Global Financial Markets Spring 2013
Wat is a Market? A market is any system, institution, procedure and/or infrastructure tat brings togeter groups of people to trade goods, services and/or information. Competition is required in a market. It differentiates a market from straigt trade between individuals. As more people want to trade, markets and competition develop. Te willingness of buyers and sellers to transact determines te price, te market clearing price. Tis elps to efficiently allocate resources to tose willing to pay te most and get te most from eac asset.
Wat are Financial Markets? Financial markets bring people togeter to buy and sell financial securities, commodities, and oter fungible financial assets wit low transaction costs. Financial markets develop as more people want to buy and sell te financial assets. Wy are some securities sold Over-te-Counter (OTC)? Prices are determined by te current and future expected supply and demand for different assets. Supply and demand depend on expected casflows Markets require a degree of trust between te buyer and seller. How does tat trust develop?
Examples of Financial Markets Standard markets Stock, bond, foreign excange and commodity Derivatives futures, forwards, options and swaps Alternative markets Islamic Finance a system of banking or banking activities tat are consistent wit Islamic law (Saria) principles and guided by Islamic economics. Microfinance loans, savings, and oter basic financial services to small investors. Oter?
Types of Financial Markets Capital markets (stock, bond etc.) Unites suppliers and demanders of capital Foreign excange markets Conversion of currencies to facilitate trade or, increasingly, to speculate. Commodity markets Derivatives markets (futures, options, swaps etc.) Teir value is based on te value of anoter financial asset (is derived from a relationsip to anoter financial asset) Derivative products are financial products wic are used to control risk or, in some cases, to exploit risk.
Functioning of Financial Markets Financial markets are inter-related. In Canada, te stock market and Canadian dollar increase in value as te price of commodities increases. In te US, te stock market and US dollar decrease in value as te price of commodities increases. In Mexico? Wat factors influence te stock market? In general, stock markets increase in value as interest rates decrease. Wy? Are tese ard and fast rules for financial markets? January 2012: equities went down, commodities went down, te US dollar was steady and bond yields went down! We will start by discussing te FX market.
Do We Need a Market for Currencies? People need currencies to buy and sell goods. Te FX market developed as trade increased and tere was growt in demand to buy and sell currencies. Transfer of Purcasing Power Example: A Britis firm buys US equipment; tis requires te excange of pounds for U.S. dollars. Hedging of Foreign Excange Risk Tere are contracts tat allow market participants to convert currencies at a known rate on a future date. Participants Mainly banks, importers, and exporters. Recently speculators, edge funds, and oter large institutional investors ave also entered. Wy?
Currency Markets
Factors Affecting te Excange Rate Wit a floating currency, te excange rate is determined by supply and demand. If consumers want Canadian products tey will buy Canadian dollars. Tis increases te demand for dollars and tus te Canadian dollar will appreciate in value. Current account vs capital account? Balance of payments? Politics? If investors are concerned about te Canadian political situation, tey will sell teir Canadian assets and tus sell Canadian dollars. Tis increases te supply of Canadian dollars and tus decreases its value. Wat appens as uncertainty increases about Greece? Wat appens if te price of oil increases? Wat is te role of a Central Bank or Monetary Autority? How does tis influence te value of te currency?
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 in te sort-term increasing demand for te dollar. Wat do iger interest rates in Canada imply about investing in Canada? Wy would Canadian interest rates increase? Wat about in Mexico?
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 many of 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 2010 was $5.1 trillion US dollars/day 37% in te spot market, 57% in te forward and swap markets, and 5% 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. Re-instated te Gold Standard in 1926, but broke down in 1929. 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 1961. In 1961 reverted to a fixed excange rate. Floating excange rate since 1970 (oter major currencies ave been floating since 1972 and 1973).
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Canada US dollar, 1870 to present 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Source: GlobalFinancialData.com and Bank of Canada
Canada US dollar, 1950 to present 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Bank of Canada
Peso US dollar, 1993 to present 18 16 14 12 10 8 6 4 2 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Federal Reserve
Peso US dollar, 1973 to present Source: Trading Economics
Location of FX Trading Activity 2004 2007 2010 Amount Sare (%) Amount Sare (%) Amount Sare (%) United Kingdom $753 31.3 $1,359 34.1% $1,854 36.7% United States $461 19.2 $664 16.6% $904 17.9% Japan $199 8.3 $238 6.0% $312 6.2% Singapore $125 5.2 $231 5.8% $266 5.3% Germany $118 4.9 $99 2.5% $109 2.1% Switzerland $79 3.3 $242 6.1% $263 5.2% Hong Kong $102 4.2 $175 4.4% $238 4.7% France $63 2.6 $120 3.0% $152 3.0% Australia $81 3.4 $170 4.3% $192 3.8% Neterlands $49 2.0 $24 0.6% $18 0.4% Canada $54 2.2 $60 1.5% $62 1.2% Italy $20 0.8 $36 0.9% $29 0.6% Oter countries $302 12.6 $571 14.3% $692 12.2% Total $2,406 100.0 $4,281 100.0 $5,056 100.0 Source: Bank for International Settlements
Global FX Activity by Currency 1992 1995 1998 2001 2004 2007 2010 US dollar 82.0 83.3 87.3 90.4 88.7 86.3 84.9 Euro - - - 37.6 37.2 37.0 39.1 Deutsce Mark 39.6 36.1 30.1 - - - - Frenc Franc 3.8 7.9 5.1 - - - - Oter EU currencies 11.8 15.7 17.3 - - - - Japanese Yen 23.4 24.1 20.2 22.7 20.3 16.5 19.0 Pound Sterling 13.6 9.4 11.0 13.2 16.9 15.0 12.9 Swiss Franc 8.4 7.3 7.1 6.1 6.1 6.8 6.4 Canadian Dollar 3.3 3.4 3.6 4.5 5.5 4.2 5.3 Australian Dollar 2.5 2.7 3.1 4.2 4.2 6.7 7.6 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 0.8614 = $CAD 1.00 or 0.8614 USD/CAD European terms number of foreign currency units per $US e.g., $CAD 1.1609 = $US 1 or 0.8248 = $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 rip-off rule can be used to elp identify te buying and selling price. Buy low Sell ig (for te dealers for me?)
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 $1.9800-20 in New York and te Euro is $0.9250-55 in Frankfurt. At te same time London banks are offering pounds sterling at Euro 2.1390-95 ( / ). Cross-rates can be calculated to be: 2.1394 2.1427
Computing Cross Rates 1/0.9250 = 1.081 (E/$) 1/0.9255 = 1.080 (E/$) Wat is te implied Euro/Pound cross rate? We know: 1.9800-20 USD/GBP and 0.9250-55 USD/EUR Cross-rate 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 = 1.9800USD/GBP, ten convert te 1.98 USD you would ave from te Pound you sold to Euros: 1.98USD 1/0.9255 USD/EUR = 2.1394 EUR for 1 GBP Cross-rate Ask = How many Euro for you to buy a Pound? Sell Euros to buy 1 Dollar, convert tese to Pounds Ask = 1/0.9250 USD/EUR 1.9820 USD/GBP = 2.1427 EUR/GBP
Terminology Wat are Eurodollars? U.S. dollar-denominated 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 no longer wanted to old its US dollar reserves at te Federal Reserve Bank of NY. Te reserves were left in Western Europe, mainly London. Being eld outside te US tese funds remain beyond te influence of te Fed and tus not at risk of being frozen.
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., EuroYen are Japanese Yen outside of Japan). Centered in London, but not limited to London or Europe. Trives because it remains relatively free from government interference and as significant competition. LIBOR (London Interbank Offered Rate) is based on te interest rate carged on Eurocurrency loans between banks in London (LIBOR scandal?). 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.
Current Spot Rates Bencmark Currency Rates USD EUR JPY GBP CHF CAD AUD HKD USD 1.3558 0.0110 1.5768 1.0913 0.9970 1.0430 0.1289 EUR 0.7376 0.0081 1.1630 0.8050 0.7354 0.7694 0.0951 JPY 91.30 123.79 143.95 99.65 91.03 95.24 11.7689 GBP 0.6342 0.8594 0.0069 0.6923 0.6324 0.6616 0.0818 CHF 0.9164 1.2417 0.0100 1.4448 0.9137 0.9556 0.1181 CAD 1.0029 1.3590 0.0110 1.5815 1.0946 1.0459 0.1293 AUD 0.9589 1.2994 0.0105 1.5120 1.0465 0.9561 0.1236 HKD 7.7588 10.5133 0.0850 12.2340 8.4673 7.7358 8.0912 Source: www.bloomberg.com January 30, 2013
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 marked-to-market.
Futures Quotations (CAD/USD) Mont Last Volume Op Int Mar-13 0.9966 64,353 137,542 Jun-13 0.9946 149 3,801 Sep-13 0.9927 2 1,834 Dec-13 0.9906 125 1,906 Mar-14 0.9883 10 42 Source: www.cmegroup.com January 30, 2013
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 60-day period, te Canadian company is subject to excange rate risk. Tis risk can be avoided by entering into a 60-day 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 $2.88M Hedged cost of 1.2 M 2.2 2.4 2.6 Dollar Value of te Pound in 60 Days ($/ )
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.
Foreign Currency Options Quotations Option Strike Price Calls-Last Puts-Last And Underlying Feb Mar. Apr. Feb Mar. Apr ----------------------------------------------------------------------------------------------------------------------------- -- 10,000 USD CAD cents per USD 99.00 1.45 1.73 2.04 0.16 0.39 0.62 99.50 1.06 1.39 1.73 0.27 0.54 0.80 100.00 0.74 1.10 1.45 0.45 0.76 1.03 100.50 0.50 0.85 1.22 0.71 1.02 1.29 Wat factors influence te value of options? Source: www.m-x.ca January 2013
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.
Profit and Loss for Buyer of a Put Option Suppose you bougt a January put option on Euros wit a strike price of 8950 ($0.8950/EUR), wic sells for $0.0046/EUR Profit $/EUR In te money At te money Out of te money Unlimited profit up to $0.8904/EUR -0.0046 0.85 0.8904 0.8950 0.95 Spot Price $/EUR Limited loss 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 $/EUR 0.0046 Unlimited loss up to $0.8858/DM 0.8804 Limited profit 0.8950 Spot Price $/EUR Break even price
Types of Transactions (cont d) Swaps Simultaneous sale and purcase of contracts in different currencies wit different maturities. Credit market swaps firms borrow te same principal but in different currencies. Tey make te oter s payments. Tis allows firms to effectively 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?
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 $/EUR 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) -0.0046 0.8904 0.8950 Spot Price $/EUR Limited loss Break even price
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 $0.895. 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 $/EUR 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 -0.0092 Limited loss 0.8950 0.9042 Spot Price $/EUR Break even price