Chapter 1

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3 Kinds of FX Markets: Spot Market - By and sell based on current price Forward Market By currency today at pre-determined price, but complete transaction at a time specified in the future Swap Market Return to this topic later in class FX Market has no physical location (trade in OTC market) Open 24 hours on weekdays (flexible) How money invest for speculative returns vs. long-run return If you do not have regulations in place, you should not open your market to speculators (East Asian Crisis of 1998)

Indirect quote => foreign currency/home currency Direct quote => home currency/foreign currency Banks or airports Easier for a domestic person to understand Cross-rate => foreign currency/foreign currency 0.0001 = 1 basis point = .01% Spot Market Cross-rate example: Derive CAD/EUR cross-rate $0.98 USD/CAD $1.22 USD/EUR (1.22 USD/EUR) / (0.98 USD/CAD) = 1.2449 CAD/EUR

Sometimes in the business world, it is possible to find cross-rate that does not match the mathematical derivative Way to make profit by taking advantage of the difference Arbitrage = risk-free profit

Now that trading is done by computer, arbitrage is no longer possible

Currency change given a direct quote: (Ending Price Opening Price) / Opening Price If given an indirect quote, convert to direct quote first o 1 / indirect quote If given a cross-rate, ensure that your are consistent FX Currency Change Example 1: Day 1: 0.98 USD/CAD Day 2: 1.02 USD/CAD (1.02-0.98)/0.98 = .0408 (4 decimal places) CAD appreciated against USD by 4.08%

FX Currency Change Example 2 (cross-rate): Day 1: 1.23 CAD/EUR Day 2: 1.19 CAD/EUR (1.19-1.23)/1.23 = -.0325 EUR depreciated against CAD by 3.25%

Absolute Bid-Ask Spread Example: Dealer buys at 1.2000 USD/EUR (Bid Price) Dealer sells at 1.2200 USD/EUR (Ask Price) 1.22 1.20 = $0.02 USD profit (Absolute Bid-Ask Spread) If turnover/volume is low, the dealer will charge higher commission to make profit If currency is very liquid, profit margin is small but turnover/volume is high (allowing them to make profits) Relative Bid-Ask Spread (Ask price Bid price) / Ask price Used to standardize the bid-ask spread because it gives a percentage value Allows you to measure transaction cost

Relative

Bid-Ask Spread Example: Dealer buys at 1.2000 USD/EUR (Bid Price) Dealer sells at 1.2200 USD/EUR (Ask Price) (1.22-1.2)/1.22 = 1.64% (Relative Bid-Ask Spread) If trading $1000 USD, o $1000 * 1.64% = $16.40 (Transaction Cost)

Relative Bid-Ask Spread (transaction cost) Example: Buy EUR, sell 1000 USD to the dealer 1000 USD / (1.22 USD/EUR) = 819.67 EUR Sell 819.67 EUR back to the dealer and buy USD 819.67 EUR * 1.20 USD/EUR = $983.60 USD $983.60 - $1000 = -$16.40 (transaction cost) Transaction cost is round trip

OANDA FX Game Example: EUR/USD o EUR = primary currency o USD = secondary currency Buying/selling the primary currency for/with the secondary currency XAU = gold XAG = silver

Short sell selling an asset that you do not have Borrow from the dealer Sell acquired asset in the market for current (market) price (Hopefully) when the asset drops in the market, you buy back the asset and return it to the dealer (plus interest) Margin Account Only have to pay a portion of the price (borrow the rest) Have to put more into your account (margin call) if you losses exceed the amount you put in o If you do not put more money into your account, the dealer will close it

Dealer charges interest for the time you buy on margin

8/30/2012 4:57:00 PM Goal of financial management? Maximize Cash flow Maximize Profit Maximize Market share

Corporate company structure Assets (controlled by mangers/employees) Debt holders (liability) Shareholders (equity) Must act in the best interest of shareholders Shareholders value Stock price * #shares outstanding Firm value = CF1/(1+i) + CF2/(1+i)2++CFn/(1+i)n i=discount rate discount rate reflects rate of return you are expecting given the risk of the company Increase firm value by increasing cash flows and/or decreasing risk Reasons for going abroad Develop new markets Cheap labor Outsourcing (costs, strengths of labor force) Regulation at home Risk diversification Natural resources International risks Political risk Foreign market risk Cultural difference Natural disaster Differing management style Control

Corporation benefits Limited liability Easier to raise capital

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Current Account
Trade Balance = Export Import Surplus (if positive) or Deficit (if negative) GDP = Consumption + Investment + Government Spending + Trade Balance 1) Inflation Inflation of U.S. o Inversely related with U.S. export o Directly related with U.S. import Inflation of foreign country o Directly related with U.S. export o Inversely related with U.S. import

2) FX Rate US FX Rate o Inversely related with U.S. export o Directly related with U.S. import Depreciation alone is an ineffective policy o Competitors cut their own price/depreciate their own currency o Transfer price / Inter-firm trade International trade between subsidiaries of single MNC Not effected by external exchange rate

J-curve Negative in short run due to delays o Contract signed 2-3 months before shipping products o Shipping takes another 2-3 months o 90 days for accounts receivable period Trade balance = (USD price * # units exporting) (foreign price * # units importing) o Even if FX rates change, short term demand is already set by contract (# units) o Adjustment occurs in the long run 3) US National Income Inversely related with U.S. export Directly related with U.S. import Wealth Effect Tariff (only US) or Quota (only US) or Dumping or Government Subsidies US Export up, US Import down, Trade Balance up Harder to see effect if trade partners also introduce tariffs o Hurt international trade Known as trade frictions

Financial Account

Foreign Direct Investment Economic growth/strength Institutions (government/culture) Tax Government Policy International Portfolio Investment Interest rate o Attracts Hot money not good for economy Tax Government Policy Others

Fixed exchange regime All countries fix their exchange rates to USD After WWII o US had the gold to support the currencies Bretton Woods Agreement Ends in 1971 o France first to say USD is overvalued

8/30/2012 4:57:00 PM Unholy Trinity Can only achieve 2 at once Currency stability Open capital market Independent monetary policy Effects of having a fixed rate currency Exporting inflation o Hong Kong rate fixed to USD Inflation in US goes up Demand for Hong Kong products go up Prices in Hong Kong go up

Exporting unemployment o US unemployment goes up Imports go down o Demand for Hong Kong products goes down Hong Kong job cuts up Unemployment up

Examples of FX Markets (Japan Perspective) Spot market o Sell yen o Buy dollar Forward market o Buy yen o Sell dollar Swap market o Selling today o Repurchase in the future at a fixed price Currency Inventory Cost Opportunity cost of keeping cash in banks The higher the interest rate on currency, the higher the opportunity cost Euro prefix describe offshore currencies

Eurodollar name to describe offshore US dollars Euroeuro name to describe offshore euros

Syndicator Group of banks that share risk/loans given to client Lead bank to organize administration between banks International bond market Loan maturity generally greater than 5 years o Due to large size of the bond 2 Types of bonds o Eurobond currency denomination of bond is different from the issuing countys currency Bearer form anonymous owner / amount of bond Attractive for investors looking to avoid taxes on income generated from investment o Foreign bond - currency denomination of bond is same as the domestic markets currency

Capital Reserve Amount that banks have on hand Focus on standardization reserve requirements o Basel Accord 8% ADR American Depository Receipt Foreign firm -> US Depository Bank -> ADR -> US Investors ARD I only traded in OTC market

Financial Derivatives

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Hedging strategy to reduce risk Foreign exchange rate risk o Exporting Receive foreign currency If FX rate depreciates, revenue goes down o Importing Pay foreign currency If FX rate appreciates, cost to import goes up Forward Contract o Example: Forward Contract for 3 months later at $1.00/euro Current FX rate $1.00/euro Future FX rate $1.50/euro ($1.50/euro - $1.00/euro) * 10,000 euro = $5,000 = price of contract Buy 10,000 euro at $1.00/euro using contract for $10,000 Sell 10,000 euro in the market and get $15,000 $5,000 profit

o Both buyer and seller are bound to the contract Hedging Strategies Payable of foreign currency (import) o Buy forward o Buy futures o Buy call option Receivable of foreign currency (export) o Sell forward o Sell futures o Buy put options Need to make payment of Euros in three months (hedge against euro rising) o Buy euro forward (for large institutional investors) o Buy euro futures o Buy call option

Forwards & Futures

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Parts of a Forward Contract 1. Quantity 2. Future Date 3. Type of Assets 4. Price of Assets 5. Buyer and Seller i. Obligation to buy and sell at agreed upon date in the future at agreed upon price ii. Can only be traded OTC Forward rate = rate 3 months in the future Forward premium (When Forward rate > Spot rate) Expectation of how much the currency will appreciate in the future Forward discount (When Forward rate < Sport rate) Expectation of how much the currency will depreciate in the future (Forward rate Spot rate) / Spot rate = Forward premium or discount Annualized forward premium or discount Multiple by 4 Calculate Profit/Loss in Forward Contract Buyer: (Forward rate Spot rate) * Contract Size Seller: (Spot rate Forward rate) * Contract Size Assuming no transaction cost Futures contract is similar to a forward contract, but can be traded publically on an organized securities exchange Very liquid (can buy/sell in secondary market) Highly structured Mark-to-Market Margin account do not need to pay 100% of amount for the trade Margin call if your account balance drops below maintain amount

o Your account will be closed if you fail to pay Cannot accumulate gains/losses like with a forward account Buyer of Futures/Forward Make money when FX futures go up Seller of Futures/Forward Make money when FX futures go down Forward contracts are only between individuals with very high credit ratings since there is no oversight to avoid default Held until maturity date o Physical delivery Illiquid market Privately negotiated contract Gains and losses calculated at the end of contract

The futures market is better for smaller traders, because the margin accounts has measures to monitor/prevent default Usually sell before maturity date in the market o Cash settlement Very liquid market Highly standardized contract Gains and losses calculated on a daily basis using margin account (mark-to-market)

Buyers/sellers of both forward and futures contracts are obligated to buy/sell the assets in the contract at the agreed upon price at maturity date Example: Futures Contract Buyer o Maintainers Margin: $2,240 o Day 1 AUD futures: 100,000 AUD .98 USD/AUD Initial margin: $2450/contract o Day 2

 1.00 USD/AUD (1.00 0.98) * 100,000 * 100 = $200,000 Margin = 200,000 + (2,450*100) = $445,000 o Day 3 .97 USD/AUD (0.97 1.00) * 100,000 *100 = -$300,000 Margin = -300,000 + $445,000 = $145,000 (Margin Call) $224,000 - $145,000 = $79,000 to margin account to maintain Cross-hedging (in futures contract) Due to standardization, you may not be able to find the exact asset you are looking to hedge against

Options

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Buyer has the right to choose if they want to buy at maturity date Seller has the obligation to sell at maturity date Call Option Give the buyer the right to buy underlying assets Put Option Give the buyer the right to sell underlying assets

Time t = future time when contract reaches maturity Buyer Call Option - Have the right to buy underlying asset at a fixed price at time t (when you expect price to go up) - Pay premium to the seller Put Option - Have the right to sell underlying asset at a fixed price at time t (when you expect price to go down) - Pay premium to the seller Call Option contract Exercise/Strike Price Quantity Time (date) Asset Type Premium European Options vs. American Options American Option has a higher premium because it has more flexibility o Can buy the underlying asset at any date vs. only at expiration for European option Seller - Have the obligation to sell underlying asset at a fixed price at time t - Receive premium from buyer - Have the obligation to buy underlying asset at a fixed price at time t - Receive premium from buyer

Example: European call option 100,000 euros Strike price = $1.20/euro Premium = $.02/euro Buyer: If euro FX rate (St) = $1.30/euro o Exercise call option because strike price <St o (100,000 euro * $1.20/euro) + (100,000 euro * $.02/euro) = $122,000 USD = cost of euros Profit on option of $8,000 Buyer: If euro FX rate (St) = $1.10/euro o Do not exercise call option because strike price > St o (100,000 euro * $1.10/euro) + (100,000 euro * $.02/euro) = $112,000 USD = cost of euros Loss on option of $2,000

Call Option Generalizations Strike price (X) < Market price (St) o Exercise the call o In the money (St X premium) * Contract Size Strike price (X) > Market price (St) o Do not exercise the call o Out of the money premium * contract size

Call option premium determinants Risk of underlying asset price positively related positively related to option value premium Time to maturity positively related to option value premium Market price(St) positively related to option value premium Strike price(s) negatively related to option value premium

Option Pricing Boundaries Lower Bounds o Call option premium > Max (0, S-X)

o Put option premium > Max (0, X-S) Upper Bounds o Call option premium < S o Put option premium < X Where S is the underlying spot exchange rate; X is the exercise price of the option

Option Strategies Long Straddle o Buy both a call option and a put option

o o Expect volatility o Profit on upside and downside o Expensive Short straddle o Sell both a call option and a put option

o Long Strangle o Buy 1 out of the money call and 1 out of the money put

o Short Strangle o Sell 1 out of the money call and 1 out of the money put

Swaps

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Exchange cash flows at periodic intervals Interest rate swap Decide you want to switch between fixed or floating rate without refinancing Currency swap Switch currencies based on specific exchange rates an fixed or floating interest rates Example US firm wants to finance 1000000 euro plant in UK British firm wants to borrow $1.6 million

International Parity Conditions

F = S0 * (1+i$) / (1+if)

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Fisher Effect Nominal Interest Rate= Real Interest Rate+ Inflation Rate Higher interest rate = higher spot rate Higher interest rate = lower exchange rate

Risk Exposure
USD FX Rate Up Company A Net Income Down 2% Company B Net Income Down 2% o More exposed to risk

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3 Types of Exposure in FX Market Transactional Exposure o Hedge with Contracts o Amount and Timing o Receivable (Fear depreciation of foreign currency) Buy put option to lock rate at fixed price at future time Sell futures of foreign currency Sell forward of foreign currency o Payable (Fear appreciation of foreign currency) Buy call option to lock rate at fixed price at future time Buy futures of foreign currency Buy forward of foreign currency o Translation Exposure FX Rates affect numbers on accounting statements