Dispense International Financial and Foreign Exchange Markets (IBM)- parte. prof. Ziliotto, Dispense di Finanza

Scarica Dispense International Financial and Foreign Exchange Markets (IBM)- parte. prof. Ziliotto e più Dispense in PDF di Finanza solo su Docsity! LECTURE 1 – IFFEM INTRODUCTION IFFEM IF à INTERNATIONAL FINANCE Finance has become more and more international as a consequence of the growing development of both 1. international trade 2. foreign investments 1. INTERNATIONAL TRADE increased due to • progressive removal of barriers to trade (LIBERALIZATION) à e.g., tariffs (ad valorem tax, a tax levied on the value of imported goods), quotas (restriction on quantity that can be imported), subsidies (price aids to support domestic producers) • developments in new TECHNOLOGIES à improvements in communication and transportation ADVANTAGES OF INT TRADE J DISADVANTAGES OF INT TRADE L COMPARATIVE ADVANTAGE AND PRODUCTION EFFICIENCIES Principle of Comparative Advantage: Country should specialize in and exports those goods for which it is relatively less inefficient. Enhanced Production Efficiencies: in intuitive (informal) terms, countries can specialize in the production of things they do well and use the earnings from these activities to purchase from others those items for which they are high-cost producers ⇒ free competition is essential: § Domestic producers have stronger incentives to keep high quality standards § Weaker domestic oligopolies (high-cost producers are forced out of the market) ⇒ lower prices ARE TRADE BARRIERS TRULY USEFUL TO PROTECT DOMESTIC EMPLOYMENT? WATCH OUT: The long-run effect of trade barriers is NOT to increase total domestic employment, but AT BEST to reallocate workers away from export industries towards less efficient import-competing industries. ⇓ INEFFICIENT UTILIZATION of RESOURCES TERMINOLOGY Comparative advantage: relative efficiency (lower opportunity cost) in producing something (i.e. static production efficiency) - D. Ricardo Competitive advantage: the edge a country enjoys from dynamic factors affecting international competitiveness (including dynamic factors such as the existence of supportive industries, experienced management. . . ) - M. Porter Tariffs (excise taxes): taxes on imports, generally based on value (ad valorem) or on weight Quotas: restrictions on the quantity of a good that can be imported § Enhanced comparative (Ricardo, relative efficiency in producing something, lower production costs) and competitive advantages (Porter, edge a country enjoys from dynamic factors affecting competitiveness. exam qst differences between competitive and comparative adv. § Development of related industrial clusters (group of companies sharing similar interest like final market, customer base, row material) à e.g motor valley in Modena § Interdependencies contribute to spread crisis on an international scale § Forex risk à exposure to foreign exchange risk and uncertainty § Exposure to country risk REGIONAL INTEGRATION VS MULTILATERALISM Increase in international trade occurred in two different ways, through • MULTILATERALISM à Aim at promoting trade liberalization through worldwide agreements, based on the Principle of Non-Discrimination, all countries are treated the same, WTO. • REGIONAL ARRANGEMENT à agreement among a limited group of countries to promote free trade ONLY among them while discriminating and erecting barriers against the rest of the world. Examples of agreement, when go ahead the level of interdependence goes up: o Free trade area: free trade, no trade barriers, among member countries however they maintain their own restrictions towards the rest of the world (e.g., NAFTA) o Customs union: free trade among member countries + they adopt a set of common restrictions towards RoW (non-participants) o Common market: free trade + common restrictions + free movement of goods, services, capitals, and people (e.g., European Union) o Economic union: fiscal, social, military, and monetary harmonized policies and administered by a supranational institution à agreement to transfer national sovereignty to a supranational institution à also includes the concept of Monetary Union ADVANTAGES OF REGIONAL INTEGRATION J WELFARE IMPLICATIONS OF REGIONAL TRADE ARRANGEMENTS § Static effects: productive efficiency and consumer welfare § Dynamic effects: long-run rates of growth STATIC EFFECT World composed of 3 Countries (USA, Germany, and Luxembourg): Lux and Ger decide to form a Customs Union (USA is a non-Member) Lux is too small to influence foreign prices of grain • Under free trade and without Customs Union, USA supplies grain at 3 USD per bushel, while Germany is slightly more inefficient (3.25 USD per bushel) ⇒ Free trade equilibrium: domestic consumption in Lux amounts to 23 bushels and domestic production is equal to 1; imports from US=22 • A tariff of 0.5 USD per bushels is imposed on all imports ⇒Tariff equilibrium: domestic consumption in Lux amounts to 17 bushels and domestic production is equal to 7; imports from US=10 • When the Customs Union is formed, the tariff is imposed on imports from non-Members only: Germany now becomes the low-price supplier ⇒ Customs union equilibrium: domestic consumption in Lux amounts to 20 bushels and domestic production is equal to 4; imports from Ger=16 What is the Overall Welfare Effect of the Customs Union? • Trade-Creation Effect ⇒ welfare-increasing • Trade-Diversion Effect ⇒ welfare-decreasing Whether the Customs Union has been beneficial or not depends on the relative strength of these two opposing forces what is the differences between fiscal policy and monetary policy Exam qst FISCAL POLICY: falls within the government responsibility to carry out public expenditures and taxes MONETARY POLICY: falls within the central bank responsibility to set the appropriate interest rate to maintain the appropriate inflation rate § negotiations are normally quicker (getting a very large number of Countries to agree on reforms can be difficult - WTO) § greater economic integration among its members (greater commonality of interests) § self-reinforcing process: free-trade area enlarges ⇒ increasingly more attractive for non- Members to join § regional liberalization encourages partial adjustment of workers out of import-competing industries and into export-competing industries 2. FOREIGN INVESTMENTS We referred both on • FDIs: effective control on the target entity (more than 10%) • PORTFOLIO INVESTMENT: defined residually as anything that does not qualify as FDI. ADVANTAGES OF FOREIGN INVESTMENT J DISADVANTAGES OF FOREIGN INV L Foreign Direct Investments (FDI) “Cross-border investment by a resident entity in one economy with the objective of obtaining a lasting interest in an enterprise resident in another economy. The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence by the direct investor on the management of the enterprise. Ownership of at least 10% of the voting power, representing the influence by the investor, is the basic criterion used” (Source: OECD) Portfolio Investments: “International investment that covers investment in equity and debt securities (e.g. government and corporate bonds...), excluding any such instruments that are classified as direct investment or reserve assets” (Source: OECD) FIL ROUGE BETWEEN IF AND FEM FEM à FOREX EXCHANGE MARKET The international flows of goods, services, people, capitals previously referred to, are also the source of supply and demand for foreign currencies (link between IF and FEM) Is it possible to locate forex? Where are they located? Some characteristics: • Foreign exchange markets have no physical location, are everywhere and nowhere. • Forex markets work 24/7 • Unregulated OTC markets à much more flexible, OTC: Over The Counter which is opposed to regulated exchanges (like Borsa Italiana, LSE London Stock Exchange, NYSE, Euronext) • 2 different segments: o SPOT à the market for immediate delivery that take in place in T+1, T+2 o FORWARD à the market for future delivery that take in place at T+n, n>2 days 1. SPOT MARKET • Mainly decentralized (i.e. no precise physical location) • 24h trading • The market can operate both directly (interbank) and indirectly (broker-based) § Forex risk § Exposure to country risk § Better allocation of capital § Achieve higher diversification benefits à reduce risk of losing everything by allocating capitals in different investment 1. DIRECT à INTERBANK / DEALER- BASED o It is a market player that deals for his own portfolio o All the participating banks act as a market makers à market player that provide with buying (BID: price at which the price provider is willing to buy, denaro lettera) and selling (ASK: price at which the price provider is willing to sell) prices for a given asset on a continuous basis all through the trading day, so non-stop à LEGAL OBLIGATIONS § BID < ASK in order for the price provider to make money § ASK – BID à bid/ask spread à it tends to significantly vary all through the trading day. 1. B/A spread tends to be higher, the higher is uncertainty and volatility 2. B/A spread tend to narrow as more dealers are in the market ** o They provide for liquidity CHARACTERIZING FEATURES § Decentralized à no central physical location § Continuous à quotations of prices are continuously available all over the trading day § Open à trading intentions do not have to be disclosed. market participants must quote both buying and selling prices (bid/ask quotations), so that the buy or sell intention and the corresponding amount need not to be specified when a bank calls another market maker § Double auction à both parties of a transaction publish buying/selling prices. market participants on both sides of a transaction can quote buying and selling prices (relatively more or less “aggressively”, depending on their trading interest) 2. INDIRECT à BROKER-BASED o It is a market player that act as a middleman, the agent tries to match buying and selling proposals but does not deal for his own account CHARACTERIZING FEATURES § Quasi-centralized à broker collects information, helps facilitate transactions § Continuous à all over the world when a market closes the other opens § Limit-book à trading intentions need to be disclosed to the broker both in terms of direction and in terms of price and quantity, e.g., I am not willing to buy over a price of… and I am not willing to sell under a price of… § Single auction à the agent being approached, but not the person making the approach, provides with buying and selling prices (even though buyer and seller provide limit is the agent that gives them the actual level of market prices) DIRECT AND INDIRECT VS REGULATED MKTS SETTLEMENT Spot transactions carried out today are to be regulated (settled) in 1 or 2 business days, when the buyer that has purchased foreign currency will have to pay the seller. Settlement Risk: risk that one party of a FX transaction will deliver the currency it sold, but not receive the bought currency, [thus] resulting in the loss of principal Settlement on Regulated Markets The settlement generally takes place via a Clearing House • Clearing House: institution at which banks keep funds which can be moved from one bank account to another to settle interbank transactions. Settlement on FX Markets When FX transactions involve settlement in USD, the longer established clearing house is the so-called “CHIPS” (Clearing House Interbank Payments System). CHIPS is a computerized mechanism through which member banks hold USD accounts to pay each other when buying or selling FX. The CLS System An alternative system has been available since 2002: the CLS (Continuous Linked Settlement). CLS was created to reduce settlement risk through a continuous payment versus payment system, specifically conceived to prevent all situations where a bank pays for a currency before receiving it. How the CLS settlement works • Following a FX trade, Settlement Members submit payment instructions to CLS. These payment instructions are then authenticated and matched by CLS and stored in the system until the settlement date • The CLS daily settlement cycle operates with settlement occurring during a five-hour window (7:00am CET to 12:00am CET), when RTGS systems in the CLS settlement currency jurisdictions are open and able to make and receive payments. This enables simultaneous settlement of the payments on both sides of a FX transaction. • On each settlement date, CLS simultaneously settles each pair of matched payment instructions by making the corresponding debit and credit entries across Settlement Members’ accounts. Buy Stellantis shares Day T à Trade date/TRANSACTION date (data contabile) No cash changes Pay € and receive SHARES SETTLEMENT DATE / EXECUTION DATE / DELIVERY DATE (data valuta) 𝑆 ( ' = ! ! " 1.2: Assume Poland’s currency (the zloty) is worth USD 0.17 and the Japanese yen is worth USD 0.008. What should be the cross rate of the zloty with respect to yen to prevent arbitrage opportunities? 𝑆 * + = 21.25 à It needs 21.25 (units of) yen for a (unit of) Zloty 1. 𝑆 $ ) = 0.17 𝑆 $ * = 0.008 2. 𝑆 * $ = +$ - = 125 3. 𝑆 * ) = 𝑆 $ ) x 𝑆 * $ = 0.17 x 125 = 21.25 1.3: True or false? Do not forget to justify your claim. • A Change from USD 1.75/GBP to USD 1.50/GBP can be defined as a depreciation of the USD vs the GBP FALSE, it takes less units of USD, that went from 1.75 to 1.50, to buy a unit of GBP, so USD value increased, hence appreciated while GBP depreciated. • A Change from USD 1.75/GBP to USD 1.90/GBP can be defined as a appreciation of the GBP vs the USD TRUE, it takes more units of USD, that before were 1.75 and now are 1.90, to buy a unit of GBP, hence USD value decreased and it depreciated, while GBP value increased and it appreciated 1.4: Find the appropriate cross-rates: A B C D E A … 40.5 0.3125 4.5 0.63 B 0.025 … 0.007 0.11 0.016 C 3.2 142.86 … 14.4 2.016 D 0.22 9 0.069 … 0.14 E 1.59 62.5 0.05 7 … LECTURE 2 – INTERNATIONAL FINANCIAL AND FOREX FX MARKET PRACTICE SPOT FX MARKET TRADING BOOK ASSETS (SECURITY) SPECIFIC à every single security has its own trading book. • Bid: rate at which a certain market player is willing to buy • Ask: rate at which a certain market player is willing to sell Bid<Ask BUYING SECTION (BID SECTION) SELLING SECTION (ASK SECTION) Qty Px 5 110 15 100 20 100 Qty Px 5 140 20 150 50 150 All buying and selling orders gather on the trading book. Bid à Buying order to purchase 15 units at 100€ Ask à Selling order to sell 20 units at 150€ Both orders were entered at 9:05 am. At 9:10 am another market player enters a buying order for 20 units at 100€ and a selling order for 50 units at 150€. At 9:30 am a market player enters a buying order for 5 units at 110€ and a selling order for 5 units at 140€ Notice that à trader is willing to buy at higher price, at the same time the trader is willing to sell at a lower price, compared to the existing orders on the trading book. TERMINOLOGY o BID SECTION => buying proposals, ascending prices. o ASK SECTION => selling proposals, descending prices o MARKET DEPTH => ability to sustain large market orders without significantly impacting the price of the security. The market is deep enough to sustain my order. A very large order will not significantly move the price of a security. o MARKET WIDTH => it refers to the cost of executing a given order (a trade of a given size). Related to the notion of Bid/Ask spread à The lower the spread, the narrowed the market, the lower the transaction cost. à Ceteris paribus (all things being equal), a trader would prefer a deep and narrow market. On the trading book there are 2 ranking criteria: 1. PRICE PRIORITY, high bids and low asks have the priority à if you want to buy at a higher price and sell at lower price you have the priority, and they will be ranked first on the trading book Anytime criterion 1. cannot be applied because prices are the same, then second criterion is applied 2. TIME PRIORITY, first arrived, first served à the order that first entered has the higher priority. Traders want to be ranked first (at the very top of the trading book) - TO BE BEST BID/ASK à to be ranked first on the bid or ask side - TO BE BEST à means to be ranked first both on the bid and ask side BID/ASK 𝑆 ./0 % 234& à px at which the price provider is willing to BUY B against (/in terms of/ vis-à-vis) selling A The higher the price, the better The lower the price, the better 𝑆 ,-. $ 012% à px at which the price provider is willing to SELL B against (/in terms of/ vis-à-vis) buying A E.g., 1 𝑆 ./0 % 234& = 1.0758 < 𝑆 ,-. $ 012% = 1.0759 § Buying price is less than selling price à first consistency checked The price provider is willing to buy B at 1.0759 A The price provider is willing to sell B at 1.0759 A E.g., 2 𝑆 ./0 % 234& = 113.05 < 𝑆 ,-. $ 012% = 113.07 § Consistency checked The price provider is willing to buy a unit of B at 113.05 units of A The price provider is willing to sell a unit of B at 113.07 units of A There is a sharp difference between PRICE PROVIDER and a PRICE TAKER - PRICE PROVIDERà active part that decide - PRICE TAKER à passive part that need to accept When the price taker needs to buy, he must look for a price provider willing to sell (ASK). When the price taker needs to sell, he must look for a price provider willing to buy (BID). !! the price taker buys at ASK and sells at BID. BID/ASK SPREAD The BID-ASK SPREAD can be conceived as a transaction cost. Bid/Ask Spread = Ask - Bid Apart from two notable exceptions (GBP and EUR), all the other major currencies are quoted in European terms, that is FOREIGN CURRENCY PER USD. 𝑆 5 𝐔𝐒𝐃 à think of these exchange rates as the buying and selling prices of USD For instance: S 9:; <=>?@A à rate at which a certain mkt player is willing to buys USD against CHF S 9:; BCD?@A à rate at which the same mkt player is willing to sells USD against CHF PRACTICE EXAMPLE S EFG <=>?@A = 113.05 à the price provider is willing to buys USD at 113.05 JPY S EFG BCD?@A =113.06 à the price provider is willing to sells USD at 113.06 JPY Conversely, EUR and GBP are quoted in USD EQUIVALENT. 𝑆 HIJ 𝐅 à think of these exchange rates as the buying and selling prices of EUR or GBP For instance: S ?@A <=>LMF à rate at which a certain mkt player is willing to buys GBP against USD S ?@A BCDLMF à rate at which the same mkt player is willing to sells GBP against USD PRACTICE EXAMPLE S ?@A <=>N?O = 1.0758à the price provider is willing to buy EUR AT 1.0758 USD S ?@A BCDN?O = 1.0759à the price provider is willing to sell EUR at 1.0759 USD EQUIVALENT NOTATION S ?@A <=>LMF = S BCD?@A <=>LMF à rate at which the price provider is willing to buys GBP against (selling) USD à the buying rate for GBP and the selling rate for USD S ?@A BCDLMF = S <=>?@A BCDLMF à rate at which the price provider is willing to sells GBP against (buying) USD à the buying rate for USD and the selling rate for GBP ------------------------PUT INTO PRACTICE ----------------------------------- 2.1 Based on the table below, answer the following questions: • How much would you lose if you converted USD 1000 into Currency1 and then back into USD? USD à C1 à USD STEP 1 à sell USD and buy C1 I need to find a px provider willing to buy USD and to sell C1 S 9:; =?@ 345 A& = 1.35227 $/c1 $1000 : 1.35227 $/c1 = 739,49 c1 STEP 2 à sell C1 and buy USD I need to find a px provider willing to buy C1 and sell USD S 345 =?@ 9:; A& = 1.35135 $/c1 c1 739,49 x 1.35135 $/c1 = 999.31 $ 999.31 – 1000 = - 0.69 $ à I would lose 0.69 USD à the px taker loses what the px provider gains, this is a zero-sum game • What is the bid-ask spread for S ABCCDEFGH =?@ ? BID/ASK SPREAD = ASK-BID ASK – BID = 83.3925 – 83.365 = 0.0275 • What is the bid-ask spread for S ABCCDEFGH ABCCDEFG& ? BID S AH A& = S =?@ 9:;A& X S AH 9:;=?@ = 1.35135 X 83.365 = 112.655 C2/C1 ASK S AH A& = S =?@ 345A& X S AH 345=?@ = 1.35227 X 83.3925 = 112.769 C2/C1 BID ASK S Currency2 Currency1 112.655 112.769 Bid/Ask Spread C2/C1 = ask – bid = 112.769 – 112.655 = 0.114 • How much would you lose if you converted USD 1000 into Currency1, then into Currency2 and finally back into USD? USD à C1 à C2 à USD STEP 1 à sell USD and buy C1 S 9:; =?@ 345 A& = 1.35227 $/c1 $1000 : 1.35227 $/c1 = 739,49 c1 STEP 2 à sell C1 and buy C2 S 345 AH 9:; A& = 112.655 c2/c1 c1 739,49 x 112.655 c2/c1 = 83307.25 c2 STEP 3 à sell C2 and buy USD S 9:; AH 345 =?@ = 83.3925 c2/$ C2 83307.25 : 83.3925 c2/$ = 998.97$ 998.97 - 1000= - 1.03 $ à I would lose 1.03 USD 2.2: Fill in the table below and answer the following questions: S !"" #$% = S &'( #$% X S !"" &'( = 0.8039 x 11.3065 = 9.0892 à BID • S &'( #$% = 1/ S #$% &'( = 1/1.2439 =0.8039 S !"" #$% = S &'( #$% X S !"" &'( = 0.7999 x 11.3235 = 9.0576 à ASK • S &'( #$% = 1/ S #$% &'( = 1/1.2501 =0.7999 S #$% )*" = S &'( )*" X S #$% &'( = 0.08106 x 1.2439 = 0.1008 à BID • S &'( )*" = 1/ S )*" &'( = 1/12.3363 =0.08106 S #$% )*" = S &'( )*" X S #$% &'( = 0.08098 x 1.2501 = 0.1012 à ASK • S &'( )*" = 1/ S )*" &'( = 1/12.3479 =0.08098 S &'( +,- = 1/ S +,- &'( = 1/42.7512 =0.02339 à BID S &'( +,- = 1/ S +,- &'( = 1/42.7983 = 0.02336à ASK Find the bid-ask spread for the S <=> AIJ quote. BID S <=> AIJ = S 678 AIJ X S <=> 678 = 0.02339 X 1.2439 = 0.02909 ASK 9.0892 x 9.0576 0.1008 0.1012 0.02339 0.02336 S <=> AIJ = S 678 AIJ X S <=> 678 = 0.02336 X 1.2501 = 0.0292 ASK – BID = 0.0292 – 0.02909 = 0.00011 How much would you lose if you converted 1500 DKK into GBP, then into EUR, further into NOK and finally back into DKK? DKK à GBP à EUR à NOK à DKK STEP 1 à sell DKK to buy GBP S ./0 !"" 234 &'( = 11.3235 Dkk 1500 : 11.3235 dkk/£ = 132.467 £ STEP 2 à sell GBP to buy EUR S 345 <=> 9:; 678 = 1.2439 £ 132.467 x 1.2439 €/£ = 164.775 € STEP 3 à sell EUR to buy NOK S 9:; <=> 345 KLM = 0.1012 € 164.775 : 0.1012 €/nok = 1628.211 nok STEP 4 à sell NOK to buy DKK S 345 @MM 9:; KLM = 0.9161 S !"" )*" = S #$% )*" X S !"" #$% = 0.1008 x 9.0892 = 0.9161à BID Nok 1628.211 x 0.9161 dkk/nok = 1491.60 dkk 1491.60 –1500 = - 8.4 dkk à I would lose 8.40 dkk LECTURE 3 – INTERNATIONAL FINANCIAL AND FOREX THE RELATIONSHIP AMONG SPOT, FWD AND MONEY MKT RATES MONEY MARKET SPOT MARKET ß---------------------------------à FORWARD MARKET MONEY MARKET Market for short term investment /borrowing (< 1 year) EXAMPLE Suppose to have 1 USD to invest for 3 months (money market). How to choose between domestic and foreign currency-denominated securities? 1. invest domestically in a $-denominated security yielding rUSD after 1 year 2. invest abroad in a £-denominated security yielding rGBP after 1 year !! when deciding to invest either domestically or abroad, relying exclusively on INTEREST RATE DIFFERENTIAL, can be seriously MISLEADING. à DO NOT FORGET EXCHANGE RATE (FX) DYNAMICS. Both interest and exchange rates should be taken into due account. 1. INVEST DOMESTICALLY t0 1$ --------------------à t3M 1 . (1 + 𝒓𝑼𝑺𝑫 𝟒 ) à Amount of $ at the end of the investment period r = interest rate (divided by 4 because it was expressed in years, so 4 quarters) 2. INVEST ABROAD STEP 1 à convert USD into GBP on the spot market S $5! &'( $ : $ £ 𝟏 𝑺𝑼𝑺𝑫𝑮𝑩𝑷 à the amount of £ retrieved at the end of step 1 STEP 2 à Invest in a £-denominated security t0 + =efghPi -----------à t3M 𝟏 𝑺𝑼𝑺𝑫 𝑮𝑩𝑷 . (𝟏 + 𝒓𝑮𝑩𝑷 𝟒 ) à amount of £ at the end of the investment period STEP 3 à convert GBP back into USD on the fwd market (this allows to establish at t0, so at the very beginning, the exchange rate at which the conversion is going to take place 3 months from nowà 0.25) à NO FOREIGN EXCHANGE RATE RISK FP.HR =?@ 678 à £ x $ £ + =efg hPi . (1 + CD'E F ) . FP.HR =?@678 An investor will be indifferent as to whether to invest at home or abroad, as long as the two alternatives yield the same. 1=2 (1 + jHIJ k ) = F0.25 USD GBP @!"# %&' . (1 + jl&m k ) COVERED INTEREST RATE PARITY If we allow for compounding à GENERALIZE VERSION OF THE FORMULA (1 + jJ k )n = ;( # ) I* + . (1 + rF)n à COVERED INTEREST RATE PARITY (CIRP) COVERED: hedge/protected against FX risk, via the fwd rate Compounding means that interest is earned on interest EXAMPLE t0 100€ 2% p.a t+1y 100(a+2%)=102 at the end of the second investing period 102 (1+2%) = 100(1+2%)(1+2%) = 100(1+2%)2 When steps have been taken to avoid foreign exchange risk by use of forward contracts (hence the term “covered”), rates of return on investments and costs of borrowing will be equal, irrespective of the currency of denomination (ceteris paribus). There must be no frictions for the CIRP to hold perfectly, meaning no legal restrictions on the movement of K, no tax advantages among different countries... DEVIATION FROM EQUILIBRIUM AND ARBITRAGE OPPORTUNITIES Suppose that (1 + rD )n < ;( # ) I* + . (1 + rF)n The best thing to do would be to borrow in your domestic currency and to invest simultaneously in a foreign currency-denominated security. At the end of the investment period, the hedged transaction will allow you to get more than required to repay the initial debt (i.e. you will receive more domestic currency) If, conversely, (1 + rD )n > ;( # ) I* + . (1 + rF)n The best thing to do would be to borrow foreign currency and to invest simultaneously in a domestic currency-denominated security. At the end of the investment period, the hedged transaction will allow you to get more than required to repay the initial debt DEVIATIONS FROM EQUILIBRIUM: A GRAPHICAL APPROACH What Happens above the CIRP Line? For all the points lying above the equilibrium line (A,B and C), it must be that (rUSD − rGBP ) < 4 . ;( !"# %&' oI ,-* ./0 I,-* ./0 This further implies: § Covered investment in GBP yields more than in USD § Borrowing in USD is cheaper than covered borrowing in GBP The adjustment procedure driving A, B, and C down towards the equilibrium line works as follows: 1. Borrow USD, thus tending to increase rUSD 2. Buy spot GBP with the borrowed USD, thus tending to increase 𝑆 789 :;< 3. Buy a GBP-denominated security, thus tending to reduce rGBP 4. Sell the GBP investment proceeds forward for USD, thus tending to reduce Fp.rs ?@A LMF Points 1 to 4 will all push A, B and C back down to the CIRP line What Happens below the CIRP Line? For all the points lying below the equilibrium line (D, E and F), it must be that (rUSD − rGBP ) > 4 . ;( !"# %&' oI ,-* ./0 I,-* ./0 This further implies: § Covered investment in USD yields more than in GBP § Borrowing in GBP is cheaper than covered borrowing in USD The adjustment procedure driving D, E, and F up towards the equilibrium line works as follows: 1. Borrow GBP, thus tending to increase rGBP 2. Buy spot USD with the borrowed GBP, thus tending to decrease 𝑆 HIJ l&m 3. Buy a USD-denominated security, thus tending to reduce rUSD 4. Sell the USD investment proceeds forward for GBP, thus tending to increase Fp.rs ?@A LMF Points 1 to 4 will all push D, E and F back up to the CIRP line Persistent deviations from the CIRP are unlikely to occur, because this would give rise to arbitrage opportunities (No Free Lunch Principle) AND WHAT IF WE INCLUDED TC? Covered investment/borrowing involve two FX transactions (one on the spot market and the other on the forward market). Transaction costs have to be faced twice. One may be lead to think there could be deviations from interest rate parity due to the extra transaction costs of investing/borrowing in foreign currency... Is it always and necessarily so? CASE 1: ROUND-TRIP TRANSACTIONS Based on the CIRP, (1 + rBUSD )n = ;( !"# 123 %&' I ,-* 456 ./0 . (1 + rIGBP)n This is NOT a perfect equilibrium line on the CIRP diagram, but more a “band” drawn around mid-rates. This is because of the transactions costs to be faced: § Bid/Ask spread = 𝑆 HIJ ./0 l&m - Ft ?@A <=> LMF § Borrowing/Investment spread: (rBUSD -rIGBP) CASE 2: ONE-WAY TRANSACTIONS If you need GBPn sometime in the future and you have USD0 today, you could: § Alternative 1: invest the USD you have in USD- denominated security and use the proceeds of the foregoing investment to buy GBP fwd (when they are needed) § Alternative 2: sell the USD you have to buy GBP and invest them in a GBP-denominated security, yielding the GBP amount you need at maturity 3.2: The following exchange rates and one-year interest rates exist. You have 100 A to invest for 1 year. Would you benefit from engaging in covered interest arbitrage? 1. INVEST 100 A à rA LOAN A 100 • (1+ 0.09) = 109 A 2. CONVERT A INTO B ON THE FWD MARKET TO REPAY THE LOAN A 109 : F <=> R BCD M = 109 : 1.53 = 71.241 B 3. BORROW B à rB DEPOSIT B 71.241 • (1+ 0.04) = 74.09 B 4. CONVERT B INTO A ON THE SPOT MARKET B 74.09 • S BCD R <=> M = 74.09 • 1.52 = 112.62 A 112.62 – 100 = 12.62 à gain from arbitrage 5.1: You have been given the following information: where • rUSD= annual interest rate on USD short term paper • rGBP= annual interest on GBP short term paper On the basis of the foregoing data: In which paper would you invest? In which currency would you borrow? (1 + rUSD )v = ;> !"# %&' I ,-* ./0 . (1 + rGBP)v (1 + 0.05 )v = =+ ,-. /01 >.@ . (1 + 0.06)> F> $5! &'( = 1.4858 à theoretical, 1.4858 units of USD are needed for a unit of GBP in practice F> $5! &'( = 1.4895 à > theoretical - more USD needed for a unit of GBP à USD undervalued à BORROW in USD - GBP overvalued à INVEST in GBP What is the profit from interest arbitrage? Borrow 100 USD ----------------à 100 • (1+0.05) = 105 USD Convert USD into GBP on spot market 100 : 1.5 = 66.67 GBP --------------à 66.67 (1+0.06) = 70.66 GBP Convert back GBP into USD on the forward market 70.66 • 1.4895= 105.24 USD 105.24 – 105 = 0.24 gain from arbitrage LECTURE 4 – INTERNATIONAL FINANCIAL AND FOREX FX PARITY CONDITIONS PARITY CONDITIONS 1. LAW OF ONE PRICE (LoP) à PURCHASING POWER PARITY (PPP) 2. COVERED INTEREST RATE PARITY (CIRP) à UNCOVERED INTEREST RATE PARITY (UIRP) 3. FISHER OPEN CONDITION 4. FWD RATE UNBIASED General definition: Parity condition can be conceived as a long-run equilibrium condition, that leave the investor indifferent between two available alternatives. n INDIFFERENT: Whenever parity conditions hold, there is no arbitrage opportunities to be exploited. n LONG-RUN EQUILIBRIUM o also called cointegration o NO causality/derivation involved à exam qst: the causal relationship in the parity equilibrium…FALSE Parity conditions rely heavily on the no free lunch principle⇒ violations of parities may give rise to arbitrage opportunities, that would be exploited and reabsorbed in a very short span of time. 1. LAW OF ONE PRICE (LoP) LoPà The price of a given item, when converted into a common currency, shall be the same all over the world. It is the basis of the Big Mac Index. LoP à Pi DC = Pi FC x 𝐒 𝐃𝐂 𝐅𝐂 DC= domestic currency, FC= foreign currency, i= a single product There must be no frictions for the LOP to hold, meaning no legal restrictions on the movement of goods, no transportation costs and no tariffs. In reality, LoP is quite an unrealistic condition. 1. PURCHASING POWER PARITY (PPP) The conditions for LoP’s applicability are too strict and unrealistic in some cases. We need to generalize. PPP à Instead of considering one single product i, focus on a broad basket of goods and services (the ones that national statistical agencies use to compute inflation). PPP can be conceived as a parallel parity condition referring to the product markets. PDC = P FC x 𝐒 𝐃𝐂 𝐅𝐂 à PPP in ABSOLUTE/STATIC FORM § Whenever 𝐒 𝐃 𝐅 > SPPP ⇒ the domestic currency (D) is undervalued or, equivalently, the foreign currency (F) is overvalued § Whenever 𝐒 𝐃 𝐅 < SPPP ⇒ the domestic currency (D) is overvalued or, equivalently, the foreign currency (F) is undervalued Significant limitation due to the fact that the underlying basket composition depends on consumers tastes, needs, preferences, etc. à IT VARIES FROM COUNTRY TO COUNTRY t1: PDC (1+ΔPDC) = PFC (1+ΔPFC) X ( 1+ Δ S A9 ;9 ) Change (Δ) in the domestic px level Change (Δ) in the foreign px level Change (Δ) in the spot rate v p à F#?(vw‚F#?) m*A = F)? (vw‚F)?) m+A X @#?)? ( vw ‚ @ #? )? ) @#?)? (1+ΔPDC) = (1+ΔPFC) X ( 1+ Δ S A9 ;9 ) (vw‚F#?) (vw‚F)?) -1 = Δ S A9 ;9 Δ S A9 ;9 = vw‚F#?ovo ‚F)? (vw‚F)?) à assuming no hyperinflation Δ S A9 ;9 = ΔPA9 − ΔP;9 à PPP in RELATIVE/DYNAMIC FORM à i.e. the exchange rate varies so as to offset inflation rate differentials Exam qst: Suppose DC is €, suppose Italian inflation is 6% and South Africa inflation is 2%, is the € expected to appreciate or depreciate? Δ6 – Δ2= 4à DEPRECIATE, the higher DC inflation, the more DC depreciates 2. COVERED INTEREST RATE PARITY (CIRP) à UNCOVERED INTEREST RATE PARITY (UIRP) CIRP: (1 + rD)S = Fn 𝐷 F T!" (1 + rF)S Assuming risk neutrality and zero transaction costs, it should be that: 𝐅𝐧 𝑫 𝐅 = 𝑺𝑬 𝑫 𝐅 (1 + rD)S = T#!" T!" (1 + rF)S à UIRP there is not fwd rate to hedge against fx rate fluctuation the mathematical expression is almost analogous to the one used for CIRP, apart from the fact that foreign exchange exposure is not covered with a forward exchange contract 𝑆† J 5 = 𝑆 U V (1 + Δ S D F )S (1 + rD)S = SDF (&XΔ S D F) $ SDF (1 + rF)S 1 + rD = 1 + Δ S A ; + rF + Δ S A ; . rF Δ S @ Z = rD – rF àUIRP, high yield currencies tend to depreciate over time § If rD goes up, Δ spot rate increases as well (S A ; it expresses the number of unit of D required per unit of F à if D goes up we now need more units of D per unit of F) à but this means that D has depreciated 3. FISHER OPEN CONDITION UIRP: Δ S A ; = rD – rF PPP: Δ S A ; = ΔPA − ΔP; The exhange rate values … ..so as to offset inflation differenti als % . % = neglibible amount that tends to 0 4. POLITICAL RISK à risk involves uncertainty that funds invested abroad are confiscated, frozen, made inconvertible, cannot be repatriate. You will demand a RISK PREMIUM to invest in riskier countries. à DEVIATION FROM THE PARITY LINE, the band does not have to be of equal width on the two sides of the CIRP line, if one country is seen as riskier than the other. 5. TRANSACTION COSTS (TC) a. ROUND-TRIP TRANSACTION à you start with a given currency; you end up with the same currency à DEVIATION FROM THE PARITY LINE i. Borrow USD à convert USD into GBP on the spot marketà invest in a GBP- denominated security à convert GBP back into USD on the fwd market to repay the loan à Borrow USD… ii. rUSD – B à borrowing (rate applied by the bank) b. ONE-WAY TRANSACTION à you try to find the best way to exchange one currency into another. You start with a currency; you end up with a different one. à NO DEVIATION FROM THE PARITY LINE a. ROUND-TRIP TRANSACTION (1 + 𝑟HIJo&)n = ; !"# 123 %&' @ !"# 789 %&' (1 + 𝑟l&mo‰)n 2 TCs: 1) B/A spread 2) I/B spread b. ONE-WAY TRANSACTION you have USD and you need GBP in the future COMBINING a and b ($%&ABCDE) ( FGH IJK LMN = $ ) FGH IJK LMN (1 + 𝑟*+,-.) (1 + 𝑟/01-.)= ( FGH IJK LMN ) FGH IJK LMN (1 + 𝑟*+,-.) Borrow USD rUSD – B à borrowing (rate applied by the bank) Convert USD into GBP on the spot market 𝑆 HIJ ./0 l&m Invest in a GBP- denominated security rGBP – I Convert GBP back into USD on the fwd market to repay the loan 𝐹 HIJ 234 l&m ALTERNATIVE 1 Invest in a USD-denominated security and convert the proceeds at maturity on the fwd market (1 + 𝑟HIJo‰)n [USD] : [?@A LMF ] (1 + 𝑟HIJo‰) F USD ask GBP ALTERNATIVE 2 Convert USD into GBP on the spot market and then invest in a GBP-denominated security, expiring when GBP are needed. [USD] S ?@A BCD LMF [ ?@A LMF ] & ? '() *+, ./0 à amount to be invested in a GBP- denominated security & ? '() *+, ./0 (1 + 𝑟l&mo‰) à amount that I have at the end of the investment period virtually NO TC à ASK/ASK & I/I à a. and b. are offsetting forces à TC, do NOT bring about significant DEVIATION FROM PARITY TERMINOLOGY Real Exchange Rate: broad summary measure of the prices of one country’s goods and services relative to the prices of another’s⇒ useful to assess the purchasing power of a currency in a foreign country. If PPP holds, the real exchange rate is perfectly constant. Risk Neutrality: investor attitude according to which the value of a sure chance of gain or loss is considered to be equal to an unsure chance of the same amount of gain or loss Carry Trade: Trading strategy consisting in selling a relatively low interest rate currency and using the funds to purchase another yielding a higher interest rate. ------------------------PUT INTO PRACTICE ----------------------------------- 5.2 Focus on the table below: Which is the most overvalued currency? Why? The most overvalued currency is the one of Iceland because has a valuation against dollar of +118% Which is the most undervalued currency? Why? The most undervalued currency is the one of Qatar because has a valuation against dollar of -78% 5.3: Assume that the inflation rate in Brazil is expected to increase substantially. How will this affect Brazil’s nominal interest rates and the value of its currency? If the IFE holds, how will the nominal return to U.S. investors who invest in Brazil be affected by the higher inflation in Brazil? Justify your claims. The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation. Nominal interest rates do not account for inflation while real interest rates do. The real rate will rise by the increase in the expected rate of inflation. In general, inflation tends to devalue a currency since inflation can be equated with a decrease in a money's buying power. As a result, countries experiencing high inflation tend to also see their currencies weaken relative to other currencies. If inflation rate is expected to increase, nominal interest rate will increase, and value of its currency will depreciate. The nominal return to US investors is not affected by higher inflation, it is the real return on investment negatively affected by inflation. 5.4: Assume the following information is available for US and Europe: Does the CIRP hold? According to the PPP, what is the expected change in the spot rate of the Euro in one year? Δ S A9 ;9 = ΔPA9 − ΔP;9 0.05 – 0.02 = 0.03 à depreciate According to the UIRP, what is the expected change in the spot rate of the Euro in one year? Δ S @ Z = rD – rF 0.06 – 0.04 = 0.02 à depreciate While with futures profits and losses are accounted for on a daily basis, through the mark-to-market procedure à more conservative and prudential FUTURES PAYOFF PROFILE 1. it is a band because interests are earned on the margin balance. Benefits and Risks of Futures • Low Flexibility o Mainly major currencies o Fixed, standardized maturities and notional amounts o Well-defined trading time and trading rules • CCTP: No settlement risk • High mkt liquidity 3. OPTIONS They are agreement that give their holder the right to buy or to sell the underlying asset at a given price on/up to a certain future date. RIGHT - The optionality (no obligation) whether to buy or to sell TO BUY - The option is called CALL OPTION TO SELL - The option is called PUT OPTION GIVEN PRICE - The price is called STRIKE PRICE à price at which you will be able to buy the underlying asset ON a certain future date - The option is called EUROPEAN UP TO a certain future date - The option is called AMERICAN FUTURE DATE - Called expiry date, settlement date or EXERCISE DATE HOLDER - He has the RIGHT to buy or to sell - Is the one who has bought the option - The price he aspects to BUY the option is called PREMIUM WRITER - Is the one who has sold the option - He has the LEGAL OBLIGATION to buy or to sell Exam qst CALL PUT HOLDER (who buys) Right to BUY Right to SELL WRITER (who sells) Obligation to SELL Obligation to BUY !! The writer is the one subjected to the daily mark-to market The holder does not have to do anything, he only has the right and no obligations. MONEYNESS x= strike px S= underlying price at maturity Premium=0 S<x S=x S>x CALL OUT OF THE MONEY (OTM) The option is said to be AT THE MONEY (ATM) IN THE MONEY (ITM) PUT IN THE MONEY (ITM) AT the MONEY (ATM) OUT OF THE MENY (OTM) INTRINSIC VALUE = extent to which an option is ITM MAJOR DRIVERS OF OPTIONS’ PREMIA Which are the factors that most significantly affect the price of an option. 1. INTRINSIC VALUE = the more the option is in the money, the higher is the option premium à ↑ IV, ↑ premium 2. EUROPEAN AND AMERICAN OPTIONS = American options offer a wide timespan to exercise, are more flexible à ceteris paribus they are more expensive, more valuable than European 3. TIME TO EXPIRY = the longer the better 4. VOLATILITY OF THE UNDERLYING = the higher the volatility, the better and the higher the premium 5. FWD PREMIUM/DISCOUNT CALL premium ↑, for assets trading at a fwd premium PUT premium ↓, for assets trading at a fwd premium the greater is the fwd discount (i.e. the expected decline in the FX value of a currency), the higher (lower) is the value of a put (call) option. The reverse holds for fwd premia 6. INTEREST RATE LEVEL = the higher the interest rates, the lower the present value of the exercise price. This should increase the mkt value of a call, and reduce the market value of a put. r ↑ à PV (K) ↓ present value of the strike price ↓ 𝑃𝑉 = Š (vwj↑)I ↑ px of CALL à ↓ px of PUT PAYOFF PROFILE OF A LONG CALL OPTION Bought a call option at 0.03 (premium) Strike priceà K = 1.53 Px scenarios for the underlying at maturity 1.50 1.53 1.56 1.59 PnL -0.03 (1.53-1.53) – 0.03 = -0.03 (1.56-1.53) -0.03= 0 à break-even point (1.59-1.53) -0.03 = 0.03 !! exam qst This is a zero-sum game: what I gain, you lose and vice versa BeP both for the long and for the short position PAYOFF PROFILE OF A LONG PUT Bgt a put at 0.03 K=1.53 Px scenarios for the underlying at maturity 1.50 1.53 1.56 1.59 PnL (1.53-1.50) -0.03 = 0 à break-even point -0.03 -0.03 -0.03 Benefits and Risks of Options • Low Flexibility o Mainly major currencies o Fixed, standardized maturities and notional amounts o Well-defined trading time and trading rules • CCTP: No settlement risk • High mkt liquidity • Optionality MAIN DIFFERENCES BETWEEN FORWARD, FUTURE and OPTIONS Forwards are negotiatied on OTC Futures are negotiated or regulated exchanges, higher settlement risk Options have optionality, meaning no obligation (for the option holder) P-C = 𝐱𝑼𝑺𝑫𝑬𝑼𝑹 (𝟏X𝒓𝑼𝑺𝑫)𝒕 - 𝐒𝑼𝑺𝑫𝑬𝑼𝑹 (𝟏X𝒓𝑬𝑼𝑹)𝒕 à PUT-CALL-FWD PARITY TERMINOLOGY Currency Fwds: tailor-made agreement to exchange currencies at a pre-determined price on a future date Currency Futures: standardized contracts drawn either to buy or to sell a fixed amount of foreign currency on a pre-determined date sometime in the future Currency Options: derivative contracts that give the buyer the opportunity to buy or to sell the underlying asset at a given price sometime in the future OTC market: Widespread aggregation of dealers who make markets in many different securities. Unlike an exchange on which trading takes place at one physical location, OTC trading occurs through telephone or computer negotiations between buyers and sellers. Market Maker: liquidity providing intermediary that quotes both buying and selling prices for a given financial instrument on a continuous basis. PUT INTO PRACTICE 6.2: A call option on Canadian dollars with a strike price of USD 0.60 is purchased (LONG POSITION) by a speculator for a premium of USD 0.06 per unit. Assume each option calls for the delivery of 50,000 CAD (NOTIONAL AMOUNT). 1. If the Canadian dollar’s spot rate is USD 0.65 at the time the option is exercised, what is the net profit to the speculator? 2. What would the spot rate need to be at the time the option is exercised for the speculator to break even? 3. What is the net profit to the seller of this option? 4. Draw the buyer’s and the seller’s payoff charts. 1) Strike price à x=0.6 Premiumà C=0.06 S=0.65 PnL= (S-x) – C=(0.65 – 0.6) -0.06 = -0.01 à the speculator exercises his right but incurred in a loss, but this loss is minimized. In fact this component help minimizing the loss 3) it is a zero-sum game and specular so the seller obtain a PnL= 0.01 2) S=0.66 PnL= (0.66-0.6) - 0.06 = 0 Break even! !!exam qst: what is the required market price for the seller to break even answer: the same because we are dealing with a zero-sum game, the break point is identical for the buyer and for the seller 4) qualitative terms Exam qst: which of the line represent the short position? The red line Exam qst: which position has the unlimited upside potential? Long position 6.1: A put option on Australian dollars with a strike price of USD 0.80 is purchased by a speculator for a premium of USD 0.02. If the Australian dollar’s spot rate is USD 0.74 on the expiration date, should the speculator exercise the option on this date or let the option expire? Draw the buyer’s and the seller’s payoff charts. 6.3: Given the information below (investment period 1 yr), find the put premium put-call-fwd parity à P-C = 𝐱𝑼𝑺𝑫𝑬𝑼𝑹 (𝟏X𝒓𝑼𝑺𝑫)𝒕 - 𝐒𝑼𝑺𝑫𝑬𝑼𝑹 (𝟏X𝒓𝑬𝑼𝑹)𝒕 P - 0.01 = 𝟎.𝟔𝟑 (𝟏X𝟎.𝟎𝟓𝟓)𝟏 - 𝟎.𝟔𝟐𝟓 (𝟏X𝟎.𝟎𝟕𝟓)𝟏 = LONG POSITION (buyer) - UNLIMITED UPSIDE POTENTIAL (unlimited gain) SHORT POSITION (seller) - UNLIMITED DOWNSIDE POTENTIAL (unlimited loss) LECTURE 6 – INTERNATIONAL FINANCIAL AND FOREX BALANCE OF PAYMENTS (BoP) WHAT IS BoP? BALANCE OF PAYMENT is a nation-wide accounting document summing up all the reasons why the domestic currency is supplied or demanded. § Nation-wide: every country has its own § Accounting: double-entry accounting principle applies, debit entries are offset by corresponding credit entries § Supplied: the transaction is registered with a minus (-) § Demanded: the transaction is registered with a plus (+) DC FC Supply = Demand Demand = Supply WHEN DC IS SUPPLIED § Pay for imports § Unilateral transfers directed abroad à unilateral: a unique flow of money from a country to another with nothing in change from that, normally directed to poorer country (e.g., donation, development grants, non-military aids, remittances: immigrant workers that bring the salary back to their countries to help their families) § Income payments àpayments of dividends, coupons, rents, royalties) to foreign residents that have previously invested in our country § Increase in foreign assets held by domestic residents § Decrease in domestic assets held by foreign residents that decide to divest § Repayment of foreign debt à this happens to poorer countries that finance themselves through foreign countries investments WHEN DC IS DEMANDED § Exports § Income receipts § Unilateral transfers directed at home § Decrease in foreign assets held by domestic residents § Increase in domestic assets held by foreign residents § Settlement of foreign credits BoP CURRENT ACCOUNT BALANCE (CAB) It includes § Imports – § Exports + § Unilateral transfers o Directed abroad – o Directed at home + § Income payments – § Income receipts + CAPITAL ACCOUNT BALANCE (KAB) § Repayment of foreign debts - § Settlement of foreign credits + § Decrease in foreign assets held by domestic residents + CURRENT ACCOUNT BALANCE (CAB) CAPITAL ACCOUNT BALANCE (KAB) OFFICIAL RESERVES SETTLEME NT (ORS) STATISTICAL DISCREPANCIES The CAB can be seen as a firm’s income statement: • BoP Credit entries ⇒ Firm’s revenues • BoP Debit entries ⇒ Firm’s costs If the firm has a surplus on its income statement, it can add to its investments or build up reserves against possible losses in the future. If the firm has a deficit in its income statement, it must borrow, raise more equity, or divest itself of assets purchased in the past. If this were the whole story, all CAB deficits should be conceived as imbalances that have to be corrected as such. This said, what if costs > revenues because the firm is expanding and enhancing its K stock through heavy investments in new technologies? A negative CAB is not necessarily a matter of concern as long as the deficit results from capital investments (infrastructures, new technologies...) and is not the result of current operating and debt costs exceeding current revenues Common wisdom: even though running CAB deficits may be healthy if it is due to importing K equipment, it is better to achieve trade surpluses than deficits. ⇓ Objection: even running persistent surpluses may be detrimental, provided that indefinite trade surpluses mean a country is living below its means National Income Accounting Identity Y = C + I + G + (Exp − Imp) Where • Y= GDP • C= Private Consumption • I= Gross Investment • G= Public Expenditures • Exp-Imp= Net Exports BoP Imbalances and National Income Accounting Identity (Exp − Imp) = Y − (C + I + G) Exp-Imp: Running a persistent surplus (deficit)... Y-(C+I+G):...means producing more (less) than what it is absorbed by the economy in the form of C, I and G ⇓ Persistent trade deficits⇒ a country is living above its means Persistent trade surpluses⇒ a country is living below its means ORS and FX regimes When exchange rates are fixed, central banks participate actively in the FX markets to prevent their currency from falling/rising (non-zero OR’s balance) When exchange rates are floating, CBs do not enter the FX markets, leaving the exchange rate to be determined by the market forces of supply and demand (zero OR’s balance). Watch out: even when exchange rates are deemed to be flexible, the CB always tries to smooth excessive fluctuations in the domestic currency value, so that, in practice, it is very likely that OR ̸=0 Imbalances and the Recent Financial Crisis Understanding global trade and capital imbalances helps us gain a deeper insight into the recent financial crisis. Three related points to bear in mind: • Imbalances need not be destabilizing in and of themselves! • Trade imbalances can persist even for a very long time, whenever they have been incurred to finance new productive investments. Once these projects have become fully operative, however, imbalances should be gradually reabsorbed (higher production of goods and services, lower imports, more resources available to pay foreign debt back) • If, conversely, trade imbalances have been brought about by policy distortions (e.g tariffs, quotas, currency manipulation, poorly regulated financial environments...), adjustment can be violent and is very likely to lead to financial instability and economic recession Re-adjustment should be twofold: heavily indebted countries must necessarily deleverage (i.e. reduce debt), while surplus countries should conversely focus on economic policies aimed at boosting internal consumption. Austerity alone is not enough The Long Run Implications Assume that the foregoing twofold adjustment process were gradually completed... ⇓ What do you think will be the long run effect on FX rates (EUR, USD, RMB. . . )? ⇓ Will these currencies appreciate/depreciate? Could you explain why? MECHANISMS FOR BOP ADJUSTMENTS ORS enable Countries to sustain temporary BoP deficits until the other adjustment mechanisms can operate to correct the disequilibrium.... ⇓ Over the medium term, BoP imbalances can be adjusted via Prices Interest Rates Income Money Price Adjustments and the Classical Economists The Gold Standard Characterized by 3 conditions 1. Money supply consisted of gold or paper money backed by gold 2. Each Country defined the official price of gold in terms of its national currency and was prepared to buy/sell gold at that price 3. Free import and export of gold was permitted Under such a framework • Balance of payment surplus⇒Gold inflows⇒Money expansion • Balance of payment deficits⇒Gold outflows⇒Money contraction Quantity Theory of Money whereby MV=PQ • M: a Country’s money supply • V: Velocity of money (i.e. the number of times per year the average currency unit is spent on final goods) - assumed to be constant • P: Average price level • Q: Volume of all final goods produced - assumed to be fixed (i.e. the economic system is at full employment) ⇓ A change in M induces a direct and proportionate change in P Hume’s Theory Suppose Country A runs a trade surplus that results in an inflow of gold ⇓ This increases the amount of money in circulation ⇓ Rise in inflation: prices in Country A increase relative to its trading partners ⇓ Country’s A residents starts to purchase from abroad (increase in imports) ⇓ The trade surplus will be gradually reabsorbed Drawbacks of the Classical Theory The economy may not be at full employment V is unlikely to be constant Some prices and wages are inflexible in a downward direction: changes in M will rather affect Q Interest Rate Adjustments • World of 2 Countries: A (CAB surplus) and B (CAB deficit) • Country A: gold inflows⇒increase in money supply⇒decrease in domestic interest rates • Country B: gold outflows⇒decrease in money supply⇒increase in domestic interest rates • Investors in A will send additional funds to B, where returns are more appealing • Progressive restoration of equilibrium in both Countries Income Adjustments Domestic income levels have a direct implication on imports and can thus reverse BoP disequilibria. The economy is originally in equilibrium: X-M=S-I • A sudden increase in exports leads the X-M schedule shifting upwards to X’-M (higher domestic income level) • The economy is no longer in equilibrium: trade surplus of USD 100⇒ Notice that the initial increase in exports is partially offset by an increase in imports (due to higher income level) • Over time, the increase in imports generated by increased domestic expenditures will tend to reduce (and erode) the trade surplus Money Adjustments Disequilibria in the BoP reflect an imbalance between the demand and the supply of money. • In order to finance a budget deficit, the Canadian CB creates additional money • Excess of money supply: Canadian consumers increase their spending instead of holding additional cash balances • The rise in home spending will drive prices up: rise in imports and a fall in exports • Canada will have to finance its deficit transferring international reserves to foreigners: money supply will fall back towards the desired level, restoring the BoP imbalances Reversing BoP disequilibria via Prices, Interest Rates, Income and Money may come at the expense of recession or inflation ⇓ The cure may be perceived as worse than the disease ⇓ To counteract disequilibria, FX rates may be allowed to fluctuate FX Rates and BoP Adjustments Under which circumstances will currency depreciation/devaluation succeed in reducing a payment deficit? • Elasticity Approach: Depreciation works best when demand elasticities are high ------------------------------------------------------------------------------------------------------- TO PUT IT INTO PRACTICE I 7.1: The Central Bank of China aims at preventing a further appreciation of the RMB against the USD: is it consistent with the Chinese government’s desire to fight inflation? Please, explain. 7.2: What does the monetary model predict about the effect of higher expected inflation on the exchange rate? 7.3: Would the U.S. balance-of-trade deficit be larger or smaller if the dollar depreciates against all currencies, versus depreciating against some currencies but appreciating against others? Explain. 7.4: Suppose that South Korea’s export growth stalls: some South Korean firms suggest that South Korea’s primary export problem is the weakness in the Japanese yen. How would you interpret this statement? 7.5: You are given the following info for Country X • Please, find the CAB • Do you think Country X is a developed/developing country? Why? LECTURE 7 – INTERNATIONAL FINANCIAL AND FOREX RISK MANAGEMENT INVESTMENT COMPANY Let’s focus on a typical investment company to understand what risk management is. The investment company has: RISK MANAGEMENT PROCESS (RMP) 1. Risk identification à the risk manager is required to identify all the potential risks the firm is exposed to à Updating the risk register ↓ 2. Risk Assessment à once identified, risks are to be prioritized to focus on those that are likely to be more severe. ↓ 3. Risk Management à once risks are ranked, the next step is preparing adequate responses to risks: • Not to do anything à risks are accepted as they are. • Hedge à take steps to isolate the value of assets from the consequences of one or more pre-identified risk factors, o i.e., to protect, to cover o you cannot hedge against everything 1. RISK IDENTIFICATION RISK ≠ EXPOSURE • Risk: VARIABILITY in the value of a given asset à variance or standard deviation • Exposure: AMOUNT at risk à monetary variable The main risks that a company has to face are: § CREDIT RISK à risk that a counterparty is unable to fulfill his obligations § SETTLEMENT RISK à risk that a counterparty fails to deliver the terms of a contract (securities/cash) à however, to minimize if not eliminate the settlement risk, regulated exchanges rely on a “middleman” called the Clearing House that act as the central counterparty. o Exam qst: differences between forward and future - Fwrds à OTC à no clearing house à higher settlement risk - Futuresà regulated exchanges à clearing house à no settlement risk à mark-to-market procedure § MARKET RISK à risk of losses stemming from market-specific events o Equity risk o Interest rate risk FRONT OFFICE ↓ departments active on the market à Trading desks MIDDLE OFFICE ↓ • Treasury departments • Risk management BACK OFFICE ↓ Execution and settlement services DEAL CAPTURE SYSTEM Trades are captured and transferred to the BO for execution to take place as required o Commodity risk o Foreign exchange risk § OPERATING RISKà risk of losses stemming from inadequate/failing internal processes, people, and systems à residual risk § COUNTRY RISK à risk of losses stemming from country-specific events (e.g., war, revolution, social upheavals or disorders, political instability, bribery, confiscation [government takeover without compensation], expropriation [gov takeover with some compensation]) o Sovereign riskà risk of losses on claims held towards the government o Political risk à it includes the sovereign risk and refers to risk of losses on claims held towards public and private entities ------------------------------------------------------------------------------------------------------------------------------------------ 2. RISK ASSESSMENT COUNTRY RISK o Macroeconomic assessment à focus on GDP growth, unemployment rate, inflation rate, currency stability, public debt, public deficit 1. Exam qst: difference between debt and deficit § deficit refers to a specific time period and occurs any time expenditures > revenues § debt is a progressive accumulation of deficit over time o Analytical assessment à based on ratings 1. rating is a “wrap up” measure of the creditworthiness of a given debtor § the higher the rating, the higher the credit merit § the lower the rating, the higher the default probability o Market-based assessment à it can be divided into 2 approaches 1. CDSà Credit Default Swaps Agreement between 2 parties called the protection buyer and the protection seller to hedge against the risk of default (technically called the credit event) of a given reference entity (gov, local agency, firm) à The riskier the reference entity, the higher the fee à conditional cashflow, occurring if and only if the reference entity default 2. SDS à Sovereign Default Spreads Spread hence a difference !! HIGHER SPREAD= HIGHER RISK An example is the Italian government bond (BTP) and German bond (BUND) BTP/BUND SPREAD - BTP à yield ITA Govt bonds, with maturity 10 years - BUND à yield GER Govt bonds, with maturity 10 years PROTECTION BUYER PROTECTION SELLER Periodic fee (insurance) Notional under default YIELD ON GOV BOND i,t i: country under assessment t: maturity tenure YIELD ON GOV BOND j,t j: country perceived to be as risk-free t: maturity tenure - FINANCIAL INSTRUMENTS !! exam qst: o buy call à right to buy, sell callà obligation to sell o buy a put à right to sell, sell put à obligation to buy o when you buy a derivative, you bumped into a risk to have unlimited losses Linear Products: An Example A US bank that has entered into a forward contract with a corporate client where it agreed to sell the client 1 million EUR for USD 1.3 million in one year. Assume that the EUR and USD interest rates are 4% and 3% with annual compounding. This means that the present value of a 1 million EUR cash flow in one year is 1, 000, 000 ÷ 1.04 = 961, 538EUR . The present value of 1.3 million dollars in one year is 1, 300, 000 ÷ 1.03 = 1, 262, 136USD . Suppose that S is the value of one EUR in USD today. The value of the contract today in dollars is ⇓ 1,262,136-961,538S (linear product) ⇓ δ= -961,538: The position can be hedged by buying 961,538 EUR Ex non-constant. Sold a call on 100.000 shares δ0 = 0.522 how would you hedge the position(exposure)? Since I’ve sold the call option, the sign is minus hence I have a short exposure. In order to hedge I will have to buy. How many shares? The number of shares to be bought will be equal to δ • shares (notional) = 0.522 •100.000= 52.200 At time t, δt = 0.458 Number of shares to be bought if the position were open today: δ • Notional = 0.458 • 100.000= 45.800 à The new delta implies that I have too many shares, hence I have to adjust the original hedge. I need a lower amount of underlying assets to be hedge. We compute the difference 52.300 – 45-800 = 6.400 à number of shares to be sold to rebalance the original hedge. δ hedging is appropriate for small market movement. Otherwise, approximation mistakes can be made. COSTANT DELTA or linear instruments (those with linear payoff) e.g., forwards and futures hedge and forget policies apply, meaning that you hedge and then you can forget about it, since delta is not going to change. Exam qst: if you have a portfolio made up of only linear instruments periodically rebalance is requires? No because when is done is done. NON-COSTANT DELTA Non-linear instruments Hedging is to be adjusted from time to time. e.g., options - non-constant slope - non-constant delta - delta is the tangency line For significant market movements, δ hedging alone is not enough! We have to consider the rate of change in the δà we need gamma Gamma γ γ = Ž @m ŽI@ SECOND DETIVATIVE: rate of change of delta with respect to the price of the underlying asset Useful to hedge against big market movements. Suppose we have a δ-neutral portfolio, meaning 0 delta, with gamma = γ. Add an option: - gamma = γT - quantity = a the resulting gamma = γ + a• γT how would you make this portfolio gamma neutral (γ=0)? γ + a• γT = 0 aγT = - γ a = - • •– à this is the quantity of option to be added to our portfolio to make it γ-neutral. Ex. δ-neutral portfolio γ= -3000 (minus hence we need to add) add an option with these features: - δT = 0.62 - γT = 1.50 How would you make it gamma neutral? a = - • •– = —ppp v.s = 2000 à these are the number of options to be added to be gamma neutral !! The portfolio is no longer delta neutral How to make it delta neutral again? a• δT = 2000 • 0.62 = 1240 à number of units of the underlying asset to be sold to preserve delta neutrality we sell because we bought the option, and we have a +2000 so with a plus what we have to do is sell. Exam qst: what do you think is the gamma of a linear instruments? It is zero, because when we have a constant delta by definition the second derivative is zero. Theta θ θ = Žm Ž’ Change is the value of your portfolio with respect to the passage of time. Ceteris paribus, θ < 0 it doesn’t make sense to hedge against the passage of time Rho ϱ ϱ = Žm Žj 𝜕𝑟 à interest rate level !! The higher the interest level, the lower the present value of the strike price, and this in term will have a positive implication on the value of a call. The reverse is true for a put option. Vega v v = Žm Ž˜@ 𝜕𝜎r market volatility !! Delta, Gamma, and Vega neutrality can be simultaneously achieved only relying on 2 derivatives (options). A portfolio that is gamma neutral will not, in general, be vega neutral, and vice versa. ⇓ If a hedger requires a portfolio to be both gamma and vega neutral, at least two traded derivatives dependent on the underlying asset must usually be used. When bonds and interest rate derivatives are part of the portfolio, traders usually consider carefully the ways in which the WHOLE term structure of interest rates can change MACAULAY’S DURATION Duration of a bond that provides cash flow ci at time ti is Duration measures the sensitivity of percentage changes in the bond’s price to changes in its yield Ex duration: The price (B) of a bond is 94.213 and its duration (D) is 2.653: Modified Duration When the yield y is expressed with compounding m times per year CONVEXITY The convexity of a bond is defined as § Be in a long straddle mean there is an unlimited profit potential. A short position is something like that: Total - 0.10 - 0.05 0 0.05 0 - 0.05 - 0.10 SHORT STRADDLE PAYOFF CHART § Profit is limited § Loss is unlimited • A short straddle allows you to hedge against relatively small market movements STRANGLES A long (short) strangle is obtained by purchasing (selling) both a call and a put option with identical maturity, but different strike prices (most common type of strangle: KPut < KCall ) EX LONG STRANGLE PAYOFF CHART Strangles are generally cheaper than straddles: could you explain why? A long strangle allows you to hedge against even more extreme market movements (if compared to a long straddle) WHAT ABOUT THE SHORT STRANGLE? SPREADS Combination of two (or more) call options/ of two (or more) put options § on the same underlying § with different strike prices⇒Money spreads § or times to maturity⇒Time spreads BULL AND BEAR SPREADS • Bull spreads are profitable when the underlying appreciates • Bear spreads are profitable when the underlying depreciates Bull Spreads with Call Options Suppose that, at time t, you bought a call option on the 455 exchange rate. she price — 5 » Strike price = 0.64 455 » Premium = 0.019 485 » Notional = 50,000 AUD At the same time, you also sold a call option on the 45D exchange rate. » Strike price = 0.65 USD » Premium = 0.015 45D » Notional = 50,000 AUD Bull Spreads with Put Options Suppose that, at time t, you bought a put option on the 450 exchange rate. » Strike price = 0.64 452 » Premium = 0.015 42 » Notional = 50,000 AUD At the same time, you also sold a put option on the 452 exchange rate. » Strike price = 0.65 452 » Premium = 0.019 458 » Notional = 50,000 AUD Would you be able to determine the payoff chart? Bear Spreads with Call Options Suppose that, at time t, you bought a call option on the 4$P exchange rate. » Strike price = 0.65 E » Premium = 0.015 UP > Notional = 50,000 AUD At the same time, you also sold a call option on the 952 AUD exchange rate. » Strike price = 0.64 452 » Premium = 0.019 USD » Notional = 50,000 AUD Bear Spreads with Put Options Suppose that, at time t, you bought a put option on the USD exchange rate. » Strike price = 0.65 450 » Premium = 0.019 250 » Notional = 50,000 AUD At the same time, you also sold a put option on the USB exchange rate. » Strike price = 0.64 452 » Premium = 0.015 255 » Notional = 50,000 AUD Would you be able to determine the payoff chart?  FORWARD HEDGING Basic rationale: buying/selling a forward contract eliminates the uncertainty about future exchange rate dynamics FUTURE HEDGING Basic rationale: buying/selling futures eliminates the uncertainty about future exchange rate dynamics (exactly as it was for fwds...) 2- IFR/IFD The European regulation and directive are no longer applicable to UK, after Brexit. UK has created a UK version of this regulatory framework, called MIFIDPRU. New rules to determine the minimum capital requirements. In particular, minimum capital is now defined as the maximum of the following three points: - Permanent Minimum Requirement (PMR) à depending on the activity the firms are allowed to do the regulator defines an initial minimum capital requirement à permanent = constant through time - Fixed Overhead Requirement (FOR) à determined as a function of the firms’ relevant expenditures à to be computed based on the latest audited available financials - K-factors requirements à risk-based requirements of the new framework. An investments companies is exposed to 3 families of risks: o Risk to clients à e.g., K-AUM requirements (AUM: Assets Under Management) o Risk to market à e.g., K-NPR requirements (NPR: Net Position Risk) o Risk to firm à e.g., K-CON requirements (CON: Concentration risk) Min K= max (PMR, FOR, K-factors) TERMINOLOGY Long/short position: An investor is long (short) in a currency if she or he gains (loses) when the spot value of the currency increases, and loses (gains) when it decreases. Contractual assets and liabilities: assets or payment obligations with a fixed face and market values (e.g. bank accounts/ deposits, accounts receivable/ payable...) Non contractual assets and liabilities: assets or payment obligations without a fixed face and market values (e.g. shares, foreign currency-denominated bonds...) Leaning against the Wind: countercyclical monetary policy where central banks take action to damp down inflationary booms or to boost growth when the economy is flagging (source: FT) Confiscation: Government takeover without compensation Expropriation: Government takeover with compensation Sovereign Risk: possibility of losses on claims to foreign governments or governmental agencies Political Risk: additional possibility of losses on private claims (including FDIs) PUT INTO PRACTICE 9.1: The treasurer of the XYZ company based in Country 1 is expecting a dividend payment of 10 mio Currency 2 from a subsidiary located in Country 2 in two months. His/her expectations of the future SCurrency1/Currency spot rate are mixed and thus decides to hedge, with the aim of minimizing FX risk. The current exchange rate is SCurrency1/Currency2 =0.63. The two-month futures rate is at F2/12 Currency1/Currency2 =0.6279. The two-month Country 2 interest rate is 0.075. The two-month Country 1 T-Bill yields 0.055. Puts on Currency 2 with maturity of two months and strike price of KCurrency1/currency2 =0.63 are traded on the CME at Currency 1 0.0128. Compare and assess à all the hedging alternatives are to be asses in terms of the resulting cash inflow (perchè ci devono pagare) (the higher, the better) the following choices offered to the Treasurer: • Sell a futures on Currency 2 for delivery in two months for a total amount of 10 mio Currency 2 • Buy 80 put options on the CME with expiration in two months (Assume that 1 put option is for 125000 Currency 2 ànotional amount) • Set up a forward contract with the firm’s bank XYZ !! If I receive money à cash inflowà the higher the better If I have to pay à cash outflow à the lower the better 9.2: Consider the following option strategy, involving the simultaneous sale of two different options (call and put, same maturity, same strike): Call option premium: USD 0.01 Put option premium: USD 0.015 Strike: KUSD/GBP =1.35 Each option calls for the delivery of GBP 45,500 • Draw the payoff profile • Would you use the foregoing option strategy to hedge against small market movements Why? LECTURE 8 – INTERNATIONAL FINANCIAL AND FOREX PORTFOLIO INVESTMENT Opposite of this is Foreign Direct Investment (features: at least 10% of the voting power). Portfolio Investment: anything that does not qualify as an FDI. Markowitz theory: a rational investor tries to build his own portfolio - minimizing risk per unit of expected return, - or equivalently to maximize expected return per unit of risk. EXPECTED RETURN = weighted average of the returns of the constituent assets E(rp) = ∑ 𝒙𝒊 • 𝑬(𝒓𝒊)𝒏 𝒊u𝟏 - xi: weight assigned to asset i example xi E(ri) A 30% 6.5% B 70% 1.8% E(rp) = 30% • 6.5% + 70% • 1.8% RISK = variability in the value of assets Exposure: the amount at risk Variabilityà quantified/measured via the statistical notions of variance or standard deviation. - STD Deviation is the squared root of the variance √𝑉𝐴𝑅𝐼𝐴𝑁𝐶𝐸 - STD Deviation is preferred because it is expressed in the same unit of measurement as the variable under consideration otherwise with the variance the unit of measurement would be squared. Var(p)=∑ (𝑥𝑖 • 𝜎𝑖)r + ∑ ∑ 𝑥𝑖 • 𝑥𝑗 • 𝑐𝑜𝑣(𝑖; 𝑗)n ™š3›v n 3›v n 3›v à 𝜎𝑖: sts deviation à c𝑜𝑣(𝑖; 𝑗): covariance à measure the degree of linear co-movement between two variables When j goes up i does the same, when j goes down i does the same à positive degree of co-movement à cov(i;j)>0 When j goes up i does the same, when j goes down i does the same à when j increase, i decrease, when j decrease i increaseà negative co-movement à cov(i;J)<0 Cloud of points, exhibiting lo linear co-movement à i and j are said to be linearly independent à cov(i;j)=0 !! what is the covariance between asset i and asset I (covariance of something with itself)? It is the VARIANCE à cov(i;i) = Var(i) “Pure” variance term Covariance term The shape of the frontier varies depending on inter-assets correlations. The final portfolio selection will depend exclusively on individual risk appetite What If We Added a Riskless Asset? Suppose there are only 2 risky assets on the market (a and b, ρ(a, b) = −0.5 - step back to the previous section) and a riskless portfolio (made up of MM instruments and Govt Bonds), yielding 0.05. How to determine which optimal risky portfolio is to be best combined with the riskless security basket? Adopted Selection Criteria: Max[REWARD to RISK] The best achievable combination riskless asset/risky portfolio is the one that maximizes the Sharpe Ratio • Where would you represent the risk-free portfolio? Why? • Investors will combine the tangency portfolio with the risk-free asset to form their overall portfolio: the allocation they choose depends on their preferences for risk • The foregoing tangency line is known as Capital Allocation Line • Depending on the proportions of your wealth that you decide to invest in the risky asset and in the riskless portfolio respectively, you will move along the straight line • Assuming that α and (1 − α) represent the proportions of your wealth invested in the risky portfolio and in the risk-free asset respectively, which point on the line represents α = 0? • Which point on the line represents α = 1? INTERNATIONAL DIVERSIFICATION The benefits of diversification are even higher when investment decisions are taken on an international scale. • Rewards: Significant reduction in the volatility of the resulting portfolio • Risks: An internationally-diversified portfolio is however subject to the risk of unexpected FX rate fluctuations Even though it would be beneficial (for risk reduction) to diversify on an international scale, the global holding of foreign securities is largely sub-optimal ⇓ Home-Equity Bias The major drivers of HEB: • Legal barriers to foreign investments • Higher transaction costs on foreign securities • Indirect barriers to foreign investments (e.g. the difficulty in finding -and interpreting- information about foreign securities) • Additional risks to be hedged (FX risk, country risk...) PUT INTO PRACTICE