Capital Markers Section 1 Foreign Exchange Markets

Πανεπιστήμιο Πειραιώς, Τμήμα Τραπεζικής και Χρηματοοικονομικής Διοικητικής Μεταπτυχιακό Πρόγραμμα «Χρηματοοικονομική Ανάλυση για Στελέχη» Capital Markers Section 1 Foreign Exchange Markets Michail Anthropelos, Ph.D. anthropel@unipi.gr http://web.xrh.unipi.gr/faculty/anthropelos/ 1

The Market for Foreign Exchange The Market of Foreign Exchange (FX or FOREX) is the largest financial market in the world. Daily Global FOREX trading Volume in Trillions $ 6,00 5,30 5,00 4,00 3,00 3,21 3,60 1,88 2,00 1,50 1,19 1,20 0,65 0,82 1,00 0,26 0,01 0,06 0,00 1973 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Source: Bank of International Settlements The FOREX market encompasses: the conversion of purchasing power from one currency into another, the bank deposits of foreign currencies, the extension of credit denominated in a foreign currency, the foreign trade financing and the trading in foreign currency derivative contracts. 2

Function and structure of the FOREX Market The spot and the forward foreign exchange markets are mainly an over-the-counter (OTC) (there is no central marketplace where buyers and sellers congregate). Rather, all market participants are connected via a network (the largest communication system in the world). The FOREX market participants can be categorized in the following groups: reporting dealers (38.9%), non-financial customers (9%) and other financial institutions (such as non-reporting banks, funds, insurance companies & central banks, 53%). The FOREX market (regarding the volume) can be discriminated as: A. Wholesale market or interbank market: where banks, brokers and nonbank announce the exchange rates at which they are willing to sell and buy (it accounts for 95%). B. Retail market: where every individual can buy or sell small amounts of foreign currencies in a given exchange rates. 3

Spot, Forward and Swap FX transactions A transaction in a FX market can be in spot rate (τρέχουσα ισοτιμία), in forward rate (προθεσμιακή ισοτιμία) or as a part of currency swap. According to 2015 BIS statistics, 38% of the global FX market transactions were settled in spot rate, 13% in currency forward contracts, 42% were part of currency swap contracts and rest was associated with options and other derivative products. 1. Spot transaction involves (almost) the immediate purchase or sale of foreign exchange (usually 2 trading days). 2. Forward transaction involves the delivery of the foreign currency on a certain future date (after 30, 60, 90, 180 days), at a exchange rate which is determined today. For example, currency forwards (προθεσμιακά συμβόλαια σε συνάλλαγμα) and currency futures (συμβόλαια μελλοντικής εκπλήρωσης σε συνάλλαγμα). 3. A swap is the transaction that combines a spot rate and at least one forward rate transaction in the opposite direction. 4

The Spot Rate Spot rate currency quotations can be stated in direct or indirect terms. The direct quotation (άμεση αναφορά) gives the price of one unit of a foreign currency priced in domestic currency. For example, in Europe the US$ is referred in i.e., $1= 0.8898 and for British pound 1= 1.3575 (spot rates on 03/09/15). Similarly, the indirect quotation (έμμεση αναφορά) gives the price of one unit of the domestic currency priced in a foreign currency. For example, 1= $1.1238 and 1= 0.7366. Notation S(j/k) refers to the spot rate of one unit of currency k in terms of currency j. i.e., S( /$)= 0.8898. Note that S( /$)=1/S($/ ). 5

The Bid-Ask Spread Each international bank that gets involved in the FX markets announces two spot rates: 1. the rate at which it is willing to buy a foreign currency: the bid price. 2. the rate at which it is willing to sell a foreign currency: the ask price. Spread = ask price bid price or Percentage spread = (ask price bid price)/ask price x 100 What does determine the size of the spread at a currency? 1) The spread reflects the depth and the liquidity of the specific currency market. 2) The uncertainty about the currency value (its volatility). 3) The deposit of the specific currency that a particular bank has. The quotes in the financial press refer to the interbank market for transaction exceeding $1mil. Why such a spread exists? 6

The Cross-Exchange Rate Quotations Usually, in the interbank transactions all the currencies are quoted against the American $. The cross rate (σταυρωτή ισοτιμία) is given by the combination of the spot rates of two currencies against $. Example: Suppose that a (European) bank announces the following spot rates: This means that: S($/ b )= 1. 1235, S($/ a )= 1.1236 and 1= $1.1235-36 and 1 = 0.7362-63 S( /$ b )=1/S($/ a )=0.8899, S( /$ a )=1/S($/ b )= 0.8900 S( / b )= 0.7362, S( / a )= 0.7363 and S( / b )=1/S( / a )=1.3580, S( / a )=1/S( / b )=1.3582. Suppose that the firm CM has $100 and wants to exchange them to. 1. CM sells $100 to the bank at S( /$ b ) and gets 88.99. 2. Then, CM sells the euros at S( / b )=0.7362 and gets 65.51. This means that the bank uses S( /$ b )=0.6551. Similarly, S( /$ a )=S( /$ a ) x S( / a )= 0.8900 x 0.7363=0.6553, i.e., 1 =$0.6551-53. 7

The Cross-Exchange Rate Quotations, cont d More generally, we have that: where the above spot rates are equal in the case of no spread. Note that given N currencies, one can calculate a triangular matrix of N(N-1)/2 cross exchange rates. 8 ), / ( ) / ( ) / ( ) / ( ) / ( and ) / ( ) / ( ) / ( ) / ( ) / ( b b a b b a a b a a k l S l j S l k S l j S k j S k l S l j S l k S l j S k j S

The Cross-Exchange Rate Quotations, cont d Spot Rates on 02/09/2015 Source: Bloomberg 9

A Typical Exchange Rate Quotations Rates on 03/09/2015 Source: www.oanda.com 10

The Cross-Exchange Rate Quotations, cont d We have that: S( / b )=0.7362, S( / a )=0.7363 S($/ b )= 1.1235, S($/ a )= 1.1236 S($/ b ) = 1.5259 and S($/ a ) = 1.5261. Note that S( / b ) x S($/ b ) = 1.234 S($/ b ). 11

Triangular Arbitrage If there are some direct quotes which are not consistent with the crossrate spread, a possibility of certain profit (profit without risk) is emerged. This situation is defined as triangular arbitrage in FX markets. In other words, triangular arbitrage (or currency arbitrage) involves buying a currency in one market and selling it in another. Example: Suppose that: a) a London bank offers at S( / b ) = 0.7362, b) a European bank in Frankfurt offers at S( /$ b ) = 0.8899 and c) on that day a bank in NY buys at S($/ b ) = 1.6500 (very high). An arbitrageur would sell dollars for euros in Frankfurt, use the euros to acquire pounds in London and sell the pounds for dollars in NY. 12

Triangular Arbitrage cont d More precisely, if the arbitrageur has available (say) $1 mil.: 1. He gets 889,900 in Frankfurt. 2. He sells theses euros for 655,144= 889,900 x 0.7362 in London. 3. He resells theses pounds in NY for $1,080,988= 655,144 x 1.65. The riskless immediate profit is $80,988. S($ / b) S($/ Euro b) S(Euro / b) This arbitrage is created because:. The above situation would tend to cause the euro appreciation against US dollar, which will be canceled by the depreciation of euro againgst the pound. At the same time, pound will tend to fall in NY against dollar. The currency arbitrage opportunities are very rare nowadays (due to extensive network, high-speed information, quotes against a specific currency). Minimal deviations may exist due to additional transaction costs. 13

The Forward Rate A currency forward or futures contract is an agreement between two parties (two banks or one bank and one of its clients) for the delivery of a certain amount of a foreign currency on a certain future date, at a certain exchange rate (agreed at the starting of the contract). Two parties: Long position: The buyer of the foreign currency. Short position: The seller of the foreign currency. Why trade at forward contracts? 1. Hedging (reduction of risk exposure). 2. Speculation (undertaking more risk and more expected profit). 3. Arbitrage (certain profit without undertaking more risk). Note: The outcome of a forward contract is a zero-sum game. 14

The Forward Rate (cont d) Forward rates for USD/EUR on 03/09/15 Source: www.cmegroup.com Of course, there is a spread in forward rates too, which is actually higher than the corresponding spread in spot market (why?) 15

The Forward Rate (cont d) Notation: refers to the price of one unit of currency k in terms of currency j, for delivery in N months. F N ( j / k) Example: On 02/09/16 the $/ rates were: S($/ )=1.1238 F 1 ($/ )=1.1240 F 3 ($/ )= 1.1258 F 12 ($/ )= 1.1336 In this case, we say that is trading at a premium to $. Similarly, we say that $ is trading at a discount to. Generally, a foreign currency is said to be at a forward premium if the forward rate expressed in units of the domestic currency is higher than the spot rate. Otherwise, the foreign currency is at a forward discount. 16

The Forward Premium/Discount It is common to express the premium or the discount of a forward rate as an annualized percentage deviation from the spot rate (it is more convenient for comparisons). More precisely, the forward premium or discount is given as: f N FN ( j / k) S( j / k) 12 ( j / k) S( j / k) N Example: On 05/09/13, it holds that: f F3 ($ / Euro) S($ / Euro) 12 ($ / Euro) 0. 178% S($ / Euro) 3 3 We say that is trading vs $ at a 0.31% premium, for delivery in three months. What do you think determines whether we have discount or premium? 17

The Exchange Rates as Equilibria The exchange rates (spot/forward) are market clearing prices that equilibrate supplies and demands in foreign exchange market. $/ example: Demand for euros = American demand for Euroland goods, services and euro-denominated financial assets. Demand for dollars = European demand for American goods, services and American-denominated financial assets. Demand for euros = Supply of dollars Why does this equilibrium on goods and assets fluctuate so much? 18

Factors that Affect the Exchange Rate Equilibria Some of the factors that influence currency supply and demand: 1. Relative inflation rates: In general, a nation running a relative high rate of inflation will find its currency declining in value relative to the currencies with lower inflation rate. (why?) 2. Relative (real) interest rates: A rise in domestic real interest rate (ceteris paribus) will increase the demand of the domestic securities and will result a currency appreciation. 3. Relative economic growth: Relative stronger economic growth implies currency appreciation. 4. Political and economic risk: Less stability implies currency depreciation. Note: What affects the changes in exchange rates is mostly the market s expectations on the above factors. 19

The Interest Rate Parity (IRP) The Interest Rate Parity, IRP, (διεθνής ισοδυναμία επιτοκίων) is an arbitrage condition that must hold when international financial markets are in equilibrium (equilibrium in the sense that there is no arbitrage opportunity in the exchange market). Suppose that an investor in Athens has 1. He has two alternative ways to invest this euro in riskless (default-free) positions for a year. 1. Invest in euro (risk-free) interest rate r : 1 In one year (1+r ) 2. Invest in dollar (risk-free) interest rate r $ : First convert 1 in $S($/ ) and $S($/ ) In one year $S($/ )*(1+r $ ) Finally, convert the outcome in euros: S($/Euro) ( 1 r$ ) F ($/Euro) 12 20

The Interest Rate Parity (IRP) cont d Hence, if there is no arbitrage in the euro/dollar exchange market, it should hold: 1 r which is the formal statement of the IRP. More generally we have: (1 r S( $/Euro ) (1 F ( $/Euro ) r euro $ 12 k ) N /12 S(j/k) ( 1 r F (j/k) N where, N is the number of months, r j and r k are the annual risk-free interest rates at currency j and k respectively. Hence if IRP holds, S(j/k) F N (j/k) r k ) r j j. ) N /12 21

The Interest Rate Parity (IRP) cont d The IRP is equivalent to: r eu r$ S($/Eu) F ($/Eu) 12 which is sometimes approximated by: S($/Eu) F12($/Eu) F ($/Eu) The last equation provides a link between interest rates in two different countries and the corresponding spot and forward exchange rates. It is important to have in mind that difference of interest rates does NOT mean that spot future in the future will change accordingly. and are different quantities (the later is stochastic). F 12 ($/Eu) r eu r$ S 12 ($/Eu) When the IRP is violated, one can get a risk-free profit by exploiting the gap. This situation is called covered interest rate arbitrage. 12 S($/Eu) F12($/Eu) F ($/Eu) 12 22

Covered Interest Arbitrage (CIA) Example: Suppose that r $ = 5% and r = 8%, S($/ ) = 1.5 and F 12 ($/ ) = 1.48 Assume that an investor in NY up to $1 mil. 1. First we note that the IRP does not hold: 2. Borrow $1 mil. at r $. (F 12 /S)x(1+r ) = 1.0656 > (1+r $ ) = 1.05. 3. Buy 666,667 in London and invest them at r. After a year: 1. Get 720,000=666,667(1.08). 2. Sell the pounds forward in exchange for $1,065,600= 720,000xF 12. 3. Return in NY bank $1,050,000. Risk-free profit = $1,065,600 - $1,050,000 = $15,600. 23

Facts about IRP The IRP is one of the best-documented relationships in international finance. The CIA does not last for long. As soon as investors get informed about this opportunity the gap in IRP will immediate close. The IRP may not hold (precisely) all the time due to two basic reasons: 1. Transaction costs (there is a spread in borrowing and lending interest rates and in the spot and forward exchange rates). 2. Capital controls or threat of them, (governments restriction rules, e.g. taxes, bans). 3. Control of risks (default risk may be a reason for not exploiting the CIA). If default risk is significant, CIA is not a real arbitrage. In fact, CIA is a way to speculate on the creditability of borrowers. Could IRP be used to forecast spot exchange rates in the future? 24

Purchasing Power Parity (PPP) The Purchasing Power Parity, PPP, (ισοδυναμία της αγοραστικής δύναμης) states that the exchange rate between the domestic and a foreign currency will adjust to reflect changes in the price levels of the two countries. The (relative) version of the PPP is given in the following equation: S N ( j / k) S( 1 i j / k) 1 i where, S N (j/k) is the spot exchange rate after N months and i j and i k are the rates of inflation for the two currencies for N months. The PPP is sometimes written in the following equivalent form: e N i j i 1 i where, e N stands for the change rate in the exchange rate in N months. k k j k 25

Facts about PPP PPP states that the exchange rate changes may indicate nothing more than the difference in the inflation rates between countries. If PPP holds, the differential inflation rates between countries are exactly offset by exchange rate changes. Hence, the counties competitive positions in the world export market will not be systematically affected by the exchange rate changes. If PPP doesn t hold, fluctuations in the exchange rates change the real exchange rate. The real exchange rate can be defined as follows: q N 1 i j (1 e )(1 i N k ) S( j / k) S ( j / k) (1 i (1 i It measures the deviations of the PPP. q N different than 1 implies changes in the counties competitiveness. In reality PPP is usually violated. Why? Even if PPP may not hold, it still very useful (used as benchmark for currency valuations and for comparisons). N j k ) ) 26

The Fisher Effects The Fisher Effect states that an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country. More precisely, the Fisher Effect (FE) states that the interest rate in a country (currency) r is made up two components: or equivalently: r 1 r ( 1 ρ) ( 1 E[ i]) ρ E[ i] ρ E[ i] ρ E[ i] where, ρ is the real (required) rate of return and E[i] is the expected inflation rate. In the generalized version of the Fisher effect, among the countries between which there is no capital restrictions and risk differences, the real interest rate should be the equal: ρ j = ρ k. Currencies with high inflation should bear high nominal interest rates. 27

The Fisher Effects cont d ρ j = ρ k implies that: r k r j E[ ik ] E[ i j i.e. currencies with high rates of inflation should bear higher interest rates than currencies with lower rates of inflation (and similar creditability). When we apply the above equation into the PPP we get the following approximation: E[ S N ( j / k)] S( The above relationship is called the International Fisher Effect (IFE). ] 1 r j / k) 1 r j k N /12 Combination of IFE and IRP implies that F N can be seen as an estimation of S N. Empirical evidence shows that IFE holds in long run (currencies with high interest rates tend to depreciate). Deviation of the IFE may be caused by capital movements of investors that take advantage of the interest rate differentials (the carry trade strategy for instance). 28

The Recent FOREX Market Euro weakened versus all but one of its 16 major counterparts after President Mario Draghi said policy makers adjusted the parameters of their bond-buying program and lowered economic forecasts. The ECB raised the limit on its bond purchases under its quantitative-easing program to 33 percent per issue from 25 percent previously. From Bloomberg. (Connect the stimulus, with the currency depreciation) Turkey s lira slid toward its weakest close on record and bonds fell as a faster-than-forecast pickup in inflation spurred speculation policy makers need to do more to rein in price growth [ ] Inflation accelerated to 7.14 percent in August from 6.81 percent in July, Turkey s statistics bureau said. From Bloomberg. (Connect the above discussion with PPP) 29

The Recent FOREX Market news India will use its foreign-exchange reserves to stem rupee swings as stocks and currencies fall around the globe, Reserve Bank of India Governor Raghuram Rajan said, adding that the nation has about $380 billion in reserves [ ] The central bank has been buying dollars to build reserves to shield local markets from global events, including a potential increase in U.S. interest rates [ ] Speculation the Federal Reserve will refrain from tightening this month amid a fragile global economy is also helping curb currency swings. From Bloomberg. (how the CB influences its currency stability? How the US interest rate increase will depreciate the Indian rupee?) The behavior of Australian dollar against US dollar the last month is illustrated below. (Why such sharp depreciation?) 30

Foreign Exchange Risk Definition: The foreign exchange risk is the possibility of changes in the values of a company s assets and liabilities, which are results of fluctuations in the exchange rates of foreign currencies with respect to the domestic currency. The sources of foreign exchange risk can be categorized in three types of risk exposure: 1. Economic exposure: changes in the value of a company caused by unanticipated changes in exchange rates. 2. Transaction exposure: changes in a company s contractual cashflows denominated in foreign currencies caused by unanticipated changes in the corresponding exchange rates. 3. Translation exposure: refers to the potential that the company s consolidated financial statements can be affected by changes in exchange rates. 31

Management of Transaction Exposure The magnitude of a firm s transaction exposure on a given foreign currency is equal to the amount of the currency that is receivable or payable. In this section, we focus on (some) ways to hedge the transaction exposure using various financial contracts: o o o o Forward market hedge. Money market hedge. Option market hedge. Other ways of hedging. A generic example: Suppose that the firm CM is going to receive 1 mil. in a year and r = 4% and r = 5% p.a., S( / ) = 1.2 and F 12 ( / ) =1.1885. 32

The Forward Market Hedge Perhaps the most direct way of hedging transaction exposure is by a currency forward contracts. If a firm goes long (short) in a forward contract this, it is going to buy (sell) a certain amount of a foreign currency at a given (the forward) rate. In our generic example: The firm CM could hedge its pound risk exposure by going short in a forward contract on the amount of 1 mil. In one year time, it going to receive 1 mil. and sell them at the (known) one year forward rate, that is F 12 ( / ) = 1.1885. Hence, CM is going to get 1.1885, regardless the spot exchange rate after a year S 12 ( / ). The gain/loss from forward hedging is given by: G/L = [F 12 ( / ) - S 12 ( / )]xm where M is the total amount of the hedged position. 33

Facts about Forward Market Hedge Hedging with forward contracts eliminates the downside risk at the expense of forgoing the upside potential. It costs nothing to enter a forward contract. A forward contract is a zero-sum game against another investor. This implies the existence of credit risk. Why not futures contracts? No credit risk, but: A margin account should be set up. Usually, not suitable delivery dates and sizes. Transactions on forward contracts capture 12% of the global FOREX market transactions. 34

The Money Market Hedge The money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the value of the future foreign currency cash flows in terms of the domestic currency. A firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency. In our generic example: The firm CM can eliminate its pound exposure by: (a) first borrowing in pounds and converting the loan into euros. (b) then investing these euros at the domestic interest rate. (c) In one year, CM is going to use the pounds that is supposed to receive in order to pay off the pound loan. The key point is that the amount in pounds borrowed is equal after a year to the receivable amount, the risk exposure becomes zero. 35

The Money Market Hedge cont d CM borrows y such that i.e., CM borrows 953,380. 1mil.=y(1+ r ) Step 1: Borrow 953,380 at r = 5% for a year. Step2: Convert 953,380 into 1.1429mil. at S( / ) = 1.2. Step 3: Invest 1.1429mil. in Euroland at r = 4% for a year. Step 4: Collect 1mil. and use it to repay the pound loan. Step 5: Receive the maturity value of the euro risk-free investment, that is 1,188,571. What is the G/L from the money market hedging? Money market and forward hedge should have the same outcome in the case where there is no transaction cost. What about the case where there is some transaction costs (bid-ask spread)? 36

Option Market Hedging Currency options provide a flexible optional hedge against the exchange risk exposure compared to the forward and money market hedge. In our generic example: The firm CM can reduce (but not eliminate) its pound exposure by: (a) Buy (OTC) a put option on 1 mil. with strike price 1.25 / at a cost of say 0.08 /, i.e., CM pays 80,000. That is CM pays upfront 80,000 and gets the right to sell 1 mil. after a year at 1.25 /. (b) After a year, CM exercises its right in the case where the spot rate at that time is less than 1.25. If CM exercises the option the net euro proceeds is 1,250,000-80,000x(1+0.04) = 1,166,800. This is a guaranteed income from pounds selling. However, a higher income is also possible ( limit the download risk while preserving the upside potential ). 37

Other Ways of Hedging The use of the Currency Swap: This derivative contract can be used to exchange periodic obligations (or incomes) dominated in one currency for obligations (or incomes) dominated in another currency. Currency Collar: This is a contract that protects against currency rate fluctuations outside an agreed-upon range. If the actual rate is outside this range the effective rate will be the corresponding bound. Currency Risk Sharing: This is a contract in which the counterparties agree to exchange a cashflow at a currency exchange rate, which belongs in a mutually agreed neutral zone. Cross-Hedging: If there is no future contract on a certain currency, a futures on a highly correlated currency can be used instead. 38

The FOREX Mini-Case Study Setting Suppose that a European company, called EC, has to pay 1 mil. Indian Rupees in 3 months. EC s financial manager is considering hedging its Rupee exposure and is wondering which is the most preferable way to do so. He receives from his broker the following quotes: Spot rate: 73.36 Indian Rupees/Euro. Forward rate (3 months): 79.29 Indian Rupees/Euro. 3 month put option on euro at 74 Indian Rupees/Euro: 1.5% premium. 3 month call option on euro at 75 Indian Rupees/Euro: 2% premium. Euribor 3 months interest rate: -0.033%. Indian Rupee 3 months borrow/lending interest rates: 8%/8.5%. Questions 1. What are the hedging choices for the company? 2. Apply the money to market hedge and calculate its cost. 3. Use an option for the hedge. 4. Make a graph of the effective price that EC is going to pay at any possible exchange rate after 3 months, when it uses the available ways of hedging. 5. Is there any arbitrage opportunity with this data? 39

Bibliography C. Eun & B.G. Resnick: International Financial Management, 5 th ed., Chapters 4, 5 and 13. A.C. Shapiro: Multinational Financial Management, 9 th ed., Chapters 2, 4, 7 and 10. Rene M. Stulz: Risk Management & Derivatives, Chapter 6. 40