Lecture in International

Finance
Chinese University of Technology
Foued Ayari, PhD
 About Dr Ayari
Assistant Professor of Finance in New York
President & CEO of Bullquest LLC, a financial training
company.
Partner at Goldstone Property Group Inc
Author of a recently published book:
Credit Risk Modeling: An Empirical Analysis on
Pricing, Procyclicality and Dependence
Author of a forthcoming book published with Wiley &
Sons,
Understanding Credit Derivatives: Strategies &
New Market Developments.
 Outline
The FX market
Currency Forwards
Eurobond Market
Eurocurrency Market
Currency Swaps

Strategies in FX
 Foreign Exchange Markets
BACKGROUND
Foreign Exchange markets come under Global Markets
Division within Banks. It features are as follows:
OTC market
Major international banks
Spot market and forward market
London is the largest centre
7/24 Market with daily Turnover of more than $3,200 Billions
(BIS, 2007)
All currencies are primarily valued against the USD dollar:
USD 1 = JPY 112.26 (in this quote, the most common type, the
USD is the base currency)
EUR 1 = USD 1.2594 (in this quote the USD is the variable
currency)
 Correspondent Banking
Relationships
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.
 Spot Market Participants and
Trading
FX MARKET STRUCTURE
The foreign exchange spot markets are QUOTE DRIVEN
markets with international banks as the wholesale participants.
This market is also known as the FX inter-bank market.

International banks act as MARKET MAKERS. They make

each other two-way prices on demand:
The bank MAKING the quote bids for the BASE currency on the
left and offers (ask) it on the right. e.g:
GBP 1 = USD 1.8850 (Bid), GBP 1 = USD 1.8860 (Ask)
Becomes:
1.8850/60
or even
50/60
 The Foreign Exchange Market
TYPES OF EXCHANGE MARKETS AND CONVENTIONS

Exchange markets

FX Market

Spot Market Forward Market FX Swaps Market

Deals for delivery T + Deals for delivery up Deals with one spot
2 to 12 months later component and one
than T + 2 forward component
 Spot & Forward
A spot contract is a binding commitment for an exchange of funds,
with normal settlement and delivery of bank balances following in
two business days (one day in the case of North American
currencies).
A forward contract, or outright forward, is an agreement made today
for an obligatory exchange of funds at some specified time in the
future (typically 1,2,3,6,12 months).
Forward contracts typically involve a bank and a corporate
counterparty and are used by corporations to manage their
exposures to foreign exchange risk.
An FX swap (not to be confused with a cross currency swap) is a
contract that simultaneously agrees to buy (sell) an amount of
currency at an agreed rate and to resell (repurchase) the same
amount of currency for a later value date to (from) the same
counterparty, also at an agreed rate.
Non Deliverable Forwards
How Factors Can Affect Exchange Rates
 Forwards
Spot Rates
Spot is the term used for standard settlement in the FX markets. The spot date is two business
days after the trade date: T+2.
Spot rates are quoted as two way prices between the banks that populate the FX markets:

Source: Bloomberg
 The Spot Market
Spot Rate Quotations
The Bid-Ask Spread
Spot FX trading
Cross Rates
 Spot Rate Quotations
Direct quotation
the U.S. dollar equivalent
e.g. a Japanese Yen is worth about a penny
Indirect Quotation
the price of a U.S. dollar in the foreign
currency
e.g. you get 100 yen to the dollar
 Spot Rate Quotations
USD equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.7830 0.7836 1.2771 1.2762

Brazil (Real) 0.3735 0.3791 2.6774 2.6378

Britain (Pound) 1.9077 1.9135 0.5242 0.5226

1 Month Forward 1.9044 1.9101 0.5251 0.5235

3 Months
Forward 1.8983 1.9038 0.5268 0.5253

6 Months
Forward 1.8904 1.8959 0.5290 0.5275

Canada (Dollar) 0.8037 0.8068 1.2442 1.2395

1 Month Forward 0.8037 0.8069 1.2442 1.2393

3 Months
Forward 0.8043 0.8074 1.2433 1.2385

6 Months
Forward 0.8057 0.8088 1.2412 1.2364
 Spot Rate Quotations

USD equiv USD equiv Currency per Currency per

Country Friday Thursday USD Friday USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762
The direct quote for
Brazil (Real) 0.3735 0.3791 2.6774 2.6378 British pound is:
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
1 = $1.9077
1 Month Forward 1.9044 1.9101 0.5251 0.5235
3 Months
Forward 1.8983 1.9038 0.5268 0.5253
6 Months
Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months
Forward 0.8043 0.8074 1.2433 1.2385
6 Months
 Spot Rate Quotations

USD equiv USD equiv Currency per Currency per The indirect quote
Country Friday Thursday USD Friday USD Thursday for British pound
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 is:
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 .5242 = $1
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
1 Month Forward 1.9044 1.9101 0.5251 0.5235
3 Months
Forward 1.8983 1.9038 0.5268 0.5253
6 Months
Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months
Forward 0.8043 0.8074 1.2433 1.2385
6 Months
 Spot Rate Quotations

USD equiv USD equiv Currency per Currency per Note that the
Country Friday Thursday USD Friday USD Thursday direct quote is the
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 reciprocal of the
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 indirect quote:
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
1 Month Forward 1.9044 1.9101 0.5251 0.5235
3 Months
Forward 1.8983 1.9038 0.5268 0.5253
1
6 Months
Forward 1.8904 1.8959 0.5290 0.5275 1.9077 =
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
.5242
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months
Forward 0.8043 0.8074 1.2433 1.2385
6 Months
 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
A dealer could offer
bid price of $1.25 per
ask price of $1.26 per
While there are a variety of ways to quote that,
The bid-ask spread represents the
dealers expected profit.
 The Bid-Ask Spread

big figure small figure

Bid Ask
S($/) 1.9072 1.9077
S(/$) .5242 .5243
A dealer would likely quote these prices as 72-
77.
It is presumed that anyone trading $10m
already knows the big figure.
 Spot FX trading
In the interbank market, the standard size
trade is about U.S. $10 million.
A bank trading room is a noisy, active
place.
The stakes are high.
The long term is about 10 minutes.
 Cross Rates
Suppose that S($/) = 1.50
i.e. $1.50 = 1.00
and that S(/) = 50
i.e. 1.00 = 50
What must the $/ cross rate be?
$1.50 1.00 $1.50
=
1.00 50 50
$1.00 = 33.33
$0.0300 = 1
 Triangular Arbitrage

Suppose we observe
these banks posting $
these exchange rates.
Barclays
Credit Lyonnais
S(/$)=120
S(/$)=1.50

Credit Agricole
First calculate any implied
cross rate to see if an
arbitrage exists. S(/)=85

1.50 $1.00 1.00

=
$1.00 120 80
 Triangular Arbitrage
As easy as 1 2 3:
$
1. Sell our $ for , Barclays
2. Sell our for , Credit Lyonnais
S(/$)=120 3 1
3. Sell those for $. S(/$)=1.50
2

Credit Agricole

S(/)=85
 Triangular Arbitrage
Sell $100,000 for at S(/$) = 1.50
receive 150,000
Sell our 150,000 for at S(/) = 85
receive 12,750,000
Sell 12,750,000 for $ at S(/$) = 120
receive $106,250
profit per round trip = $106,250 $100,000 = $6,250
 Triangular Arbitrage
Here we have to go clockwise to
make moneybut it doesnt
matter where we start.
$
Barclays
Credit Lyonnais
S(/$)=120 2 3 S(/$)=1.50
1

Credit Agricole

S(/)=85
If we went counter clockwise we would be the source of arbitrage profits, not the
recipient!
 Triangular Arbitrage
As a quick spot method for triangular arbitrage, write the three rates out with
a different denominator in each:
1.3285 CHF / USD
0.00851 USD / JPY
88.20 JPY / CHF
If there is parity:
CHF USD JPY
=1
USD JPY CHF

If this is greater, or less than, 1 an arbitrage opportunity exists.

An answer < 1 means that one of the component rates (fractions) is too low. An
answer > 1 mean that one of the rates is too high.
If the total is less than one, assume that any of the fractions is too low, e.g. CHF/USD.
This would imply that CHF is too low (overvalued vs USD) or USD is too high
(undervalued vs CHF); this tells us to either buy the undervalued or sell the
overvalued currency.
 The Forward Market
A forward contract is an agreement to buy
or sell an asset in the future at prices
agreed upon today.
 Forward Rate Quotations
The forward market for FX involves
agreements to buy and sell foreign
currencies in the future at prices agreed
upon today.
Bank quotes for 1, 3, 6, 9, and 12 month
maturities are readily available for forward
contracts.
Non Deliverable Forwards
 Forward Rate Quotations
Consider the example from above:
for British pounds, the spot rate is
$1.9077 = 1.00
While the 180-day forward rate is
$1.8904 = 1.00
Whats up with that?
 USD
equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday
Argentina
(Peso) 0.3309 0.3292 3.0221 3.0377
Australia
(Dollar) 0.7830 0.7836 1.2771 1.2762
Brazil (Real) 0.3735 0.3791 2.6774 2.6378 Clearly the market
Britain participants
(Pound) 1.9077 1.9135 0.5242 0.5226 expect that the
1 Month pound will be
Forward 1.9044 1.9101 0.5251 0.5235
worth less in
3 Months dollars in six
Forward 1.8983 1.9038 0.5268 0.5253
months.
6 Months
Forward 1.8904 1.8959 0.5290 0.5275
Canada
(Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month
Forward 0.8037 0.8069 1.2442 1.2393
3 Months
Forward 0.8043 0.8074 1.2433 1.2385
6 Months
Forward 0.8057 0.8088 1.2412 1.2364
 Forward Rate Quotations
Consider the (dollar) holding period return of
a dollar-based investor who buys 1 million
at the spot and sells them forward:
gain $1,890,400 $1,907,700 $17,300
$HPR= = =
pain $1,907,700 $1,907,700

$HPR = 0.0091

Annualized dollar HPR = 1.81% = 0.91% 2

 Forward Premium
The interest rate differential implied by
forward premium or discount.
For example, suppose the is appreciating
from S($/) = 1.25 to F180($/) = 1.30
The 180-day forward premium is given by:
F180($/) S($/) 360 1.30 1.25
f180,v$ = = 2 = 0.08
S($/) 180 1.25
 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.
 Payoff Profiles
profit If you agree to sell anything in the future at a set
price and the spot price later falls then you gain.

S180($/)
0

F180($/) = .009524
If you agree to sell anything in the future at a set
price and the spot price later rises then you lose.

loss Short position

 Payoff Profiles
profit
short position
Whether the payoff
profile slopes up or down
depends upon whether
you use the direct or
indirect quote:

0 F (/$) = 105 or
S180(/$)180
F180($/) = .009524.
F180(/$) = 105

-F180(/$)
loss
 Payoff Profiles
profit
short position

S180(/$)
0

F180(/$) = 105
When the short entered into this forward
contract, he agreed to sell in 180 days at
-F180(/$)
loss F180(/$) = 105
 Payoff Profiles
profit
short position

15

S180(/$)
0
120
F180(/$) = 105
If, in 180 days, S180(/$) = 120, the short will make
a profit by buying at S180(/$) = 120 and
-F180(/$)
loss delivering at F180(/$) = 105.
 Payoff Profiles
profit Since this is a zero-sum game, the long position
F180(/$) payoff is the opposite of the short. short position

S180(/$)
0

F180(/$) = 105

-F180(/$) Long position

loss
 Payoff Profiles
profit
The long in this forward contract agreed to BUY
-F180(/$)
in 180 days at F180(/$) = 105
If, in 180 days, S180(/$) = 120, the long will
lose by having to buy at S180(/$) = 120
and delivering at F180(/$) = 105.
S180(/$)
0
120
F180(/$) = 105
15
Long position
loss
 Interest Rate Parity Defined
IRP is an arbitrage condition.
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 dont typically observe persistent
arbitrage conditions, we can safely
assume that IRP holds.
 Interest Rate Parity Carefully
Defined
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
exchangeFuture
ratevalue
risk by selling
= $100,000(1 + i)
the future F
value
$/ of the
British investment forward. S$/
Since these investments have the same risk, they must have the same future value
(otherwise an arbitrage would exist)

(1 + i)
F $/
= (1 + i$)
S $/
 Alternative 2: $1,000 IRP
Send your $ on
S$/
a round trip to
Step 2:
Britain
Invest those
pounds at i
$1,000 Future Value =
$1,000
(1+ i)
S$/
Step 3: repatriate
Alternative 1: future value to the
invest $1,000 at i$ U.S.A.
$1,000
$1,000(1 + i$) = (1+ i) F$/
S$/
IRP

Since both of these investments have the same risk, they must have the same future value
otherwise an arbitrage would exist
 Interest Rate Parity Defined
The scale of the project is unimportant

$1,000
$1,000(1 + i$) = (1+ i) F$/
S$/

F$/
(1 + i$) = (1+ i)
S$/
 Interest Rate Parity Defined
Formally, 1+i $ F $/
=
1+i S
$/

IRP is sometimes approximated as

i$ i FS

S
 Forward Premium
Its just the interest rate differential implied
by forward premium or discount.
For example, suppose the is appreciating
from S($/) = 1.25 to F180($/) = 1.30
The forward premium is given by:

F180($/) S($/) 360 $1.30 $1.25

f180,v$ = = 2 = 0.08
S($/) 180 $1.25
 Interest Rate Parity Carefully
Defined
Depending upon how you quote the
exchange rate ($ per or per $) we have:

1 + i F /$ 1+i $ F $/
= or
=
1 + i$ S/$ 1+i S
$/

so be a bit careful about that

 IRP and Covered Interest
Arbitrage
If IRP failed to hold, an arbitrage would exist.
Its easiest to see this in the form of an
example.
Consider the following set of foreign and
domestic interest rates and spot and
forwardSpotexchange
exchange rate rates.
S($/) = $1.25/
360-day forward rate F360($/) = $1.20/
U.S. discount rate i$ = 7.10%
British discount rate i = 11.56%
 IRP and Covered Interest
Arbitrage
A trader with $1,000 could invest in the U.S. at 7.1%, in
one year his investment will be worth
$1,071 = $1,000 (1+ i$) = $1,000 (1,071)
Alternatively, this trader could
1. Exchange $1,000 for 800 at the prevailing spot
rate,
2. Invest 800 for one year at i = 11,56%; earn
892,48.
3. Translate 892,48 back into dollars at the forward
rate F360($/) = $1,20/, the 892,48 will be exactly
$1,071.
Alternative 2:
Arbitrage I
buy pounds
800
1 Step 2:
800 = $1,000
$1.25 Invest 800 at
i = 11.56%
$1,000 892.48 In one year 800
will be worth
Step 3: repatriate 892.48 =
to the U.S.A. at 800 (1+ i)
F360($/) = $1.20/

Alternative 1:
invest $1,000 $1,071 F(360)
at 7.1% $1,071 = 892.48
1
FV = $1,071
 Interest Rate Parity
& Exchange Rate Determination
According to IRP only one 360-day forward
rate,
F360($/), can exist. It must be the case that

F360($/) = $1.20/
Why?
If F360($/) $1.20/, an astute trader could
make money with one of the following
strategies:
 Arbitrage Strategy I
If F360($/) > $1.20/
i. Borrow $1,000 at t = 0 at i$ = 7.1%.
ii. Exchange $1,000 for 800 at the
prevailing spot rate, (note that 800 =
$1,000$1.25/) invest 800 at 11.56% (i)
for one year to achieve 892.48
iii. Translate 892.48 back into dollars, if
F360($/) > $1.20/, then 892.48 will be
more than enough to repay your debt of
$1,071.
Step 2: Arbitrage I
buy pounds
800
1 Step 3:
800 = $1,000
$1.25 Invest 800 at
i = 11.56%
$1,000 892.48 In one year 800
will be worth
892.48 =
Step 4: repatriate 800 (1+ i)
to the U.S.A.
Step 1:
borrow $1,000 More F(360)
Step 5: Repay than $1,071 $1,071 < 892.48
1
your dollar loan
with $1,071.
If F(360) > $1.20/ , 892.48 will be more than enough to
repay your dollar obligation of $1,071. The excess is your profit.
 Arbitrage Strategy II

If F360($/) < $1.20/

i. Borrow 800 at t = 0 at i= 11.56% .
ii. Exchange 800 for $1,000 at the
prevailing spot rate, invest $1,000 at 7.1%
for one year to achieve $1,071.
iii. Translate $1,071 back into pounds, if
F360($/) < $1.20/, then $1,071 will be
more than enough to repay your debt of
892.48.
Step 2:
buy dollars Arbitrage II
800
$1.25
$1,000 = 800 Step 1:
1
borrow 800
$1,000
More Step 5: Repay
Step 3: your pound
Invest $1,000 than
892.48 loan with
at i$
892.48
Step 4:.
repatriate to
the U.K.
In one year $1,000
F(360)
will be worth $1,071 $1,071 > 892.48
1

If F(360) < $1.20/ , $1,071 will be more than enough to repay

your dollar obligation of 892.48. Keep the rest as profit.
 IRP and Hedging Currency Risk
You are a U.S. importer of British woolens and have just
ordered next years inventory. Payment of 100M is due in
one year.
Spot exchange rate S($/) = $1.25/
360-day forward rate F360($/) = $1.20/
U.S. discount rate i$ = 7.10%
British discount rate i = 11.56%

IRP implies that there are two ways that you fix the cash outflow to a
certain U.S. dollar amount:
a) Put yourself in a position that delivers 100M in one yeara long
forward contract on the pound.
You will pay (100M)(1.2/) = $120M in one year.
b) Form a forward market hedge as shown below.
 IRP and a Forward Market
Hedge
To form a forward market hedge:
Borrow $112.05 million in the U.S. (in one year
you will owe $120 million).
Translate $112.05 million into pounds at the
spot rate S($/) = $1.25/ to receive 89.64
million.
Invest 89.64 million in the UK at i = 11.56%
for one year.
In one year your investment will be worth 100
millionexactly enough to pay your supplier.
 Forward Market Hedge
Where do the numbers come from? We owe our
supplier 100 million in one yearso we know that
we need to have an investment with a future value of
100 million. Since i = 11.56% we need to invest
89.64 million at the start of the year.
100
89.64 =
1.1156

How many dollars will it take to acquire 89.64 million at the start of the year if S($/) =
$1.25/?

$1.00
$112.05 = 89.64
1.25
 Is the Forward Rate a good
predictor of future spot?
FORWARD RATES AS PREDICTORS OF
FUTURE SPOT RATES
12 month forward rates from
November 05 to May 06
 and the spot rate 12 months later
Forecasts
Forecasts
 Purchasing Power Parity and
Exchange Rate Determination
The exchange rate between two currencies
should equal the ratio of the countries price
levels: P$
S($/) =
P
For example, if an ounce of gold costs $300 in
the U.S. and 150 in the U.K., then the price of
one pound in terms of dollars should be:
P$ $300
S($/) = = 150 = $2/
P
USD/JPY PPP
 Purchasing Power Parity and
Exchange Rate Determination
Suppose the spot exchange rate is $1.25 =
1.00
If the inflation rate in the U.S. is expected to be
3% in the next year and 5% in the euro zone,
Then the expected exchange rate in one year
should be $1.25(1.03) = 1.00(1.05)

F($/) = $1.25(1.03) = $1.23

1.00(1.05) 1.00
 Purchasing Power Parity and
Exchange Rate Determination
The euro will trade at a 1.90% discount in the forward
market:
$1.25(1.03)
F($/) 1.00(1.05) 1.03 1 + $
= = =
S($/) $1.25 1.05 1 +
1.00

Relative PPP states that the rate of change in the

exchange rate is equal to differences in the rates of
inflationroughly 2%
 Purchasing Power Parity
and Interest Rate Parity
Notice that our two big equations today
equal each other:

PPP IRP
F($/) 1 + $ 1 + i$ F($/)
= = =
S($/) 1 + 1 + i S($/)
 Expected Rate of Change in
Exchange Rate as Inflation
Differential
We could also
reformulate our F($/) 1 + $
=
equations as inflation or S($/) 1 +
interest rate differentials:
F($/) S($/) 1 + $ 1 + $ 1 +
= 1=
S($/) 1 + 1 + 1 +

F($/) S($/) $
E(e) = = $
S($/) 1 +
 Expected Rate of Change in
Exchange Rate as Interest Rate
Differential

F($/) S($/) i$ i
E(e) = = i$ i
S($/) 1 + i
 Quick and Dirty Short Cut
Given the difficulty in measuring expected
inflation, managers often use

$ i$ i
 Currency Strategies
Momentum trading seeks to take advance of
market trends, purchasing currencies with the
best recent performance and selling the weakest
performers.
Mean reversion strategies in are some ways
the opposite of momentum strategies. It is based
on the idea that currencies are prone to move too
far too fast and then are reversed in part or in full.
Carry trades seek to take advantage of interest
rate differentials, selling low yielding currencies
and buying higher yielding currencies.
 Currency Swaps
In a plain vanilla cross-currency swap transaction, one party
typically holds one currency and desires a different currency.

Each party will then pay interest on the currency it receives in the
swap and the interest payment can be made at either a fixed or a
floating rate.

Contrary to the Interest Rate Swap there is an actual exchange of

cash flow at initiation

Frequent bond issuers often issue bonds in currencies demanded by

investors.
 Cross-Currency Swaps
Positions
Party A holds
Party B holds $

4 Possibilities:
A pays fixed rate on $ received and B pays fixed rate
on received.
A pays floating rate on $ received and B pays fixed
rate on received.
A pays fixed rate on $ received and B pays floating
rate on received.
A pays floating rate on $ received and B pays floating
rate on received.
 Example of a Currency Swap
Below are cash flows for 10m 4 year swap 5% fixed for fixed / $:
US Interest Rates: 10% UK Interest Rates 8% Party A holds 10m
From the perspective of A
Receive $20m Receive 0.8m Receive Receive Receive
0.8m 0.8m 10.8m

Termination
date

Pays Pay Pay Pay Pay

10m $2m $2m $2m $22m
Contrary to
IRS there is
exchange of
cash flows at
initiation and
termination
Other Instruments in International
Finance
EUROCURRENCY MARKETS

EUROBOND MARKETS