FINS3616 International Business Finance

Globalised Economy

• Financial investments abroad are on the rise as:

  • Diversification needs

  • Chasing higher returns in more mature markets

  • Ease of access (rise of ETFs, app brokers etc)

• World economy also becoming more globalised:

  • MNCs dominate our environment

  • International production

  • Import of intermediate goods

  • Export of the final product

  • Even domestic firms will have significant international components

Rise of MNCs

• The raw material seekers go abroad to explore raw materials

  • multinational oil and mining companies (BHP, Exxon)

• The market seekers go overseas to produce and sell in foreign markets

  • Unilever, Proctor&Gamble, Nestle, Maccas, Coke

• The cost minimisers invest in lower cost production or production technologies overseas to remain cost competitive

  • Apple, SHEIN, Uniqlo, H&M, Zara (Countries like India, Bangladesh, China, etc)

• The knowledge seekers enter foreign markets to gain information

  • Production processes in terms of technology, foreign innovation

• The domestic customer followers try to deliver services to customers abroad

  • banks, law, consulting firms that set foreign practices following their MNC clients (KPMG, PwC, Deloitte)

• Financial market imperfection exploiters reduce taxes and benefit from diversification

  • American companies relocating their corporate HQ to ireland due to tax benefits

  • BHP moving HQ to SGP

International Markets

• Classified by asset class

  • Stocks

  • Bonds

  • Currencies

  • Derivatives

  • Many more but not covered in course

Bond Market

• The bond market is as large as the stock market

  • International bonds: US$32 Trillion

  • Domestic bonds: US$101 Trillion (US?)

• By sector

  • Governments: US$60 Trillion

  • Financial institutions: US$42 Trillion

  • Non-financial corporations: US$17 Trillion

FX Market

• largest market in the world in terms of activity

  • growing exponentionally since the 1980s

  • daily volume of US$ 7.5 Trillion

  • Instrument wise:

Exchange rate quotations

• A/B (in this course)

• USD/EUR

  • EUR is the quoted currency

  • USD is the base

• 1 USD to 1.20 Euros

• If say 1 USD is now worth 1.3 Euros

  • we say that the USD has depreciated and that the Euro has appreciated

  • and vice versa if the other way around

Percentage as a measure of depreciation / appreciationm

Examples of FX effects for importers vs exporters

• Multiply when the rate is expressed as domestic currency per unit of foreign currency (AUD/BRL) — this converts foreign currency costs into domestic currency terms, where a stronger foreign currency means higher costs and lower profit.

• Divide when the rate is expressed as foreign currency per unit of domestic currency (EUR/USD); multiply when the rate is expressed as domestic currency per unit of foreign currency (USD/EUR) — both convert foreign currency revenue into domestic currency terms

Finding the return of an invesment in a foreign currency

• The total return in domestic currency (AUD) reflects both the asset's price return in foreign currency (JPY) and the FX rate change — multiply the foreign currency total by the FX rate (AUD/JPY) to convert to AUD, then calculate the return as (Final AUD Value − Initial AUD Value) / Initial AUD Value

Exchange rate risk

• Companies and investors pay risk if they hvae to receive and pay an amount in foreign currency

• The future exchange rate is uncertain

• And unfavourable exchange rate movements may result in a loss

Important exchange rates in the FX market

• Spot rates

  • quoted for immediate currency transactions

• Forward exchange rates

  • contracted today but with delivery and settlement in the future

Covered Interest Rate Parity

• The forward rate that makes the two investments equal must be given by (F = future.S = spot,r = interest rate)

• assumes that there is a non-arbitrage relationship (no difference between investing in two markets)

Premium of the forwards contract

• Premium is dependant on the interest rate differential (F = future.S = spot,r = interest rate)'

Covered Interest Rate Parity in practice

• In practice it is generally empirically verified

• However in the GFC it was violated, as trust in financial institutions faltered and the term “risk-free’ was threatened

• Factors that may prevent a potential arbitrage

  • Counterparty default risk on:

    • the loan leading to higher interest rates as banks want to prevent bank runs (technically not arbitrage but the risk premium)

    • the forward contracts (people do not have faith in the next year leading to the rates changing)

  • Exchange rate controls and tax differences

    • Countries may limit the ability to exchange currencies

    • Taxes may be higher than expected and erode profits

  • Transaction costs

    • Transaction costs which may seem minute can add up

Forward rate replication

Forex (Foreign Exchange, FX) Market

• main exchange rate market

• OTC market (no one specific exchange during transaction)

  • Exchanges by phone or an electronic platform

  • 24 hours a day on weekdays

  • Inter-bank market: 80% of transactions

  • Daily volume: $6.6 Trillion in 2024

  • Largest market in the world by volume traded

    • Daily volume of US stocks for example is only $1 Trillion in 2024

Main participants in the forex market

• Commercial and investment banks

  • Dealer and market makers

  • Offering liquidity in the market

• FX brokers

  • financial intermediaries (link between buyers and sellers)

• Central banks, mutual funds and hedge funds

  • Growing players

Transactions in the FX market

• Interbank spot market, payment / receipt of FX requires 2 business days

  • One day for admin, another for time zone differences

  • Exception is USD/CAD (done in one day)

• Electronic exchange rate trading platforms

  • Thomson Retuers

  • Electronic Brokering Service (EBS)

  • More than 50% of transactions route through these services

  • Anonymous transactions

Trading in the FX Market

• Trading is done via the Society for Worldwide Interbank Financial Telecommunications (SWIFT) system

• SWIFT links 11000 banks and institutions in more than 200 countries

• Operates by sending messages containing transaction information and instructions between FIs

• Messages are exchanged in a standardised format, ensuring compatibility between different systems and FIs

Quotations

• No exchanges for all exchange rates

  • However all currencies are exchanged against the USD

  • Use of cross rates

    • AUD/BRL = AUD/USD * USD/BRL

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:

    • USD 1.3364 / Euro

    • JPY 123.52 / USD

    • JPY/EUR = USD/EURO x JPY USD = 1.3364 × 123.52 =165.07

    • Therefore one euro is worth 165.07 or JPY 165.07/EURO

Order of operations

Cross rate arbitrage

• Attempting to leverage mispricing between 2 different FX institutions

• Ideally borrow money Buy EUR using JPM and sell GBP via UBS

Bid-ask spread

• Bid price: amount purchased by the bank / seller

  • Bank buys EUR at USD 1.24969 / EUR

• Ask price: amount sold by the bank / seller

  • Bank sells EUR at USD 1.5 / EUR

• Equavilent quotations

  • USD / EUR: 1.24969-1.25000

  • EUR / USD: 0.80000-0.80020

  • EUR/ USD: 0.80000-20

Bid-ask spread size

• Bid ask spread rating for USD / EUR: 1.24969-1.25

  • 3.1 pips (price interest point = unit of change)

  • One pip = one unit to the 4th decimal place (e.g. USD 0.0001 except for JPY where JPY 0.01)

• Can be expressed in relative terms

• Spread = round-trip transaction costs

  • Spread size for major international currencies

  • Spread size for physical currency exchange

    • The difference is opportunity costs (no interest)

  • Spread at the airport: 20-30%

• Historically bid ask spread for emerging and advanced markets was quite different, not the case anymore as globalisation and the rise of fintech has allowed converence in liquidity for the currencies of AE and EMs

bid-ask spread size

• Size varies according to market conditions

• Allows traders (dealers) to manage inventory risks

exchange rate volatility as a determinant on the bid-ask spread size

• The bid ask spread increases with exchange rate volatility (connected with uncertainty)

• An example is the GFC, august 2024 where there was high uncertainty

forward contracts as a determinant of the bid-ask spread size

• Bid ask spread increases with the maturity of the forward contracts

  • A bank’s default risk increases with the horizon

  • More difficult to find counterparty willing to do such a transaction

  • Increases the bank’s inventory riosk

• Higher bid ask spread for forward contracts than for spot rates

• Real world example:

  • Very significant counterparty risk in 2008-2009

    • Following bankruptcy of Lehman Brothers in 2008, bid ask spreads for 3 month forwards were double the spread for spot contracts

• IF FORWARD BID ASK SPREAD IS NARROWER THAN SPOT IT IS A WRONG CALCULATION

Liquidity as a determinant of bid ask spread size

• Forward market less liquid than the spot market

  • Especially for long-term contacts

  • Banks often impose an order limit or ask for collateral

• If there is high liquidity, there will be pressure narrowing down the bid ask spread

• High transaction costs for long term forward contracts encouraged the development of another market

  • long term currency swap

Intra-day variations of the bid ask spread

• Generally higher spread at the beginning of the market and at the end of the day

  • less news less trading

  • Economic statistics announcements during the day can significantly move prices

Calculating cross rate calculation with bid ask spreads

• As a general rule of thumb, the bid ask spread should be maximised (take the worst)

  • Bid rate (buying price) should be as small as possible

  • Ask rate (selling price) should be as high as possible

• Formula

  • (A/B) bid = (A/C) bid / (B/C) ask = (A/C) bid * (C/B) bid; given that (C/B) bid = 1 (B/C) bid

  • (A/B) ask = (A/C) ask / (B/C) bid = (A/C) ask * (C/B) ask; given that (C/B) ask = 1 (B/C) ask

Examples:

• Note to keep the bid as low as possible and ask as high as possible

• J.P. Morgan

  USD/EUR: 1.2000-1.2050

  USD/GBP: 1.7950-1.8100

  UBS

  EUR/GBP: 1.5050-1.5100

• Multiply top with top and bottom with bottom

• There is no arbitrage in this sense as we buy at 1.5083 from JPM and sell to UBS at a price of 1.505

  • easy way to determine arbitrage is to construct a diagram showing both bid ask spreads:

Covered Interest Rate Parity in the context of a bid ask spread

• Theoretically nothing much changes in regards to the currency that is invested in the home country’s bank, however the only difference is that when converting pay the bid spread (which will be lower than the market value), and when converting back to original currency pay the ask spread (which will be higher than the market value)

Covered Interest Rate Parity in the context of a bid ask spread with different borrowing rates

• Different borrowing rates may exist for each country’s FI, after all banks will charge higher for borrowing money and will often pay less for the guarantee of a riskless investment return

• Therefore the rate differences may actually eliminate the ability to conduct an arbitrage

• As we see in the example: the borrowing rate for the EURO is 5% making the arbitrage unprofitable as the cost of capital is too high

Exchange rate risk

• CAD / USD has a range of 1-1.6 / USD over the past 50 years indicating the USD has appreciated and CAD has depreciated

• MXN / USD has a range of 3-25 / USD over the past 30 years indicating the USD has appreciated and MXN has depreciated

• Quantification of losses / gains require a description of the uncertainty related to exchange rate fluctuations

Using historical data to determine the distribution of exchange rate changes (returns)

• Take the return of the exchange rate per a certain interval (daily, monthly, yearly whatever period)

• Calculate the mean and volatility of the exchange rate returns

• Assume a normal distribution (bell curve, no extreme returns)

• Include skewness (asymmetric shape) and kurtosis (extreme returns) if the distribution is not normal

Example:

• Skewness indicates that there are more positive outliers in the distribution indicating a high volume of change in MXN / USD (depreciation)

• Kurtosis measures the fatness of tails, the MXN / USD has a fat right tail indicating that there are more extreme depreciation events that are likely to happen in the future

• Missing the 95% confidence interval which measures (Clarify on this)

Currencies of Advanced vs Emerging Markets

• Currencies of advanced countries

  • Reasonable to consider symmetrical distribution in view of the symmetry of the returns

  • More appropriate to consider a distribution that takes into account of fat tails, extreme values

• Currencies of emerging markets

  • Symmetrical distribution is not appropriate

    • Historical distribution is generally very skewed and shows large magnitude changes

    • Mainly due to significant depreciation / devaluation of these currencies that have occured

Exchange rate volatility changing

• Time-varying volatility can be estimated with different approaches:

  • Rolling standard deviation of the returns

  • Autoregressive (GARCH) model on returns

• Important to use recent data to get more realistic, more accurate results from more complicated models as complicated models are easier to break

• Statistical models may determine how exchange rate returns (and their volatility) vary over time. However, they do not help us understand why exchange rates fluctuate in such a way. Therefore it is key to remember the fundamentals (interest rates, macroeconomics)

Absolute Purchasing Power Parity (PPP)

• The same good is at the same price everywhere (law of one price)

• The exchange rate equals the consumer price ratio

• Assumes:

  • No transaction costs

  • Same basket of goods in all countries

Example:

IF APPP holds RPPP will hold

Relative PPP

• Considers price growth (rate of inflation) rather than price levels

  • Expected exchange rate growth = inflation differential

  • Same simplifying assumptions as absolute PPP

PPP in the real world

• PPP gives a framework as to where currencies are trading in the bigger picture

• Long-term fundamental valuation

  • Useful in the long term

  • Not very effective in the short term

• Common CPI alternatives

  • Big Mac Index (used to predict exchange rate index)

  • IKEA Billy Bookshelf Index (produced in one area and shipped to other countries, better index)

PPP investment application

• Sort currencies into portfolios based on 5 year change of PPP

• Portfolio 1: 25% of currencies that are most overvalued

• Portfolio 4: 25% of currencies that are most undervalued

Result:

• Find predictive power for the cross-section of currency excess returns

• Buy P4 and Sell P1, Long-short

• Theoretically will hold but there may be difficulties finding some currencies (CFA franc for example)

Uncovered Interest Rate Parity

• Hypothesis that the expected return on the uncovered (unhedged) foreign money market investment equals the known return from investing in risk free rates internationally

• Idea:

  • The expected growth of the exchange rate depends on the interest rate differential

  • We are not hedging anything we are just using the spot rate

Explanation for parity:

• Interest rate differential across countries on bonds of similar credit risk should reveal the expectation of depreciation

• Initially, attractive interest rates (say australian rates are higher) should be met by an FX move (AUD depreciates by the same amount, cancelling the effect of rates), resulting in the same return

• The ex post realised exchange rate will not necessarily equal the rate expected on average

• Basically the same as CIRP, but now even in uncovered transactions, there is nothing to earn

Formally”

• Assumes free capital mobility and the absence of taxes on capital transfers

• The zero investment (zero-cost) portfolio of money market instruments should yield 0 in expectation if investors are rational and risk neutral

Current exchange ratre formula UIP

Implications of UIP

• Interest rate differential, CP = expectation of exchange rate return

  • The USD Return on a risk free investment must be the same for all countries

• Not interesting in a country with higher rates

  • Expected depreciation is expected to offset the higher rate

• Exchange rate coverage without cost

  • forwards contract price = expected exchange price

  • Essentially we dont need the forward rate

Valuation model with monetary shock

• Impact of a money supply shock (one time and permanent shock) in the USA (QE)

  • American consumers are endowed with more money

  • Initially all invested in risk free bonds (banks) so bond yield / interest rate (R usd) will fall

  • Then consumers will gradually buy goods

  • Interest rates increases again and inflation slowly picks up

  • In the long run all money invested has been spent on goods

  • Therefore higher consumer prices while interest rate goes back to the initial value

Represented by:

• Overshooting is the phenonmenon where the exchange rate is temporarily higher than it should be, and takes time before settling

Forecast of exchange rate devaluation

• Majority of currencies are not floating

• Devaluation can be forecasted using:

  • Balance of the current account (trade + financial balance)

  • Monetary growth

  • Interest rate and inflation differential

  • Measures of overvaluation using PPP

Use of interest rate parity for predicting devaluation

• ARS interest rate is higher than USD indicating that ARS is expected to depreciated by the market

• Using expectation spot rate formula:

Floating exchange rate system

• Free float (clean): determined solely by supply and demand

• Dirty float: market forces with some central bank intervention

• Managed float: more central bank intervention than a dirty float

• Assume in this course that otherwise mentioned all currencies are using the floating exchange rate system

Fixed / Pegged exchange rate system

• Target exchange rate set by the government with the central bank intervening to prevent significant deviation

• Requires coordinated monetary policies and commitment to the target rate

Target zone agreement

• allows market forces but only within a margin around agreed upon fixed exchange rate

Crawling Peg

• Currency deprecation against a reference currency on a regular controlled basis, used to ease transition from fixed to fluctuating exchange rate

What is money?

• Serves as a store of value, medium of exchange, and unit of account

• Managed by different institutions (Federal Reserve, RBA for USD and AUD)

Previous exchange rate systems

• Gold / Silver

  • 1 Pound Sterling = 1 Pound of Sterling Silver

  • $35 = 1 Oz of Gold (US Bretton Woods)

• Features

  • Exchange rate based on the law of one price

  • Extremely stable inflation

  • Rigid supply restrictions

Bretton Woods (1944-1971)

• US held 2/3 of all gold reserves in the entire world

• Gold was pegged to the dollar at a fixed rate, other currencies were pegged to USD

• IMF was introduced to provide liquidity to nations in crisis

Nixon Shocks (1971)

• Ended the convertibility of USD to Gold

• Huge US deficits (due to the vietnam war, foreign banks demanding gold redemptions)

• Marked the shift to fiat currencies

• The dollar retained the status of the premier currency despite no gold backing

Floating exchange rate

• Exchange rate between two freely traded currencies

• Exchange rate fluctuations are determined by supply and demand:

  • Market equilibrium

  • High exchange rate volatility

• Limited central bank intervention

  • Temporary stabilisation only

• Exchange rate risk:

  • Can be determined by historical FX volatility

  • Historical return distribution is useful for predicting up/down movements

  • Possible intervention by monetary authorities

  • Determines some ceiling or treshold

    • SNB sets a floor at 1.21/1 CHF / EUR in 2011

Fixed exchange rate

• Predetermined exchange rate at a fixed level

• Determined in advance by the central bank

• There is still some exchange rate risk

  • Collapse of the fixed regime (IDR, ARP)

  • Abrupt and substantial devaluations of currency (GBP post suez)

• Arrangement is not credible in the long term

  • Devaluation incentive in case of economic crisis

  • Subject to speculative attacks (George Soros GBP)

Pegged exchange rate

• Predetermined exchange rate with authorised adjustment

• Compromise between fixed and floating regimes

  • Free fluctuations within a certain range

  • Adjustments are based on economic fundamentals

    • inflation, growth, current accounts

  • Low short-term volatility

• Exchange rate risk

  • low daily volatility is not real risk

  • latent volatiliy is the real risk (political risk esp if developing countries)

  • Difficult to quantify as there is no historical data

  • Called the “Peso” problem

• Agreement not very credible in the long term

  • Devaluation incentive in case of economic crisis

  • Subject to speculative attacks

Impossible trinity

• one currency can only have 2 of these charactheristics but not all three

Factors that determine exchange rates

• Balance of payments

  • international trade and capital flows

• Economic fundamentals

  • inflation, growth, commodities

• Financial conditions

  • interest rates, stock market performances, level of uncertainty

Balance of Payments

Synthesis of international financial flows observed during a given period

• accounting identity

• Each flow is associated with currency demand or supply

• Significant edia, analyst, investor, media attention

• main source: IMF open source data, easy to access / public

Balance between trade and financial flows

• Current + Financial accounts = 0

• Accounting balance due to changes in the foreign currency reserves of the central bank

  • Current account + financial account = Delta reserve

  • Example: decrease in reserves if total balance < 0

• Economically in a floating exchange rate system, the exchange rate would appreciate / depreciate to keep the system balanced

trade deficit

• Trade balance = not informative per se about the direction of the exchange rate, if

  • current account deficit = financial account surplus

• it is important to analyse the entire balance of payments as trade deficit leads to financial surplus (generally)

Financial account

• main aspect to be analysed

• if foreign investors want to finannce a trade deficit = no problem

  • balance between depreciation (trade deficit) and appreciation (financial surplus) of the currency

  • natural situation in the case of strong economic growth

    • Consumption > production: trade deficit

    • High profitability = high returns on investment: financial surplus

• if foreign investors no longer want to finance a trade deficit it could lead to

  • liquidiation of financial investments (capital flight)

  • currency depreciation (no one wants the currency, no demand)

Case study for BOP (USA)

• Scenarios are unlikely as US has a lot of economic power (innovating companies, leading products that are exported)

Case study for BOP (Emerging Market)

Practical application of the above concepts for emerging markets

• net foreign position (asset - liabilities at a country level) relates to currency returns

• the intuition is that investors demand a risk premium to hold debtor nations currencies due to the risks, this is especially true if the currency is held in a foreign currency

Observed effects of economic fundamentals

• Appreciation of a currency occurs ceteris paribus if there is:

  • 1.) Strong economic growth

    • Increase in investment returns

      • Increased foreign investment

    • Interest rates with expected economic growth

      • taylors rule

      • also interest rates hike from the central bank to reduce inflation from the increase in economic growth

    • Note that the effect is partially offset if import > export growth

  • 2.) Higher commodity prices for exporting countries (Australia, Canada, NZ)

    • more corporate profits and equity prices (BHP, Rio Tinto)

    • improve the country’s economic conditions

    • speculative component for FX investors

  • 3.) Rise in domestic interest rates

    • increase in demand for domestic bonds (carry trades)

    • can signal stronger economic growth and higher stock prices

    • not necessary due to higher economic growth and higher inflation

  • 4.) Foreign interest rate cut

    • decline in demand for foreign bonds → depreciates foreign currency relative to domestic currency therefore domestic currency appreciates

  • 5.) Good times for cyclical countries

    • Ex: emerging market countries

    • Currency “speculative” growth and periods of calm (low volatility)

  • 6.) Times of crisis for non-cyclical countries

    • Ex: USA, Japan, Switzerland

    • safe haven currencies in recessions and period of uncertainty

Central Bank and Exchnage Rates

• Purpose of intervention

  • Influence exchange rates to influence a currency

  • In general, to limit the appreciation/depreciation of the currency

    • Appreciation: Loss of competitiveness of exporters

    • Depreciation: Rising “imported” inflation

  • Interventions can be:

    • Sterilised

    • Unsterilised

Unsterilised Intervention

• There are downsides:

  • Increased money supply (500 Billion USD more circulating in the economy)

  • Medium / long term inflation effects

• Therefore there is a potential conflict when seeking price stability

  • Sterilisation can solve this

Sterilised Intervention

Example of intervention

Intervention Success depends on

• Size of intervention relative to daily volume

• Size of the available foreign exchange reserves

• Current market trends

• Coordination between nations (Plaza Accords 1985 took Japan, Germany and USA to depreciate USD)

• Number of interventions

• Sterilised or Non-Sterilised intervention

• It is often easier to prevent appreciation than a depreciation

• Markets are also typically pessimistic about the success of an intervention

Forecasting exchange rate

• still a prevailing view that exchange rate changes are difficult to predict in the short term

• A random walk model performs just as well as any estimated model in the short term (1-12 month time horizon)

• exchange rates are asset prices like stock prices and therefore we should expect they behave like other assets which are also hard to predict

Investment profitability without currency hedging

• The return has two drivers: the interest rate differential and the currency movement. USD appreciation boosts returns; depreciation hurts them.

  • Interest rate differential: When converting, one earns the USD interest rate instead of the AUD rate. If R_usd > R_aud, already profitable before currency moves

• Profit if the USD ends up stronger than the forward rate predicted as converting back to AUD at a better rate than expected.

• The break-even rate is the future exchange rate at which these two effects exactly cancel out — where what you gained from the interest rate differential is precisely wiped out (or matched) by the currency move, leaving you with zero excess return. That break-even point turns out to equal the forward exchange rate.

  Loss if the USD ends up weaker than the forward rate predicted getting less AUD when converting back than the forward rate implied.

• Real return always compared against the forward rate

Forward Contracts

• Is an agreement between two parties to buy or sell a security (or currency) at a pre-specified price on a pre-specified date T.

• Party agreeing to buy (sell) the underlying currency in the future is said to “buy (sell) a forward” and will have a long (short) position in that currency

Speculation Strategy based on the direction of exchange rate

Example of Forecasts and speculation transaction

Note: Example evaluates Warburg and Citi predictions

Usefulness of professional forecasts

• Generally there is some ability to predict future movements in the exchange rate (and in the right direction)

• Forecasters do this by:

  • Extrapolating recent trends (technical analysis), while at longer horizons they tend to forecast a return to a long term equilibrium, such as PPP.

  • Capture information like:

    • real exchange rate

    • ratio of current account balance to GDP

    • currency risk premium

Forward rate premium and discounts

• USD is quoted at a forward premium if forward rate is higher than spot rate

• USD is quoted at a forward discount if forward rate is lower than spot rate

• Basically pay more AUD for one USD in the future if there is a premium

• The forward rate is typically annualised and in %

Forward exchange rate as a predictor of the future spot rate

• Recall

  • CIP: F_t,t+1 = S_t (1+r_aud) / (1+r_usd)

  • UIP: E_t (S_t+1) = S_t (1+r_aud) / (1+r_usd)

  • with S and F expressed as AUD/USD (AUD for 1 USD)

• Combine UIP with CIP: E_t (S_t+1) = F_t,t+1

  • E_t (S_t+1) - S_t = F_t,t+1 - S_t

  • Expected currency return: E_t (S_t+1) - S_t / S_t

  • Forward premium: F_t,t+1 - S_t / S_t

  • E_t (S_t+1) = f_t,t+1

  • r_t^AUD - r_t^USD, S = AUD/USD

• UIP (together with CIP) implies that forward exchange rate is an unbiased predictor of the future spot exchange rate

• Forecast error = 0 on average

Economic background behind the forward exchange rate

Empirical Test behind forward premium theory

Interpretations:

• a = -10.03 USD at a discount because R_JPY < R_USD, therefore USD depreciates on average

• b = -2.18 if USD becomes more at a discouint because R_JPY - R_USD is more than < 0, USD should depreicate but it appreciates

Implications:

• the constant (a) is in the right direction (higher interestr rate currencies depreciate on average in the long run)

• the slope (b) suggests that UIP does not hold in short-term: countries with higher interest rates = future currency appreciation

• This may be due to the risk premium

Risk Premiums

• Assumes that the true model of exchange rate changes is

• E_t (S_t+1) = F_t,t+1 + RP_t

  • where RP_t is a risk premium adjustment

  • if risk premium is always 0, UIP Holds

  • But we have seen it fail empirically

• In practice RP_t is often positive when f_t,t+1 is negative

  • AUD depreicates in bad times against JPY so RP_t > 0

  • Domestic inteest rates (AUD) are higher than foregin interest rates (JPY) So f_t,t+1 < 0

Forecasting techniques

• Fundamental Analysis

  • Econometric / Statistical models

  • Economic and financial fundamentals

• Technical Analysis

  • Chartists (patterns)

  • Statistical analysis (filters, momentum, regressions)

Technical Analysis

• The idea that currencies follow trends and reversals

  • The majority of strategies are based on the temporal evolution of a currency

  • Filter-based strategies

    • to distinguish trrends and reversals from noise

• Typically economists have a negative view of this method as it is inconsistent with the efficient market hypothesis

• Typically short term and used by retail traders

• In the long term fundamental analysis is always favoured

Hedging with Forward Contracts vs Money Market — Which to Choose?

• Forward Contract = (Amount × Forward rate) / Domestic interest rate

  • Forward contract → use forward rate and domestic interest rate

• Money Market = (Amount / Foreign interest rate) × Spot rate

  • Money market → use foreign interest rate and spot rate

• Never mix rates between the two methods

Foreign Currency Risk Premium & Domestic Currency Return

• Risk Premium (approximation):

Expected exchange rate appreciation − Interest rate differential = Expected appreciation − (r_domestic − r_foreign)

UIP holds if: risk premium = 0 (expected appreciation = interest rate differential) UIP does not hold if: risk premium ≠ 0

• Domestic Currency Return on Foreign Bond (two methods):

Method 1: Domestic rate + Risk premium Method 2: Foreign rate + Expected appreciation

Method 2: Foreign rate + Expected appreciation

Both give the same answer

Example:

• UK rate 5%, Swiss rate 3.75%, expected CHF appreciation 2%

• Risk premium = 2% − (5% − 3.75%) = 0.75%

• UIP does not hold

• Domestic return = 3.75% + 2% = 5% + 0.75% = 5.75%

Forward and Future contract

• A promise to buy or sell a specific quantity of a currency on a specific date

Characteristics of Forward Contracts

• Private agreement between two parties (OTC)

  • Terms of the contract specific to the needs

    • Fixed maturities: 1,2,3,6, or 12 months

  • Large contracts

  • Significant credit (counterparty risk)

    • As it is only between two parties, there is always a risk that the other party may go bankrupt, hence not be able to pay

  • Main actors are typically large institutions

    • Banks, Hedge funds, MNCs

  • No quotes → no secondary market

  • Fixed and non-reversible position unless there is mutual agreement between parties

  • No action until contract expiry

  • No margin call but a large initial deposit is required

  • Its main use is to receive currency at a predetermined price

• Prices are derived from the CIRP (see flashcard)

Characteristics of Future Contracts

• Contracts are traded on a organised exchange (CME)

• Standardised contracts

  • Small sizes

• Fixed expiry date

  • 4x per year: Mar, Jun, Sep, Dec: IMM Dates (3rd Wed of the month)

• High daily liquidity but not enough for a large player (>100 Million USD position)

• Price is quoted around the clock as positions are marked to market

• Easy to close position even before maturity

• No credit risk but maintain a margin account

  • Guarantees the counterparty the payment of future losses and risk of possible margin calls

• Mainly used for heading and short term speculators

  • Currency is rarely physically received or delivered

  • Betting on the uncertainty of timing and amount

Initial margin

• Amount to be deposited when the contract is bought / sold

  • Depends on exchange rate volatility

  • USD 1000 to 4000 per contract on CME

• Typically cash or collateral (gov bonds)

  • Shares listed at NYSE or physical gold can also be margin

  • Valued only at 70% of current value though

• There is an oppoiortnity cost if the initla margin did not come from colateral (foregone interest)

Maintenance margin

• Minimum margin level required each day

  • 70 to 100% of the initial deposit level

  • The client must cover his / her loss

    • the contract can be closed if necessary

Example:

Main participants

• Arbitragers

  • Seek to earn risk free profits by taking advantage of differences in interest rates amongst countries

  • Use forward contrats to eliminate the exchange rate risk

• Commercial traders / hedgers

  • use forward contracts to elimintate or cover the risk of loss on export / import orders

  • Mostly MNCs

• Speculators

  • Make profits from FX fluctuations

Currency Swaps

• Fixed for fixed currency swap

• Exchange of interest payments and capital in one currency to interest payment sand capital into another currency

• Characteristics:

  • Private agreement between a client and a bank (OTC)

  • Appear off balance sheet

  • No secondary market

  • Reversible position only by mutual agreement