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1、International Finance:A gentle introduction,WONG Ka Fu10th January 2001,International Finance is about.,Exchange rateOpen Macroeconomies,International Finance studies,Effects of changes in exchange rates on economies:price levels,unemployment,output,import-export,etc.The determinants of exchange rat
2、es:fiscal and monetary policies,performance of the economies,etc.The operations and interdependence of open economies,Exchange rate is important because,Each country has its own currency,and hence monetary policy.Countries are open,i.e.,non-zero international trade among countries.,Exchange rate mar
3、ket facilitates the trade of goods between two countries,Japanese products,US products,Problem:double coincidence of wants,Exchange rate market facilitates the trade of goods between two countries,Japanese products,US products,Japanese Yen,US dollar,Foreign exchange market,What is exchange rate?,The
4、 price of a currency in terms of another currencyExamples:the price of USD in terms of HKD,7.8 HKD/USDthe price of USD in terms of Yen,116.96 Yen/USDthe price of Euro in terms of USD,0.9436 USD/EuroRates from at 7:46a.m.10/1/1999 HKT,Exchange Rate and Its Derivatives,Exchange rate defined:The price
5、of currenciesThe amount of domestic currency you have to pay to buy a unit foreign currency(banks selling rate of the foreign currency)The amount of domestic currency you will receive when you sell a unit of foreign currency(banks buying rate of the foreign currency),Where can you find the rates?,Fo
6、r examples:Bank of East Asia http:/http:/http:/merce.ubc.ca/CNNFN:http:/others available in our Internet resources page.,Supply and demand conditions determines exchange rate,Exchange rate is determined by supply and demand because,Foreign exchange market is competitive,Exchange rate is a price and,
7、Supply and demand conditions determines exchange rate,Suppose,Demand for JPY increases,Suddenly a lot of people want to switch from USD to JPY,Price of JPY will increase,i.e.,need more USD to buy one unit of JPY,Supply of USD increases,Price of USD will decrease,i.e.,need less JPY to buy one unit of
8、 USD,Bank-note market e.g.,http:/,Banks selling rate Banks buying rateselling rate-buying rate=spread because of the paper work involvedbanks opportunity cost and risk of holding foreign currenciesnecessary security precautionspossibility of receiving counterfeit bills,Telegraphic transfer,Often wri
9、tten in short form TT.For TT,spread is smallerbecause of less paper work involvedbasically bank has no opportunity cost and risk of holding foreign currenciesno need for security precautionsno need to worry about the possibility of receiving counterfeit bills,Spread,Varies with the size of your orde
10、r/purchase.The larger your order size,the smaller the spread,that is,the bank can offer you a better rate.Mainly because less paper work is involved.,Banks buying rate Banks selling rate?,Definition:Banks buying(selling)rate is the“exchange rate”when the bank buys(sells)the foreign currency from(to)
11、you.Banks buying rate Banks selling rate if the rate is quoted as foreign currency per local currency,e.g.,in US.Banks buying rate Banks selling rate if the rate is quoted as local currency per foreign currency,e.g.,in HK.That is,what you see from the Bank of East Asia page(http:/,Banks buying rate
12、Banks selling rate if the rate is quoted as foreign currency per local currency,e.g.,in US.,Banks buying rate=the amount of USD you have to give to the bank in order to obtain one HKD(note:the bank buys USD from us,and we sell USD to the bank.)Banks selling rate=the amount of USD you will receive fr
13、om the bank when you sell one HKD(note:the bank sells USD to us,and we buy USD from the bank.),Spot foreign exchange market,Most players have a host of different currency-denominated bank accounts.The deposits are transferred from sellers to buyers accountBanks and brokers are linked together by tel
14、ephone,telex,a satellite communications network(SWIFT)and electronic broker systems(EBS)Spread 0.1%currency value,in general,News sources:,Dow Jones Telerate Reuters Bloomberg CNN Financial News,Example of players:,CitiBank,Bank of Tokyo-MitsubishiBank of ChinaHKMAand many more institutional players
15、 and central banksand many more individuals trading through internet,Cross Exchange Rates,S(j/k)is the number of units of currency j per unit of currency k in the spot exchange marketE.g.,j=Hong Kong dollars;k=U.S.dollarsS(HK/US)=7.8 approximately.,S(HKD/USD)vs S(HKD/JPY)S(JPY/USD),Suppose no transa
16、ction costTo get HKD,a holder of USD can use the rate S(HKD/USD)Or,he/she can buy JPY at the rate S(JPY/USD)and then use JPY to buy HKD at the rate S(HKD/JPY).In effect he/she is exchanging at a rate of S(HKD/JPY)S(JPY/USD),S(1/3)vs S(1/2)S(2/3)1=HKD;2=JPY;3=USD,Suppose no transaction costTo get cur
17、rency 1,a holder of currency 3 can use the rate S(1/3)Or,he/she can buy currency 2 at the rate S(2/3)and then use currency 2 to buy currency 1 at the rate S(1/2).In effect he/she is exchanging at a rate of S(1/2)S(2/3),S(HKD/USD)vs S(HKD/JPY)S(JPY/USD),HKD,JPY,USD,S(HKD/JPY),S(JPY/USD),S(HKD/USD),S(
18、USD/HKD),S(USD/JPY),S(JPY/HKD),S(HKD/USD)S(HKD/JPY)S(JPY/USD),HKD,JPY,USD,S(HKD/JPY),S(JPY/USD),S(HKD/USD),USD,HKD,The Principle of No Arbitrage,If S(1/3)S(1/2)S(2/3)and there is no transaction cost(say,S(1/3)=3,S(1/2)=2,S(2/3)=1)We can sell one unit of currency 3 for currency 1 at the rate of S(1/3
19、)We can sell S(1/2)S(2/3)unit of currency 1 for currency 3We gain S(1/3)-S(1/2)S(2/3)unit of currency 1-sure profit.,Cross exchange rates,The principle of no arbitrage says sure profit cannot last long.If S(1/3)S(1/2)S(2/3)and there is no transaction cost,everyone will try to take the sure profitThu
20、s,there will be a huge demand for currency 1 and a huge supply of currency 3-until S(1/3)=S(1/2)S(2/3),Cross exchange rates,Thus,there will be a huge demand for currency 1 and a huge supply of currency 3-until S(1/3)=S(1/2)S(2/3)Thus,there will be a huge demand for HKD and a huge supply of USDHKD ap
21、preciate relative to USD,I.e.S(HKD/USD)decreases-until S(HKD/USD)=S(HKD/JPY)S(JPY/USD),The Principle of No Arbitrage,S(1/3)=S(1/2)S(2/3),Given exchange rates S(1/2)and S(2/3),one can easily compute S(1/3),or,Given exchange rates S(j/k)and S(k/m),one can easily compute S(j/m),Nonzero Transaction Cost
22、s,S(j/ask k)-offer or ask rate-is the price that must be paid to the bank to buy one unit of currency k with currency j.S(j/bid k)-bid rate-is the number of currency j received from the bank for the sale of one unit of currency k for currency j.,S(j/ask k),S(j/bid k),Nonzero Transaction Costs,S(USD/
23、ask HKD)is the amount of USD paid to the bank to buy 1 HKD.S(HKD/ask USD)is the amount of HKD paid to the bank to buy 1 USD.S(USD/bid HKD)is the amount of USD received from the bank for the sale of 1 HKD.S(HKD/bid USD)is the amount of HKD received from the bank for the sale of 1 USD.,Suppose 7.8 HKD
24、=1 USD,fixed by HKMAand you sell 1 USD to the bank for HKD,S(HKD/bid USD),1 USD,(7.8-x)HKD,x=the transaction cost the bank will charge you,Suppose 7.8 HKD=1 USD,fixed by HKMAand you buy 1 USD from the bank using HKD,S(HKD/ask USD),(1/7.8-y)USD,1 HKD,y=the transaction cost the bank will charge you,Su
25、ppose 7.8 HKD=1 USD,fixed by HKMAand you buy 1 USD from the bank using HKD,S(HKD/ask USD),1 USD,(7.8+z)HKD,z=the transaction cost the bank will charge you,If I observe S(HKD/bid USD)and S(HKD/ask USD),can I conclude that the exchange rate net of transaction cost is S(HKD/bid USD)+S(HKD/ask USD)/2?,I
26、n other words,x=z?,Suppose 7.8 HKD=1 USD,fixed by HKMA,S(HKD/bid USD),1 USD,(7.8-x)HKD,S(HKD/ask USD),1 USD,(7.8+z)HKD,Nonzero transaction cost,With nonzero transaction cost,S(j/ask k)S(j/bid k)in generalS(j/ask k)=1/S(k/bid j)S(j/bid k)=1/S(k/ask j)No-arbitrage condition gives onlyS(1/ask 3)S(1/bid
27、 2)S(2/bid 3),S(HKD/USD)S(HKD/JPY)S(JPY/USD)without transaction cost,A HKD,AB JPY,ABC USD,S(JPY/HKD)=B,S(USD/JPY)=C,S(HKD/USD)=A,1 USD,A HKD,Positive arbitrage profit if,ABC 1S(HKD/USD)*S(JPY/HKD)*S(USD/JPY)1S(JPY/HKD)*S(USD/JPY)1/S(HKD/USD)S(JPY/HKD)*S(USD/JPY)S(USD/HKD)No arbitrage in this directi
28、on if ABC 1Note that when transaction cost is zero1/S(HKD/USD)=S(USD/HKD),How do the arbitrage activities eliminate the arbitrage opportunities?,Note that we have three markets:1.USD-HKD,2.HKD-JPY,3.JPY-USDarbitrage opportunities are present if ABC=S(HKD/USD)*S(JPY/HKD)*S(USD/JPY)1if ABC1 the route
29、of arbitrage is USD HKD JPY USD HKD.,If ABC1 the route of arbitrage is USD HKD JPY USD HKD.,In the USD-HKD market,we sell(supply)USD and buy(demand)HKD.S(HKD/USD)=A will decrease.In the HKD-JPY market,we sell(supply)HKD and buy(demand)JPY.S(JPY/HKD)=B will decrease.In the JPY-USD market,we sell(supp
30、ly)JPY and buy(demand)USD.S(USD/JPY)=C will decrease.Now ABC decreases because A,B and C decrease as arbitrage activities occur.The arbitrage activities continues until ABC=1.,S(HKD/USD)S(HKD/JPY)S(JPY/USD)without transaction cost(reversing the previous strategy),A HKD,AB JPY,ABC USD,S(HKD/JPY)=1/B,
31、S(JPY/USD)=1/C,S(USD/HKD)=1/A,1 USD,A HKD,Positive arbitrage profit if,ABC 1S(HKD/USD)*S(JPY/HKD)*S(USD/JPY)1S(JPY/HKD)*S(USD/JPY)1/S(HKD/USD)S(JPY/HKD)*S(USD/JPY)S(USD/HKD)No arbitrage in this direction if ABC 1Note that when transaction cost is zero1/S(HKD/USD)=S(USD/HKD),Thus,without transaction
32、cost,we must have,ABC=1S(HKD/USD)*S(JPY/HKD)*S(USD/JPY)=1S(JPY/HKD)*S(USD/JPY)=1/S(HKD/USD)S(JPY/HKD)*S(USD/JPY)=S(USD/HKD),with transaction cost,A HKD,AB JPY,ABC USD,S(JPY/bid HKD)=B,S(USD/bid JPY)=C,S(HKD/bid USD)=A,1 USD,A HKD,Positive arbitrage profit if,ABC 1 S(HKD/bid USD)*S(JPY/bid HKD)*S(USD
33、/bid JPY)1S(JPY/bid HKD)*S(USD/bid JPY)1/S(HKD/bid USD)S(JPY/bid HKD)*S(USD/bid JPY)S(USD/ask HKD)No arbitrage opportunity if S(JPY/bid HKD)*S(USD/bid JPY)S(USD/ask HKD)I.e.,S(2/bid 3)S(1/bid 2)S(1/ask 3)where 1=USD,2=JPY,3=HKD.,No arbitrage profit if,S(JPY/bid HKD)*S(USD/bid JPY)S(USD/ask HKD)Or S(
34、2/bid 3)S(1/bid 2)S(1/ask 3)where 1=USD,2=JPY,3=HKD.,with transaction cost Can we arbitrage by reversing the previous strategy?,A HKD,AB JPY,ABC USD,S(JPY/bid HKD)=B,S(USD/bid JPY)=C,S(HKD/bid USD)=A,1 USD,A HKD,?,?,?,?,?,?,with transaction cost Can we arbitrage by reversing the previous strategy?,A
35、 HKD,AB JPY,ABC USD,S(JPY/bid USD)1/C,1 USD,A HKD,S(HKD/bid JPY)1/B,S(USD/bid HKD)1/A,A=S(HKD/bid USD),C=S(USD/bid JPY),B=S(JPY/bid HKD),We are not sure if we will have a positive arbitrage profit if,1/(ABC)1;I.e.ABC 1Note that S(JPY/bid USD)S(JPY/ask USD)=1/S(USD/bid JPY)=1/CThus,it may happen that
36、 S(JPY/bid USD)*S(HKD/bid JPY)*S(USD/bid HKD)1 but ABC1.,Why is S(j/ask k)S(j/bid k)in general?,A HKD,AB USD,S(USD/bid HKD)=B,S(HKD/bid USD)=A,1 USD,A HKD,Why is S(j/ask k)S(j/bid k)in general?,No arbitrage if AB 1S(HKD/bid USD)*S(USD/bid HKD)1S(HKD/bid USD)1/S(USD/bid HKD)S(HKD/bid USD)S(HKD/ask US
37、D)because S(j/ask k)=1/S(k/bid j),from their definitions.,Can we claim:S(2/bid 3)S(1/bid 2)S(1/bid 3)?,We know from the no-arbitrage condition:S(2/bid 3)S(1/bid 2)S(1/ask 3)Also S(1/bid 3)S(1/ask 3)However,we cannot derive the claim from what we have gotten so far although common sense tell us that
38、we should receive more JPY if we buy JPY directly instead of indirectly through a third currency.,Claim:S(3/bid 1)S(3/ask 2)S(2/ask 1),We have S(2/bid 3)S(1/bid 2)S(1/ask 3)and S(j/ask k)=1/S(k/bid j)1/S(3/ask 2)1/S(2/ask 1)1/S(3/bid 1)Hence,S(3/ask 2)S(2/ask 1)S(3/bid 1)Again,from this result,we ca
39、nnot claim S(2/ask 3)S(1/ask 2)S(1/ask 3),Bid-ask rates,I have the bid-ask quotes of foreign exchange for a trading day-from Reuters trading system D-2000,Forward Foreign Exchange,The forward exchange rate is the rate that is contracted today for the exchange of currencies at a specified date in the
40、 future.Fn(k/j)k,j:currenciesn:n-year forward,n is flexible(say,3/365),Forward Premium/Discount,Fn(k/j)-S(k/j)/n S(k/j)Discount if 0,Forward Rate vs.Expected Spot Rate,Expected spot rate:Sn*(k/j)If risk-neutral and zero transaction costFn(k/j)=Sn*(k/j)Otherwise,Fn(k/j)Sn*(k/j),Swap,a spot transactio
41、nplusa forward transaction,Swap,A swap is an agreement to buy and sell foreign exchange at pre-specified exchange rate where the buying and selling are separated in time,or borrowing one currency and lending another other.,SWAP-an example,JP time deposit,JPY,HKD,S(JPY/HKD),S(HKD/JPY)?,HKD,JPY,Deposi
42、t Maturesafter one year,Interest rate R,Risk about future exchange rate(after a year),may be avoided by signing a forward contract to sell JPY for HKD,Who would use swap?,A person who invests in a foreign treasury bill can use a spot forward swap to avoid foreign exchange risk.,Currency futures,simi
43、lar to forwardsstandardized contracts that trade like conventional commodity futures on the floor of a futures exchangeMargin requirement:A loser has to supplement the margin dailyHence,interest cost,Who buys or sells currency futures?,Currency futures are more likely to be preferred by speculators
44、because gains on futures contracts can be taken as cash and because the transactions costs are small.,Currency options,currency options give the buyer the opportunity,but not the obligation,to buy or sell at a pre-agreed price-the strike price,or exercise price-in the future.,Type of options,European optionscan exercise the right only on maturityAmerican optionscan exercise the right on any date up to maturityCall:the right to buyput:the right to sell,Want to know more about these?,Read Chapter 2,3 and 4 of Levi.,
