Foreign Exchange (FX) market - Introduction

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1 Foreign Exchange (FX) market - Introduction Ruichang LU ( 卢瑞昌 ) Department of Finance Guanghua School of Management Peking University

2 The Foreign Exchange (forex) Market The forex market is the physical and institutional structure through which one country s currency is exchanged for that of another. Before 1972, interbank FX market Since 1972, International Money Market (IMM) The forex market is the largest and most traded financial market in the world. $5 Trillion per day. Usual rankings: Largest forex-trading countries: See BIS triennial survey UK, 40.9% 2. US, 18.9% 3. SG, 5.7% 4. JP, 5.6% 5. HK, 4.1%

3 Countries for trading forex

4 World trade and forex comparisons

5 Role of Financial Institutions in Foreign Exchange Transactions

6 BIS triennial survey of forex activity Who is trading? Counter-party statistics. (see pg 6) Mostly financial institutions Most traded currencies? (see page 5) USD, EUR, JPY, GBP Most traded currency pairs? (page 15) USD/EUR, JPY/USD. Types of transactions? (see pg 8) Spots (transact now deliver now), forward (transact now deliver later), swaps (pairs of transactions)

7 Types of FX quotes Direct (home currency per unit foreign currency) versus indirect (foreign currency per unit home currency) European terms (foreign currency per unit USD) versus American terms (USD per foreign currency) Market quotes: The default convention to quote a currency is to express all currencies in foreign currency per USD (European terms) except for 4 currencies which will be expressed in American terms. The four are EUR, GBP, AUD, and NZD mdc_topnav_2_3021

8 WSJ quote EUR, GBP, AUD, and NZD

9 Most important concept for FX Remember which currency is the reference currency. Treat the reference currency as the currency being bought or sold. 1USD=118.89JPY, USD is the reference currency, since we can buy one USD for JPY. Think of it this way: imagine we can buy one pencil for JPY. The pencil is the asset being transacted, not JPY, although buying one pencil is equivalent to selling JPY.

10 Cross Exchange Rates A cross-exchange rate is an exchange rate between two non-usd currencies. Calculating cross-exchange rates from USD exchange rates: e.g.:

11 Cross-Rates example Example USD per = USD per CAD= What is the Canadian dollar per?

12 Bid-Ask Spread Usually no explicit commissions in forex, but there are bid-ask spreads! Bid-ask spreads complicate forex computations. To avoid confusion, remember the reference currency is the asset that you are buying or selling. Foreign exchange dealers buy currency at the bid price and sell currency at the ask price. Let S b represent the spot rate bid quotes, and S a represent the ask quotes. Example: GBP per USD b = This is a bid price for the USD. The dealer will buy USD at GBP This means that the dealer is selling GBP at (1/0.5242) = USD per GBP. So, USD per GBP a =

13 Bid-Ask Spread Using the following bid-ask quotes for GBP per USD, compute the respective bid-ask quotes for USD per GBP.

14 Cross bid-ask Rates Bid and ask cross-exchange rates Practice Problem: Given the below quotes, calculate the Mexican Peso per GBP bid-ask quotes.

15 Answer

16 Triangular Arbitrage Making a profit with three transactions involving three currencies. Example: trading out of the USD into a second currency, trading it into a third currency, which is then traded back into USD. Triangular arbitrage takes advantage of discrepancies between the quoted exchange rates and the implied cross-rates.

17 Exercise 1 Suppose the following rates prevail: a) Is there any arbitrage opportunity? If so, how would you take advantage of it?

18 Exercise 2 (with bid ask rates) Suppose the rates now have bid ask spreads Is there any arbitrage opportunity? If yes, what would you do?

19 Euro/CHF Jan. 15, 2015

20 Swiss Franc Black Swan Event A black swan event is a metaphor that describes an event that comes as a surprise and has major consequences. The Swiss National Bank (SNB) abandoned the cap on the currency's value against the euro. An $830 million hedge fund is closing after suffering heavy losses on Switzerland's shock decision to remove the franc s euro peg. Largest Retail FX Broker Stock Crashes 90% As Swiss Contagion Spreads, 100:1 leverage 4 retail FX brokers (FXCM lost 230M, Excel Markets bankruptcy, OANDA, and Alpari bankruptcy) have announced "issues"

21 Overview: How do exchange rates move? Several conditions govern how exchange rates move. We will examine in detail: Purchasing power parity (PPP) Fisher effects Forward rates Interest rate parity Most parity conditions rely on the law of one price, which must hold in an arbitrage equilibrium. Arbitrage is basically the simultaneous buying and selling of assets for the purpose of making a risk-free profit.

22 Absolute Purchasing Power Parity PPP states that exchange rates between 2 currencies should be equal to the ratio of the countries price levels. Formally (note reference currency is foreign currency, i.e. American terms): Spot ($ per FC) = P$ /PFC, or P $ = Spot x P FC The dollar price of a commodity basket in the US should be the same as the dollar price of the same commodity basket in any foreign country. E.g.: a Big Mac should cost the same (in US dollars) in France, or the US. Refer to big-mac currencies article. What are the shortcomings of the big mac method?

23 Big mac currencies e.g. In Jan 2013, Cost of big mac in USA= $4.367, in Switzerland= 6.50 Franc. Implied PPP exchange rate= 6.50/4.367 = Actual rate is CHF per USD Big mac price in Switzerland in USD terms is 6.5/0.9123= $ Big mac is too expensive in Switzerland by (7.125/4.367) 1=63.15%. It needs to fall by 63% in order for PPP to hold. (i.e. CHF to depreciate or big mac price in CHF to drop) How would you arbitrage (if possible to trade big macs)? Transportation Cost, tariffs, quotas

24 Relative Purchasing Power Parity--- inflation/fx Relative PPP: If the US inflation rate is higher than the foreign country s inflation rate, the FC should appreciate against the USD. Example: =6%; =4%. e=? The GBP should appreciate by about (1.06/1.04)-1=1.923% against the USD.

25

26 Fisher Effect FE states that an increase in a country s inflation rate should be accompanied by a proportionate increase in the interest rate in that country. Formally: The nominal (what we observe) interest rate i$ should equal 1+equilibrium real interest rate multiplied by 1+expected inflation rate E( ). The fisher effect can be applied to each country.

27 International Fisher Effect---Interest/FX IFE states that interest rate differentials reflect the expected (i.e. ex ante) change in exchange rates. The IFE is derived if the fisher effect holds in each country, the real interest rate is the same in both countries, And PPP holds. E.g., if interest rate is 5% p.a. in the US and 3% p.a. in Japan, then by IFE, the JPY is expected to appreciate against the USD by (1.05/1.03)-1=1.942% per year.

28 Historic BBA LIBOR rates

29 Forward contracts Forwards are agreements to purchase or sell a currency at a later date. Spot=sale now and deliver currencies now; forward=sale now and deliver currencies later. Contracts are usually for the short term, 1month (1M), 3months (3M), though there are 5 year (5Y) forwards.

30 Interest rate parity Interest rate parity is an arbitrage condition that holds when international markets are in equilibrium. Simply put, interest rate parity states that the following two investment strategies should yield the same proceeds: Invest $1 in the US (in a risk-free deposit) at r$ for one year. Convert $1 into FC and invest the FC in a risk-free asset at rfc for one year. Enter a forward contract now to sell the FC at the one-year forward rate to convert the FC into USD. Both strategies are riskless and as a result, they should yield the same rate of return.

31 Interest rate parity condition Assume FC is the reference currency (USD per FC) Your US $1 investment will yield = $1 (1+rUS ) Your FC investment will yield In equilibrium, both are equal, and we will obtain the IRP condition. Remember that the reference currency is always on the right.

32 Forward rate as predictor If the foreign currency (FC) is at a forward premium: F > S This means that the FC is expected to appreciate against the USD. As such, US interest rates will be higher than the FC interest rates to compensate investors for the expected depreciation of the USD. How about if the FC is at a forward discount?

33 European terms (foreign currency per unit USD) versus American terms (USD per foreign currency) EUR, GBP, AUD, and NZD Is the USD at a forward premium or discount against the Swiss Franc? 1. USD is ref currency. So USD at fwd discount (1.2207Sfr versus Sfr) which means Sfr is at forward premium). Implies that USD interest rates are higher than Swiss. Is the USD at a forward discount or premium against the EUR? EUR is ref currency. So EUR is at fwd premium ( versus ). Therefore USD is at fwd discount. USD interest rates are higher than EUR s.

34 Covered Interest Arbitrage If IRP does not hold, you can generate arbitrage profits. Steps: Check which side of the IRP equation gives you a larger number. Invest in the currency that gives you larger returns and borrow the other currency to fund the investment, and reverse these transactions with a forward contract to sell the currency that you invested in.

35 Example

36 IRP does not hold and there are arbitrage profits to be earned. We see that investing in USD is more profitable than investing in JPY. We should borrow JPY now to invest in USD and lock in the profits with a forward to sell USD. Assume a figure of 106,000,000 for the calculations.

37

38

39 Short Summary The IRP theory focuses on why the forward rate differs from the spot rate and on the degree of difference that should exist. It relates to a specific point in time. In contrast, the PPP theory and IFE theory focus on how a currency s spot rate will change over time. Whereas PPP theory suggests that the spot rate will change in accordance with inflation differentials, IFE theory suggests that it will change in accordance with interest rate differentials.

40 Uncovered interest rate parity All theory suggests that high interest rate currencies will depreciate: PPP Intl Fisher effect Interest rate parity But ask a man in the street: conventional wisdom suggests its better to invest in a currency with higher interest rates. Hence the carry trade: long high interest rate currencies, short low interest rate currencies.

41 Uncovered interest rate parity Interest rate parity always holds because of arbitrage. But uncovered interest rate parity may not hold. Borrow in low interest rate currency and invest in high interest rate currency and not hedging your position with a forward contract. Does this yield zero returns? (This is profits from uncovered interest arbitrage) Indeed, buying high interest rate currencies yield higher returns (Engel, 1996; Lewis 1995) This is also known as the forward discount puzzle: i.e. a FC is at a forward discount, so it should depreciate but it on average appreciates instead.

42 Carry Trade Here's an example of a "yen carry trade": a trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

43 How can carry trade make $? Carry trade risk premium Carry trade is risky, so it deserves higher returns. Lustig, Roussanov, Verdelhan (2012 RFS) shows that high interest rate currencies returns are positively correlated with equity returns. See US stock returns and carry trade graph. Jurek (2008) shows that the premium could be due to a crash risk some probability that the carry trade will earn a large negative return in the future. Indeed this happened in See also article in WSJ: (Carry trade can be unforgiving) Peso problem: Its possible that carry trade does not make money at all. We think it makes money because the crash is yet to occur in the data for some currencies. (the classic Peso problem)

44 The Carry Trade Can Be Unforgiving By JEFF D. OPDYKE Updated Feb. 20, :01 a.m. ET Billions of dollars are wagered daily in the "carry trade," in which traders sell the currencies of countries with low interest rates like the U.S. and Japan while simultaneously buying the currency of countries with higher rates like Australia and Brazil. These arbitrage opportunities can persist for years at a time. But before you try your hand at the carry trade, be aware that currency values can change in seconds, causing sudden losses. And because currency trading typically involves heavy financial leverage traders borrow as much as $500 for each dollar they invest to amplify results the carry trade can rapidly become the scary trade. That is what happened in the fall of 2008, when traders suddenly rushed to the safety of U.S. dollars during the financial crisis. Those who had sold the dollar and Japanese yen to own higher-yielding currencies quickly piled up big losses as these other currencies sank in value. The losses wiped out several years' worth of gains in the carry trade. While amateur traders see the carry trade as a road to riches, "I see it as a way to get broke," says Amarjit Sahota, chief executive at HiFX Inc., which helps companies and individuals manage currency exposure.

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