dr Bartłomiej Rokicki Chair of Macroeconomics and ...coin.wne.uw.edu.pl/brokicki/wsp_images/oem___lecture_5.pdf · profit in zloty, and the company's profit is transferred to the

dr Bartłomiej Rokicki

Chair of Macroeconomics and International Trade Theory

Faculty of Economic Sciences, University of Warsaw

Main definitions

Foreign exchange market – a market where one country’s currency is exchanged for the other

Currency – used as a synonym to a word money, most of all in the context of international relations

Foreign currency – all foreign coins, banknotes, deposits in foreign banks and other foreign short-run financial assets (up to 1 year)

Exchange rate and types of quotations:

• Direct quotation: price of a foreign currency expressed in a domestic currency (American quotation, e.g. PLN/USD)

• Indirect quotation: price of a domestic currency expressed in a foreign currency (European quotation, e.g. USD/PLN)


Open Economy Macroeconomics

Foreign currency market



Exchange rate



• Foreign trade – e.g. if a Polish company exports its products to Germany, the contractor pays the amount in euros. The company bears the costs in zlotys (salaries, raw materials, energy, etc.) and therefore has to sell the euro on the currency market (to transfer it into zloty) � it increases the supply of euros.

• Remuneration of factors of production employed abroad – e.g. if an American company has subsidiaries in Poland, acting on the Polish market, it records a profit in zloty, and the company's profit is transferred to the U.S. - first zloty must be converted (in the currency market) the U.S. dollar � demand for dollars growing.

• The flow of capital - e.g. Finnish pension fund buys bonds of the Polish government; since the fund is denominated in euro, and the government sells bonds in zloty, the buyer must first use the currency market � euro supply increases.

Sources of demand and supply for currency



• Nominal exchange rate

• Real exchange rate

• Nominal effective exchange rate

• Real effective exchange rate

• Floating exchange rate

• Fixed exchange rate

• Spot exchange rate

• Future exchange rate

Different types of exchange rate



• Nominal exchange rate - the actual foreign exchange quotation, without adjustment for transaction costs or differences in purchasing power.

• Real exchange rate - a nominal exchange rate adjusted for the different rates of inflation between the two currencies. It shows the purchasing power of two currencies relative to one another.

• Nominal effective exchange rate – a weighted average of exchange rates of a given country’s currency against currencies of its trading partners, where weights are the shares of each currency in the exchange with a given trading partner.

• Real effective exchange rate - a weighted average of a country's currency relative to an index or basket of other major currencies adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country's currency, with each other country within the index.

Nominal exchange rate versus real exchange rate



Floating exchange rate versus fixed exchange rate

e2

e1

Central bank intervention

Floating exchange rate Fixed exchange rate

nominal exchange rate

nominal exchange rate



• Spot exchange rate - the exchange rate for which two parties agree to trade two currencies at the present moment. The spot exchange rate is usually at or close to the current market rate because the transaction occurs in real time and not at some point in the future.

• Forward exchange rate - the exchange rate set today for a foreign currency transaction with payment or delivery at some future date.

• Spot currency contract - immediate delivery of currency (the end of a second working day after concluding the transaction).

• Forward currency contract - an agreement between two parties to exchange two currencies at a given exchange rate at some point in the future, usually 30, 60, or 90 days hence. A forward currency contract mitigates foreign exchange risk for the parties and is most useful when both parties have operations or some other interest in a country using a given currency. Forward currency contracts are over-the-counter contracts (negotiated between brokers and

dealers).

Spot exchange rate versus forward exchange rate



• Role of intermediation in the foreign exchange market

• Bid and ask rate

• Spread as a dealers’ source of intermediary’s profit

• Determinants of spread

• Main participants:

• Individual and corporate clients

• Foreign exchange dealers

• Foreign exchange brokers

• Arbitrage makers

• Governments

International exchange market



Foreign exchange dealers



Arbitrage

• The simultaneous purchase and sale of an asset in order to profit from a difference in the price

• It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets

• Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time

• Currency arbitrage

• By buying 10 mln euro at market 1 and selling it at market 2 � profit of 327000 PLN (3,27%)

RateRateRateRate BidBidBidBid AskAskAskAsk

Market 1 EUR/PLN 3,8695 3,8855

Market 2 EUR/PLN 3,8882 3,9012



The arbitrage condition

• The arbitrage is possible only in case of price differences of identical or similar financial instruments, on different markets.

• Hence, in case of currency arbitrage we will define the arbitrage condition for three different currencies j,k,m, as:

ejkekmemj = 1 where e stands for nominal exchange rate • If the left hand side of the above equation is higher than1 then it is profitable

to conduct a currency arbitrage.

• Moreover, from the above it follows that:

0=∆

+∆

+∆

mj

mj

km

km

jk

jk

e

e

e

e

e

e



Question 1. A US dollar costs 7.5 Norwegian kroner, but the same dollar can be purchased for 1.25 Swiss francs. What is the Norwegian kroner/Swiss franc exchange rate? Question 2. On the first of January 1 EUR cost 1.3855 USD, and at the same time 1 EUR cost NOK 8.3122. During the year Norwegian kroner has appreciated by 4% while USD has depreciated by 18%. Calculate spot exchange rates at the end of the year. Question 3. Suppose the quotations (note that USD/EUR 1.2597 means 1 EUR is worth USD 1.2597) of bilateral exchange rates between US dollar, euro and yen are given in the table below. Explore the possibility of three-point arbitrage. Suppose you have 1,000,000 USD. How would you realize your profits? Show the example of such transaction. USD/EUR 1.2597 JPY/USD 119.06 JPY/EUR 150.08



Question 4. In reality there is a small spread between bid and ask rates. Suppose that the exchange rates between euro, U.S. dollar and the yen are given in the table below. Explore the possibility of three-point arbitrage between these currencies once you have $1,000,000. Bid Ask USD/EUR 1.2596 1.2599 JPY/USD 119.04 119.08 JPY/EUR 149.96 150.00 Question 5. Below you can find the quotations in two periods. Verify the arbitrage condition using the relative change of exchange rates. t0 t1 USD/EUR 1.2596 1.2256 JPY/USD 119.04 121.18 JPY/EUR 149.94 148.52



Question 6. Below you can find the price of “The Economist” in three different countries:

price exchange rate

USA 4.95 USD - Italy 3.55 EUR 0.7974 EUR/USD Japan 670 JPY 119.51 JPY/USD • Calculate the price in US dollars in each country.

• Calculate what should be the price in each country if there were no transport costs and purchase parity condition held.

• Which currency is overvalued and which undervalued against US dollar? Why?

Question 7. How has changed the real exchange rate of euro against US dollar if euro appreciated 3% in nominal terms and the prices in US have grown faster than in the EU by about 1.6%?



• Futures - similar to forward contracts concluded in advance, with a standardized value of the transaction, guaranteed by a clearing house, available only for major currencies.

• Currency options - give their holders the right (no obligation) to buy or sell a currency at a fixed price at any period until its expiry. Writer of an option is required to accomplish transaction:

• Put option - the right to sell foreign currency at a fixed price

• Call option - the right to purchase currency at a fixed price

• Purchasing an option involves the payment of a fee called the option premium

• Currency swaps - the exchange of one currency for another at some rate with a simultaneous opposite transaction

• Advantage: much lower transaction costs than two separate transactions

Derivatives of the foreign exchange market



Exchange rate risk

• If a fixed exchange rate regime prevailed in all countries (as it was up to 1973 to some extent) the forward transactions would not make any sense.

• However now, most countries (at least the major economies) use the system of floating exchange rate – economic agents in these countries are exposed to foreign exchange risk.

• Exchange rate risk - the risk of loss due to change in the exchange rate level

• We are always exposed to an exchange rate risk, when we have an open currency position in some currency.

• Open currency position - sums of our receivables and payables in a given currency are not equal.

• Short currency position:

receivables < payables (we are afraid of foreign currency appreciation)

• Long currency position:

receivables > payables (we are afraid of foreign currency depreciation)



• Similarly to the exchange rate derivatives we may also find interest rate derivatives such as interest rate futures or interest rate swaps.

• Interest rate futures in the US markets are traded on the CME (Chicago Mercantile Exchange). All CME interest rate futures contracts are traded using a price index, which is derived by subtracting the futures' interest rate from 100.00. For instance, an interest rate of 5.00 percent translates to an index price of 95.00 (100.00 - 5.00 = 95.00).

• In case of Eurodollar contracts (which reflect the yield on a bank deposit for three months for $1 million in a European account on a dollar-denominated account) each change in the interest rate of one basis point (1% of 1%, or 0.0001, will cause the price to move in the opposite direction of 1 cent. Therefore, a fall in the interest rate of one basis point will add $25 to the margin account. This is because $1 million x 0.0001 equals $100. But the future is for a Eurodollar bank deposit of three months, so the gain is $100/4 and equals $25.

Interest rate derivatives



FOREX market daily turnover



FOREX market main currencies



37%

18% 6%

5%

5%

5%

4%

3%

2%

2% 13%

United Kingdom United States Japan Singapore

Switzerland Hong Kong SAR Australia France

FOREX market geographical structure of turnover



Question 8. The current spot exchange rate is 1.95$/£ and the three-month forward rate is 1.90$/£. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be 1.92$/£ in three months. Assume that you would like to buy or sell £1,000,000.

• What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation?

• What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be 1.86$/£.

Question 9. Show different operations on currency futures and forwards if you have to pay €10m in three months for a delivery of parts from Germany invoiced in euros and you want to avoid a currency risk. Suppose that both 3-month euro futures and forwards contracts are priced at 1.2550$/€.

• Show what will happen if the euro is 1.30$/€ in 3 months.

• What will occur if the euro is 1.20$/€ in 3 months?



Question 10. Treasurer learns on March 3, 2005 that his company will receive $20m in June 2005 from the sale of merchandise, and these funds will need to be invested for 3 months in the money market. Current 3-month LIBOR is 2.95% and expected 3-month LIBOR in June 2005 according to futures trading is 3.44%. Treasurer decides to lock in at that rate to eliminate interest rate risk, taking a LONG position (BUYS Eurodollar futures contracts at a price of 96.56 to lock in 3.44% rate). To hedge the entire amount of $20m, he buys 20 Eurodollar contracts worth $1m. What interest income will guarantee this strategy? What will happen if at expiration, 3-month LIBOR is only 3.10%? What will happen if at expiration, 3-month LIBOR is 3.50%?

Question 11. Consider the euro call options for June 2005 (€62,500 per contract). Premium = 0.0459$/€, with an Exercise Price = 1.30$/€. One contract costs €62,500 x 0.0459$/€ = $2,868.75, which gives you the right to buy euros at $1.30. What will be your profit if the euro sells at $1.36 on expiration? What will be your profit if the euro sells at $1.29 on expiration?



Question 12. The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale to the European Union market. The plant is expected to cost €4,920,000, and to take about one year to complete. The plant is to be financed over its economic life of eight years. The borrowing capacity created by this capital expenditure is $1,700,000; the remainder of the plant will be equity financed. Centralia is not well known in the Spanish or international bond market; consequently, it would have to pay 9 percent per annum to borrow euros, whereas the normal borrowing rate in the euro zone for well-known firms of equivalent risk is 7 percent. Centralia could borrow dollars in the U.S. at a rate of 8 percent. Suppose a Spanish MNC has a mirror-image situation and needs $1,700,000 to finance a capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed rate in the United States for dollars, whereas it can borrow euros at 7 percent. The exchange rate has been forecast to be 1.20$/€ in one year. Set up a currency swap that will benefit each counterparty and calculate the contractual exchange rate for the initial exchange, the contractual rate for annual debt services exchanges and the contractual rate of final currency exchange.

Documents

dr Bartłomiej Rokicki Chair of Macroeconomics and ...coin.wne.uw.edu.pl/brokicki/wsp_images/oem___lecture_5.pdf · profit in zloty, and the company's profit is transferred to the