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International
Financial Markets
US Domestic German
Market EUR0CURRENCY MARKET Domestic
Market
Euro-Deutsche Mark
Eurodollar Market
Market Foreign
Exchange
Market Japanese
Euro-Yen Domestic
Market Market
Foreign Exchange
Exchange Rates
Spot
How (2 business Forward
Currency quoted days) (90 days)
British US$ 1.632 1.617
pounds per
(GBP) GBP
Japanese Yen per 117.5 116.3
yen (JPY) US$
Bid Offer
Spot
Forward points
Rule:
add if bid<offer,
subtract if bid>offer
Outright forward
Exchange Rates
Spot
How (2 business Forward
Currency quoted days) (90 days)
British US$ 1.632 1.617
pounds per
(GBP) GBP
Japanese Yen per 117.5 116.3
yen (JPY) US$
JPY
Sony
Sony BBof
ofAA
Hedging approaches:
uOpen
uForward
uSpot plus swap
uRollover
uMoney market
SHORT LONG
Today
T+2
T+90
Methods:
- Spot + swap
- Spot + rollover swap
- Money market
- Outright forward
Probability
68%
95%
Money Money
market 1 market 2
Spot Forward
Money
Money
NKR
3 MO
DEP
Interest
Interest rate
rate
differential
differential
Covered interest Uncovered interest
rate parity rate parity
Expected
Expected
Forward
Forward %
% change
change in
in
premium
premium exchange
exchange rate
rate
Unbiased
forward rate
Copyright ©2002 Ian H. Giddy International Financial Markets 28
Interest-Rate Parity
Anglo’s Answer
EXCHANGE
RATE Spot
Forward
Actual
Probability
EXCHANGE distribution
RATE of actual
Spot exchange rate
Forward
Actual
P$/DM = E(R$/DM )
Probability
distribution
Spot of actual
exchange rate
INTEREST
RATE
DIFFERENTIAL
Forward
Actual
TIME
Today In three
months
That is,
Interest-rate differential
equals
Expected annual rate of change of
exchange rate
Copyright ©2002 Ian H. Giddy International Financial Markets 36
Cost of Hedging
p=Sp*
The Price of Tin
In New York On the Kuala On the
Lumpur London Metal
Market Metal
Exchange
273c per lb. 15.37 ringgit US$5830 per
= US$6.02 per kilogram tonne
per kilograma =US5.70 = US5.83
per kilogramb per kilogramc
a1 avoirdupois pound = 0.45359 kilograms
S t=1-St = I-I*
St 1+I*
EXCHANGE-
RATE
CHANGE
Deviations from
Purchasing Power Parity
140
REAL EXCHANGE RATE
130
120
JAPAN
110
100
90
80 UNITED STATES
70
60
1996Q1
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies,
adjusted for change in relative wholesale price of domestic manufactures. A fall in the index
indicates improved international competitiveness.
Deviations from
Purchasing Power Parity
140
REAL EXCHANGE RATE
130 JAPAN
120 GERMANY
110
100 FRANCE ITALY
90
80 UNITED STATES UK
70
60
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996Q1
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies,
adjusted for change in relative wholesale price of domestic manufactures. A fall in the index
indicates improved international competitiveness.
US
US Expected
Expected Inflation
Inflation Rate
Rate 2%
2%
Canadian
Canadian Expected
Expected Inflation
Inflation Rate
Rate 7%
7%
US
US Interest
Interest Rate
Rate 5%
5%
Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
US
US Expected
Expected Inflation
Inflation Rate
Rate 2%
2%
Canadian
Canadian Expected
Expected Inflation
Inflation Rate
Rate 7%
7%
US
US Interest
Interest Rate
Rate 5%
5%
Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Expected
Expected Rate
Rate of
of Change
Change
of
of the Exchange Rate
the Exchange Rate
Copyright ©2002 Ian H. Giddy International Financial Markets 47
Giddy International Financial Markets/20
Borrow
Borrow at
at US
US Interest
Interest Rate
Rate 5%
5%
Invest
Invest at
at Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Borrow
Borrow at
at US
US Interest
Interest Rate
Rate 5%
5%
Invest
Invest at
at Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Buy
Buy Canadian
Canadian Dollars
Dollars Forward
Forward
(at
(at discount
discount of
of 5%)
5%)
Borrow
Borrow at
at US
US Interest
Interest Rate
Rate 5%
5%
Invest
Invest at
at Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Buy
Buy Canadian
Canadian Dollars
Dollars Forward
Forward
(at discount of 5%)
(at discount of 5%)
Buy
Buy Canadian
Canadian Dollar
Dollar Futures
Futures
(at
(at discount
discount of
of 5%)
5%)
RELATIVE
EXCESS
MONEY
SUPPLY
1
RELATIVE
INFLATION
RATES
2 3
RELATIVE 4 EXCHANGE
INTEREST RATE
RATES CHANGE
5 6
FORWARD
EXCHANGE
PREMIUM
OR DISCOUNT
A Framework
Country A Country B
DOMESTIC DOMESTIC
ECONOMIC ECONOMIC
POLICIES POLICIES
INFLATION INFLATION
RATE RATE
EXCHANGE
RATE
INTEREST INTEREST
RATE RATE
FORWARD
RATE
Copyright ©2002 Ian H. Giddy International Financial Markets 52
Turkey, 1995
Turkish Lira:
Down 33.5%
Contact Info
Ian H. Giddy
NYU Stern School of Business
Tel 212-998-0426; Fax 212-995-4233
Ian.giddy@nyu.edu
http://giddy.org