Learning Objectives • Understand the importance of international transactions for the Australian economy. • Read, interpret and use foreign exchange rates. • Understand the roles of interest rates and inflation rates in exchange-rate determination. • Understand the empirical evidence on the behaviour of exchange rates.
Learning Objectives (cont.) • Understand the techniques that can be used to manage exchange risk. • Explain the advantages of international diversification of investments. • Identify the characteristics and uses of currency swaps. • Identify the main sources of foreign currency borrowing used by Australian companies.
Background Statistics • International trade now represents about 20% of Australia’s gross domestic product: Table 21.1, Source: Reserve Bank of Australia, Bulletin.
Historically, Australia has been a net importer of capital. Levels of foreign investment in $A billion: non-official sector: Background Statistics (cont.) Table 21.2, Source: Reserve Bank of Australia
Background Statistics (cont.) • The extent of Australia’s external indebtedness is shown below: Table 21.3, Source: Reserve Bank of Australia
Foreign Exchange Market • No actual market, instead a communications network linking banks and other dealers in foreign exchange. • This market determines the prices of foreign currencies. • These prices are called ‘exchange rates’. • ‘Exchange rate’ — the price at which one country’s currency can be exchanged for another country’s currency in the foreign exchange market.
The Spot Exchange Rate • ‘Spot rate’: rate for transactions for immediate delivery. In the case of foreign exchange, the spot rate is for settlement in 2 days. • Examples of spot rates for one Australian dollar, as at 30 June 2004, are shown in Table 21.4.
The Spot Exchange Rate (cont.)for $A1 as at 30/6/2004 Table 21.4, Source: Australian Financial Review
The Spot Exchange Rate (cont.) • In Table 21.4: • Column (1) provides the exchange rate applicable where a customer has foreign currency and wishes to obtain Australian dollars. • Column (2) provides the exchange rate applicable where a customer has Australian dollars and wishes to obtain foreign currency. • The difference (spread) between the rates is one source of the foreign exchange dealer’s profit. • Column (3) shows how the spread varies from currency to currency. • Essentially, those currencies that are traded most frequently (from an Australian viewpoint) are the currencies with the smallest spreads.
Foreign Exchange Trading in Australia Market Share by Currency Pair, April 1998, 2001 and 2004 Table 21.5, Source: BIS survey reported by RBA
The Forward Exchange Rate • ‘Forward rate’: exchange rate that is established now, but with payment and delivery to occur at a specified future date. • Commonly for time periods of 1, 3 or 6 months. • Forward contracts for periods exceeding 1 year are unusual, only about 3% of all contracts. • Forward exchange rates are usually quoted in terms of the difference between the spot rate and the forward rate. Referred to as the ‘forward margin’.
The Forward Exchange Rate (cont.) • Suppose that for US dollars (per one AUD) you are told that the spot rate is 0.5460/70 and the 3 months’ forward margin is –16/–16. Table 21.6
The Forward Exchange Rate (cont.) • In this case, the spread between the buying and selling rates for the forward contract is: 0.5454 – 0.5444 = 0.0010. • We can see that the spread for the spot contract • in this case is also only 0.0010. • The spread for a forward contract is always greater than or equal to the spread for the matching spot contract.
There are only four types of calculation. The UK pound exchange rates are used as an example. Assume the following exchange rates: Customer sells Customer buys £ and buys $A1 £ and sells $A1 UK pounds (GBP)0.3862 0.3767 Calculations Using Foreign Exchange Rates
Calculations Using Foreign Exchange Rates (cont.) • Type 1: to obtain a given sum in $A using £: • A UK resident may wish to obtain $A10 000. • How many pounds are needed? • As £0.3862 is needed for every $A1 required, the answer is: £(10 000 × 0.3862) = £3862
Calculations Using Foreign Exchange Rates (cont.) • Type 2: to convert a given sum of £ to $A: • An Australian company has been paid £10 000 and wishes to exchange this for Australian dollars. • How many Australian dollars will this buy? • As each $A will cost £0.3862 to buy, the answer is: $A (10 000 / 0.3862) = $A25 893.32
Calculations Using Foreign Exchange Rates (cont.) • Type 3: to obtain a given sum in £ using $A: • An Australian company may wish to obtain £10 000. • How many Australian dollars are needed? • As $A1 will obtain £0.3767, the answer is: $A(10 000 / 0.3767) = $A26 546.32
Calculations Using Foreign Exchange Rates (cont.) • Type 4: to convert a given sum of $A to £: • A UK resident has been paid $A10 000 and wishes to exchange this for pounds. • How many pounds will this buy? • As each Australian dollar will buy £0.3767, the answer is: £(10 000 × 0.3767) = £3767
Triangular Arbitrage and Cross Rates • ‘Cross rates’: exchange rates between two currencies derived from the exchange rates between the currencies and a third currency. • Suppose that the following spot rates are observed simultaneously: • $A1 = US$0.6000 and US$1 = £0.7000 • Using only these two spot rates, the spot rate linking AUD and GBP must be: • $A1 = £(0.6000 × 0.7000) = £0.4200
Triangular Arbitrage and Cross Rates (cont.) • If this were not the case, a riskless profit could be made. • For example, if the spot rate was $A1 = £0.4180 instead, then a foreign exchange dealer could profit from undertaking the following three transactions simultaneously: • Sell $A1 for US$0.6000 • Sell US$0.6000 for £(0.6000 × 0.7000) = £0.4200 • Sell £0.4200 for $A(0.4200 / 0.4180) = $A1.0048 • A risk-free profit of $A0.0048 for every AUD transacted in the first step.
Size of Foreign Exchange Market in Australia • The Australian dollar is one of the more actively traded currencies in the world. • Average daily turnover in the Australian Foreign Exchange Market in 2003 is nearly $A126b, with $A61b against Australian dollars. • Australian exports plus imports for the entire year 2003amounted to only $A306b! • Approximately two-thirds of the trading volume is between foreign exchange dealers and banks overseas.
Interest Rates, Inflation Rates, Spot and Forward Exchange Rates • Assumptions • Market participants are risk-neutral. • There are no barriers or frictions in any market. • Analysis applies to any two currencies; Australian dollars and UK pounds are used for illustration. • Analysis could be applicable to any time period; we assume that the period is 1 year for illustration.
Interest Rates, Inflation Rates, Spot and Forward Exchange Rates (cont.) • Notation
Interest Rate Parity Interest rate parity maintains that: Interest rate parity states that relative interest rates determine the relativity between the forward exchange rate and the spot exchange rate.
Interest Rate Parity (cont.) • If interest rate parity does not hold, then arbitrage would be possible. • ‘Covered interest arbitrage’: movement of funds between two currencies to profit from interest rate differences, while using forward contracts to eliminate exchange risk. • Because of interest rate parity, a foreign investment with forward cover is equivalent to a domestic investment.
Interest Rate Parity (cont.) • Example 21.1 • An investor has $A1m to invest for 1 year in government securities. • The interest rate on Australian dollars is 6.2% and the interest rate on UK pounds is 4.1%. • The spot exchange rate is $A1 = £0.5265 and the forward exchange rate for 1 year is $A1 = £0.5161. • Calculate the return on an Australian investment, and the return (in Australian dollars) on an equivalent UK investment.
Interest Rate Parity (cont.) Example 21.1 (cont.) • Invest $A1 million in Australian securities for 1 year: Cash inflow after 1 year = $A1 000 000 × 1.062 = $A1 062 000 • Invest $A1 million in UK securities for 1 year: Spot conversion of $A1 million to pounds: $A1 000 000 = £(1 000 000 × 0.5265) = £526 500 Cash inflow (in pounds) after 1 year investment: = £526 500 × 1.041 = £548 086.50
Interest Rate Parity (cont.) Example 21.1 (cont.) • Reconversion to Australian dollars at the forward rate: £548 086.50 = $A(548 086.50 / 0.5161) = $A1 061 977.33 • The difference between these two investments is trivial, about $A22.67 on an investment of $A1m.
Interest Rate Parity (cont.) • The following example shows how a set of exchange rates and interest rates can be examined to determine whether covered interest arbitrage is feasible. • Example 21.2 • Spot rate: $A1 = US$0.7525 • Forward rate (1 month): $A1 = US$0.7474 • $A interest rate (1 month): 1.25% per month • US$ interest rate (1 month): 0.65% per month • Assumption that the spread is zero and there are no transaction costs.
Interest Rate Parity (cont.) • Example 21.2 (cont.) However: The forward rate indicated by interest rate parity is (0.994 074) (0.7525) = 0.7480, compared with the actual forward rate of 0.7474, implying there is an arbitrage opportunity.
Interest Rate Parity (cont.) • Example 21.3 • Illustrate covered interest arbitrage by assuming that an arbitrager simultaneously undertakes the following four transactions: • Borrows $A5 million for 1 month at 1.25% p.m. • Converts the sum of $A5 million to US dollars, thereby obtaining US$(5 000 000 × 0.7525) = US$3 762 500 • Lends US$3 762 500 for 1 month at an interest rate of 0.65% p.m., producing a future cash repayment to the arbitrager of US$3 762 500 × 1.0065 = US$3 786 956.25
Interest Rate Parity (cont.) • Example 21.3 (cont.) • Sells forward (1 month) the sum of US$3 786 956.25, thereby ensuring an AUD inflow in 1 month’s time of: $A(3 786 956.25/ 0.7474) = $A5 066 840.05 • The loan requires a repayment of $A5 000 000 × 1.0125 = $A5 062 500 • After 1 month, the inflow of $A5 066 840.05 can be used to make the repayment of $A5 062 500, thereby giving the arbitrager a profit of $A4340.05 for a net investment of zero. • Since the arbitrager made no net outlay, and all transactions were undertaken simultaneously, there was no exposure to risk.
Unbiased forward rates imply: If market participants are risk-neutral and there are no transaction costs, the market will set the forward rate, f, equal to the spot rate that is expected tobe observed at the date on which the forward contract matures. If this result did not hold, then risk-neutral speculators would trade in foreign currency until the forward rate was equal to the expected spot rate. Unbiased Forward Rates
Purchasing Power Parity • Purchasing Power Parity (PPP) maintains that: • PPP holds that the expected change in the exchange rate is due to differences in expected inflation rates in the respective countries.
Purchasing Power Parity (cont.) • The simplest derivation of PPP assumes that the law of one price is valid. This states that the dollar price of any given commodity should be the same everywhere in the world. • If all markets were free and frictionless, and all goods were traded internationally, then the law of one price would hold because, otherwise, an arbitrage could be undertaken.
Purchasing Power Parity (cont.) • However, for many commodities, the law of one price clearly does not hold. • Fortunately, PPP may also be proved by making the weaker assumption that the ratio of dollar prices for the same commodity in two countries will stay constant as time passes.
Purchasing Power Parity (cont.) • Example 21.4 • Suppose the spot rate is $A1 = £0.3325. • If the expected inflation rates are 9% in Australia and 4% in the UK, what is next year’s spot rate expected to be? • By year’s end $A1 = £0.3172, a depreciation of 4.6% in the value of the $A in terms of UK pounds.
Message of Purchasing Power Parity • A country with a high inflation rate can expect to have a depreciating exchange rate (a ‘weak’ currency). • Whereas a country with a low inflation rate can be expected to have an appreciating exchange rate (a ‘strong’ currency).
If interest rate parity and unbiased forward rates hold simultaneously, then: This implies that the spot exchange rate will tend to adjust in the direction indicated by interest rates in the two currencies. In particular, a country’s currency will tend to appreciate (depreciate) relative to another currency if its interest rate is lower (higher) than the interest rate on the other currency. Uncovered Interest Parity or the International Fisher Effect
Empirical Evidence on the Behaviour of Exchange Rates • Interest rate parity: evidence • Where the interest rate data are collected from unregulated markets (Eurodollar market), the overseas evidence nearly always supports interest rate parity. • An early study by Bird, Dyer and Tippett (1987) found that after the floating of the AUD in 1983, there were few opportunities for covered interest arbitrage if interest rates were measured by rates on government securities and transaction costs were included.
Empirical Evidence on the Behaviour of Exchange Rates (cont.) • Unbiased forward rates: evidence • Most tests of unbiased forward rates relationships have found that the forward rate is not an unbiased estimate of the future spot rate. • Sources of this bias are not obvious — one possibility is risk aversion among foreign exchange participants, requiring a risk premium for holding currency.
Empirical Evidence on the Behaviour of Exchange Rates (cont.) • Purchasing power parity: evidence • In practice, the law of one price does not hold for a great many commodities. • Where a commodity is readily defined, cheaply transportable and frequently traded in organised markets, it is likely that the law of one price will provide an accurate description of reality. • Baldwin and Yan (2004) find some parity between US and Canada for highly standardised products but Canadians pay up to 4% premiums for some products and up to 8% less for some services.
Empirical Evidence on the Behaviour of Exchange Rates (cont.) • Purchasing power parity: evidence (cont.) • Generally, PPP is found to give a poor description of exchange rate behaviour, unless a long time period is used for testing. • This makes international comparisons using current exchange rates misleading. • For example, OECD data shows per capita GDP in Australia in 2002 to be US$20 700 using current exchange rates, but US$28 100 using PPP-adjusted figures.
Empirical Evidence on the Behaviour of Exchange Rates (cont.) • Uncovered interest parity: evidence • The interest rate difference between currencies is typically found to give a biased forecast of the future spot rate, and often does not even predict the direction of movement correctly.
Empirical Evidence on the Behaviour of Exchange Rates (cont.) • Forecasting exchange rates • Little evidence in Australia that market participants can forecast successfully the AUD–USD exchange rate. • Hunt (1987) studied short-term forecasts by 16 foreign exchange dealers. • Found no evidence that dealers could forecast the spot rate — random walk performed better. • Easton and Lalor (1995) found no evidence that longer-term exchange rate forecasts are accurate.
Management of Exchange Risk • What is an exchange risk? • The variability of an entity’s value that is due to changes in exchange rates. • The exchange risk arising from trade-related contracts is often termed ‘transaction risk’. • The exchange risk arising from capital-related contracts is often termed ‘translation risk’.
Management of Exchange Risk (cont.) • Who faces exchange risk? • Exchange risk arises whenever a company needs to deal, now or in the future, in a currency other than the currency that shareholders use to finance their consumption. • However, an electronics retailer may never transact in the foreign currency market, yet it will face exchange risk because it may obtain CD players from Australian wholesalers who, in turn, import CD players from overseas. • Some entities exposed to exchange risk include tourism operators and universities — both provide services in Australia to foreign customers whose demand is sensitive to exchange movements.
Management of Exchange Risk (cont.) • The ‘hedging principle’ • A financial strategy that will ensure that the Australian dollar value of a commitment to pay or receive a sum of foreign currency in the future is not affected by changes in the exchange rate. • The basic principle of hedging is to undertake another, offsetting, commitment in the same foreign currency. • For example, an Australian importer who is committed to making a cash payment in UK pounds can hedge by entering into a commitment to receive UK pounds for the same amount and on the same date.
Management of Exchange Risk (cont.) • Forward rate hedge • For example, suppose that an Australian importer is committed to paying a future sum in UK pounds. In effect, this is a contract to buy UK pounds in the future. • By entering into a forward contract to buy UK pounds, the value of the commitment can be fixed in Australian dollar terms. • The future outflow of UK pounds required by the import contract is matched by an inflow of UK pounds required by the forward contract.