CHAPTER 5

1. Function and Structure of the FX Market:

Foreign exchange market is a worldwide linkage of bank currency traders, nonbank dealers, and FX
brokers, who assist in trades, connected to one another via a network of telephones, computer
terminals, and automated dealing systems.

The structure of the foreign exchange market is an outgrowth of one of the primary functions of a
commercial banker: to assist clients in the conduct of international commerce.

The spot and forward foreign exchange markets are over-the-counter (OTC) markets; that is,
trading does not take place in a central marketplace where buyers and sellers congregate.

1.1 FX Market Participants:

 The FX market is a two-tiered market:

 Interbank Market (Wholesale)

 Client Market (Retail)

 FX market participants can be categorized into five groups:

 International banks: provide the core of the FX market. Approximately 100 to 200
banks worldwide actively “make a market” in foreign exchange, that is, they stand
willing to buy or sell foreign currency for their own account.

 Bank customers: broadly include MNCs, money managers, and private speculators

 Nonbank dealers: are large nonbank financial institutions such as investment banks,
mutual funds, pension funds, and hedge funds,

 FX brokers: match dealer orders to buy and sell currencies for a fee, but do not take a
position themselves. Brokers have knowledge of the quotes offered by many dealers
in the market.

 Central banks: has intervened in the foreign exchange market in an attempt to

influence the price of its currency against that of a major trading partner, or a country
that it “fixes” or “pegs” its currency against

1.2 Correspondent Banking Relationships:

 The interbank market is a network of correspondent banking relationships, with large

commercial banks maintaining demand deposit accounts with one another, called
correspondent banking accounts.

 International commercial banks communicate with one another with:

 SWIFT: The Society for Worldwide Interbank Financial Telecommunications.

  CHIPS: Clearing House Interbank Payments System

 ECHO Exchange Clearing House Limited, the first global clearinghouse for settling
interbank FX transactions.

2. The Spot Market- introduction.

 The spot market involves almost the immediate purchase or sale of foreign exchange.

 Typically, cash settlement is made two business days (excluding holidays of either the buyer or
the seller) after the transaction for trades between the U.S. dollar and a non–North American
currency.

 This part will introduce:

i. Spot Rate Quotations v. Spot FX Trading

ii. Cross-Exchange Rate Quotations vi. The Cross-Rate Trading Desk

iii. Alternative Expressions for the Cross- vii. Triangular Arbitrage

Exchange Rate
viii. Spot Foreign Exchange Market Microstructure
iv. The Bid-Ask Spread

2.1 Spot Rate Quotations

(1) Direct quotation:

◦ the U.S. dollar equivalent

◦ e.g. “a Japanese Yen is worth about a penny”

(2) Indirect Quotation:

◦ the price of a U.S. dollar in the foreign currency

◦ e.g. “you get 100 yen to the dollar”

See the exhibit 5.7 from your textbook.

2.2 Cross-Exchange Rate Quotations:

A cross-exchange rate is an exchange rate between a currency pair where neither
currency is the U.S. dollar.
 Ignore the transaction costs of trading temporarily while we develop the
concept of a cross-rate.
 The cross-exchange rate can be calculated from the U.S. dollar exchange rates
for the two currencies, using either European or American term quotations.
 (5.10)

 The American term quotation: (5.3)

 The European term quotation:

(5.4)
2.3 Alternative Expressions for the Cross-Exchange Rate
 For some purposes, it is easier to think of cross-exchange rates calculated as
the product of an American term and a European term exchange rate rather
than as the quotient of two American term or two European term exchange
rates.
 Equation 5.3 to be rewritten as:

= x (5.7)
= 1.3158 x .8903 = 1.1715 (difference due to rounding)
 In general terms, S( j/k) = S($/k) × S( j/$) (5.8) and taking reciprocals of both
sides of Equation 5.8 yields
 S(k/j) = S(k/$) × S($/j) (5.9)
2.4 The Bid-Ask Spread:
 The bid price is the price a dealer is willing to pay you for something.
 The ask price is the amount the dealer wants you to pay for the thing.
 The bid-ask spread is the difference between the bid and ask prices.
 The bid-ask spread represents the dealer’s expected profit.
 (5.11)

A dealer would likely quote these prices as 72-77.

It is presumed that anyone trading $10m already knows the “big figure”.
2.5 Spot FX Trading:
 In the interbank market, the standard size trade is about U.S. $10 million.
 A bank trading room is a noisy, active place.
 The stakes are high.
 The “long term” is about 10 minutes.
2.6 The Cross-Rate Trading Desk
 In dealer jargon, a nondollar trade such as this is referred to as a currency against currency
trade.

 Recognizing transaction costs implies the following restatement of Equation 5.8:

Sb(SF/£) = Sb($/£) × Sb(SF/$) (5.12)

 Taking reciprocals of Equation 5.12 yields:

Sa(£/SF ) = Sa(£/$ ) × Sa($/SF ) (5.13)

 2.7 Triangular Arbitrage:
Triangular arbitrage is the process of trading out of the U.S. dollar into a
second currency, then trading it for a third currency, which is in turn traded
for U.S. dollars.
The purpose is to earn an arbitrage profit via trading from the second to
the third currency when the direct exchange rate between the two is not in
alignment with the cross-exchange rate.
2.8 Spot Foreign Exchange Market Microstructure
 Market Microstructure refers to the mechanics of how a marketplace
operates.
 Bid-Ask spreads in the spot FX market:
o increase with FX exchange rate volatility and
o decrease with dealer competition.
 Private information is an important determinant of spot exchange rates.

3. The Forward Market

1. Forward Rate Quotations
2. Long and Short Forward Positions
3. Non-deliverable Forward Contracts
4. Forward Cross Exchange Rates
5. Forward Premium
6. Swap Transactions
 A forward contract: is an agreement to buy or sell an asset in the
future at prices agreed upon today.
 If you have ever had to pre-order a new-released iphone, then you
have entered into a forward contract.
3.1 Forward Rate Quotations:
  The forward market for FX involves agreements to buy and sell foreign
currencies in the future at prices agreed upon today.
 The forward price may be the same as the spot price, but usually it is higher
(at a premium) or lower (at a discount) than the spot price.
 Forward exchange rates are quoted on most major currencies for a variety
of maturities. Bank quotes for 1, 3, 6, 9, and 12 month maturities are
readily available for forward contracts.
 To learn how to read forward exchange rate quotations, let’s examine
Exhibit 5.4
3.2 Long and Short Forward Positions
 If you have agreed to sell anything (spot or forward), you are “short”.
 If you have agreed to buy anything (forward or spot), you are “long”.
 If you have agreed to sell FX forward, you are short.
 If you have agreed to buy FX forward, you are long.
3.3 Non-deliverable Forward Contracts
 For many of these currencies (such as the Chinese yuan and Russian
ruble), trading in non-deliverable forward (NDF) contracts exists.
 A non-deliverable forward contract is settled in cash, usually U.S. dollars,
at the difference between the spot exchange on the maturity date of the
contract and the NDF rate times the notional amount of the contract.
Forward Cross-Exchange Rate:
 For example, using the forward quotations in Exhibit 5.7, the three-month
A$/SFr cross-exchange forward rate:

Using American term quotes (Equation 5.16) is:

Using European term quotes (Equation 5.17) is:

3.5 Forward Premium:
 The forward premium (or discount) is useful for comparing against the
interest rate differential between two countries.
 The forward premium or discount can be calculated using American or
European term quotations
 The formula for calculating the forward premium or discount for currency j in
American terms is:

In European terms the forward premium or discount for the U.S. dollar is
calculated as:

3.5 Swap Transactions

 A swap is an agreement to provide a counterparty with something he
wants in exchange for something that you want.
 A forward swap transaction is the simultaneous sale (or purchase) of spot
foreign exchange against a forward purchase (or sale) of approximately an
equal amount of the foreign currency.
 From the bank’s standpoint, an outright forward transaction is an
uncovered speculative position in a currency, even though it might be part
of a currency hedge to the bank customer on the other side of the
transaction. Swap transactions provide a means for the bank to mitigate
the currency exposure in a forward trade.
Summary:
1. The FX market is the largest and most active financial market in the
world. It is open somewhere in the world 24 hours a day, 365 days a year.
In 2016, average daily trading in spot and forward foreign exchange was
$4.74 trillion.
2. The FX market is divided into two tiers: the retail or client market and the
wholesale or interbank market. The retail market is where international
banks service their customers who need foreign exchange to conduct
international commerce or trade in international financial assets. The great
majority of FX trading takes place in the interbank market among
international banks that are adjusting inventory positions or conducting
speculative and arbitrage trades.
3. The FX market participants include international banks, bank customers,
nonbank FX dealers, FX brokers, and central banks.
4. In the spot market for FX, nearly immediate purchase and sale of
currencies take place. In the chapter, notation for defining a spot rate
quotation was developed. Additionally, the concept of a cross-exchange
rate was developed. It was determined that nondollar currency
transactions must satisfy the bid-ask spread determined from the cross-rate
formula or a triangular arbitrage opportunity exists.
5. In the forward market, buyers and sellers can transact today at the
forward price for the future purchase and sale of foreign exchange.
Notation for forward exchange rate quotations was developed. The use of
forward points as a shorthand method for expressing forward quotes from
spot rate quotations was presented. Additionally, the concept of a forward
premium was developed.
6. Exchange-traded currency funds were discussed as a means for both
institutional and retail traders to easily take positions in nine key
currencies.

CHAPTER 6
1. Interest Rate Parity
 Interest Rate Parity (IRP) is an arbitrage condition that must hold when
international financial markets are in equilibrium.
 If IRP did not hold, then it would be possible for an astute trader to
make unlimited amounts of money exploiting the arbitrage opportunity.
 Since we don’t typically observe persistent arbitrage conditions, we can
safely assume that IRP holds.
Example: Consider alternative one year investments for $100,000:
1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$)
2. Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£ while
eliminating any exchange rate risk by selling the future value of the British
investment forward.
Interest Rate Parity Defined
The scale of the project is unimportant:

(1 + i$)
F$/£ = S$/£ ×
(1+ i£)

Formally : 1 + i$ F$/ £
1 + i£ = S$/ £

Or

IRP is sometimes approximated as :

F–S
i$ – i £ ≈
S
Covered Interest Arbitrage:
 When IRP doesn’t hold, the situation also gives rise to covered interest
arbitrage opportunities.
 Consider the following set of foreign and domestic interest rates and spot
and forward exchange rates.
 Example 6.1 (p154):

Spot exchange rate S($/£) = $1.8/£

360-day forward rate F360($/£) = $1.78/£

U.S. discount rate i$ = 5%

British discount rate i£ = 8%

EXHIBIT 6.1 - Covered Interest Arbitrage: Cash Flow Analysis

EXHIBIT 6.2 - The Interest Rate Parity Diagram

Because every trader will
(i) borrow in the United States as much as possible,
(ii) lend in the U.K.,
(iii) buy the pound spot, and, at the same time,
(iv) sell the pound forward, the following
Adjustments will occur to the initial market condition described in Equation 6.5:
1. The interest rate will rise in the United States (i$↑).
2. The interest rate will fall in the U.K. (i£↓).
3. The pound will appreciate in the spot market (S↑).
4. The pound will depreciate in the forward market (F↓).
IRP and Exchange Rate Determination:
Being an arbitrage equilibrium condition involving the (spot) exchange rate,
IRP has an immediate implication for exchange rate determination.
 Equation 6.6 indicates that given the forward exchange rate, the spot
exchange rate depends on relative interest rates. All else equal, an
increase in the U.S. interest rate will lead to a higher foreign exchange
value of the dollar

where
 St+1 is the future spot rate when the forward contract matures,
 It denotes the set of information currently available.
Uncovered Interest Rate Parity:
When the forward exchange rate F is replaced by the expected future spot
exchange rate, E(St+1), we obtain:

i$  i£   E e 
Uncovered interest rate parity :
• Interest rate differential between a pair of countries is
(approximately) equal to the expected rate of change in the
exchange rate
Currency Carry Trade:
 Unlike IRP, the uncovered interest rate parity often does not hold, giving
rise to uncovered interest arbitrage opportunities
  Currency carry trade involves buying a high-yielding currency and funding it
with a low-yielding currency, without any hedging
 The carry trade is profitable if the interest rate differential is greater than
the appreciation of the funding currency against the investment currency
Reasons for Deviations from Interest Rate Parity:
 Transactions Costs
◦ The interest rate available to an arbitrager for borrowing, ia,may
exceed the rate he can lend at, ib.
◦ There may be bid-ask spreads to overcome, Fb/Sa < F/S
◦ Thus (Fb/Sa)(1 + i£b)  (1 + i$ a)  0
 Capital Controls
◦ Governments sometimes restrict import and export of money
through taxes or outright bans.

2. Purchasing Power Parity

Purchasing Power Parity (PPP):
 Theory of purchasing power parity (PPP): The exchange rate between two
currencies should equal the ratio of the countries’ price levels:

S($/£) = P $ : P£
Purchasing Power Parity and Exchange Rate Determination;
 The PPP relationship of Equation 6.12 is called the absolute version of PPP.
When the PPP relationship is presented in the “rate of change” form, we
obtain the relative version:
  where e is the rate of change in the exchange rate and π$ and π£ are the
inflation rates in the United States and U.K., respectively.

PPP Deviations and the Real Exchange Rate:

 If there are deviations from PPP, changes in nominal exchange rates cause
changes in the real exchange rates, affecting the international competitive
positions of countries. This, in turn, would affect countries’ trade balances.
 The real exchange rate, q, which measures deviations from PPP, can be
defined as follows:

To summarize,
q = 1: Competitiveness of the domestic country unaltered.
q < 1: Competitiveness of the domestic country improves.
q > 1: Competitiveness of the domestic country deteriorates.

Evidence on PPP:
 PPP has been the subject of a series of tests, yielding generally negative
results, especially over short horizons
 Generally unfavorable evidence about PPP suggests that substantial
barriers to international commodity arbitrage exist
• As long as there are nontradables (for example, haircuts, housing,
etc.), PPP will not hold in its absolute version
• If PPP holds for tradables and the relative prices between tradables
and nontradables are maintained, then PPP can hold in its relative
version

3. Fisher Effect
  The Fisher effect holds that an increase (decrease) in the expected
inflation rate in a country will cause a proportionate increase (decrease)
in the interest rate in the country.
 Formally, the Fisher effect can be written for the United States as
follows:

Where :
o $ is the equilibrium expected “real” U.S. interest rate
o E($) is the expected rate of U.S. inflation
o i$ is the equilibrium expected nominal U.S. interest rate

International Fisher Effect:

o If the Fisher effect holds in the U.S.
E($) = (i$ - $ ) / (1 + $ ) ≈ i$ - $
o and the Fisher effect holds in U.K,
E( £ ) = (i £ -  £ ) / (1 +  £ ) ≈ i £ -  £
o and if the real rates are the same in each country
$ =  £
o then we get the International Fisher Effect (IFE): suggests that the nominal
interest rate differential reflects the expected change in exchange rate.
E(e) ≈ i$ - i£

o Lastly, when the international Fisher effect is combined with IRP, that is,
(F – S)/S = (i$ - i£) /(1 + i£ )
o We obtain
(F – S)/S = E(e)
 o which is referred to as forward expectations parity (FEP). FEP states that
any forward premium or discount is equal to the expected change in the
exchange rate.
o When investors are risk-neutral, forward parity will hold as long as the
foreign exchange market is informationally efficient.

4. Forecasting Exchange Rates

 Many business decisions are now made based on forecasts, implicit or
explicit, of future exchange rates
 Forecasting teachniques can be classified into three distinct approaches:
1. Efficient market approach
2. Fundamental approach
3. Technical approach
4.1 Efficient Markets Approach:
 Financial Markets are efficient if prices reflect all available and relevant
information.
 If this is so, exchange rates will only change when new information
arrives, thus:
St = E[St+1]
 In a sense, the random walk hypothesis suggests that today’s
exchange rate is the best predictor of tomorrow’s exchange rate.
and
Ft = E[St+1| It]
 Predicting exchange rates using the efficient markets approach is
affordable and is hard to beat.
4.2 Fundamental Approach
 Involves econometrics to develop models that use a variety of
explanatory variables.
 s = α + β1(m − m*) + β2(v − v*) + β3( y* − y) + u (6.19)
where:
 s = natural logarithm of the spot exchange rate.
 m − m* = natural logarithm of domestic/foreign money supply.
 v − v* = natural logarithm of domestic/foreign velocity of
money.
 y* − y = natural logarithm of foreign/domestic output.
 u = random error term, with mean zero.
 α, β’s = model parameters.
Generating forecasts using the fundamental approach would involve
three steps:
 Step 1: Estimation of the structural model like Equation 6.18 to determine
the numerical values for the parameters such as α and β’s.
 Step 2: Estimation of future values of the independent variables like (m −
m*), (v − v*), and (y* − y).
 Step 3: Substituting the estimated values of the independent variables into
the estimated structural model to generate the exchange rate forecasts.
The downside is that fundamental models do not work any better than the
forward rate model or the random walk model.
 Fundamental Approach
◦ Uses various models to forecast exchange rates :
 Three main difficulties of this approach:
1. One must forecast a set of independent variables to forecast the
exchange rates, and forecasting the former will certainly be subject
to errors and may not be necessarily easier than forecasting the
latter
 2. Parameter values that are estimated using historical data may
change over time because of changes in government policies and/or
the underlying structure of the economy
3. Model itself can be wrong
 Technical Approach:
 First analyzes the past behavior of exchange rates for the purpose of
identifying “patterns” and then projects them into the future to generate
forecasts
• Based on the premise that history repeats itself
• At odds with the efficient market approach
• Differs from fundamental approach in that it does not use the key
economic variables, like money supplies or trade balances, for
purpose of forecasting
• Two examples of technical analysis:
1. Moving average crossover rule
2. Head-and-shoulders pattern

4.3 Technical Approach

 Technical analysis first analyzes the past behavior of exchange rates for the
purpose of identifying “patterns” and then projects them into the future to
generate forecasts..
o Clearly it is based upon the premise that history repeats itself.
o Thus it is at odds with the EMH

4.4 Performance of the Forecasters

o Forecasting is difficult, especially with regard to the future.
o As a whole, forecasters cannot do a better job of forecasting future
exchange rates than the forward rate.
 o The founder of Forbes Magazine once said:
o “You can make more money selling financial advice than following
it.”

Summary
1. Interest rate parity (IRP) holds that the forward premium or discount
should be equal to the interest rate differential between two countries. IRP
represents an arbitrage equilibrium condition that should hold in the
absence of barriers to international capital flows.
2. If IRP is violated, one can lock in guaranteed profit by borrowing in one
currency and lending in another, with exchange risk hedged via forward
contract. As a result of this covered interest arbitrage, IRP will be restored.
3. IRP implies that in the short run, the exchange rate depends on (a) the
relative interest rates between two countries, and (b) the expected future
exchange rate. Other things being equal, a higher (lower) domestic interest
rate will lead to appreciation (depreciation) of the domestic currency.
People’s expectations concerning future exchange rates are self-fulfilling.
4. Purchasing power parity (PPP) states that the exchange rate between
two countries’ currencies should be equal to the ratio of their price levels.
PPP is a manifestation of the law of one price applied internationally to a
standard commodity basket. The relative version of PPP states that the rate
of change in the exchange rate should be equal to the inflation rate
differential between countries. The existing empirical evidence, however, is
generally negative on PPP. This implies that substantial barriers to
international commodity arbitrage exist.
5. There are three distinct approaches to exchange rate forecasting: (a) the
efficient market approach, (b) the fundamental approach, and (c) the
technical approach. The efficient market approach uses such market-
determined prices as the current exchange rate or the forward exchange
rate to forecast the future exchange rate. The fundamental approach uses
various formal models of exchange rate determination for forecasting
purposes. The technical approach, on the other hand, identifies patterns
from the past history of the exchange rate and projects it into the future.
 The existing empirical evidence indicates that neither the fundamental nor
the technical approach outperforms the efficient market approach.

CHAPTER 3:
Balance of Payments Accounting
Balance of Payments Accounts
• The Current Account
• The Capital Account
• The Financial Account
• Statistical Discrepancy
• Official Reserves Account
The Balance of Payments Identity
Balance of Payments Trends in Major Countries

Balance of Payments Accounting 1:

o Balance of payments is the statistical record of a country’s international
transactions over a certain period of time presented in the form of double-
entry bookkeeping
o Important to study for a few reasons:
1. Provides detailed information concerning the demand and supply of
a country’s currency
2. May signal its potential as a business partner for the rest of the world
3. Used to evaluate the performance of the country in international
economic competition
o Any transaction that results in a receipt from foreigners will be recorded as
a credit, with a positive sign, in the U.S. balance of payments
• For example, foreign sales of U.S. goods and services, goodwill,
financial claims, and real assets
 o Any transaction that gives rise to a payment to foreigners will be recorded
as a debit, with a negative sign, on the U.S. balance of payments
• For example, U.S. purchases of foreign goods and services, goodwill,
financial claims, and real assets
International transactions can be grouped into the following four main types:
1. Current account includes the export and import of goods and
services
2. Capital account consists of capital transfers and the cross-border
acquisition and disposal of nonproduced nonfinancial assets
3. Financial account (excluding official reserves) includes all purchases
and sales of financial assets, such as stocks, bonds, bank accounts,
etc.
4. Official reserve account covers all purchases and sales of
international reserve assets

 The Current Account 1:

 Divided into four finer categories:
1. Goods trade represents exports and imports of tangible goods (for
example, oil, wheat, clothes, automobiles, computers, etc.)
2. Services include payments and receipts for legal, consulting,
financial, and engineering services; royalties for patents and
intellectual properties; shipping fees; and tourist expenditures
3. Primary income consists largely of payments and receipts of interest,
dividends, and other income on foreign investments that were
previously made
4. Secondary income involves “unrequited” (đơn phương) payments

 Current account balance, especially the trade balance, tends to be sensitive

to exchange rate changes
 • Currency depreciation or devaluation can improve (worsen) the trade
balance if imports and exports are responsive (inelastic)
 J-curve effect refers to the initial deterioration and eventual improvement
of trade balance following the depreciation of a country’s currency

The capital account:

The capital account includes capital transfers and acquisitions and disposals of
nonproduced, nonfinancial assets.
• Nonproduced, nonfinancial asset : natural resources (land, mineral
right , airspace ), marketing assets (brand, domain names , contracts ,
lease and licenses).

 The Financial Account

Measures the difference between U.S. sales of assets to foreigners and U.S.
purchases of foreign assets
Can be divided into three categories:
1. Foreign direct investment (FDI) occurs when the investor acquires a
measure of control of the foreign business
2. Portfolio investment mostly represents sales and purchases of
foreign financial assets, such as stocks and bonds, that do not involve
a transfer of control
3. Other investment includes transactions in currency, bank deposits,
trade credits, etc.

 Statistical Discrepancy:
Exhibit 3.1 shows a statistical discrepancy of −$40.5 billion in 2018
• Recordings of payments/receipts arising from international
transactions are done at different times and places, possibly using
different methods
• Financial transactions may be mainly responsible for discrepancy
Overall balance is the cumulative balance of payments including the current
account, capital account, financial account, and the statistical discrepancies

 The Official Reserves Account

Official reserve account includes transactions undertaken by the authorities to
finance the overall balance and intervene in foreign exchange markets
Post-1945, international reserve assets comprise:
1. Gold
2. Foreign exchange
3. Special drawing rights (SDRs)
4. Reserve positions in the IMF

 The Balance of Payments Identity (BOPI)

BCA  BKA  BFA  BRA  0

where
 BCA = balance on current account
 BKA = balance on capital account
 BFA = balance on financial account
 BRA = balance on the reserves account
 Under fixed exchange regime, countries maintain official reserves that
allow them to have BOP disequilibrium

 BOP Trends in Major Countries

 U.S. has experienced continuous deficits on the current accounts since
1982 and continuous surpluses on the financial account; with the sole
exception of 1991
• Magnitude of U.S. current account deficits is far greater than any that
other countries ever experienced during the 36-year sample period
  Japan has had an unbroken string of current account surpluses (and
financial account deficits) since 1982 even though the value of the yen rose
steadily until the mid-1990s
 U.K. recently experienced continuous current account deficits, coupled with
financial account surpluses
• Magnitude is far less than that of the U.S.
 Germany traditionally had current account surpluses, but between 1991 to
2001 experienced current account deficits
• Attributed to German reunification and the resultant need to
absorb more output domestically to rebuild the East German
region
• Since 2002, Germany has returned to its earlier pattern
 China tends to have a surplus on the current account, as well as the
financial account (until recently)
 “Global imbalance”
• Overall, U.S. and U.K. generally use up more outputs than they
produce, whereas the opposite holds for China, Japan, and Germany

CHAPTER 1:
 What’s Special about “International” Finance?
Three major dimensions set international finance apart from domestic finance
1. Foreign exchange risk and political risks
2. Market imperfections
3. Expanded opportunity set
Largely stem from the fact that sovereign nations have the right to issue
currencies, formulate their own economic policies, impose taxes, and regulate
movements of people, goods, and capital across their borders
 What’s Special about “International” Finance: Foreign Exchange
Risk
Foreign exchange risk is the risk of facing uncertain future exchange rates
• In addition to businesses, individuals and households may also be
seriously exposed to uncertain exchange rates
• Exchange rates among major currencies (for example, U.S. dollar,
Japanese yen, British pound, and euro) fluctuate continuously in an
unpredictable manner
• Exchange rate uncertainty influences all major economic functions,
including consumption, production, and investment (luồng chảy của
capital)

 What’s Special about “International” Finance: Political Risk

Political risk arises from potential losses to the parent firm resulting from adverse
political developments in the host country
• Ranges from unexpected changes in tax rules to outright
expropriation of assets held by foreigners
• Arises from the fact that a sovereign country can change the “rules of
the game” and the affected parties may not have effective recourse
• Especially relevant in those countries without a traditional rule of
law- quyền bảo vệ tài sản cá nhân của bản thân

 What’s Special about “International” Finance: Market

Imperfections
Market imperfections may be described as various frictions, such as transaction
costs and legal restrictions, that prevent the markets from functioning perfectly
• World markets are highly imperfect
• Numerous barriers hamper the free movement of people,
goods, services, and capital across national boundaries
(for example, legal restrictions, excessive transaction and
transportation costs, information asymmetry (bất đối xứng
 thông tin) , and
discriminatory taxation)
• Restrict the extent to which investors can diversify their portfolios

 The Example of Nestlé’s Market Imperfection:

Nestlé used to issue two different classes of common stock, bearer shares and
registered shares
• Foreigners were only allowed to hold bearer shares
• Swiss residents could buy registered shares
• The bearer stock was more expensive
On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing
them to hold registered shares as well as bearer shares
• Price spread between the two types narrowed drastically

 What’s Special about “International” Finance: Expanded

Opportunity Set
Firms may benefit from an expanded opportunity set when they venture into the
arena of global markets
• Firms can gain from greater economies of scale when their tangible
and intangible assets are deployed on a global basis
• True for corporations, as well as individual investors
• “It just doesn’t make sense to play in only one corner of the
sandbox.”
 Goals for International Financial Management:
 The focus of the text is to provide today’s financial managers with an
understanding of the fundamental concepts and the tools necessary to be
effective global managers
• Fundamental goal of sound financial management is
shareholder wealth maximization, which means the firm
 makes all business decisions and investments with an
eye toward making the owners of the firm
(that is, shareholders) better off financially
• Generally accepted in Anglo-Saxon countries, but not as
widely embraced in other parts of the world

 Other Stakeholders:
In other countries shareholders are viewed as merely one among many
“stakeholders” of the firm, others being:
• Employees
• Suppliers
• Customers
• Banks
In Japan, managers have typically sought to maximize the value of the
keiretsu—a family of firms to which the individual firms belong

 Corporate Governance
As shown by a series of recent corporate scandals at companies like Enron(MỸ) ,
WorldCom, Parmalat, and Global Crossing, managers may pursue their own
private interests at the expense of shareholders when they are not closely
monitored
• This “agency problem” is a major weakness of the public corporation
Reinforces the importance of corporate governance, the financial and legal
framework for regulating the relationship between a firm’s management and its
shareholders

 Globalization of the World Economy: Major Trends and

Developments
o Emergence of Globalized Financial Markets
o Emergence of the Euro as a Global Currency
 o Europe’s Sovereign Debt Crisis of 2010
o Trade Liberalization and Economic Integration
o Privatization
o Global Financial Crisis of 2008 to 2009

o Brexit
 Emergence of Globalized Financial Markets:
 Deregulation of foreign exchange and capital markets
 Financial innovations resulted in the introduction of various instruments:
• Currency futures and options
• Multicurrency bonds
• International mutual funds
• Country funds
• Exchange-traded funds (ETFs)
• Foreign stock index futures and options
 Advances in computer and telecommunications technology

 Emergence of the Euro as a Global Currency

 Momentous event in history of world financial system
 Currently more than 300 million Europeans in 19 countries are using the
common currency on a daily basis
• Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece,
Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands,
Portugal, Slovakia, Slovenia, and Spain
 Transaction domain of the euro may become larger than that of the U.S.
dollar in the future

 Europe’s Sovereign-Debt Crisis of 2010

In December 2009, the new Greek government revealed that its budget deficit for
the year would be 12.7% of GDP, not the 3.7% previously forecast
• Investors sold off Greek government bonds, and the ratings agencies
downgraded them to “junk”
• Panic spread to other weak European countries (especially Ireland,
Portugal, and Spain) and quickly escalated to a Europe-wide debt
crisis
• Revealed a profound weakness of the euro as the common currency;
Lack of fiscal discipline in a euro-zone country can always become a
Europe-wide crisis

 Trade Liberalization and Economic Integration :

 Principal argument for international trade is based on the theory of
comparative advantage
• It is mutually beneficial for countries if they specialize in the
production of those goods they can produce most efficiently and
trade those goods among them
• Policy implication is that liberalization of international trade will
enhance the welfare of the world’s citizens
 Over the years, international trade has been liberalized at both the global
and regional levels
 General Agreement on Tariffs and Trade (GATT) is a multilateral
agreement among member countries that has reduced many barriers to
trade
 The World Trade Organization (WTO) has the power to enforce the rules of
international trade
 Regional arrangements have also been instituted to promote economic
integration
• The European Union (EU), for example, includes 28 member states
that have eliminated barriers to the free flow of goods, capital, and
people
  North American Free Trade Agreement (NAFTA):
North American Free Trade Agreement (NAFTA) called for phasing out
impediments to trade between Canada, Mexico, and the United States over a 15-
year period beginning in 1994
• In November 2018, the three countries signed a new accord, the
U.S.-Mexico-Canada-Agreement (USMCA), but the new accord needs
to be ratified in three countries
In Mexico, the ratio of export to GDP has increased dramatically from 2.2% in
1973 to 35.6% in 2017

 Recent Free Trade Agreements:

 Trans-Pacific Partnership (TPP) designed to slash tariffs and facilitate trade
among 11 Pacific Rim member countries
• Signed March 2018
• U.S. withdrew from the pact citing President Trump’s “America first”
philosophy
 African Continental Free Trade Agreement (AfCFTA)
• Signed by 49 African countries
• Aims to stimulate intra-African trade and investment by reducing
tariffs, protecting intellectual property rights, and lowering barriers
to migration

 Privatization:
Privatization is the act of a country divesting itself of ownership and operation of
business ventures by turning them over to the free market system
• May be described as a denationalization process and often viewed as
a means to an end
• Selling state-owned businesses brings in hard-currency foreign
reserves to the national treasury
• Often seen as a cure for bureaucratic inefficiency and waste
 • Some economists estimate privatization improves efficiency and
reduces operating costs by as much
as 20%

 Chinese Privatization
 State-owned enterprises (SOEs) have been listed on organized stock
exchanges, making them eligible for private ownership
 China launches two stock exchanges in the early 1980s
• As of 2018, approximately 3,600 companies are currently listed on
China’s stock exchanges
• “A-shares” are primarily reserved for Chinese citizens, while
foreigners may invest in “B-shares” or “H-shares”
 Chinese government still retains the majority stakes in most public firms

 Global Financial Crisis of 2008 to 2009

Factors that drove the financial crisis:
• Households and financial institutions borrowed too much and took
too much risk
• Crisis was amplified and transmitted globally by securitization;
financial engineers designed opaque and complex mortgage-based
securities that could be used for excessive risk-taking
• “Invisible hands” of free markets apparently failed to
self-regulate excesses, contributing to the banking crisis
• International financial markets are highly interconnected and
integrated

 Brexit
 “Brexit” describes the voting decision of a majority of Britons to leave the
EU
• Likely to weaken the United Kingdom and the EU, both economically
and politically
 • London’s position as the dominant center of European finance may
deteriorate if the UK loses unrestricted access to Europe’s single
market
 How did this happen?
• Majority of voters outside of London felt alienated from the
globalized economy and were worried about competition for jobs
from immigrants
• 60% of Londoners voted to remain in the EU; 45% of voters in the
rest of England voted the same way

Multinational Corporations:
A multinational corporation (MNC) is a firm that has been incorporated in one
country and has production and sales operations in other countries
• Approximately 60,000 MNCs in the world with over 500,000 foreign
affiliates
Benefit from the economy of scale in many ways:
• Spreading R&D expenditures and advertising costs over their global
sales
• Pooling global purchasing power over suppliers
• Utilizing their technological and managerial know-how globally with
minimum additional costs

TỔNG HỢP CÔNG THỨC:

1. Spot exchange rate:

s = α + β1(m − m*) + β2(v − v*) + β3( y* − y) + u

where:
 s = natural logarithm of the spot exchange rate.
  m − m* = natural logarithm of domestic/foreign money supply.
 v − v* = natural logarithm of domestic/foreign velocity of
money.
 y* − y = natural logarithm of foreign/domestic output.
 u = random error term, with mean zero.
 α, β’s = model parameters.
2. Cross-exchange rate :
2.1 American :

2.2 European :

3. Alternative expression for the Cross-exchange rate :

4. The bid- Ask spread :
5. Cross rate trading desk :

6. Forward cross exchange rate :

7. Forward premium:
8. Interest rate parity :

9. IRP :
 10.Uncovered interest rate parity:

11, Exchage rate:

11.Real exchange rate:

12.Fisher effect :