International Financial Management:

Introduction & Basic Concepts

Arie E. Gozluklu

Warwick Business School

Week 1

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De…nition of Exchange Rates
The exchange rate is the price of one currency in terms of another

Commodity Currency
1 Book 62 GBP 100 USD 62 GBP

Functions of money
medium of exchange, unit of account, store of value

What is the value of money?

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Currency Abbreviations

The International Organization for Standardization (ISO 4217):

two-digit country code + a letter from the name of the currency

The notation for the US dollar is USD (vehicle currency), British pound
GBP, Euro EUR , Japanese yen JPY, Swiss franc CHF

Australian Dollar: AUD

Brazilian Real: BRL

Canadian Dollar: CAD

Yuan/Renminbi: CNY

Precious Metals: Gold XAU, Silver XAR

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Currency Nicknames

Traders also use nicknames to describe currencies

Symbol Country Curreny Nickname Sign

USD United States Dollar Buck $
EUR Euro zone Euro Fiber e
GBP United Kingdom Pound Cable £
CHF Switzerland Franc Swissy SFr
CAD Canada Dollar Loonie C$
AUD Australia Dollar Aussie A$
NZD New Zealand Dollar Kiwi NZ$

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Alternative Exchange Rate Regimes

Floating Currencies
freely determined in the FX market
e.g. AUD, USD, JPY, GBP
Managed Floating
monetary authorities intervene
e.g. ARS, BRL, MXN, ZAR
Fixed or Pegged Currencies
against a single currency or basket of currencies
e.g. SDR (special drawing rights), CNY, NAD, DKK
No Separate Legal Tender
e.g. Euro area, Ecuador, San Marino, Zimbabwe

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Direct Quotation

The direct quotation between the domestic currency D and a

foreign currency F gives the domestic currency price of one unit of
foreign currency.

How many units of domestic currency

per unit of foreign currency?

Foreign currency as base currency and domestic currency as

pricing currency.

A higher level of the exchange rate implies appreciation of the foreign

currency and depreciation of the domestic currency, and vice versa.
Direct quotation from the US perspective: American terms

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Direct Quotation

Example (Perspective of a US investor)

On 13 January 2012
USD1.2667/EUR
which is the price of one Euro (foreign currency) in terms of US Dollar.

On 13 January 2013
USD1.3366/EUR
which indicates an increase in the price of one Euro in terms of US dollar:
=) appreciation of EUR (foreign currency)
=) depreciation of USD (domestic currency)

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Direct Quotation of EUR from the US perspective
2012 (First half) ) EUR depreciation
2012 (Second half) ) EUR appreciation

Source: Thomson Reuters Datastream

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Direct Quotation of USD from the UK perspective
Long (40 years) vs. short (1 year) sample

Source: Thomson Reuters Datastream

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Indirect Quotation

The indirect quotation between the domestic currency D and a

foreign currency F gives the foreign currency price of one unit of
domestic currency.

How many units of foreign currency

per unit of domestic currency?

Domestic currency as base currency and foreign currency as

pricing currency.

A higher level of the exchange rate implies appreciation of the

domestic currency and depreciation of the foreign currency, and vice
versa.
Indirect quotation from the US perspective: European terms
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Indirect Quotation

Example (Perspective of a US investor)

On 13 January 2012
EUR0.7895/USD
which is the value of one US Dollar (domestic currency) in terms of Euro.

On 13 January 2013
EUR0.7482/USD
which indicates a decrease in the value of one US Dollar with respect to
Euro
=) appreciation of EUR (foreign currency)
=) depreciation of USD (domestic currency)

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Indirect Quotation of EUR from the US perspective

mirror image of direct quotation from the US perspective

Source: Thomson Reuters Datastream

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Direct vs Indirect Quotation
A direct quotation from the perspective of one country is an indirect
quotation from the perspective of another.

For instance, the exchange rate between Japan and Australia

JPY 94.37/AUD

is the direct quotation from a Japanese perspective but indirect

quotation from a Australian perspective.

The direct quotation is the reciprocal of the indirect quotation (and

vice versa)
1
AUD0.0106/JPY =
| {z } JPY 94.37/AUD
Direct Quotation for AUD | {z }
Indirect Quotation for AUD

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Appreciation vs. Depreciation: USD / EUR
Let S = A/B , where A is the pricing currency and B is the base currency
Example
S0 : spot rate at time 0 (13 Jan-12), S1 : at time 1 (13 Jan-13)

Computing (base) currency appreciation: B = EUR

( S1 S0 )
= (1.3366-1.2667)/1.2667=0.055
S0
=) EUR appreciated 5.5% against USD

Computing (pricing) currency depreciation: A = USD

(1/S1 1/S0 ) ( S0 S1 )
= = (1.2667-1.3366)/1.3366=-0.052
1/S0 S1
=) USD depreciated 5.2% against EUR

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Continuously Compounding

Annual (n=1) rates with k times compounding) appreciation

" 1 #
a k n S1 k n
S0 ( 1 + ) = S1 ) a = k 1
k S0

Annual rates (n=1) with k times compounding) depreciation

2 !k1n 3
0
0 d k n 0 S1
S0 ( 1 ) = S1 ) d = k 4 1 0
5
k S0
0 1 0 1
S0 = ,S =
S0 1 S1
Continuous compounding: k ! ∞
appreciation: S0 e a = S1 ) a = s1 s0 , ln St = st
0 0 0 0 0 0
depreciation: S0 e d = S1 ) d = s0 s1 , ln St = st

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What is used in practice?

Exchange rates are generally expressed as units of foreign currency

per unit of US Dollar
indirect quotation from a US perspective (JPY 89.40/USD)

There are some exceptions to this rule:

direct quotation for the USD against the EUR (USD1.3366/EUR)
direct quotation for the USD against the GBP (USD1.6067/GBP)
direct quotation for the USD against the former British
Commonwealth countries (Australia, New Zealand, South Africa).

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Di¤erent Notation
Most textbooks use
S = A/B = pricing currency / base currency

meaning units of currency A per unit of base currency B

For example, on 15 January 2013

USD/GBP = 1.61076

means 1.61076 units of US dollar to buy 1 unit of British pound

USD as domestic currency, GBP as or foreign currency

But: Forex trading platforms/banks/media use di¤erent notation:

base currency / pricing currency
base currency : pricing currency
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Cross Exchange Rate

The cross exchange rate is the exchange rate between two currencies
derived from their exchange rates against another currency.

If A, B , and C are three currencies, then

A/C
A/B =
B /C
In practice, C is the USD because exchange rates are normally quoted
against the US dollar whereas not all possible combinations of
bilateral exchange rates are available.

The cross exchange rate may be de…ned as the exchange rate between
two currencies, neither of which is the US dollar.

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Cross Exchange Rate

Bilateral Currency Rates

Country USD EUR GBP
Argentine Peso ARS 4.9510 6.6086 7.9662
Indian Rupee INR 54.6000 72.8801 87.8514
Norwegian Krone NOK 5.5652 7.4284 8.9543
Thai Baht THB 30.0300 40.0841 48.3183
Source: Financial Times, 15 January 2013

Example

THB/USD 30.0300
THB/ARS = = = 6.0654
ARS/USD 4.9510
INR/GBP 87.8514
INR/NOK = = = 9.8111
NOK/GBP 8.9543

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Cross Exchange Rate

Given N currencies, we can determine N (N 1)/2 cross exchange rates.

Cross Currency Rates

Country ARS AUD BRL CAD CNY
Argentina ARS 1 5.2237 2.4295 5.0330 0.7968
Australia AUD 0.1914 1 0.4651 0.9635 0.1525
Brazil BRL 0.4116 2.1501 1 2.0717 0.3280
Canada CAD 0.1987 1.0389 0.4827 1 0.1583
China CNY 1.2550 6.5558 3.0490 6.3166 1
Source: Financial Times, 15 January 2013

The upper triangular matrix is the reciprocal of the lower triangular one

AUD/ARS = 0.1914 and ARS /AUD = 5.2237

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The Bid-Ask Spread

Market makers quote exchange rates in terms of two numbers

the bid(ask) rate is the rate at which the dealer is willing to buy(sell)
the midquote is the average of the bid and ask rates
The ask rate is higher than the bid rate (positive bid/ask spread)

Bid-Ask Spread = (A/B)ask (A/B)bid

Percentage bid-ask spread

Bid-Ask Spread (A/B)ask (A/B)bid

=
midquote ((A/B)ask + (A/B)bid )/2

Note: (A/B)bid = 1/(B /A)ask , (A/B)ask = 1/(B /A)bid

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The Bid-Ask Spread: Example

Example (Source: OANDA, On 15 January 2013)

US Dollar - Euro: USD/EUR
Bid rate: you sell 1 EUR, you get 1.33690USD.
Ask rate: you buy 1 EUR, you pay 1.33702USD.
=) Bid-Ask spread of 1.2 bp (or pip)
=) Percentage Bid-Ask spread of 0.9 bp (or pip)
US Dollar - Botswana Pula: USD/BWP
Bid rate: you sell 1 BWP, you get 0.12536USD.
Ask rate: you buy 1 BWP, you pay 0.12924USD.
=) Bid-Ask spread of 38.8 bp (or pip)
=) Percentage Bid-Ask spread of 305 bp (or pip)

Note: Actively traded pairs typically have a lower bid-ask spread. Why?

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Bid-Ask Spread Determination

The market maker obtains compensation for three main determinants

Cost of Dealer Services
compensation for providing liquidity
the cost of acquiring know-how
subscriptions to electronic information and trading systems (Reuters)
Adverse Selection
dealers and customers have asymmetric information (access to
di¤erent information)
the dealer cannot distinguish between a liquidity-motivated customer
and an insider (private information)

Inventory Risk
compensation for inventory holdings (there is an opportunity cost of
holding currency)

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Foreign Exchange Market

The foreign exchange market (FX or FOREX market)

is the largest …nancial market in terms of trading volume (turnover)
the trading activity follows the sun around the globe

Unlike the stock or futures markets, which are organised exchanges,

the FX market is mainly an over-the-counter (OTC) market
buyers and sellers are linked via a network of telephones, computer
terminals and automated dealing systems (e.g. Reuters, EBS)

Three market segments and major trading centres

Australasia (Sydney, Tokyo, Hong Kong, Singapore, and Bahrain)
Europe (Zurich, Frankfurt, Paris, and London)
North America (New York, Toronto, Chicago, and San Francisco)

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FX Market Activity

Highly active and highly decentralized market with non-stop trading

exchange rate and market conditions can change very fast
Activity is not regular but follows a cycle (market liquidity)
periods of very heavy activity and periods of relatively light activity
most of the trading takes place when the largest number of potential
counterparties is available on a global basis
sellers (buyers) want to sell (buy) when they have access to the
maximum number of potential buyers (sellers)

Heavy business when US markets and the European markets overlap

morning in New York and afternoon in London
little activity after European markets have closed and before the Tokyo,
Hong Kong, and Singapore markets have opened.

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AROUND THE CLOCK (GMT)

Activity is highest in the beginning hours of the three major currency

markets— Tokyo, London, and New York.
It decreases around lunch time

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AROUND THE CLOCK (GMT)

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FX Market Participants
Interbank market and retail market
direct Interbank: Reuters Dealing 2000-1
brokered Interbank: Reuters Dealing 2000-2 and EBS
retail: FX connect, FXall, Currenex
Dealers trade for their own account) inventory
bank dealers (international banks)
non-bank dealers (investment banks, pension funds and hedge funds)

Brokers match dealer orders to buy and sell currency for a fee
they do not take a position but act as intermediary for one or both
sides of the transaction

Customers use the services of international banks to buy and sell

foreign currencies for international trade and investment operations

Central banks may intervene to a¤ect the exchange rate level

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Example: Swiss Case

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Customer Types in Retail Segment

Parties involved in International Trade

import/export foreign good and services
hedging against transaction/operational risks
Financial Investment
internationally diversi…ed portfolio
manage exchange rate exposure
Feedback customers
technical/chartist algorithms using benchmarks (e.g. trends)
"pull" (passive) customers vs. "push" (active) customers
Non-feedback customers
e.g. hedge-funds, currency overlay managers
speculators

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Interdealer market

Interdealer market declines, around 39% of spot trading (BIS, 2010)

OTC market with market makers
FX electronic trading platforms run by brokers
EBS: EUR, JPY, CHF
Reuters: GBP, AUD, CAD
illiquid currencies over voice brokers
Dealers prefer zero inventory
try to pass on inventory to other dealers)"hot potato trading "
spreads highest during overnight period (19.00pm-22.00pm GMT)
for liquid (illiquid) currencies, interdealer spread around 0.5-2 (40) pips
(Osler et al., 2011)
to attract customer information) narrow spreads for large trades

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FX Market Turnover by Counterparty

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Unique Features (King et al., 2011)

FX market is mainly unregulated, but

market conventions and best practices, e.g. front-running
short-sale restrictions cannot be de…ned
very liquid, hence manipulation by single players unlikely
Minimal reporting requirements, lack of aggregate data
Triennial BIS survey
most research via proprietary data from banks/brokers
Information sources
dealers (Rime, Sarno and Sojli, 2010)
leveraged investors)hedge funds, commodity trading advisors (CTA)
central banks are important players) intervention (e.g. Swiss case)

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BIS Survey

The BIS Triennial Survey provides a comprehensive source of

information on the size and structure of the FX market

statistics are not immediately available for an OTC market

worldwide cooperative e¤ort coordinated by the Bank for International
Settlements (BIS) every three years
latest survey, in 2010 (since 1989), carried out by 53 central banks and
monetary authorities (data from 1309 banks)

Global Turnover
average daily turnover is $4 trillion ($3.3 trillion in 2007)
20% increase in activity in FX market compared to 2007 (72% rise in
activity between 2004 and 2007)
London is the most active trading centre (37% of total turnover),
followed by New York (18%), Tokyo (6%), and Singapore (5%).

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Geographical Distribution

Table 1.2 Geographical Distribution of FX Market Turnover

(Daily Average in USD billions)

1995 1998 2001 2004 2007 2010

United Kingdom 479 685 542 835 1483 1854

United States 266 383 273 499 745 904
Japan 168 146 153 207 250 312
Singapore 107 145 104 134 242 266
Hong Kong 91 80 68 106 181 238
Switzerland 88 92 76 85 254 263
Australia 41 48 54 107 176 192
China ... 0.2 0.0 0.6 9.3 19.8
Source: Bank for International Settlement (2010)

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FX Market Turnover by Currency Pair

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FX Market by delivery date
A spot exchange rate is the quotation for immediate exchange of
the currencies
cash settlement is made two business days later
one day between Canada and the US and between Mexico and the US

A forward exchange rate (or outright forward) is a rate agreed

today for the delivery of a currency at a speci…ed date in the future
forward rate higher/lower than spot rate (premium/discount)
quotes for maturities of 1,3,6,9, and 12 months are readily available,
quotes beyond 1 year becoming more frequent

A foreign exchange swap is the simultaneous sale of a currency for

spot delivery and purchase of that currency for forward delivery
generally used to manage the maturity structure of currency positions

A currency swap is the exchange of debt service obligations of a

bond/loan denominated in two di¤erent currencies
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Global FX Market Turnover by Instrument

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FX Market by delivery date

Example
Consider the following quotations for the USD/EUR

S (USD/EUR ) = 1.3348
F1 (USD/EUR ) = 1.3351
F3 (USD/EUR ) = 1.3357
F12 (USD/EUR ) = 1.3387

Source: Financial Times, 15 January 2013

From these quotations, we can see that USD/EUR is quoted at a

premium and the premium increases out to one year.

The market expects the Euro to appreciate relative to the US dollar.

It costs more dollars to buy Euro forward.

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FX Market by delivery date

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FX Market by delivery date

Example
Consider the following quotations for the USD/GBP

S (USD/GBP ) = 1.6090
F1 (USD/GBP ) = 1.6087
F3 (USD/GBP ) = 1.6084
F12 (USD/GBP ) = 1.6064

Source: Financial Times, 15 January 2013

From these quotations, we can see that USD/GBP is quoted at a

discount and the discount increases out to one year.

The market expects the British pound to depreciate relative to the

US dollar. It costs less dollars to buy a pound forward.

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What drives trading activity?

Momentum trading (buy “winners” and sell “losers”)

systematic purchase of currencies with persistent trend of appreciation
and sale of currencies with clear trend of depreciation
high-frequency algorithmic trading

Hedging Activity
multinational …rms tend to minimize the exposure to exchange rate risk
after the crisis, many market participants involve in FX hedging
minimize " embarrassement risk"

Arbitrage or Speculation
are there new arbitrage opportunities?

speculative strategies, e.g. carry trades

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High Trading Activity

Many trading platforms (e.g OANDA) support margin

(colateral)-based trading
leverage ) easy access with limited resources
Arbitrage
spatial arbitrage
triangular arbitrage
covered interest rate arbitrage
price latency arbitrage
Speculation based on di¤erent factors
fundamentals, interest rate di¤erentials, momentum, volatility
di¤erent views on making money

With excessive leverage traders pick up nickels in front of a bulldozer.

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How does Leverage work in FX market?

Net Asset Value (NAV) is the account balance plus unrealized

pro…ts/losses.

Trading platforms allow di¤erent leverage ratios

e.g. OANDA 20:1(illiquid pairs) or 50:1 leverage(liquid pairs)
A margin closeout (margin call) is triggered if your NAV drops to
half the margin required by your open trades.

Example
Assume that you have £ 1000 to trade. At 20:1(50:1) leverage, you can
open a position for £ 20,000(£ 50,000).

If the price moves up 100pips ) NAV=£ 1200(£ 1500)

If the price moves down 100pips ) NAV=£ 800(£ 500)

Note: In the second case (down movement), at 50:1 leverage, the open position
is automatically closed.
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Spatial Arbitrage

Law of one price

Identical assets in di¤erent markets must have the same price
buy the underpriced and the sell the overpriced currency
riskless pro…t without any initial investment

Spatial arbitrage arises when the exchange rate between two given
currencies assumes two di¤erent values in two …nancial centres at the
same time

Equilibrium
the exchange rate A/B in two di¤erent locations

(A/B)1 = (A/B)2

if this condition is violated, arbitrage restores the equilibrium condition

via changes in the forces of supply and demand

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Bid-Ask Spread Arbitrage

Equilibrium
Any two banks’quotes should overlap by at least one point

Violation (A/B)bid ask

1 > (A / B)2

pro…t by buying B at (A/B)ask bid

2 and selling it for (A / B)1

Example
Bank A Bank B
USD/GBP 1.5888/1.5892 1.5782/1.5788

buy 1 GBP from B (at 1.5788) and resell it to B (at 1.5888)

net pro…t worth 0.01 USD for each GBP purchased

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Triangular Arbitrage

Trading sequentially three currencies

misalignment between bilateral and cross exchange rates

Clockwise direction
A/C
A/B <
B /C
1 sell A and buy B
2 sell B and buy C
3 sell C and buy A

Arie E. Gozluklu (WBS) IB9Y40 Week 1 47 / 54

Triangular Arbitrage
Counterclockwise direction
A/C
A/B >
B /C
1 sell A and buy C
2 sell C and buy B
3 sell B and buy A

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Triangular No-Arbitrage

No arbitrage condition

A/C A B C
A/B = ) =1
B /C B C A
A B C
< 1 ) clockwise strategy
B C A
A B C
> 1 ) counter-clockwise
B C A

The same no arbitrage condition holds for more currency pairs

A B C D E
=1
B C D E A

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Triangular Arbitrage Example

Example
Exchange rates are quoted in London, Kuala Lumpur and New York:

USD/GBP = 1.5785
MYR/GBP = 4.8672
USD/MYR = 0.3259

Equilibrium condition

USD USD/GBP 1.5785

0.3259 = > = = 0.3243
MYR MYR/GBP 4.8672

Counter-clockwise triangular arbitrage

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Triangular Arbitrage Example

Example
Strategy 1: USD =) MYR =) GBP =) USD
1 Sell 1 USD for MYR =) 1 = 3.0684 MYR
0.3259
2 Sell 3.0684 MYR for GBP =) 3.0684 = 0.6304 GBP
4.8672
3 Sell 0.6304 GBP for USD =) 0.6304 1.5785 = 0.9951 USD
Loss-making sequence!!!

Strategy 1: USD =) GBP =) MYR =) USD

1 Sell 1 USD for GBP =) 1 = 0.6335 GBP
1.5785
2 Sell 0.6335 GBP for MYR =) 0.6335 4.8672 = 3.0834 MYR
3 Sell 3.0834 MYR for USD =) 3.0834 0.3259 = 1.0049 USD
Pro…table sequence (49bp)!!!

Arie E. Gozluklu (WBS) IB9Y40 Week 1 51 / 54

Accounting for Bid/Ask Spread

Example
In reality, exchange rates are quoted with a bid/ask spread:

USD/GBP = 1.5783/1.5787
MYR/GBP = 4.8668/4.8676
USD/MYR = 0.3256/0.3262

Strategy 1: USD =) GBP =) MYR =) USD

1 Sell 1 USD for GBP =) 1 = 0.6334 GBP
1.5787
2 Sell 0.6334 GBP for MYR =) 0.6334 4.8668 = 3.0826 MYR
3 Sell 3.0826 MYR for USD =) 3.0826 0.3256 = 1.0037 USD
Still Pro…table (37bp), 12bp transaction costs!

Arie E. Gozluklu (WBS) IB9Y40 Week 1 52 / 54

Bottomline

Warren Bu¤ett:

Rule No.1: Never lose money.

Rule No.2: Never forget rule No.1

Arie E. Gozluklu (WBS) IB9Y40 Week 1 53 / 54

References

Bekaert and Hodrick (BH, Ch. 2)

Bank for International Settlements (2010), “Triennial Central Bank
Survey of Foreign Exchange and Derivatives Market Activity,” Basel.
(http://www.bis.org/publ/rpfx10.pdf).
King, M.R. and D. Rime (2010). “The $4 Trillion Question: What
explains FX Growth since the 2007 Survey,” BIS Quarterly Review.
King, M.R, C. Osler, and D. Rime (2011). “Foreign Exchange Market
Structure, Players and Evolution,” Working paper, Norges Bank.

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