INTERNATIONAL FINANCE

Ganesh Kumar N.

IF - Modules
1. FOREIGN EXCHANGE MARKETS AND INTERNATIONAL PARITY CONDITIONS 5 sessions 2. BALANCE OF PAYMENTS, CAPITAL FLOWS AND CAPITL ACCOUNT CONVERTIBILITY 4 sessions 3. EXCHANGE RATE SYSTEMS AND THEIR IMPACT 6 sessions

Evaluation
Component Quizzes
CP+ Case Analysis End Term

Wt. 30%
30% 40%

Exchange Rate Risk

Fluctuations in exchange rate will have impact on companies whether they are directly exposed to exchange rate changes such as importers/ exporters, or indirectly exposed. Changes in exchange rate are some times temporary, some times permanent. These changes calls for different responses from firms.

Rupee to appreciate on a long term: Morgan Stanley, Nov 20, 2007 "Indian rupee will be appreciating further. We expect rupee to reach to the level of Rs 36-37 per dollar by the end of next year," Managing Director, Morgan Stanley

K V Kamath sees Re 1 gain against dollar every year DNA, Tuesday, November 20, 2007

The rupee has risen 13.7% over a year. He said the Indian currency would continue to appreciate further in future. If I were in company management, I would allow at least Rs 2 per year or Re 1 a year strengthening,

What happened after 2008?

Rising Yen in 1980s

Long term trends in exchange rate. Much more difficult for companies to manage calls for strategies such as relocation of production.

APPRECIATION OF JAPANESE YEN IN 1980s

THE FOREX MARKET Interbank market/ Whole sale market: Players: Banks, Big firms with active treasury, central banks

Retail market: Banks

Retail clients: Exporters, importers, travelers etc.

Spot FX Market
Spot FX rates are determined in the interbank market based on demand and supply Bid-Ask spread Bid-Ask(offer) spread. Bid rates<ask rates. Market makers quote bid-offer rates. Example - Rupee-$ rate: 59.20/59.30 Bid rate is the rate at which market maker buys the asset (market user sells). WE BUY rate. Ask rate is the rate at which market maker sells the asset (market user buys). WE SELL rate. The difference is market makers profits.

Retail vs. Interbank spot rate

Retail rates are based on interbank rates, but spread will be higher Retail quotes are adjusted less frequently than inter bank rates.

FOREIGN EXCHANGE MARKETS

Fixed (base) currency and variable currency Fixed currency is the currency against which all other (variable) currencies are quoted Cross rate is the rate between two currencies when none of them is US$

FOREIGN EXCHANGE MARKETS

Quotation: Market convention: DLR |INR: 59.20/30. Fixed|Variable Bid rate is 59.20, ask rate 59.30. Text book: S(INR/US$): 59.20/30 variable/fixed S(INR /bid$) =59.20 or Sb(INR/$) =59.20 S(INR/ask$): 59.30 or Sa(INR/$) = 59.30

FOREIGN EXCHANGE MARKETS

Two basic contracts in FX markets
FX Spot contract is an agreement made today to buy or sell FX at the current market price FX forward contract is an agreement made today that represents an obligation to buy/sell FX at pre specified price (forward rate) at some future date (maturity or settlement date). Most common maturities are 1,2,3,6,12 months. However, they can be negotiated.

FOREIGN EXCHANGE MARKETS

Forward premium / discount If a currency is more (less) expensive in the forward market when compared to the spot market, we say it is at forward premium (discount). Forward premium (+) / discount (-) on currency j vis--vis currency i (premium on fixed currency, j) :

Fn (i/j) - S(i/j) 100 nS (i/j)

Example: Spot DLR|INR 59.00 1 month Forward rate 59.50

FOREIGN EXCHANGE MARKETS

Forward premium (+) / discount (-) on currency i vis-vis currency j (premium on variable currency, i)=

S(i/j) - Fn (i/j) 100 nFn (i/j)

Example:

Premium is always expressed as % p.a.

What is the premium/ discount on INR

Spot DLR|INR 59.00 1 month Forward rate 59.50

FOREIGN EXCHANGE MARKETS

Example. Suppose US$|INR: 59.00 / 59.50 INR|US$ or S(US$/INR)?
Market makers selling (ask) rate of INR should be the reciprocal of the bid (buying) rate for DLR (Why?). Bid rate for INR should be the reciprocal of ask rate for DLR.
1 S ( j / bid i ) S (i / ask j ) 1 S ( j / ask i ) S (i / bid j )

FOREIGN EXCHANGE MARKETS

Cross rate calculation
Example. Suppose you have the following information US$|INR: 59.00/20 GBP|US$ 1.565/70 Question: Calculate GBP|INR

S ( INR / bidGBP) S ( INR / bid $) S ($ / bid GBP) S ( INR / ask GBP) S ( INR / ask $) S ($ / ask GBP)

FOREIGN EXCHANGE MARKETS

Cross rate calculation
S(Pound/Euro): 0.9035/40 S(US$/Euro):1.5000/10 S(US$/Pound)?

S (US $ / bid Pound) S (US $ / bid Euro) S ( Euro / bid Pound)

1 S (US $ / bid Euro ) S ( Pound / ask Euro )

S (US $ / ask Pound) S (US $ / ask Euro) S ( Euro / ask Pound)

1 S (US $ / ask Euro ) S ( Pound / bidEuro)

Triangular or Round trip arbitrage

What if cross rate is mispriced? There will be arbitrage opportunity. Triangular arbitrage involves taking positions in three currencies so as to exploit mispricing S(INR/US$) = 59.20 S(US$/Euro) = 1.25 A dealer quotes: S(INR/Euro) = 74.50 How will you do triangular arbitrage? What is the arbitrage profit on INR 100?

Triangular or Round trip arbitrage with transaction cost

BID S(INR/USD)
S(USD/EUR)

ASK 56.0
1.257

55.8
1.255

Dealers quote S(INR/Euro): 69.50/69.60

Is triangular arbitrage possible?

What is the arbitrage profit on INR 100?

Outright forward exchange and swaps

Outright forward transaction involves only one transaction (buy or sell) Swap involves two components spot & forward or two forward transactions in the opposite directions. Swap is an agreement to buy and sell foreign exchange at pre-specified rates where buying and selling are separated in time, or borrowing in one currency and lending in another.

Buy-sell and Sell-Buy swaps

Swap in USD- buying USD in spot and selling it forward (Buy-sell or swap in) Swap out USD: Selling USD in spot and buying it forward (sell-buy or swap out) What kind of swap you need if you are investing overseas? What kind of swap you need if you are borrowing from overseas?

Swap quotations
Conventionally forward rate is quoted in terms of spot rate and swap points (forward points)

Outright forward exchange and swaps

Spot DLR|INR 46.19/62 46.19/62
Spread

30 day 25/37 46.44/99 55

60 day 55/70
Swap quote quote

46.74/47.32 Outright 58

43

Outright forward exchange and swaps

Spot GBP|DLR 1.5980/85 1.5980/85 Spread: 5 30 DAY 19/17 90 DAY 55/50 180 DAY
95/85

1.5999/1.6002 1.6035/1.6035 1.6075/1.6070 3 0 -5

If the fixed currency is at forward discount you deduct swap points.

Outright forward exchange and swaps

Spot GBP|DLR 30 DAY 90 DAY 55/50 180 DAY 95/85

1.5980/85

19/17

1.5980/85
Spread: 5

1.5961/1.5968

1.5925/1.5935

1.5985/1.5900

10

15

Spot +/- forward points = forward rate. Forward points are added (subtracted)if they are in ascending (descending) order.