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FIN 40500: International Finance

FIN 40500: International Finance. Introduction to International Finance. “Sherman, set the way-back machine for 1850!”. Prior to the late 1800s, international transactions were made with gold and silver coins…no exchange rate was necessary!!. The most prominent coins were Spanish.

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FIN 40500: International Finance

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  1. FIN 40500: International Finance Introduction to International Finance

  2. “Sherman, set the way-back machine for 1850!” Prior to the late 1800s, international transactions were made with gold and silver coins…no exchange rate was necessary!! The most prominent coins were Spanish US Coins were modeled after Spanish coins One US Dollar = .86 ounces of Silver One Peseta = .86 ounces of Silver One Doubloon = .88 ounces of Gold (one Doubloon = 16 Pesetas) Twenty US Dollars = 1.07 ounces of Gold

  3. 1 Dollar = .86 oz. silver 20 Dollars = 1.07 oz. gold 1 Pound = 16 oz. silver Note that if, for example, the US was running a trade deficit with Britain, Gold and Silver would flow out of the US and into Britain (price-specie flow mechanism)….when this happens, what happens to prices? 1 Sovereign = .5 oz. gold

  4. As countries moved to paper currency in the late 1860s, governments would regulate the value of that currency by fixing the price of gold VS $20.67 Per Ounce 4.40 Per Ounce These two prices imply an exchange rate between the US Dollar and the British Pound $20.67 Per Ounce = $4.70 Per 4.40 Per Ounce

  5. Suppose that the exchange rate were $4.00 per (The British Pound is Undervalued) $20.67 Per Ounce 1 Start with $1, convert it to Pounds ( = .25 ) 4.40 Per Ounce 2 Buy Gold in England ( .0658 oz ) 3 Ship the gold back to the US and sell it ( = $1.17 ) The gold standard era saw very stable exchange rates!

  6. The Gold Standard maintained the price-specie flow mechanism $20.67 Per Ounce $4.70 Per 4.40 Per Ounce Note that if, for example, the US was running a trade deficit with Britain, Excess demand for British pound notes would cause the Pound to appreciate – arbitrage would cause gold to flow out of the US and into England

  7. In July 1944, delegates from 44 nations gathered at the Mount Washington hotel in Bretton Woods New Hampshire. The result was the Bretton Woods Agreement $1 = 360 JPY $1 = .2481 GBP $1 = 3.33 DEM 1 oz = $35 $1 = 119 FRF $1 = 575 ITL

  8. The British Pound is attacked – The Bank of England devalues by 14% Johnson’s Great Society programs and the Vietnam war create large US deficits 1966 1968 1971 1965 1967 1970 1972 Bretton Woods collapses and the currency boom begins! August 15, 1971: Nixon is forced to suspend convertibility of dollars to gold

  9. From 1971 until 1987 the US followed a policy of managed floating (market based exchange rate with periodic “re-alignments”). USD/JPY The Plaza Accord (1985)purposely devalued the dollar against the Yen and Deutschmark by 51% The Louvre Accord (1987)ended the dollar devaluation policy of the plaza accord The Smithsonian Agreement (1971-1973)attempted to return to the Bretton Woods system but without dollar/gold convertibility

  10. In the meantime, the Europeans were developing an exchange rate system of their own. Called the ERM (European exchange rate mechanism), this system involved member countries to peg to an artificial currency called a European Currency Unit The ECU was the original recipe for the Euro

  11. In 1992, George Soros (Quantum Fund) believed the British pound was overvalued and began selling. On September 19, 1992 the British government was forced to withdraw from the ERM and devalue the pound. GBP/USD George Soros made a profit of $1B!!!

  12. Political turmoil and economic weaknesses led to a collapse of the Mexican Peso in 1994. This currency problem eventually spread through Latin America through what has become knows as the “Tequila Effect” (Not to be confused with the other “Tequila Effect”)

  13. 1998 2000 2002 1997 1999 2001 2003 Currency markets have had a turbulent decade!!!

  14. In January, 2002, the Euro officially entered circulation in Europe. Since the emergence of the Euro in 1999, the dollar has had a bumpy ride! USD/EUR Will the Euro survive as a major currency?

  15. The foreign exchange market is unique not just because of its geographic dispersion, but also because of its extreme liquidity and tremendous volume – around $1.9T PER DAY!! • $600B in Spot market Transactions • $1.3T in Derivative Market Transactions • $200B in Forwards • $1T in Swaps • $100B in Options The ten most active traders account for 73% of the volume

  16. With trading centers in New York City, London, Tokyo and Sydney, currency markets operate 24 hours a day, 5 days a week. Eastern Standard Time 11 PM 12 AM 3 AM 8 AM 12 PM 5 PM 9 PM Australia: 5PM - 2AM 8PM - 5AM Tokyo London: 3AM -11AM New York City: 8AM -5PM

  17. Unlike other asset markets, England dominates foreign exchange trading Why is this?

  18. The “Majors” The six “Majors” are: The US Dollar (USD), Japanese Yen (JPY), Euro (EUR), British Pound (GBP), Swiss Franc (CHF), Australian Dollar (AUD), and the Canadian Dollar (CAD)

  19. Spot transactions are executed immediately. A spot exchange rate is simply the price of one currency in terms of another currency. VS USD/JPY = 110.49 (1 USD = 110.49 JPY) The dollar appreciated against the Yen in the early eighties (USD/JPY increased ) USD/JPY Overall, the trend is a dollar depreciation (A decreasein USD/JPY)

  20. In currency markets you need to PAY ATTENTION TO THE UNITS!!!! VS EUR/USD = 1.2885 (1 EUR = 1.2885 USD) The dollar has been depreciating against the Euro since 2001 (an increase in EUR/USD) The dollar appreciated sharply against the Euro after its 1999 release (a decrease in EUR/USD)

  21. Suppose that you take a long position and a short position in Japanese Yen. Long: $10,000,000 USD/JPY 110.00 Short: $10,000,000 USD/JPY 110.10 These prices are in terms of Yen per dollar!! Profit = .10 ( $10,000,000) = Y 1,000,000 Y 1,000,000 = $9,082.65 110.10 Again…pay attention to the units!!!

  22. As a currency dealer, you need to decide where to buy, where to sell and at what prices USD/CHF = 1.2050 – 1.2055 Spread = 5 “Pips” Bid Price for Dollars Offer Price for Dollars .0005 CHF Profits (Per dollar traded) = $1 (.0005)= = $0.0000417 1.2055 What influences the spread? Liquidity News/Announcements Trade Size Why can’t we increase the spread to increase profits?

  23. Unlike other assets, there is no centralized exchange that determines currency prices. The “market” is a network of dealers. As an individual dealer, you “skew” your price relative to the market USD/AUS You: 1.2882 – 1.2888 ? Market = 1.2884 – 1.2890 You: 1.2884 – 1.2890 ? You: 1.2886 – 1.2892 ? What affects your price? Economic Fundamentals Technical Analysis Order Flow Your Position We will talk about both of these methods this semester

  24. You are the Market Maker Market: EUR/USD = 1.2882 – 89 Current Order: Buy10 Million Euro What price will you quote? Scenario #1: Your current position is long 25M Euro Scenario #2: Your current position is short 25M Euro Scenario #3: Your current position is square; order to sell 20M Euro if 1.2881 deals stop loss Scenario #4: Your current position is long 25M Euro; order to sell 20M Euro if 1.2881 deals stop loss Scenario #5: You’re short 20M Euros. NEWS: FED SEEN BUYING EUROS IN THE MARKET

  25. You are the Market Maker Market: EUR/USD = 1.2882 – 89 Current Order: 10 Million Euro What price will you quote? Scenario #1: German unemployment soars to 8.9%, much higher than expected Scenario #2: Fed raises Fed Funds 50 Basis Points Scenario #3: S&P downgrades Japanese debt to A from Aa Scenario #4: Rice’s trip to the Middle East ends with no resolution. Violence continues Scenario #5: US department of labor announces 350,000 new jobs created in July. Much higher than the expected number of 100,000

  26. Suppose that a dealer were offering Euro at $1.22 in New York City while a dealer in London was offering Euro at $1.24 Use the proceeds to buy Euro in New York 1 Sell Euro short in London 2 Use your newly acquired Euro to pay off your short position 3 Arbitrage insures that currency prices will be the same at different locations around the world. (Arbitrage will raise the price in NYC and lower the price in London)

  27. Suppose that a dealer in New York City was offering the following prices: Euro/USD = $1.25 USD/JPY = Y115 Euro/JPY = Y135 Use the dollars to buy Yen at Y115 2 Use the Yen to buy Euro at Y135 3 Sell Euro short at $1.25 1 Repay your short position The USD/JPY, and Euro/JPY rates imply a Euro/USD rate (Cross Rates) Y135 USD/JPY = Y115 Euro/JPY = Y135 Euro/USD = = $1.17 Y115

  28. Voice Brokers Direct Market Offer Bid/Offer Bid/Offer Bid Bid/Offer Banks contact brokers through dedicated phone lines. The broker quotes a bid or offer Traders contact market makers via phone or computer. Each trader is given a bid and offer and can accept either (or both) Electronic Exchange Bid Offer Traders submit orders to a computer network which automatically match up buys and sells Offer

  29. Since the early nineties, trading in currency markets have shifted towards electronic trading platforms. Any trade less than $10M will almost definitely be handled by computer • Prices have become more transparent • Spreads collapsing • Volume, Volume, Volume!!! 1994 2000 2002

  30. Forward contracts involve transactions to be made at a later date. • CAD/USD .9063 • 1 month forward .9065 • 3 months forward .9075 • 6 months forward .9090 Long position in CAD earns .0012 CAD profit per CAD of contract size Contract signed Transaction Made (Spot Rate = .9087)

  31. Derivative markets offer a variety of ways to hedge currency risk • Futures are standardized forward contracts, many futures are traded in centralized markets (Chicago Mercantile Exchange) • JPY: 12,500,000 Yen • GBP: 62,500 Pounds • Euro: 125,000 Euro • CAD: 100,000 Canadian Dollars • Options give the buyer the right to buy/sell currency, but not the requirement • Call: The right to buy at a specific “strike price” • Put: The right to sell at a specific “strike price” • Currency Swaps represent agreements to exchange one currency for another at multiple pre-specified prices/dates.

  32. Questions to be Answered How do Multinational Corporations deal with exchange rate risk? What causes exchange rates to change? How can we detect overvalued/undervalued currencies? What causes currency crashes? What underlying conditions make them more likely?

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