University of Economics Prague Department of International Trade. International Financial Strategies. Content: 1. Foreign Exchange Markets

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1 University of Economics Prague Department of International Trade Josef Taušer Associate Professor Office Hours: See ISIS 1 International Financial Strategies Content: 1. Foreign Exchange Markets Exchange Rate Quotations, Cross Rates. Locational Arbitrage, Triangular Arbitrage, Currency Speculations 2. Currency Derivatives FX forwards, Currency Futures, FX Swaps and Currency Swaps, Currency Options. 3. Exchange Rate Exposure Transaction, Economic and Translation Exposure; Exchange Rate Risk Measurement and Management 4. International Investement Decisions Time Value of Money, Stock Valuation, Interest Rates and Bond Valuation, Security Market Line, Investment Criteria 2 1

2 Literature Madura, Jeff: International Financial Management, Thomson South-Western, 8 th Edition, 2006 Eiteman, D. K., Stonehill, A. I., Moffet, M. H.: Multinational Business Finance, Pearson Addison Wesley, 2004 Krugman, Paul R., Obstfeld, M.: International Economics: theory and policy, Addison-Wesley, Reading International Financial Strategies 4 2

3 Exchange Rate Exchange rate is the price of one currency in units of another currency. Quotations that represent the value of a foreign currency in domestic currency are referred to as direct quotations. For example: 1 $ = 0,8000 (USD, CHF, CAD) 5 Exchange Rate Exchange rate is the price of one currency in units of another currency. Quotations that represent the number of units of a foreign currency per domestic currency are referred to as indirect quotations. for example: 1 = 1,25 $ or EUR/ USD 1,25 (EUR, GBP) 6 3

4 Exchange Rate - Quotations Foreign Currency (USD) appreciates Foreign Currency (USD) depreciates Indirect Quotation (EUR/USD) Exchange Rate falls Exchange Rate rises Direct Quotation (1 USD = x EUR) Exchange Rate rises Exchange Rate falls 7 Foreign exchange market The foreign exchange market allows currencies to be exchanged to facilitate international trade or financial transactions. There is no specific building or location where traders exchange currencies. The currencies are traded directly from the offices and dealing centers of the banks over telecommunication systems. 8 4

5 Interbank Market The market for immediate exchange is known as the spot market. Delivery takes places normally on the second following business day. Trading between banks makes up what is often referred to as the interbank market. The banks often function as market makers. Individual transactions in the interbank market are usually for larger sums that are multiplies of a million Euros, US Dollars etc. On the client market the transactions are typically for smaller 9 Exchange Rate (Bid Ask rate) Banks provide foreign exchange transactions for a fee (spread). Direct Quotation: the bid (buy) quote for a foreign currency will be less than its as (sell) quote. bid/ask spread = ask rate - bid rate ask rate 10 5

6 Exchange Rate (Bid Ask rate) Banks provide foreign exchange transactions for a fee (spread). Indirect Quotation: the bid (buy) quote for a domestic currency will be less than its ask (sell) quote. The bid/ask spread is normally greater for those currencies that are less frequently traded. The bid/ask spread is normally smaller if there is a strong competition on the market. 11 Exchange Rate Quotations /USD (on ) Bid Rate Ask Rate 1,2013 1,2295 1,2332 1,2333 1,2334 1,2361 1,2611 Cash Transactions (Bid Rate) Client (Bid Rate) Interbank (Bid Rate) Euro Fixing Interbank (Ask Rate) Client (Ask Rate) Cash Transactions (Ask Rate) Source: Stocker, K. (2001): WechselExchange Ratemanagement auf Euro-Basis, pp

7 Exchange Rate Quotations Inverse value of bid rate in direct quotation equals ask rate in indirect quotation. Example: Direct quotation: EUR/USD: 1,3292/1,3304 In indirect quotation: 0,7517 = BID (indirect quotation) 0,7523 = ASK (indirect quotation) USD/EUR: 0,7517/0, Cross Rates /1 For currencies that Euro is not directly traded with. All currencies are quoted against US Dollar Dollar may be used as a Vehicle-Currency Euro is traded only with the most important currencies. 14 7

8 Cross Rates /2 Example: How can we calculate the EUR /AZM (Azerbaijan Manat) exchange rate using US Dollar as an intermediate currency? Solution 1 EUR =? AZM EUR/USD 1,2388 and 2,0354 USD/AZM EUR/AZM 2,5215 Indirect Quotation x Direct Quotation 15 Cross Rates /3 International Arbitrage /1 All spot rates shall agree with relevant cross rates, otherwise the arbitrage opportunities do exist! Arbitrage can be defined as capitalizing on the differences in quoted prices by making risk-less profit. 16 8

9 International Arbitrage/2 3 types of arbitrages on foreign exchange markets Locational Arbitrage Triangular Arbitrage Covered Interest Arbitrage 17 Locational Arbitrage Locational arbitrage is a process of buying a currency on the market where it is relatively cheap and immediately selling it on another market where it is priced higher. Example: Paris Interbank market: EUR/USD 1,3277/1,3285 London Interbank market: EUR/USD 1,3287/1,3295 Solution: Arbitrageur buys Euros in Paris for 1,3285 USD and immediately sell Euros in London for 1,3287 USD. 18 9

10 Locational Arbitrage Locational arbitrage is possible when the bid price of one bank is higher than the ask price of another bank for the same currency. In response to the imbalance in demand and supply resulting from such arbitrage activity, the prices will adjust very quickly. 19 Triangular Arbitrage Triangular arbitrage is a process of capitalizing on the differences between the spot rates and cross rates. Example: EUR/USD 1,2900 EUR/CZK 27,850 USD/CZK 21,900 Solution: Arbitrageur sells Euros for 1,2900 USD; then he sells USD for 21,900 CZK and buys again Euros for 27,850 CZK

11 Triangular Arbitrage Triangular arbitrage is possible when a quoted cross exchange rate differs from that calculated using the appropriate spot rates. In response to the imbalance in demand and supply resulting from such arbitrage activity, the prices will adjust very quickly. Spreads reduce the arbitrage profits. 21 International Arbitrage Locational arbitrage ensures that quoted exchange rates are similar across banks in different locations. Triangular arbitrage ensures that cross exchange rates are set properly. Any discrepancy will trigger arbitrage, which will then eliminate the discrepancy. Arbitrage thus makes the foreign exchange market more orderly

12 Currency Speculations Speculators seek to profit from the exchange rate movements. To achieve a high leverage effect the speculators open short positions in weak currencies. Example: Assume you expect Euro to depreciate from EUR/USD 1.40 to 1.33 in 30 days. What is your expected profit from the speculation if your borrowing capacity is 10 MEUR or 14 MUSD and annualized interest rates are as follows: EUR 2.00% % USD 4.00% % 23 12