Financial Markets. What are Financial Markets? Major Financial Markets. Advanced Corporate Finance

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1 Financial Markets Spring 2008 Wat are Financial Markets? A financial market is a mecanism tat allows people to buy and sell financial securities, commodities, and oter fungible financial assets wit low transaction costs. Markets work by bringing interested buyers and sellers togeter. An economy wic relies primarily on te interactions between buyers and sellers to allocate resources is known as a market economy. (wat is a planned economy?) Financial markets facilitate: Te raising of capital (capital markets); Te transfer of risk (derivatives markets); and Trade (capital, commodity and currency markets). Major Financial Markets Stock markets provide financing to firms troug te issuing of sares or common stock, and enable teir subsequent trading. Bond markets provide financing to firms troug te issuing of bonds, and enable teir subsequent trading. Money markets provide sort term debt financing and investment. Foreign excange markets facilitate te trading of currencies to facilitate global trade. Commodity markets Derivatives markets (futures, options, swaps etc.)

2 Alternative Financial Markets Islamic Finance a system of banking or banking activities tat are consistent wit Islamic law (Saria) principles and guided by Islamic economics. In particular, Islamic law proibits usury, te collection and payment of interest. Microfinance loans, savings, and oter basic financial services to small investors. Te financial services of microfinance usually involve small amounts of money small loans, small savings. Te accounts are too small for banks and regular financial institutions. Uses of Financial Markets Capital markets (stock, bond, money and many alternative markets) Suppliers and demanders of capital to come togeter to provide financing. Will be discussed in detail later in te course Derivatives markets (futures, options, swaps etc.) Derivative products are financial products wic are used to control risk or, in some cases, to exploit risk. (Wy called derivatives?) Foreign excange markets Allows for te conversion of currencies to facilitate trade or, increasingly, to speculate. We will start wit te foreign excange market. Wat is te Role of te FX Market? Transfer of Purcasing Power Example: A Britis firm buys US equipment; tis will involve a trade of pounds for U.S. dollars. Hedging of Foreign Excange Risk Tere are contracts tat allow market participants to convert currencies at known rates on a future date. Participants mainly banks, importers, and exporters. Recently speculators, edge funds, and oter large institutional investors ave also entered. Four major segments of te FX market: spot, forward (futures), options and swaps.

3 Factors Affecting te Excange Rate Te excange rate is determined by supply and demand: If consumers want Canadian products tey will buy dollars. Tis increases te demand for dollars and tus te Canadian dollar will appreciate (current account vs capital account?) If investors are concerned about te Canadian political situation, for example, tey will sell teir Canadian dollars. Tis increases te supply of Canadian dollars and tus decreases its value. Wat drives te apparent relationsip between te price of oil and te Canadian Dollar? Wat role is played by te current account, capital account in te value of te Canadian Dollar? US Dollar? Factors Affecting te Excange Rate Te role of economic forces suc as: inflation and interest rates? If inflation is iger in Canada tan elsewere, te value of te Canadian dollar will decrease faster tan oter currencies. If interest rates are iger (after adjusting for inflation) in Canada, investors may coose to invest in Canada increasing demand for te dollar. Wat do iger interest rates in Canada imply about investing in Canada? Wat is te carry trade? Wat is te role of Central Banks? Factors Affecting te Excange Rate In te longrun, te excange rate sould equate te value of goods, services and financial assets around te world. For goods: te cost of a pound of oranges sould be te same in Detroit and Windsor. If prices were lower in Detroit, everyone would buy in te US and te US dollar would appreciate until te prices were te same. For financial assets: te value of borrowing or lending in Canada and te US sould be te same in te longrun. If interest rates are iger in te US, investors will invest in te US and borrow in Canada unless investors view te US as riskier (i.e., expect te US dollar to depreciate relative to te Canadian dollar) Wat is tis called? Wat does it mean in te sortrun?

4 Current Events Wat is appening to te value of te Cinese currency and wy? Te yuan rose past 7 to te dollar for te first time since Cina scrapped its fixedexcange rate in /10/2008 Wat is appening to te value of te Icelandic Krona and wy? Last week te Icelandic Krona touced a record low against te Euro, tumbling anoter 6.2% it as fallen almost 25% tis year and 17.2% tis mont 03/23/2008 History of te Foreign Excange Market Following WW II, te world s major currencies were fixed relative to te U.S. dollar (Bretton Woods). Canges were rare and te result of sustained imbalances in global capital flows. Since 1973 tese currencies ave been floating and attempts to explain and predict teir movements ave been largely unsuccessful. Currently te foreign excange (FX) market is te largest financial market in te world operating 24 ours a day 7 days a week (mainly in Tokyo, London and NY): Avg trading volume in 2007 was $4.0 trillion US dollars/day 33% in te spot market, 61% in te forward and swap markets, and 6% in options History of te Canadian Dollar Created for te Province of Canada in 1854 to facilitate trade. Set at a fixed excange rate versus gold. Tis lasted until 1914, part way troug World War I. Te government froze gold s convertibility and te ability to move it abroad. Reinstated te Gold Standard in 1926, but broke down in Bretton Woods fixed or pegged te value of major currencies against te U.S. dollar after World War II (in 1944). Flexible or floating excange rate from 1950 until In 1961 reverted to a fixed excange rate. Floating excange rate since 1970 (oter major currencies ave been floating since 1972 and 1973).

5 Canada US dollar, 1860 to /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/2000 Source: GlobalFinData.com Canada US dollar, 1950 to present Source: Bank of Canada Location of FX Trading Activity Amount Sare (%) Amount Sare (%) Amount Sare (%) United Kingdom $ $ $1, % United States $ $ $ % Japan $ $ $ % Singapore $ $ $ % Germany $ $ $99 2.5% Switzerland $ $ $ % Hong Kong $ $ $ % France $ $ $ % Australia $ $ $ % Neterlands $ $ $24 0.6% Canada $ $ $60 1.5% Italy $ $ $36 0.9% Oter countries $ $ $ % Total $1, $2, $3, Source: Bank for International Settlements

6 Global FX Activity by Currency US dollar Euro Deutsce Mark Frenc Franc Oter EU currencies Japanese Yen Pound Sterling Swiss Franc Canadian Dollar Australian Dollar Note: tese add to 200% because eac foreign excange transaction involves two currencies Source: Bank for International Settlements FX Terminology (cont d) American terms number of $US per unit of foreign currency e.g., $US = $CAD 1.00 or USD/CAD European terms number of foreign currency units per $US e.g., $CAD = $US 1 or = $US 1 Direct quote number of ome currency units bougt wit one foreign currency unit (e.g. $CAD 1.41 = 1EUR) FX Terminology (cont d) Bid te price at wic a dealer is willing to buy anoter currency. Ask or Offer te price at wic a dealer is willing to sell anoter currency. Te Bid is always smaller tan te Ask. Banks make a profit from te spread between te rates at wic tey are willing to buy and sell (wy is tere a spread?). Te ripoff rule can be used to elp identify te buying and selling price. Te pound sterling is quoted at US$/ Banks are willing to buy a pound for $ (bid) Banks will only sell a pound for $ (ask). buy low, sell ig wit respect to pounds.

7 Direct Quotes and Cross Rates Cross Rates are excange rates between two currencies neiter of wic is te US dollar (example EUR/GBP). Triangular arbitrage keeps tese excange rates in line wit excange rates quoted relative to te dollar. Example: Suppose tat te pound sterling is $ in New York and te Euro is $ in Frankfurt. At te same time London banks are offering pounds sterling at Euro ( / ). Wat do tese quotes mean wit respect to te buying and selling of te different currencies? Is tere an arbitrage opportunity? Computing Cross Rates 1/ = (E/$) 1/ = (E/$) Wat is te implied Euro/Pound cross rate? We know: USD/GBP and USD/EUR Crossrate Bid = How many Euros would you get if you sold a Pound? (te price te bank will pay you in Euros to buy a Pound) You sell 1 pound to get dollars, convert tese dollars to Euros. Bid = USD/GBP, ten convert te 1.98 USD you would ave from te Pound you sold to Euros: 1.98USD 1/ USD/EUR = EUR for 1 GBP Crossrate Ask = How many Euro for you to buy a Pound? Sell Euros to buy 1 Dollar, convert tese to Pounds Ask = 1/ USD/EUR USD/GBP = EUR/GBP Computing Cross Rates Wat if te quoted cross rate in London was: EUR/GBP; is tere an arbitrage opportunity? (Note: we calculated: EUR/GBP and EUR/GBP) At wat rate would we buy pounds in London? At wat rate would we sell pounds in Frankfurt/NY? Wat appens if we sell pounds in London? Wat if te quoted prices in London were EUR/GBP?

8 Currency Market Terminology Wat are Eurodollars? U.S. dollardenominated assets eld in a bank outside te US (Note: tis is different from te Euro, ). Te bank may be a foreign bank or te overseas branc of a US bank. Tis started in te 1950 s during te Cold War. Te Soviet Union decided it would no longer old its international US dollar reserves as deposits at te Federal Reserve Bank of New York. Tese reserves were canneled to Western Europe, mainly to London. Being eld outside of te US allows tese funds to remain beyond te direct influence of te Fed and tus not at risk of being frozen. Tis lead to te creation of te Eurocurrency markets. Currency Market Terminology (cont d) Wat is te Eurocurrency market? Te system of international banks wic old deposits or issue bonds/loans in any currency outside its domestic market (e.g., EuroCanadian dollars are Canadian dollars outside of Canada). It as trived because it remains relatively free from government interference. Low regulation and ig competition. Participants are usually sopisticated investors (i.e., banks, governments or large firms). LIBOR (London Interbank Offered Rate) is te interest rate on Eurocurrencies traded between banks in London. Also FIBOR (Frankfurt), PIBOR (Paris), HKIBOR (Hong Kong) Types of Transactions Spot currency trading A spot transaction involves payment of one currency and receipt of anoter in 2 business days (one business day for te Nort American currencies). One day for back office paperwork and a second day because of time zone differences. It is te most active part of te foreign excange market.

9 Newspaper Spot Rates Canadian U.S. Britis Euro Japanese Swiss dollar dollar pound yen franc Canadian dollar U.S. dollar Britis pound Euro Japanese yen Swiss franc Source: Globe and Mail (April 8, 2008) Types of Transactions (cont d) Forward currency trading A forward transaction involves bot te payment of one currency and te receipt of anoter at a set point in te future. No upfront payment is required. Te most commonly used maturities are 30, 60, 90 or 180 days. Negotiated wit a financial intermediary according to your needs. Futures contract trading A futures contract is similar to a forward contract except tat it involves a standardized quantity (e.g. 125,000) and standardized settlement dates (e.g. te last day of Marc, June, Sept and Dec). Tis standardization allows futures to be traded on excanges. Futures require a small upfront payment and are markedtomarket. Reading Newspaper Quotations Cdn$ per unit US$ per unit Britain (Pound) Day Forward Day Forward Day Forward Source: Globe and Mail (January 16, 2007)

10 Examples: Te Forward Market A Canadian company imports 1.2 M wort of cars from England. Tis amount as to be paid in 60 days. Since te price of te pound migt vary over te 60day period, te Canadian company is subject to excange rate risk. Tis risk can be avoided by entering into a 60day forward contract at, say, a rate of 1 = $2.4. According to tis contract, in 60 days te Canadian firm will pay $2.88 M to te bank and receive 1.2 M wit wic it can pay te Britis company (Note: $2.88M = 1.2 M 2.4 $/ ). Te Forward Market Payment Cost in $ Unedged cost of 1.2 M $2.88M Hedged cost of 1.2 M $/ 2.6 Dollar Value of te Pound in 60 Days ($/ ) Types of Transactions (cont d) Options A foreign currency option gives te buyer of te option te rigt but not te obligation to buy or sell a specified amount of foreign currency at a given excange rate. Call Option Gives te rigt to buy a specific amount of foreign currency at te excange rate stated in te contract. Put Option Gives te rigt to sell a specific amount of foreign currency at te excange rate stated in te contract.

11 Foreign Currency Options Quotations Option Strike Price CallsLast PutsLast And Underlying Jan. Feb. Mar. Jan. Feb. Mar. 125,000 Euro cents per euro Examples: Foreign Currency Options A German company is purcasing computer equipment for US$12.5 million. Tis as to be paid in 6 monts. Since te price of te Euro as been fluctuating significantly over te past year, te German firm is worried about tis risk. Te CFO believes te Euro can not got down muc furter, but e can not afford to ave te cips cost any more. He can limit te increase in cost if te Euro continues to depreciate against te U.S. dollar, and profit if te Euro appreciates against te U.S. dollar by buying an option. Euro Put Option Against US Dollars Assume te current excange rate is US$0.90/Euro Suppose you buy a put option on Euros wit a strike price of $0.895/Euro to limit te downside of your investment. Tis gives you te rigt, but not te obligation, to sell Euros for dollars at te rate of $0.895/Euro. To buy US$12.5 million, you would need to buy about 112 put option contracts (wy?). Tis would allow te German firm to profit from an appreciation of te Euro, but not suffer too muc if it were to continue to depreciate.

12 Profit and Loss for Buyer of a Put Option Suppose you bougt te January put option on Euros wit a strike price of 8950 ($0.8950/EUR), wic sells for $0.0046/EUR Profit In te money At te money Out of te money Unlimited profit up to $0.8904/EUR Spot Price Limited loss Break even price Profit and Loss for Buyer of a Call Option Suppose you buy a January call option on Euros wit a strike price of 8950 ($0.8950/EUR), wic sells at $0.0092/EUR Profit Out of te money At te money In te money Unlimited profit Limited loss Spot Price Break even price Profit and Loss for Writer of a Put Option Suppose you wrote a January put option on Euros wit a strike price of 8950 ($0.8950/EUR), wic sells for $0.0046/EUR Profit Limited profit Unlimited loss up to $0.8858/DM Spot Price Break even price

13 Profit and Loss for Writer of a Call Option Suppose you wrote te January call option on Euros wit a strike price of 8950 ($0.8950/EUR), wic sells at $0.0092/EUR Profit Limited profit Spot Price Unlimited loss Break even price Types of Transactions (cont d) Swaps Simultaneous sale and purcase of contracts in different currencies wit different maturities. Credit market swaps tis is like aving two offsetting loans. Two firms borrow te same principal but in different currencies. Tey make te oter s payments. Tis allows firms to ave a liability in a different currency, witout aving to go to te foreign market. Foreign Excange swaps one firm simply excanges one currency for anoter today (or some day in te future) for te reverse in te future wit anoter firm. Te firms do not need to go to te FX market. Comparison of Hedging Strategies A Britis company submitted a bid stating tat it will pay 100M for 75% of te common stock of a Frenc company. Te Britis firm is unsure weter te Frenc investors will tender to it or to a rival bidder. Wat sould it do? Hedging options: a Forward Contract a Futures Contract an Options Contract Wat appens if te firm does not win te tender?

14 Summary Spot contracts are for an immediate transfer of currency. It is te largest market and te one most people tink of wen talking about te foreign excange market. Forward (and futures) contracts are suc tat a set amount of currency canges ands at expiration, a set future date. Options contracts are suc tat te buyer pays te seller at initiation for te rigt to exercise in te future. Swap allows benefits from mutual coincidence of wants. Te forward contract is a firm commitment it must be completed. Te options contract is at te buyer s discretion. Supplementary Discussion: Euro Put Option Against US Dollars Wen looking at te diagrams presented earlier, we need to tink about wat using te options really means to investors. For example If te Euro continues to weaken and goes to $0.85 per Euro, we would ave to sell more Euros to buy our $12.5 million tan we would ave to by using te option we could sell eac Euro and get $0.895 using te option. Tis means we are actually saving money or we can say we are profiting by aving te option and using it! If te Euro strengtens and goes to $0.95 per Euro, we would be better off by ignoring our option and selling our Euros to get $0.95 per Euro. By trowing away te option, tis means we are losing wat we paid for te option but we are getting more dollars per Euro tis way. Now, let s go to te grap for te put option. Profit and Loss for Buyer of a Put Option Suppose you bougt te January put option on Euros wit a strike price of 8950 ($0.8950/EUR), wic sells for $0.0046/EUR Profit Here we are benefiting by aving te option. We are able to get $0.895 per Euro even toug te Euro as gone down in value (say to $0.85/Euro). Tis is te profit we get from aving te option. Here we are trowing away te option because we can do better by just selling our Euros at te current spot price (e.g. $0.95/Euro) Spot Price Limited loss Break even price

15 Supplementary Discussion: Euro Call Option Against US Dollars Wit respect to a call, tings get reversed. Te call is for buying Euros wit US dollars (not selling Euros as was te case for te put). If te Euro continues to weaken and goes to $0.85 per Euro, it would take fewer US dollars to buy Euros at tis excange rate tan if we were to exercise te option and buy eac Euro for $ As a result, we would not use te option wy would we pay more tan we ave to for te Euros? Tis means we would be spending more tan we ave to in order to get te Euros if we used te option. As a result we sould just trow away te option and lose wat we paid for it. If, owever, te Euro strengtens and goes to $0.95 per Euro, it would cost us more dollars to buy te Euros and we would be better off using te option and buying Euros for $0.895 per Euro. Tis means we are profiting by aving te option! Now, let s go to te grap for te call option. Profit and Loss for Buyer of a Call Option Suppose you buy a January call option on Euros wit a strike price of 8950 ($0.8950/EUR), wic sells at $0.0092/EUR Here we are trowing away te option because we can do better by just buying our Euros at te current spot price (e.g. $0.85/Euro) Profit Here we are benefiting by aving te option. We are able to buy Euros for $0.895 rater tan aving to go troug te market and pay, say, $0.95 per Euro. Tis is te profit we get from aving te option. Unlimited profit Limited loss Spot Price Break even price