International Finance
FIN456 ♦ Fall 2012
Michael Dimond
Foreign Exchange Markets
• Provide the physical and institutional structure to
– Exchange the money of one country for that of another
– Determine the rate of exchange between currencies
– Physically complete foreign exchange transactions
• A foreign exchange transaction is an agreement between a
buyer & seller that a set amount of one currency will be
delivered for some other currency at a specified rate
• Six main characteristics of the FOREX markets:
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–
–
–
–
–
The geographic extent
The three main functions
The market’s participants
Its daily transaction volume
Types of transactions including spot, forward and swaps
Methods of stating exchange rates, quotations, & changes in rates
Michael Dimond
School of Business Administration
Geographic Extent of the Market
• Geographically, the FOREX market spans the globe with
prices moving and currencies trading every hour of every
business day
• Major world trading starts each morning in Sydney and
Tokyo, then moves west to Hong Kong and Singapore &
finishes on the West Coast of the U.S.
Michael Dimond
School of Business Administration
Geographic Extent of the Market
Michael Dimond
School of Business Administration
Functions of the FOREX Market
• The FOREX market is the mechanism by which participants
– Transfer purchasing power between countries
• This is necessary as international trade and capital transactions normally
involve parties living in countries with different national currencies
– Obtain or provides credit for international trade transactions
• Inventories in transit must be financed
– Minimize exposure to exchange rate risk
• FOREX markets provide instruments utilized in “hedging” or transferring
risk to more willing parties
Michael Dimond
School of Business Administration
Market Participants
• The FOREX market consists of two tiers, the interbank or
wholesale market, and the client or retail market
• Five broad categories of participants operate within these two
tiers
– Bank and non bank foreign exchange dealers
– Individuals and firms conducting commercial or investment
transactions
– Speculators and Arbitrageurs
– Central banks and treasuries
– Foreign exchange brokers
Michael Dimond
School of Business Administration
Bank and Non-bank Dealers
• These participants profit from buying currencies at a bid price
and then reselling them at an offer or ask price
• Competition among dealers narrows the spread between the
bid and offer rate contributing to the market’s efficiency
• Dealers on behalf of large int’l banks often act as market
makers, buy or sell these currencies without necessarily
having a counterpart with which to unload the “inventory”
• They trade amongst other banks and dealers in order to keep
their inventory levels at manageable levels
• Currency trading is profitable and often contributes between
10% - 20% of a banks’ average net income
• Small- to medium-sized banks participate in the interbank
market but rarely act as market makers
Michael Dimond
School of Business Administration
Individuals and Firms
• Individuals and firms conduct transactions for commercial
and investment purposes. For example:
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–
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Importers
Exporters
Portfolio investors
MNCs
Tourists
• Some of these participants use the market to hedge foreign
exchange rate risk
Michael Dimond
School of Business Administration
Speculators and Arbitrageurs
• Speculators and arbitrageurs seek to profit from trading in the
market itself
• They operate for their own interest, without need or obligation
to serve clients or ensure a continuous market
• Speculators seek all their profit from exchange rate changes
• Arbitrageurs try to profit from simultaneous differences in
exchange rates in different markets
• A large proportion of speculation and arbitrage is conducted
on behalf of major banks by traders employed by those
banks
Michael Dimond
School of Business Administration
Central Banks and Treasuries
• Central banks and treasuries use the market to acquire or
spend their country’s currency reserves as well as to
influence the price at which their own currency trades
• They may act to support the value of their currency because
of their government’s policies or obligations or because of
commitments entered through joint float agreements such as
the European Monetary System (EMS)
• Consequently their motive is not to profit but rather influence
the foreign exchange value of their currency in a manner that
will benefit their interests
Michael Dimond
School of Business Administration
Continuous Linked Settlement
• Continuous Linked Settlement (CLS) system (since 2002)
eliminates losses if either party unable to settle
• CLS links with Real-Time Gross Settlement (RTGS) systems
in seven major currencies
• Eventually we expect same-day settlement instead of the
current lag of two days
• The U.S. Commodity Futures Trading Commission (CFTC)
regulates foreign exchange trading
Michael Dimond
School of Business Administration
Foreign Exchange Settlement in Europe
Michael Dimond
School of Business Administration
Transactions in the Interbank Market
• Transactions within this market can be executed on a spot,
forward, or swap basis
– A spot transaction requires almost immediate delivery of foreign
exchange
– A forward transaction requires delivery of foreign exchange at some
future date
– A swap transaction is the simultaneous exchange of one foreign
currency for another
Michael Dimond
School of Business Administration
Spot Transactions
• A spot transaction in the interbank market is the purchase of
foreign exchange, with delivery and payment between banks
to take place, normally, on the second following business day
– The settlement date is often referred to as the value date
– This is the date when most dollar transactions are settled through the
computerized Clearing House Interbank Payment Systems (CHIPS) in
New York
Michael Dimond
School of Business Administration
Outright Forward Transactions
• This transaction requires delivery at a future value date of a
specified amount of one currency for another
• The exchange rate is agreed upon at the time of the
transaction, but payment and delivery are delayed
• Forward rates are contracts quoted for value dates of one,
two, three, six, nine and twelve months
– Terminology typically used is buying or selling forward
– A contract to deliver dollars for euros in six months is both buying
euros forward for dollars and selling dollars forward for euros
Michael Dimond
School of Business Administration
Swap Transactions
• A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount of foreign
exchange for two different value dates
• Both purchase and sale are conducted with the same
counterpart
• A common type of swap is a spot against forward
– The dealer buys a currency in the spot market and simultaneously
sells the same amount back to the same bank in the forward market
– Since this transaction occurs at the same time and with the same
counterpart, the dealer incurs no exchange rate exposure
Michael Dimond
School of Business Administration
Swap Transactions
• Forward-forward swaps – A dealer sells £20,000 forward for
dollars for delivery in two months at $1.8420/£ and
simultaneously buys £20,000 forward for delivery in three
months at $1.8400/£
– The difference between the buying and selling price is equivalent to
the interest rate differential
– Thus a swap can be viewed as a technique for borrowing another
currency on a fully collateralized basis
Michael Dimond
School of Business Administration
Swap Transactions
• Non-deliverable forwards (NDFs) – NDFs possess the same
characteristics as traditional forward contracts except that
they are settled only in US dollars and the foreign currency
being sold or bought forward is not delivered
– The dollar-settlement feature reflects the fact that NDFs are
contracted offshore and are beyond the reach and regulatory
frameworks of the home country governments
– Pricing of NDFs reflects basic interest rate differentials
Michael Dimond
School of Business Administration
Size of the FOREX Market
• The Bank for International Settlements (BIS) estimates that
daily global net turnover in traditional FOREX market activity
to be USD 3.7 trillion in April 2010
– Spot transactions at $1,495 bn/day
– Outright forward transactions at $475 bn/day
– Swaps at $1,765 bn/day
Michael Dimond
School of Business Administration
Size of the FOREX Market
• The United Kingdom (London) and the United States (New
York) make up roughly 55% of the foreign exchange market
• The London trade alone makes up 36.7% of daily
transactions in the foreign exchange market, followed by the
US (17.9%), Japan (6.2%), Singapore (5.3%), Switzerland
(5.2%) and Hong Kong (4.2%)
• Asian markets growing more rapidly than European markets
Currency
exchanges
paired with the
U.S. Dollar
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• A foreign exchange quote is a statement of willingness to buy
or sell at an announced rate
– In the retail market (newspapers and exchange booths), quotes are
often given as the home currency price of the foreign currency
• Currency
Traditional Symbol
ISO 4217 Code
–
–
–
–
–
U.S. dollar
European euro
Great Britain pound
Japanese yen
Mexican peso
$
€
£
¥
Ps
USD
EUR
GBP
JPY
MXN
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Interbank quotes – professional dealers or brokers may state
quotes in one of two ways
– The foreign currency price of one dollar
• Sfr1.6000/$, read as 1.600 Swiss francs per dollar
– The dollar price of a unit of foreign currency
• $0.6250/Sfr, read as 0.625 dollars per Swiss franc
• The former quote is considered to be in “European terms”
and the latter is considered to be “American terms”
• Almost all European currencies, except two, are quoted the
European way
– The Pound Sterling and the Euro are the exceptions
– Additionally, Australian and New Zealand dollars are also quoted in
American terms
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Direct and Indirect Quotes
– A direct quote is a home currency price of a unit of a foreign currency
• Sfr1.6000/$ is a direct quote in Switzerland
– An indirect quote is a foreign currency price in a unit of the home
currency
• Sfr1.600/$ is an indirect quote in the US,
• $0.625/Sfr is a direct quote in the US and an indirect quote in Switzerland
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Interbank quotes are given as a bid and ask
– The bid is the price at which a dealer will buy another currency
– The ask or offer is the price at which a dealer will sell another
currency
• For example the bid and ask for spot euros would probably
be shown “1.2170/78” on a video screen.
• In some cases between professional traders, they may
only quote the last two digits of both the bid and ask,
“70-78” because they know what the other figures are.
Michael Dimond
School of Business Administration
Bid, Ask, and Mid-Point Quotations
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Expressing Forward Quotations on a Points Basis
– The previously mentioned rates for yen were considered outright
quotes
– Forward quotes are different and typically quoted in terms of points
– A point is the last digit of a quotation, with convention dictating the
number of digits to the right of the decimal
• Hence a point is equal to 0.0001 of most currencies
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Expressing Forward Quotations on a Points Basis
– The yen is quoted only to two decimal points
– A forward quotation is not a foreign exchange rate, rather the
difference between the spot and forward rates
– Example:
Bid
Outright spot:
Plus points (3 months)
Outright forward:
Ask
¥118.27
¥118.37
-1.43
-1.40
¥116.84
¥116.97
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Forward Quotations in Percentage Terms
– Forward quotations may also be expressed as the percent-perannum deviation from the spot rate
• This is similar to the forward discount or premium calculated earlier
– The important thing to remember is which currency is being used
as the home or base currency
• For indirect quotes (i.e. quote expressed in foreign currency terms),
the formula is
f
FC
Spot - Foward 360

x
x 100
Foward
days
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Forward Quotations in Percentage Terms
– For direct quotes (i.e. quote expressed in home currency terms), the
formula is
Forward - Spot 360
f 
x
x 100
Spot
days
H
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Forward Quotations in Percentage Terms
– Example: Indirect quote
105.65 - 105.04 360
f 
x
x 100   2.32% p.a.
105.04
90
¥
– Example: Direct quote
0.009520183 - 0.009465215 360
f 
x
x 100   2.32% p.a.
0.009465215
90
$
Michael Dimond
School of Business Administration
Exchange Rates: New York Closing Snapshot
Michael Dimond
School of Business Administration
Exchange Rates: New York Closing Snapshot (cont.)
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Cross Rates
– Many currencies pairs are inactively traded, so their exchange rate is
determined through their relationship to a widely traded third currency
– Example: A Mexican importer needs Japanese yen to pay for
purchases in Tokyo. Both the Mexican peso (MXP) and Japanese
yen (¥) are quoted in US dollars
• Assume the following quotes:
Japanese yen
Mexican peso
¥110.73/$
MXP 11.4456/$
– What is the cross rate of yen to pesos?
Michael Dimond
School of Business Administration
Key Currency Cross Rates, Tuesday, January 4, 2011
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Intermarket Arbitrage
– Cross rates can be used to check on opportunities for intermarket
arbitrage
– Example: Assume the following exchange rates are quoted
Citibank
Barclays Bank
Dresdner Bank
$1.2223/€
$1.8410/£
€1.5100/£
Michael Dimond
School of Business Administration
Foreign Exchange Rates & Quotations
• Intermarket Arbitrage
– The cross rate between Citibank and Barclays is
$1.8410/ £
$1.2223/ €
 € 1.5062/ £
– This cross rate is not the same as Dresdner’s rate quote of €1.5100/£
– Therefore, an opportunity exists for risk-less profit or arbitrage
Michael Dimond
School of Business Administration
Triangular Arbitrage by a Market Trader
Michael Dimond
School of Business Administration
Foreign Exchange Rate Determining/Forecasting
• Three basic approaches
– Parity conditions
– Balance of Payments
– Asset market
• These are not competing theories but are in fact
complementary theories
• Without the depth and breadth of the various approaches
combined, our ability to capture the complexity of the global
market for currencies is lost
Michael Dimond
School of Business Administration
Determinants of Foreign Exchange Rates
Michael Dimond
School of Business Administration
Foreign Exchange Rate Determining/Forecasting
• Along with an understanding of the theories, an understanding of
the complexities of international political economy, societal and
economic infrastructures, and random political and social events is
needed when viewing the foreign exchange markets
– Infrastructure weaknesses were among the major causes of the exchange
rate collapses in emerging markets in the late 1990s
– Speculation contributed greatly to the emerging market crises. Uncovered
interest rate arbitrage caused by extremely low interest rates in Japan coupled
with high real interest rates in the US was a problem in the 1990s
– Cross-border foreign direct investment and international portfolio
investment into emerging markets dried up during the recent crises
– Foreign political risks have been much reduced in recent years as capital
markets became less segmented from each other and more liquid
– Finally, note that most determinants of spot exchange rates are also in turn
affected by changes in the spot rate – in other words, they are not only linked
but mutually determined
Michael Dimond
School of Business Administration
Purchasing Power Parity Approach
• PPP is the oldest and most widely followed of the exchange
rate theories
• PPP is embedded within most theories of exchange rate
determination
• PPP calculations and forecasts have structural differences
across countries and significant data challenges in estimation
• Many versions of PPP (see chapter 7) but perhaps the
relevant for explaining exchange rate values is Relative
Purchasing Power Parity which explains that changes in
relative prices between countries drive the change in
exchange rates over time
Michael Dimond
School of Business Administration
Balance of Payments (Flows) Approach
• Essentially BOP approach says equilibrium exchange rate is
achieved when current account inflows match current
account outflows
• BOP transactions are widely appealing, captured, and
reported
• Criticism of the BOP approach is that it focuses on flows
rather than stocks of money or financial assets
• Relative stocks of money or financial assets do not play a
role in the theory
• Practitioners use BOP but academics largely dismiss it
Michael Dimond
School of Business Administration
Monetary Approaches
• Changes in supply and demand for money largely
determine inflation which in turn alter exchange rates
• Prices are flexible in both the short and long-run thus, the
transmission impact is immediate
• Real economic activity influences exchange rates through
any alterations in demand for money
• Omits a number of important factors for exchange rate
determination including:
– The failure of PPP to hold in the short to medium term
– Money demand appears to be relatively unstable over time
– The level of economic activity and the money supply do not
appear to be independent
Michael Dimond
School of Business Administration
Asset Market Approach (Relative Prices of Bonds)
• AKA relative price of bonds or portfolio balance approach
• argues that exchange rates are determined by supply and
demand for a wide variety of assets
– Shifts in supply and demand alter exchange rates
– Changes in monetary and fiscal policy alter expectations and thus
exchange rates
– Theories of currency substitution follow the same basis premises of
portfolio rebalance framework
Michael Dimond
School of Business Administration
Asset Market Approach (Relative Prices of Bonds)
• The Asset market approach assumes that whether
foreigners are willing to hold claims in monetary form
depends on an extensive set of investment considerations or
drivers (as per the previous exhibit)
• In highly developed countries, foreign investors are willing to
hold securities and undertake foreign direct investment based
primarily on relative real interest rates and the outlook for
economic growth and profitability
• Prospects for economic growth and profitability are an
important determinant of cross-border equity investment in
both securities and foreign direct investment
Michael Dimond
School of Business Administration
Asset Market Approach (Relative Prices of Bonds)
• Capital market liquidity is particularly important to foreign
institutional investors. Cross-border investors are not only
interested in the ease of buying assets, but also in the ease
of selling those assets quickly for fair market value if desired
• A country’s economic and social infrastructure is an important
indicator of its ability to survive unexpected external shocks
and to prosper in a rapidly changing world economic
environment
• Political safety is exceptionally important to both foreign
portfolio and direct investors. The outlook for political safety
is usually reflected in political risk premiums for a country’s
securities and for purposes of evaluating foreign direct
investment in that country
Michael Dimond
School of Business Administration
Asset Market Approach (Relative Prices of Bonds)
• The credibility of corporate governance practices is important
to cross-border portfolio investors. A firm’s poor corporate
governance practices can reduce foreign investors 'influence
and cause subsequent loss of the firm’s focus on shareholder
wealth objectives
• Contagion is defined as the spread of a crisis in one country
to its neighboring countries and other countries with similar
characteristics—at least in the eyes of cross-border
investors. Contagion can cause an “innocent” country to
experience capital flight with a resulting depreciation of its
currency
• Speculation can both cause a foreign exchange crisis or
make an existing crisis worse
Michael Dimond
School of Business Administration
Currency Market Intervention
• Foreign currency intervention, the active management,
manipulation, or intervention in the market’s valuation of a
country’s currency, is a component of currency valuation and
forecast that cannot be overlooked.
• Central bank’s driving consideration – inflation or
unemployment?
• “beggar-thy-neighbor,” policy to keep currency values low to
aid in exports, may prove inflationary if some goods MUST
be imported … e.g. oil
• Direct Intervention - This is the active buying and selling of
the domestic currency against foreign currencies. This
traditionally required a central bank to act like any other
trader in the currency market
Michael Dimond
School of Business Administration
Currency Market Intervention
• Coordinated Intervention - in which several major countries,
or a collective such as the G8 of industrialized countries,
agree that a specific currency’s value is out of alignment with
their collective interests
• Indirect Intervention - This is the alteration of economic or
financial fundamentals which are thought to be drivers of
capital to flow in and out of specific currencies
• Capital Controls - This is the restriction of access to foreign
currency by government. This involves limiting the ability to
exchange domestic currency for foreign currency
– The Chinese regulation of access and trading of the Chinese yuan is a
prime example over the use of capital controls over currency value.
Michael Dimond
School of Business Administration
Forecasting in Practice
• In addition to the three approaches to forecasting discussed
earlier (Parity Conditions, Balance of Payments, Asset
Approach) forecasting practitioners also utilize technical
analysis
• These analysts, traditionally referred to as chartists, focus on
price and volume data to determine past trends that are
expected to continue into the future
• The longer time horizon of the forecast, the more inaccurate
the forecast is likely to be
• The following summarizes the various forecasting periods,
regimes and preferred forecasting methods for each
Michael Dimond
School of Business Administration
Exchange Rate Forecasting Methods
Michael Dimond
School of Business Administration
Forecasting in Practice
• Decades of theoretical and empirical studies show that
exchange rates do adhere to the fundamental principles and
theories outlined in the previous sections – fundamentals do
apply in the long term
• Therefore, there is something of a fundamental equilibrium
path for a currency’s value
• In the short term, a variety of random events, institutional
frictions, and technical factors may cause currency values to
deviate significantly from their long term fundamental path –
this is sometimes referred to as noise
Michael Dimond
School of Business Administration
Short-Term Noise Versus Long-Term Trends
• Although the various theories surrounding exchange rate
determination are clear and sound, it may appear on a dayto-day basis that the currency markets do not pay much
attention to the theories
Michael Dimond
School of Business Administration
Forecasting in Practice
• The difficulty is understanding which fundamentals are
driving markets at which points in time
• One example of this relative confusion over exchange rate
dynamics is the phenomenon known as overshooting
Michael Dimond
School of Business Administration