IFE - international finance

Spot exchange rate

The rate you get for immediate currency exchange denoted as Xd/s which means that one pound of sterling buys Xd/s amount of dollars

No bid-ask spread

There is no difference between the rate at which traders can buy dollars and the rate at which they can sell them

Arbitrage

The simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price

Indirect quote

Measures how many dollars one pound buys Xd/s

Direct quote

Measures how many pounds we have to pay for one dollar

Future spot rate

If you want to trade in the future, you use the price of a future financial transaction

Exchange rate risk

The risk that a company’s operations and profitability may be affected by changes in the exchange rates between currencies.

Call option

A financial derivative that gives its owner the right to buy a specified security at a set price within a certain time.

Notional (call option)

The value of the underlying asset that the option gives you the right to buy.

Strike price (call option)

The price at which a put or call option can be exercised.

Expiration date (call option)

The date agreed for the transaction next year.

Premium/option price (call option)

The amount an investor pays to receive the call option.

Writer (call option)

The international bank offering the call option

Holder (call option)

Receiver of the call option

Long and short (call option)

The holder has a long position (long in the call) and the writer is short in the call.

Underlying (call option)

The target currency of the option which is the foreign currency from the perspective of the holder.

A call option

Gives the holder the right to buy the target currency under the specified conditions.

A put option

Gives the holder the right to sell the target currency.

Covered interest parity (CIP)

Theoretical financial condition that defines the relationship between interest rates and the spot and forward currency rates of two countries as being in equilibrium.

Purchasing power parity (PPP)

Comparing one currency in terms of another by using the cost of living in both countries

PPP vs CIP

PPP considers only the spot price whereas CIP is based on both the spot and forward exchange rates.

Real exchange rate

The ratio of the spot exchange rate over the PPPR

Nominal exchange rate

The number of units of the domestic currency that can purchase a unit of a given foreign currency.

Absolute PPP

Theoretical idea where exchange rates are equal and therefore only accounts for the prices of the goods

Relative PPP

Includes changes in inflation

Risk premium

The risk premium represents the additional return that an investor requires to hold a risky asset over a risk-free asset.

MH in Financial markets

When investors or market participants are able to take on excessive risk because they believe that they will be bailed out if those risks lead to losses. This can happen when the banks increase their interest rates due to low expected interest rates.

Binomial option pricing model

Investors can determine how likely they are to buy or sell at a given price in the future.

Hedging

Investors hedge one investment by making a trade in another to limit risks due to adverse price movements.

Exposure (delta)

The amount of risk in an investment.

Risk-neutral probability

Potential future outcomes adjusted for risk, which are then used to compute expected asset values.

Stochastic discount factor

Used to discount the payoffs of any asset

CAPM Capital Asset Pricing Model

A financial model that calculates the expected rate of return for an asset or investment. It does this by using the expected return on both the market and a risk-free asset, and the asset's correlation or sensitivity to the market (beta).

Idiosyncratic risk

The risk inherit in an asset or asset group due to specific qualities of that asset. Investors use other assets to offset the idiosyncratic risk therefore they do not mind it as much as say aggregate risk which cannot be offset.

Why don’t economists price idiosyncratic risk?

No risk premium needs to be paid to compensate for idiosyncratic risk because unlike systemic risk, idiosyncratic risk can be diversified away by holding many different assets.

How to tell if a currency is overvalued or undervalued?

If PPPRs/d < Xs/d then s is said to be undervalued against the dollar.

Uncovered interest rate parity (UIP)

A theory that the difference in two countries interest rates are equal to the expected changes between their currency exchange rates.

Calculating the value of an option

In the absence of arbitrage two portfolios that deliver the same payoff must have the same price.