Judicial System)

17. Factors that affect currency’s Value • Trade and Current A/c Balance • GDP – Gross Domestic Product: Market Value of all good and services produced within a country during a specific period • Why is GDP important? • Higher GDP means higher value of the currency and vice versa

18. Real and Nominal GDP • The term "real" means adjusted for inflation. • Price indexes are used to adjust income and output data for the effects of inflation. • A price index measures the cost of purchasing a market basket (or “bundle”) of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference (or base) period.

19. GDP Deflator1 GDP Deflator2 Real GDP2= Using the GDP Deflator to Derive Real GDP • The formula for converting the nominal GDP into real GDP is: Nominal GDP2 * • Data on both money GDP and price changes are essential for meaningful comparisons of output between two time periods.

20. Nominal GDP Price index Real GDP (billions of U.S. $) (GDP deflator, 1996 = 100) (billions of 1996 $) 100.0 109.4 9.4% Source: U.S. Department of Commerce. Using the GDP Deflator to Derive Real GDP • Between 1996 and 2001, nominal GDP increased by 30.7%. • But, when the 2001 GDP is deflated to account for price increases, we see that real GDP increased by only 19.4%. 1996 $7,813 $7,813 2001 $10,208 $9,331 % increase 30.7% 19.4%

21. Government Policies • An expansionary monetary policy will lead to a depreciation of the home currency. • A restrictive monetary policy will lead to an appreciation of the home currency. • A more restrictive fiscal policy should also slow down economic activity and inflation, and real Interest rates. Lower Inflation and Lower real Int. rates may have conflicting affect. • A more expansionary fiscal policy has the reverse effect. Fiscal Policy is hard to judge.

22. Exercises

23. Exchange Quotes: Direct • A direct exchange rate is the domestic price of foreign currency. • Let “DC” be the domestic currency, and “FC” be the foreign currency. • A direct quote could be represented as: For example: 0.5 DC = 1 FC 1.25DC = 1 FC

24. Indirect Foreign Exchange Quotes • An indirect exchange rate is the amount of foreign currency equivalent to one unit of domestic currency. • For example, 2 FC: 1 DC • Note this conveys the same information as our previous example. • For example: 0.0067 $/Yen would be an indirect quote in Japan.

25. Quote Conventions • Internationally most currencies are quoted in terms of 1 US$ = ?. • There are two main exceptions: • British pound (has always been quoted as dollar price of one pound). • Euro (convention adopted to quote the foreign currency value of one euro).

26. Quote Conventions • Base Currency/Counter base (Quoted Currency) • Check: www.imf.org/external/np/fin/rates/rms_rep.cfm • Quotations are usually given with five digits. For example, • USD/JPY 118.55 • GBP/US$ 1.7725 • 1.77 = Big Fig; 25 = pips, points

27. Exercises • Exercises on Quotes

28. Cross Rates • A cross rate is the exchange rate between two countries inferred from each country’s exchange rate with a third country. • For example, bank A gives the following quotations: • $/CHF = 1.3110 – 20 • $/JPY = 118.90 – 00 • Calculate the CHF/JPY rate: • CHF/JPY bid rate = 118.90 and 1.3120 are relevant • 1.3120CHF = 1 US$ = 118.90 • 118.90/1.3120 = 90.625 • CHF/Yen ask rate =119.00/1.3110 = 90.770 • Cross rate is: CHF/JPY = 90.625 – 90.770

29. Cross Rates • GBP/USD: 1.8250-60 • USD/JPY: 116.80-90 • Calculate GBP/JPY? • For Bid: 116.80 and 1.8250 are relevant • 1 US$ = 116.80JPY • 1GBP = 1.8250 US$ = 116.80 x 1.8250 = 213.16 • For Offer: 116.90 and 1.8260 are relevant • 1 US$ = 116.90 • 1 GBP = 1.8260US$ = 1.8260 x 116.90

30. Cross Rates • Rules of Thumb to remember: • If the rates of two currencies are quoted in same terms, the cross rates is really a X, i.e. bid to offer and offer to bid and it involves a division. • If the rates for two currencies are quoted in different terms, then the cross is a multiplication of bid to bid and offer to offer.

31. Exercises • Exercises for cross rate calculation

32. Risks • Risk of a long position: Price may go down • Profit of a long position: When price goes up • Risk of a short position: Price may go up • Profit on a short position: When price goes down • Market Risk • Liquidity Risk • Credit Risk • Settlement Risk

33. Forward Rates • Spot rates are quoted for immediate currency transactions (although in practice it takes place 48 hours later). • Forward exchange rates are contracted today but with delivery and settlement in the future. • In a forward, or futures, contract a commitment is irrevocably made on the transaction date, but delivery takes place later, on a date set in the contract.

34. Forward Premiums/discounts • Base currency…$, Pound, Euro • Formula: F = spot {1+(Int Rate of counter-base*days/conventional year)/1+(Int Rate of Base currency*days/ conventional year)} • Use proper days’ convention

35. Forward Rates: Calculation • GBP/US$ = 1.6400 - 10 • Assuming one can borrow/lend at market rates (6 Months) • Pound Interest Rate: 3.75 – 3.80% • US$ Interest Rate: 1.15 – 1.20% • P98,164.5 = $161,087.90 @ 1.6410 • $161,087.90 @ 1.20% = $162,065.17 • P98,164.5 @ 3.75% = P100,000 • 162065.17/100,000 = 1.62065

36. Forward Rates: Calculation • Using the Formula 1.6410 * {1+(0.012*182/360)/1+(0.0375*182/365)} =1.6410 * (1.006067/1.018699) =1.6410 * 0.9876 =1.62065

37. Forward Rates: Calculation • GBP/US$ = 1.6400 – 10 (Spread: 10 points, 0.061%) • Assuming one can borrow/lend at market rates (6 Months) • Pound Interest Rate: 3.75 – 3.80% • US$ Interest Rate: 1.15 – 1.20% • P98,140.44 = $160,950.32 • $160,950.32 @ 1.15% = $161,886.07 • P98,140.44 @ 3.80% = P100,000 • 161,886.07/100,000 = 1.61886

38. Forward Rates: Calculation • Using Formula • 1.6400 * {1+(0.0115*182/360)/1+(0.0380*182/365)} • 1.6400 * 1.005814/1.01895 • 1.6400 * 0.9871 • 1.61886

39. Forward Spread • Spot 1.6400 – 10 • Forward 1.6189 – 07 • Spread in Spot 10 points • Spread in forward 18 points

40. Forward Premiums/discounts • Spot 1.6400 – 10 • Forward 1.6189 – 07 • Difference 0.0211 - .0203 • Also called Swap Points • Is GBP at discount/Premium? • Rule: Higher interest currency is always at discount in forward and lower interest currency always at premium

41. Swaps • In inter-bank market, forwards are quoted as under: Spot GBP 1.6400-10 Swap 1-month 35 – 32 3-months 105 – 100 6-months 211 – 203 12-months 430 – 420

42. Swaps Revisited • How to use swap points: • If the bid is higher than offer of swap points, the base currency is at discount • If the bid is lower than offer, the base currency is at premium

43. Swaps Revisited • How to use swap points: • If the bid is higher than offer of swap points, Deduct swap points from spot rate • If the bid is lower than offer, Addswap points to spot rate

44. Swaps Revisited • Make Outright forward rates Spot GBP 1.6400-10 Swap 1-month 35 – 32 3-months 105 – 100 6-months 211 – 203 12-months 430 – 420

45. Swaps Revisited • Make Outright forward rates Spot CHF 1.2760-70 Swap 1-month 12 - 10 3-months 31 – 28 6-months 60 – 55 12-months 112 – 104

46. Forwards Revisited • You can construct a forward (3-month) through spot market and swap market • Spot GBP 1.6400 - 10 3-months swap 105 – 100 • You want to buy GBP forward

47. Forwards Revisited • You can buy spot first, let’s say 1 mio GBP at 1.6410 • Then at 100 you sell/buy 1 mio pound • Swap Transaction: • You sell in spot and buy in forward • Rates: Spot 1.6410 Forward 1.6310

48. Arbitrage • Arbitrage involves the simultaneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio, in order to obtain a risk free profit on the price differential. • Arbitrage keeps exchange rates in line with each other and with risk free interest rates. • For example, the $/Euro rate must be the same, at a given instant, in Frankfurt, Paris and New York.

49. Various arbitrage opportunities to consider... • With respect to the exchange rate between two countries, the rate in one country should be aligned with the rate in the other. If not, a bilateral arbitrage opportunity exists. • A triangular arbitrage opportunity occurs if the quoted cross-rate between two currencies is higher or lower than the cross-rate implied by the exchange rates of the two currencies against a third currency.

50. Triangular Arbitrage • Triangular arbitrage involves three steps: • Pick the cross-rate currency • Determine whether the cross-rate bid-ask quotes are in line with the direct quotes by determining whether it is cheaper to buy foreign currency directly or indirectly. • If the actual cross-rate quote is not in line with the quoted cross-rate quotes, an arbitrage opportunity exists.