Lecture in international finance

Lecture in International Finance Chinese University of Technology Foued Ayari, PhD About Dr Ayari • Assistant Professor of Finance in New York • President & CEO of Bullquest LLC, a financial training company • Partner at Goldstone Property Group Inc • Author of a recently published book: “Credit Risk Modeling: An Empirical Analysis on Pricing, Procyclicality and Dependence • Author of a forthcoming book published with Wiley & Sons, “Understanding Credit Derivatives: Strategies & New Market Developments” Outline • The FX market • Currency Forwards • Eurobond Market • Eurocurrency Market • Currency Swaps • Strategies in FX Foreign Exchange Markets • BACKGROUND • Foreign Exchange markets come under Global Markets Division within Banks It features are as follows: – – – – OTC market Major international banks Spot market and forward market London is the largest centre • 7/24 Market with daily Turnover of more than $3,200 Billions (BIS, 2007) • All currencies are primarily valued against the USD dollar: – USD = JPY 112.26 (in this quote, the most common type, the USD is the base currency) – EUR = USD 1.2594 (in this quote the USD is the variable currency) Correspondent Banking Relationships • International commercial banks communicate with one another with: – SWIFT: The Society for Worldwide Interbank Financial Telecommunications – CHIPS: Clearing House Interbank Payments System – ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions Spot Market Participants and Trading • FX MARKET STRUCTURE • The foreign exchange spot markets are QUOTE DRIVEN markets with international banks as the wholesale participants This market is also known as the FX inter-bank market • International banks act as MARKET MAKERS They make each other two-way prices on demand: – The bank MAKING the quote bids for the BASE currency on the left and offers (ask) it on the right e.g: • GBP = USD 1.8850 (Bid), GBP = USD 1.8860 (Ask) Becomes: • 1.8850/60 or even • 50/60 The Foreign Exchange Market • TYPES OF EXCHANGE MARKETS AND CONVENTIONS • Exchange markets FX Market Spot Market Forward Market FX Swaps Market Deals for delivery T + Deals for delivery up to 12 months later than T + Deals with one spot component and one forward component Spot & Forward • • • • • A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies) A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months) Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk An FX swap (not to be confused with a cross currency swap) is a contract that simultaneously agrees to buy (sell) an amount of currency at an agreed rate and to resell (repurchase) the same amount of currency for a later value date to (from) the same counterparty, also at an agreed rate Non Deliverable Forwards How Factors Can Affect Exchange Rates Forwards • • Spot Rates Spot is the term used for standard settlement in the FX markets The spot date is two business days after the trade date: T+2 – Spot rates are quoted as two way prices between the banks that populate the FX markets: Source: Bloomberg Forecasts Forecasts Purchasing Power Parity and Exchange Rate Determination • The exchange rate between two currencies should equal the ratio of the countries’ price levels: P$ S($/£) = P£ For example, if an ounce of gold costs $300 in the U.S and £150 in the U.K., then the price of one pound in terms of dollars should be: P$ $300 S($/£) = = £150 = $2/£ P£  USD/JPY PPP Purchasing Power Parity and Exchange Rate Determination • Suppose the spot exchange rate is $1.25 = €1.00 • If the inflation rate in the U.S is expected to be 3% in the next year and 5% in the euro zone, • Then the expected exchange rate in one year should be $1.25×(1.03) = €1.00×(1.05) F($/€) = $1.25×(1.03) €1.00×(1.05) = $1.23 €1.00 Purchasing Power Parity and Exchange Rate Determination • The euro will trade at a 1.90% discount in the forward market: F($/€) = S($/€) $1.25×(1.03) €1.00×(1.05) $1.25 €1.00 1.03 + π$ = = 1.05 + π€ Relative PPP states that the rate of change in the exchange rate is equal to differences in the rates of inflation—roughly 2% Purchasing Power Parity and Interest Rate Parity • Notice that our two big equations today equal each other: PPP F($/€) + π$ = S($/€) + π€ IRP = + i$ + i€ F($/€) = S($/€) Expected Rate of Change in Exchange Rate as Inflation Differential • We could also reformulate our equations as inflation or interest rate differentials: F($/€) + π$ = S($/€) + π€ F($/€) – S($/€) + π$ + π$ + π€ = –1= – S($/€) + π€ + π€ + π€ F($/€) – S($/€) π$ – π€ E(e) = ≈ π$ – π€ = S($/€) + π€ Expected Rate of Change in Exchange Rate as Interest Rate Differential E(e) = F($/€) – S($/€) = S($/€) i$ – i€ + i€ ≈ i$ – i€ Quick and Dirty Short Cut • Given the difficulty in measuring expected inflation, managers often use π$ – π € ≈ i $ – i € Currency Strategies • Momentum trading seeks to take advance of market trends, purchasing currencies with the best recent performance and selling the weakest performers • Mean reversion strategies in are some ways the opposite of momentum strategies It is based on the idea that currencies are prone to move too far too fast and then are reversed in part or in full • Carry trades seek to take advantage of interest rate differentials, selling low yielding currencies and buying higher yielding currencies Currency Swaps • In a plain vanilla cross-currency swap transaction, one party typically holds one currency and desires a different currency • Each party will then pay interest on the currency it receives in the swap and the interest payment can be made at either a fixed or a floating rate • Contrary to the Interest Rate Swap there is an actual exchange of cash flow at initiation • Frequent bond issuers often issue bonds in currencies demanded by investors Cross-Currency Swaps Positions • Party A holds € • Party B holds $ • Possibilities: – A pays fixed rate on $ received and B pays fixed rate on € received – A pays floating rate on $ received and B pays fixed rate on € received – A pays fixed rate on $ received and B pays floating rate on € received – A pays floating rate on $ received and B pays floating rate on € received Example of a Currency Swap • • • Below are cash flows for £10m year swap 5% fixed for fixed £ / $: US Interest Rates: 10% UK Interest Rates 8% Party A holds £10m From the perspective of A Receive $20m Receive £0.8m Receive £0.8m Receive £0.8m Receive £10.8m Termination date Pays £10m Contrary to IRS there is exchange of cash flows at initiation and termination Pay $2m Pay $2m Pay $2m Pay $22m Other Instruments in International Finance • EUROCURRENCY MARKETS • EUROBOND MARKETS ... of Finance in New York • President & CEO of Bullquest LLC, a financial training company • Partner at Goldstone Property Group Inc • Author of a recently published book: “Credit Risk Modeling:... $100,000: Invest in the U.S at i$ Future value = $100,000 × (1 + i$) Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£ while eliminating any exchange rate risk by selling the... Banking Relationships • International commercial banks communicate with one another with: – SWIFT: The Society for Worldwide Interbank Financial Telecommunications – CHIPS: Clearing House Interbank