BUS 468 - Chapter 9

Chapter 9 - FOREIGN EXCHANGE (FX) MARKETS

U.S. Banks and MNCs operate in a global economy, and need to buy, sell, and trade currencies. Foreign trade, X + M = $3T for U.S., most of it requiring the purchase or sale of FX. Also, MNCs and FIs are exposed to FX risk. Exporters receiving FX in the future are worried about foreign currencies depreciating, Importers paying FX in future are worried about $ depreciating, FX appreciating. Point: Invoicing in FX exposes MNC to currency or FX risk, as CFs are converted into or out of U.S. dollars.

International Investment also exposes investors to FX risk. Example: Investment in Japan, Mexico or Europe for one year. If foreign currency depreciates (appreciates) over the next year, the dollar value of the CFs received decreases (increases).

BACKGROUND of FX MARKETS

WWII to 1973 - Fixed exchange rates. Advantage?

Since 1973, Flexible/floating ex-rates. FX markets are OTC, mostly an inter-bank market, large banks around the world trading FX on behalf of MNC clients. Chicago Mercantile Exchange (CME) trades currency futures contracts, competing with banks offering currency forward contracts.

Futures vs. Forward markets for FX: Currency futures contracts are standardized, in terms of expiration dates (Mar, June, Sept and Dec) and contract size, exchange-traded, and are settled in cash (99%). Currency forward contracts are more flexible, can be easily customized in terms of size and maturity, OTC, are settled in currency (90%), usually in amounts of $1m and more.

$1T/day FX traded, London is largest, NYC, Tokyo. Trading is 24/7.

Recent FX development: Introduction of Euro in 2002.

FX quotes: 1) American, Direct, U.S. $ Equivalent, e.g., $1.80/£; or 2) European, Indirect, Currency Per USD, e.g., £0.5556/$. Currency trades are for $1m or more. Spot (cash) and Forward Markets for FX are both important. If a currency is expected to appreciate (depreciate), it will sell at a forward premium (discount). Spot is about 40% of FX market, and Forward contracts about 60%. Compared to 1989, forward trading has increased from 40% to 60%, more hedging, see Table 9-2 on p. 259.

Example: S = $1.80/£ to F = $1.89/£, BP is expected to appreciate, and is selling at a 5% forward premium.

S = $1.80/£ to F = $1.764/£, BP is expected to depreciate, and is selling at a 2% forward discount.

FX is traded OTC, like corporate bonds and money market securities, using telecommunications and computer networks. Electronic trading now dominates FX, about 85-95% compared to 20-30% in 1995. Reuters and EBS dominate the FX electronic trading equipment, but don't actually trade FX. FX traders operate at large commercial banks (Citibank) and FIs, usually specializing in just a few currencies. Smaller banks conduct FX trades through a line of credit at a larger bank.

See Table 9-3, p. 262, for a summary of FX positions for all U.S. banks. Notice that bank FX liabilities (deposits) are greater than bank FX assets (loans), by $24.4B, exposing banks to FX risk, especially if USD _____________.

See formula p. 262 for Net Exposure for FX risk, and Table 9-4 for net positions by currency. A positive net exposure means that banks have a Net Long Position for that currency, e.g., Euro $8.362B, and will have a profit (loss) if the Euro appreciates (depreciates). A negative net exposure means that banks have Net Short Position for that currency, e.g., CD, Yen, SF, and BP, and will have a gain (loss) if the foreign currency depreciates (appreciates). Reason: Remember that 60% of FX trading is for __________________. Point: Large bank's currency position exposes the bank to FX risk, they have to manage that risk.

Recent trend: Fewer currency traders due to: a) increased efficiency of electronic trading, b) bank mergers, and c) introduction of the Euro.

FI position in FX reflects four trading activities ( see p. 264-265):

1. FX for international trade of goods and services for bank clients.

2. FX for international investment for bank clients or FI itself.

3. FX for hedging, forward or futures contracts, for bank clients or FI itself.

4. Currency speculation.

Bank/FI takes FX positions to make money/profits, e.g., Buying currencies that they expect to appreciate.

Foreign Exchange Risk, see Example 9-1, p. 265. U.S. firm/investor plans to buy SF3m worth of bonds in one month. It buys the SF3m today @ $.6344/SF (Table 9-1 on p. 257) for $1,903,200. Deals falls through, it has to sell SF3m in month @ $.6219 for $1,865,700, at a loss of $37,500. FX risk: Holding FX that depreciates.

Hedging Strategy: Sell the SF3m forward at $.6348 (Table 9-1) for $1,904,400, to avoid the loss. (Or it could have just bought the SF forward instead of buying today?).

Example 9-2 on p. 266. Bank has matched maturity (duration) of Assets (Loans) and Liabilities (Deposits) at 1 year to avoid interest rate risk. However, it has not matched the currencies of its Loans and Deposits, exposing the bank to currency risk. Assume the CD is 8% and the one year U.S. loan is 9%, for a 1% pos spread (profit margin) for domestic business.

The $100m one year U.K. loan rate is 15%, in BP. $100m / ($1.60/£) = £62.5m x 1.15 = £71.875m in one year. FI sells the BP (£71.875m) for USD in one year.

Scenario 1: BP stays the same @ $1.60/£. Dollar return in U.K. is 15%. Total loan return is 12% (.50 x 9% + .50 x 15%), for a spread of 12% - 8% = 4%, or a profit of $200m x 4% = $8m.

Scenario 2: BP depreciates to $1.45/£. Selling £71.875m x $1.45/£ = $104.22m, which is a USD return of 4.22% on $100m. Total loan Return is now 6.61% (.50 x 9% + .50 x 4.22%), or a negative return of 6.61% - 8% = -1.39% return, or a loss of -$2.78m ($200m x -1.39%).

Scenario 3: BP appreciates to $1.70/£. Selling £71.875m x $1.70/£ = $122.188m, or a return of 22.188%. Loan return is now 15.594% (.50 x 9% + .50 x 22.188%), for a spread of 15.594% - 8% = 7.594%, or profits of $15.188m.

Bank is exposed to FX risk, especially if BP depreciates. Bank's position is net long $100m in BPs, and it will gain if the BP appreciates, lose if BP depreciates. Profits are uncertain and can range between a low of -$2.78m and a high $15.188m in the scenarios outlined above (ex-rate is from $1.45/£ to $1.70/£). Two strategies for bank to hedge risk: On-Balance-Sheet Hedge or Forward Hedge (Off-balance-sheet).

Forward Hedge, see Example 9-4, p. 270. Sell the £71.875m forward in one year, at the one-year forward rate available now, F = $1.55/£ (-3.125% discount) for $111,406m (£71.875m x $1.55) guaranteed, or a 11.406% dollar return. Total loan return is now 10.203% (9% + 11.406% / 2), spread is 2.203% (10.203% - 8%), profit is locked in at $4.406m ($200m x 2.203%). This is an off-balance-sheet hedge with a forward contract. Profit is guaranteed, certain, and no changes have been made to the balance sheet.

The guaranteed (hedged) dollar return of 11.406% on U.K. loans is much more profitable than U.S. loans at 9%. U.S. banks would borrow in U.S. @ 8% (deposits), invest in U.K. loans at 15%, buying spot BPs with dollars, and selling BPs forward. Results: 1) $1.60/£ spot rate goes up due to BP buying pressure in spot market, 2) $1.55 forward rate goes down due to BP selling pressure in forward market, and 3) the discount for the BP widens from 3.125% until it is no longer profitable to borrow in U.S. and make forward hedged investments in U.K. For example, at S = $1.625/£ and F = $1.5275/£, the forward discount for the BP is -6%, and the hedged return in U.K. is 9% (15 - 9%), the same as U.S. Interest Rate Parity (IRP).

Balance Sheet Hedge, see Example 9-3 on p. 268. Match both: a) Maturity and b) Currency of Assets (loans) and Liabilities (deposits). In this case, the FI has $100m (£100m) of dollar (pound) loans and $100m (£100m) of dollar (pound) deposits. U.K. deposit pays 11% (in pounds).

FI issues $100m of UK CDs @11%, to match the $100m of UK loans @15%. $100m is the equivalent of $100m/$1.60 = £62.5m, and the FI will receive £71.875m (£62.5m x 1.15) payoff in one year from the loan, and pay out £69.375m (£62.5m x 1.11) in one year.

YR 1: +CF = £71.875m on Loan

-CF = -£69.375m on CD

If ex-rates don't change at all, the profits will be 12% (average loan) - 9.5% (average deposit) = +2.5% x $200m = $5m net income. What if ex-rates change?

Scenario 1: BP depreciates to $1.45/£, Dollar return on U.K. loan is 4.22% like before (p. 267). $100m/$1.60 = £62.5m loan in UK * 1.15 = £71.875m due x $1.45/£ = $104.22m or 4.22%.

What about the cost of U.K. deposit? $100m CD is equal to ($100m/$1.60) £62.5m x 1.11 = £69.375m payable in one year. At S=$1.45/£, the FI pays $100.59m (£69.375m x $1.45) in USD, for a dollar cost of .59% for borrowed funds.

Loan Return = Average of 9% (US) + 4.22% (UK) = 6.61%

Deposit Cost = Average of 8% (US) + .59% (UK) = 4.295%

Spread = 2.315% (6.61 - 4.295)

Profits = $200m x 2.315% = $4.63m

Scenario 2: BP appreciates to $1.70/£, Dollar return on U.K. loan is 22.188% (p. 267) like before. Cost of funds: At S = $1.70/£, the FI pays $117.9375m (£69.375m x $1.70) in USD to CD holders, cost of funds is 17.9375%.

Loan Return = Average of 9% + 22.18% = 15.59%

Deposit Cost = Average of 8% + 17.9375% = 12.969%

Spread = 2.625% (15.59% - 12.969%)

Profits = $200m x 2.625% = $5.25m

By matching maturity (duration) AND currencies of Assets and Liabilities, the FI has hedged FX risk, and locked in a narrow spread of about 2.5% (2.315% to 2.625%) and a profit of about $5m ($4.63m to $5.25m).

OR:

US: Net interest income is $1m ($9m - $8m)

UK: Net interest income is £2.5m (£62.50m Loan x .15) = £9.375m - £6.875 (£62.50m CD x .11)

Therefore:

CFs-US CFs-UK(£s) CFs-UK($) TOTAL Net CFs($) Net Spread

$1m £2.5m x $1.60/£ = $4.0m $5m $5m / $200m = 2.5%

$1m £2.5m x $1.45/£ = $3.625m $4.625m $4.625 / $200m = 2.31%

$1m £2.5m x $1.70/£ = $4.25m $5.25m $5.25m / $200m = 2.625%

In this case, the FI has successfully hedged FX risk by adjusting the balance sheet, and is an on-balance sheet hedge.

PARITY CONDITIONS

Purchasing Power Parity (PPP). Start with Fisher equation: R = r + IP, where R = Nominal interest rate, r = Real interest rate and IP = Inflation Premium, or Expected Inflation for U.S. and U.K., see p. 271. Assume real rate is constant, then:

i_U.S. - INF_U.S. = i_U.K. - INF_U.K. (real rate in U.S. = real rate in U.K.) or

i_U.S. - i_U.K. = INF_U.S. - INF_U.K.

Nominal interest rate spread = Difference in Inflation Rates (Expected or Actual).

8% - 6% = 6% - 4% or

3% - 5% = 1% - 3%

Purchasing Power Parity (PPP)

INF_U.S. - INF_U.K. = %Ex-Rate ($/£)

Says that ex-rates adjust to reflect relative inflation rates. If U.S. has higher inflation than U.K., the $ will depreciate and £ will appreciate. If U.K. has higher inflation than U.S., the £ will depreciate and the $ will appreciate. With free trade and flexible ex-rates, PPP should hold.

2% - 6% = -4% Depreciation of £ (U.K. prices are higher and rising faster than U.S. prices, consumers want to buy cheaper U.S. goods, driving up the value of $, driving down the BP.

12% - 10% = +2% Appreciation of £ (U.S. prices are higher and rising faster than U.K. prices, consumers want to buy U.K. goods, appreciating the £ and depreciating the $.

Example 9-5, p. 272. Russian inflation (10%) is higher than U.S. (4%), the $ should appreciate by 6% and the Ruble should depreciate by 6%.

4% - 10% = -6%

S = $0.17/Ruble, Ruble depreciates by -6%, .17 - 6% = $0.1598/Ruble.

Interest Rate Parity (IRP)

IRP links spot ex-rates, interest rates and forward ex-rates, according to the formula:

1 + i_U.S. = F / S x (1 + i_U.K.), where

S = Spot ex-rate

F = Forward ex-rate, same maturity as i_U.S., i_U.K.

i_U.S. = Interest rate in U.S. on bond or CD

i_{U.K.
=}_{Interest rate in U.K. on comparable bond/CD}

Simplified IRP formula:

i_U.S. ≈ i_U.K. + (F - S) / S

where (F - S) / S is the forward discount (%) or premium (%) of the foreign currency (BP).

Example 1: S = $1.60/£ and F₃₆₀ = $1.552, BP is selling at a one-year forward discount of -3.00%. If interest rates in U.K. for one-year bank CDs is 5.50%, then according to IRP, interest rates in U.S. for one-year bank CDs should be 2.50%:

2.50% = 5.50% - 3%

Example 2: S = $1.60/£ and F₃₆₀ = $1.632, BP is selling at a one-year forward premium of +2.00%. If interest rates in U.K. for one-year bank CDs is 5.50%, then according to IRP, interest rates in U.S. for one-year bank CDs should be 7.50%:

7.50% = 5.50% + 2%

Suppose that IRP did NOT hold because F = $1.64 and forward premium for BP is 2.5%?

7.50% < 5.50% + 2.5%

7.50% < 8%

Banks would borrow deposit funds in the U.S., invest funds in U.K. loans, using forward contracts of hedge risk, which would involve buying BP spot and selling BP forward. S would rise above $1.60 due to buying pressure and F would fall below $1.64 due to selling pressure, which would narrow the spread (F - S / S), eventually to 2% (assuming interest rates did not change). One possible outcome: S = $1.6005 and F = $1.6325, which is a 2% forward premium for the BP, which would restore IRP.

IRP should hold most of the time assuming: 1) capital mobility, 2) no barriers to international financial flows, 3) low transaction costs, and 4) active and efficient FX markets (both spot and forward). Arbitrage profit opportunities would quickly eliminate deviations from IRP.

BALANCE OF PAYMENTS (BP)

Summary of all transactions between citizens (as consumers and investors) of two countries, for international trade and international investment. FX markets exist for those two activities (foreign trade and investment). BP is part of NIPA (National Income and Product Accounts) for GDP, at BEA (Bureau of Economic Analysis) at the Dept. of Commerce.

BP is Double-entry bookkeeping system of national accounting, so BP always EQUALS ZERO, (BP = 0). See Table 9-6 on p. 274, Total Current Accounts (Line 10) of approx. $417B equals the Total Capital Accounts (Line 22) of $417B.

BP = (Total Current Accounts) - (Total Capital Accounts) = 0

BP accounts for all CFs in and out of the country (-CFs and +CFs). See Table 9-6 on p. 274, all negative numbers are CASH OUT (-CF) and all positive numbers are CASH IN (+CF). Two BP Accounts: Current Account and Capital Account

1. Current Account (CA) summarizes CFs for a) Merchandise, b) Services, c) Investment income, and d) gifts, grants or aid from U.S. govt. or foundations. Exports (X) generate +CF, Imports generate -CF. For 2001, U.S. had a trade deficit of -$426B for merchandise, a trade surplus of $78B for services and a deficit on investment income of

-$19B, and a -$50B outflow for unilateral transfers (gifts, grants and aid), for a CA balance of -$417.4B.

2. Capital Account (KA) summarizes CFs for investments in assets, securities, real estate, companies. For 2001, U.S. citizens invested about $439.5B overseas in foreign assets, securities, real estate, etc., and foreigners invested about $896B in U.S. assets and securities, for a net capital inflow of about +$457B (KA surplus). A statistical discrepancy of -$39B reduces the KA surplus to +$417.4B, which results in BP = 0.

For U.S.: Trade Deficit (M > X), Capital Inflow. C > Income, Net Debtor Nation.

For Japan: Trade Surplus (X > M), Capital Outflow. Income > C, Net Creditor Nation.