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IBUS 302: International Finance

IBUS 302: International Finance. Topic 5-The Market for Foreign Exchange II Lawrence Schrenk, Instructor. Learning Objectives. Determine if triangular arbitrage exists and find the arbitrage profit . ▪ Explain the forward rate. Calculate forward cross-exchange rates.

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IBUS 302: International Finance

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  1. IBUS 302: International Finance Topic 5-The Market for Foreign Exchange II Lawrence Schrenk, Instructor

  2. Learning Objectives • Determine if triangular arbitrage exists and find the arbitrage profit. ▪ • Explain the forward rate. • Calculate forward cross-exchange rates. • Calculate the forward premium/discount.▪

  3. Triangular Arbitrage

  4. Arbitrage • Arbitrage • Guaranteed Profit • No Cost (self-financing trading strategy) • No Risk • Example: • IBM $100 in New York and $102 in Chicago. ▪ • How do you take advantage of the opportunity? • What is the arbitrage profit? • Law of One Price ▪

  5. ‘Arbitrage’ Types • Pure Arbitrage: No risk nothing and earn more than the riskless rate • Near Arbitrage: Assets are identical or almost, but there is no guarantee of profit • Speculative Arbitrage: • Investors take advantage of what they see as mispriced and similar (though not identical) assets

  6. Triangular Arbitrage • Convert money through three currencies $ → £→ € → $ • Arbitrage opportunity if the ending dollar value does not equal the beginning dollar value. $ ≠ $ £ €

  7. Triangular Arbitrage: Example • Case 1 • $1 → £0.52 → €1.33 → $1.10 GAIN $0.10 $1 ≠ $1.10 £0.52 €1.33

  8. Triangular Arbitrage: Example • Case 2 (using different FX rates) • $1 → £0.49 → €1.20 → $0.90 LOSS ($0.10) ▪ • If you get a loss of ($0.10), just go the opposite direction beginning with $0.90 and you will gain $0.10. ▪ $1.00 ≠ $0.90 £0.49 €1.20

  9. Finding Triangular Arbitrage • Is there an arbitrage opportunity? • $ → € → C$ → $ ▪ • $ → € : $1.00 x 0.6898 = €0.6898 • € → C$: €0.6898 x 1.7491 = C$1.2065 • C$ → $: C$1.2065 x 0.9422 = $1.1368 • Arbitrage Profit of $0.1368 • $1.00 x 0.6898 x 1.7491 x 0.9422 = $1.1368▪

  10. The Forward Market

  11. The Forward Market • Buying and selling ‘forward’, i.e., into the future. • Transfer purchasing power across currencies and across time • Market expectations • Forward markets are insurance markets for hedging or eliminating currency risk. • Online Data: OZForex

  12. Terminology • Forward Rate: The exchange rate to trade sometime in the future. • Forward Contract: A customizedcontract settled today for future delivery/receipt of FX.  • Futures Contract: A standardizedcontract settled today for future delivery/receipt of FX. 

  13. Forward Rates (9/11/2008) NOTE: Quotation in American Terms Source

  14. Forward Rates (9/11/2008)

  15. Bid-Ask Spread (9/11/2008)

  16. Forward Rate Features • Common Maturities • 1, 3, 6, 9 and 12 months • Perspectives • Direct versus Indirect • American versus European • Limited to Major Currencies

  17. Forward Rate Notation • Notation • FN(j/k) • number of j needed to buy 1 kin N months • Difference from Spot Rate Notations • ‘F’ not ‘S’ • N because you always need to specify the time of a forward rate • NOTE: S(j/k) = F0(j/k)

  18. Premium versus Discount • Premium: A currency is trading at a premium when (in American terms) the forward rate is increasing. • Market Expectation: The currency will appreciate and the US dollar will depreciate. • Discount: A currency is trading at a discount when (in American terms) the forward rate is decreasing. • Market Expectation: The currency will depreciate and US dollar will appreciate.

  19. Example: Trading at a Discount • Pound is trading at a discount to the dollar • Market expects dollar to appreciate with respect to the pound

  20. Market Expectations • Psychology–The ‘Black Box’ • Forward Rates are only market expectations (unless you lock them in with a contract). • All prices, rates, etc. are based on the current ‘information set’. • New information (‘News’)

  21. Long versus Short Positions

  22. Speculation versus Hedging • Speculation: Taking a position that increases the risk of your portfolio. • Hedging: Taking a position that decreases the risk of your portfolio. • In practice, the distinction can be blurred.

  23. Forward Cross-Exchange Rates • Same as spot cross-exchange rates. • Find F2(¥/€)–How many yen for a euro in two months? • If F2($/€) = 1.4497 and F2($/¥) =0.009228 • Notes: • Both are in American terms. • The first currency (¥) goes into the denominator (bottom) • The second currency (€) goes into the numerator (top)

  24. Swaps versus Forward Transactions • Forward Transaction • Sale of currency in the future • Uncovered • Swap Transaction • Sale (purchase) now and forward purchase (sale) in the future • Hedged • More on swaps later.

  25. Forward Premium/Discount • Premium or discount (f) as an annualized percentage change from the spot rate. • Notation • fN,j is the forward premium at N of currency j in American terms. • fN,$ is the forward premium at N of US dollars in European terms. • Essentially, this gives you, in percentage terms, how much the forward rate is expected to moves from the spot annually.

  26. Premium Formula Holding Period Return • Annualizing Factor ▪ NOTE: N is the normally the number of months, and needs to be converted into days for this calculation.

  27. Example: Premium Calculation • S($/£)= 1.7544 • F1($/£)= 1.7504

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