Foreign Exchange markets and international monetary arrangements

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1 Foreign Exchange markets and international monetary arrangements Ruichang LU ( 卢 瑞 昌 ) Department of Finance Guanghua School of Management Peking University

2 Some issues on the course arrangement Professor Robin Chou (National ChengChi University) will take over Larry Zheng s section. Lectures on 31 st May (Sunday afternoon 1-4pm) and 1 st June (9am- 12noon). en Quiz arrangement: Quiz for Dr. Liou s session will be held during the class on 26 May (21:00 to 21:30). Quiz for Dr. Chou s session will be held during the class on 8 June (21:00 to 21:30). Quiz for my session will be held during the class on 9 June (21:00 to 21:30).

3 Outline May 25 Background and History Effect of FX on foreign investment Foreign exchange activity, Market Participants Quotes, Spot and Cross-Rates Triangular arbitrage May 26 International parities conditions Purchasing Power Parity Interest Rate Parity Covered Interest Arbitrage Carry Trade June 8 Forward-looking Market Instruments for Forex Offshore Banking Libor Forward Rates, future, Options, Swaps Recent Practices

4 Lecture outline Effect of FX on foreign investments Background and History Foreign exchange activity, Market Participants Quotes, Spot and Cross-Rates Triangular arbitrage

5 Effect of FX on foreign investments The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the USD and the foreign currency.

6 Eg: Effect of FX on foreign investments For example, if a U.S. resident just sold shares in a British firm that had a 15% return (in pounds) during a period when the pound depreciated 5%, his dollar return is 9.25%: Foreign exchange movements can wipe out or magnify gains in foreign investments.

7 Effect of FX on export The undervalued currency resulted in exports being relatively cheap. By keeping its currency artificially weak and thus its goods more competitive on world markets.

8 Reserve currency

9 Background and History of Foreign Exchange Markets Gold standard (pre-1944) ---fixed system of exchange (gold vs. currency) Bretton Woods Agreement ( ) (73.4% gold, fixed rate, gold vs. US dollar, other currency vs. US dollar, 1 ounce gold=$35 USD) Established international monetary fund (IMF) and international bank for reconstruction and development (part of world bank today)

10 Triffin Dilemma (Robert Triffin, 1960) By the autumn of 1960, an ounce of gold could be exchanged for $40 in London, even though the rate in the United States was $35. com/news/ /triffins-dilemma edition

11 Breakdown Smithsonian Agreement (1971), boundaries increase from 1% to 2.25%, 1 ounce gold=$38 USD, refuse to redeem the gold. Smithsonian Agreement II (1973), float free The Chinese Yuan, peg to USD, /7/21, floating rate, basket of currencies As of 2015/4/20, 1USD=6.21

12 World trade and forex comparisons

13 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%

14 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)

15 Role of Financial Institutions in Foreign Exchange Transactions

16 Foreign Exchange Transactions FX swaps, which one party borrows one currency from, and simultaneously lends another to, the second party. collateral and the amount of repayment is fixed. 42% in 2013 Spot foreign exchange transactions involve the immediate exchange of currencies at the current (or spot) exchange rate, 38% in 2013 Forward foreign exchange transaction is the exchange of currencies at a specified exchange rate (or forward exchange rate) at some specified date in the future, 13% in 2013 Annually much larger than world import/export numbers. Implies that most FX trading is speculative, not trade-motivated.

17 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

18 WSJ quote EUR, GBP, AUD, and NZD

19 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.

20 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.:

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

22 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 =

23

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

25 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.

26 Answer

27 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.

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

29 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?

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